# Average Cost Method

The weighted average cost method accounting is a method of inventory valuation used to determine the cost of goods sold and ending inventory. The method assumes that units are valued at a weighted average cost per unit and applies this calculated average to the units sold and the units held in ending inventory.

The calculations used in the average cost method depend on whether the business is using a periodic inventory system of a perpetual inventory system.

## Periodic Weighted Average Cost Method

Under the periodic inventory system the average cost method calculations are carried out at the end of the accounting period. The weighted average cost per unit is based on the cost of the beginning inventory and all the purchases made during the period. This average cost per unit is then applied to the units sold and the units held in inventory.

By way of illustration.

• October 1 Beginning inventory 200 units 5.00 cost per unit
• October 4 Purchase 300 units 6.00 cost per unit
• October 10 Sell 200 units
• October 20 Purchase 100 units 8.00 cost per unit

The calculations using the periodic average cost method are summarized in the following table.

Periodic average cost method
Units Unit Cost Cost
Beginning 100 5.00 1,000
Purchase 300 6.00 1,800
Purchase 100 8.00 800
Average 500 6.20 3,100
Sell – 200 6.20 – 1,240
Ending 300 6.20 1,860

As the business uses the periodic inventory accounting system, the fact that a sale occurs (October 10) before the final purchase (October 20) can be ignored. The beginning inventory and purchases are simply combined to calculate the weighted average unit cost of 6.20 as follows:

```Average unit cost = Total cost / Total units
Average unit cost = (100 x 5.00 + 300 x 6.00 + 100 x 8.00) / (100 + 300 +100)
Average unit cost = 6.20
```

This weighted average unit cost is then applied to the number of units sold (200) to calculate the cost of goods sold of 1,240 (200 x 6.20), and to the ending inventory of 300 units to give an ending inventory cost of 1,860 (300 x 6.20).

### Simple Average Cost Method

It should be noted that the above method refers to the use of a weighted average calculation in determining the inventory valuation. An alternative approach would be to use simple averages. In the above example the simple average of the unit costs would be calculated as follows.

```Simple average unit cost = (5.00 + 6.00 + 8.00) / 3
Simple average unit cost = 6.33
```

The simple average unit cost of 6.33 compares to the weighted average cost calculate earlier of 6.20. The method gives a reasonable estimate of the inventory value when the beginning inventory and purchases are of a similar level.

## Perpetual Weighted Average Cost Method

Under the perpetual inventory system transactions are continually recorded and the average cost method calculations are carried out during the accounting period each time a purchase or sale takes place. The weighted average cost per unit is based on the cost of the beginning inventory and the purchases up to the point at which a sale takes place. This approach is sometimes referred to as the moving average cost method.

Using the information from the previous example, the calculations using the perpetual average cost method are summarized in the following table.

Perpetual average cost method
Units Unit Cost Cost
Beginning 100 5.00 500
Purchase 300 6.00 1,800
Average 400 5.75 2,300
Sell – 200 5.75 – 1,150
Average 200 5.75 1,150
Purchase 100 8.00 800
Ending 300 6.50 1,950

As the business uses the weighted average perpetual inventory system, the purchase and sales need to be dealt with in chronological order and an weighted average unit cost calculation is needed each time a sale is made.

As the weighted average is continually calculated, the perpetual inventory average cost method is sometimes referred to as the moving average cost method.

## Cost Allocation

Notice that in both cases the total cost of the beginning inventory and the purchases (3,100) is the same, and only the allocation of that cost to the cost of goods sold and ending inventory changes.

This is summarized in the following table.

Cost allocation
System COGS Ending Total
Periodic 1,240 1,860 3,100
Perpetual 1,150 1,950 3,100

The average cost method is one of the available methods used in inventory management. Clearly the method used to determine which units are sold and which remain in closing inventory determines the value of the cost of goods sold and the ending inventory. As profit depends on the cost of goods sold, the method chosen will affect the profits of a business.

Other methods of determining inventory movements included FIFO (first in first out) and LIFO (last in first out).

Average Cost Method July 17th, 2017

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