The average cost basis is the sum of the individual cost bases of a group of assets, divided by the number of assets in the group. This computation allows the owner of the assets to use one figure as the most representative cost basis for the group, instead of listing an individual basis for each asset. A mutual fund is a common example of a group of assets that uses an average cost basis as an estimate of the individual cost bases of the stocks in the fund.
Cost basis is the original value of a capital asset when purchased, adjusted for increases or decreases in its value over time. In the case of corporate stocks, for example, the cost basis is the purchase price of the stock, decreased by stock splits and capital distributions, and increased by reinvested dividends. This computation is important for income tax purposes. Governments typically require individuals to pay taxes on capital gains, or the increase in the value of the asset. To know how much the value of an asset has increased, you must first establish the base line.
In some instances, it is impractical to track the cost bases of individual assets in an affiliated group. This is frequently the case with mutual funds, which are comprised of a changing group of individual stocks. Instead of listing the cost basis of every stock in a mutual fund that may contain thousands of stocks, an average cost basis is used for the entire fund.
At the time of a sale of an interest in a mutual fund where you would have to determine the capital gain for tax purposes, the average cost basis is calculated by taking the total purchase price of the shares, divided by the total number of shares owned and multiplied by the number of shares sold. Compare the result to the actual sale amount to compute capital gain or loss. For example, say you owned 1,000 shares of a mutual fund that you purchased for $10,000 U.S. Dollars (USD). The shares of the fund are actually comprised of thousands of individual shares of companies in which the fund is invested.
To compute the capital gain or loss on a sale of some of your shares in the fund, you would divide the total dollar value of your interest in the fund, or $10,000 USD, by the number of shares. This would equal $10 USD. Then, multiply $10 USD by the number of shares sold. If you sold 100 shares, the result would be $1,000 USD. This amount is your average cost basis.
Compare the average cost basis to the actual sales price. If those 10 shares increased in value and sold for $2,500 USD, there was a capital gain on the transaction of $1,500 USD. The average cost basis allows an investor to more easily manage his reporting to tax authorities, rather than trying to determine the increase or decrease in value of each individual stock.
