As someone who has spent years in accounting and finance, I know how crucial it is to grasp inventory valuation methods. One principle that often confuses beginners is the Lower of Cost or Market (LCM) rule. In this guide, I break down LCM in simple terms, explain why it matters, and show you how to apply it correctly.
Table of Contents
What Is Lower of Cost or Market?
The Lower of Cost or Market (LCM) rule is an accounting principle that requires inventory to be reported at the lower of its historical cost or its current market value. This conservative approach ensures that inventory isn’t overstated on financial statements, which could mislead investors or creditors.
Why LCM Matters
Inventory is a significant asset for many businesses. Overvaluing it can distort financial ratios, affect loan covenants, and lead to poor decision-making. The LCM rule acts as a safeguard, preventing companies from reporting inventory at inflated values.
Key Components of LCM
To understand LCM, we need to define two main terms:
- Cost – The original purchase price plus any additional costs to bring the inventory to its present condition (e.g., shipping, handling).
- Market Value – The current replacement cost, but with upper and lower limits:
- Ceiling (Net Realizable Value, NRV) – The estimated selling price minus completion and disposal costs.
- Floor (NRV minus Normal Profit Margin) – The minimum allowable market value to prevent excessive write-downs.
The LCM Formula
The LCM rule compares three values:
\text{LCM} = \min(\text{Cost}, \text{Market Value})How to Apply LCM: A Step-by-Step Example
Let’s say I own a retail store that sells designer handbags. Here’s how I would apply LCM:
- Determine Cost:
- Purchase price per bag: \$200
- Shipping & handling: \$20
- Total cost per bag: \$220
- Find Market Value:
- Replacement Cost: \$180 (current price to buy the same bag)
- NRV (Ceiling): \$250 (selling price) – \$30 (selling costs) = \$220
- Floor (NRV – Profit Margin): \$220 - \$50 = \$170
- Compare Values:
- Since replacement cost (\$180) is between the floor (\$170) and ceiling (\$220), market value = \$180.
- LCM = min(\$220, \$180) = \$180.
- Record the Adjustment:
- If inventory was originally recorded at \$220, I must write it down by \$40 per bag.
| Component | Value ($) |
|---|---|
| Cost | 220 |
| Replacement Cost | 180 |
| NRV (Ceiling) | 220 |
| Floor | 170 |
| Market Value | 180 |
| LCM (Final Value) | 180 |
Why the Ceiling and Floor Exist
The ceiling prevents overstatement by capping market value at the net realizable value. The floor ensures excessive write-downs don’t distort future profits.
Real-World Implications
- Taxes: Writing down inventory reduces taxable income.
- Investor Confidence: Conservative valuations build trust.
- Loan Covenants: Banks may require LCM compliance.
Criticisms of LCM
Some argue LCM is too conservative, leading to:
- Volatility: Frequent adjustments affect earnings.
- Subjectivity: Estimating NRV and profit margins isn’t always precise.
Final Thoughts
Mastering LCM helps maintain accurate financial statements. While it has limitations, its conservative approach protects businesses from overvaluing inventory. If you’re new to accounting, practice with different scenarios to build confidence.
