Lower of cost or market

From Wikicpa

The lower of cost or market is a major departure from adherence to the historical cost principle of inventory valuation. If the inventory declines in value below its original cost (for example, obsolescence or damaged goods), the inventory should be written down to reflect this loss. The general rule is that the historical cost principie is abandoned when the future revenue-producing ability of the asset is no longer as great as its original cost.

A departure from (histrical) cost is justified on the basis that a loss of utility should be reflected as a charge against the revenues in the period in which it occurs. Inventories are valued therefore on the basis of the lower of cost or market instead of on an original cost basis. The term “market” in the phrase “the lower of cost or market” generally means the cost to replace the item (by purchase or reproduction). “Market,” however, is limited to an amount that should not exceed the net realizable value (that is, estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal).

Illustration

The lower of cot or market rule really means that goods are to be valued at cost or cost to replace the item, whichever is lower.

For example, material that cost $10.00 a unit when purchased, which can now be sold for $12.50, and which can be replaced for $9.00, should be priced at $9.00 for inventory purposes under the lower of cost or market rule.

To understand the rationale for the use of replacement cost, assume that a buyer and seller are negotiating on the price of a unit of merchandise and agree that the regular selling price should be reduced. It would seem logical that the replacement cost of that unit of merchandise either has decreased or will decrease because the expected revenue-producing ability of that unit has been reduced. In attempting to measure the decrease in value of the’ unit of merchandise, the accountant employs replacement cost, because changes in replacement cost usually reflect or predict a decline in selling price and they are easy to identify. Therefore, to insure that the company continues to obtain the same rate of gross profit margin, the inventory is reduced to replacement cost.