Average costing is the application of the average cost of a group of assets to each asset within that group. For example, if there are three widgets having individual costs of $10, $12, and $14, average costing would dictate that the cost of all three widgets be treated as though they were $12 each, which is the average cost of the three items.
The average costing calculation is:
Cost of goods available for sale ÷ Total units from beginning inventory and purchases
This method can also be used to determine the average amount invested in each of a group of securities. Doing so avoids the larger amount of work required to track the cost of each individual security.
Average Costing Advantages
Average costing works well in the following situations:
- Where it is difficult to track the cost associated with individual units. For example, it can be applied where individual units are indistinguishable from each other.
- When raw material costs move around an average cost point in an unpredictable manner, so that an average cost is useful for long-term planning purposes (such as in the development of a budget).
- When there are large volumes of similar items moving through inventory, which would otherwise require considerable staff time to track on an individual basis.
Also, this method requires little labor, and so is among the least expensive of the cost accounting methodologies to maintain.
Average Costing Disadvantages
Average costing does not work well in the following situations:
- When the units in a batch are not identical, and therefore cannot be treated in an identical manner for costing purposes.
- When inventory items are unique and/or expensive; in these situations, it is more accurate to track costs on a per-unit basis.
- When there is a clear upward or downward trend in product costs, average costing does not provide a clear indication of the most recent cost in the cost of goods sold. Instead, being an average, it presents a cost that may more closely relate to a period some time in the past.