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Thus, learning how to calculate average cost inventory is critical, as it’s an important component of key calculations, like COGS, with ripple effects throughout the income statement.
Below, we’ll explain what the average cost method for inventory is and how to calculate it, as well as discuss some of the drawbacks and advantages of using this approach over the others available.
What is the Average Cost Method for Inventory?
There are a few ways businesses can calculate the cost of their inventory, with one common option being the average cost method. Sometimes, this may be referred to as the weighted-average method.
As the name might suggest, when using the average cost method, companies take the total cost of all inventory purchased or produced over a certain period of time divided by the total number of items in inventory. The resulting value is the average cost for each item in the inventory.
So, even if specific items were purchased at a higher or lower rate, this method applies the same uniform cost to all inventory.
Although the term “average cost” is sometimes used in economics to refer to average total cost (ATC), the calculation serves a different purpose in inventory accounting. In this article, the term refers specifically to the inventory valuation method, which assigns a blended per-unit cost for financial reporting. This clarification helps avoid confusion with ATC, which measures production cost per unit in an economic context.
When to Use Average Cost Inventory
As we mentioned above, the average cost method isn’t the only way to find the cost of inventory. There are two other options that companies commonly use:
- Last in, first out (LIFO)
- First in, first out (FIFO)
In general, the average cost method is seen as the simplest. With this method, you don’t have to worry about the timing of when certain items are delivered and sold, unlike with LIFO and FIFO.
While the average cost method is often chosen for its simplicity, it’s helpful to compare it directly with other inventory valuation methods to understand when it’s the best choice.
This comparison highlights a key takeaway: while FIFO and LIFO focus on the timing of inventory flow, the average cost method prioritizes simplicity and consistency. For businesses that deal with large volumes of similar items, this approach reduces complexity while still providing reliable financial reporting.
The average cost method is practical in certain scenarios, including when:
- Inventory prices are relatively stable and consistent and do not fluctuate significantly over time
- A company wants a simple way to manage inventory
- The inventory consists of relatively homogeneous goods without a lot of variation between items
Companies have flexibility over which inventory valuation method they use. However, once they pick a method, they must use it consistently to support accurate financial reporting and remain compliant with generally accepted accounting principles (GAAP).
What Costs Are Included in Inventory Cost?
Inventory cost can include several components beyond the purchase price, such as transportation and handling fees, ordering costs, storage and carrying costs, and occasional shrinkage or spoilage. These expenses collectively determine the total amount allocated across all units when applying the average cost method.
How to Calculate Average Cost Inventory
Here is the formula you can use to calculate average cost inventory:
Average unit cost = Total cost of inventory / Total units in inventory
This is a relatively straightforward formula. However, there can be some nuances in calculating this value accurately, which we’ll explore in further detail below with a step-by-step example.
This calculation works by spreading the total amount spent on inventory across all units purchased, creating one consistent cost per item. It’s particularly useful when purchase prices vary over time, because it smooths out those fluctuations into a single blended rate that can be used for inventory valuation and COGS reporting. When total inventory spending comes from multiple purchases at different prices, the average cost method converts these varying amounts into a unified per-unit cost that remains stable and easy to apply across your accounting records.
Understanding Average Inventory
Average inventory represents the typical amount of inventory a business holds during a specific period. It is calculated using the following simple formula:
(Beginning Inventory + Ending Inventory) ÷ 2
Although this measurement is not part of the average cost calculation itself, it is often used alongside the average cost method to evaluate inventory levels, monitor turnover, and support broader financial analysis.
Average Cost Inventory Example
Learning how to calculate average cost inventory with the formula is only the first step toward understanding how to apply this concept in your business.
To better illustrate how to use the average cost method in the real world, we will now walk through a practical example of how this might look for an e-commerce store.
Using the Average Cost Method in COGS Calculations
Before looking at the detailed example, it's important to understand how the average cost you calculate is actually used in financial reporting. Once the average unit cost is determined, it becomes the standard rate applied to all units sold during the period. This means that instead of tracking the exact purchase price of each individual item, businesses apply one blended cost to calculate COGS, which keeps reporting consistent and easier to manage.
For instance, if an e-commerce company sells 150 units during the quarter and the average cost per unit is $5.72, the recorded COGS for those sales would be 150 × $5.72 = $858.
Company Background and Contex
Let’s use an example of an online retailer that sells pet products. They need to calculate the cost of their inventory to prepare their financial statements at the end of the period.
Order Summary
Over the past quarter, the e-commerce brand made multiple purchases of the same type of dog toy. The price of the product fluctuated over the quarter, so the cost of each purchase varied slightly.
Here is a breakdown of the purchases over the quarter:
- April 1: 50 dog toys at $6.50 each = $325 total
- May 6: 200 dog toys at $5.50 each = $1,100 total
- June 3: 125 dog toys at $5.75 each = $718.75 total
Initial Calculations
Using the above details, we need to make a few more simple calculations before landing on the average inventory cost.
Specifically, we still need to find the total cost of inventory and the total units, as shown in the above formula.
Total cost of inventory: $325 + $1,100 + $718.75 = $2,143.75
Total units of inventory: 50 + 200 + 125 = 375
So, throughout the quarter, the company purchased 375 dog toys, or total units of inventory, at a total cost of $2,143.75.
Average Inventory Cost Calculation
We now have all the necessary information to calculate the pet product company’s average inventory cost.
Average unit cost = $2,143.75 / 375
= $5.72
From our calculations, the average cost of the company’s inventory is $5.72 for the second quarter.
The company can use this value to account for the cost of goods sold based on the number of units sold over the period.
For example, if we know they sold 200 units during the quarter, we can calculate the COGS as:
COGS = 200 * $5.72
= $1,144
This value will be reported on the income statement, which is subtracted from total revenues to determine the company’s gross profit for the quarter.
Pros and Cons of Average Cost Inventory
After seeing how to calculate average cost inventory using a real-world example, it may be easier to understand why some companies are drawn to its simplicity.
However, there are some potential drawbacks of the average cost inventory method. Here is a quick view of the pros and cons of this method to round out our discussion:
Pros
- Easy to use, so it takes the team less time and resources to calculate
- Less prone to error since it’s easier to calculate
- Good for large volumes of homogenous goods, as companies don’t have to distinguish between the items to determine their value individually
Cons
- Can distort profits, as it doesn’t track the exact cost of each piece of inventory sold during the period
- It doesn’t track price fluctuations as accurately as LIFO or FIFO methods
Don’t Know How to Value Your Inventory? Leave it to the Experts
After reading through this guide, hopefully, you now have a better understanding of how to calculate average cost inventory.
Though this is typically seen as the simplest method for valuing inventory, it still requires diligent attention to the company’s purchases and careful calculations to ensure reporting accuracy and compliance.
If you’d rather not spend your valuable time poring over purchase orders so you can calculate your inventory costs, let the pros at Bob’s Bookkeepers handle it.
From basic bookkeeping service to fractional CFO support, our team can help you determine the best inventory valuation method for your company and industry, then keep your records up-to-date while you focus on growing your business.
Contact us today to speak with our team about your company’s financial support needs.
