Costing Inventory:Average Cost Valuation

   The average cost valuation system, also known as weighted average, is based on the average cost of inventory during the period and takes into consideration the quantity and the price of the inventory items by assigning the same amount of cost to identical items. In other words, it spreads the total dollar cost of the goods available for sale equally among all the units.
   The ending inventory is determined by the following procedure:

1. The cost of the total number of units available for sale (beginning inventory plus purchases) is divided by the total units available for sale.
2. The number of units in the ending inventory is multiplied by this weighted average figure.

Example 1

Referring to the data in Chart 1, the cost of the 385 units on hand would be calculated as follows:

1. $7,475 / 695 units = $10.76
2. $10.76 X 385 units on hand = $4,143 ending inventory

Example 2

    The cost of goods sold is then calculated by subtracting the value of the ending inventory from the total value of the inventory available for sale ($7,475 - $4,143 = $3,332).
   Because there were 695 units available for sale and 385 units on hand at the end of the period, the number of units sold was determined as 695 - 385 = 310 units. Therefore, another method of computation to determine the cost of good sold would be $10.76 X 310 units (cost of goods sold) = $3,336

Rounded to the nearest dollar.

   The average cost method is best used by firms that buy large amounts of goods that are similar in nature and stored in a common place. Grain, gasoline, and coal are good examples of products that could logically be costed under weighted average.

   There are some limitations that should be noted in this valuation procedure. Unit cost cannot be related to any physical purchase and does not represent any price changes. In those industries that are greatly affected by price and style change, this method will not yield specific cost determination. Also, the time needed to assemble the data is greater under this method than for FIFO or LIFO, if there are many purchases of a variety of different items bought.