This article is part of a larger series on Bookkeeping.
The weighted average cost (AVCO) method, also called the AVCO method, is one of the three inventory cost flow assumptions used in inventory costing. Just like FIFO and LIFO, the AVCO method is used to determine the cost of inventory at the end of the year and the cost of goods sold (COGS) during the year. Under this method, the cost of inventory is based on the weighted AVCO of inventory purchases during the year.
A cost flow assumption is how costs move from merchandise inventory on the balance sheet to the COGS on the income statement. Popular cost flow assumptions are AVCO, first-in, first-out (FIFO), and last-in, first-out (LIFO). The cost flow assumption adopted doesn’t have to match the actual physical flow of goods.
How the Average Cost Method Works
The AVCO method uses the weighted average purchase cost to determine a per-unit cost to apply to both ending inventory and COGS. It’s a compromise between the FIFO and LIFO methods because averaging reduces the effect of changing prices. Here’s the formula to compute the average unit cost:
|Weighted average unit cost||=||Cost of goods available for sale|
What Type of Business Average Cost Is Best For
In a periodic inventory system, this average cost is multiplied by the number of units in ending inventory to determine the cost of ending inventory. In a perpetual inventory system, this average cost is multiplied by the number of units sold for each sales transaction to determine the COGS. We provide detailed examples of both periodic and perpetual inventory systems later in this article.
- Businesses with fluctuating inventory prices: Prices change due to economic and market conditions that companies can’t control. For example, increases in the price of crude oil affect the price of other goods. With the AVCO method, you can smooth fluctuations in inventory prices by computing the average inventory cost per unit.
- Businesses with highly intertwined products: Products that are highly intertwined, or complementary goods, have limited use if used individually. For companies selling these products, the AVCO method best depicts their relationship by commingling them into one average unit cost.
- Businesses selling agricultural produce: Maintaining the individual unit cost of agricultural produce is demanding since most are sold in bulk. It’s better to use the AVCO method to make it easier to cost agricultural products without assigning a unit cost manually.
- Businesses looking for a simple inventory costing method: The weighted AVCO method is the most straightforward inventory cost flow assumption to implement. You need not keep track of purchase dates and layers to determine inventory cost.
What Type of Business Average Cost Is Not Right For
- Businesses with relatively low purchase volumes: The essence of the AVCO method is to compute the average inventory cost every time you purchase inventory. If you don’t frequently purchase merchandise to replenish stocks, then you might prefer to use FIFO to match cost flow assumption with the physical flow of goods.
- Businesses using LIFO for tax purposes: The LIFO method of inventory costing yields the lowest net income during periods of increasing costs. That’s why some businesses use LIFO to get tax savings due to a lower taxable income. Hence, the IRS requires companies to use LIFO for bookkeeping purposes if they also use it for tax purposes.
- Businesses with high-value, small-volume items: If your business deals with a small volume of high-value items, such as jewelry and vehicles, then it’s best to use the specific identification method. Since there are only a few items to keep track of, it’s easiest and most accurate to simply keep a record of the actual cost of each item.
- Businesses using cost-plus pricing strategy: Since the unit cost of inventory changes every purchase, the AVCO method isn’t suitable if you use the cost-plus pricing strategy because you have to revise the selling price when the AVCO changes.
Advantages & Disadvantages of Using the Average Cost Method
|It evens out fluctuations in unit price||The average unit cost may not reflect current costs|
|It is easier than FIFO and LIFO||It is suitable only for identical items|
|The cost of inventory is consistent because it only uses one unit cost, unlike in FIFO and LIFO, where unit costs from different purchases can build up||AVCO is prone to rounding errors and unit costs always have rounding adjustments|
|AVCO is a widely accepted method not only in the United States but in many foreign countries||Extreme values may affect or skew the averages|
How to Calculate Ending Inventory and COGS Using the Average Cost Method
Calculating the ending inventory is essential in inventory costing and management. It’s also a key element in determining the COGS. Let’s illustrate the AVCO method under the periodic and perpetual inventory system using the sample data below:
Beginning Inventory: 200 units at $20 each
200 units @ $40
300 units @ $70
200 units @ $90
100 units @ $150
Periodic Inventory System
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 AVCO per unit during the period.
Perpetual Inventory System
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.
Comparison of Ending Inventory Balance Between Periodic and Perpetual AVCO
Since the perpetual inventory system uses a moving average, the ending balances reported under perpetual inventory can differ from periodic inventory.
Total current assets under the perpetual method is higher by $9,612.
Net income under the periodic method is lower by $9,612. A higher COGS may reduce your taxable income.
Cost per Unit
The difference of $35.6 between these method only shows how averaging affects (or somehow, distorts) the unit cost.
The average cost method is a cost flow assumption that uses the averaging technique to smooth out price fluctuations and simplify costing. However, AVCO isn’t an ideal inventory costing formula for businesses that sell unrelated products. What we’ve discussed in this article is part of your small business bookkeeping. Don’t forget to conduct a physical count of inventory to verify the accuracy of your accounting records.