What it means
When identical items are bought at different prices, some rule is needed to decide what each unit sold cost. The average cost method takes the total cost of opening stock plus purchases and divides it by the total number of units, producing a weighted average cost per unit.
That average is charged to cost of goods sold for every unit sold and carried in inventory for every unit left. Because it smooths the cost across purchases, a period of rising prices produces a cost of sales lower than LIFO's and higher than FIFO's, and a closing inventory value that sits between the two.
There are two versions. The periodic weighted average calculates one average for the whole period, after all purchases are known, and is used by businesses that count and value stock at period end.
The perpetual moving average recalculates the average after every purchase and applies the current average to each sale as it happens; it is what most inventory systems do automatically. The two give slightly different results in the same period because the moving average charges early sales at the earlier, lower average.
The method suits businesses whose stock is homogeneous and mixed physically, such as bulk commodities, liquids, grains, chemicals and fasteners, where identifying which unit was bought when is impossible and meaningless. It also suits high-volume retail and distribution, where scanning systems can maintain a moving average per line with no effort.
Its weakness is the same as its strength: by averaging, it obscures the effect of recent price changes on margins, so a business in a period of sharp cost inflation may not see the squeeze in its gross margin as quickly as it would under FIFO's more current inventory value or LIFO's more current cost of sales. As with all inventory methods, the choice must be applied consistently and disclosed, closing inventory must still be tested against net realisable value, and the total cost charged over the life of the business is the same whatever method is used; only the timing differs.
In practice
Real-world examples.
Example
A fuel distributor values its tank stock on a moving average because deliveries at different prices are physically mixed and cannot be separated.
Example
A hardware retailer's point-of-sale system maintains a moving average cost for each of 40,000 product lines and updates it with every goods receipt.
Example
A grain merchant uses a periodic weighted average for each silo, calculated at month end from purchase records and the closing stock measurement.
Think of it
“Average cost uses the average price of all purchases to value inventory-smoothing out price swings.
Formula
Calculation
Weighted Average Cost per Unit = (Cost of Opening Inventory + Cost of Purchases) / (Units in Opening Inventory + Units Purchased)
Cost of Goods Sold = Units Sold x Weighted Average Cost
Closing Inventory = Units Remaining x Weighted Average Cost
Worked example. A garden centre's stock of a compost product over a quarter:
- Opening stock: 500 bags at $4.00 = $2,000
- Purchase 1: 800 bags at $4.50 = $3,600
- Purchase 2: 700 bags at $5.00 = $3,500
- Total available: 2,000 bags costing $9,100
- Sales during the quarter: 1,600 bags at $9.00 = $14,400
Periodic weighted average:
- Average cost = $9,100 / 2,000 = $4.55 per bag
- Cost of goods sold = 1,600 x $4.55 = $7,280
- Closing inventory = 400 x $4.55 = $1,820
- Gross profit = $14,400 minus $7,280 = $7,120 (49.4%)
For comparison, FIFO would charge 500 at $4.00, 800 at $4.50 and 300 at $5.00 = $7,100, giving closing stock of $2,000 and gross profit of $7,300. LIFO would charge 700 at $5.00, 800 at $4.50 and 100 at $4.00 = $7,500, giving closing stock of $1,600 and gross profit of $6,900. The average method sits between them.
Perpetual moving average, if 600 bags were sold after purchase 1 and 1,000 after purchase 2:
- After purchase 1: 1,300 bags costing $5,600; average $4.308. First sale of 600 costs $2,585; remaining 700 bags at $3,015.
- After purchase 2: 1,400 bags costing $6,515; average $4.654. Second sale of 1,000 costs $4,654; remaining 400 bags at $1,861.
- Total cost of goods sold = $7,239; closing inventory $1,861; gross profit $7,161.Case study
Seen in the real world.
A chemicals distributor used the weighted average method and reported steady gross margins of 22% through a year in which its main input cost rose 35%. The finance director, presenting the results, was pleased; the operations director, who bought the product, was puzzled, because every replacement order was costing far more than the stock it replaced. The explanation was the averaging: the cost of sales still carried a large weight of older, cheaper purchases, so the margin on sales at current prices was overstated.
When the old stock finally worked through, the reported margin fell to 15% in a single quarter, and the sales team, who had been holding prices on the strength of the reported margin, had to push through increases all at once. The company kept the average cost method for its accounts but added a replacement-cost margin report for pricing decisions, so that selling prices would move with purchase costs rather than with the average of the past.
Watch out
Common mistakes.
- Reading the reported margin as the margin on current purchases during periods of rapid cost change. The average lags.
- Mixing periodic and perpetual averaging within a period, which produces inconsistent figures.
- Forgetting the net realisable value test. Average cost still has to be written down if stock cannot be sold for more than it cost.
Questions
People also ask.
How is the average cost method different from FIFO?
FIFO charges the oldest costs to sales and carries the newest in inventory. Average cost blends all costs into one figure for both.
Which businesses should use average cost?
Those with homogeneous, physically mixed stock, and those with high volumes of lines where a system-maintained moving average is simplest. Businesses that need to see the effect of the latest costs on margin may prefer FIFO.
Does the average cost method affect tax?
It affects the timing of profit, and therefore tax, in periods of changing prices. In rising markets it reports more profit than LIFO and less than FIFO.
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