Average cost inventory method

Introduction

This tutorial will guide you through the average cost inventory method using a practical example from a fictitious company, Toy Giraffe Inc. You'll learn how to calculate the average inventory cost, understand its impact on cost of goods sold (COGS), and compare it with other inventory valuation methods like FIFO and LIFO.

Step 1: Understand the Average Cost Method

The average cost method blends the costs of all inventory purchases to determine a single average cost per unit. This approach simplifies accounting for businesses with large volumes of similar items.

Key Points:

• All purchases are pooled together.
• The average cost is calculated by dividing the total cost of inventory by the total number of units.

Step 2: Calculate Average Inventory Cost

Using Toy Giraffe Inc.’s purchases as an example:

1. January:

   • 100 units at $5/unit
   • Total Cost = 100 * $5 = $500

2. February:

   • 200 units at $6/unit
   • Total Cost = 200 * $6 = $1200

3. March:

   • 100 units at $7/unit
   • Total Cost = 100 * $7 = $700

4. Total Units and Cost:

   • Total Units = 100 + 200 + 100 = 400 units
   • Total Cost = $500 + $1200 + $700 = $2400

5. Average Cost Calculation:

   • Average Cost per Unit = Total Cost / Total Units
   • Average Cost = $2400 / 400 = $6 per unit

Step 3: Record Cost of Goods Sold (COGS)

When selling inventory, use the average cost for COGS.

Example for April:

• Sold 50 units:
  • Revenue: 50 units * $10 = $500
  • COGS: 50 units * $6 = $300
  • Gross Profit: Revenue - COGS = $500 - $300 = $200

Inventory Count After Sale:

• Remaining Inventory = 400 - 50 = 350 units
• Ending Inventory Value = 350 units * $6 = $2100

Step 4: Continue Accounting for Subsequent Months

Repeat the COGS calculation for each month:

For May:

• Sold 100 units:
  • Revenue: $1000
  • COGS: $600
  • Gross Profit: $400
  • Remaining Inventory: 250 units at $6 = $1500

For June:

• Sold 200 units:
  • Revenue: $2000
  • COGS: $1200
  • Gross Profit: $800
  • Remaining Inventory: 50 units at $6 = $300

Step 5: Conduct a Physical Inventory Count

At the end of each quarter, perform a physical inventory count to verify the actual inventory matches your accounting records. This helps ensure accuracy in financial statements.

Step 6: Compare Average Cost with FIFO and LIFO

Understanding the differences between average cost, FIFO (First In, First Out), and LIFO (Last In, First Out) is crucial.

Key Differences:

• Average Cost: Blends all purchases, applying the same cost to all units sold.
• FIFO: Assumes the oldest inventory is sold first.
• LIFO: Assumes the newest inventory is sold first.

Practical Advice:

• Choose the method that aligns with your business needs and provides the best financial insights.

Conclusion

The average cost inventory method is a straightforward approach that simplifies inventory accounting. By calculating the average cost and applying it consistently, you can effectively manage COGS and maintain accurate inventory records. For further learning, consider exploring FIFO and LIFO methods to understand their implications on financial reporting.