What is Average Cost Method?
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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. Average cost method is also known as weighted-average method.
Definition
The Average Cost Method allocates the cost of inventory items by dividing the total cost of goods purchased or produced in a period by the total number of goods purchased or produced. It is also known as the Weighted Average Method.
Origin
The origin of the Average Cost Method can be traced back to early accounting practices when businesses needed a simple way to calculate inventory costs. As industrialization progressed and businesses expanded, this method became widely adopted, especially in the early 20th century, with the establishment and refinement of accounting standards, making it a standard inventory valuation method.
Categories and Features
The Average Cost Method is mainly divided into two types: Moving Weighted Average and Periodic Weighted Average. The Moving Weighted Average recalculates the average cost after each purchase, while the Periodic Weighted Average calculates it at the end of a specific accounting period. Its features include simplifying the inventory cost calculation process and reducing the impact of price fluctuations on financial statements, though it may obscure actual cost fluctuations.
Case Studies
Case Study 1: A manufacturing company frequently purchases raw materials within a quarter and uses the Moving Weighted Average to calculate the average cost after each purchase, reflecting a more stable cost change in financial statements. Case Study 2: A retail company uses the Periodic Weighted Average at the end of the quarter to calculate inventory costs, ensuring consistent cost allocation in financial reports and avoiding profit fluctuations due to price changes.
Common Issues
Common issues investors face when using the Average Cost Method include its inability to reflect actual market price fluctuations, potentially leading to misleading interpretations of financial statements. Additionally, in markets with significant price volatility, the Average Cost Method may be less accurate than other methods.
