What Is LCM In Accounting

Introduction to Inventory Valuation for Small Businesses #

If you own a small business, managing inventory is crucial. The value of your stock affects your financial statements, business decisions, and tax payments. One way to keep inventory values accurate is by using the Lower of Cost or Market (LCM) method.

LCM ensures that businesses record inventory at its actual market price if it’s lower than the original cost. This prevents businesses from overstating asset values.

In this guide, we’ll break down LCM in simple terms. You’ll learn why it’s important, how to use it, and how it can help small businesses in India.

What is Lower of Cost or Market (LCM)? #

The LCM rule is an accounting method that ensures businesses report inventory at the lower of:

• The cost (the price paid for the inventory), or
• The market value (the current selling price of that inventory).

This prevents businesses from inflating asset values and ensures realistic financial reports.

Example of LCM

Imagine you own a phone store. You purchased a smartphone model for ₹20,000 each. However, because of new models, the market price drops to ₹18,000. With LCM, you must record the phone inventory at ₹18,000 instead of ₹20,000.

This ensures your books reflect actual market conditions and helps avoid financial loss surprises.

Why LCM is Important for Small Businesses #

• Prevents Overstating Profits: If a business lists inventory at a price higher than it can sell, profits look inflated. LCM prevents this mistake.
• Helps in Smarter Pricing: Knowing the real value of your inventory helps you set better prices. If your goods are losing value, you can reduce prices quickly to clear stock before major losses happen.
• Helps in Financial Planning: When you correctly report inventory value, you get a clear financial picture of your business. This helps in making solid decisions about restocking or reducing orders.
• Builds Trust with Investors and Banks: Banks, investors, and creditors trust businesses that follow correct financial practices. Using LCM ensures your financial statements are honest, increasing credibility.

Key Benefits of Using LCM for Small Businesses #

• Reduces Risk of Financial Surprises – You won’t suddenly discover significant losses because of incorrect valuations.
• Supports Better Decision-Making – Knowing inventory values helps in pricing, discounting, and stock management.
• Keeps Reports Compliant – Helps meet accounting standards like GAAP and Indian Accounting Standards (IND AS).
• Encourages Efficient Inventory Management – Businesses can quickly identify and sell old stock before it becomes outdated.

How to Apply Lower Of Cost or Market (LCM) in Your Business #

Identify Inventory Items: Make a complete list of all your inventory items. This should include details like purchase price, current market price, and stock quantity.

Find the Original Cost: Check how much you paid for each item. This includes purchase price, shipping, and any other costs involved in bringing the goods into stock.

Determine the Market Value: Find the current market price of each product. Usually, this is either:

• The replacement cost (how much it would cost to buy that product now), or
• Net realizable value (how much you could realistically sell it for after deducting selling costs).

Compare Cost and Market Value: For each item, compare the original cost and the market value. Choose whichever is lower and use that as the recorded value in your accounts.

Record the New Values: Update your financial records to reflect these new values. This ensures that you always report your inventory accurately.

Repeat the Process Regularly: Markets change constantly. Conduct a review of inventory values every quarter to keep your books up to date.

Challenges in Using LCM and How to Overcome Them #

• Market Prices Can Fluctuate Often: Businesses should review inventory valuation quarterly rather than expecting daily updates.
• Determining Market Value Can Be Complicated: Check competitor prices, supplier rates, and external reports for accurate comparisons.
• Some Businesses May Resist Adjustments: Train staff to understand how LCM benefits the company long-term, even if short-term adjustments seem negative.
• Manual Calculations Can Be Tedious: Use inventory management software to automate inventory tracking and valuation.

Real-Life Example #

A Clothing Store

A clothing store buys winter jackets at ₹2,500 each. However, summer arrives, and demand drops. The jackets are now selling at ₹1,900.

Using LCM, the store adjusts its inventory value to ₹1,900 to reflect real market conditions. This prevents listing old, unsellable stock at a high value.

An Electronics Business

A mobile shop stocks 50 units of a phone bought at ₹15,000. A new model comes out, and the market price drops to ₹12,500.

Using LCM, the business updates the inventory value to ₹12,500, which prevents losses from hiding.

FAQ’s: #

What is the LCM method?

LCM records inventory at the lower of its cost or current market value to prevent overstating assets.

Why is LCM important?

It ensures accurate financial reporting, prevents inflated profits, and helps in better inventory management.

How often should we apply LCM?

Ideally, businesses should review and update inventory values quarterly to reflect market changes.

What challenges arise with LCM?

Frequent market fluctuations, difficulty in determining value, and resistance to adjustments are common challenges.

Can software help with LCM?

Yes, inventory management tools like automated valuation, make LCM easier to apply.

Conclusion #

By applying LCM properly, small businesses can strengthen financial decision-making, maintain accurate records, and improve business profitability. Start using LCM today to manage your inventory smarter!