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The Lower of Cost or Market of Inventory: Definition & Method

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Instructor
Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

Expert Contributor
Steven Scalia

Steven completed a Graduate Degree is Chartered Accountancy at Concordia University. He has performed as Teacher's Assistant and Assistant Lecturer in University.

No matter what kind of inventory a company has, that inventory has value. In this lesson, we'll talk about valuing inventory using the lower of cost or market rule.

LCM Defined

I love to shop, and I'm a sucker for a sale. There's just nothing better than going shopping and coming home with things that I have purchased for less than half of their original price. And having racks and racks of choices, well, that's just icing on the cake!

Sometimes the accounting fanatic comes out in me and I find myself wondering what the value is of all the inventory in my favorite stores. I know that generally accepted accounting principles (GAAP), which are the guidelines for financial recording and reporting, require that on hand inventory at the end of an accounting period be valued at the lowest value possible, but how is that done, and what exactly is inventory valuation anyway?

Inventory valuation is the total dollar amount that is attributed to the inventory on hand. Though there are three GAAP-approved ways to value inventory, in this lesson, we're going to discuss one of those: the lower of cost or market. The lower of cost or market, which is also known as LCM, is the inventory valuation method that records inventory value as the lower of cost or market. That seems simple enough, doesn't it?

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  • 0:06 LCM Defined
  • 1:19 Cost
  • 2:13 Market
  • 4:48 Lesson Summary
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Cost

Well, now let's break it down into the two components: cost and market. Cost is the acquisition price of inventory. Now notice that I didn't just say it was the purchase price of the inventory, because it isn't. Cost, in this case, is the sum of the purchase price, shipping costs, storage costs, and any other costs that are directly associated with the inventory item. It can be a little confusing, so let's look at a quick example.

I own a retail store. I purchased 50 scarves to sell in my store. I paid the supplier $150 for the scarves. Shipping costs were $18. Storage costs for keeping the scarves in inventory and ready for sale were $13. So the total cost of the scarves that would be used for inventory value would be $181, or $3.62 per scarf.

Market

Market, which is the other part of this concept, is a bit more complex. Market is defined as the amount that would have to be paid to replace a unit of inventory with an identical product. Market has limits on the amount that it can be. The upper limit, which is called the ceiling, is the net realizable value of the inventory. The net realizable value (NRV) is the sales price of an item minus the selling costs associated with that item. The lower limit, which is called the floor, is the net realizable value minus the expected profit of the item. I know, that's quite a few terms, so let's look at another example to bring this concept into perspective.

Remember the scarves that I purchased to sell in my store? I paid $3.00 per scarf when they were purchased. The current replacement cost of each scarf is $2.80. I'm selling the scarves for $7.00 each. I expect to incur $2.50 in selling expenses per scarf. Using these numbers, it's easy to see that the NRV per scarf is $4.50. Since the ceiling is equal to the NRV, then the market ceiling is $4.50.

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Additional Activities

Lower of Cost or Market of Inventory - A Practical Exercise

The following exercise is designed to enable students to apply their knowledge on the principle of lower of cost or market of inventory rule.

Scenario

You are an accountant for Not-Cool Clothing Inc, a fashion company located in New York City that produces high-end leather gloves and purses. The company uses the same leather for both of its products since it is a special type of leather obtained from Italy. You are now preparing the financial statements for the company's 2019 fiscal year. This year was tough for the company. The leather gloves, in particular, did not sell well at all. This was largely due to a review in Vogue magazine stating that the gloves were "so 2018 style". That being said, the purses performed very well. You collect the following information:

ItemCostMarket Value
Leather - Raw Materials$550,000$550,000
Gloves - Finished Goods$900,000$200,000
Purses - Finished Goods$400,000$1,100,000
Total$1,850,000$1,850,000

Exercise

1. Using the lower of cost or market of inventory rule, compute the value of inventory that will be reported on the balance sheet in compliance with GAAP.

2. Your colleague does not agree with your answer. She says that the total value of cost is equal to the total value of the market value, so no write-down is necessary. What is your response?

Solution

1. See below.

ItemCostMarket valueLower of Cost or Market
Leather -Raw Materials$550,000$550,000550,000
Gloves - Finished Goods$900,000$200,000200,000
Purses - Finished Goods$400,000$1,100,000400,000
Total 1,150,000

The answer is thus $1,150,000.

2. As per GAAP, the lower of cost or market of inventory rule must be applied to each type of inventory separately. Therefore, the answer above is correct.

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