How QuickBooks Calculates Average Cost
For an inventory item, average cost is the total value of the items currently in stock divided by the quantity on hand. If you have a total Widget value of $20.00 and 10 units on hand, the average cost is $2.00 ($20.00/10).
QuickBooks uses average cost—and not another method such as LIFO or FIFO—to determine the value of your inventory. However, with that said, I must mention that since 2013 QuickBooks Enterprise Users who subscribed to 'Advanced Inventory' can opt to turn on FIFO as their cost methodology in lieu of average cost.
Note: This article (Part 1) of this series covers the calculation of average cost for normal and intended QuickBooks use devoid of user entry errors or data file setup errors. Subsequent parts of this article series will cover aberrations involved due to user errors or changing list information and/or historical transactions.
QuickBooks recalculates average cost during normal QuickBooks use in the following ways:
- When you record the purchase of an Inventory Part Item or the purchase of an Inventory Assembly Item. QuickBooks adds the cost of the new items to the cost of the existing stock and then divides by the total number of new and old items. If the per‐unit cost of the Inventory Part or Assembly Item you purchase is the same as the current average cost, the average cost recalculation will not cause any change. For example, assuming you have no quantities of widgets on hand, if you purchase 10 widgets for $2.00 per widget the average cost is $2.00. If you then purchase 8 more widgets at $2.00 per widget, QuickBooks will re‐calculate average cost but the calculation will not cause any change to average cost for the widgets on hand. The average cost for widgets will remain $2.00.
- When you change the value or quantity of an Inventory Part Item or Inventory Assembly Item using an Inventory Adjustment. As with a purchase, an inventory adjustment will or will not cause a change to average cost for an item, depending on how you adjust the quantities and total value for each part. On an inventory adjustment you can preserve the average cost if you change the quantity on hand and value proportionally. For example, if you have 10 widgets with an average cost of $2.00, the total value is $20.00 ($2.00 x 10). If on an Inventory Adjustment you change the quantity of widgets to 20 units and the total value to $40.00, QuickBooks recalculates average cost, but the average cost does not change. The average cost is still $2.00 ($2.00 x 20 = $40.00). By way of contrast, if you change the quantity on hand for widgets to 20 but leave the total value at $20.00, the average cost will change to $1.00 ($1.00 x 20 = $20.00)
- Record a build of an Inventory Assembly Item. This calculation is the most complex around Average Cost because there are multiple average costs involved. As with the first two examples the build will cause average cost to recalculate, but may or may not change average cost. QuickBooks considers the following around average cost when you record a build transaction:
- The average cost of each Inventory Part Item in the Bill of Materials. To calculate the value of the Inventory Assembly Item you are building, QuickBooks uses the average cost for each Inventory Part Item in the Bill of Materials as of the date and time you record the build. For example, you can build 1 Assembled Gadget from 1 unit of “Widget A”, 1 unit of “Widget B” and 1 unit of “Widget C”. If each of the Widget items (components) has an average cost of $1.00 QuickBooks calculates a $3.00 cost for the one Assembly Gadget you build ($1.00 +$1.00 + $1.00 = $3.00).
- The average cost of any Gadgets already in stock. Then, QuickBooks absorbs this $3.00 Gadget into the average cost of existing Gadgets on hand. (This is similar to how QuickBooks recalculates average cost when you purchase a new inventory part, only you are building rather than purchasing.) For example, if you have 2 Assembled Gadgets on the shelf with an average cost of $2.00 per gadget, the total value of the assembled gadgets on hand is $4.00 ($2.00 x 2). If you assemble 1 new gadget (as described above) and the per‐unit value of the 1 newly assembled gadget is $3.00 you add $3.00 of value to the assembled gadgets on the shelf and one unit to the on hand quantity. You now have 3 assembled gadgets in stock (2 + 1) with a total value of $7.00 ($4.00 + $3.00). The average cost for all gadgets in stock will be the new value ($7.00) divided by the new quantity (3), or $2.34.
Average Cost and the Sale of Inventory
The sale of Inventory Part Items and Inventory Assembly Items does not change average cost. However, average cost does play a key role. QuickBooks posts a credit to Inventory Asset and a debit to Cost of Goods Sold for each inventory item you enter on a sales form. QuickBooks calculates this post to Inventory Asset/Cost of Goods Sold using the average cost of the item as of the date and time you record the sales transaction.
For example, if you record an invoice for the sale of 3 Widgets at $10.00 per Widget ($30.00 total) and the Widgets have a $2.00 average cost, QuickBooks will post the following to the General Ledger (assuming no sales tax or other charges):
The average cost for the Widgets does not change because the quantities decreased proportionally to the value. For example, 10 Widgets with a total value of $20.00 have an average cost of $2.00. 7 widgets with a total value of $14.00 have the same average cost of $2.00.
In our next article we will cover the various aberrations involved due to user error or changing list information and historical transactions.