Accounting 101 - Average cost inventory method

Here’s an example of inventory cost accounting using the average cost method. We will do the inventory accounting for a fictitious company called Toy Giraffe Inc, a company buying and selling toy giraffes. ⏱️TIMESTAMPS⏱️ 00:00 Average cost example 00:45 Calculating average inventory cost 01:18 Average cost and COGS 02:22 Average cost inventory valuation 03:33 Physical inventory count 03:46 Benefits of average cost method 04:19 Average cost vs FIFO and LIFO 04:52 FIFO and LIFO inventory flow 06:22 FIFO LIFO and average cost inventory valuations If you are looking for powerful #inventory software that’s easy to use, and provides you visibility to your COGS and margins, then try InFlow inventory management software for free: https://inflow.grsm.io/AVCO In the first quarter of the year, Toy Giraffe Inc is building up its inventory. In January, they buy 100 units (packed in 2 boxes of 50 units each) at $5 per unit. In February, 200 units (4 boxes of 50 units) at $6 per unit. In March, another 100 units (2 boxes of 50 units) at $7 per unit. The cost per unit for buying these toy giraffes is going up fast. The Q1 ending inventory is 400 units at a total purchase price of $2400, so on average $6 per unit. In the warehouse, the company does not specifically identify the boxes, they just stack them on a big pile. The same goes for cost accounting and inventory valuation using the average cost method: stack the boxes on a big pile, and blend the weighted average cost together. $6 average cost per unit is all we need to remember going into Q2! We can now perform the cost accounting for the next few months, where we start selling the boxes of toy giraffes. AVCO means average cost. The ending inventory of Q1 is the beginning inventory of Q2: 400 units at $6 each, $2400 of inventory value in total. The first box of toy giraffes (50 units) is sold in April. We will do the income statement accounting vertically, in the middle, and the inventory accounting horizontally. Revenue is 50 times $10 is $500. Cost Of Goods Sold (or COGS) is 50 units times $6 average cost per unit is $300, and Gross Profit is $200 (50 times $4 per unit). 350 units (beginning inventory minus units sold) remain in inventory at the end of April, at the average cost of $6 per unit, so $2100 of inventory value. The ending inventory of April is the beginning inventory of May. Two boxes of toy giraffes are sold in May. In the income statement for May, revenue is 100 units times $10 = $1000, Cost Of Goods Sold (or COGS) is 100 units times $6 = $600, and Gross Profit is $400. The remaining 250 units (beginning inventory minus units sold) go into the ending inventory, at the average cost of $6 per unit, so $1500 of inventory value. The ending inventory of May is the beginning inventory of June. Four boxes of toy giraffes are sold, sales are really picking up the pace. Revenue for June is 200 units times $10 = $2000, Cost Of Goods Sold (or COGS) is 200 units times $6 = $1200, and Gross Profit 200 times $4 = $800. The remaining 50 units go to the ending inventory, once again at the average cost of $6 per unit, so $300 of ending inventory value. It is useful to perform a physical count at the end of the quarter, to verify that the expected number of inventory units shown in the accounting system is physically there. The average cost method for inventory accounting is very simple, especially for companies that deal with large volumes of very similar items. Average costing requires minimal work to apply and is, therefore, the least expensive of all the inventory cost accounting methods. The #averagecost inventory method blends all purchases together, and comes up with one number per unit to apply in both Cost Of Good Sold in the income statement and inventory valuation on the balance sheet. What is the difference between the average cost method on one side and FIFO/LIFO on the other side? The average cost inventory method blends all purchases together, and comes up with one number. FIFO and LIFO are cost accounting fictions that use a concept called #inventory layering. For cost accounting and inventory valuation purposes, when using FIFO or LIFO, the company needs to keep track of the timing of the buys and the unit cost. Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Learn the business and #accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers finance training in various formats: YouTube videos, livestreams, classroom sessions, and webinars. Connect with me through Linked In! Want to get access to bonus content, and/or express your gratitude by buying me a cup of tea? Join my channel as a member through https://www.youtube.com/channel/UCQQJnyU8fALcOqqpyyIN4sg/join