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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.
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.
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:
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.
The average cost method is practical in certain scenarios, including when:
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).
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.
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.
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.
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:
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.
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.
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:
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.
