May 13, 2022 May 13, 2022/ Steven Bragg
The lower of cost or market rule states that a business must record the cost of inventory at whichever cost is lower – the original cost or its current market price. This situation typically arises when inventory has deteriorated, or has become obsolete, or market prices have declined. The rule is more likely to be applicable when a business has held inventory for a long time, since the passage of time can bring about the preceding conditions. The rule is set forth under the Generally Accepted Accounting Principles accounting framework.
The “current market price” is defined as the current replacement cost of the inventory, as long as the market price does not exceed net realizable value; also, the market price shall not be less than the net realizable value, less the normal profit margin. Net realizable value is defined as the estimated selling price, minus estimated costs of completion and disposal.
Additional factors to consider when applying the lower of cost or market rule are:
Analysis by category. You normally apply the lower of cost or market rule to a specific inventory item, but you can apply it to entire inventory categories. In the latter case, an LCM adjustment can be avoided if there is a balance within an inventory category of items having market below cost and in excess of cost.
Hedges. If inventory is being hedged by a fair value hedge, then add the effects of the hedge to the cost of the inventory, which frequently eliminates the need for a lower of cost or market adjustment.
Last in, first out layer recovery. You can avoid a write-down to the lower of cost or market in an interim period if there is substantial evidence that inventory amounts will be restored by year end, thereby avoiding recognition of an earlier inventory layer.
Raw materials. Do not write down the cost of raw materials if the finished goods in which they are used are expected to sell either at or above their costs.
Recovery. You can avoid a write-down to the lower of cost or market if there is substantial evidence that market prices will increase before you sell the inventory.
Sales incentives. If there are unexpired sales incentives that will result in a loss on the sale of a specific item, this is a strong indicator that there may be a lower of cost or market problem with that item.
A recent update to the rule simplifies matters somewhat, but only if a business is not using the last in, first out method or the retail method. The variation states that the measurement can be restricted to just the lower of cost and net realizable value.
Example of the Lower of Cost or Margin
Mulligan Imports resells five major brands of golf clubs, which are noted in the following table. At the end of its reporting year, Mulligan calculates the lower of its cost or net realizable value in the following table:
| Product Line |
Quantity on Hand |
Unit Cost |
Inventory at Cost |
Market per Unit |
Lower of Cost or Market |
| Free Swing | 1,000 | $190 | $190,000 | $230 | $190,000 |
| Golf Elite | 750 | 140 | 105,000 | 170 | 105,000 |
| Hi-Flight | 200 | 135 | 27,000 | 120 | 24,000 |
| Iridescent | 1,200 | 280 | 336,000 | 160 | 192,000 |
| Titanium | 800 | 200 | 160,000 | 215 | 160,000 |
Based on the table, the market value is lower than cost on the Hi-Flight and Iridescent product lines. Consequently, Mulligan recognizes a loss on the Hi-Flight product line of $3,000 ($27,000 - $24,000), as well as a loss of $144,000 ($336,000 - $192,000) on the Iridescent product line.
Accounting for the Lower of Cost or Margin
If the amount of a write-down caused by the lower of cost or market analysis is immaterial, then charge the expense to the cost of goods sold; this is usually the case. If the loss is material, then you may want to track it in a separate account (especially if such losses are recurring), such as “Loss on LCM adjustment,” in order to separately report on this information. To use the information in the preceding example, the journal entry would be:
| Debit | Credit | |
| Loss on LCM Adjustment | 147,000 | |
| Finished Goods Inventory | 147,000 |
May 13, 2022/ Steven Bragg/
Rationale Behind Lower of Cost or Market (LCM)
When inventory is purchased by a company, it sits on the balance sheet at cost. However, over time, the value of the inventory may depreciate or appreciate. To increase the reliability of financial statements, the changing value of inventory, to an extent, must be accounted for.
For example, if a company purchased inventory at the cost of $100,000 but the market value of the inventory is $20,000, users of financial statements would want the lower value to be reflected in the books. If the inventory value were not reassessed to the appropriate value, it would overstate the company’s assets and mislead users. However, as will be discussed below, the lower of cost or market inventory valuation method is not as simple as just comparing cost and market.
Valuing Inventory at Lower of Cost or Market (LCM)
In the lower of cost or market inventory valuation method, the company’s inventory purchased at cost is compared against the market value of that inventory. The market value of inventory is essentially the replacement cost of that inventory or the amount of money it would take to replace the inventory in the open market. However, there are some caveats for understanding replacement value:
- The replacement cost cannot exceed the net realizable value (NRV).
- The replacement cost cannot be lower than net realizable value less a normal profit margin.
Net realizable value is the sale price of the inventory minus any costs incurred to prepare the inventory for sale. A normal profit margin is the average spread between the cost and sale price of the inventory. Such caveats for replacement cost establish a floor and ceiling for replacement cost. It is illustrated as follows:
Here are the steps to valuing inventory at the lower of cost or market:
1. First, determine the historical purchase cost of inventory.
2. Second, determine the replacement cost of inventory. It is the same as the market value of inventory.
3. Compare replacement cost to net realizable value and net realizable value minus a normal profit margin. If:
- Replacement cost > net realizable value, use net realizable value for replacement cost.
- Replacement cost < net realizable value minus a normal profit margin, use net realizable value minus a profit margin for replacement cost.
- Net realizable value minus a normal profit margin < replacement cost < net realizable value, use replacement cost.
4. Compare the cost of inventory to replacement cost. Lastly, if:
- Historical cost of inventory < replacement cost, a write-down is not necessary.
- Cost of inventory > replacement cost, write-down inventory to replacement cost.
To fully understand the concepts, a comprehensive example is prepared below.
Examples of Lower of Cost or Market (LCM)
Example 1
ABC Company sells wallets. Cost information regarding the inventory of ABC Company is presented below:
- The purchase cost: $250
- The replacement cost: $150
- The net realizable value: $160 ($200 – $40)
- The net realizable value minus a normal profit margin: $140 ($160 – $20).
In this example, replacement cost falls between net realizable value and net realizable value minus a normal profit margin. Therefore, the replacement cost used is $150. Comparing the amount to the purchase cost of $250, a $100 write-down is necessary.
Example 2
ABC Company sells wallets. Cost information regarding the inventory of ABC Company is presented below:
- The purchase cost: $250
- The replacement cost: $120
- The net realizable value: $160 ($200 – $40)
- The net realizable value minus a normal profit margin: $140 ($160 – $20)
In this example, replacement cost falls below the net realizable value minus a normal profit margin. Therefore, the replacement cost used is $140. Comparing the amount to the purchase cost of $250, a $110 write-down is necessary.
Example 3
ABC Company sells wallets. Cost information regarding the inventory of ABC Company is presented below:
- The purchase cost: $250
- The replacement cost: $240
- The net realizable value: $160 ($200 – $40)
- The net realizable value minus a normal profit margin: $140 ($160 – $20)
In this example, replacement cost is above net realizable value. Therefore, the replacement cost used is $160. Comparing the amount to the purchase cost of $250, a $90 write-down is necessary.
Recording Lower of Cost or Market
If the market cost is lower than the cost, a write-down is necessary. The journal entry would be as follows:
| Loss from the decline in inventory value | Dr. XX |
| Inventory | Cr. XX |
The loss from the decline in inventory value would be reflected in the income statement and reduce net income. Inventory would be reflected in the balance sheet and reduce the value of inventory.
The journal entry for the three examples above would be:
Example 1
| Loss from the decline in inventory value | Dr. 100 |
| Inventory | Cr. 100 |
Example 2
| Loss from the decline in inventory value | Dr. 110 |
| Inventory | Cr. 110 |
Example 3
| Loss from the decline in inventory value | Dr. 90 |
| Inventory | Cr. 90 |
More Resources
Thank you for reading CFI’s guide to Lower of Cost or Market. To keep advancing your career, the additional CFI resources below will be useful:
- IFRS vs. US GAAP
- Inventory Audit
- Market Valuation Approach
- T Accounts Guide