Lower of cost or market accounting is generally based off of the accounting concept conservatism. It generally states that certain accounts should be stated at their historical costs or market costs whichever is lower.
The lower of cost or market means that accounts like inventory will often show unrealized gains or losses depending on how historical costs and market costs relate to each other. This means that if the market is lower than what it cost the company to produce a product, then the company is operating at an unrealized loss. The Gross Margin may be higher, but the true and actual costs to the company are higher. If it is the other way around the company will be operating at an unrealized gain in which the company’s historical costs are lower than the market. It should be noted that the market cannot exceed the sales price and likewise it cannot be less than the profit margin that a company would realize.
David is responsible for the accounting of inventory for Wawadoo Inc., which specializes in the production of widgets. After careful analysis David finds that the costs to the company to produce a widget cost $10 a piece. However, market conditions have worsened over the past few months, and the value of the inventory on hand is now only equal to $8 a piece. Therefore, David must write down the inventory on Wawadoo’s books by $2 for every widget in stock. Note that if you were selling these widgets for $12 then the company was producing a gross margin of $2. However, with the reduction in market cost many of Wawadoo’s competitors will drop their selling price. Thus Wawadoo must drop its price as well. If Wawadoo were to drop its selling price to $10 the company would be operating at breakeven because of the current inventory on hand.