Average Cost Method : The next method is average cost method. The principal on which the average cost method is based that all of the materials in store is so mixed up that an issue cannot be made from any particular lot of purchases, and, therefore, it is proper if the materials are issued at the average cost of materials in store. Average may be of two types :
(i) Simple Arithmetic Average:
(ii) Weighted Arithmetic Average.
i) Simple average Price : It is “A price which is calculated by dividing the total of the price of the materials in stock from which the material to be priced could be drawn, by the number of prices used in that total”.
Simple average price is calculated by dividing the total of unit purchase prices of different lots in stock on the date of issue by the number of pieces used in the calculation and quantity of different lots is ignored.
(ii) Weighted Average Price : It is “A price which is calculated by dividing the total cost of materials in the stock from the material to be priced could be drawn, by the total quantity of materials in that stock.”
Thus, the weighted average price takes into account the price and quantity of the materials in store. It is better to issue the material and weighted average price method because it recovers the cost price of the materials from production. In periods of heavy fluctuations in the prices of material, the average cost method gives better results because it tends to smooth out fluctuations in prices by taking the average of prices of various lots in stock.
Advantages of Average Cost Method
1. Average price methods is considered to be the best method when prices fluctuate considerably because this method tends to smooth out fluctuations in prices.
2. Issue prices are not to be calculated each time issues are made. Issue prices are charged only when new lot of materials is received.
3. This method recovers the cost of materials from production.
4. This method maintains the issue pi ices as near to the market price as possible.
5. This method eliminates the necessity for adjustments in stock valuation.
Disadvantages of Average Cost Method
1. The greatest disadvantage of this method is that a fresh rate calculation will have to be made as soon as a new lot of materials is purchased which may involve tedious calculation. Thus, there are chances of clerical errors.
2. Issue price of materials does not represent actual cost price of materials issued but it represents average cost of materials in stores.
It is the average cost method which is mostly used by most organizations because it satisfies most of the conditions of a good method of valuing material issues.