If you buy the same product at different prices, what did the unit you just sold cost you? The answer decides your profit on every sale and the value of the stock on your balance sheet. The average cost method gives a simple, consistent answer. This guide explains it with numbers, and shows how it flows into your accounts.
The problem: one product, several prices
A trader buys the same item many times, and the price changes. Suppose you buy 100 units at Rs 200 in the first week and 100 units at Rs 220 in the second. When you sell 120 units, you have to decide what they cost. Three methods are common:
| Method | Idea |
|---|---|
| Average cost | Every unit costs the blended average |
| FIFO (first in, first out) | The oldest units are sold first |
| LIFO (last in, first out) | The newest units are sold first |
Average cost is the easiest to run and the hardest to argue about, which is why many trading businesses use it.
How average cost works
Each time you buy, the average cost is recalculated:
New average cost = (value of stock on hand + value of the new purchase) ÷ (quantity on hand + quantity bought)
Each time you sell, the units leave at the current average cost, and the average itself does not change.
A worked example
| Step | Quantity | Price (Rs) | Stock quantity | Stock value (Rs) | Average cost (Rs) |
|---|---|---|---|---|---|
| Buy | 100 | 200 | 100 | 20,000 | 200 |
| Buy | 100 | 220 | 200 | 42,000 | 210 |
| Sell | 120 | 80 | 16,800 | 210 | |
| Buy | 20 | 250 | 100 | 21,800 | 218 |
Check the last line: 16,800 + 5,000 = 21,800, and 21,800 ÷ 100 = 218.
When you sold 120 units, they went out at Rs 210 each: 120 × 210 = Rs 25,200. That is your cost of goods sold for that sale.
What the accounts show
If the sale price was Rs 300 per unit, the sale produced Rs 36,000 of revenue.
| Account | Debit | Credit |
|---|---|---|
| Customer (or cash) | 36,000 | |
| Sales | 36,000 | |
| Cost of goods sold | 25,200 | |
| Inventory | 25,200 |
Gross profit on the sale is 36,000 − 25,200 = Rs 10,800.
How it compares with FIFO
Under FIFO the same sale would have cost the first 100 units at Rs 200 and 20 units at Rs 220: 20,000 + 4,400 = Rs 24,400. The difference is Rs 800 on this one sale. In a period of rising prices, FIFO shows a slightly higher profit than average cost, and the stock value on the balance sheet is higher too. Over a year the totals usually differ by little, but the method must be applied consistently.
Why traders like average cost
- One cost per product. Nobody has to track which batch a unit came from.
- Consistent. The balance sheet stock value and the cost of goods sold come from the same rule.
- Easy to check. Quantity × average cost equals stock value, always.
Things that upset the average
- Selling before the purchase is recorded. The cost used is out of date.
- Entering a purchase at the wrong price. Every later sale carries the error.
- Wrong opening cost. The first average is wrong, so every later one is.
- Freight and duties left out. If landed cost matters, include it in the purchase cost.
Common mistakes
- Changing the method halfway through the year.
- Typing the average cost by hand to "fix" a margin.
- Recording a return at today's average instead of the original cost.
- Ignoring negative stock.
How OneAccounts handles it
OneAccounts values stock at a running average cost. Each product shows an expandable working table with the running quantity and running average cost, so you can see how a figure came about. When you correct a product's opening quantity or cost, the average is recalculated from the opening figure and the full purchase history. Each sale posts cost of goods sold against inventory at the average cost at that time, and keeps that cost on the invoice line. Returns reverse the sale at the original cost. FIFO and LIFO are not offered.
See Trading ERP software and how to stop selling stock you do not have.
Frequently asked questions
What is the average cost method?
It values every unit of a product at the blended average of all purchases, recalculated each time you buy.
Does selling change the average cost?
No. Sales take units out at the current average. Only purchases change it.
Is average cost accepted for accounts and tax?
It is a widely used method. Confirm with your accountant that it suits your reporting.
Which is better, average cost or FIFO?
Neither is better in every case. Choose one, apply it consistently and make sure your software supports it.
What happens to the average if I return goods to a supplier?
The units leave at their cost and the stock value falls. Your software should reverse the original purchase effect.