Learn the U.S. GAAP lower-of-cost-or-market test for LIFO and retail-method inventory, including replacement cost, the NRV ceiling, and the profit-margin floor.
Lower of cost or market (LCM) is a U.S. GAAP inventory measurement rule that reports covered inventory at the lower of recorded cost or a constrained market amount. For this rule, “market” generally starts with current replacement cost but cannot exceed net realizable value (the ceiling) or fall below net realizable value less an approximately normal profit margin (the floor).
LCM now primarily applies to inventory measured using LIFO or the retail inventory method. Other U.S. GAAP inventory is generally measured at lower of cost and net realizable value after FASB ASU 2015-11. IFRS uses an NRV-based model and does not permit LIFO.
The process has two stages.
Start with current replacement cost and constrain it:
Ceiling = net realizable value
Floor = net realizable value - approximately normal profit margin
Designated market = middle of replacement cost, ceiling, and floor
If replacement cost exceeds the ceiling, use the ceiling. If replacement cost is below the floor, use the floor. Otherwise, use replacement cost.
Reported inventory = lower of recorded cost or designated market
This prevents replacement-cost changes from producing an inventory amount above expected recovery or an excessively low amount that effectively recognizes a normal profit before sale.
Assume a LIFO inventory item has:
| Measure | Amount |
|---|---|
| Recorded cost | $100 |
| Current replacement cost | $82 |
| Net realizable value, or ceiling | $90 |
| Approximately normal profit margin | $15 |
Floor ($90 - $15) | $75 |
Replacement cost of $82 is below the $90 ceiling and above the $75 floor, so designated market is $82.
LCM carrying amount = lower of $100 cost or $82 market = $82
The company records an $18 write-down.
Now assume replacement cost is $96. Because $96 exceeds the $90 ceiling, designated market becomes $90, and the write-down is $10, not $4 and not zero.
If replacement cost is $68, it falls below the $75 floor. Designated market becomes $75, and the write-down is $25 rather than $32.
The ceiling prevents inventory from being carried above the amount expected to be recovered through sale. The floor limits the write-down so the company does not recognize an amount that would embed more than an approximately normal profit loss before the goods are sold.
The model is therefore not pure replacement-cost accounting. It uses replacement cost as an input to a conservative cost-based measurement with recoverability constraints.
| Issue | Traditional LCM | Lower of cost and NRV |
|---|---|---|
| U.S. GAAP scope | LIFO and retail-method inventory | Inventory measured using other methods, including FIFO and average cost |
| Comparison input | Constrained replacement cost | Net realizable value directly |
| Ceiling and floor | Explicit ceiling and normal-profit floor | No replacement-cost middle value |
| IFRS use | Not the IAS 2 model | IAS 2 uses lower of cost and NRV |
The two tests can produce different amounts. Assume cost is $100, replacement cost is $80, NRV is $95, and the LCM floor is $75. LCM designated market is $80, producing a $20 write-down. A direct lower-of-cost-and-NRV test would compare $100 with $95 and produce only a $5 write-down.
The retail inventory method estimates inventory cost by applying a cost-to-retail relationship to ending inventory stated at retail prices. Markups, markdowns, and the exact version of the method affect the estimate. FASB excluded retail-method inventory from the ASU 2015-11 NRV simplification because changing the model could disrupt existing retail calculations, including treatment resembling the traditional floor.
“Retail method” does not mean that any retailer automatically applies LCM in the same way. The company must disclose its method, and analysts need the actual cost-flow and retail-method policy.
When designated market is below cost, the reduction is recognized in current income, often through cost of goods sold or a separate inventory loss, depending on materiality and presentation policy. The write-down reduces:
The entry is noncash when recognized, but it can signal economic loss through obsolescence, lower selling prices, excess purchasing, or reduced replacement economics.
LCM calculations depend on current accounting guidance and company facts. This page is educational and is not accounting, audit, tax, or investment advice.