Under the Average Cost Method, it is assumed that the cost of inventory is based on the average cost of goods that are available for sale during the period.
The average cost is calculated by dividing the total cost of goods available for sale by the total units available for sale. This gives you a weighted-average unit cost that is applied to units in the ending inventory.
There are two commonly used average cost methods:
- Simple weighted average cost method.
- Perpetual weighted average cost method.
Weighted Average Cost Method.
Weighted Average Cost is a method of calculating inventory cost.
It takes the Cost of Good Available for Sale and divides it by the number of units available for sale. This gives the Weighted Average Cost per Unit. A physical inventory count is then performed on the ending inventory to determine the number of goods that remain. This quanitity is multiplied by Weighted Average Cost per Unit to give an estimate on the ending inventory cost. The cost of goods sold valuation is the amount of goods sold multiplied by the weighted-average cost per unit. The sum of these amounts equals the actual cost of all purchases and beginning inventory.
Perpetual weighted-average cost method.
Assume that both the beginning inventory and beginning inventory costs are known. The Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, the purchase costs are added to beginning inventory cost to get Cost of Current Inventory. The number of units that are bought, is added to beginning inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods.
During the year, multiple sales may also take place. The Current Goods Available for Sale is deducted by the amount of goods sold. The Cost of Current Inventory is deducted by the amount of goods sold multiplied by the latest Current Cost per Unit on Goods. This deducted amount is then added to Cost of Goods Sold.
At the end of the financial year, the last Cost per Unit on Goods, along with a physical count is used to determine ending inventory cost.