Inventory Valuation: Lower of Cost or Net Realizable Value with Examples

The Lower of Cost or NRV Rule

Under ASC 330, inventory must be measured at the lower of cost or net realizable value (NRV). NRV is the estimated selling price in the ordinary course of business, minus reasonably predictable costs of completion, disposal, and transportation. This rule prevents inventory from being carried at an amount exceeding the benefit expected from its sale. ASU 2015-11 simplified the prior rule (which used a floor/ceiling approach with market value) for most inventory methods, but retained the old approach for LIFO and retail inventory method users.

NRV Calculation

Example: Finished Goods

A company holds Widget A in inventory. Cost: $50 per unit. Expected selling price: $55. Estimated selling costs (commissions, shipping): $8 per unit.

NRV = $55 - $8 = $47
Cost = $50
Lower of cost or NRV = $47
Write-down per unit: $50 - $47 = $3

If the company holds 1,000 units, the total write-down is $3,000, recorded as an increase to cost of goods sold or as a separate loss line item.

Example: Raw Materials

Raw materials are written down only if the finished goods into which they will be incorporated are expected to be sold below cost. If the finished goods are expected to sell at or above cost, raw materials are not written down even if their replacement cost has declined. This prevents premature loss recognition on materials that will ultimately be sold profitably as part of the finished product.

LIFO and Retail Method Exception

Entities using LIFO or the retail inventory method continue to apply the lower of cost or market rule from the prior standard. Under this rule, market is replacement cost, subject to a ceiling (NRV) and a floor (NRV minus normal profit margin). The designated market value is the middle value of replacement cost, ceiling, and floor. Inventory is then reported at the lower of cost or designated market.

LIFO Market Determination Example

An item in inventory has the following per-unit data: Cost (LIFO): $40. Replacement cost: $33. Selling price: $50. Costs to complete and sell: $10. Normal profit margin: $8.

Ceiling (NRV): $50 - $10 = $40
Floor (NRV - normal profit): $40 - $8 = $32
Replacement cost: $33
Designated market: $33 (middle of $40, $33, $32 is $33, since $33 falls between floor and ceiling)
Lower of cost or market: lower of $40 and $33 = $33
Write-down: $40 - $33 = $7 per unit

When Replacement Cost Exceeds the Ceiling

Suppose replacement cost is $42. Ceiling is $40. Floor is $32. Designated market = $40 (replacement cost exceeds ceiling, so use ceiling). Lower of cost ($40) or market ($40) = $40. No write-down needed.

When Replacement Cost Falls Below the Floor

Suppose replacement cost is $30. Ceiling is $40. Floor is $32. Designated market = $32 (replacement cost is below floor, so use floor). Lower of cost ($40) or market ($32) = $32. Write-down: $8 per unit.

Application Methods

The lower of cost or NRV (or market) comparison can be applied on an individual item basis, by category of similar items, or on a total inventory basis. The individual item method produces the most conservative (lowest) inventory valuation because it prevents gains on some items from offsetting losses on others. Most entities apply the test on an individual item or category basis.

Individual vs. Category Example

Category A has two items:

Item 1: Cost $10,000, NRV $12,000. No write-down individually.
Item 2: Cost $8,000, NRV $6,000. Write-down of $2,000 individually.

Individual basis total: $10,000 + $6,000 = $16,000 (write-down $2,000).

Category basis: Total cost $18,000, Total NRV $18,000. No write-down on a category basis because the gain on Item 1 offsets the loss on Item 2.

Journal Entry for Write-Down

The write-down can be recorded by directly crediting inventory or by establishing a valuation allowance:

Direct method: Debit: Cost of Goods Sold (or Loss on Inventory Write-Down) $3,000; Credit: Inventory $3,000
Allowance method: Debit: Cost of Goods Sold $3,000; Credit: Allowance to Reduce Inventory to NRV $3,000

Key Exam Tips

For FIFO and weighted average: use lower of cost or NRV (simple comparison, no floor/ceiling).
For LIFO and retail method: use lower of cost or market with the ceiling/floor framework.
NRV = selling price minus costs to complete and sell. The floor = NRV minus normal profit margin.
Under U.S. GAAP, inventory write-downs are not reversed. Under IFRS, write-downs may be reversed up to original cost.
Know how to apply the comparison on an individual item, category, and total inventory basis.