Meaning of Average of Cost Methods
Average cost method of Inventory valuation method are based on the assumption that when materials purchased in different lots are stored together, their identity is lost and therefore, issues should be charged at an average price.
Basically average prices are of two types:
(a) Simple average
(b) Weighted average
(A) Simple Average Cost Method
Simple average price is calculated by dividing total of unit purchase prices of different lots in stock by the number of prices used in the calculation.
Unit prices of latest consignment are taken into account for this purpose. Average cost method of Inventory valuation method does not take into account the quantities of materials in stock while calculating the average.
Suppose, the following five lots of materials are in stock when material is to be issued.
1,000 units purchased @ Rs. 25
800 units purchased @ Rs. 30
500 units purchased @ Rs. 35
300 units purchased @ Rs. 401
200 units purchased @ Rs. 45
Simple Average Price = 25+30+35+40+45 / 5
=175 / 5 = Rs.35
Advantages of Average of Cost Method
Following are the advantages of this method:
1. It is a simple method.
2. This method smoothens out the variations in the materials price.
3. Under this method. issue rate remains same until a fresh purchase is made. This reduces clerical work.
Disadvantages of Average of Cost Method
This method suffers from the following disadvantages:
1. It takes into account only the purchase prices but not the quantities.
2. Under this method, the issue prices do not confirm the current market price. So we come across and element of unrealized profit or loss in every job.
3. Closing stock value also not confirm to current market price. This distorts the balance sheet of the concern.
Suitability – This method be suitable when purchases are numerous and prices fluctuate within narrow limits. One it is not, generally, regards as a good method.
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