Average Cost Method – Definition

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Average Cost Method Definition

The average cost method is a technique used to calculate the cost of ending inventory and the products sold using the weighted average cost of inventory.

A Little More on What is the Average Cost Method for Inventory

Average cost methods help in calculating the cost of final inventory and goods sold over a given period using weighted average unit costs. The method uses the formula given by;

Weighted Average = Total Cost of Inventory/Unit Cost/Total units’ inventory

Besides LIFO and FIFO methods, average costs method (AVCO) is also used to calculate the cost of inventory in an organization. The method is used differently based on the inventory system based on whether it is a periodic system or perpetual system. The calculation of the average cost per unit of inventory in the periodic system involves the entire class of the inventory. The entire class of inventory is multiplied by the total number of units sold and the number of inventories at the end to find the cost of goods sold and the inventory remaining. On the other hand, the perpetual inventory system considers calculating the average unit cost before each sale transaction.

The use of example provides an in-depth explanation of how the cost of inventory is calculated using the weighted average method.

Example of Average Cost Method

Use the average cost method of inventory evaluation to calculate the inventory costs for the following information using both the periodic and perpetual inventory system. Determine the value of inventory at hand at the end of March (31 March) and the costs of goods sold during March.

March 1st

The inventory at the beginning was 60 units @ $15.00 per units

March 5th

Purchase 140 units @ 15.50 per unit

March 14th

Sale 190 units @ $19.00 per unit

March 27th

Purchased 70 units @ $16.00 per unit

March 29th

Sale 30 units @19.50 per unit

Solution

The average cost method in the periodic system

Total units available for sale = 60+ 140+ 70 = 270

Total units sold = 190 + 30= 220

The total units at the end = 270- 220= 50 units

Weighted average unit cost

DateUnitsUnit costTotal
March 1st60$15.00$900.00
March 5th140$15.50$2170.00
March 27th70$16.00$1120.00
270$15.52$4190

The cost of goods sold is therefore given by;

220 * 15.52 = $34414

Ending inventory

50* 15.52 = $776

References for Average Cost Method

Academic Research for Average Cost Method

  • Examining the differences between United States Generally Accepted Accounting Principles (US GAAP) and International Accounting Standards (IAS): implications for …, Ampofo, A. A., & Sellani, R. J. (2005, June). In Accounting forum (Vol. 29, No. 2, pp. 219-231). This accounting guideline provides and explains in details the various methods used to calculate the inventory costing in the organization. This accounting measurement standard presents that the current trends in the accounting system are comprised of continuous movement towards harmonizing the accounting standards. However, the harmonization is influenced by the pressure of the political and financial market that push the movements towards the opposite directions. This paper further explores the conceptual framework aimed at achieving Global Generally Accepted Accounting Principles (GAAP) (International Accounting Standards, IAS) and U.S. GAAP. In the current accounting system, various transactions are evaluated based on the International Accounting Standards, IAS and American Generally Accepted Accounting Principles. This compels many countries to use these principles in presenting their accounting information the act that has made it difficult to achieve the harmonization in the accounting system. Besides the implications of the accounting standards are based on the arguments for and against the GAAP.
  • Thermoeconomic optimization of a single effect water/LiBr vapor absorption refrigeration system, Misra, R. D., Sahoo, P. K., Sahoo, S., & Gupta, A. (2003). International Journal of Refrigeration, 26(2), 158-169. This paper explores and discusses the thermo-economic theories that used to optimize the economic elements of one effect of water/LiBr vapor absorption. It also concerns the refrigeration of system for the application of the air conditioning focused on reducing the amortization costs and the general and the overall operations. The evaluation of the optimization based on the numerical and mathematical techniques of the thermal system face difficulties due to complexities that occur within the plant. As such, the process is evaluated using a simplified method of minimization to determine the economic costs of the whole internal flows and system products by developing exergoeconomic cost equations. After determining the costs, the cost is evaluated thermoeconomically to detect the effects of the variables in the design on cost. This allows for critical evaluation and suggestion of the values of the design variables would enhance the effectiveness of the general system. Lastly, the method uses the sequential local optimization of the system to obtain an approximate optimum design. The result obtained from the process compares the sequential optimum with the base case and indicate the proportion variation in terms of percentage variations in the amortization costs and system operation.
  • Methods for measuring shrinkage, Chapman, P., & Templar, S. (2006). Security Journal, 19(4), 228-240. This paper provides the findings obtained from the research conducted amongst European grocery retailers into their methods for measuring shrinkage. According to the research, it was revealed that the techniques used to determine or state the shrinkage does not dominate one another. In other words, the research portrays that there is no dominant method to determine the shrinkage. The research also revealed that people tend to ignore the shrinkage that occurs in the supply chain. According to the author, data is important in determining precisely when and where the loss occurs in the system. Most of the retails obtain data at the stock keeping unit level every six months. The findings further revealed that there are challenges that occur in benchmarking between retailers. This is attributed to the inconsistencies that occur between the methods of measurements. It also presents that several opportunities are available for the retailers that can be used to improve the shrinkage measurement through the adoption of known good practice.
  • ACCA Paper 1.2 Assignment Financial Information for Management, Corner, F. B. (2003). This paper presents the mechanism used to evaluate the financial system and aid the management in making a critical decision regarding finances.
  • Inventory Valuation according to German Commercial and Tax Legislation, Thormählen, V., & Bull, A. G. (1996). This paper provides more insights into the regulations provided by the German tax legislation regarding the inventory evaluation.
  • A reverse logistics valuation method for inventory control, Teunter, R. H. (2001). International Journal of Production Research, 39(9), 2023-2035. This paper proposes the methods that can be used to value new, recoverable, and recovered assemblies which include; the products, components, and parts in the production system that has reverse logistics. According to the author, the value of the assemblies has considerable impacts on their rates of opportunity holding costs and therefore play an important role in comparing different inventory strategies in the average cost models. The paper argues that the proposed that the method used is correct based on the discounted cash flow model point of view. The method considers previous results in valuing assemblies without the disassembly of returned products. The results of the simulation method confirm that the method leads to discounted cashflow optimal inventory strategies
  • IAS/IFRS in Belgium: Quantitative analysis of the impact on the tax burden of companies, Haverals, J. (2007). Journal of International Accounting, Auditing, and Taxation, 16(1), 69-89. This paper evaluates the adoption of International Accounting Standards and the International Financial Reporting Standards (IAS/IFRS) in the European Union. It tends to provide the harmonization of the European Commission’s global tax policy that aims at establishing a common and consolidated corporate tax base. The paper also presents the impact of an IAS/IFRS-based tax accounting tax on the tax burden experienced by the Belgian companies is huge and lacks uniformity across sectors. Some of the sectors in the industries such as automotive vehicles and construction face a continuous increase in the effective tax burden than others. This impact is relatively important in the global perspective. The European Tax Analyzer (ETA) is used to analyze multi-period programs to determine the tax burden among the companies. In the context of European, IAS/IFRS-based tax accounting is focused on increasing to raise the effective tax burden among the selected member countries. The proposal to increase the tax base could provide an opportunity that would help in reducing the rate of corporate tax income without changing the effective tax burden.
  • Ownership structure and inventory method choice, Niehaus, G. R. (1989). Accounting Review, 269-284. This paper explores the connections between the choice of inventory methods and both the managerial and outside ownership contractions. It is assumed that the choice of inventory method can create a conflict of interest between the managers and the shareholders. However, the ownership structure determines the solutions for the conflicts of interests in case it occurs. This hypothesis provides consistent evidence as the choice of the inventory tends to be related to both the managers and the shareholder’s contraction. When the managerial ownership is minimized, the LIFO is likely to be negatively related to the managerial ownership. On the other hand, when the managerial ownership is high, LIFO is likely to be positively related to managerial ownership, and the higher shareholders’ ownership is likely to increase the LIFO
  • The authority of history in inventory valuation, Vance, L. L.a (1943). The Accounting Review, 18(3), 219-227. This paper presents various methods used to evaluate the inventory in an organization. It further explores the accounting models that are important in developing an effective inventory evaluation.

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