# Average Cost Method

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## One approach for valuing inventory is the average cost method, which determines the cost of each item in inventory by dividing the total cost of products bought or produced over a certain period by the total number of things bought or produced.Â

The weighted average approach is another name for this technique. Businesses that offer commodities or raw materials, that are not immediately distinct from one another, can benefit from using the average cost method.

To calculate the average cost per unit, the following formula is used:

Average cost per unit = Total cost of goods available for sale / Total units available for sale

The total cost of goods available for sale is the sum of the beginning inventory cost and the purchases or production cost during the period. The total units available for sale are the sum of the beginning inventory units and the purchases or production units during the period.

To calculate the cost of goods sold (COGS) using the average cost method, the following formula is used:

COGS = Average cost per unit x Units sold

The COGS is an important figure for businesses, investors, and analysts as it is subtracted from sales revenue to determine gross margin on the income statement.

To calculate the ending inventory value using the average cost method, the following formula is used:

Ending inventory value = Average cost per unit x Units in ending inventory

The ending inventory value represents the cost of goods that are still available for sale at the end of the period.

Let's look at an example of how to apply the average cost method. Suppose a company sells widgets and has the following inventory transactions in January:

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To calculate the average cost per unit, we need to add up the total cost of goods available for sale and divide it by the total units available for sale.

Total cost of goods available for sale = \$1,000 + \$2,400 + \$4,500 = \$7,900

Total units available for sale = 100 + 200 + 300 = 600

Average cost per unit = \$7,900 / 600 = \$13.17

To calculate the COGS for each sale, we need to multiply the average cost per unit by the units sold.

COGS for Jan 15 sale = \$13.17 x 150 = \$1,975.50

COGS for Jan 25 sale = \$13.17 x 250 = \$3,292.50

Total COGS for January = \$1,975.50 + \$3,292.50 = \$5,268

To calculate the ending inventory value, we need to multiply the average cost per unit by the units in the ending inventory.

Ending inventory value = \$13.17 x 200 = \$2,634

The following table summarizes the results of applying the average cost method:

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The average cost approach has the benefits of being easy to use and requiring little labor. Additionally, it lessens COGS and gross margin distortion brought on by inflation or deflation and smooths out price swings.

The average cost technique has the drawbacks that it may not accurately reflect the flow of commodities and may not reflect current market pricing. Additionally, it might not be appropriate for companies that offer goods with a limited shelf life or that are susceptible to obsolescence.

According to generally accepted accounting standards (GAAP), a corporation must utilize an inventory valuation method consistently after choosing it in order to maintain the comparability and accuracy of its financial statements.

Along with first in first out (FIFO), and last in first out (LIFO), the average cost method is one of the three widely used techniques for valuing inventory. Every method has pros and cons, and it could produce a varied COGS and ending inventory value. Businesses must select the approach that most accurately reflects their operations and goals.
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