What Numbers Are Included When Calculating the Cost Using the LCM Method?

by Will Gish

Retail stores use the lower of cost or market (LCM) method of evaluation when determining the worth of goods a company may experience difficulty in selling or that may in some way produce a loss in expected profits. This accounting method proves pertinent in cases such as product obsolescence, flooded markets or a reduction in price by the manufacturer or competitors. A handful of numbers figure prominently in calculating LCM, most notably cost and market value.

Retail accountants must consider the LCM method when a business holds a product with an inability to meet its expected value. For instance, assume a store purchases 50 computers from a manufacturer at a cost of \$500 and expects to sell each computer for \$750 dollars. After the store sells 20 computers, the manufacturer cost lowers from \$500 to \$350, as a new model becomes available, meaning competitors can now sell the computer for \$600. In order to remain competitive, the store must reduce its price and thus see a \$150 reduction in profit on each item. LCM seeks to rectify how a business should deal with listing diverging values of an item on a balance sheet. LCM relies on principles of conservatism by stressing the importance of using the lowest value.

Cost and Market

Cost and market value constitute the two most important numbers when using the LCM method. Accountants must decide which of these numbers to include on a balance sheet when keeping financial accounts for a retail store. Cost represents the actual cost of an item as paid by a business. Market value refers to a range of values, of which three exist: the floor, ceiling and replacement cost. Ultimately, the LCM method only uses one of these market value numbers, but considers all of them. When calculating LCM, accountants always choose the lower of the cost or market value for a product.

The Three Market Values

Three types of market values exist, the ceiling or Net Realizable Value (NRV), the floor or Net Realizable Value minus the normal profit and the replacement value of an item. The replacement value refers to the amount a business must expend to replace an item when different from the original cost of that item. The Net Realizable Value equals the expected selling price minus the amount of money required to prepare an item for sale. The NRV minus normal profit equates the NRV minus the expected profit on an item. For instance, if an item with a replacement cost of \$6 sells for \$10 but a business spends \$3 preparing it for sale, the NRV, or ceiling, equals \$7, or 10 - 3. Assuming 20 percent of a sale constitutes profit, the profit on a \$10 item equals \$2. Thus the floor market value equals \$5, or NRV - profit, 7 - 2. When calculating market value, accountants choose the middle of these three values.

Calculating LCM

Three phases go into calculating the LCM value of an item. First, an accountant determines the actual cost of an item, which entails nothing more than looking over receipts. The second phase entails calculating the three market values, which includes deducing the replacement cost, product ceiling or expected retail value minus cost to prepare, and product floor, or product ceiling minus normal profit. Assume a store bought an item for \$150, with a replacement cost of \$125. That item retails for \$200, with a market value ceiling of \$185 and a floor of \$145. With potential market values of \$125, \$145 and \$185, the accountant chooses the middle number, of \$145. This item holds a market value of \$145 and a cost of \$150. As per the principles of the LCM method, the accountant chooses the lower cost and records the item at \$145 on a balance sheet.