How to Calculate Net Realizable Value

Net Realizable Value (NRV) is a method used to estimate the true cash value of an asset, specifically inventory and accounts receivable. By calculating NRV, a business determines the net amount it realistically expects to receive from an asset’s sale after accounting for all associated costs. This process provides a conservative valuation that ensures the value of these assets is not overstated in financial reporting.

The Lower of Cost or Net Realizable Value Rule

Calculating NRV for inventory is based on a principle from United States Generally Accepted Accounting Principles (GAAP). For companies using methods like first-in, first-out (FIFO) or average cost, inventory must be reported at its original purchase cost or its net realizable value, whichever is lower. This is the “lower of cost or NRV” rule. In contrast, companies using last-in, first-out (LIFO) or retail inventory methods apply a different standard called the “lower of cost or market” rule. If market conditions cause inventory value to fall below its original cost, this rule forces the company to recognize that loss immediately, ensuring the balance sheet reflects a realistic recovery value.

Information Needed for the NRV Calculation

To accurately calculate NRV, three specific pieces of information are required.

• The estimated selling price of the inventory, which is determined by referencing current market prices, analyzing recent company sales data, or using prices stipulated in firm sales contracts.
• The estimated costs of completion for any inventory that is not yet finished, including remaining raw materials, direct labor, and an allocation of manufacturing overhead required to complete the goods.
• All estimated costs associated with the disposal or sale of the inventory, such as sales commissions, shipping costs, specialized packaging, and direct advertising expenses for that product line.

The NRV Calculation Formula and Application

The formula for Net Realizable Value is NRV = Estimated Selling Price – (Total Estimated Costs of Completion and Disposal), which provides the net cash amount a company expects to gain from its inventory.

To illustrate, consider a company with an unfinished product that has a projected selling price of $150 per unit once completed. The company determines it will cost an additional $20 in materials and labor to finish each unit and will spend $10 per unit on sales commissions and shipping. Following the formula, the calculation is: $150 (Estimated Selling Price) – $30 ($20 Completion Costs + $10 Disposal Costs). The resulting Net Realizable Value for this inventory item is $120.

Recording an Inventory Write-Down

When an inventory’s NRV is less than its original cost, a write-down is required to adjust the asset’s value on the books. This adjustment is recorded through a journal entry. The company debits an expense account, such as Cost of Goods Sold or “Loss on Inventory Write-Down,” and credits the Inventory asset account. This entry reduces the inventory’s book value and increases expenses, which in turn reduces the reported net income for the period.

For example, if an inventory item cost $100 but its NRV is calculated to be $80, a $20 write-down is necessary. The journal entry would show a $20 debit to Cost of Goods Sold and a $20 credit to Inventory. This entry formally recognizes the economic loss that has occurred due to the decline in the inventory’s value.