The average cost method is a way of calculating inventory costs for accounting purposes. It’s one of the three principal techniques – the others being “first in first out” (FIFO) and “last in first out” (LIFO). The average cost method advantages and disadvantages are significant, so you should use care in choosing how you handle your inventory accounting.
Generally, when items in inventory are sold, the revenue is reported as income, and the cost of goods sold (COGS) is subtracted from this figure to arrive at the gross margin. COGS represents inventory costs or what the company paid to produce the items in inventory.
If a company always pays the same amount for each item, then calculating COGS is easy. However, what if a company has 5,000 items in inventory, and it paid different amounts for them over time due to variations in what the suppliers charged? In that case, calculating COGS becomes much more difficult.
The FIFO and LIFO methods require that you calculate the actual cost of each unit. FIFO assumes that when you sell 1,000 units, you take the oldest 1,000 out of inventory, whereas LIFO assumes that when you sell 1,000 units, you take the newest 1,000 out of inventory. With the average cost method, you create a weighted average of the cost of all 5,000 items, and it doesn’t matter which items you sell.
To use this method, at the end of each inventory accounting period, you add the cost of the products in inventory at the beginning of the period plus the cost of new purchases. Then you take the number of units at the beginning plus the number of units purchased minus the number of units sold. The average weighted cost is the first figure divided by the second figure.
There are pros and cons of a weighted average method. The method makes it easier to calculate your inventory costs when you have a high volume of goods and tracking individual costs would be difficult or time-consuming or when your software can’t handle the complexity of valuing individual items.
The weighted average method can also save time in setting prices. For example, if you’re estimating a price for a customer based on a percentage markup of the COGS, the calculation is simple.
Some people like the fact that the average cost method makes it harder to manipulate accounting figures and provides a more accurate picture of how the business is doing. For example, if supplier costs have recently risen sharply, using the FIFO accounting method can result in a rosier picture of cash flow than is warranted.
One disadvantage to the weighted average mean method is that, if your costs have gone up recently and you’re calculating prices based on a standard markup of COGS, you might end up selling some items at a loss.
Another factor is that the weighted average method works best when you have a large number of identical products. If you have a lot of products with minor variations or feature upgrades, calculating the actual cost per item might be simpler and less likely to lead to mistakes.
Despite the pros and cons of the weighted average method, it is acceptable under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
Whatever method you choose, it’s important to use the method you choose consistently. Varying the method makes it harder to get a clear picture of the business’s performance and usually requires an explanation in any financial statements.