What is inventory costing method How does it work?

The four main ways to account for inventory are the specific identification, first in first out, last in first out, and weighted average methods. As background, inventory includes the raw materials, work-in-process, and finished goods that a company has on hand for its own production processes or for sale to customers. Inventory is considered an asset, so the accountant must consistently use a valid method for assigning costs to inventory in order to record it as an asset.

The valuation of inventory is not a minor issue, because the accounting method used to create a valuation has a direct bearing on the amount of expense charged to the cost of goods sold in an accounting period, and therefore on the amount of income earned. The basic formula for determining the cost of goods sold in an accounting period is:

Beginning inventory + Purchases - Ending inventory = Cost of goods sold

Thus, the cost of goods sold is largely based on the cost assigned to ending inventory, which brings us back to the accounting method used to do so. There are several possible inventory costing methods, which are noted below.

Specific Identification Method

Under the specific identification method, you separately track the cost of each item in inventory, and charge the specific cost of an item to the cost of goods sold when you sell the specific item to which that cost has been assigned. This approach requires a massive amount of data tracking, so it is only usable for very high-cost, unique items, such as automobiles or works of art. It is not a viable method in most other situations.

Cost Layering Methods

When you buy inventory from suppliers, the price tends to change over time, so you end up with a group of the same item in stock, but with some units costing more than others. As you sell items from stock, you have to decide on a policy of whether to charge items to the cost of goods sold that were presumably bought first, or bought last, or based on an average of the costs of all items in stock. Your choice of a policy will result in using either the first in first out method (FIFO), the last in first out method (LIFO), or the weighted average method. The following bullet points explain each concept:

• First in, first out method. Under the FIFO method, you are assuming that items bought first are also used or sold first, which also means that the items still in stock are the newest ones. This policy closely matches the actual movement of inventory in most companies, and so is preferable simply from a theoretical perspective. In periods of rising prices (which is most of the time in most economies), assuming that the earliest units bought are the first ones used also means that the least expensive units are charged to the cost of goods sold first. This means that the cost of goods sold tends to be lower, which therefore leads to a higher amount of operating earnings, and more income taxes paid. Also, it means that there tend to be fewer inventory layers than under the LIFO method (see next), since you will continually use up the oldest layers.

• Last in, first out method. Under the LIFO method, you are assuming that items bought last are sold first, which also means that the items still in stock are the oldest ones. This policy does not follow the natural flow of inventory in most companies; in fact, the method is banned under International Financial Reporting Standards. In periods of rising prices, assuming that the last units bought are the first ones used also means that the cost of goods sold tends to be higher, which therefore leads to a lower amount of operating earnings, and fewer income taxes paid. There tend to be more inventory layers than under the FIFO method, since the oldest layers may not be flushed out for years.

• Weighted average method. Under the weighted average method, there is only one inventory layer, since the cost of any new inventory purchases are rolled into the cost of any existing inventory to derive a new weighted average cost, which in turn is adjusted again as more inventory is purchased.

Both the FIFO and LIFO methods require the use of inventory layers, under which you have a separate cost for each cluster of inventory items that were purchased at a specific price. This requires a considerable amount of tracking in a database, so both methods work best if inventory is tracked in a computer system.

The average cost method assigns a cost to inventory items based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced. The average cost method is also known as the weighted-average method.

Key Takeaways

• The average cost method is one of three inventory valuation methods, with the other two common methods being first in first out (FIFO) and last in first out (LIFO).
• The average cost method uses the weighted-average of all inventory purchased in a period to assign value to cost of goods sold (COGS) as well as the cost of goods still available for sale.
• Once a company selects an inventory valuation method, it needs to remain consistent in its use in order to be compliant with generally accepted accounting principles (GAAP).

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Understanding the Average Cost Method

Businesses that sell products to customers have to deal with inventory, which is either bought from a separate manufacturer or produced by the company itself. Items previously in inventory that are sold off are recorded on a company’s income statement as cost of goods sold (COGS). The COGS is an important figure for businesses, investors, and analysts as it is subtracted from sales revenue to determine gross margin on the income statement. To calculate the total cost of goods sold to consumers during a period, different companies use one of three inventory cost methods—first in first out (FIFO), last in first out (LIFO), or average cost method.

The average cost method uses a simple average of all similar items in inventory, regardless of purchase date, followed by a count of final inventory items at the end of an accounting period. Multiplying the average cost per item by the final inventory count gives the company a figure for the cost of goods available for sale at that point. The same average cost is also applied to the number of items sold in the previous accounting period to determine the cost of goods sold.

Example of the Average Cost Method

For example, consider the following inventory ledger for Sam’s Electronics:

Purchase date

Number of items

Cost per unit

Total cost

01/01

20

$1,000

$20,000

01/18

15

$1,020

$15,300

02/10

30

$1,050

$31,500

02/20

10

$1,200

$12,000

03/05

25

$1,380

$34,500

Total

100

$113,300

Assume the company sold 72 units in the first quarter. The weighted-average cost is the total inventory purchased in the quarter, $113,300, divided by the total inventory count from the quarter, 100, for an average of $1,133 per unit. The cost of goods sold will be recorded as 72 units sold x $1,133 average cost = $81,576. The cost of goods available for sale, or inventory at the end of the period, will be the 28 remaining items still in inventory x $1,133 = $31,724.

Benefits of the Average Cost Method

The average cost method requires minimal labor to apply and is, therefore, the least expensive of all the methods. In addition to the simplicity of applying the average cost method, income cannot be as easily manipulated as other inventory costing methods. Companies that sell products that are indistinguishable from each other or that find it difficult to find the cost associated with individual units will prefer to use the average cost method. This also helps when there are large volumes of similar items moving through inventory, making it time-consuming to track each individual item.

Special Considerations

One of the core aspects of U.S. generally accepted accounting principles (GAAP) is consistency. The consistency principle requires a company to adopt an accounting method and follow it consistently from one accounting period to another. For example, businesses that adopt the average cost method need to continue to use this method for future accounting periods. This principle is in place for the ease of financial statement users so that figures on the financials can be compared year over year. A company that changes its inventory costing method must highlight the change in its footnotes to the financial statements and apply the same method retrospectively to prior period comparative financial statements.

What Is the Average Cost Method Formula?

The average cost method formula is calculated as:

Total Cost of Goods Purchased or Produced in Period / Total Number of Items Purchased or Produced in Period = Average Cost for Period

The result can then be applied to both the cost of goods sold and the cost of goods still held in inventory at the end of the period.

Why Should I Use Average Cost Method?

Average cost method is a simple inventory valuation method, especially for businesses with large volumes of similar inventory items. Instead of tracking each individual item throughout the period, the weighted average can be applied across all similar items at the end of the period.

What Inventory Cost Methods Are Acceptable Under GAAP?

GAAP allows for LIFO, FIFO, or the average cost method of inventory valuation. On the other hand, International Financial Reporting Standards (IFRS) does not allow LIFO because it does not typically represent the actual flow of inventory through a business.

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