What it means
When a business buys the same product at different prices through the year, it needs a rule for deciding which cost to charge when a unit is sold. The average cost method sidesteps the question by treating every unit as having the same cost.
That cost is the total spent on stock divided by the total number of units. There are two common ways to apply it.
Under the periodic approach, the average is worked out once at the end of the period using all purchases. Under the perpetual approach, a new average is calculated after every purchase, which keeps stock records up to date throughout the period.
Compared with FIFO (first in, first out) and LIFO (last in, first out), the result sits in the middle. In a period of rising prices, FIFO gives a lower cost of goods sold and higher profit, LIFO gives a higher cost of goods sold and lower profit, and the average method lands between them.
This makes it a popular choice for businesses whose products are interchangeable, such as fuel, grain, chemicals or bulk components. The method is simple to use and hard to manipulate, since the business cannot choose which batch of stock to treat as sold.
However, it may not reflect the actual physical flow of goods, and it can be slow to respond when prices change sharply. Some accounting frameworks restrict the choice of method, so a company should confirm which are allowed where it reports.
The choice of method affects reported profit, the value of inventory on the balance sheet and sometimes the tax bill. Once chosen, it should be applied consistently, and any change usually has to be disclosed and justified.
From a control point of view, the method fits well with modern stock systems, which can recalculate the average automatically after every receipt. That reduces the manual effort and the risk of arithmetic mistakes.
Finance teams should still reconcile the system's stock value to a physical count at least once a year.
In practice
Real-world examples
Example 1
A fuel distributor buys petrol in large batches at changing prices and stores everything in one tank. Because the batches mix together, it values its stock at the average cost of all fuel purchased.
Example 2
A bakery supplier buys flour in monthly deliveries at prices that move with the market. The accountant uses the average cost method, so a single expensive delivery does not make one month's profit look unusually poor.
Example 3
An electronics assembler buys identical capacitors from several suppliers at slightly different prices. Using the average cost, the finance team allocates a single cost per component to each product without tracking the batch it came from. Stock records are reviewed against a physical count at the year end to confirm the average-cost valuation.
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 = Total cost of goods available for sale / Total units available for sale
Cost of goods sold = Units sold x Average cost per unit
Ending inventory = Units remaining x Average cost per unit
Suppose a hardware wholesaler starts the month with 100 units that cost $10 each ($1,000). It then buys 300 units at $12 each ($3,600). Total cost available = 1,000 + 3,600 = $4,600 for 400 units, so the average cost = 4,600 / 400 = $11.50 per unit.
The wholesaler sells 250 units. Cost of goods sold = 250 x 11.50 = $2,875. Ending inventory = 150 x 11.50 = $1,725. Check: 2,875 + 1,725 = $4,600, which matches the cost available.Case study
Seen in the real world
Kingfisher Paints is an illustrative, fictional trade paint distributor. In a year of rising raw material costs, the cost of a drum of white paint went from $40 to $52 across four purchases.
The company held 500 drums at the start of the year at $40, then bought 500 at $44, 500 at $48 and 500 at $52. With 2,000 drums available at a total cost of $92,000, the average cost was $46 a drum, and when it sold 1,500 drums the cost of goods sold was $69,000.
Under FIFO the same sales would have carried a lower cost, and under LIFO a higher one. The finance director chose the average method because it gave a steady profit pattern across the year, and the illustrative outcome was fewer arguments with the sales team about margins. Because the method needed no tracking of batches, the warehouse team also spent less time on stock records, which the finance director counted as a further benefit.
Watch out
Common mistakes
- Taking a simple average of the purchase prices, when the calculation must be weighted by the number of units bought at each price.
- Switching between methods from year to year to improve profit, when accounting rules require consistency and disclosure of any change.
- Forgetting to recalculate the average after each purchase under the perpetual system, which leaves stock valued at an outdated cost.
Questions
People also ask
What is the difference between the average cost method and FIFO?
FIFO assumes the oldest units are sold first, while average cost assigns the same blended cost to every unit.
Is the average cost method allowed everywhere?
Most accounting frameworks allow it, although rules on other methods differ, as international standards prohibit LIFO while US rules permit it, so local rules should be checked.
Does it affect taxes?
Yes, because cost of goods sold changes taxable profit, though the method used for tax may need to follow local tax rules.
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