Average Costing in Inventory Control

Average costing in inventory control

A costing methodology for inventory control that can be utilized is average costing. Other available options are standard, average, LIFO, and FIFO & the costing methodology chosen for the organization is usually set up in its ERP system at the company level.

Every item in an inventory location keeps track of 3 costs - the average cost, the last (received) cost, and the last issued cost of the item. The average cost of an item in an inventory location can be effected by the following transactions:

When purchase orders for inventory items are received the system calculates and maintains the weighted average cost of each item.

If an invoice is entered against a PO for an inventory item and the invoice cost is different from the PO cost by an amount greater than the established tolerance it creates an invoice buyer message which will have to be resolved by the buyer. If the buyer approves a cost different from the PO cost (which was used to update the item’s average cost) then the AP module will re-update the average cost IF any of that item is still in inventory (i.e. if the item has already been completely issued out there is no update, if only part of the original receipt is still in stock it will update that quantity..)

As individual items are returned to inventory via Issue Returns it is necessary to ‘tell’ the system at what cost to bring an item back into inventory. The current procedure is to check the Last Issue Cost box so that the system will use that cost. If this is different from the item’s average cost then the average cost will be recalculated. Note: in this scenario the item may be brought back into inventory at a different cost than at which it was originally issued, since intervening transactions could have changed the average cost and last issued cost.

If most or all of the items were originally issued on a requisition and are subsequently returned and the original requisition number is also known, then a Requisition Return can be performed. In this case the item is brought back into inventory at the exact cost at which it was originally issued.

The average cost can also be changed during Inventory Adjustments. When the on-hand quantity of an item is adjusted upward it is necessary to provide the appropriate cost for the 'extra' product being added back to inventory. This can be entered manually or the item can be flagged to use the ‘Last Issue Cost’. The cost entered will cause the item’s average cost to be recalculated.

If freight is added to a purchase order and spread across the lines then it will roll into the calculation of the average cost of the item.

Finally, a variable that can effect the calculations referenced is if any of the item already on hand in inventory is already allocated for a department. For example, when an inventory adjustment causes a recalculation of average cost this occurs on the available quantity and not the on-hand quantity (i.e. it excludes the allocated quantity).

Given the number of factors that can have an impact on the average cost of an inventory item, it is evident that using an average costing methodology guarantees that even one PO price change will result in multiple changes in average cost of an inventory item. This is clearly illustrated by the simplified scenario below:


1. Item X is purchased at $200 for a BX/10. At the start of the scenario there are 40 on hand in the inventory location.

2. 5 of item X issued to Department A.
3. 2 BX of Item X purchased at  $300 for a BX/10. 
4. 15 of Item X issued to Department A.
5. The item from Step 2 is returned via Requisition Return (so comes back at the cost on the original requisition).
6. 25 of Item X issued to Department B.
7. 2 BX of Item X purchased at $300 for a BX/10.
8. 25 of item X issued to Department A.
9. 2 BX of Item X purchased at $300 for a BX/10.
10. 30 of item X issued to Department A.
11. 10 of item X from step 4 returned via requisition return (so comes back at original requisition cost of $23.64).
12.  10 of item X returned from step 6 via IC21 (returned at Last Issued Cost of $28.55 when actually originally issued at $23.24).

Trans  Start Qt.  	Qt Rec   	    Qt Iss/(Ret):		End Qt.	        Avg Cost:		Iss At:
1	40	  		   		40		$20.00		
2	40			5		35		$20.00		$20.00	
3. 	35	2BX @ $300				55		$23.64	
4.	55			15		40		$23.64		$23.64	
5. 	40			(5)		45		$23.24		($20.00)
6.	45			25		20		$23.24		$23.24
7.	20	2BX @ $300				40		$26.62			
8.	40			25		15		$26.62		$26.62
9.	15	2BX @ $300				35		$28.55		
10.	35			30		05		$28.55		$28.55
11. 	05			(10)		15		$25.28		($23.64)	
12.	15			(10)		25		$25.28		($28.55)	
13.	25			20		05		$26.59		$26.59

Thus we see that one contract or PO price change will result in multiple average costs as the average cost changes at each subsequent receipt and potentially at each return or adjustment. In this example one contract price change resulted in seven different average costs as:

Successive receipts at the new cost started moving the average cost from the ‘old’ value to the ‘new’ value.
Returns and requisition returns also resulted in changes in average cost.

The trigger is a change in the cost of the item, which may occur for several reasons, e.g. those listed below:

Valid contract price change.
Possible error e.g. incorrect price on purchase order (due to incorrect price load or UOM mismatch)
Item purchased through STAT order incurring freight costs. Freight entered as add-on cost and spread over item resulting in increase in average cost. (Note: freight entered as a miscellaneous add-on cost does not update average cost.)
More expensive substitute purchased as usual item is manufacturer backordered or otherwise unavailable.
Item is not on contract and we are paying list or distributor acquisition price at time of purchase (which can change periodically).
Vendor invoices less than contract cost causing reduction in average cost of an item (this is rare, but can occur)

Pro: An argument in favor of utilizing average costing is that it can ‘smooth’ out price fluctuations. If an item’s pricing increases substantially the user departments do not immediately see the increase as it is spread out - the average cost gradually moves from its initial level to the new level over a period of time.
Con: This smoothing is also a reason against using this costing methodology, as it may be desirable that the impact of price changes be felt immediately.