Average Cost Method in Manufacturing
The average cost approach is one strategy used by manufacturers to control inventory expenses. This is important because the cost of production is a key factor in determining profitability in manufacturing. The average cost method is a method of inventory valuation where the cost of goods sold and the ending inventory are valued at the average cost of all the units available for sale. This approach is used by manufacturers to control costs, monitor inventory, and precisely determine profitability. In this article, we will discuss average cost method for manufacturers
Average Cost Method Definition
The cost of goods sold (COGS), a type of inventory valuation, is computed using the average cost method, which is an accounting approach. According to this strategy, each unit’s cost is equal to the average cost of all the units in stock, and the cost of all commodities is evenly distributed across the total inventory. To calculate the price, divide the total cost of the available units by the total cost of the commodities for sale. This approach is frequently applied in fields like perishable items or those with high price volatility where it is challenging to estimate the cost of each unit.
The average cost technique, as defined by Investopedia, “uses the total cost of the securities acquired divided by the number of shares purchased to get the cost basis of an investment.” Investors frequently employ this technique to ascertain the typical price paid for shares of a mutual fund or stock over a specified time frame.
Formula for the Average Cost Technique
The cost of goods sold (COGS) and ending inventory value are calculated using the average cost method formula.
The average cost approach’s formula is as follows:
[Total Cost of Items Available for Sale] / [Total Units Available for Sale] = Average Cost Per Unit
The cost of beginning inventory and any acquisitions made throughout the accounting period are added together to get the total cost of the goods that are ready for sale.
Total Units on the Market: the total of the initial inventory plus the quantity of units bought over the accounting period.
The COGS and the value of ending inventory are computed once the average cost per unit has been calculated. The average cost per unit is multiplied by the quantity of units sold to determine the COGS. In contrast, the value of ending inventory is determined by dividing the number of units on hand by the average cost per unit.
Sample Calculation with Sample Numbers
Consider an organization that has 100 items of initial inventory that are priced at $10 each. They spend a further $200 throughout the accounting period on 200 more units, each costing $12. It is possible to determine the typical unit price as follows:
($2,800) is the amount that is the product of the available goods’ total costs (100 x $10) and (200 x $12). Units Up for Sale as a Whole = 100 + 200 = 300
Average cost per piece = $2,800/300 = $9.33
The COGS can be identified as follows if the company sells 150 units over the course of the accounting period:
COGS = 150 x $9.33 = $1,399.50
The value of the ending inventory can be determined using the formulas below if the company has 100 units on hand at the conclusion of the accounting period. 100 times $9.33, or $933, is the value of the final inventory.
8 Advantages of Average Cost Method for Manufacturers
Cost control is essential to conducting a manufacturer’s business successfully. The average cost approach is a popular cost accounting technique. Using this method, the average cost of inventory items is determined by dividing the total cost of the things that are for sale by the total number of units that are available. The average cost approach can support producers’ decisions regarding pricing, inventory control, and overall profitability in this manner. The average cost method has advantages for manufacturers.
1. Simplified Accounting
By applying a single cost for all inventory units, the average cost technique simplifies accounting. It is no longer necessary to keep track of each item’s cost, which can be tedious and challenging, particularly for businesses with huge inventory. Businesses can quickly and simply determine the cost of products sold and the value of ending inventories for financial reporting reasons by using an average cost per unit.
2. Consistent Pricing
The method provides a consistent price for inventory, making it easier to calculate profit margins and product pricing. This consistency also helps businesses maintain pricing stability, as customers will appreciate knowing that prices will not fluctuate wildly due to inventory cost changes.
3. Accurate Inventory Valuation
The approach reflects the real costs associated with product sales, resulting in a more precise inventory assessment. Manufacturers should pay special attention to this since they need to keep accurate inventory records to comply with regulations and pay taxes. The average price approach makes sure that the inventory valuation appropriately reflects the price of the goods being sold.
4. Reduces the Impact of Price Fluctuations
The method reduces the impact of price fluctuations on inventory valuation because it averages out the inventory cost over time. This benefits manufacturer who purchase raw materials or components with fluctuating costs. Using an average cost, they can reduce the impact of these fluctuations on their financial statements.
5. Reduces Errors
The method reduces the risk of errors with other inventory valuation methods, such as FIFO and LIFO. These methods require businesses to track the cost of each item individually, which can lead to errors in data entry and calculations. this implifies the process, reducing the risk of human error.
6. Easy to Use with QuickBooks
easy to use with QuickBooks, is a popular accounting software for small businesses. QuickBooks has a built-in feature that allows businesses to track inventory using it. This makes it easy for small business owners to use this method without specialized accounting knowledge.
Saves time: The method saves time by simplifying accounting and reducing the need for manual calculations.
7. Cost-effective
The method is cost-effective because it does not require expensive software or specialized accounting knowledge. the method is relatively simple and can be done with a basic understanding of accounting principles. This makes it a cost-effective option for businesses that want to maintain accurate inventory records without incurring high accounting costs.
8. Adaptable
Both large and small organizations can utilize the strategy because it can be adjusted to work with different inventory systems. The average cost technique is a flexible choice for companies of all sizes because it can be applied to both perpetual and periodic inventory systems. The technique can also be applied to several forms of inventories, such as finished goods, work-in-progress, and raw materials.
Weighted Average Cost Method vs. FIFO vs. LIFO
The financial statements and profitability of a manufacturing can be dramatically impacted by choosing the right inventory costing method. The Weighted Average Cost Method, First-In, First-Out (FIFO) Method, and Last-In, First-Out (LIFO) Method are the three generally used methods for inventory costing. Each method has unique benefits and drawbacks, so manufacturers must choose the one that best suits their unique requirements and business strategies. What are the three methods?
Weighted Average Cost Method
By taking into account the cost and quantity of each item, the weighted average cost technique determines the average cost of all inventory items. Due to its ease of use and relative simplicity, this technology is well-liked by small firms. For manufacturers who deal with a lot of inventory goods with similar costs, it is perfect. The drawback is that it might require to precisely depict the actual cost of each inventory item.
FIFO (First-In, First-Out) Method
The FIFO technique allocates the cost of the oldest inventory items to the cost of products sold since it anticipates that they are sold first. This approach is helpful when prices are rising since it lowers tax obligations and boosts profitability. Yet, it can result in greater taxes while prices are declining and be difficult to manage if there are a lot of inventory products.
LIFO (Last-In, First-Out) Method
The LIFO technique allocates the cost of the newest inventory items to the cost of products sold since it assumes that these things will be sold first. This approach is helpful when prices are rising since it lowers taxes and boosts profitability. Conversely, it may result in inflated inventory values and decreased profitability when prices are declining.
Comparison
Whereas FIFO and LIFO are more difficult, the weighted average cost method offers a straightforward approach to inventory costing. The FIFO and LIFO systems are effective in controlling inventory costs while prices are on the rise. The weighted average cost technique, in comparison, may be more precise for firms working with a large number of inventory products with comparable costs. Depending on pricing movements, FIFO and LIFO may result in higher or lower taxes and profitability, however the weighted average cost approach offers a constant cost value.
Wrapping Up
Manufacturers may successfully control their costs, keep track of their inventories, and compute profits using the average cost approach. This strategy may be especially useful for producers who produce a large number of units at comparable costs, albeit it might only be appropriate for select of them. , manufacturers can increase their profit margin and make wiser business decisions.
