Average Cost Flow Assumption

What Is Average Cost Flow Assumption?

Average cost flow assumption is a calculation companies use to assign costs to inventory goods, cost of goods sold (COGS), and ending inventory. An average is taken of all of the goods sold from inventory over the accounting period and that average cost is assigned to the goods.

Average cost flow assumption is also called "the weighted average cost flow assumption."

Understanding Average Cost Flow Assumption

Inventory represents all the finished goods or materials used in production that a company has possession of. Once sold, these items are then expensed on the income statement as COGS — an important metric used to measure profitability and evaluate how efficient a company is at managing its labor and supplies in the production process.

Companies have several methods at their disposal to roughly figure out which costs are removed from a company's inventory and reported as COGS. One of them is the average cost flow assumption. This particular approach takes an average of the cost of items sold, leading to a mid-range COGs figure.

The average cost flow assumption assumes that all goods of a certain type are interchangeable and only differ in purchase price. The purchase price differentials are attributed to external factors, including inflation, supply, or demand.

Under the average cost flow assumption, all of the costs are added together, then divided by the total number of units that were purchased. The number of units sold can be multiplied by the average price per unit to establish COGS and the ending inventory — the value of goods still available for sale and held by a company at the end of an accounting period.

Example of Average Cost Flow Assumption

Let's assume that Wexel's Widgets Inc. utilizes the average cost flow assumption when assigning costs to inventory items. During the accounting period, Wexel sells 25 widgets from bucket A, each of which cost $25 to produce; 27 widgets from bucket B, each of which cost $27 to produce; and 30 widgets from bucket C, each of which cost $30 to produce.

The widgets are all interchangeable, only differing in the cost of production, due to an increase in the cost of the plastic explosive used in the manufacturing process. To compute the total COGS, Wexel utilizes the average cost flow assumption method. It calculates the cost of each widget as follows: [(25x$25) + (27x$27) + (30x$30)] / (25+27+30).

Average Cost Flow Assumption vs. FIFO vs. LIFO

Companies generally use one of three methods to assign costs through different production phases. Alternatives to the average cost flow assumption include:

The First-In, First-Out (FIFO) method assumes that the first unit making its way into inventory is sold first. FIFO is generally preferable in times of rising prices as the costs recorded are low, and income is higher. 

The Last-In, First-Out (LIFO) method takes the opposite approach, assuming that the last items to arrive in inventory are sold first. This particular accounting technique is generally adopted when tax rates are high because the costs assigned will be higher and income will be lower.

Important

The method utilized to assign costs to inventory and COGS can have a big bearing on a company's key financials, reported profitability, and tax obligations.

Advantages and Disadvantages of Average Cost Flow Assumption

The average cost flow assumption eliminates the need to track each individual item, which can come in handy, particularly when there are large volumes of similar goods moving through inventory. This technique requires minimal labor, is much cheaper than other inventory cost methods to apply, and, in theory, is less likely to manipulate income.

There are drawbacks, though. The average cost flow assumption assumes that all units are identical, even though that not might always be the case. Newer batches of the same product or material, for instance, might be slightly superior than older ones, and, as a result, may command a higher price.

Special Considerations

Generally accepted accounting principles (GAAP), a common set of accounting principles, standards, and procedures that all public companies in the U.S. are required to abide by, champions consistency. Financial statements are expected to be easily comparable from one accounting period to the next to make life simpler for investors.

That means that it is not possible to frequently chop and change inventory costing methods. Regular alterations are frowned upon and, when necessary, must clearly be highlighted in the company’s footnotes to the financial statements.