The term “average” refers to the result obtained by dividing the sum of individual values by the number of the values in a set (Dodge 1997, p. 55). This method helps to calculate the relative value of an individual unit in the set by assuming that all units have the same value (Dodge 1997). Average-based costing is an application of this method to the Accounting profession. It helps accountants to find the relative value of a single product in a batch. Costing is very important because of the role it plays during the calculation of margins and other business ratios.
The following are some of the reasons why some accountants use average-based costing. First, average-based costing simplifies the calculation of various financial ratios (Dallas 2002). It is very difficult to prepare books of accounts based on unit prices of individual products in businesses that handle large inventories. In such cases, it is easier to use average-based costing to calculate the financial ratios. Secondly, average-based costing can resolve problems associated with different selling prices for the same product (Phillips 2006). Businesses often sell their products at different prices to different customers. These price differences arise from trade discounts or from negotiations with customers. The third reason for the use of average-based costing is the possibility of analyzing its derivatives to find trends (Dodge 1997). For instance, an accountant can use moving averages to identify significant trends emerging from changes in the prices of goods over a given period.
Criticisms against the use of average-based costing are as follows. First, in situations where the prices of goods fluctuate, average-based costing is not an accurate quantity (Dodge 1997). For instance, if the price of a product changes drastically because of changes in tax policies or because of market forces, average-based costing does not reveal the impact of such changes. Secondly, average-based costing can mask the impact of price changes on the profitability of a company (Dallas 2002). If a profitable company uses average-based costing for its turnover calculations, it may fail to notice batches of products sold at a loss. The company may also fail to take advantage of unique opportunities because of the masking effect of average-based costing. Thirdly, the use of average-based costing can lead to inaccurate analysis in cases where products lack uniformity. In addition, low unit sales make average-based costing ineffective. (Dallas 2002). For instance, the use of average-based costing in a used car dealership can lead to very confusing conclusions since each used car is unique. In such situations, the application of average-based costing requires care.
Average-based costing can be useful to a company under some conditions. The first condition is whether the company uses it to calculate its annual ratios (Dodge 1997). In this situation, average-based costing makes the work of accountants easier. It also helps to simplify financial reports. Secondly, average-based costing is useful when the quantity of goods sold is very large (Dodge 1997). In this situation, tracking individual sales may be ineffective or impossible. Average-based costing can help a company to control its finances. The third condition for the use of average-based costing is if the company sells large volumes of similar products with small deviations in price (Phillips 2006). In this situation, it is more convenient to use an average based costing for ease of computation. These examples summarize ways in which organizations use an average-based costing system.
References
Dallas, M 2002, ‘The Journey from Cost to Value’, Journal of Value Management, vol 6, no. 3, pp. 8-12.
Dodge, R 1997, Foundations for Business Accounting, Cengage Learning, Boston MA.
Phillips, R 2006, Pricing and Revenue Optimization, Stanford University Press, Stanford, CA.