Average Costing Method–Materials and Inventory Costing:

Learning Objectives:

1. Define and explain average costing method.
2. Give an example of Average costing method.
3. What are advantages and disadvantages of average costing.

1. Definition and Explanation of Average Costing Method
2. Advantages of Average Costing Method
3. Example

Definition and explanation:

Issuing materials at an average cost assumes that each batch taken from the storeroom is composed of uniform quantities from each shipment in stock at the date of issue. Often it is not feasible to mark or label each materials item with an invoice price in order to identify the used units with its acquisition cost. It may be reasoned that units are issued more or less at random as for as the specific units and the specific costs are concerned and that an average cost of all units in stock at the time of issue is satisfactory measure of materials cost. However, average costing may be used even though the physical withdrawal is an identifiable order. If materials tend to be made up of numerous small items low in unit cost and especially if prices are subject to frequent changes.

Advantages of Average Costing Method:

Average costing method has the following main advantages:

1. It is a realistic costing method useful to management in analyzing operating results and appraising future production.
2. It minimizes the effect of unusually high or low materials prices, thereby making possible more stable cost estimates for future work.
3. It is practical and less expensive perpetual inventory system.

The average costing method divides the total cost of all materials of a particular class by the number of units on hand to find the average price. The cost of new invoices are added to the total in the balance column; the units are added to the existing quantity; and the new total cost is divided by the new quantity to arrive at the new average cost. Materials are issued at the established average cost until a new purchase is recorded. Although a new average cost may be computed when materials are returned to vendors and when excess issues are returned to the storeroom, for practical purposes, it seems sufficient to reduce or increase the total quantity and cost, allowing the unit price to remain unchanged. When a new purchase is made and a new average is computed, the discrepancy created by the returns will be absorbed.

Example:

Calculations for the above transactions would be as follows

Average Costing Method Calculation Illustrated

You may also be interested in other useful articles from “controlling and costing materials” chapter:

1. Purchases of productive material
2. Purchases of supplies, services, and repairs
3. Materials purchasing forms
4. Receiving materials
5. Invoice approval and data processing
6. Correcting invoices
7. Electronic data processing (EDP)  for materials received and issued
8. Cost of acquiring materials
9. Storage and use of materials
10. Issuing and costing materials into production
11. Materials ledger card – perpetual inventory
12. First-in-First-Out (FIFO) Costing Method
13. Average Costing Method
14. Last-in-First-Out (LIFO) Costing Method
15. Other Methods-Month end average cost, last purchase price or market price at date of issue, and standard cost
16. Inventory valuation at cost or market whichever is lower
17. American Institute of Certified Public Accountant (AICPA) cost or market rules
18. Adjustments for departures from the costing method used
19. Inventory pricing and interim financial reporting
20. Transfer of materials cost to finished production
21. Physical inventory
22. Adjusting Materials Ledger Cards and Accounts to Conform to Inventory Accounts
23. Scrap and waste
24. Spoiled goods
25. Defective work
26. Discussion Questions and Answers about Controlling and Costing Materials