In our previous articles on Lower of Cost or Market Concept, we have given a short introductory lecture on that method. Today you will learn how any company applies the method of lower-of-Cost-or-Market in their operational activities through this example:
For example ABC Company applied the lower-of- cost-or-market method in each individual type of food. Though, any company could apply the lower-of-cost-or-market rule either directly to each item of each category, or to the total item of the inventory. ABC Company applies the lower-of-cost-or-market method by following a major category or total inventory approach, then it increases in market prices tend to offset decreases in market prices. That means ABC Company divides the food products into two major categories, frozen and canned. Now If ABC Company applied the lower-of-cost-or-market rule to individual items, then the amount of inventory will be $200,000. If ABC Company applies this rule to major categories, then the amount of inventory will be increases to $250,000.
If the company applies the lower-of-cost-or-market rule to the total inventory, it totals $284,000. Now the question is why these differences among these amount of inventory? Because when a company uses a major categories or total inventory approach, then market values higher than cost offset market values lower than cost. ABC Company, using the major categories approach partially offsets the high market value for the product of ABC company spinach. Using the total inventory approach totally offsets it. Any company usually price inventory on an item-by-item basis. Even the tax rules require that companies use an individual-item basis barring practical difficulties. Moreover, the individual-item approach could provide the most conservative valuation for balance sheet purposes. Generally a company prices its inventory on a total-inventory basis if the company offers only one end product which is consists of many different raw materials. If it produces several end products, a company might use a category approach instead. That method should select which could most clearly reflect income. Whichever method a company selects, it should be consistently applied by the company from one period to another
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