Under this method, you determine the market value of each item on hand as of the inventory date, compare the market value with the cost of each item, and use the lower of the two as the inventory value of that item.
The lower of cost or market method can be used for goods purchased and on hand, and for the basic components of work in process and finished goods, including direct materials, direct labor, and certain indirect costs.
This method cannot be used for goods that are being produced for delivery at a fixed price under a firm sales contract. Neither can it be used for inventory identified under the LIFO method. In these cases, the inventory must be valued at cost.
When you use the lower of cost or market method, you must value each item of inventory (or groups of items that are the same) separately. You then take the lower amount between cost or market value for each item, and add them together to arrive at the total inventory value. You do not compare the total cost to the total market value and take the lower amount.
For example:
You have three items in inventory: Product A has a cost of $10, Product B has a cost of $15, and Product C has a cost of $18. The total cost of the three is $43.
Product A has a market value of $12, Product B has a market value of $14, and Product C has a market value of $11. The total market value of the three is $37.
Taking the lower of cost or market by product results in: Product A: $10; Product B: $14; Product C: $11. The total is $35. This is the lower of cost or market for the inventory.
Market value means the usual bid price to you, under normal circumstances for normal goods. This may not be the same price that the same goods are available to a different buyer. Prices could vary depending on the volume of goods you are buying, for example.