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. Purchases: 800 units @ $10.25
June 07. Sales: 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:

Date No. of units Cost per unit Total cost
June 01 200 10.15 2,030
June 05 800 10.25 8,200
June 12 600 10.40  6,240
June 20 400 10.50 4,200
June 25 800 10.70  8,560
June 30 600 10.85  6,510
———- ———-
Total 3,400 35,740
———- ———-

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

= $10.5118 per unit

Number of units available for sale 3,400
Less number of units sold (400 + 500 + 1,400 + 200) 2,500
——-
Number of units in inventory (unsold units) 1,100
——-

Cost of goods sold: 2,500 units × $10.5118 = $26,280
Cost of ending inventory: 900 units
× $10.5118 = $9,460

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:

Date Purchases Sales Balance
June 01
Beginning balance   200units×$10.150=$2,030
June 05 800units×$10.250=$8,200
1000units×$10.230=$10,230
June 07 400units×$10.230=$4,092 600units×$10.230=$6,138
June 12 600units×$10.400=$6,240 1,200units×$10.315=$12,378
June 14 500units×$10.315=$5,158 700units×$10.315=$7,221
June 20 400units×$10.500=$4,200 1,100units×$10.383=$11,421
June 25 800units×$10.700=$8,560 1,900units×$10.516=$19,981
June 26 1,400units×$10.516=$14,722 500units×$10.516=$5,258
June 28 200units×$10.516=$2,103 300units×$10.516=$3,155
June 30 600units×$10.850=$6,510 900units×$10.739=$9,665

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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