Average costing is a way of accounting for your inventory that assigns all units of inventory with a single cost price, which is arrived at by taking the average cost for all those units. It’s an alternative method to FIFO or LIFO, which use the actual prices paid for each unit, even when the costs fluctuate.
For retailers or wholesalers that acquire inventory from overseas, or multiple vendors, it’s not a great option as it won’t always give you the most accurate cost of inventory on your balance sheet.
Average cost method example
Let’s walk through an example:
- I buy a shirt at $10. If I were to make a sale, the cost of goods sold would be $10
- Before I sell that shirt, I buy another in at $15, bringing my average cost up to $12.50 (which means even if I sold that original shirt, that’s what would get posted to my accounts!)
- Still no sales, but I buy another shirt in at $20 and bring the average cost up to $15
- I then sell a shirt, and the cost of goods sold is $15 (more than I paid for it, and therefore $5 profit has just disappeared!)
Advantages of using average costing to account for inventory
- For those without an inventory management system, it’s less admin to work with an average than it is to properly track purchase orders or any other handling fees that would affect the value of their inventory.
Disadvantages of using average costing to account for inventory
- As per the earlier example, it's no good if the cost of a stocked item fluctuates - when you make a sale, the profit reported isn’t always going to be correct, and with volume, this can result in some pretty nasty reporting errors.
- Building on the previous point, the average cost method assumes that all individual units are completely identical, which may not be the case for some industries such as electronics. A product may have been upgraded to have additional features or be made from a different material, and if so, it may be charged at a higher price than older units.
Now that there’s tools and software that automate all of the admin for you, there really is no need to operate using average costing. At Brightpearl, we operate using FIFO, which automatically tracks the exact costs paid for inventory (along with additional landed costs like insurance or freight), and will record the costs of goods sold automatically in a First In First Out order, meaning that you’ve got the most accurate financials and sales reports possible.