Lesson 36: Average Cost Method and Inventory Costing
In this lesson, we will learn what the average cost method is,
and learn how to
calculate COGS and the ending inventory figure using this method.
We've reviewed the specific identification and FIFO methods, now let's review
the final method of inventory costing, the average cost method. This method
will give us an average cost for each item of inventory that we will use to
calculate the cost of goods sold and ending inventory figures.
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The average cost method will yield a different cost of goods sold figure for
the periodic system than it will for the perpetual system. This means that we
will need to calculate the figures separately for each system, because they
will not come up with the same results.
In contrast to the FIFO method where we used the different unit costs for the
bread, with the average cost method we will be using the same unit price for
each piece of inventory to expense the cost of goods sold.
Let's take a look at an example of the periodic system first,
as it is the simpler of the two systems.
We will use the same table of purchases as we did when reviewing the FIFO method.
Let's examine how the average cost figure will be calculated. In order to get a
full picture of how to accurately use this method, we will first look at the
incorrect way of calculating the average cost. The reason for this is because
people often make mistakes when using the average cost method and you want to
avoid calculating the wrong value.
The incorrect way would be to add up all of the unit costs and
divide by the number of purchases. In this case, a common misconception would
be to use the standard average, as shown above.
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The correct way of calculating the average cost is to use the weighted average,
which involves actually multiplying each purchase line by the unit costs to
come up with the total inventory cost. This figure is then divided by the total
number of units to come up with the average unit cost. Take a look at the
breakdown of how this is calculated above.
Next, we will use the average unit cost to calculate the cost of goods sold. In
order to calculate this figure, we will simply use the average cost of $3.05 to
expense each unit sold. Let's look how this applies to the sale entries above.
The cost of goods sold is a total of $1,
677.50 which reflects the 2 sale entries multiplied by the average cost of $3.05.
To find out the ending inventory figure, we will simply subtract the cost of
goods sold from the total inventory. In this example the total inventory was
$2,750 less the COGS of $1,677.50 would net the ending inventory value of
$1,072.50.
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Keep in mind this example only applies to the periodic inventory system as we
will be reviewing how to use the average cost method for the perpetual system
in an upcoming lesson.