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Valuation At Lower Of Cost Or Market Definition

Lower of cost or market (LCM) is an accounting method that values inventory at a cost lesser than the historical cost or the current market price. The historical cost refers to the purchasing cost of the inventory.

Overview of Valuation At Lower Of Cost Or Market

The lower of cost or market (LCM) method is a part of the GAAP (Generally Accepted Accounting Principles) deployed in the United States (US) and the international business. The value of goods tends to fluctuate gradually over time. LCM is of significance as the sellable cost of inventory goes below the net realizable value of the product, inducing loss to the company. Thus, the LCM method is applied to record the loss.

The LCM rule enables the company to record the losses by writing down the worth of affected inventories. This value is reduced to the market cost, which is the ‘middle value’ relative to the replacement cost of inventory. This cost is the difference between the net realizable value and the usual profit gained on the items. The amount at which the inventory is written off is included under the COGS (Cost of Goods Sold) on the balance sheet.

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Valuation At Lower Of Cost Or Market DefinitionOverview of Valuation At Lower Of Cost Or MarketLCM Valuation:Stages of LCM Valuation:

LCM Valuation:

The LCM rule allows for a comparative evaluation of the inventory cost with that of the market price for a particular inventory. In such a comparison, it is usually found that the market value equals the replacement cost. However, there are certain exceptions to the replacement value:

  • The replacement value cannot supersede the NRV (net realizable value).
  • The replacement cost cannot fall lower than NRV minus a normal profit margin.

The value of the NRV equals the value of the inventory’s selling price minus costs that were paid in preparing the inventory. The difference between the selling price and cost price of such an inventory is termed as the normal profit margin. The conditions for replacement and inventory costs compared in the LCM method are illustrated below:

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Stages of LCM Valuation:

The inventory is valued in the following stages as per the LCM principle:

  • Firstly, the cost price of the inventory has to be determined.
  • The next stage would be to identify the replacement cost of inventory. The value of this would equal the market value of this inventory.
  • The replacement cost has to be compared with the NRV and NRV minus a normal profit margin if:
  • Replacement Cost>NRV{\rm{Replacement \text\ Cost > NRV}}Replacement Cost>NRV (NRV should be considered as the replacement cost)
  • Replacement Cost<NRV−Normal Profit margin{\rm{Replacement \text\ Cost < NRV – Normal \text\ Profit \text\ margin}}Replacement Cost<NRV−Normal Profit margin(NRV minus the profit margin for replacement cost is to be considered)
  • NRV – Normal Profit Margin < Replacement Cost < NRV\text{NRV — Normal Profit Margin < Replacement Cost < NRV}NRV – Normal Profit Margin < Replacement Cost < NRV (Replacement Cost has to be considered)

Lastly, the inventory cost has to be compared to the replacement cost if:

  • Inventory Cost < Replacement Cost\text{Inventory Cost < Replacement Cost}Inventory Cost < Replacement Cost (Write-down is required)
  • Inventory Cost>Replacement Cost{\rm{Inventory \text\ Cost > Replacement \text\ Cost}}Inventory Cost>Replacement Cost(Inventory to Replacement Cost has to be written down)

Factors Considered for the LCM Method

The factors to be considered for LCM applications are:

  • Category Evaluation – Generally, the LCM method standard is applied to certain inventories, but one can apply it to all types of inventories. In the other case, LCM adjustment can be dropped if there is an equilibrium within the set of inventory items having lesser and excess market costs.
  • Hedges – In instances where the inventory is hedged by a fair cost hedge, the effects of hedge should be added to the cost of inventory, obliterating the need for LCM adjustments.
  • Last-in, First-Out Layer Recovery – A write-down to the LCM can be skipped during the interim tenure if there is considerable evidence suggesting the storage of the inventory until the year end, thereby avoiding the realization of a previous layer of inventory.
  • Raw Materials – The cost of raw materials should be written off if the finished goods are estimated to sell at the same or at increased costs.
  • Recovery – A write-down to the LCM can be avoided if substantial evidence suggests a surge in market prices before the inventory sale.
  • Sales or Promotional Incentives – There are chances of potential issues to exist on certain items, where yet-to-be-expired sale incentives are still on-going.

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