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INVENTORY
Alternative Valuation Methods
Remember!
3 spaces = LCM
4 spaces = DV LIFO Retail
11 spaces = FISH!!
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10-
LOWER OF COST OR MARKET
(LCM)
 Inventories must be carried at original cost or
current “market” value, whichever is lower.
 LCM is a departure from historical cost and is a
conservative accounting method.
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LOWER OF COST OR MARKET
Application Procedure
“MARKET”
COST
GAAP
Lower of
Cost
or Market
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Lower of Cost or Market
(LCM)


“Market” is the current replacement cost of
an item in inventory.
Constraints on “market”
– Net Realizable Value (NRV) = “CEILING”
• Estimated selling price less the costs of
completion and disposal.
• Market cannot be more than this amount.
– NRV less “normal profit margin = “Floor”
• Market cannot be less than this amount
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LOWER OF COST OR MARKET
Ceiling
NRV
Application Procedure
Not
More
Than
MARKET
COST
“Constrained”
Replacement
Cost
Not
Less
Than
GAAP
Lower of Cost
or Market
NRV less
Normal
Profit Margin
Floor
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LOWER OF COST OR MARKET
“Constrained Market” Value
 If replacement cost falls between the ceiling
and floor, select replacement cost as market.
 If replacement cost is below the floor,
select the floor as market.
 If replacement cost is above the ceiling,
select the ceiling as market.
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“MARKET” CONSTRAINTS
Rationale
n Ceiling
Prevents overstatement of ending inventory and
failure to recognize full extent of loss in the
current year
n Floor
Prevents recognizing large inventory losses in
one year followed by abnormally large profits in
the following year
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APPLICATION OF LCM
Compare cost and market separately for each
item of inventory.
Compare cost and market separately for each
classification of inventory.
Compare total cost with total market for the entire
inventory.
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REPORTING LCM
Direct Inventory Reduction Method
– Record and report inventory holding loss each
accounting period.
Inventory Allowance Method
– Record holding loss in a contra inventory
account, “Allowance to Reduce Inventory to
LCM.”
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ESTIMATING INVENTORY
Because of the cost and time required
to take a complete physical inventory, it
is sometimes necessary to estimate the
cost of ending inventory.
Two popular methods are . . .
– Gross Margin Method
– Retail Method
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GROSS MARGIN METHOD
Assumes that the historical gross
margin rate is reasonably constant in
the short run.
We must know the following:
–
–
–
–
Net sales for the period.
Cost of beginning inventory.
Net purchases for the period.
The historical gross margin rate.
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GROSS MARGIN METHOD
• Estimate historical Gross margin %
• Compute Cost of goods available
• Beg. inventory + Net purchases
• Compute CGS % = 100% - Gross margin %
• % must be based on sales
• Compute estimated CGS = Sales x CGS %
• Compute estimated Ending inventory
• Cost of goods available – Estimated CGS
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RETAIL METHOD
This method was developed for retail
operations like department stores.
Uses both the retail value and cost of
items for sales to calculate a cost to
retail ratio.
Convert ending inventory at retail to
ending inventory at cost.
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RETAIL METHOD
To use this method we must know:
– Sales for the period.
– Beginning inventory at retail and cost.
– Net purchases at retail and cost.
– Adjustments to the original retail price:
• Additional markups and markdowns,
markup and markdown cancellations,
employee discounts
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RETAIL METHOD
MARKUPS AND MARKDOWNS
• Markup - Increase in sales price above the
original sales price.
• Markup Cancellation - cancellation of some or
all of an additional markup.
• Markdown - reduction in original sales price.
• Markdown Cancellation - increase in sales
price after a markdown.
RETAIL METHOD
STEPS TO FOLLOW
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• Determine cost of goods available in retail and
cost terms
• Appropriate consideration of markups and markdowns
• Calculate the cost/retail percentage.
• Subtract sales from retail value of goods available
= ending inventory at retail.
• Cost/retail percentage x ending inventory at retail
= estimated ending inventory at cost
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RETAIL METHOD
“Conventional” Method
Approximates Average Cost (LCM)
Cost
ratio
=
Cost of beginning inventory + net purchases
Retail value of beginning inventory +
net purchases + NET markups
NET markdowns are NOT considered
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RETAIL METHOD
AN EVALUATION
Can be used in financial statements and for
income tax purposes.
Of value for interim financial reporting.
Company must still take a physical inventory
periodically.
Provides an overall test for reasonableness of
inventory counts.
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RETAIL METHOD
Dollar-Value LIFO BASIS
Dollar Value LIFO (DV LIFO) is the only acceptable
method of converting retail data to a LIFO basis.
We previously discussed DV LIFO
Remember how we established a LIFO base for the
first year, and added or deducted layers for each
subsequent year.
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RETAIL METHOD
DOLLAR-VALUE LIFO BASIS
1. Compute ending inventory in both retail and cost
terms
• Appropriate consideration of markups and
markdowns
2. Calculate the cost/retail %
Cost of net purchases
Cost ratio = Retail value of net purchases +
net markups - net markdowns
COST % IGNORES BEGINNING INVENTORY
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RETAIL METHOD
DOLLAR-VALUE LIFO BASIS
3.
Convert to LIFO Retail Cost
• Compute ending inventory at base retail
prices

Utilize an internal or external conversion price
index for the appropriate period
•
Determine changes in layers using base
retail prices
•
Use appropriate cost/retail ratios to
convert to Dollar-value LIFO retail
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INVENTORY. . . Enough Said!