Additional Topics in Inventory Valuation



Lower of Cost or Market

In lower of cost or market (LCM), inventory items are written down to market value when the market value is less than the cost of the items.

Learning Objectives

Explain how a would use the Lower of Cost or Market to value inventory

Key Takeaways

Key Points

  • The basic assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or will fall.
  • Ending inventory is normally stated at historical cost (what was paid to obtain it), but there are times when the original cost of the ending inventory is greater than the cost of replacement. Thus, the inventory has lost value.
  • Any loss resulting from the decline in the value of inventory is charged to cost of goods sold (COGS) if non-material, or loss on the reduction of inventory to LCM if material.

Key Terms

  • stated value: par value
  • purchase price: The price at which something is actually purchased, especially from the point of view of the purchaser.
  • historical cost: The original monetary value of an economic item and based on the stable measuring unit assumption. Improvements may be added to an asset’s cost.
  • market value: The price which a seller or insurer might reasonably expect to fetch for goods, services or securities on the open market.

Lower Of Cost or Market

Lower of cost or market (LCM) is an approach to valuing and reporting inventory. Ending inventory is normally stated at historical cost (what was paid to obtain it), but there are times when the original cost of the ending inventory is greater than the cost of replacement. Thus, the inventory has lost value. If the inventory has decreased in value below historical cost, then its carrying value is reduced and reported on the balance sheet. The criterion for reporting this is the current market value. Any loss resulting from the decline in the value of inventory is charged to cost of goods sold (COGS) if non-material, or loss on the reduction of inventory to LCM if material.

The basic assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or will fall.

LCM In Practice

Under LCM, inventory items are written down to market value when the market value is less than the cost of the items. For example, assume that the market value of the inventory is USD 39,600 and its cost is USD 40,000. The company would then record a USD 400 loss because the inventory has lost some of its revenue-generating ability. Employees should check the stock of certain items to maintain an accurate record for dollars of inventory in stock.

Friedrich Von Hayek: Austrian economist Friedrich von Hayek, along with University of Chicago economist Milton Friedman are two classic liberal economists attributed with the return of laissez-faire economics and deregulation.

The company must recognize the loss in the period the loss occurred. On the other hand, if ending inventory has a market value of USD 45,000 and a cost of USD 40,000, the company would not recognize this increase in value. To do so would recognize revenue before the time of sale. A company may apply LCM to each inventory item (such as Monopoly), each inventory class (such as games), or total inventory.

Under the class method, a company applies LCM to the total cost and total market for each class of items compared. One class might be games, while another might be toys. The company then values each class at lower its cost or market amount.

Business Insight

Procter & Gamble markets a broad range of laundry, cleaning, paper, beauty care, health care, food, and beverage products around the world. Procter & Gamble’s footnote in its Notes to Consolidated Financial Statements in its annual report illustrates that companies often disclose LCM in their notes to financial statements.

Inventories are valued at cost, which is not in excess of current market price. Cost is primarily determined by either the average cost or the first-in, first-out method. The replacement cost of last-in, first-out inventories exceeds carrying value by approximately USD 169 million.

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Businesses need to manage their inventories.: Here a woman is checking stock of certain items to maintain an accurate record for dollars of inventory in stock.

Methods in Retail Inventory

For some companies, taking a physical inventory is impossible or impractical so the Retail Inventory Method is used to estimate.

Learning Objectives

Explain how to calculate inventory using the retail inventory method

Key Takeaways

Key Points

  • In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost through methods such as RMA.
  • The advantage of the RMA method is that companies can estimate ending inventory (at cost) without taking a physical inventory. Thus, the use of this estimate permits the preparation of interim financial statements (monthly or quarterly) without taking a physical inventory.
  • Because RIM/RMA only provides an approximation of inventory value, physical inventory must also be performed periodically to ensure the accuracy of inventory estimates due to issues such as shoplifting.

Key Terms

  • gross profit: The difference between net sales and the cost of goods sold.
  • shortage: a lack or deficiency
  • inventory: A detailed list of all of the items on hand.

Retail Inventory Method (RIM or RMA)

In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. Two very popular methods are:

  1. Retail inventory method, and
  2. Gross profit (or gross margin) method.

The retail inventory method uses a cost to retail price ratio. The physical inventory is valued at retail, and it is multiplied by the cost ratio (or percentage) to determine the estimated cost of the ending inventory. Note that both the gross margin and the retail inventory methods can help you detect inventory shortages.

Advantages

The advantage of this method is that companies can estimate ending inventory (at cost) without taking a physical inventory. Thus, the use of this estimate permits the preparation of interim financial statements (monthly or quarterly) without taking a physical inventory.

Disadvantages

Because RIM only provides an approximation of inventory value, physical inventory must also be performed periodically to ensure the accuracy of inventory estimates due to issues such as shoplifting.

How to find the ending inventory with RMA

The steps for finding the ending inventory by the retail inventory method are:

  1. Total the beginning inventory and the net amount of goods purchased during the period at both cost and retail prices.
  2. Divide the cost of goods available for sale by the retail price of the goods available for sale to find the cost/retail price ratio.
  3. Deduct the retail sales from the retail price of the goods available for sale to determine ending inventory at retail.
  4. Multiply the cost/retail price ratio or percentage by the ending inventory at retail prices to reduce it to the ending inventory at cost.

Example

To illustrate how you can determine inventory shortages using the retail method, assume that a physical inventory taken at year end, showed only $62,000 of retail-priced goods in the store. Assume that use of the retail method for the fourth quarter showed that $66,000 of goods should be on hand, thus indicating a $4000 inventory shortage at retail. After converting the $4000 to $2400 of cost ([latex]$4,000 \cdot 0.60[/latex]) you would report this as a “Loss from inventory shortage” in the income statement. Knowledge of such shortages may lead management to reduce or prevent them, by increasing security or improving the training of employees.