The lower of cost or market rule is an inventory accounting principle that requires a business to carry goods on its books at whichever figure is lower: the original cost paid to acquire or produce them, or their current market value. The rule reflects accounting conservatism, keeping the balance sheet from reporting inventory at amounts a company cannot realistically recover through sales. How you calculate “market” depends on which inventory method you use. Since 2015, businesses on FIFO or weighted-average cost compare cost against a single figure, net realizable value, while businesses on LIFO or the retail inventory method still work through a three-part market test with a ceiling and a floor.
What Counts as Cost
Before you can compare cost to market, you need the cost figure right. For purchased merchandise, cost begins with the invoice price and includes transportation to bring goods to your warehouse, import duties, and non-recoverable taxes paid during procurement. For manufactured goods, cost includes direct materials, direct labor, and a reasonable share of production overhead.
Some expenses stay out of inventory no matter how closely they relate to the product. Selling, marketing, and advertising costs are expensed in the period incurred. General and administrative costs such as executive compensation and headquarters overhead are excluded unless a specific portion is clearly tied to production. Abnormal waste, spoilage, and excess freight from unusual circumstances hit expense immediately. Outbound shipping to customers goes to cost of sales rather than inventory.
Which Rule Applies to Your Inventory
The most common source of confusion with lower of cost or market is that there are now two different comparisons, and which one you use depends entirely on your inventory method.
If your inventory is measured using FIFO or weighted-average cost, you follow the simplified rule from ASU 2015-11: compare cost to net realizable value and record the lower of the two. No replacement cost, no ceiling, no floor.
If your inventory is measured using LIFO or the retail inventory method, the traditional three-part market test still applies. You calculate replacement cost, a ceiling, and a floor, take the middle figure as “market,” and then compare that to cost.
People studying lower of cost or market often learn the three-part test first and assume it’s universal. For most inventory methods, it was retired years ago.
The NRV Rule for FIFO and Average Cost
Under ASU 2015-11, net realizable value is the estimated selling price in the ordinary course of business, minus reasonably predictable costs of completion, disposal, and transportation. That single number replaces the older three-figure comparison.
You compare NRV to the item’s cost. If NRV is lower, you write inventory down to NRV. If cost is lower, no adjustment is needed.
The Three-Part Market Test for LIFO and Retail Method
Under the traditional framework, “market” is not simply what you could sell an item for. It is replacement cost, constrained by a ceiling and a floor. Three figures go into the calculation:
- Replacement cost: what you would pay today to buy or reproduce the same item from a supplier under current market conditions.
- Ceiling, equal to net realizable value: estimated selling price minus costs to complete and sell the item. This prevents “market” from being set so high that you’d recognize a loss when the goods actually sell.
- Floor, equal to NRV minus a normal profit margin: this prevents “market” from being set so low that you’d recognize an artificially large gain at the point of sale.
The designated market value is whichever of the three sits in the middle. If replacement cost falls between the ceiling and the floor, replacement cost is market. If replacement cost is above the ceiling, the ceiling becomes market. If it is below the floor, the floor becomes market. You then compare that market figure to historical cost and record the lower of the two.
Item, Category, or Total Inventory
For financial reporting under GAAP, businesses can apply the comparison at three levels: individual items, product categories, or total inventory. The item-by-item approach almost always produces the lowest inventory value and the largest write-down, because gains on some items cannot offset losses on others. Category-level and total-level comparisons allow some netting and generally produce a higher reported value.
Applying the comparison item by item is the most common practice for GAAP purposes. Whatever level a company picks, the consistency principle means using it across reporting periods. Switching between methods to manage reported profit is not permitted.
Tax rules are stricter. The IRS requires taxpayers using lower of cost or market to compare market to cost for each item separately. You cannot lump all inventory together and compare aggregate totals on your return. As a result, the tax write-down is often larger than what a company using category-level or total-level comparison reports on its GAAP financial statements.
How the IRS Defines Market
For tax purposes, “market” means the aggregate of current bid prices for the basic elements of cost: direct materials, direct labor, and the indirect costs required under the applicable capitalization rules. This definition roughly parallels replacement cost on the GAAP side.
Two categories of inventory cannot use LCM on a tax return:
- LIFO inventory. A taxpayer on LIFO must value tax inventory at actual LIFO cost. The company may still use lower of LIFO cost or market on its financial statements without violating the LIFO conformity requirement, but the tax return has to reflect straight LIFO cost.
- Goods under firm sales contracts. If goods on hand are committed to delivery at a fixed price under a contract that neither party can legally cancel, those goods must be inventoried at cost.
When no open market exists for a product, or when available price quotations are merely nominal because the market is inactive, the IRS requires the best available evidence of fair market value on the date nearest the inventory date.
Recording the Write-Down
When market value drops below cost, the business records a write-down in the current period. The entry debits either Cost of Goods Sold or a separate Loss on Inventory Write-Down account, depending on how the company wants to present the loss. The offsetting credit goes either directly to the Inventory account or to a contra-asset account, often called Allowance to Reduce Inventory to Market, which reduces the net inventory balance without changing the gross Inventory line.
Under U.S. GAAP, this write-down is permanent. If the market price recovers next quarter, you cannot reverse the adjustment and write inventory back up. The reduced figure becomes the new cost basis for every future calculation, whether that means computing cost of goods sold when the goods are sold or running the LCM comparison again at the next reporting date. Companies reporting under IFRS can reverse write-downs up to original cost, but that option does not exist under U.S. standards.
Damaged, Obsolete, and Subnormal Goods
Goods that cannot be sold at normal prices because of damage, defects, style changes, broken lots, or similar problems get special treatment under both GAAP and tax rules. Instead of running through the standard LCM comparison, they are valued at their actual offering price minus the direct cost of selling them. This applies whether the company otherwise uses cost or lower of cost or market as its overall method.
For raw materials or partially finished goods that are damaged or impaired, valuation rests on a reasonable assessment of usability and condition, but the value can never fall below scrap value. The IRS defines “bona fide selling price” as the price at which goods are actually offered for sale during a window ending no later than 30 days after the inventory date. The burden of proof is on the taxpayer to show these items genuinely qualify as subnormal, and the company must keep records tracking how the goods were ultimately sold or disposed of.
Changing Your Inventory Valuation Method
You cannot switch inventory valuation methods on your tax return from one year to the next on your own. The IRS treats this as a change in accounting method that requires filing Form 3115, Application for Change in Accounting Method, whether you’re moving from an impermissible method to a permissible one or switching between two permissible methods.
Most businesses qualify for automatic change procedures, which means attaching the original Form 3115 to a timely filed return for the year of change and sending a signed copy to the IRS National Office. No user fee applies for automatic changes. The filing must include Schedule D, Parts II and III. If the automatic procedures don’t apply, the company must request advance consent, which involves a longer review and a filing fee.
Using an impermissible method, or switching without filing Form 3115, can lead the IRS to recompute inventory values and adjust taxable income for the affected years, with interest and penalties on any underpayment.