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What is average cost method?

The average cost method is an accounting technique used to determine the cost of inventory or securities in an investment portfolio. It calculates the average cost per unit by dividing the total cost of goods purchased by the total number of units purchased.

Here are key points to understand about the average cost method:

1. Calculation: To calculate the average cost per unit, the total cost of all purchases of inventory or securities is divided by the total number of units acquired.

   Average Cost per Unit = Total Cost / Total Quantity

2. Inventory Valuation: The average cost method assigns the average cost per unit to the ending inventory balance. This means that the value of the inventory is based on the average cost of all units acquired, regardless of the actual purchase prices.

3. Cost of Goods Sold (COGS): When units are sold, the cost of goods sold is calculated by multiplying the number of units sold by the average cost per unit at the time of the sale. This ensures that the cost of goods sold reflects the average cost of the units sold.

4. Simple and Easy to Apply: The average cost method is relatively straightforward and easy to apply. It smooths out the fluctuations in purchase prices by using an average cost, making it simpler for record-keeping and accounting purposes.

5. Recalculation: Each time additional purchases are made, the average cost per unit is recalculated. This ensures that the average cost reflects the total cost of all units acquired up to that point.

6. Impact of Inflation or Deflation: In periods of inflation, the average cost method tends to result in a lower cost of goods sold and higher inventory valuation because the average cost includes older, lower-priced inventory. In periods of deflation, the method may yield a higher cost of goods sold and lower inventory valuation.

7. Applicability: The average cost method is commonly used for financial reporting and tax purposes. It provides a reasonable estimate of the cost of inventory or securities and is suitable for industries where specific identification of costs is not necessary.

The average cost method simplifies inventory valuation and cost of goods sold calculations by using an average cost per unit. It provides a reasonable approximation of the cost of inventory or securities, allowing businesses and investors to track their costs and make informed decisions.