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Lower of Cost or Market Method Definition
The lower of cost or market method refers to an inventory costing approach that values a company’s stock on the balance sheet either at its current market cost or historical cost. The term historical cost refers to the cost of purchasing inventory, although there is a possibility of the value of a good change.
If the value of the stock decreases below the historical price of the product causing loss to the company, then the market or lower of cost method can be applied to record the damage. The lower of cost or market method assumes that if the item’s purchasing price falls, its selling price will also go down.
A Little More on What is Lower of Cost or Market Method
According to LCM or market rule, every business must record the inventory at its current market price or the original cost. The law operates under the Generally Accepted Accounting Principles (GAAP) accounting framework.
The situation usually comes up when there is a decline in market prices or when inventory becomes obsolete. The LCM rule is, in most cases, applicable when a business holds the stock for a more extended period. Note that the above conditions usually occur as time passes by.
There is a simple rule that you must apply when using LCM. When the cost and the market value are equal, there is no loss or gain recognized. However, when the price happens to be higher than the market value, there is a loss acknowledged.
What LCM method does is that it allows a business to record a loss by writing down the affected inventory items’ value. You can reduce the item’s value to the market value, also known as the ‘middle value’ when comparing:
- The cost to replace the inventory
- The variance between the profit on the item and the net realizable value
- The net realizable value of the item
Steps for Valuing Inventory at the LCM
There are several steps involved when valuing inventory at lower of cost or market. They are as follows:
Step one: Determine the inventory’s purchase cost
Step two: Determine the inventory’s replacement cost
Step three: Compare the net realizable value to the cost of replacement first, followed by the net realizable value minus average profit margin.
If the replacement cost is higher than the net realizable value, then a net realizable value for replacement cost is used. However, if the replacement cost is less than the net realizable value, minus a normal profit margin, you can use the net realizable value for replacement cost. Where the net realizable value minus a normal profit margin is less than the replacement cost and less than the net realizable value, you can apply a replacement cost.
Step four: Compare the inventory’s cost to replacement cost. Where the inventory’s price is less than the cost of replacement, there is no need for a write-down. However, if the inventory’s price happens to be higher than the replacement cost, then a write-down inventory to cost of replacement becomes necessary.
Other Factors Applicable to Lower of Cost or Market Value
Category analysis: Although LCM or market rule applies to a specific inventory item, you can also use it on other inventory categories.
Raw Materials: When you are expecting to sell the finished goods either at the cost or above the raw materials’ expense, then you are not supposed to write down the raw materials’ cost.
Hedges: When there is hedging of inventory by a fair value hedge, then adding the hedge’s effects to the inventory’s cost is necessary because it removes the need for market adjustment or lower price.
Recovery: You can avoid a write-down to LCM if there is evidence that before selling the inventory, the market prices will increase.
Sales incentives: If there is a loss on an item’s sales resulting from unexpired sales incentives, it is an indication that there could be a market problem with the object or a lower cost.