Average costing method

Under average costing method,the average cost of all similar items in the inventory is computed and used to assign cost to each unit sold. Like FIFO and LIFO methods,  this method can also be used in both perpetual inventory system and periodic inventory system.

Average costing method in periodic inventory system:

When average costing method is used in a periodic inventory system, the cost of goods sold and the cost of ending inventory is computed using weighted average unit cost. Weighted average unit cost is computed using the following formula:

Weighted average unit cost = Total cost of units available for sale / Number of units available for sale

Example:

The Meta company is a trading company that purchases and sells a single product –  product X. The company has the following record of sales and purchases of product X for the month of June 2013.

June 01: Balance on hand at the beginning of the month; 200 units @ $10.15.
June 05: Purchased 800 units @ $10.25.
June 07: Sold 400 units.
June 12: Purchases: 600 units @ $10.40.
June 14: Sales: 500 units
June 20: Purchases: 400 units @ $10.50
June 25: Purchases: 800 units @ $10.70
June 26: Sales: 1,400 units
June 28: Sales: 200 units
June 30: Purchases: 600 units @ $10.85

Required: Compute inventory cost at June 30, 2013 using average cost method assuming the Meta company uses periodic inventory system.

Solution:

Units available for sale:

weighted-average-costing-method-of-inventory-valuation-img1

Weighted average unit cost = $35,740 / 3,400 units
= $10.51176 per unit

Units in ending inventory = Total units available for sale – Total units sold during the period
= 3,400 units – (400 units + 500 units + 1,400 units + 200 units)
= 3,400 units – 2,500 units
= 900 units

Cost of goods sold: 2,500 units × $10.51176 = $26,279.40
Cost of ending inventory: 900 units
× $10.51176 = $9,460.60

Average costing method in perpetual inventory system:

When average costing method is used in a perpetual inventory system, an average unit cost figure is computed each time a purchase is made. This average unit cost figure is then used to assign cost to each unit sold until a new purchase is made. This technique is also referred to as moving average method.

Using the data from above example we can compute the cost of goods sold and the cost of ending inventory as follows:

Solution:

weighted-average-costing-method-of-inventory-valuation-img2

Cost of goods sold: $4,092 + $5,158 + $14722 + $2,103 = $26,075 (Total of sales column)
Cost of ending inventory:
$9,665 (Balance column)

The use of average costing method in perpetual inventory system is not common among companies.

The main advantage of using average costing method is that it is simple and easy to apply. Moreover, the chances of income manipulation are less under this method than under other inventory valuation methods.

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5 Thoughts on Average costing method

  1. Usama Ghareeb

    Thanks for your valuable information, but it will be better if you also add the journal entries to be a complete example.

    Thanks and best regards,
    Usama Ghareeb.

  2. Aayan Arif

    What if sale made is of greater amount than present in invenory?

  3. Accounting For Management

    How can you sell more than what you have? Can you sell 50 units to your customers when you have only 20 units in stock?

  4. Irshad karam

    Thank you for sharing your knowledge, if you add some entries about sales returned and purchases returned in above example, that will be more valuable information for the students and other viewers.

    Thank you and best Regards Irshad Karam

  5. patro

    What is the average rate if the company maintains different location. Whether the average rate should calculate considering all the stock(i.e. including branches) or it should calculate separate average cost for different location.

    Also please explain what are the disadvantages of maintaining separate average for different location?

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