Average Costing

The most commonly used costing method - calculates cost as weighted average of all purchases.

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How Average Costing Works

Average Cost Calculation
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Average Cost = Total Inventory Value / Total Quantity

After each receipt:
  New Average = (Old Value + Receipt Value) / (Old Qty + Receipt Qty)

Example:
  Starting: 100 units @ $10 = $1,000
  Receipt:   50 units @ $14 = $700
  ─────────────────────────────────────
  New:      150 units @ $11.33 = $1,700

  Average Cost = $1,700 / 150 = $11.33

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Cost Flow Diagram

Average Costing Flow
─────────────────────────────────────────────────────────────────

Receipt #1: 100 @ $10      Receipt #2: 50 @ $14
     │                          │
     ▼                          ▼
┌─────────────────────────────────────────────┐
│           INVENTORY POOL                    │
│                                             │
│  150 units @ $11.33 average                 │
│  Total value: $1,700                        │
│                                             │
└─────────────────────────────────────────────┘
                    │
                    │ Sale: 75 units
                    ▼
            COGS: 75 @ $11.33 = $850

Remaining: 75 units @ $11.33 = $850

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Transaction Examples

Purchase Receipt

Purchase Receipt Example
─────────────────────────────────────────────────────────────────

Before Receipt:
  On Hand: 100 units
  Average Cost: $10.00
  Total Value: $1,000

Receipt: 50 units @ $14.00 = $700

After Receipt:
  On Hand: 150 units
  New Average: ($1,000 + $700) / 150 = $11.33
  Total Value: $1,700

GL Impact (Purchase)

Account	Debit	Credit	Why?
Inventory Asset	$700		Add at purchase price (Asset ↑)
IRNB (or A/P)		$700	Liability for receipt

Note: No variance - inventory records at actual purchase price.

Sale

Sale Example
─────────────────────────────────────────────────────────────────

Before Sale:
  On Hand: 150 units
  Average Cost: $11.33
  Total Value: $1,700

Sale: 75 units @ $11.33 average = $850

After Sale:
  On Hand: 75 units
  Average Cost: $11.33 (unchanged)
  Total Value: $850

GL Impact (Sale)

Account	Debit	Credit	Why?
COGS	$850		Cost of goods sold at average (Expense ↑)
Inventory Asset		$850	Reduce at average cost (Asset ↓)

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Average Cost Recalculation

Average cost changes only on receipts, not sales:

Average Cost Timeline
─────────────────────────────────────────────────────────────────

Event           Qty    Cost    Value    Avg Cost
─────────────────────────────────────────────────
Starting        100    $10.00  $1,000   $10.00
Receipt +50      50    $14.00  $700     ─────
After Receipt   150            $1,700   $11.33  ← Recalculated
Sale -75        -75    $11.33  -$850    ─────
After Sale       75            $850     $11.33  ← Same
Receipt +100    100    $8.00   $800     ─────
After Receipt   175            $1,650   $9.43   ← Recalculated

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Adjustments and Transfers

Inventory Adjustment

Adjustment Impact on Average Cost
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Adjustment Increase (found inventory):
  - Adds quantity at CURRENT average cost
  - Average cost UNCHANGED

Adjustment Decrease (lost inventory):
  - Removes quantity at current average cost
  - Average cost UNCHANGED

Example:
  Before: 100 units @ $10 = $1,000
  Adjustment: +20 units (found)
  After: 120 units @ $10 = $1,200
  (Average stays $10 - adds at current average)

Inventory Transfer

Transfer Impact on Average Cost
─────────────────────────────────────────────────────────────────

Transfer between locations:
  - Uses current average cost
  - No cost change at either location
  - Just moves quantity

Example:
  Location A: 100 units @ $10
  Transfer 50 to Location B

  After:
    Location A: 50 units @ $10 = $500
    Location B: 50 units @ $10 = $500

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Advantages and Disadvantages

Advantages

Advantage	Description
Simple	Easy to understand and calculate
Smooth	Evens out price fluctuations
No layers	Don't need to track purchase batches
Matches cash flow	Cost approximates actual spending

Disadvantages

Disadvantage	Description
Not specific	Can't trace actual cost
Requires recalc	Must recalculate on each receipt
Inflation lag	Slower to reflect current costs
Complex returns	Returns affect average calculation

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Returns and Average Cost

Customer Returns

Customer Return Impact
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Return adds inventory at CURRENT average cost (not original cost)

Before Return:
  On Hand: 75 units @ $11.33 = $850

Customer Returns: 10 units

After Return:
  On Hand: 85 units @ $11.33 = $963
  (Returns added at current average)

Vendor Returns

Vendor Return Impact
─────────────────────────────────────────────────────────────────

Return removes inventory at CURRENT average cost

Before Return:
  On Hand: 150 units @ $11.33 = $1,700

Return to Vendor: 20 units

After Return:
  On Hand: 130 units @ $11.33 = $1,473
  (Removed at current average)

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Best Practices

Practice	Benefit
Regular receipts	Keeps average current
Avoid manual cost changes	Maintains integrity
Monitor cost trends	Catch unusual fluctuations
Reconcile regularly	Ensure accuracy

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Quick Reference

When Average Changes

Event	Average Cost Changes?
Purchase Receipt	Yes - recalculates
Vendor Bill	No (cost set at receipt)
Sale	No
Adjustment (qty only)	No
Adjustment (with cost)	Yes
Transfer	No
Customer Return	No
Vendor Return	No

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Next Steps

• Standard Costing - Fixed costs with variances
• FIFO/LIFO Costing - Layer-based methods
• Costing Overview - Compare all methods