Inventory management is a critical aspect of running a successful ecommerce business.

It involves the acquisition, storage, and distribution of goods, with the goal of ensuring that products are available when customers need them while minimizing costs and optimizing profits.

One of the most fundamental aspects of inventory management is inventory costing, which is simply assigning a value to the products held in stock.

The three most common ways to assign costs to inventory are:

• FIFO (first-in, first-out)
• LIFO (last-in, first-out)
• Average cost (also called weighted average cost, and sometimes shortened to WAC, AVCO, or WAVCO)

Average cost sits between first-in, first-out (FIFO) and last-in, first-out (LIFO). When prices are rising, cost of goods sold under LIFO tends to come out highest because it reflects the most recent, more expensive purchases, while under FIFO it tends to come out lowest because older, cheaper stock is sold first. Average cost uses a weighted average, so results fall somewhere in between. For a comparison of all four methods, see our guide to inventory costing methods.

Weighted average cost per unit = total cost of goods available for sale ($) ÷ quantity of goods available for sale (units)

In this guide, we explain the average cost method, its advantages and limitations, when it fits, and how to calculate it step by step.

What is the average cost method (AVCO)?

The average cost method is an inventory valuation method that calculates the cost of goods sold (COGS) and the value of the ending inventory by averaging the costs of all units in stock.

Under this method, the total cost of all units in stock is divided by the total number of units to determine the average cost per unit. This average cost is then used to value the cost of goods sold and ending inventory.

The average cost method can be used in both perpetual and periodic inventory systems. In a perpetual inventory system, inventory levels are continuously updated, and each sale and purchase is recorded as it occurs.

In a periodic inventory system, inventory levels are only updated periodically, usually at the end of a reporting period.

How do inventory valuation methods actually work?

The average costing method is just another form of inventory valuation. And inventory valuation is simply calculating the value of the goods held by your business that you intend to sell to generate revenue.

The two essential formulas that all inventory valuation methods start with are:

Opening inventory + additional inventory purchases = total cost of goods available for sale

Total cost of goods available for sale − COGS (cost of goods sold) = closing inventory value

This closing inventory value is the true value of your inventory at the end of a given accounting period (it’s also called your ending inventory).

It’s important to remember that when you make a sale, you not only earn revenue but also incur a cost, and the inventory cost flow assumptions help estimate what that cost should be.

These are things that drastically affect your balance sheet and income statement, so it’s critical to understand the process of how they’re calculated.

Not to overwhelm you with formulas, but the final one you need to know is for AVCO itself:

Weighted average cost per unit = total cost of goods available for sale ($) ÷ quantity of goods available for sale (units)

What is the value of using the average cost method for ecommerce businesses?

The average cost method can be very useful for ecommerce businesses for several reasons.

First, it allows businesses to determine their average inventory cost for a given period. This information is essential for financial planning and decision-making, as it enables businesses to understand the average cost of each unit in their inventory.

Weighted average costing also smooths the effect of price changes. Because it blends the cost of every unit available for sale, cost of goods sold and margins move less from one batch to the next than they do under FIFO or LIFO. That makes pricing and forecasting easier when supplier costs fluctuate.

Using the average cost method also allows businesses to calculate the weighted average unit cost for their inventory. This is calculated by dividing the total cost of goods available for sale by the total number of units available for sale.

The weighted average unit cost is important because it can help businesses make informed decisions about pricing, as well as determine profitability.

(If you’re not a math person, stick with us. We’ll go through a step-by-step process of calculating AVCO in a later section.)

Moreover, the average cost method is a useful way to track sales revenue and profit. By accurately determining the cost of goods sold, businesses can calculate gross profit, which is found by subtracting the cost of goods sold from the total sales revenue.

This can help ecommerce businesses make informed decisions about pricing, marketing, and inventory management.

When weighted average cost fits

Weighted average cost works best when units are interchangeable and it makes little sense to track which batch a unit came from. Typical examples are bulk and commodity-style goods, such as manufacturing inputs, agricultural products, petroleum, chemicals, and gas, as well as ingredients used in food service. These businesses turn stock over continuously, so averaging smooths price swings and saves tracking every batch.

It’s a weaker fit when batches differ a lot in cost or specification, when items are individually distinct, or when purchases are infrequent with long gaps between them. FIFO or specific identification show the cost of each unit more precisely in those cases.

Which methods you can use also depends on where you operate. For example, IFRS doesn’t permit LIFO, while US GAAP does. Check the rules for your jurisdiction and talk to your accountant before choosing. For a side-by-side comparison, see our guide to inventory costing methods.

Weighted average cost vs. simple average cost

Two terms are easy to confuse, so it helps to separate them before the calculation.

Simple average cost adds up the unit prices and divides by the number of prices, ignoring how many units you bought at each. Weighted average cost divides the total cost by the total number of units, so each price counts in proportion to the quantity bought at that price.

Example: you buy 100 units at $10 and 10 units at $20.

• Simple average: ($10 + $20) ÷ 2 = $15
• Weighted average: ($1,000 + $200) ÷ 110 units = $10.91

The simple average overstates the cost, because most of your stock cost $10. The weighted average reflects what you actually paid per unit, which is why accounting uses it. The rest of this guide uses the weighted average, and in almost every case that’s the one to use. Spreadsheets and inventory management software will do the arithmetic for you.

A four-step process to calculating AVCO

The four-step process for calculating the weighted average cost (AVCO) involves creating an inventory cost flow table, entering the known data, filling in the blanks, and calculating the total cost of goods sold and the closing inventory.

Let’s walk through the steps with a hypothetical example:

Step 1: Create an inventory cost flow table

The inventory cost flow table is a five-column table that tracks the inventory transactions of a business.

The columns are Date, Description, Quantity, Cost per unit, and Total cost. This table helps to visualize how the inventory costs flow through a business.

Here’s an example inventory cost flow table for a business that sells books.

Step 2: Enter the known data

The known data includes the opening inventory, additions, and sales. The opening inventory is the quantity of goods held by the business at the beginning of the period.

Additions are purchases made during the period, while sales are the quantity of goods sold during the period.

In our example, the business started the period with 100 books in its inventory, which cost $5 each, for a total of $500. On January 15th, the business purchased 50 more books for a total cost of $200. On January 20th, the business sold 75 books.

Step 3: Fill in the blanks

Anyone who’s played a round of Sudoku knows the more blanks you fill in, the easier the solution to the puzzle becomes. Your inventory cost flow table works the same way.

The blank spaces in the inventory cost flow table are filled in by calculating the cost of the opening inventory, the cost per unit of the additions, the total cost of goods available for sale, and the weighted average cost per unit of the goods available for sale.

To calculate the cost of goods available for sale in our example, we add the cost of the opening inventory to the cost of the additions ($500 + $200 = $700).

To calculate the quantity of goods available for sale, we add the opening inventory to the additions (100 + 50 = 150).

The weighted average cost per unit is calculated by dividing the total cost of goods available for sale by the quantity of goods available for sale ($700 ÷ 150 = $4.67 per unit, rounded from $4.6667).

Step 4: Calculate the total cost of goods sold and closing inventory

The total cost of goods sold is calculated by multiplying the quantity of goods sold by the weighted average cost per unit. The closing inventory is calculated by subtracting the cost of goods sold from the cost of goods available for sale.

To calculate the cost of goods sold, we multiply the quantity of goods sold by the weighted average cost per unit: 75 × $4.6667 = $350.00.

To calculate the closing inventory value, we subtract the cost of goods sold from the cost of goods available for sale: $700 − $350.00 = $350.00. That matches the 75 units that remain, at $4.6667 each.

Here’s our completed table. It rounds the unit cost to $4.67, which produces $350.25 and $349.75. In practice, carry the unrounded average through your calculations and round only the final totals, so the figures balance.

By following these four steps, a business can use the weighted average cost method to determine the cost of goods sold and the value of closing inventory.

Final thoughts

We know this can be confusing, especially if you don’t have a background in accounting.

By practicing the steps of the process on your own, you can become more confident in your understanding of AVCO and gain greater control over your inventory management.

Additionally, don’t be afraid to consult with a professional accountant or financial advisor to ensure that you’re using the appropriate accounting methods for your business.

With time and practice, you’ll be able to accurately calculate your cost of goods sold and closing inventory using the weighted average cost method, which can help you make more informed business decisions and achieve long-term success.

Linnworks brings your inventory, orders, and listings into one platform, so the stock and sales data behind your costing is accurate across every channel.

It also connects to your accounting software. Linnworks has a QuickBooks Online integration, and SyncTools syncs sales, purchases, refunds, and taxes from Linnworks to QuickBooks Online and Xero, which reduces manual entry and the risk of errors.