What is the Average Cost Method?

Average costing is the application of the average cost of a group of assets to each asset within that group. The concept is most commonly applied to inventory, but can also be used with fixed assets. For example, if there are three widgets having individual costs of $10, $12, and $14, average costing would dictate that the cost of all three widgets be treated as though they were $12 each, which is the average cost of the three items. This method can also be used to determine the average amount invested in each of a group of securities. Doing so avoids the larger amount of work required to track the cost of each individual security.

How to Calculate Average Cost

The average costing calculation for inventory is as follows:

Cost of goods available for sale ÷ Total units from beginning inventory and purchases = Average cost

The same approach to the calculation can be used for groups of fixed assets or securities.

Related AccountingTools Courses

Accounting for Inventory

Cost Accounting Fundamentals

When to Use Average Costing

Average costing works well when it is difficult to track the cost associated with individual units. For example, it can be applied where individual units are indistinguishable from each other. The method can also be used when raw material costs move around an average cost point in an unpredictable manner, so that an average cost is useful for long-term planning purposes (such as in the development of a budget). Finally, average costing can be used when there are large volumes of similar items moving through inventory, which would otherwise require considerable staff time to track on an individual basis.

When Not to Use Average Costing

Average costing does not work well when the units in a batch are not identical, and therefore cannot be treated in an identical manner for costing purposes. It also does not work when inventory items are unique and/or expensive; in these situations, it is more accurate to track costs on a per-unit basis. Finally, average costing does not work when there is a clear upward or downward trend in product costs, average costing does not provide a clear indication of the most recent cost in the cost of goods sold. Instead, being an average, it presents a cost that may more closely relate to a period some time in the past.

Advantages of Average Costing

There are several key advantages associated with average costing. They are as follows:

Ease of use. The average costing method requires little labor, and so is among the least expensive of the cost accounting methodologies to maintain (the other major cost accounting methods are the FIFO and LIFO methods). This is an especially important issue for businesses that maintain records for many types of inventory.
Reduces price fluctuations. Since average costing blends the cost of older and newer inventory, it smooths out price fluctuations that can occur with rising or falling purchase prices. This helps to stabilize the cost of goods sold and inventory valuation on the balance sheet. This, in turn, reduces the variability of reported profits.
Minimizes inventory manipulation. It is relatively more difficult for someone to manipulate the reported level of profit or loss when the average cost method is used. It is somewhat easier to engage in reporting fraud when the FIFO or LIFO methods are used. For example, under FIFO, a company may intentionally sell older, cheaper inventory first to artificially lower its cost of goods sold during periods of rising prices. Average costing avoids this by averaging costs, ensuring that inventory valuation is less subject to timing games.
Reflects pricing trends. In industries where prices are stable or rising/falling gradually, average costing can provide a more accurate reflection of long-term cost trends. It helps a business avoid extreme shifts in inventory valuation that may not reflect their underlying operational performance.

Presentation of Average Costing

When average costing is applied to inventory, the nature of the method used is commonly included in the footnotes that accompany the financial statements. Investors may find this information useful. These footnotes are not released when financial statements are only being issued internally, since the management team is already aware of the costing method being used.