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Average Cost Method

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Moneyzine Editor
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January 8th, 2024
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Average Cost Method

Definition

The financial accounting term average cost refers to one of several acceptable approaches to inventory valuation. The average cost method uses a weighted average approach to determine the value of inventory appearing on the company's balance sheet.

Calculation

Average Cost per Unit = Total Cost of Goods Available for Sale / Number of Units

Explanation

Also referred to as the AVCO method, the average cost method of inventory valuation assumes the cost of inventory is an "average" at any one point in time. Once the average cost per unit is calculated, that value is then applied to the total number of units remaining in inventory at the end of an accounting period.

Accurate inventory valuation will ensure the proper reporting of assets on the company's balance sheet. It's also important to understand the ending inventory value for one year is the beginning inventory value in the following year. Inventory errors also have an effect on net income. For example, if the beginning inventory is understated, net income in that period will be overstated.

Example

The yearend inventory results for Company A include a cost of goods available for sale of $500,000, with 500 units available for sale. The ending number of units in inventory is 200. The value of Company A's inventory using the average method would be:

Cost of Goods Available for Sale

$500,000

Units Available for Sale

500

Average Unit Cost

$1,000

Company A has 200 units remaining at year end, therefore the value of inventory appearing on the balance sheet would be:

= $1,000 per unit x 200 units, or $200,000

Related Terms

Inventory
The financial accounting term inventory is used to describe the balance sheet line item that includes the value of raw materials, work in process, finished goods ready for sale, and returned goods that can be resold.
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Balance Sheet
Also known as a statement of financial position, the balance sheet is used to show the financial health of a company at a particular point in time. The balance sheet consists of assets, liabilities, and owner's equity in the company. It is one of the four key financial statements issued by public companies.
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First In First Out Method (FIFO)
The financial accounting term first-in, first-out refers to one of several approaches to inventory valuation. The first-in, first-out method assumes the oldest items held in inventory are the first items to be sold when determining the value of inventory appearing on a company's balance sheet.
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Last In First Out Method (LIFO)
The financial accounting term last-in, first-out refers to one of several acceptable approaches to inventory valuation. The last-in, first-out method assumes the newest items held in inventory are the first items to be sold when determining the value of this asset as it appears on a company's balance sheet.
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Lower of Cost or Market
The financial accounting term lower of cost or market refers to an inventory valuation rule that states items should be valued at their original cost or their current market cost, whichever is lower.
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Gross Profit Method
The financial accounting term gross profit method refers to an approach to valuing ending inventory which is based on an assumption the gross profit ratio on the items held in inventory remains consistent from one accounting period to the next.
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