Average Cost – What is Average Cost?
Average cost is a method of stock valuation where the cost of all goods is averaged in order to find the cost of goods sold and the ending inventory.
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The average cost stock valuation method (AVCO) is a straightforward way to determine the cost of goods in an inventory at the end of an accounting period. It takes the weighted average cost of all units available for sale during the period and then uses that average to determine the value of a company's cost of goods sold and ending inventory.
FIFO, LIFO and AVCO are accounting techniques are used for managing a company’s stock and inventory finances. They help businesses determine the value of available stock and raw materials. They are also used to manage cost flow assumptions related to stock and stock repurchases (if purchased at different prices).
Average cost produces results that fall somewhere between FIFO and LIFO.
The average cost is a weighted average which is determined by dividing the average cost of all units by the number of units. So:
Average cost of goods / total number of units
To illustrate how average cost works in practice, we can use the example of a company that produces mobile phone cases.
If this company produces 500 cases on Wednesday at a cost of £2 each, and 500 more on Thursday at £2.25 each, they will have 1,000 cases in stock at a total value of £2,125.00.
Using the AVCO approach, if the company were to then sell 500 cases, the cost of goods sold for those 500 cases would be the average cost of all the units (£2,125/1,000 units) - therefore £2.12 per case, or £1,062.50 for all 500 (recorded on the income statement).
The remaining 500 cases would be allocated to the company’s ending stock at £2.12 each (recorded on the balance sheet), resulting in an ending stock balance of £1,062.50.