The weighted average for the year inventory cost flow method is applicable to which inventory system

This article is part of a larger series on Bookkeeping.

The weighted average cost (AVCO) method, also called the AVCO method, is one of the three inventory cost flow assumptions used in inventory costing. Just like FIFO and LIFO, the AVCO method is used to determine the cost of inventory at the end of the year and the cost of goods sold (COGS) during the year. Under this method, the cost of inventory is based on the weighted AVCO of inventory purchases during the year.

A cost flow assumption is how costs move from merchandise inventory on the balance sheet to the COGS on the income statement. Popular cost flow assumptions are AVCO, first-in, first-out (FIFO), and last-in, first-out (LIFO). The cost flow assumption adopted doesn’t have to match the actual physical flow of goods.

How the Average Cost Method Works

The AVCO method uses the weighted average purchase cost to determine a per-unit cost to apply to both ending inventory and COGS. It’s a compromise between the FIFO and LIFO methods because averaging reduces the effect of changing prices. Here’s the formula to compute the average unit cost:

What Type of Business Average Cost Is Best For

In a periodic inventory system, this average cost is multiplied by the number of units in ending inventory to determine the cost of ending inventory. In a perpetual inventory system, this average cost is multiplied by the number of units sold for each sales transaction to determine the COGS. We provide detailed examples of both periodic and perpetual inventory systems later in this article.

• Businesses with fluctuating inventory prices: Prices change due to economic and market conditions that companies can’t control. For example, increases in the price of crude oil affect the price of other goods. With the AVCO method, you can smooth fluctuations in inventory prices by computing the average inventory cost per unit.
• Businesses with highly intertwined products: Products that are highly intertwined, or complementary goods, have limited use if used individually. For companies selling these products, the AVCO method best depicts their relationship by commingling them into one average unit cost.
• Businesses selling agricultural produce: Maintaining the individual unit cost of agricultural produce is demanding since most are sold in bulk. It’s better to use the AVCO method to make it easier to cost agricultural products without assigning a unit cost manually.
• Businesses looking for a simple inventory costing method: The weighted AVCO method is the most straightforward inventory cost flow assumption to implement. You need not keep track of purchase dates and layers to determine inventory cost.

What Type of Business Average Cost Is Not Right For

• Businesses with relatively low purchase volumes: The essence of the AVCO method is to compute the average inventory cost every time you purchase inventory. If you don’t frequently purchase merchandise to replenish stocks, then you might prefer to use FIFO to match cost flow assumption with the physical flow of goods.
• Businesses using LIFO for tax purposes: The LIFO method of inventory costing yields the lowest net income during periods of increasing costs. That’s why some businesses use LIFO to get tax savings due to a lower taxable income. Hence, the IRS requires companies to use LIFO for bookkeeping purposes if they also use it for tax purposes.
• Businesses with high-value, small-volume items: If your business deals with a small volume of high-value items, such as jewelry and vehicles, then it’s best to use the specific identification method. Since there are only a few items to keep track of, it’s easiest and most accurate to simply keep a record of the actual cost of each item.
• Businesses using cost-plus pricing strategy: Since the unit cost of inventory changes every purchase, the AVCO method isn’t suitable if you use the cost-plus pricing strategy because you have to revise the selling price when the AVCO changes.

Advantages & Disadvantages of Using the Average Cost Method

How to Calculate Ending Inventory and COGS Using the Average Cost Method

Calculating the ending inventory is essential in inventory costing and management. It’s also a key element in determining the COGS. Let’s illustrate the AVCO method under the periodic and perpetual inventory system using the sample data below:

Beginning Inventory: 200 units at $20 each

Periodic Inventory System

In a periodic inventory system, all inventory purchases are initially recorded in the Purchases account, which substitutes for the COGS expense during the period. At the end of the period, a physical inventory count is performed and the costs in the Purchases account are separated between units sold (COGS) and units on hand (inventory) based on the AVCO per unit during the period.

First, calculate the total cost of purchases made during the entire period. In our sample data above, we show the total cost of purchases was $62,000. Then, add the total cost of purchases to the cost of beginning inventory to arrive at the cost of goods available for sale. Finally, divide the cost of goods available for sale by the total units available for sale.

The periodic inventory system requires a physical inventory count at the end of the period. If you’re using the periodic system on a monthly or quarterly basis, you can estimate the units in ending inventory. However, you must take an actual physical inventory count at year’s end.

Assume a physical inventory count reveals 270 units in ending inventory.

Now that we know the ending inventory in units, let’s multiply the weighted average unit cost by the number of units in ending inventory:

Cost of ending inventory = 270 units x $66 per unit = $17,820

Perpetual Inventory System

Under the perpetual inventory system, inventory records are maintained continuously throughout the accounting period. Whenever there’s a purchase or sale, inventory records are updated automatically. You can determine the running balance inventory under a perpetual inventory system easily without a physical count. Let’s see how the moving average method works with a perpetual inventory system.

You must perform the following steps for each inventory sale during the period or choose accounting software that will do it for you.

In a perpetual inventory system, a subsidiary ledger is kept for every inventory item. If you do this manually, you need to have a 10-column subsidiary ledger book for every item of inventory. However, accounting software programs can make things easier. QuickBooks Online is our best small business accounting software and uses the perpetual inventory system to record inventory purchases and sales in the Inventory account. If you want to learn more about it, read our QuickBooks Online review for a comprehensive analysis.

Here’s the subsidiary ledger format that we’ll use:

The COGS and Inventory calculations in the perpetual system are the same as in the periodic system, except you need to adjust the average unit cost in real-time for each purchase and sale. This is why good accounting software is ideal to use the perpetual system because maintaining perpetual records manually requires a lot of work.

In a perpetual inventory system, we always need to update our subsidiary ledgers for every sale or purchase. In our example, we started on a clean slate. Let’s first enter our beginning inventory balances in the first line of the subsidiary ledger.

The rule in a perpetual inventory system using AVCO is to always update the average unit cost before a sale. This average unit cost is called the moving average because it changes every time you purchase new inventory. The formula to compute moving average unit cost is presented below:

Then, let’s record the purchase on January 2. Enter the purchase details under the Purchases column. Always remember that the Inventory entry should present the running balances. In the quantity column, we should present the running balances. Hence, our units on hand as of January 2 are 400 units (200 units from beginning inventory and 200 units recently purchased). We’ll do the same to arrive at the total cost of $12,000.

In our books, we record the purchases directly to Merchandise Inventory since we’re using the perpetual inventory system. Remember, the periodic system records purchases in a COGS account.

We’ve determined the total cost of inventory at $12,000, but we don’t know its unit cost. Let’s use the moving average unit cost formula above:

Let’s now place the average unit cost under the Unit Cost column. In succeeding sales, we’ll now use $30 to compute COGS.

When we record a sale, we use the new average unit cost to compute the COGS. In our ledger below, we multiplied 250 units by the new average unit cost of $30.

In our books, we transfer $7,500 from our inventory account to our COGS account. Let’s now extend the sales information to the Inventory entry. First, deduct 250 units from 400 units on hand as of January 2. Then, compute the cost of inventory on hand by subtracting $7,500 COGS from the prior cost of inventory of $12,000. Notice the AVCO per unit doesn’t change when a sale is made.

In the perpetual inventory system, steps 3–4 are ones that you have to repeat in every transaction. Let’s complete our subsidiary ledger as we compute our month-end balances:

Purchase of 300 units on January 5

Let’s repeat step 3 here. First, let’s add the existing inventory and recent purchases. Then, compute the moving average unit cost.

Sale of 245 units on January 6

Let’s repeat step 4 here. Our current moving average unit cost is $56.67 (rounded). To approximate our cost of goods sold, let’s extend our moving average unit cost to at least five decimal places and round off the dollar amount to the nearest hundredths place.

COGS = 245 units x $56.66667 = $13,883.33

That’s why the manual perpetual system can be tedious because of constant averaging. Using an accounting software program or inventory management system can make things easier for you, especially in computing the moving averages.

Purchase of 200 units on January 8

For illustration purposes, let’s keep our moving average unit cost at $73.13. But if we compute for COGS, let’s extend to five decimal places to minimize rounding differences.

Sale of 235 units on January 11

COGS = 235 units x $73.12758 = $17,184.98

Purchase of 100 units on January 13

Since January 13 is our last transaction, let’s assume that no other transactions occurred during the month. Let’s foot the columns by adding the total costs under the Purchases and Cost of Goods Sold columns.

For ending inventory, we just pick the last total in the column. In this case, the ending inventory to be presented in the balance sheet is $27,431.69 and the COGS to be presented in the income statement is $38,568.31.

Comparison of Ending Inventory Balance Between Periodic and Perpetual AVCO

Since the perpetual inventory system uses a moving average, the ending balances reported under perpetual inventory can differ from periodic inventory.

Bottom Line

The average cost method is a cost flow assumption that uses the averaging technique to smooth out price fluctuations and simplify costing. However, AVCO isn’t an ideal inventory costing formula for businesses that sell unrelated products. What we’ve discussed in this article is part of your small business bookkeeping. Don’t forget to conduct a physical count of inventory to verify the accuracy of your accounting records.