What is an Average Cost Method?

The average cost method is a method of judging the value of a group of assets to measure their worth as a whole. This is done by dividing the total cost for all units of the asset in question by the total number of units. Inventory managers often use the average cost method as a way of determining the overall cost of goods sold in the midst of constantly changing prices. In addition, this costing method is also valuable to investors to account for stocks which rise and fall in value.

While it may not be as elaborate as some methods used to determine the cost of assets, the average cost method benefits from its simplicity. Since it is a relatively easy calculation to perform, it can be quickly used to keep up with assets that are constantly changing. Using this method, a company can keep track of its inventory as it takes in new items and sells old items to the public, or an investor can easily maintain some perspective on the purchases and sales he has made on the market.

As an example of the average cost method, imagine that a hardware store has bought 40 hammers from a vendor at a cost of $10 US Dollars (USD) per hammer, for a total of $400 USD spent. Later on, the store buys 10 more hammers, but the price has risen to $20 USD per hammer, making the total cost in this purchase $200 USD. The company has now spent $600 USD for 50 total hammers. Dividing the $600 USD by 50 yields an average cost per hammer of $12 USD.

Using the average cost method can allow companies to set prices more accurate prices. Since the average is a good way of measuring the cost of goods sold, a company can adjust its resale price accordingly to maintain a sizable profit margin. In the example above, the company would have made a mistake by setting a price of $11 USD per hammer based on the initial shipment. Based on the average cost of all the hammers it has in inventory, it should set its price somewhere above $12 USD per hammer.

Stock market investors can also use the average cost method as a way of judging stocks that they possess and accounting for prices paid for those stocks. An investor might buy different amounts of shares in the same stock at different prices on multiple occasions over a certain time period. Taking the average cost of all of these shares can reduce confusion about how much they're worth.