Average Costing Method--Materials and Inventory Costing:

Learning Objectives:

1. Define and explain average costing method.
2. Give an example of Average costing method.
3. What are advantages and disadvantages of average costing.
4. Definition and Explanation of Average Costing Method
5. Advantages of Average Costing Method
6. Example

Definition and explanation:

Issuing materials at an average cost assumes that each batch taken from the storeroom is composed of uniform quantities from each shipment in stock at the date of issue. Often it is not feasible to mark or label each materials item with an invoice price in order to identify the used units with its acquisition cost. It may be reasoned that units are issued more or less at random as for as the specific units and the specific costs are concerned and that an average cost of all units in stock at the time of issue is satisfactory measure of materials cost. However, average costing may be used even though the physical withdrawal is an identifiable order. If materials tend to be made up of numerous small items low in unit cost and especially if prices are subject to frequent changes.

Advantages of Average Costing Method:

Average costing method has the following main advantages:

1. It is a realistic costing method useful to management in analyzing operating results and appraising future production.
2. It minimizes the effect of unusually high or low materials prices, thereby making possible more stable cost estimates for future work.
3. It is practical and less expensive perpetual inventory system.

The average costing method divides the total cost of all materials of a particular class by the number of units on hand to find the average price. The cost of new invoices are added to the total in the balance column; the units are added to the existing quantity; and the new total cost is divided by the new quantity to arrive at the new average cost. Materials are issued at the established average cost until a new purchase is recorded. Although a new average cost may be computed when materials are returned to vendors and when excess issues are returned to the storeroom, for practical purposes, it seems sufficient to reduce or increase the total quantity and cost, allowing the unit price to remain unchanged. When a new purchase is made and a new average is computed, the discrepancy created by the returns will be absorbed.

Example:

February (1)Beginning balance: 800 units @ $6 per unit. (4)Received 200 units @ $7 per unit. (10)Received 200 units @ $8 per unit. (11)Issued 800 units. (12)Received 400 units @ $8 per unit. (20)Issued 500 units. (25)Returned 100 excess units from the factory to the storeroom to be recorded at the latest issued price. (28)Received 600 units @ $9 per unit.

Calculations for the above transactions would be as follows

Average Costing Method Calculation Illustrated

01. Beginning balance	800 units @ $6	$4,800
04. Received	200 units @ $7	$1,400
Balance	1000 units	$6,200	$6.20
10. Received	200 units @ $8	$1,600
Balance	12,00 units	$7,800	$6.5
11. Issued	800 units @ $6.50	$5,200
Balance	400 units	$2,600	$6.5
12. Received	400 units @ $8	$3,200
Balance	800 units	$5,800	$7.25
20. Issued	500 units @ $7.25	$3,625
Balance	300 units	$2,175	$7.25
Returned to storeroom	100 units	$725
Balance	400 units	$2,900	$7.25
28. Received	600 units @ $9	$5,400
Balance	1000 units	$8,300	$8.30

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