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Average Cost Method: Definition, Formula, Advantages and Disadvantages

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Added on  2019-09-30

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This blog explains the Average Cost Method, a method of inventory costing, its definition, formula, advantages and disadvantages. It also covers the objectives of the method, the way to calculate it, and its application. The blog is relevant for accounting and finance students and professionals.

Average Cost Method: Definition, Formula, Advantages and Disadvantages

   Added on 2019-09-30

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BLOG: AVERAGE COST METHODWHAT IS AVERAGE COST METHOD AND HOWTO CALCULATE?
Average Cost Method: Definition, Formula, Advantages and Disadvantages_1
What is Average Cost Method and how to calculate?25thJune, 2019The industrial revolution has instigated the need for developing cost accounting because of therapid growth and development of businesses. Prior to industrialisation, most of the businessorganisations were small and medium in size. Therefore, those organisations operate their regularbusiness by using conventional accounting system to accounting purpose. That time, they did notrealise the need for a separate accounting system that could assist them to measure and analysecosts in a separate manner. After that, the era of industrial revolution turned the face of businessorganisations in respect of operations, scale, and structure. Business organisations have grownand developed vastly and due to this, the complexities of business operations also increased.Most importantly, in large business organisations the need for tracking costs become crucial forthe successful and hassle-free business operations. Thus, the increasing complexities in businessoperations and dynamic business environment instigated the need for effective management andthis accordingly becomes the reason behind the emergence of the cost accounting system.The need of improving management system and business activities of large and medium sizecompanies has provoked the evolution of cost accounting system. Cost accounting is a branch ofaccounting that solely involves in collecting, analysing, recording, summarising, interpreting,and reporting financial data and information of a business organisation. Over the passing time,cost accounting system developed and a number of arms are added to it. One of its arms isaverage cost method. Average cost methodrefers to a method of inventorycosting and byapplying this method cost of every single item in a company's inventory is computed on the basisof the average costof all the similar items present in the total inventory. This methodiscalculated by dividing thetotal costof items (goods) in inventory by the total unit of goods,present in the total inventory, available to the company for conducting sales activities. This method is also known as weighted average method. Under this method, the cost ofinventory is assumed on the basis of the average cost of goods available in a company's hand forsale during a particular period.
Average Cost Method: Definition, Formula, Advantages and Disadvantages_2
Definition and Objectives of Average Cost MethodThe average cost method is a method of calculating the cost of inventory. In order to calculatethe average cost of inventory, the total cost of inventory and number of items or units present inthe total inventory is considered. The average cost method is a process of assigning relevantcosts to each item in inventory at the time of selling such inventory item. Some businessorganisations choose to apply average method rather than using other inventory valuationmethods such as LIFO (last-in-fast-out) or FIFO (first-in-first-out) because average costmethoduses to minimise the drastic and sometimes negative effects of allocating costs on theinventory items on the basis of such item’s value on the date of purchase.The objective of using the average cost method for inventory valuation is to calculate the cost ofending inventory by using weighted-average cost per unit. It is applied for determining per unitcost of similar kinds of inventory items like identical electrical equipment in a hardware shop ortoy in a toy store. Since the inventory items are alike, companies become able to assign the samecost per unit. The two major objectives of average cost method include assisting a company tocalculate its inventory in a simple and easy manner and helping the company to compute incomefrom business accurately. This method also aimed to help a company to avoid manipulation inincome calculation and unnecessary complexities while calculating its inventory. Anotherobjective of average cost method is ensuring the company about the accuracy of inventory costand cost of goods sold both of which are highly significant for measuring a company’s actualincome for a specific financial period. Description and formula of Average Cost MethodA company that offers products and services to customers needs to deal with inventories. Acompany offers products to the final customers by either purchasing the same from one of twomanufacturers of the products or produced by it. The items of inventory a company uses to sellout must be recorded on the income statement of the company asCOGS (Cost of Goods Sold).Cost of Goods Sold is a fundamental element for companies, investors, and trade analysts
Average Cost Method: Definition, Formula, Advantages and Disadvantages_3

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