We're going to tell you the definition of this one and you're going to complain "well, that's kind of obvious." Maybe. But, would you really prefer if it was confusing? Would you prefer if it was called "Mean Inventory Outlay Accounting Methodical Process (MIOAMP)." We thought not.
Anyway, the average cost method represents a way to record the value of inventory on a balance sheet. As the name implies, you divide the total cost of the inventory by the amount you have in stock. So each piece of inventory is recorded at the average price of all the inventory (this way you don't have to track specific costs for individual inventory pieces).
You own a company that installs entertainment systems. You keep a bunch of TVs in stock for rush jobs. However, sometimes you get a deal on the TVs. Sometimes you don't.
So you have five TVs in stock that cost you $500 each, you have three in stock that cost you $600, and two from way back before you knew how to negotiate that cost you $1,000 each. The total cost of all the TVs is $6,300, and there are 10 TVs in stock. So average cost of the TVs is $630 each. When one of them is sold, you subtract $630 from the inventory on the balance sheet, regardless of which specific TV was installed and what its original cost was.
Related or Semi-related Video
Finance: What is Average Down?8 Views
Finance, a la shmoop what is average down or dollar cost averaging well remember the
movie Black Hawk Down, Navy SEALs who were shot down in Somalia then bravely [Solider shooting a rifle]
shot their way to safety until they ran out of bullets yeah [Guy looks upset that he's out of ammo]
well that has nothing to do with average down although you'd think it was an [Guy holding popcorn in the theater]
anthem for how we select politicians in this country but we digress when you
average down you thought you were oh so clever in paying eighty two dollars a
share for slip and slide roof shingles sounded like a real winner at the time
well the stock could hit par or a hundred bucks a share and not really par [Guy sliding on some roof tiles in the rain]
but it just sounds cool when equity investors call out par for an equity so
the stock was 100 bucks and you believe the brokers you were sure it'd be [Clock ticking by]
two hundred dollars in two years so you bought and then they missed their next
quarter and then their next you still are a big believer in the stock if you [Girl looking unhappy at the newspaper]
weren't you would take your losses but if you had conviction at eighty two
dollars a share well you still have conviction it'll get to $200 soon right
all right so now the stock sits at 47 bucks a share and you buy another [Stock price chart showing the price going down]
hundred shares to add to the hundred you paid eighty two dollars a share for
seven months ago and then they miss another quarter and you buy another
hundred shares now at the bargain basement price of $35 a share well you
bought in three separate tranches each one cheaper than the next the first one
cost you 100 times eighty two bucks or eighty two hundred dollars, nice job
buying there... second tranche cost you 100 times 47 bucks or 47 hundred dollars [Working being written out]
and applying concepts beyond calculus here the third tranche cost you a
hundred times thirty-five dollars or thirty five hundred dollars well what
did you do you averaged down your initial cost from 82 bucks a share to a final
average cost of 82 hundred plus forty seven hundred plus thirty five hundred
divided by three hundred shares you own which is about 54 sixty-seven a share
your dollar cost average then is $54 sixty-seven cents and you should also
note that although the number one reason to average down is because you're a [Guy sat on a roof]
believer in the stock long term, a second more Machiavellian reason at least if
you're a professional money manager is that it looks a whole lot
better when you report to shareholders that you bought in at a lower average
price when eventually it goes up again so nice going there would be Warren B [Stock price going up again on the chart]
let's hope that SNS shingle starts including an inflatable rescue mattress [Boy sliding down the roof]
with every purchase and every quarter they report [Boy flies off the roof, into a tree and then falls to the floor]
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Tax basis is your cost for assessing how much you owe in taxes, and is determined by multiplying your gains by your tax rate.