What Is the Average Cost Method? How To Calculate & Example

When market prices rise, the average cost is lower than the actual price. This difference has several implications—lower average cost would mean lower cost of goods sold, higher net income, and higher income taxes. However, a low average cost would not affect the amount that we’ll pay to suppliers.

Below is a graph depicting the actual price of inventory vs the computed average cost.

Prices & Average Cost Relationship at Rising Prices

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• Price
• Average Cost

Interact with the chart above and navigate around number 5. You’ll see that the actual price at this time is $170 and yet the average cost is only $90. We still have to pay $170 per unit to suppliers even though our costing is at $90.

Now let’s take a look at declining prices. It’s possible that prices of goods decline over time, which can be a good sign. However, it may also have effects under the AVCO method.

When prices decline, we expect the average cost to be higher than the actual price. A higher average cost would result in higher COGS, lower net income, and lower income taxes. While this is good because taxes are lower, it might not look good in the income statement.

Price & Average Cost Relationship at Declining Prices

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• Price
• Average Cost

When prices fluctuate, the average cost method offsets the fluctuations and smooths out the price trend. It removes erratic changes and helps you to report COGS without sudden drops or shoot ups.

The graph below shows how AVCO can help with fluctuating prices:

Price & Average Cost Relationship at Fluctuating Prices

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• Price
• Average Cost

The blue line is the actual price of goods. It’s erratic with very steep curves. But with AVCO (red line), the average cost is smooth. Small ups and downs don’t really matter since the deviation from the trend isn’t that significant.

In a periodic inventory system, all inventory purchases are initially recorded in the Purchases account, which substitutes for the COGS expense during the period. At the end of the period, a physical inventory count is performed and the costs in the Purchases account are separated between units sold (COGS) and units on hand (inventory) based on the average cost per unit during the period.

Step 1

Compute the Weighted Average Cost per Unit

First, calculate the total cost of purchases made during the entire period. In our sample data above, we show the total cost of purchases was $62,000. Then, add the total cost of purchases to the cost of beginning inventory to arrive at the cost of goods available for sale. Finally, divide the cost of goods available for sale by the total units available for sale.

Step 2

Count the Units in Ending Inventory

The periodic inventory system requires a physical inventory count at the end of the period. If you’re using the periodic system on a monthly or quarterly basis, you can estimate the units in ending inventory. However, you must take an actual physical inventory count at year’s end.

Assume a physical inventory count reveals 270 units in ending inventory.

Step 3

Compute the Cost of Ending Inventory

Now that we know the ending inventory in units, let’s multiply the weighted average unit cost by the number of units in ending inventory:

Cost of ending inventory = 270 units x $66 per unit = $17,820

Step 4

Compute the Cost of Goods Sold

Under the perpetual inventory system, inventory records are maintained continuously throughout the accounting period. Whenever there’s a purchase or sale, inventory records are updated automatically. You can determine the running balance inventory under a perpetual inventory system easily without a physical count. Let’s see how the moving average method works with a perpetual inventory system.

You must perform the following steps for each inventory sale during the period or choose accounting software that will do it for you.

Step 1

Prepare a 10-column Subsidiary Ledger

In a perpetual inventory system, a subsidiary ledger is kept for every inventory item. If you do this manually, you need to have a 10-column subsidiary ledger book for every item of inventory. However, accounting software programs can make things easier. QuickBooks Online is our best small business accounting software and uses the perpetual inventory system to record inventory purchases and sales in the Inventory account. If you want to learn more about it, read our QuickBooks Online review for a comprehensive analysis.

Here’s the subsidiary ledger format that we’ll use:

The COGS and Inventory calculations in the perpetual system are the same as in the periodic system, except you need to adjust the average unit cost in real time for each purchase and sale. This is why good accounting software is ideal to use the perpetual system because maintaining perpetual records manually requires a lot of work.

Step 2

Record Beginning Inventory Information in the Purchases Column

In a perpetual inventory system, we always need to update our subsidiary ledgers for every sale or purchase. In our example, we started on a clean slate. Let’s first enter our beginning inventory balances in the first line of the subsidiary ledger.

Step 3

Update the Inventory Column After Recording the Purchase and Compute the Moving Average Unit Cost

The rule in a perpetual inventory system using AVCO is to always update the average unit cost before a sale. This average unit cost is called the moving average because it changes every time you purchase new inventory. The formula to compute moving average unit cost is presented below:

Then, let’s record the purchase on January 2. Enter the purchase details under the Purchases column. Always remember that the Inventory entry should present the running balances. In the quantity column, we should present the running balances. Hence, our units on hand as of January 2 are 400 units (200 units from beginning inventory and 200 units recently purchased). We’ll do the same to arrive at the total cost of $12,000.

In our books, we record the purchases directly to Merchandise Inventory since we’re using the perpetual inventory system. Remember, the periodic system records purchases in a COGS account.

We’ve determined the total cost of inventory at $12,000, but we don’t know its unit cost. Let’s use the moving average unit cost formula above:

Let’s now place the average unit cost under the Unit Cost column. In succeeding sales, we’ll now use $30 to compute COGS.

Step 4

Record a Sale by Using the New Average Unit Cost and Update Inventory Balances

When we record a sale, we use the new average unit cost to compute the COGS. In our ledger below, we multiplied 250 units by the new average unit cost of $30.

In our books, we transfer $7,500 from our inventory account to our COGS account. Let’s now extend the sales information to the Inventory entry. First, deduct 250 units from 400 units on hand as of January 2. Then, compute the cost of inventory on hand by subtracting $7,500 COGS from the prior cost of inventory of $12,000. Notice the AVCO per unit doesn’t change when a sale is made.

Step 5

Repeat the Process in Steps 3 & 4

In the perpetual inventory system, steps 3–4 are ones that you have to repeat in every transaction. Let’s complete our subsidiary ledger as we compute our month-end balances:

Purchase of 300 units on January 5

Let’s repeat step 3 here. First, let’s add the existing inventory and recent purchases. Then, compute the moving average unit cost.

Sale of 245 units on January 6

Let’s repeat step 4 here. Our current moving average unit cost is $56.67 (rounded). To approximate our cost of goods sold, let’s extend our moving average unit cost to at least five decimal places and round off the dollar amount to the nearest hundredths place.

COGS = 245 units x $56.66667 = $13,883.33

That’s why the manual perpetual system can be tedious because of constant averaging. Using an accounting software program or inventory management system can make things easier for you, especially in computing the moving averages.

Purchase of 200 units on January 8

For illustration purposes, let’s keep our moving average unit cost at $73.13. But if we compute for COGS, let’s extend to five decimal places to minimize rounding differences.

Sale of 235 units on January 11

COGS = 235 units x $73.12758 = $17,184.98

Purchase of 100 units on January 13

Step 6

Sum the Column Totals To Compute Ending Balances

Since January 13 is our last transaction, let’s assume that no other transactions occurred during the month. Let’s foot the columns by adding the total costs under the Purchases and Cost of Goods Sold columns.

For ending inventory, we just pick the last total in the column. In this case, the ending inventory to be presented in the balance sheet is $27,431.69 and the COGS to be presented in the income statement is $38,568.31.

This method is popular because of its simplicity in computing unit cost. Unlike FIFO and LIFO, which determine the cost of each unit sold following assumptions about which units are sold first, the AVCO method simply uses the average unit purchase price as the cost for units sold.

All inventory cost flow assumptions have pros and cons. The average cost is not the best cost basis method—as there is really no best method. However, AVCO is the simplest and will usually generate the most stable unit cost of goods sold.