What is the Average Cost Method?

Also known as the weighted-average method, the average cost method is all about assigning a cost to inventory items on the Basis of the total cost of products bought or manufactured in a period of time and divided by the total number of products bought or manufactured.

Average Cost Method Formula

The formula to calculate the average cost method will be:

Average Cost Method = Total cost of products purchased or manufactured / total number of products purchased or manufactured

Explaining the Average Cost Method

Businesses that are functioning to sell varying items to customers have to take care of their inventories, which are either purchased from a third-party or manufactured In-House. And then, products that have been sold from the inventory get recorded on the Income statement of the business in the form of Cost of Goods Sold (COGS).

This one is an essential figure for all those who are associated with the business, such as the analysts, investors and more, as COGS is deducted from the sales revenue to comprehend the gross margin on the income statement. However, to evaluate the total cost of goods sold within a specific period, different businesses use one of these methods:

• First In First Out (FIFO)
• Last In First Out (LIFO)
• Average Cost Method

Basically, the average cost method uses a straightforward average of all the similar products in the inventory, irrespective of the purchase date and count the final items available in the inventory at the end of a period.

Thus, multiplying the average cost for each item by the final count in the inventory offers a round figure for the cost of goods that are available to be sold. Moreover, a similar average cost can also be applied to the number of products sold in the previous periods to figure out the cost of goods sold.

Example of the Average Cost Method

To understand this concept better, let’s take an average cost method example. Here is a record from the inventory of an electronics shop.

Now, suppose that the company managed to sell 70 units in the first quarter. So, here is how weighted-average cost can be calculated.

Weighted average cost = total inventory bought in the quarter / total inventory count in the quarter

= 113300 / 100 = Rs. 1133 / unit

The cost of goods sold will be:

70 units x 1133 = Rs. 79310