Average cost method is a popular inventory valuation method that takes into account the rapidly changing prices of goods. The average cost method assigns cost to inventory and cost of goods sold (COGS) based on the weighted average cost of units purchased in a given period. This method is beneficial for companies who purchase items of the same type in multiple batches that differ in price, as it assigns an average price to all units. This helps avoid a major cost discrepancy between inventory and the COGS, resulting in an accurate product cost.

The average cost method may also be referred to as weighted average or moving average cost. Weighted average models the cost of goods sold (COGS) by averaging the cost of each inventory unit over time. The formula for weight average cost is the following:

Weighted Average Cost = (Total Cost of Inventory / Total Quantity of Inventory)

Once the weighted average cost is calculated, the company may apply it to any inventory purchased in the period, including the inventory that is still available for sale. This simplifies the process of assigning cost, as well as more accurately depicts the costs associated with different stock.

When utilizing the average cost method, a company must be aware that changes in the pricing schedule may result in unfair cost-averaging. Prices may rise faster than the average cost, resulting in an inaccurate COGS calculation. However, when using average cost method, the company has a broader view of the cost of their inventory and costs associated with each item.

Overall, average cost method provides an average cost of inventory and cost of goods sold that takes into account the cost of multiple purchases. When selecting an inventory valuation method, it is important for a company to remain consistent with its method to comply with GAAP regulations and properly reflect their financials. Average cost method allows companies to refigure COGS even if they make more expensive purchases over time.