Lower of Cost or Market Concept
Every inventory is recorded at its cost. If the cost of and inventory decrease from its original cost then a major removal from the historical cost principle occurs. The decrease in original price of any inventory could be occur for variety of reasons the damaged goods, changes in the price level and so on. No matter what the cause for a decrease in the inventory, the company should report the decline price or the losses of inventory to the market. When the revenue-producing ability of the asset reduces from its original cost then a company do not applies the principle of historical cost. Abandon of historical cost principle in the inventory lead the companies to record the inventories at the lower-of-cost-or-market at each reporting period. As cost is the acquisition price of inventory which is computed using one of the historical cost-based methods for example average cost, FIFO, or LIFO.
Lower of Cost or Market (LCM) method means the cost which is used to replace the item by purchase or reproduction. The meaning of the term market could be varying according to the person such as a retailer considered the market as the place where the goods are purchased not sold. But for a manufacturer the term “market” refers (to goods at cost or cost to replace, whichever is lower). A departure from cost is justified because a company should charge a loss of utility against revenues in the period in which the loss occurs, not in the period of sale. The inventory could be measured or valued properly through applying the lower-of-cost-or-market, as this method is a traditional approach to inventory valuation. The company also can uphold a regular rate of gross profit on sales due to replacement cost.
But a decline in the replacement cost of an item often fails to specify a related decline in its utility. The lower-of-cost-or-market generally requires using two additional valuation limitations to value ending inventory, these are:
- Net realizable value and.
- Net realizable value less a normal profit margin.
Net realizable value (NRV) is the expected selling price in the operational business activities of any company, which are less practically expected costs of completion and disposal. A normal profit margin is subtracted from that amount to determine the net realizable value less a normal profit margin. Suppose ABC company has unfinished inventory of $3000, expected cost of completion and disposal of $900, and a normal profit margin of 30% then the net realizable value of ABC company is:
Inventory—sales value $3,000
Less: Estimated cost of completion and disposal $ 900
Net realizable value $2100
Less: Allowance for normal profit margin (30% of sales) $ 630
Net realizable value less a normal profit margin $ 1470
Under lower-cost-of-market the market amount is limited by two amounts of limits:
- (1) an upper limit, or “ceiling,” and
- (2) a lower limit, or “floor.”
If these two limits established for the value of the inventory then these limits can prevents companies from over- or understating inventory.
The upper limit (ceiling) is the net realizable value of inventory. This limit states that the market amount cannot be higher than NRV. The NRV will be used as the market amount, if the existing replacement cost of an inventory is greater than NRV. And the lower limit (floor) is the net realizable value (NRV) less the normal profit. Reversely this limit states that the market amount cannot be lower than NRV less the normal profit. The NRV less the normal profit is used as the market amount, if the existing replacement cost of an item in inventory is less than the NRV less the normal profit.