Average Cost Method for Cost of Goods Sold

The average cost method for cost of goods sold expense is an alternative method to the more commonly used FIFO and LIFO methods. If you were to make an exhaustive survey of businesses, you would find out that some businesses use average cost or even other methods besides FIFO and LIFO to measure cost of goods sold expense and inventory cost.

Compared with the FIFO and LIFO methods, the average cost method for cost of goods sold expense and inventory cost seems to offer the best of both worlds. For example:

  • The costs of many things in the business world fluctuate, and business managers tend to focus on the average product cost over a time period.

  • The averaging of product costs over a period of time has a desirable smoothing effect that prevents cost of goods sold from being overly dependent on wild swings of one or two acquisitions.

However, to many businesses, the compromise aspect of the average cost accounting method is its worst feature. Businesses often want to go one way or the other and avoid the middle ground. If they want to minimize taxable income, LIFO gives the best effect during times of rising prices. Why go only halfway with the average cost method?

If the business wants its ending inventory to be as near to current replacement costs as possible, FIFO is better than the average cost method. Plus, recalculating averages every time product costs change, even with computers, is a real pain. But the average cost method is an acceptable method under GAAP and for income tax purposes.