CHAPTER 9: LCM AND METHODS OF ESTIMATING INVENTORY
(add Appendix 9A)
I.
Lower of cost or market
A. General information
1. based on conservatism; write inventory down below cost, but do not carry
above cost
2. may be applied to (1) each inventory item, (2) major classes, or (3) the
inventory as a whole
B. Calculations
1. "market" is defined as replacement cost (RC) of the inventory, as long as the
value falls within certain limits as defined in (2) and (3)
2. the upper limit on market (ceiling) is defined as net realizable value (selling
price lest cost of completion and disposal)
3. the lower limit on market (floor) is defined as net realizable value reduced by
an allowance for normal profit margin
Note: the ceiling is useful for obsolete or damaged goods, where the decline in
value is continuous and permanent. The floor is useful to prevent excessive
writedowns on inventories that are experiencing a temporary decline.
4. after RC, Ceiling and Floor have been determined, choose the middle value to
represent market
5. compare "market" to cost, and choose LCM
C. Recording LCM in the accounts
1. Loss method - recognize loss on reduction of inventory:
Loss on Reduction of Inventory
x
Inventory
x
2. COGS method (direct adjustment)
COGS
Inventory
x
3. Allowance method (preferred method)
Loss on Reduction of Inventory
x
Allowance to reduce inv. to market
x
x
Allowance account should be closed when the inventory causing the decline
is sold (a gain on reversal is recognized at the time of the reversal). A new
account can be established if subsequent inventory needs to be reduced.
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II. Valuation Bases
A. Net realizable value – under certain conditions, NRV may be used as “market”
instead of replacement cost. Example: meat processing makes it difficult to
determine the cost of each individual part. It is much easier to determine selling
price, and costs to process.
B. Relative sales value – allocate cost to various components based on the relative
sales value.
C. Purchase Commitments
1. If subject to cancellation – do not record in the financials.
2. Noncancelable contracts – require disclosure upon inception of the
commitment, and may require subsequent journal entries.
III. Inventory estimation - gross profit method
A. Used to estimate the cost of EI. Does not require knowledge of units in EI.
Used most often to estimate monthly or quarterly inventory values for interim
reporting. This method can be used by retailers or manufacturers.
B. Based on historical knowledge of the gross margin (GM) percentage and the
following relationships:
1. S - COGS = GM (or S - GM = COGS)
2. BI + P(net) - EI = COGS
C. Methods of stating GM
1. GM as a percentage of sales
2. GM as a percentage of cost (COGS)
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IV. Inventory estimation - retail estimating techniques
A. The retail estimating techniques (like the GM method) do not require
knowledge of the number of units in ending inventory. These techniques are
used most often to estimate monthly or quarterly inventory levels for interim
reporting. These techniques apply to retailing operations that maintain
information about markups and markdowns on the retail sales.
B. Price movements after initial establishment of selling price
1. Markups on selling price
2. Markup cancellations
3. Markdowns on selling price
4. Markdown cancellations
C. Process
1. Find EI at retail
2. Compute the cost to retail ratio
3. Compute (estimate) the EI at cost by multiplying (1) times (2)
D. Format for the calculation is based on BI + P (net) - COGS = EI. However,
since cost is not known, we look at the retail relationship (where Sales =
COGS at retail): BI at retail + P (net) at retail - Sales = EI at retail. Once EI
at retail is found, we use the known cost information to estimate EI at cost.
E. Methods for estimating EI - different methds can be approximated as we
make different assumptions in the calculation of the cost to retail ratio. The
various possibilities are shown in the boxes below:
BI + P
BI separate from P
Include MD
Average Retail
FIFO Retail
LIFO Retail
DVL Retail
Exclude MD
Average LCM
(Conventional Retail)
FIFO LCM
LIFO LCM
F. Special issues relating to ratio calculation
1. abnormal spoilage - deduct from cost and retail above the cost to retail
ratio
2. normal spoilage - deduct from retail below the cost to retail ratio
3. sales discounts - should be excluded from computations
G. Example problem (next two pages)
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1. Average Retail (BI + P, include MD)
Beginning inventory
Cost
$ 200,000
Purchases (net)
1,400,000
$
Retail
280,000
2,140,000
Markups (net)
80,000
Markdowns (net)
30,000
Sales (net)
2,200,000
Ending inventory at retail
270,000
Ending inventory at cost
________
2. Conventional Retail (BI + P, exclude MD to approximate LCM estimate)
Cost
Retail
Beginning inventory
$ 200,000
$
280,000
Purchases (net)
1,400,000
2,140,000
Markups (net)
80,000
Markdowns (net)
30,000
Sales (net)
2,200,000
Ending inventory at retail
270,000
Ending inventory at cost
________
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3. FIFO Retail (Separate BI, P; include MD)
Cost
Beginning inventory
$ 200,000
Purchases (net)
$
1,400,000
Retail
280,000
2,140,000
Markups (net)
80,000
Markdowns (net)
30,000
Sales (net)
2,200,000
Ending inventory at retail
270,000
Ending inventory at cost
________
4. LIFO Retail – Appendix 9A (separate BI, P; include MD)
Cost
Beginning inventory
$ 200,000
$
Purchases (net)
1,400,000
Retail
280,000
2,140,000
Markups (net)
80,000
Markdowns (net)
30,000
Sales (net)
2,200,000
Ending inventory at retail
270,000
Ending inventory at cost
________
Assume that EI at Retail (in part 4)=$400,000. Convert to cost using LIFO Retail:
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V. Dollar Value LIFO Retail (Appendix 9A)
A. Combines DVL and LIFO Retail
B. Process
1. Find EI at Retail using LIFO Retail
2. Compare to BI Retail - in base year dollars
3. Modify retail layers
4. Extend back to cost
Multiple period example. Given the following information for 2012 and 2013:
Purchases
Net markups
Net markdowns
Sales
2012
Cost
Retail
$200,000 $420,000
20,000
10,000
400,000
2013
Cost
Retail
$250,000 $550,000
30,000
40,000
600,000
The company adopted LIFO on January 1, 2012, when the cost and retail values of the
inventory were $50,000 and $100,000 respectively. The following price indexes are
applicable for the company: 1/1/12, 100; 12/31/12, 108; 12/31/13, 115.
Required: Compute the cost of ending inventory for 2012 and 2013 using Dollar Value
LIFO Retail (see solution next page):
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2012 Ending Inventory
1) Find EI using LIFO Retail
C/R
Cost
.500 BI
50,000
.465 P,MU,MD 200,000
-Sales
=EI at Retail
Retail
100,000
430,000
(400,000)
130,000
3) Modify retail layers
Base $
2) Compare BI and EI at Base $ (retail)
x 100/100 = 100,000
x 100/108 = 120,370
20,370 layer increase (retail base $)
4) Extend back to cost using C/R ratios
Index
Base layer 100,000 @ 100/100
2012 layer 20,370 @ 108/100
x .500 = 50,000
x .465 = 10,230
$60,230 EI at cost
2013 Ending Inventory
1) Find EI using LIFO Retail
C/R
Cost
.500 BI
50,000*
.465 BI
13,950*
.463 P,MU,MD 250,000
- Sales
=EI at Retail
Retail
100,000
30,000
540,000
(600,000)
70,000
3) Modify retail layers
Base $
2) Compare BI and EI at Base $ (retail)
x
100/108 = 120,370
x
100/115 = 60,870
59,500 layer decrease
4) Extend back to cost using C/R ratios
Index
Base layer 100,000 @ 100/100
2012 layer 20,370 @ 108/100
-59,500 (20,370 @ 108/100)
(39,130 @ 100/100)
Balance
60,870 @ 100/100
(all base layer)
x .500 = $30,435 EI at cost
*Note that the BI for 2013 is derived by extending the EI calculations for 2012 using the LIFO
Retail technique:
2012 EI at Retail = 130,000; now extend back to cost: 100,000 @ .500 = 50,000
30,000 @ .465 = 13,950
These cost layers roll forward as 2013 beginning inventory. The extension back to cost for
beginning inventory is not required for the multiperiod example, but the retail layers and the cost
to retail ratios must be separately maintained, and carried forward to the new year.
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