Lower of Cost or Market (LCM) Rule
Assets are generally stated in the financial statements according to the cost principle. However, in case of inventory, cost principle is abandoned and lower of cost or market (LCM) rule takes its place. This rule states that inventory should be measured at the lower of:
- Cost; or
- Market Value
Market value means the replacement cost of the inventory. Replacement cost may be in the form of purchase cost or manufacturing cost. In other words, market value is amount that we would have to pay to acquire inventory of the same quantity and quality through purchase or through manufacture. However, upper and lower limits have been placed on the market value of inventory.
- Upper limit (also called ceiling) is the net realizable value (NRV) of inventory. NRV equals expected selling price less the sum of expected cost of completion and expected cost needed to make the sale.
- Lower limit (also called floor) is net realizable value less normal profit margin on the inventory.
The LCM rule can be applied to inventory on individual items basis, inventory class basis or to entire inventory. However the choice must be consistent.
Company A owns an item of inventory having original cost of $900. Its replacement cost is $880. The company expects to sell it at $980. However an expense of $40 must be incurred to make the sale. Calculate the value of inventory according to lower of cost of market rule.
|Upper Limit: NRV||= 980 − 40||= $940|
|Replacement Cost||= $880|
|Lower Limit: NRV − Normal Profit||= 940 − (980 − 880)||= $840|
Since the replacement cost of $880 lies within the limits set by LCM rule, it is allowable market value of the inventory. This market value is to be compared to the original cost of inventory which is $900. Since the market value of inventory is lower than its original cost therefore it should be stated at $880 in the financial statements.