Average Cost Method

Average a simple but important tool for decision making which is used by almost every individual, businessman, and even institutions on daily basis. It would be hard to find a person on this planet who ever have not been used averages to know daily, monthly, or yearly income and expenses or to analyze any information involving values.

Average cost is the weighted average cost of different periods, products, departments, divisions, or so many objects as per the requirements or specifications. In finance the use of average cost is almost a routine matter and often used in approximations, feasibility studies, comparisons, and analysis. Simply the cost or expenses on individual periods or objects are added and the sum is divided on the number of items used in the analysis. For a layman the concept of average cost can be best understood by the following example.

A person’s weekly expenses are as follows:

Average weekly expenses = $704 / 7 = $100.57

It can be described that person’s average weekly cost of living is $100.57

In statistical terms the average cost is called the mean value of costs over a certain period or mean value of the cost of production of different products. The concept of average is basically the derivation of statisticians who used it for the analysis of vide spread data. From statistics the concept of average penetrated into finance and economics due to ease of understanding and its trait of a quite reliable analysis tool.

Though limited in finance and statistics the average cost concept is used to a great extent in economics. In economics, the similar concept of average cost is used and is calculated in the like way i.e. dividing total cost by number of units produced. It can also be derived by totaling average variable cost and average fixed cost. In supply and demand theory the role of average cost is quite significant. In a situation of stiff competition due to impact of marginal cost the price is often lower than the average cost. But it can not be mixed up with pricing theory because the average cost is actually a different concept from pricing and depends on the relationship of demand and supply.

Many decisions in the real finance world are made through extensive use of average cost analysis. Further analyses in management accounting and finance such as standard deviations, expected values, correlation and, regression techniques depend upon average costs to a great extent. The raw data about costs of different periods, goods, services, and industry competitors may not give meaningful information until it is converted in to average costs of the same. It would be undoubtedly true that average cost is the fundamental component in financial analysis and planning.

On the other hand one can not argue that average cost is the only reliable tool for any kind of financial analysis. In some cases where cost objects are different in nature and vary according to the occurrence, size, and industry the use of average cost concept to get a single useful figure for analysis purpose would give deceiving results and will completely be unreliable and inappropriate. So a financial manager must know that how and when to use average cost concept.