Special Inventory Valuation Methods 4.1. Valuation at Lower of Cost or Market (LCM)

4.
SPECIAL INVENTORY VALUATION METHODS

4.1. Valuation at lower of cost or market (LCM)
In applying LCM, cost is the acquisition price of inventory computed using one of the
historical cost methods - specific identification, FIFO, LIFO, and Weighted average; market
is defined as the current market value (cost) of replacing inventory. It is the current cost of
purchasing the same inventory items in the usual manner. It is important to know that market
is not defined as the sales prices. A decline in market cost reflects a loss of value in
inventory. This is because the recorded cost of inventory is higher than the current market
cost. When this occurs, a loss is recognized. This is done by recognizing the decline in
merchandise inventory from recorded cost to market cost at the end of the period.
LCM is applied in one of three ways:
(1) Separately to individual item
(2) To major categories of items
(3) To the whole of inventory
The less similar the items are that make up inventory, the more likely it is that companies
apply LCM to individual items. Advances in technology further encourage the individual
item application.
Illustration
The following are the inventory of ABC motor sports, retailer.
Inventory units per unit
Items on hand cost market
Cycles:
Roadster 50 Br. 15,000 Br. 14,000
Sprint 20 9,000 9,500
Off Road:
Trax-4 10 10,000 11,200
Blaz’m 6 16,000 14,500
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Let us see LCM computation under the three ways:
(1) Separately to each individual item
Inventory items Total cost Total market LCM
Roadster Br. 750,000 Br. 700,000 Br. 700,000

Sprint 180,000 190,000 180,000
Categories sub total Br. 930,000 Br. 890,000
Trax-4 100,000 112,000 100,000
Blaz’m 96,000 87,000 87,000
Categories sub total Br. 196,000 Br. 199,000
Totals Br.1,126,000 Br. 1,089,000 Br. 1,089,000
(2) Major categories of items

Inventory Categories Categories LCM
categories total cost total market
Cycles Br. 930,000 Br. 890,000 Br. 890,000
Off. Road 196,000 199,000 196,000
Totals Br. 1,126,000 Br. 1089,000 Br. 1,089,000
When LCM is applied to the whole of inventory, the market cost is Br. 1,089,000. Since this
market cost lower than Br. 1,126,000 recorded cost, it is the amount reported for inventory on
the balance sheet. When LCM is applied to individual items of inventory, the marked cost is
Br. 1,067,000. Since market is again less than Br. 1,126,000 cost, it is the amount reported for
inventory. When LCM is applied to the major categories of inventories, the market is Br.
1,086,000 which is also lower than cost.
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4.2. Retail method of inventory costing
This method is mostly used by retail business. The estimate is made based on the relationship
between the cost and the retail price of merchandise available for sale.
The steps to be followed are:

(1) Calculate the cost to retail ratio = Cost of merchandise available for sale
Retail Price of merchandise available for sale
(2) Calculate the ending inventory at retail price

Ending inventory at retail price = retail price of merchandise available for sale – Sales
(3) Calculate the estimated cost of ending inventory

Estimated cost of ending inventory = Cost to retail ration X Ending inventory at retail
Example
Cost Retail
Sep. 1, beginning inventory Br. 25,000 Br. 40,000
Purchases in September (net) 125,000 160,000
Sales in September (net) 140,000
(1) Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75

Br. 40,000 + Br. 160,000
(2) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000
(3) Estimated ending inventory at cost = 0.75 X Br. 60,000
= Br. 45,000
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4.3. Gross profit method
This method uses an estimate of the gross profit realized during the period to estimate the
cost of inventory. The gross profit rate may be estimated based on the average of previous
period’s gross profit rates.
The steps are as follows:
(1) The gross profit rate is estimated and then estimated gross profit is calculated.
Estimated gross profit = Gross profit rate X Sales
(2) Cost of merchandise sold is estimated

Estimated cost of merchandise sold = Sales - Estimated gross profit
(3) Calculate the estimated cost of ending inventory

Estimated cost of ending inventory =
Cost of merchandise available for sale – Estimated cost of merchandise sold.
Example
Oct. 1, beginning inventory (cost) – Br. 36,000
Net purchases during October (cost) 204,000
Net sales during October 220,000
Estimated gross profit rate is 40%
The ending inventory is estimated as follows:
(1) Estimated gross profit = 0.4 X 220,000
= Br. 88,000
(2) Estimated cost of merchandise sold

= Br. 220,000 – Br. 88,000
= Br. 132,000
(3) Estimated cost of ending inventory

= (Br. 36,000 + 204,000) – Br. 132,000
= Br. 240,000 – Br. 132,000
= Br. 108,000
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1. Net Realizable Value (NRV):
- Example: Assume a company has inventory with a historical cost of $10,000, but the
estimated selling price is expected to be $8,000, and it would incur $500 in selling expenses
to complete the sale.
- The net realizable value of the inventory would be:
- Estimated selling price: $8,000
- Less: Expected costs to complete the sale: $500
- Net realizable value: $8,000 - $500 = $7,500
- If the net realizable value is lower than the cost, the inventory is written down to $7,500.
2. Specific Identification:
- Example: Assume a company has inventory items with unique serial numbers and costs as
follows:
- Item A: Serial number 001, cost $100
- Item B: Serial number 002, cost $150
- If the company sells Item A, the COGS would be $100.
3. Retail Inventory Method:
- Example: Assume a company has inventory with the following details:
- Cost of goods available for sale: $10,000
- Retail selling price of goods available for sale: $15,000
- Retail value of ending inventory: $5,000
- The cost-to-retail percentage calculation would be:
- Cost-to-retail percentage = Cost of goods available for sale / Retail selling price of goods
available for sale = $10,000 / $15,000 = 0.67
- The value of ending inventory would be:
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- Ending inventory at retail value * Cost-to-retail percentage = $5,000 * 0.67 = $3,350
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4.

SPECIAL INVENTORY VALUATION METHODS

Inventory items Total cost Total market LCM

Roadster Br. 750,000 Br. 700,000 Br. 700,000

(2) Major categories of items

The steps to be followed are:

(2) Calculate the ending inventory at retail price

(3) Calculate the estimated cost of ending inventory

(1) Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75

(2) Cost of merchandise sold is estimated

(3) Calculate the estimated cost of ending inventory

(2) Estimated cost of merchandise sold

(3) Estimated cost of ending inventory

- The net realizable value of the inventory would be:

- Estimated selling price: $8,000

- Less: Expected costs to complete the sale: $500

- Net realizable value: $8,000 - $500 = $7,500

- Item A: Serial number 001, cost $100

- Item B: Serial number 002, cost $150

- If the company sells Item A, the COGS would be $100.

3. Retail Inventory Method:

- Example: Assume a company has inventory with the following details:

- Cost of goods available for sale: $10,000

- Retail selling price of goods available for sale: $15,000

- Retail value of ending inventory: $5,000

- The cost-to-retail percentage calculation would be:

- The value of ending inventory would be:

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