Average Cost (AVCO) Method

Average value of cost (AVCO) method or simple average cost method, as the name suggests, determines the value of ending inventory and cost of sales on the basis of average cost of units available for sale.



Average cost of inventory available for sale is calculated using a simple formula as follows:

Average Cost per unit = Cost of total inventory available for sale
Units of total inventory available for sale

AVCO method assumes that inventory is held collectively at one place and thus each batch loses its individuality. And entity use or consume the units randomly unlike FIFO or LIFO method where it is fixed if oldest units are taken or newest ones. Therefore, cost is averaged out and one single rate is used for inventory valuation unlike FIFO and LIFO where remaining units from the batch are carried at the respective purchase or production cost.

The implications of AVCO usage in different economies depends not only on pricing but also the quantity purchased.

  1. In economies with rising prices if entity has made large purchases at or near the end of the period then it will result in higher average cost. However, if entity buys annual demand at or near the start of the period then it will result in lesser average cost per unit.
  2. Similarly in economies with falling prices, if entity buys purchases major portion of annual demand at or near the end of the period then it will result in lesser average cost per unit. On the other hand if large purchases of inventory are made at or near the start of the period then it will result in higher average cost per unit.

1 AVCO under different inventory systems

As discussed before that management may choose to follow either of the two inventory recording systems i.e. perpetual inventory system or periodic inventory system, the choice of inventory system will affect the ending inventory value and cost of sales value under AVCO method unlike FIFO method which gives the same result.

With periodic system in place the calculations are done at the end of the period. Therefore, average cost will be calculated on the basis of all the units that were available for sale i.e. beginning inventory + inventory purchased during the period. As the calculate also consider the number of units for each price therefore it is considered weighted average method as it gives weighted average cost per unit. So at the end a single rate is computed and the same is used to determine cost of ending inventory and cost of units sold.

Under perpetual system however, the recording is done as and when inventory related transaction occur. New average cost per unit is calculated every time new batch of inventory is purchased. Especially if price per unit of inventory bought is different from average cost per unit of inventory held. Because of this if price per unit of new purchase is lesser than computed average cost per unit than it will result in lower average cost and if price per unit is higher then it will push the average cost higher too. As new average is calculated after every purchase and thus practically it is an example of moving average method and also used to mean AVCO under perpetual method.

The following example explains the application of AVCO under periodic and perpetual inventory systems.

Example: AVCO under Periodic and Perpetual Inventory Systems

1-Jul
3-Jul
7-Jul
15-Jul
18-Jul
22-Jul
25-Jul
28-Jul
31-Jul
Starting inventory
Purchases
Purchases
Sales
Purchases
Sales
Sales
Purchases
Sales
76 units @ $10/unit
150 units @ $12/unit
50 units @ $11/unit
100 units
80 units @ $15/unit
120 units
10 units
200 units @ $14/unit
67 units

Calculate the Cost of Sales and Ending inventory value using FIFO method under:

(a) Periodic system
(b) Perpetual system

Solution:

(a) AVCO Inventory valuation under Periodic system

Calculation of total units available for sale and related total cost

DateTransactionUnitsRateTotal
1-Jul
3-Jul
7-Jul
18-Jul
28-Jul
Opening inventory
Purchases
Purchases
Purchases
Purchases
76
150
50
80
200
10
12
11
15
14
760
1800
550
1200
2800
5567110

Calculation of average cost per unit:

Average cost per unit = 7110 = 12.788
556

Physical count of inventory:

As we cannot count the inventory here so we are assuming it be same as we expect after all the transactions of purchases and sales and we can calculate the units:

= Units available for sale – Sales = Ending inventory
= 556 – (100+120+10+67)
= 556 – 297
= 259

Valuation of Ending inventory and Cost of Sales

Ending inventory 259 units @ 12.788 = 3312
Cost of Sales 297 units @ 12.788 = 3798

(b) AVCO Inventory valuation under Perpetual system

Under perpetual system all changes inventory are recorded as they happen, therefore we have a chronological record of all the transactions and at the end of the period we automatically get the cost of goods sold and value of ending inventory.

DatePurchasesSalesBalance
JulyQty.RateTotalQty.RateTotalQty.RateTotal
17610.000760
315012180022611.3272560
7501155027611.2683110
1510011.268112717611.2681983
188015120025612.4343183
2212012.434149213612.4341691
251012.43412412612.4341567
2820014280032613.3954367
6713.39589725913.3953469
2973641

Just to clarify, even in this situation we are using the same formula as discussed above for average cost per unit calculation. However, it is recalculated after every purchase. For example by July 3 the status of inventory was:

Inventory in store 76 @ $10/unit 760
Inventory purchased 150 @ $12/unit 1800
226 2560

Average cost per unit is: 2560 / 226 = 11.327

And same approach is used every time purchase is done. And for the units sold the immediate last average rate in balance is used. For example for sales of 100 units on July 15, the rate of 11.268 is used that was calculated after the purchase of July 7.