Average Cost (AVCO) is one of the method to assign costs to inventory and determine cost of sales value. And it can be used with either periodic inventory system or perpetual inventory system.
AVCO has many advantages that is why it is widely popular among accountants and analysts however it does have some limitations that are discussed in detail below.
1 Advantages of AVCO method
- Biggest advantage of using AVCO method over other cost formulas like FIFO or LIFO is that it significantly simplifies calculation and record keeping and can easily process even if entity has high frequency of inventory ordering. As bookkeepers don’t have to keep track of each and every batch bought and its respective price, volume of record and probability of human error greatly reduces.
- AVCO is much better method than FIFO or LIFO when it comes to goods that cannot be separated or it is impossible to distinguish one batch of goods from the other for example, earth produce like oil, wheat, iron ore etc. When they are extracted the batches loose their individual identity and thus used in random. AVCO treats the inflow of inventory in the same way as identity of each batch is lost when average cost is calculated. Therefore, it is much suited and relevant in such industries.
- AVCO is widely accepted method for inventory valuation and it is also permitted under numerous accounting standards and guidelines e.g. IFRSs permit use of AVCO method.
- AVCO method automatically adjust the effects of random price hikes and dips especially near the end and start of the period. Suppose entity has units left from only that batch that was bought in the last month when prices suddenly increased many folds but are expected to go normal again then in such case if FIFO method is used it will cause disproportion because of increased ending stock value. But AVCO method will manage it much better as it will spread the effect of hike and thus normalize sudden fluctuations.
- Cost of sales calculation will be much more consistent and less affected by prices changes under AVCO method as compared to FIFO and LIFO. In case of rising prices, unlike FIFO method which gives understated cost of goods sold, or LIFO method which will give cost of goods sold of the whole period as per prices prevailing at the end of period, AVCO will be in the middle of both. Therefore, the making period-to-period comparisons much more meaningful and requiring lesser adjustments unlike FIFO or LIFO that may require price adjustments for analysis purposes.
2 Disadvantages of AVCO Method
- Cost of ending inventory determined under AVCO method may be significantly different from the prices prevailing for similar products at such date. Thus making it difficult to make appropriate judgement regarding lower of cost and NRV rule. As closing stock figure is significant in profit and current asset totals, these figures may be unreliable for decision making purposes and may require reinstatement for assessment purposes.
- If entity is using cost plus pricing strategy to price its products, then every time new purchase is made at a different rate than previous it will cause price to change as well. Such frequency of price change may annoy customers and also difficult for management to quote to its potential clients and related pricing and costing decisions.
- Under AVCO method each batch loses its identity, thus it may become hard to correctly value the items where age of unit plays an important role. In such situations, AVCO will be of much lesser help than FIFO or LIFO that keep track of individual batch of units produced or bought.
- The average cost calculation often give cost per unit in long decimals that are rounded for record purposes. Such approximation differences may become material collectively by the end of the period especially if it involves large volumes of transactions. And may end up distorting gross profit and current asset figures.
- Although AVCO method help normalize the fluctuations but it may still be affected if large quantities of inventory are purchased at the start or end of the period especially when prices differ from the rest of the period.