Average Cost | Detailed explanation of Average cost

 

1.       Average Cost

In accounting, the term "average cost" refers to a method of inventory valuation. It is used to calculate the cost of goods sold (COGS) and the value of remaining inventory based on the average cost of all units available.

The average cost method assumes that the cost of inventory items is the average of the costs of all similar items available for sale during a particular accounting period. Here's how the average cost is calculated and applied:

1. Determining the Average Cost:

   The average cost is computed by dividing the total cost of goods available for sale by the total quantity of goods available for sale. This gives the average cost per unit.

   Average Cost per Unit = Total Cost of Goods Available for Sale / Total Quantity of Goods Available for Sale

2. Cost of Goods Sold:

   When units of inventory are sold, the average cost per unit is used to determine the cost of goods sold. The formula for calculating the cost of goods sold using the average cost method is:

   Cost of Goods Sold = Average Cost per Unit x Quantity Sold

   This calculation assigns the average cost to each unit sold, resulting in a cost of goods sold value.

3. Remaining Inventory:

   After the cost of goods sold is determined, the average cost per unit is used to value the remaining inventory. The formula for calculating the value of the remaining inventory using the average cost method is:

   Value of Remaining Inventory = Average Cost per Unit x Quantity of Inventory on Hand

   This calculation assigns the average cost to each unit remaining in inventory, providing a value for the unsold items.

4. Consistency in Application:

   It is important to apply the average cost method consistently throughout the accounting period. If new inventory is acquired at a different cost, the average cost is recalculated to include the new purchases. This ensures that the average cost reflects the true average for all units available for sale.

The average cost method is commonly used in situations where inventory items are not easily distinguishable from one another, such as in the case of homogeneous goods. It provides a straightforward approach to determine the cost of goods sold and the value of remaining inventory. However, it should be noted that different inventory valuation methods, such as first-in, first-out (FIFO) or last-in, first-out (LIFO), may be used based on the specific circumstances and accounting policies of a business.

Average cost