As a small business owner, you have to deal with many challenges— including some you may not have heard of such as lower of cost or market. This article can help explain how lower of cost or market can affect your business.
What is Lower of Cost or Market?
Lower of cost or market, or LCM, is a rule accounting for the possibilities of loss from an inventory’s value when there are drops in the inventory’s price. This inventory valuation is required for businesses that follow the Generally Accepted Accounting Principles (GAAP).
The LCM means that when you’re valuing your company’s inventory on a balance sheet, it’s marked at either its historical cost or market cost. Cost refers to the original price of inventory. The market value refers to the inventory’s replacement cost.
Why Do You Need to Calculate Lower of Cost or Market?
A small business owner has to calculate lower of cost or market to accurately reflect the changing value of inventory. Since you’re a small business owner, you have to keep meticulous track of your inventory. For example, let’s say you bought inventory at a cost of $50,000. However, if the market value of your inventory drops to $25,000, the lower value has to be recorded in your financial statements for accuracy. However, if you make mistakes with the calculations, it could be costly.
When Do You Record Lower of Cost or Market?
When you’re checking inventory, you measure the lower of cost or market when there’s a drop in market prices for the services or products you’re selling. You can also record lower of cost or market when a specific item you’re selling becomes obsolete.
4 Steps to Value Inventory at Lower of Cost or Market
If the price of your inventory is higher than the market value, there is a loss. That loss must be acknowledged in your lower of cost or market journal. Here are four additional steps to take when you record entries in a LCM journal entry.
- Determine your inventory’s original purchase cost.
- Figure out your inventory’s replacement amount.
- Compare the net realizable value to the cost of replacement. The net realizable value is the sale price of the inventory less the costs to get the inventory ready for sale.
- If the net realizable value is < than replacement cost, you would use net realizable value for the replacement cost.
- If the net realizable value is > than replacement cost, you would use this formula: net realizable value-profit margin=replacement cost.
In summary, the LCM formula is:
If the net realizable value-profit margin is < than replacement cost, then you use the net realizable value for replacement cost
- Compare the inventory’s cost to replacement cost.
- If the replacement cost is < than the cost of inventory, a write-down of inventory is not necessary.
- If the replacement cost is > than the historical cost of inventory, a write-down of inventory is necessary.
Factors That May Affect Lower of Cost or Market
There are other factors that may impact recording lower of cost or market in an LCM journal:
- Recovery: If you’re expecting that your inventory prices will increase before sales, then you don’t have to write down the inventory.
- Sales incentives: If there are sales incentives that haven’t expired that will lead to a loss on a sales item, there may be a lower of cost or market problem.
- Hedges: If your inventory is hedged by a fair value hedge, then add the cost of the hedge to the inventory cost. That lowers the need for an adjustment to lower cost or market.
- Category analysis: You can apply the LCM rule to specific and broader inventory categories.
- Raw materials: If you’re selling your goods at the cost or above the raw material’s expense, you don’t have to write down the raw material’s expense.
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