Rebekiah has taught college accounting and has a master's in both management and business.
Bo owns a retail store that caters to hunters and fisherman. He always tries to keep the store stocked with the most up-to-date hunting and fishing equipment that there is out there. Running out of something just isn't an option in his book. That idea may be a good thing, but in the end, it also means that he carries quite a bit of inventory that must be valued at the end of an accounting period.
Do you know how inventory is valued? It may surprise you to know that it isn't valued at the wholesale or retail cost. It's valued based on something called the net realizable value. The net realizable value, also known as NRV, is the return that you would expect to get on an item after the item has been sold and the cost of selling that item has been subtracted.
Calculating NRV is fairly simple. You simply take the selling price of an item and you subtract any costs that you incurred getting that item ready for sale. So, let's look at an example:
Bo has deep sea fishing rods that he plans to sell for $120. It is going to cost him $4 to package the rods to get them ready to be sold. Since NRV = selling price - selling cost, then NRV = $120 - $4. So, the NRV of the deep sea fishing rods is $116.
One very important thing that you must realize at this point, though, is that NRV and profit are not the same. We have already said that NRV is the selling price of an item minus any costs associated with selling that item. Profit is the amount of money that is made in excess of the purchase cost of an item. Do you see the difference? The NRV is based on selling price and profit is based on purchase price.
So, let's look at another example to clarify this concept.
I have a car lot. I purchased a car for $12,000 and plan to resell that car for $16,000. It's going to cost me $250 to get the car ready for sale, and the commission that the employee who sells the car will make is $400. So, what is the NRV of this car?
To answer this question, I need to know two things: the selling price and selling cost. The selling price is $16,000. The costs that are associated with the sale are $250 + $400, which equals $650. Now, I need to subtract the costs from the sales price. So, $16,000 - $650 = $15,350.
Importance of NRV
Now that you know what NRV is and how to calculate it, let's talk about why it's so important. Any business that carries any kind of inventory has to value that inventory. The manner in which inventory is valued is specified by generally accepted accounting principles, which are also known as GAAP. GAAP are the guidelines for financial reporting and recording, and they're established by the Financial Accounting Standards Board.
GAAP requires that inventory be valued at the lower of cost or market. The lower of cost or market (LCM) means that inventory is valued at the lower of the total cost of purchasing the material or the current market replacement cost. As the definition states, cost is the total price of purchasing an item. Market is the replacement cost.
So, here is where the NRV comes into play. When determining the market price for LCM, there are certain restrictions that apply. The market price can't be higher than the market ceiling nor lower than the market floor. The market ceiling of a product is the NRV. The market floor is the NRV minus the normal profit that is expected to be received from the sale of the inventory item. So, if the market price of an item falls between these two figures, then it is deemed an acceptable price. If the market price is above the ceiling, then the price to be used for the LCM comparison is the NRV. If the market price is below the NRV, then the market floor is the price used for the comparison.
I know that's a lot of information to try to absorb, so we're gonna use an example to help you out.
Look back at Bo and the deep sea fishing rod and reels. The rod and reels cost Bo a total of $78 each. But he sells those for $120 each. The total profit that Bo expects to make off of each rod and reel is $42. The current market replacement cost for the rod and reels is $118. The NRV of the rods and reels is $116. What are the prices that Bo will use when trying to decide the lower of cost or market?
First, we know that the price that is associated with cost will be $78. The current market price is $118. However, is this the market price that should be used for comparison? At this point, we don't know. We are going to have to figure the market ceiling and market floor. The market ceiling is the same as the NRV, which is $116. The market floor is the NRV minus expected profit. So, to figure that, we would take the NRV of $116 and subtract the $42 that Bo expects to make off of each rod and reel. That makes the market floor be equal to $74.00.
Now to decide which market value to use. The current market price is $118. We know that the market value can't be more than the market ceiling or less than the market floor. In this case, the market price is more than the market ceiling. So, because of that, the value that we must use for the market is $116.
The cost of each rod and reel is $78. The market of each rod and reel is $116. Since we are looking for the lower of cost or market price to use when valuing inventory, then the price we'll use for the rod and reels is the cost of $78.
What would happen if the market price of the rod and reels had tumbled? Let's say that the current market price is $70. What would be the value used in the LCM then?
We already know that the NRV of the rod and reels is $116 each. We also know that the market ceiling is the same as the NRV and the market floor is $74. Since the current market price is lower than the market floor, we would have to use the market floor price of $74 to value the inventory.
What if the market price was $75? Well, in this case, since the current market price falls between the market ceiling and the market floor, then that price is acceptable and can be used in the comparison.
Valuing on hand inventory is not as easy as some may think. Inventory items can't be valued at their sales price. There has to be a few calculations done to come up with the correct dollar amount to assign to inventory.
One of those calculations is to find out what the net realizable value of an item is. The net realizable value is the return that you would expect to get on an item after the item has been sold and the cost of selling that item has been subtracted. The NRV, as it also known, is calculated by subtracting any expenses that were incurred getting an item ready for sale from the sales price.
But why is it important to know? Because GAAP principles require that inventory be valued at the lowest price possible. And since GAAP, also known as the generally accepted accounting principles, are the the guidelines for financial reporting and recording, then what they say goes. The concept that follows the GAAP guidelines for inventory valuation is known as the lower of cost or market (LCM), where inventory is valued at the lower of the total cost of purchasing the material or the current market replacement cost. Cost is the total price of purchasing an item. Market is the replacement cost of an item.
It's in the calculation of the market price that NRV plays a part. There are limitations on what market price can be. The market ceiling, or the top price, is the same as the NRV. The market floor, or lowest price, is the NRV minus the normal profit that's expected to be received from the sale of the inventory item.
If the current market price is higher than the market ceiling, the rule is that the market ceiling price is the one that's to be used for inventory valuation purposes. If the price is lower than the market floor, then the market floor price is the one that should be used. If the price falls between the ceiling and the floor, then the current market price should be used. Once the decision over which market price is the one that is to be used, it's compared to the price that is associated with cost and the lower of the two prices is the one that is used to calculate inventory value.
Following this video lesson, you will be able to:
- Define net realizable value (NRV)
- Summarize the GAAP guidelines of lower of cost or market (LCM) for inventory valuation
- Explain how to find the market ceiling and the market floor and how these values relate to NRV
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