The average cost method simply keeps a running average of what an item is costing rather than estimate what an item should cost as standard costing does.

With the average costing method, the average cost of goods available for sale is not predefined by you; rather it is computed and the units in both the cost of goods sold and ending inventory are costed at this average cost. It is a weighted average. That is, each unit cost is weighted by the number of units with that cost. In QAD Enterprise Applications, a new average unit cost is calculated after each receipt and optionally during supplier invoicing.

For purchased items, the quantity received is multiplied by the purchase order price and added to the quantity on-hand multiplied by the current average material cost. This sum is divided by the new quantity on-hand to determine the new average material cost. The value of inventory is adjusted to reflect this new average cost. (See example in figure.)