How to Use Lower of Cost or Market
Using the lower of cost or market means comparing the market value of each item in ending inventory with its cost and then using the lower of the two as its inventory value.
The difference between cost and market value
Cost is how much the company pays for the item if it buys the item or, if the company is the manufacturer, how much it costs to make the item. The market value of an item is usually its replacement cost. However, this assumption has one caveat: Market can’t go above the item’s net realizable value (ceiling) or below the item’s floor.
Floor? Ceiling? What the heck does this mean and how does it affect the carrying value of inventory?
Net realizable value (NRV): The NRV is the expected selling price of an item minus any selling costs or costs to complete the item (for example, the cost to reclassify in process inventory to finished goods inventory).
Floor: The floor is the NRV minus a normal profit on the item.
Still a little fuzzy on this concept? Here’s an example of how it works:
ABC, Inc., has unfinished goods sitting in work-in-process inventory with a sales value of $25,000 and an estimated cost to complete of $3,200. ABC has a normal profit on these items of 35 percent.
Different application methods
You can apply lower of cost or market (LCM) to the entire inventory, or you can cherry-pick between inventory items. The general rule is to apply LCM on an item-by-item basis because this method is the most conservative.
Consider an example of applying LCM. The following figure shows how to calculate LCM for four different inventory items.
The following figure shows alternative applications of LCM. You can see that, if you apply LCM by item, your ending inventory is $2,630; if you apply LCM for the inventory as a whole, your ending inventory is $2,790.