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Lower of Cost or Market (LCM)

Lower of Cost or Market Overview

The lower of cost or market is a requirement in Generally Accepted Accounting Principles that you record the cost of inventory at whichever cost is lower: its original cost or its current replacement cost on the open market.

Market is the current replacement cost of inventory, provided that market does not exceed the net realizable value, and that market shall not be less than net realizable value as reduced by an allowance for normal profit margin. Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal.

You should always reduce the cost of inventory in the current period when its utility is less than its cost. This situation typically arises when the inventory has physically deteriorated, is obsolete, or there are reduced selling prices.

Do not write down the value of raw materials if the finished goods into which they are incorporated are expected to sell at or above cost. Further, if inventory is the hedged item in a fair value hedge, then include the effects of the hedge in the inventory’s cost basis (why may eliminate the need for a lower of cost or market adjustment).

The write down to net realizable value is normally on an individual item basis, but can also be applied to major inventory categories or to the total of all inventory.

Lower of Cost or Market Example

Grand Teton Designs is a Wyoming manufacturer of climbing equipment. It has five major product lines, which are noted in the following table. At its fiscal year-end, Grand Teton calculates the lower of its cost or net realizable value (NRV) in the following table:

Based on the table, the market value is lower than cost on the outerwear and rope product lines. Accordingly, Grand Teton should recognize a loss on the outerwear product line of $14,250 ($128,250 –  $114,000) and a loss on the rope product line of $50,000 ($225,000 - $175,000).

If the amount of a lower of cost or market write-down is not material, then charge the expense to the cost of goods sold account. If the loss is material, then you should track it in a separate account, such as Loss on LCM Adjustment. An example entry using the information just described for Grand Teton Designs is:

You should write inventory down to the lower of cost or market unless there is substantial evidence that market prices will recover before the entity sells the inventory or, in the case of last-in, first-out inventory, there is substantial evidence that inventory amounts will be restored by year-end.

If there is a sales incentive that will result in a loss on the sale of a related product, this may be an indicator of impairment of the existing inventory for that item.

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