Introduction
There are a number of different cost flow methods available for Inventory / Cost of Goods Sold (COGS) valuations. Perpetual systems continuously update the inventory, avoiding issues inherent with periodic-based systems. For cost flow, there are three (3) accepted cost methodologies: FIFO, LIFO, and Weighted-Average Cost (also commonly referred to as Average Cost).
- FIFO or First-In, First-Out, always assigns the cost of the earliest unit available at the time of sale to COGS, regardless of which unit from the inventory pool is used.
- LIFO or Last-In, First-Out, always assigns the cost of the newest unit available at the time of sale to COGS, regardless of which unit from the inventory pool is used.
- Average Cost calculates the cost that is assigned to COGS and inventory each time new units are purchased and added to the inventory.
*This method is supported by Xorosoft as standard functionality.
Why Move to Perpetual Average Cost Method
The Perpetual Average Cost method is widely accepted by numerous accounting standards, including US GAAP and IFRS. It is, at its most simplistic, just an average. Using an average significantly simplifies the calculations and recordkeeping associated with maintaining the inventory and determining the Cost of Goods Sold. Both FIFO and LIFO require that individual items be tracked, which can be expensive. When there are large volumes of items, the Average Cost is superior to FIFO and LIFO, especially when the items are indistinguishable from one another or when tracking individual items would be highly inefficient. Average Cost can also effectively normalize cost fluctuations and volatilities and help reduce the inappropriate manipulation of income.
Perpetual Average Cost Method
Perpetual Average Cost, aka Moving Average Cost, calculates a new average unit cost for the inventory after each purchase of new units. To be more specific, the recalculation should occur when the items are “received”/ “produced” and are available. The new average cost is then used to value the inventory and Cost of Goods Sold until the next purchase of new units is received. At that time, the average cost is recalculated and this new average cost is used.
The average cost formula is:
A sale of inventory does not impact the average cost and does not trigger a recalculation. When inventory is sold, the quantity available for sale is reduced and the Cost of Goods Sold / Inventory GL transactions associated with an Invoice is recorded. This transaction uses the current Average Cost assigned to the inventory at that time.
Altering an older transaction
When you alter an older transaction, the system will recalculate the average cost of relevant subsequent transactions.
If you are trying to make an adjustment that can result in a negative on hand while recalculating the average cost, the system will by default give an error.
The below example shows how the average cost is computed at each point.
Common Mistakes
Doing a value adjustment in the inventory may result in affecting the average cost.
Both Value and (Qty and Value) adjustments should be done with caution.
Doing a quantity adjustment only uses the current average cost only.
How do I see my average cost for all transactions?
You can see your average cost calculations clearly using the “Inventory Valuation Report”
Go to Reports > Operation > Run “Inventory Valuation Report”
Enter “Item Number”
Drill down to see all the transactions and affected average costing
Also read The Average Cost Calculation
