Average Cost Method

The average cost method is a way of determining the value of a group of like assets
without an in-depth appraisal of each individual component. Basically, this method
derives results by adding the costs of all individual assets, and then dividing by the
number of assets in the group, producing a measure of the value of each individual asset.
The average cost method has the virtue of being simple and easy to understand, and is
generally as accurate as more elaborate methods of cost derivation.

Average Cost Method Formula

The formula used in average cost method accounting is the same as in typical averaging
methods. Basically, it can be expressed as: • Total Cost for all Units / Total Number of
Units = Average Cost per Unit This formula is the same whether dealing with the average
cost method of inventory control or for securities; for high-volume investors, however,
the process of deriving the total cost for all securities purchased for average cost method
accounting can be time-consuming and complex.

Average Cost Method Example for Securities

For instance, if an investor purchases three shares of stock in a particular company over
the course of three weeks, the price per share will likely vary with each individual
purchase. If the price for the first share is $10.00, the second $9.00, and the third $20.00,
then by applying the average cost method formula, the investor would add together the
three amounts and arrive at a total cost of $39.00 for all three. By then dividing $39.00 by
3, the investor would derive the average cost of $13.00 per share, which can be used as a
cost basis for all shares in determining net gain or loss upon eventual resale.

FIFO

FIFO operates under the assumption that the first product that is put into inventory is also
the first sold. An example of this in action can be made when we assume that a widget
seller acquires 200 units on Monday for $1.00 per unit. The next day, he spots a good
deal and gets 500 more for $.75 per unit. When valuing inventory under the FIFO
method, the sale of 300 units on Wednesday would create a cost of goods sold of $275.
That is, 200 units at $1.00 each and 100 units at $.75 each. In this way, the first 200 units
on the income statement were valued higher. The remaining 400 widgets would be valued
at $.75 each on the balance sheet in ending inventory.
LIFO

LIFO assumes instead that the last unit to reach inventory is the first sold. Using the same
example, the income statement and balance sheet would instead show a cost of goods
sold of $225 for the 300 units sold. The ending inventory on the balance sheet would be
valued at $350 in assets. When this method is used on older inventories, the company’s
balance sheet can be greatly skewed. Consider the company that carries a large quantity
of merchandise over a period of 10 years. This accounting method is now using 10-year-
old information to value its assets.

Weighted Average
Average Cost works out a weighted average for the cost of goods sold. It takes an
average cost for all units available for sale during the accounting period and uses that as a
basis for the cost of goods sold. To site our example again, we would calculate the cost of
goods sold at [(200 x $1) + (500 x $.75)]/700, or $.821 each. The remaining 400 units
would also be valued at this rate on the balance sheet in ending inventory.

Unit Price

The "Unit Price" (or "unit cost") tells you the cost per liter, per
kilogram, per pound, etc, of what you want to buy.

Just divide the cost by the quantity:

Example: 2 liters for $3.80 is $3.80/2 liters = $1.90 per liter

Comparing
Comparing Unit Prices can be a good way of finding which is the "best buy".

Example: What is best

• 2 liters of Milk at $3.80, or

 • 1.5 liters of Milk at $2.70 ?

In this case the "Unit" is 1 liter, and the Unit Prices are:

• $3.80 / 2 liters = $1.90 per liter

• $2.70 / 1.5 liters = $1.80 per liter

So the lowest Unit Price (and the best bargain) is 1.5 liters at $2.70.

Of course it doesn't tell you the quality of what you are buying, but it can help you make
a decision.

If something is sold in number of items (for example "10 pencils") then the same method
can be used:

Example: What is best

• 10 pencils for $4.00, or

• 6 pencils for $2.70 ?

Here is the Unit Cost:

• $4.00 / 10 = $0.40 per pencil

• $2.70 / 6 = $0.45 per pencil

So the lowest Unit Price (and the best bargain) is 10 pencils for $4.00