What is the average cost method?

Modified on Mon, 4 Mar at 12:21 PM

The average cost method is when parts inventory is valued at the average “cost” of all the parts that are currently on hand. When parts are received into inventory the average cost is recalculated. When parts inventory is sold the average cost of the part is used when posting the cost to the general ledger.  


How is this different than replacement cost? 

Replacement cost values all inventory at the last cost you received that part into inventory at or at the current market value at that part as derived from a price file from your vendor. 

Here's a breakdown of how they differ:

Average Cost Method:

  • The inventory is valued at the average cost of an item on hand.
  • Cost is recalculated when new inventory is received.
  • Smooths out price fluctuations over time.
  • No immediate adjustment needed for price updates from vendors.

Replacement Cost Method:

  • Inventory is valued at the cost to replace items at current market prices or the last acquisition cost.
  • Requires adjustments when new inventory is received or when market prices change.
  • Reflects current market conditions more closely.
  • Immediate adjustments are needed for price updates from vendors.

How do I handle price file updates from vendors?

If average cost is used, nothing needs to be done. The new prices will be implemented as business continues. However, if replacement cost is used, a report should be run that quantifies the value of inventory on hand that has changed due to the application of updated price. In an inflationary society, this will typically be an increase to the inventory value, with the offset as income.

How does the costing method affect the value of slow-moving parts?

If replacement cost is used and the cost increases typically associated with price updates are recorded, over time the value of slow-moving parts will increase. Using average cost these parts remain in the inventory at their value at the time of purchase. 

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