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