Average Cost

The average cost method attempts to create a balance between FIFO and LIFO by using an average cost for the calculation of ending inventory and COGS. For each sale, the average cost per unit is calculated by dividing the total cost paid for all the units on hand (before the sale took place) by the number of units on hand. When average cost is used, the ending balance for inventory and the amount of cost of goods sold, and thus net income, will be somewhere in between what they would have been under FIFO and LIFO.

The IRS does not permit the average cost method to be used on a company’s tax return. If a company chooses to use the average cost method for financial reporting, it can use only FIFO for income tax reporting. Using the average cost method for financial reporting and LIFO for income tax reporting is not an option, because, as noted above (in “Limitations of LIFO”), if LIFO is used on the income tax return, tax regulations in the U.S. state that LIFO must be used for financial reporting as well.

Average Cost in the Periodic System: A Weighted Average

In the periodic system, average cost is called the weighted average method. At the end of the period, the company determines the total number of units it had available for sale during the period (beginning inventory plus inventory purchased during the period) and the total cost it paid for all the units available for sale. By dividing the total cost by the total units available for sale, the company determines an average cost for each unit of inventory available for sale during the period. The average cost per unit is applied to the units on hand at the end of the period as well as to the units sold to calculate ending inventory and COGS, respectively. The calculation of the weighted average cost in the periodic system is done only at the end of the period.

Average Cost in the Perpetual System: A Moving Average

When the average cost method is performed on a perpetual basis, the method is called the moving average method because the average applied to ending inventory and COGS is constantly changing because of calculating a new average cost after each purchase of inventory.

The process of using average cost in a perpetual system is slightly difficult mathematically because of the need to keep track at all times of the current inventory in respect to both units and total cost. Each time a new purchase is made, a new average cost must be calculated, and this new average cost is then used as the cost per unit for all sales made afterwards until the next purchase is made, at which point a new average cost will be calculated.

The perpetual system provides a more accurate reflection of inventory transactions than the periodic system, but it requires extensive time and effort to collect, input, and process the data.