Average Cost Method

The average cost method is a way of determining the value of a group of like assets without an in-depth appraisal of each individual component. Basically, this method derives results by adding the costs of all individual assets, and then dividing by the number of assets in the group, producing a measure of the value of each individual asset. The average cost method has the virtue of being simple and easy to understand, and is generally as accurate as more elaborate methods of cost derivation.

Average Cost Method Formula



The formula used in average cost method accounting is the same as in typical averaging methods. Basically, it can be expressed as: • Total Cost for all Units / Total Number of Units = Average Cost per Unit This formula is the same whether dealing with the average cost method of inventory control or for securities; for high-volume investors, however, the process of deriving the total cost for all securities purchased for average cost method accounting can be time-consuming and complex.

Average Cost Method of Inventory Control



Many retail sites use an average cost method inventory system in order to better adjust to changes in the wholesale price of items; the average cost method of inventory control allows companies to maintain a more accurate basis for pricing goods for sale. For instance, if a vendor purchases widgets for resale at a cost of $1.00 per widget, and the cost later rises to $2.00 per widget, the vendor can use the average cost method in order to determine a cost basis for the resale price, ensuring that the profit margin is preserved. If the vendor purchased two widgets at $1.00 each and two widgets at $2.00 each, the total cost would be $6.00 for four widgets. Using the average cost method, the vendor would divide the total cost by the total number of widgets to derive an average cost of $1.50 per widget. This average cost changes as more purchases are made; ensuring that the cost basis remains current and that profit margins are maintained.

Average Cost Method Accounting for Securities



For investors, the average cost method accounting system is used to calculate the cost basis for securities bought or sold during a certain year for tax purposes. The value for purchased stocks is derived by taking the total cost of purchasing shares and dividing them by the total number of shares; this derives an average figure for each share, which is used to determine the cost basis. This figure is then offset against the gain or loss derived when the stocks are sold.

Average Cost Method Example for Securities



For instance, if an investor purchases three shares of stock in a particular company over the course of three weeks, the price per share will likely vary with each individual purchase. If the price for the first share is $10.00, the second $9.00, and the third $20.00, then by applying the average cost method formula, the investor would add together the three amounts and arrive at a total cost of $39.00 for all three. By then dividing $39.00 by 3, the investor would derive the average cost of $13.00 per share, which can be used as a cost basis for all shares in determining net gain or loss upon eventual resale.
Tim Ord
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