Copyright © 2008, The McGraw-Hill Companies, Inc.
Specific identification is a reasonable method to use when each item is readily
distinguishable from the other items, and has a high enough value to be kept track of sepa-
rately. A car dealer, for example, might use specific identification, since the cars he has in
inventory differ from each other in make, model, accessories, color, VIN (vehicle identifi-
cation number), etc., and each car is expensive enough that the dealer would keep cost and
sales records matched up to each individual car bought or sold.
There are many other situations, though, where specific identification is not a reasonable
approach to take. A hardware store, for example, would probably not be expected to track of
the specific cost of each box of screws that it sells. While the store would need to keep track
of how many boxes it buys and sells, and the costs and sale prices of these boxes, the store
is unlikely to keep a separate record for each individual box of screws. One 5-pound box
of 2^1 ⁄ 2 -inch wood screws is pretty much the same as another, and the value of each box is
not large enough to justify tracking individually. With most merchandise, while it is impor-
tant to keep track of the purchases, sales, and inventory of each particular type of item, we
would not keep track of the individual items to be able to use specific identification.Average Cost Method
With the average cost method, a business considers the cost of each item it has in stock to
be the average cost of all items of that type. This average is calculated in the usual way:
divide the total cost of all of the items by the total number of items.Example 15.2.1 Stassler Hardware ordered 500 Kandelrite brand 14-watt compact
fl uorescent light bulbs. The total cost of this order was $750. Realizing that this order
was not large enough, the company placed an additional order for 900 more at a cost
of $1,278. Using the average cost method, what is the store’s cost per bulb?Cost per bulb ______________$750 $1,278
500 900$2,028_______
1400 $1.45 per bulbNote that this fi gure is rounded. If the store wants greater precision in its cost calculations,
this could be carried out to more decimal places.Note that the first order of bulbs cost $750/500 $1.50 each, while the second order cost
$1,278/900 $1.42 each. Even if the store is able to accurately track which order each
individual bulb came from, though, it does not make much sense to consider some bulbs as
costing $1.50 and others as costing $1.42 since they are identical. The average cost takes
the logical step of considering all of these identical bulbs as having the same cost.
Of course, a hardware store does not just place an order or two for light bulbs and then hold
onto them forever. The store will be continually selling the bulbs and ordering new ones to
replenish their stock. If the new bulbs come at a different price, this will affect the average cost.Example 15.2.2 The light bulbs sold well, and Stassler Hardware soon placed a new
order for another 1,200 bulbs at a cost of $1,560. When this order arrived, the store
had 475 bulbs left from the original orders. What is the value of its inventory of this
particular bulb once the new order arrives, based on the average cost method?The fi rst step of this calculation is to determine the store’s total cost for the 475 light bulbs
still in stock.There are two ways to do this calculation; each will produce a slightly different result because
of rounding.One method is to use the $1.45 per bulb average cost that we calculated previously and
multiply that by 475 bulbs. This would give a total cost of $688.75 for those bulbs. There is
a small amount of inaccuracy in this fi gure, though, due to the fact that the $1.45 per bulb
cost was rounded.A second, more precise method, would be to calculate the cost of these bulbs as a percent
of the total cost of the original orders. The original orders included 1,400 bulbs, so it makes
sense to consider that the remaining bulbs’ cost is 475/1,400 of the total.15.2 Inventory 593