There is nothing mystical or deceiving about average cost. It is an extremely straightforward accounting concept. The calculation gives the average cost of similar goods sold during a specific time period. Its purpose is to allocate the cost of goods available for sale on the basis of the weighted average unit cost incurred.
Average Cost Formula
Calculating average cost assumes that the goods are similar in nature, meaning the average cost formula shouldn't be used to figure the average cost of apples and oranges, but of apples separately from oranges. The formula used by the accounting community to figure average cost is:
Cost of goods available for sale/Total units available for sale = Weighted average unit cost
Average Cost and Cost Structures
Not all products are sold using the same cost structure. Some products are sold using a unit of measurement (pound, ounce, fluid ounce, dozen, half-dozen, etc.) and other products are sold per unit. For example, the average cost of apples is:
$5,000/8,525 pounds of apples = $0.59 per pound
However, the average cost of oranges is:
$5,000/3,900 oranges = $0.78 per orange
Because the cost structure of apples and oranges is different (per pound vs. per unit), the average cost will be different.
Average Cost and Cost of Goods Available for Sale
The cost of goods available for sale is the sum of the beginning merchandise inventory and the cost of those goods. For example, the cost of goods available for sale for apples:
Date.........Description.....................Units........Unit Cost........Total Cost
1-Jan........Beginning Inventory.........1,500........$0.50.............$750.00 28-Feb......Purchase.......................750...........$0.65.............$487.50 15-Apr......Purchase.......................1,250........$0.60..............$750.00 31-May.....Purchase.......................875...........$0.50.............$437.50 29-Jul.......Purchase.......................1,500........$0.45.............$675.00 10-Aug.....Purchase.......................1,000........$0.55.............$550.00 30-Sep.....Purchase........................750..........$0.60.............$450.00 5-Nov.......Purchase........................900..........$1.00.............$900.00 ...............Total:..............................8,525............................$5,000.00
Average Cost and Cost of Goods Sold
Cost of goods sold is an accounting term meaning the cost of goods sold during a specific period. The formula used for determining cost of goods sold is:
Cost of goods available for sale during the period – Ending inventory = Cost of goods sold
Average Cost and Ending Inventory
Ending inventory is the amount of inventory left at the end of the period. Ending inventory is separated into units, unit cost and total cost (units multiplied by unit cost). This amount of inventory will be called Beginning Inventory at the beginning of the next period.