Average Cost Inventory Method, AVCO

By Yuriy Smirnov Ph.D.

Definition

The average cost inventory method is an accounting technique used to calculate the cost of goods sold and ending inventory. The idea behind it is to assign a weighted average unit cost to the cost of a product.

Formula

The formula of weighted average unit cost can be expressed as follows:

Calculation Example

XYZ Ltd has made following transactions during the first quarter:

Let’s compute the ending inventory on 31st of March and cost of goods sold using the weighted average cost inventory method.

AVCO Periodic Inventory System

In the periodic inventory system, the inventory balance is updated once at the end of the accounting period. Thus, we should find the weighted average unit cost first.

Total units available for sale = 45,000 + 75,000 + 90,000 + 60,000 = 270,000 units

Inventory’s total cost = 45,000 × $150 + 75,000 × $165 + 90,000 × $175 + 60,000 × $170 = $45,075,000

Weighted average unit cost = $45,075,000 ÷ 270,000 = $164.94

Second, we should compute the number of units sold to find the ending inventory.

Units sold = 23,000 + 27,000 + 35,000 + 65,000 + 35,000 + 42,000 = 227,000 units

Ending inventory = 270,000 – 227,000 = 43,000 units

Ending inventory cost = 43,000 × $166.94 = $7,178,611.11

Please note that the cost of goods sold (COGS) is a balancing figure that is calculated as follows:

COGS = Beginning Inventory + Purchases - Ending Inventory

Beginning inventory = 45,000 × $150 = $6,750,000

Purchases = 75,000 × $165 + 90,000 × $175 + 60,000 × $170 = $38,325,000

COGS = $6,750,000 + $38,325,000 – $7,178,611.11 = $37,896,388.89

AVCO Perpetual Inventory System

In the perpetual inventory system, the “Cost of Goods Sold” account and “Inventory” account are updated each time a transaction is made.

Jan 1

Inventory = 45,000 units

Inventory Account Balance = 45,000 × $150 = $6,750,000

Jan 10

Inventory = 45,000 + 75,000 = 120,000 units

Inventory Account Balance = $6,750,000 + 75,000 × $165 = $19,125,000

Weighted average unit cost = $19,125,000 ÷ 120,000 = $159.38

Jan 15

COGS = 23,000 × $159.38 = $3,665,625

Inventory = 120,000 – 23,000 = 97,000 units

Inventory Account Balance = $19,125,000 – $3,665,625 = $15,459,375

Jan 27

COGS = 27,000 × $159.38 = $4,303,125

Inventory = 97,000 – 27,000 = 70,000 units

Inventory Account Balance = $15,459,375 – $4,303,125 = $11,156,250

Feb 3

COGS = 35,000 × $159.38 = $5,778,125

Inventory = 70,000 – 35,000 = 35,000 units

Inventory Account Balance = $11,156,250 – $5,778,125 = $5,778,125

Feb 12

Inventory = 35,000 + 90,000 = 125,000 units

Inventory Account Balance = $5,778,125 + 90,000 × $175 = $21,238,125

Weighted average unit cost = $21,238,125 ÷ 125,000 = $170.63

Feb 21

COGS = 65,000 × $170.63 = $11,090,625

Inventory = 125,000 – 65,000 = 60,000 units

Inventory Account Balance = $21,238,125 – $11,090,625 = $10,237,500

Mar 4

Inventory = 60,000 + 60,000 = 120,000 units

Inventory Account Balance = $10,237,500 + 60,000 × $170.63 = $20,437,500

Weighted average unit cost = $20,437,500 ÷ 120,000 = $170.31

Mar 14

COGS = 35,000 × $170.31 = $5,960,937.5

Inventory = 120,000 – 35,000 = 85,000 units

Inventory Account Balance = $20,437,500 – $5,960,937.5 = $14,476,562.5

Mar 25

COGS = 42,000 × $170.31 = $7,153,125

Inventory = 85,000 – 42,000 = 43,000 units

Inventory Account Balance = $14,476,562.5 – $7,153,125 = $7,323,437.5

The total cost of goods sold amounted to $37,751,562.5, and the ending inventory is $7,323,437.5.

Please note that the cost of goods sold may differ in both the periodic and perpetual average cost inventory system!

Average Cost Inventory System Journal Entries

The journal entries differ for the perpetual and periodic average cost inventory systems. Let’s assume that RetailPro Ltd has made following transactions during June:

Periodic Inventory System

The periodic inventory system assumes that all purchases of inventory during the accounting period are recorded in the “Purchases” account, which is updated after each transaction. The “Inventory” account is updated only once at the end of the accounting period. Let’s assume that all purchases and sales were made on credit. In that case, an accountant should make following journal entries:

Sale of inventory is recorded by debiting the “Accounts Receivable” account and crediting the “Sales” account. Purchase of inventory should be recorded by debiting the “Purchases” account and crediting the “Accounts Payable” account.

In the periodic inventory system, the closing entry should be made at the end of the accounting period to update the “Inventory” and “Cost of Goods Sold” accounts.

Beginning inventory = 3,000 × $75 = $225,000

Total units available for sale = 3,000 + 4,500 + 3,500 = 11,000 units

Inventory’s total cost = 3,000 × $75 + 4,500 × $80 + 3,500 × $90 = $900,000

Weighted average unit cost = $900,000 ÷ 11,000 = $81.82

Purchases = 4,500 × $80 + 3,500 × $90 = $675,000

Units sold = 1,600 + 2,300 + 2,800 = 6,700 units

Ending inventory = 11,000 – 6,700 = 4,300 units

Ending inventory cost = 4,300 × $81.82 = $351,818.18

COGS = $225,000 + $675,000 – $351,818.18 = $548,181.82

Thus, the closing entry should look as follows:

Perpetual Inventory System

In the perpetual inventory system, the update of the “Inventory” account balance and “Cost of Goods Sold” account balance is made each time a purchase or sale is made.

Jun 1

Inventory is represented by 3,000 units at a cost of $75 per unit.

Jun 6

COGS = 1,600 × $75 = $120,000

Inventory Account Balance = (3,000 – 1,600) × $75 = $105,000

Jun 9

Purchase = 4,500 × $80 = $360,000

Inventory Account Balance = $105,000 + $360,000 = $465,000

Weighted average unit cost = $465,000 ÷ (1,400 + 4,500) = $78.81

Jun 14

COGS = 2,300 × $78.81 = $181,271.19

Jun 23

COGS = 2,800 × $78.81 = $220,677.97

Inventory Account Balance = $283,728.81 – $220,677.97 = $63,050.84

Jun 23

Purchase = 3,500 × $90 = $315,000

Inventory Account Balance = $63,050.84 + $315,000 = $378,050.85

If all purchases and sales are made on credit, journal entries should look as follows:

Any sale requires two entries in the journal. The first entry is debiting the “Accounts Receivable” account and crediting the “Sales” account by sale value. The second entry is debiting the “Cost of Goods Sold” account and crediting the “Inventories” account by the cost of goods sold value.

Any purchase of inventory is recorded by debiting the “Inventory” account and crediting the “Accounts Payable” account.

Advantages and Disadvantages

Advantages

1. The biggest advantage of the average cost method is its simplicity because there is no need to track each batch as in the FIFO and LIFO inventory methods.
2. It is permitted by many accounting standards, including GAAP and IFRS.
3. It is also very convenient when it is impossible to distinguish each separate batch. Common examples of such goods are such commodities as crude oil, iron ore, steam coal, wheat, and soya bean.
4. The AVCO method helps to normalize unexpected price fluctuations.

Disadvantages

1. The average cost inventory should not be applied if prices from batch to batch vary greatly. The problem is that the cost of more expensive units are understated, and the sales price will not cover the actual cost of a unit.
2. The method is appropriate only for identical units. If units in a new batch have some extra features, it is correct to mix them with older ones.