Cost averaging is a strategy that assumes the average cost of assets or expenses in a common pool is equal to their value, and can be used to determine the average cost of shares or inventory. It works well with FIFO and LIFO accounting and can be useful for budgeting.
Also known as the average cost method, cost averaging is a strategy that assumes that the average cost of assets or expenses in a common pool is equal to the value of those same expenses or assets. This approach can be used in a number of situations, including determining the average cost of shares of a given stock that are purchased over time, or calculating the cost associated with available and available-for-sale products. Unlike some costing methods, average cost can work equally well with first-in, first-out, or FIFO, and last-in, first-out, or LIFO accounting.
One of the easiest ways to understand how cost averaging works is to consider a series of purchases of shares issued by a specific company, with each purchase over the course of several months. Most likely, the actual purchase prices of the shares vary each time more shares are purchased. Instead of trying to keep up with which shares were bought at what rate, an average value is assigned to the total number of shares bought.
For example, if one share is purchased for $100 US Dollars (USD), the next share is purchased for $150 USD, the average cost is determined by dividing the combined purchase amounts by the number of shares purchased. In this example, that means the average cost of each action is $125 USD. If an investor wishes to sell the two shares at a later date, he or she will want to earn a minimum of $125 per share to break even on the trade.
Businesses sometimes use average cost to determine the current inventory cost related to items held in 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 purchases, the department that ultimately receives one of those parts is charged based on of the average cost of the Two purchases. Whether the actual cost of the issued component was more or less than the other component is irrelevant when trying to adjust the cost of inventory. From this perspective, the average cost is also useful when preparing budgets for the coming year, since the average cost of essential goods will show an increase over the previous period and will allow justifying an increase in a particular budget item.
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