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Definition: Lower of Cost and Market Method
Lower of Cost and Market Method is a valuation approach in business which is a conservative way of valuing and reporting inventory stored. If the cost of new goods has increased, then the value of the kept inventory decreases relatively. Hence, the price of the new goods was also set at the inventory price, thus reducing the value of the new goods.
The financial reporting frameworks of countries like USA require the companies to record the inventory at value which is lower of the following:
• Cost to produce it
• Cost to repurchase it
• Net realizable value
This method provides two bound on the valuation of inventory:
1. Inventory Ceiling: inventory should be reported at a value not greater than the net realizable value less expenses.
2. Inventory floor: inventory value should not be lower than the net realizable value plus normally attainable profit.
Our retail store named: ABC Retailers has 20 perfumes in stock which were purchased at Rs.1500 per piece and are intended to be sold at Rs 2,000 per piece which is in line with the prices of the competitors
Now unexpectedly the perfume manufacturers announce a reduction in the per perfume price to Rs.1350 instead of RS.1500. This will trigger the competitors to buy these perfrume and pass on the savings to the consumers by selling them for Rs.1850. This means that now you also have to sell at the same price. This will reduce the planned profit per piece from Rs.50 to Rs. 35 i.e. a holding loss of Rs.300 on these 20 perfumes you already have in stock.
Hence according to the Lower of Cost and Market Method, inventory must be recorded at (20*Rs.1350) i.e Rs.27000 instead of (20*Rs.1500) i.e Rs 30000.Because the lower of the replacement cost or production cost is taken. This is in line with the conservative accounting policy.