What Is the Average Cost Method? (Example and Calculation)
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Companies use different methods to track their inventory and the costs of goods sold so that they can generate accurate financial statements. The average cost method is one such method, and it calculates the average cost of inventory on hand. Knowing about this method is important for both investors and managers so they can make informed decisions about a company's finances. In this article, we define average cost method, highlight types of inventory cost methods, including formulas, benefits, limitations, and when to use the method, and view some factors that can affect it.
What is the average cost method?
The average cost method is a pricing strategy that companies use to determine how much to charge for their products. The average cost of an inventory item is determined by taking the total cost of the production process and dividing it by the number of units produced. This information is then used to set a price for each unit that covers the costs of production and generates a profit.
Types of inventory cost methods
To evaluate the cost of goods sold (COGS) and ending inventory, businesses use one of three primary inventory cost methods:
First-in, first-out (FIFO)
FIFO is the most common inventory cost method. Under FIFO, businesses assume that the first products they gained are also the first products they sell. This method is easiest to use when inventory levels are low and there is high turnover. The advantages of using FIFO are that it more accurately matches revenues with expenses and is easy to understand and implement.
Last-in, first-out (LIFO)
The LIFO inventory method assumes that the most recent products or services purchased or produced are the first ones sold. The primary advantage of LIFO is that it better matches current revenues with current expenses, leading to a lower tax bill. Businesses often use this method in inflationary environments when the prices of inventory items are constantly rising.
Weighted average cost
This method calculates the average cost of all inventory items on hand, regardless of when you acquired them. Businesses often use this method in manufacturing environments where it's difficult to track the specific cost of each inventory item. The primary advantage of using this method is that it's easy to calculate.
Calculating the average cost
To use this method, companies may calculate the cost of goods sold (COGS) by adding up the cost of all the raw materials, labour, and overhead expenses associated with production during a specific period. This period can be a month, quarter, or year. This way, you can also calculate the cost of goods that are still in the inventory.
COGS is important for businesses because it helps them determine the gross margin on the income statement by subtracting COGS from sales revenue. The gross margin shows the amount of revenue left after accounting for the cost of goods sold and measures profitability. Once you've calculated the COGS, the company can determine the average cost per unit by dividing the total cost by the number of units produced during the period. Here is the formula for the average cost per unit:
Average Cost Per Unit = Total Cost of Goods Sold / Number of Units Produced
When to use this method
Businesses commonly use this method to price their inventory because it's easy to calculate and doesn't require companies to track the specific cost of each inventory item. Here are a few other reasons businesses might choose to use this method:
To match revenues with expenses: This method can accurately match revenues with expenses on the income statement. This is because you calculate the COGS using the average cost of all inventory items rather than the specific cost of each item.
To reduce the impact of inflation: The method can help businesses to reduce the effect of inflation because it averages out the cost of inventory items.
Inventory turnover: It can also calculate inventory turnover, which measures how quickly you sell inventory. This information can be useful for businesses because it helps them manage their inventory levels and keeps costs under control.
To simplify inventory tracking: This method is also a simpler way to track inventory because businesses don't keep track of the specific cost of each inventory item. This can be helpful for businesses with large inventories or multiple SKUs.
To minimize tax liability: It can also minimize tax liability by reducing the value of ending inventory on the balance sheet. The method often results in a lower inventory value than the specific cost method.
Example of this method
Here's an example of using this method to calculate the average cost:
A company purchases 100 widgets in a month and the total cost of goods sold is $1,000. The average cost per unit is $10 ($1,000 / 100). To set a selling price, the company may add to its desired profit margin. If executives wanted to make a 20% profit margin, they multiply the average cost by 1.2 to get a selling price of $12 per widget. If they want to calculate COGS for a period, they can add up the total cost of all the inventory sold during that period.
What are the benefits of this method?
This has several benefits for businesses. Some of these are:
Easy to use
This method is relatively easy to calculate and doesn't require businesses to keep track of specific costs for each unit produced. Companies may track the total cost and the number of units produced. This information is usually readily available.
Provides a consistent price
The weighted cost method can help businesses to charge a consistent price for their products. This is because the price is based on the actual costs of production and not on fluctuating market prices. It may be challenging to constantly adjust prices based on changes in the market so that the method can provide some stability.
Allows businesses to make a profit
This method ensures that businesses cover their costs and make a profit. They can set the price based on the total cost of production divided by the number of units produced. This price includes a margin for profit.
This is the least expensive method. Businesses don't need intensive accounting practices to keep track of specific costs. Only a few people can make this calculation, so there's no requirement to spend extra money on accounting staff or software.
Helps in long-term planning
This method is consistent and provides businesses with a stable price. This can help businesses better predict their costs and plan for the future. It also makes it easier to budget and forecast.
What are the limitations of this method?
There are a few potential limitations to using this method:
This method is not always accurate, as it doesn't consider specific costs, so the price of the product may not reflect all the costs incurred by the business. This could lead to businesses making a loss if they have incurred higher than expected costs. To prevent this, businesses may track actual costs carefully and monitor them against the prices set using this method.
Doesn't consider changes in cost
The method doesn't consider changes in the costs of production. This means that if costs go up, the price of the product may not reflect this. This could lead to businesses making a loss if costs increase and they're unable to increase the price of their product. It's a good idea to review prices regularly to ensure they're still accurate.
Doesn't consider changes in demand
This method also doesn't account for changes in demand, so if demand for a product decreases, the price may not reflect this. This could lead to businesses making a loss, as they may sell their products at lower prices. To prevent this, businesses may monitor demand carefully and adjust prices accordingly.
Not suitable for every situation
This method doesn't work well when there are a lot of changes in costs or demand. For example, it can't work well for businesses that produce seasonal products, as costs and demand can fluctuate. In these situations, businesses may use a different pricing method and review prices more frequently.
Factors affecting this method
There are a few factors that can affect this method, including:
The number of units produced**:** The more units that are produced, the lower the average cost. This is because you can spread the fixed costs can over a larger number of units.
The mix of products produced: The mix of products produced can also affect the average cost because different products may have different costs. For example, a business that produces both high-end and low-end products has a higher average cost than a business that only makes one type of product.
The level of production: The level of production can also affect the average cost. This is because the fixed costs can be higher when the business produces at a higher level.
The costs of production: The costs of production can also affect the average cost. This is because the total cost of production can be higher when the costs are high.
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