The lower of cost or market (LCM) rule is an accounting principle used to value inventory for financial reporting purposes. Under the LCM rule, a company must value its inventory at either its cost or its market value, whichever is lower.
For a video explanation of the Lower of Cost or Market Rule, watch this:
The cost of inventory is the amount a company paid to acquire or produce the inventory, including all associated expenses, such as shipping and handling fees. Market value refers to the current selling price of the inventory, which can be determined by reference to actual market prices, if available, or by using estimates such as replacement cost or net realizable value.
To determine if a write-down is necessary, a company compares the cost of its inventory to its market value. If the market value is lower than the cost, the company must write down the value of the inventory to the market value. This write-down reduces the value of the inventory on the balance sheet and increases the cost of goods sold on the income statement.
For example, suppose a company has 100 units of a particular product in its inventory, and the cost to acquire or produce each unit is $10. The company normally sells the product for $20 per unit, but due to market conditions, the current market price has dropped to $15 per unit. In this case, the company must value the inventory at the lower of its cost ($10 per unit) or its market value ($15 per unit). Since the market value is lower than the cost, the company must write down the value of the inventory to $15 per unit, resulting in a write-down of $500 (100 units x ($10 – $15) per unit).
The LCM rule is an important accounting principle that helps ensure that inventory is valued appropriately on the balance sheet. By requiring companies to value inventory at the lower of its cost or market value, the LCM rule helps prevent overstatement of inventory values and provides a more accurate reflection of a company’s financial position.
For homework help to understand the Lower of Cost or Market Rule using ceiling, floor, and replacement costs, watch this video for an example:
For more about Inventory Write-Downs using the Lower of Cost or Net Realizable Value Rule, check out this article (with video):
Inventory Write-Downs: Lower of Cost or Net Realizable Value