The average cost method computes inventory cost based on total cost of purchases divided by the number of goods purchased. Since AVCO uses an average cost of goods in inventory, rather than tracking individual units, it’s simpler to use than first-in, first-out (FIFO) or last-in, first-out (LIFO). The main highlight of the average cost method is its ability to keep inventory costs at stable levels when prices are fluctuating.
Here’s the formula to compute the average unit cost:
| Average Unit Cost | = | Total Cost of Purchases or Production Quantity Purchased or Produced |
Use Cases
- Average Cost Is Best For
- Average Cost Is Not Ideal For
- Businesses with fluctuating inventory prices: Prices change because of economic and market conditions that companies can’t control, such as increases in the price of crude oil affect the price of other goods. With the average cost 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 average cost method to make it easier to cost agricultural products without assigning a unit cost manually.
- Businesses looking for a simple inventory costing method: The 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.
- Businesses with relatively low purchase volumes: The essence of the average cost 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 because of 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 keep a record of the actual cost of each item. We discuss this method in detail in our specific identification method guide.
- Businesses using cost-plus pricing strategy: Since the unit cost of inventory changes every purchase, the average cost method isn’t suitable if you use the cost-plus pricing strategy because you have to revise the selling price when the average cost changes. To help you determine the cost of your products, check out our pricing strategy list, which also includes some examples.
Advantages & Disadvantages of the AVCO Method
| ADVANTAGES | DISADVANTAGES |
|---|---|
| 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 | It is prone to rounding errors, and unit costs always have rounding adjustments |
| It is a widely accepted method not only in the United States but in many foreign countries | Extreme values may affect or skew the averages |
A cost flow assumption is how costs move from merchandise inventory on the balance sheet to the cost of goods sold (COGS) on the income statement. Popular cost flow assumptions are AVCO, FIFO, and LIFO. The cost flow assumption adopted doesn’t have to match the actual physical flow of goods.
Understanding the Average Cost Method
To better understand this method, let’s experiment a bit by looking at three different price scenarios: rising prices, declining prices, and fluctuating prices. Averaging numbers finds the middle ground between two price points, and averaging impacts the average cost we want to determine. Let’s understand the effects of averaging in inventory prices and cost using the AVCO method.
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.
Tip:
The less inventory you keep on hand, the closer your average cost of inventory will be to the current price of inventory.
How To Calculate Ending Inventory & 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. Calculating ending inventory and COGS under average cost method depends on the inventory system.
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
Date | PURCHASES | Price |
|---|---|---|
1/2 | 200 units @ $40 | $ 8,000 |
1/5 | 300 units @ $70 | 21,000 |
1/8 | 200 units @ $90 | 18,000 |
1/13 | 100 units @ $150 | 15,000 |
TOTAL | $ 62,000 | |
Date | SALES |
|---|---|
1/3 | 250 units |
1/6 | 245 units |
1/11 | 235 units |
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
- Step 2
- Step 3
- Step 4
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.
Beginning inventory (200 units x $20) | $ 4,000 | |
Purchases | 62,000 | |
Cost of goods available for sale | 66,000 | |
Divide: Total units available for sale | ||
Units in beginning inventory | 200 units | |
Total purchases | 800 units | ÷ 1,000 |
Weighted average cost per unit | $ 66 |
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.
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
Compute the Cost of Goods Sold
Beginning inventory | $ 4,000 |
Purchases | 62,000 |
Cost of goods available for sale | 66,000 |
Less: Ending inventory | (17,820) |
COGS | $ 48,180 |
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
- Step 2
- Step 3
- Step 4
- Step 5
- Step 6
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:
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
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.
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.
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
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:
| Moving average unit cost | = | Cost of units purchased + Cost of existing units number of goods available for sale |
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.
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | ? | 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:
| Moving average unit cost | = | $12,000 400 units |
| Moving average unit cost | = | $30/unit |
Let’s now place the average unit cost under the Unit Cost column. In succeeding sales, we’ll now use $30 to compute COGS.
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | $30 | 12,000 | |||
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.
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | $30 | 12,000 | |||
1/3 | 250 | $30 | 7,500 | ||||||
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.
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | $30 | 12,000 | |||
1/3 | 250 | $30 | 7,500 | 150 | $30 | $ 4,500 | |||
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
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | $30 | 12,000 | |||
1/3 | 250 | $30 | 7,500 | 150 | $30 | $ 4,500 | |||
1/5 | 300 | $70 | $ 21,000 | 450 | $56.67 | $ 25,500 | |||
Let’s repeat step 3 here. First, let’s add the existing inventory and recent purchases. Then, compute the moving average unit cost.
Cost of inventory available for sale (4,500 + 21,000) | 25,500 |
Divide: Total units available for sale (150 + 300) | ÷ 450 |
Moving average unit cost | $56.67 |
Sale of 245 units on January 6
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | $30 | 12,000 | |||
1/3 | 250 | $30 | 7,500 | 150 | $30 | $ 4,500 | |||
1/5 | 300 | $70 | $ 21,000 | 450 | $56.67 | $ 25,500 | |||
1/6 | 245 | $56.67 | 13,883.33 | 205 | $56.67 | 11.616.67 | |||
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
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | $30 | 12,000 | |||
1/3 | 250 | $30 | 7,500 | 150 | $30 | $ 4,500 | |||
1/5 | 300 | $70 | $ 21,000 | 450 | $56.67 | $ 25,500 | |||
1/6 | 245 | $56.67 | 13,883.33 | 205 | $56.67 | 11.616.67 | |||
1/8 | 200 | $90 | 18,000 | 405 | $73.13 | 29,616.67 | |||
Cost of inventory available for sale (11,616.67 + 18,000) | 29,616.67 |
Divide: Total units available for sale (205 + 200) | ÷ 405 |
Moving average unit cost as of January 8 | $73.12758 |
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
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | $30 | 12,000 | |||
1/3 | 250 | $30 | 7,500 | 150 | $30 | $ 4,500 | |||
1/5 | 300 | $70 | $ 21,000 | 450 | $56.67 | $ 25,500 | |||
1/6 | 245 | $56.67 | 13,883.33 | 205 | $56.67 | 11.616.67 | |||
1/8 | 200 | $90 | 18,000 | 405 | $73.13 | 29,616.67 | |||
1/11 | 235 | $73.13 | 17,184.98 | 170 | $73.13 | 12,431.69 | |||
COGS = 235 units x $73.12758 = $17,184.98
Purchase of 100 units on January 13
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | $30 | 12,000 | |||
1/3 | 250 | $30 | 7,500 | 150 | $30 | $ 4,500 | |||
1/5 | 300 | $70 | $ 21,000 | 450 | $56.67 | $ 25,500 | |||
1/6 | 245 | $56.67 | 13,883.33 | 205 | $56.67 | 11.616.67 | |||
1/8 | 200 | $90 | 18,000 | 405 | $73.13 | 29,616.67 | |||
1/11 | 235 | $73.13 | 17,184.98 | 170 | $73.13 | 12,431.69 | |||
1/13 | 100 | $150 | 15,000 | 270 | $101.60 | 27,431.69 | |||
Cost of inventory available for sale (12,431.69 + 15,000) | 27,431.69 |
Divide: Total units available for sale (170 + 100) | ÷ 270 |
Moving average unit cost as of January 8 | $101.59885 |
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.
PURCHASES | COST OF GOODS SOLD | INVENTORY | |||||||
|---|---|---|---|---|---|---|---|---|---|
Date | Qty | Unit Cost | Total | Qty | Unit Cost | Total | Qty | Unit Cost | Total |
1/1 | $ - | $ - | 200 | $20 | $ 4,000 | ||||
1/2 | 200 | $40 | 8,000 | 400 | $30 | 12,000 | |||
1/3 | 250 | $30 | 7,500 | 150 | $30 | $ 4,500 | |||
1/5 | 300 | $70 | $ 21,000 | 450 | $56.67 | $ 25,500 | |||
1/6 | 245 | $56.67 | 13,883.33 | 205 | $56.67 | 11.616.67 | |||
1/8 | 200 | $90 | 18,000 | 405 | $73.13 | 29,616.67 | |||
1/11 | 235 | $73.13 | 17,184.98 | 170 | $73.13 | 12,431.69 | |||
1/13 | 100 | $150 | 15,000 | 270 | $101.60 | 27,431.69 | |||
1/31 | 800 | $62,000 | 730 | $38,568.31 | 270 | $101.60 | $27,431.69 | ||
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.
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.
Perpetual | Periodic | Effect | |
|---|---|---|---|
Ending Inventory | $27,432 | $17,820 | Total current assets under the perpetual method is higher by $9,612. |
COGS | $38,568 | $48,180 | Net income under the periodic method is lower by $9,612. A higher COGS may reduce your taxable income. |
Cost per Unit | $101.60 | $66.00 | The difference of $35.6 between these method only shows how averaging affects (or somehow, distorts) the unit cost. |
Frequently Asked Questions (FAQs)
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.
Bottom Line
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.
