Also known as the average-cost method, average costing is a strategy that assumes the average cost of the assets or expenses in a common pool are equal to the value of those same expenses or assets. This approach can be employed in a number of situations, including determining the average cost of shares of a given stock that are acquired over time, or calculating the cost associated with products that are on hand and available for sale. Unlike some methods of calculating costs, average costing can with equally well with first-in-first-out or FIFO accounting and last-in-first-out or LIFO accounting.
One of the easiest ways to understand how average costing functions is to consider a series of purchases of shares of stock issued by a specific company, with each purchase occurring over the course of several months. Chances are the actual purchase prices for the shares vary each time more shares are acquired. Rather than attempt to keep up with which shares were purchased at what rate, the total number of shares purchased are assigned an average value.
For example, if one share is purchased for $100 US Dollars (USD), then the next share is purchased for $150 USD, the average costing is determined by dividing the combined purchase amounts by the number of shares acquired. In this example, that means the average cost for each share comes to $125 USD. Should an investor wish to sell the two shares at a later date, he or she will want to obtain a minimum of $125 USD per share in order to break even on the trade.
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Businesses sometimes make use of average costing in order to determine the current inventory cost involved with items that are held in an inventory. In a situation where a specific replacement component is purchased twice during a six week period, and there is a difference in the price paid for each of those purchase, the department that ultimately receives one of those parts is charged based on the average cost of the two purchases. The fact that the actual cost of the issued component was more or less than the other component is irrelevant when it comes to adjusting the inventory cost. From this perspective, average costing also comes in handy when preparing budgets for the upcoming year, since the average costing for essential goods will show an increase over the previous period, and make it possible to justify an increase in a particular budget line item.