Definition: Average cost method, also called weighted average, is a way of assigning costs to inventory when it is sold. Some companies choose to use the average method instead of other valuation methods like FIFO or LIFO because the weighted average method minimizes the drastic effects of assigning costs based on the purchase date.
What Does Average Cost Method Mean?
For instance, FIFO assigns costs to the sold inventory based on the first purchase date. The first product purchased will be the first item sold. As inventory ages and prices continue to rise, the FIFO method tends to overstate inventory levels because only higher priced inventory purchased at later dates remains on the balance sheet. The first purchased inventory that was purchased at a lower cost is sold off first.
Conversely, LIFO has the opposite effect on the balance sheet by selling the last items purchased first. This method results in an understated inventory level and a lower net income for the period.
You can look at the average cost method as a middle ground between these two inventory valuation methods. It calculates the average cost of all inventory on hand and uses that as the cost when an item is sold. The average cost method formula is calculated by dividing the cost of goods available for sale by the total units available. This is the cost assigned to each piece of inventory sold.
Let’s assume that Ashley’s Furniture store has 10 pieces of inventory. She bought the first 3 for $1,000 each, the second 3 for $1,500 each, and the last 4 for $2,000 each. Her total cost of available inventory for sale is $15,500, so here average cost per item is $1,550.
Ashley would record a cost of $1,550 when she sells each piece of furniture by debiting cost of goods sold and crediting inventory.