average cost accounting

average cost accounting

The Significance of Average Cost Accounting in Business Management

1. Introduction to Average Cost Accounting

Although average cost accounting is widely used due to its simplicity, it is not specifically approved by authoritative accounting bodies. This is because it violates the matching principle, as costs from one period are combined with costs from another, which goes against the objective of cost accounting and generally accepted accounting principles. To accurately attribute certain costs to specific goods, the specific identification or FIFO methods should be used to determine the cost of goods sold or in ending inventory. Business managers who are responsible for the profitability of their operations should understand the importance of cost accounting and the cost accumulation techniques used by their accounting departments to compile the balance sheet and income statement. They should also be aware of the limitations of average cost accounting.

Average cost accounting is a method of cost accounting that calculates the average cost for each unit of product by averaging the actual production costs over a period. This includes both used and unsold units in ending inventories. Under average cost accounting, the actual costs for one period are averaged to determine the costs for the current period. The average cost is calculated by dividing the total production costs for the ending inventory of goods in process and the goods completed and on hand to be sold by the total physical unit equivalents in inventory. This method is suitable when there is a large physical output and the cost elements that make up the production cost remain relatively constant from period to period. The average cost method is discussed in relation to issues that affect inventory flow assumptions.

2. Key Concepts and Formulas in Average Cost Accounting

The parameter κk equals pi(Qk)/γki(Qk) and represents the opportunity cost of capital in period k, where pi(Qk) is the cumulative joint probability payable by a competitive firm in period k to change its maintenance-adjusted installed possessed capital from the actual level Kk to the sustainable profit-maximizing level Ki. This parameter only enters the analysis when we discuss how the no arbitrage condition of Margrabe (1970) is modified for the case of a capital-constrained continuous-time competitive firm. When the competitive firm lacks the capital to maintain installed capital at the sustainable profit-maximizing level for some periods and is forced to use a lesser stock Ki/Qk of capital services than Pi/Qk, suboptimal production choices will be taken and an economically meaningful annual removal and replacement policy will have to characterize the cost functions.

Here we elaborate on several key concepts and formulas from the literature of cost accounting that will later be used throughout our analysis. The discussion is rather brief. All definitions are given for a single homogeneous product and a constant production intensity. M is the number of periods in the analysis, q is the number of units of a homogeneous product produced in each period, which is identical to the number of units sold in a competitive long-run equilibrium analysis. Kk is the capital used in period k, Qk is the production in period k (that equals q). Kk/Qk is the capital intensity of production, and the cost γki(Qk) almost never increases and never decreases when q changes from zero to positive values.

3. Applications and Benefits of Average Cost Accounting

The publicly reported financial results and their fundamentals reported by external general purpose financial statements communicate price and profitability information in terms of these income statements and their asset and liability footnotes. External financial reporting received enhanced economic focus through a wide range of private practice and government-sponsored influences. The benefits of the resulting broad framework have also been supplemented with the availability of further clarified guidance sponsored by accounting theory research. Use the average costs of external business price and performance data in conducting financial analysis to communicate financial management expects the average cost concept to be valuable.

The average costing is the most common method and its own application relates to intermediate cost data. However, it is a principle which the decision maker’s normal apprehension easily grasps and its patterns of use are included in a wide range of business environments. It is also widely used for cross checks with other methods and it establishes desired cost compliance statements for a number of business control purposes. Even in the method dominantly influenced by manufacturing managers, average cost reporting is not only used, but it is also a deeply rooted system of accounting which surpasses the performance of inventory accounting cost layer valuations. Medium-term profit is the common objective of business. Consequently, the prices businesses pay for the basic production materials and other factors of production, the prices at which market goods and services are sold, and the cost-related performance attributes of products themselves are particularly integral decision-relevant data.

4. Challenges and Limitations of Average Cost Accounting

The difficulties are not, however, insurmountable. With a changing product mix and production levels, average cost analysis becomes both daunting as well as complicated. These do not mean that average cost data would be of little or no significance in real business management. Sensible techniques can go a long way in refining average cost data so that they can become guides for economic decisions. Average cost accounting, for the sake of continuity and to effect easy comparability, also should conform to cost accounting principles and techniques. This study is devoted to answering these and related queries that are of concern to business managers and others of similar interests.

Under average cost accounting, the state of the low performing models must be studied. The analysis is made to know their roots, the structural significance of the roots, and to suggest remedies. Remedies must not dominate the exclusive concern with the study of survival. The models that survived, the reasons for their survival, and the lessons that survival affords must be given prime importance. Another realm of weakness in average cost accounting pertains to the general disbelief in the legitimacy of average costs. There are advocates of the view that it is dangerous to use average cost as a guide for price and output decisions. A third query raised was how to employ the concept of average cost to determine the economic volume of concern in the operation of a business entity.

5. Best Practices and Strategies for Implementing Average Cost Accounting

In this paper, business management strategy is applied to the opportunities afforded by average cost accounting. Since the number of cost components affects the use of an average costing method to set prices that result in profit maximization, calculation of estimated long-run gain potential and underworld demand potential is important. Business managers will price each product to achieve the highest possible profit. The average cost method determines the profit potential of each product. The assumption is that the short-run average cost will be used to develop the profit margin in the competitive commercial market. Then the completed product can be sold at a competitive price, and overheads and other costs added to determine the company’s profitability. Business management strategies to exploit opportunities afforded by the average cost accounting method are developed. They include pricing and marketing product lines, determining inventory norms, and product line mix flexibility. Business managers can use average cost accounting to define and segregate product lines by product characteristics that maximize profit while meeting customer needs. Item-to-item comparison is important in business management. Then the potential of special flow methods to achieve particular overhead conditions needs consideration. Business management considerations imply that the necessary cost of modifications corresponds to the expected financial returns of the changes.

2. Business Management Strategy

In previous chapters, an approach to applying the formulas of average cost accounting to business management is developed. From these formulas, it is possible to calculate the average costs of production, inventory, and sales, and thereby reduce the LIFO conformity rule to a matter of honest accounting. The accounting then follows business norms, rather than distorting business management. Loss prevention is a significant measure of business success. Weak cost components in income and loss statements are helpful to assess the effectiveness of such practices as good purchasing and production policies, excellent administration, and sales of products. Business enterprise development and assessment of product management, by guiding attention to the prevailing income and loss situation of an investment, serve the same purpose. A firm must achieve satisfactory characteristics at a net loss level just as much as during profitable times.

1. Introduction