Advantages and Disadvantages of Average Cost Method
The weighted average cost method is an accounting method used to value a company’s inventory, that applies the average cost of the inventory on-hand for an SKU, to each inventory item in the group. As with all costing methods, this average costing has advantages and disadvantages that will determine how appropriate it is for a given business. Following, are some of the advantages and disadvantages.
Average Costing Advantages
If the following conditions prevail, average costing works well:
- Where individual units of an SKU are indistinguishable from each other.
- Where it is difficult to track the cost associated with individual units.
- When the cost of raw materials may change often, but remain within a range that itself is fairly stable. In other words, the day-to-day costs may be unpredictable, but the average cost moves slowly over time.
- In the instance of increasing costs for merchandise, the FIFO method tends to yield lower cost of goods sold (GOGS), and therefore to a higher profit and higher income taxes. The average costing method would be closer to reality for the COGS, and mitigate the tax impact.
- When the inventory is relatively fast moving, there will tend to be little difference between average prices and LIFO prices.
- If the organization purchases materials on a regular basis, average costing works well.
- The simplicity of using average costing makes it easier to work with, because minimal maintenance is required since the transactions, in effect, do the maintenance, and therefore it tends to yield more accurate cost computations, which would otherwise require considerable staff time to track on an individual basis.
Average Costing Disadvantages
If the following conditions prevail, average costing does not work as well:
- When the units in a batch are not identical, and/or expensive, and therefore cannot be treated in an identical manner for costing purposes, it is more accurate to track costs on a per-unit basis.
- If you are a bulk purchaser, and purchases are larger and further between, the weighted average cost can be significantly different from other costing methods.
- Typically, if you need to track overhead costs, a standard costing method allows you to do this detail level costing for individual cost elements. But average costing tends to work better for purchasing environments. Average costing makes it more difficult to maintain cost in detail by cost elements.
- Standard costing allows you to re-value on-hand inventory.
- When there is a clear upward or downward trend in inventory costs, average costing lags behind the most last cost. This would have the effect of minimizing or maximizing the COGS, and therefore profit. The tax ramifications would need to be examined.
- In the average method, the work-in-process figures are not kept separately. Instead, they are pooled with material costs and then divided out. This can create confusion and could make it more difficult to track work-in-process effectively for company records.
Future articles will examining other costing methods, so please share your experiences in the comment section below.
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