Lower of Cost or Market (LCM)
Writing down inventory when values drop—conservatism in action.
Why This Matters
You're a retailer. Last year, you bought 500 smartphones for $400 each—$200,000 in inventory. They were hot sellers.
Then the new model dropped. Suddenly, nobody wants last year's phone. The market price crashed to $250 each.
Question: What's your inventory worth on the balance sheet?
Your gut says $200,000—that's what you paid. But here's the problem: you can't sell them for $200,000 anymore. If you tried, you'd get maybe $125,000.
Accounting Rule:
You can't pretend inventory is worth more than you can sell it for.
This is the Lower of Cost or Market (LCM) rule. It forces companies to write down inventory when market values drop below what they paid. It's one of the most important applications of conservatism in accounting—the principle that says: when in doubt, report the worse number.
The Core Rule
1. Cost
What you paid for it
2. Market
What it's currently worth
LCM Logic
If Cost < MarketReport at COST (no action)
If Cost > MarketReport at MARKET (write-down)
You NEVER write UP inventory.
You only write DOWN when market drops below cost.
What Is "Market"?
This is where it gets tricky. "Market" doesn't simply mean "whatever someone will pay."
IFRS & Modern US GAAP
Simplified approach for most companies:
Market = NRV
Estimated Selling Price
- Estimated Costs to Sell
= Net Realizable Value (NRV)
No ceiling/floor gymnastics. Just: What did you pay? What can you sell it for (minus selling costs)? Report the lower one.
Traditional US GAAP
Used by companies on LIFO or Retail method:
(Replacement Cost)
Ceiling: Prevents overstating market value above what you can sell it for.
Floor: Prevents excessive write-downs that create artificial future profits.
Real-World Examples
Example 1: Tech Retailer (Write-Down)
ElectroMart has 200 tablets.
- Cost: $300 each
- Est. Selling Price: $280
- Selling Costs: $30
1. Calculate NRV:
$280 - $30 = $250 per unit
2. Compare:
Cost ($300) > NRV ($250)
Write-down required: $50/unit
// 200 units × $50 = $10,000 loss
Loss on Inventory Write-Down10,000
Inventory10,000
Example 2: Fashion Retailer (Seasonal Markdown)
TrendyClothes has 100 winter coats left over.
- Cost: $150 each
- Est. Selling Price (clearance): $80
- Selling Costs: $10
1. Calculate NRV:
$80 - $10 = $70 per unit
2. Compare:
Cost ($150) > NRV ($70)
Write-down required: $80/unit
// 100 units × $80 = $8,000 loss
Loss on Inventory Write-Down8,000
Inventory8,000
Example 3: ToolCo (No Write-Down)
ToolCo has 500 hammers.
- Cost: $12 each
- Est. Selling Price: $25
- Selling Costs: $2
1. Calculate NRV:
$25 - $2 = $23 per unit
2. Compare:
Cost ($12) < NRV ($23)
No write-down needed
Inventory stays at original cost.
No journal entry.
Applying LCM: Levels of Detail
Companies can apply LCM at different levels. Item-by-item is the most common because it's the most conservative.
| Inventory | Cost | Market | Item-by-Item |
|---|---|---|---|
| Category A - Electronics | |||
| Item 1 | $5,000 | $4,500 | $4,500 |
| Item 2 | $3,000 | $3,200 | $3,000 |
| Category B - Appliances | |||
| Item 3 | $8,000 | $7,000 | $7,000 |
| Item 4 | $2,000 | $2,500 | $2,000 |
| TOTALS | $18,000 | $17,200 | $16,500 |
Common Triggers
- 💻
Tech Obsolescence
Last year's model
- 🧥
Seasonal Goods
Winter coats in April
- 🥛
Expiration/Spoilage
Food near sell-by date
- 📉
Market Price Drops
Commodity crash
Can You Reverse It?
US GAAP: NO
Once written down, it's permanent. Emphasizes reliability (lock in the loss).
IFRS: YES
But only up to the original cost. Emphasizes relevance (show current value).
Original Cost: $10,000
Written Down: $7,000 (market dropped)
Market Later: $9,000 (recovered)
US GAAP Inventory: $7,000
IFRS Inventory: $9,000
Red Flags: What Write-Downs Signal
When you see large inventory write-downs on a company's financials, ask yourself:
1. Are they recurring?
Signals poor inventory management. The company consistently overstocks or misjudges demand.
2. Are they massive?
A large write-down relative to total inventory means a huge portion of stock is obsolete. Warning sign.
3. Happening in Q4?
Possible earnings management. Management is trying to "clear the decks" before the new year.
4. New Management?
"Big bath" accounting. New CEO takes all losses at once to blame the predecessor and make future years look great.
Key Takeaway
Lower of Cost or Market (LCM) requires companies to report inventory at the lower of what they paid (cost) or what it's currently worth (market/NRV). This is conservatism in action—recognize losses immediately when values drop, but never write up inventory when values rise.
Write-downs reduce both inventory on the balance sheet and income on the income statement. Large or recurring write-downs often signal inventory management problems, obsolescence, or changing market conditions.
Test Your Understanding
See if you've got the basics down. Click each option and check your answer.
Question 1: A company has inventory with a cost of $50,000 and a net realizable value of $45,000. Under LCM, the inventory should be reported at:
Question 2: Under US GAAP, if inventory was written down from $20,000 to $15,000, and the market value later recovers to $18,000, what is the inventory value?
Question 3: Which principle does LCM primarily reflect?
Question 4: A tech company has 1,000 laptops purchased at $800 each. New models launched, and these can now only sell for $600 each with $50 selling costs. What is the write-down amount?
Question 5: A company applies LCM on an item-by-item basis. Item A: Cost $10,000, Market $12,000. Item B: Cost $8,000, Market $6,000. Total inventory value?
Ready to Practice?
You now understand when and how to write down inventory. The Practice Lab challenges you to identify which items need write-downs, calculate NRV, and record the journal entries.
Try the Practice LabWhat's Next?
You've covered inventory valuation—now let's look at Prepaid Expenses, another current asset that transforms into an expense over time.