What Is LCM (Lower of Cost or Market) in Accounting?

The “Lower of Cost or Market” (LCM) is an inventory valuation method used in accounting to ensure that inventory assets are not overstated on a company’s balance sheet. This principle reflects a conservative approach to financial reporting, which guides accountants to recognize losses as soon as they are probable, but defer gains until they are realized. By applying LCM, businesses value their inventory at the lower of its original cost or its current market value, preventing the reporting of inventory at an amount greater than its anticipated future economic benefit. This method helps provide a more realistic portrayal of a company’s financial position, especially when inventory values decline due to factors such as obsolescence, damage, or decreased demand.

Understanding Inventory Cost

The “cost” component in the Lower of Cost or Market rule represents the historical cost incurred to acquire or produce the inventory. It includes all expenditures necessary to bring inventory to its present condition and location, ready for sale. For purchased goods, this typically includes the purchase price, freight-in charges, and applicable import duties or taxes.

For manufactured goods, the cost extends beyond raw materials to include direct labor costs and a portion of manufacturing overhead. These costs determine the total historical cost of each inventory item. This historical cost is the initial book value recorded for the inventory before market value considerations.

Defining Market Value

Market value for LCM purposes centers around Net Realizable Value (NRV). NRV is the estimated selling price less predictable costs of completion and disposal. Disposal costs include selling expenses, packaging, and transportation. For example, if an item is expected to sell for $100 but costs $10 to package and $5 to ship, its NRV would be $85.

NRV also establishes a “ceiling” for market value, meaning inventory should not be valued above its NRV, even if its replacement cost is higher. This prevents inventory from being valued above its recoverable amount. Conversely, a “floor” is set by subtracting a normal profit margin from the NRV. The floor prevents undervaluation that would lead to excessive future profits.

The “market” value used for comparison with historical cost is the middle value among three amounts: current replacement cost, the NRV ceiling, and the NRV less a normal profit margin (the floor). Replacement cost is what it would currently cost to acquire or produce the same inventory item. This three-pronged determination ensures a balanced and conservative valuation that accounts for both potential losses and future profitability.

Applying the Lower of Cost or Market Rule

Once cost and market value are established for an inventory item, a direct comparison is made. The LCM rule dictates inventory must be valued at the lower of these two amounts. This ensures prompt recognition of any decline in inventory utility or value.

Businesses can apply the LCM rule using one of three common methods. The “item-by-item basis” compares cost and market value for each individual item, choosing the lower figure. This method generally results in the lowest overall inventory valuation and is considered most conservative.

The “category basis” groups similar items, applying LCM to the total cost and market value of each category. The “total inventory basis” applies LCM to the aggregate cost and market value of the entire inventory. This method typically yields the highest inventory valuation among the three. Consistency in application is important for comparability of financial statements.

Recording Inventory Adjustments

When inventory market value falls below historical cost, an inventory write-down is necessary under the LCM rule. This write-down is recorded by debiting a loss account and crediting the inventory account. If not substantial, it may be debited directly to Cost of Goods Sold. For significant losses, a separate “Loss on Inventory Write-Down” account is used to highlight the impact.

This adjustment directly affects a company’s financial statements. On the income statement, the loss increases expenses (or Cost of Goods Sold), reducing net income. On the balance sheet, the inventory asset is reduced to its lower market value, providing a more accurate representation of its worth.

Under U.S. Generally Accepted Accounting Principles (GAAP), once inventory is written down, it cannot be written back up in subsequent periods, even if market conditions improve. This rule reinforces the conservative nature of U.S. GAAP regarding inventory valuation.