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LCM Method

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Home >Financial Accounting >Inventories >LCM Rule

Lower of Cost or Market (LCM) Rule

Assets are generally stated in the financial


statements according to the cost principle.
However, in case of inventory, cost
principle is abandoned and lower of cost or
market (LCM) rule takes its place. This rule
states that inventory should be measured
at the lower of:

◾ Cost; or

◾ Market Value Get Paid Faster Online


Market value means the replacement cost Look Professional & Save
of the inventory. Replacement cost may be Time. Start Your Free Trial
Now.
in the form of purchase cost or
manufacturing cost. In other words, market
value is amount that we would have to pay
to acquire inventory of the same quantity and quality through purchase or through manufacture.
However, upper and lower limits have been placed on the market value of inventory.

◾ Upper limit (also called ceiling) is the net realizable value (NRV) of inventory. NRV equals
expected selling price less the sum of expected cost of completion and expected cost needed to
make the sale.

◾ Lower limit (also called floor) is net realizable value less normal profit margin on the
inventory.

The LCM rule can be applied to inventory on individual items basis, inventory class basis or to entire
inventory. However the choice must be consistent.

Example

Company A owns an item of inventory having original cost of $900. Its replacement cost is $880. The
company expects to sell it at $980. However an expense of $40 must be incurred to make the sale.
Calculate the value of inventory according to lower of cost of market rule.

Solution
AccountingExplained
Upper Limit: NRV = 980 − 40 = $940
Replacement Cost = $880
Lower Limit: NRV − Normal Profit = 940 − (980 − 880) = $840

Since the replacement cost of $880 lies within the limits set by LCM rule, it is allowable market value of
the inventory. This market value is to be compared to the original cost of inventory which is $900.
Since the market value of inventory is lower than its original cost therefore it should be stated at $880
in the financial statements.

Written by Irfanullah Jan

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