What it means
In business, you normally record inventory at its historical cost, which is the actual amount you paid to acquire or manufacture the items. However, market conditions change quickly.
Consumer tastes shift, technology improves, or competitors drop their prices, making your current stock less desirable or obsolete. When this happens, the inventory may no longer be worth what you originally paid for it.
The Lower of Cost or Net Realizable Value rule protects you from painting an overly optimistic picture of your financial health. Net realizable value represents your estimated selling price in the ordinary course of business, minus any predictable costs of completion, disposal, and transportation.
By comparing this estimated future selling value directly against your original purchase cost, accounting standards force you to choose the lower figure. If the estimated net realizable value drops below your original cost, you must write down the value of that inventory immediately.
This reduction is recognised as an expense on your income statement for the current period, which directly reduces your profit. While taking a lower profit hurts in the short term, it ensures your balance sheet remains honest and realistic about the true worth of the assets you hold.
This practice follows the fundamental accounting principle of conservatism, which advises that businesses should anticipate potential losses rather than recording anticipated profits. For non-finance managers, understanding this rule is vital because inventory write-downs directly impact your operating margins, cash flow planning, and tax calculations at the end of the financial year.
In practice
Real-world examples.
Example
A boutique clothing entrepreneur bought 100 winter coats for 50 pounds each, totaling 5,000 pounds. Due to an unusually warm winter, similar coats now sell for only 35 pounds, with 5 pounds needed for shipping. The net realizable value is 30 pounds, so the inventory must be written down to 3,000 pounds.
Example
A regional hardware store holds 50 lawnmowers originally purchased for 150 pounds each. A newer model was just released, forcing the store to slash its selling price to 120 pounds, with 10 pounds in handling costs. The inventory is written down from 150 pounds to the net realizable value of 110 pounds.
Example
A software developer produced 200 physical backup drives for 25 pounds each. Cloud storage adoption spiked, and the drives can now only be sold for 15 pounds, minus 2 pounds in packaging costs. The company values the stock at the net realizable value of 13 pounds per drive instead of the original cost.
Think of it
“Imagine buying a vintage car for 10,000 pounds to resell. If a sudden flood damages the engine and the car is now only worth 4,000 pounds, you would not insure or list it on a personal asset sheet at 10,000 pounds. You would immediately adjust its value to the realistic 4,000 pounds.
Formula
Calculation
Cost = 80 pounds per unit. Estimated Selling Price = 90 pounds. Costs to Sell = 15 pounds. Net Realizable Value = 90 - 15 = 75 pounds. Compare Cost (80 pounds) and Net Realizable Value (75 pounds). Since 75 pounds is lower, you value the inventory at 75 pounds per unit and record a 5 pound write-down per unit.Case study
Seen in the real world.
BrightGadgets Ltd manufactures smart home devices, stocking 1,000 units of a first-generation hub at a historical cost of 40 pounds each, totalling 40,000 pounds. Halfway through the year, a competitor launches an upgraded version with voice control. Demand for BrightGadgets' older hub plummets.
The finance manager reviews the inventory value at the end of the quarter. The current estimated selling price for the old hub has dropped to 30 pounds, and the company must pay 5 pounds in online marketplace fees and shipping for each unit sold. This makes the net realizable value 25 pounds per unit (30 pounds minus 5 pounds).
Applying the Lower of Cost or Net Realizable Value rule, the manager compares the original cost of 40 pounds with the new net realizable value of 25 pounds. Because 25 pounds is lower, the inventory must be written down. The total inventory value on the balance sheet is adjusted from 40,000 pounds down to 25,000 pounds (1,000 units multiplied by 25 pounds). BrightGadgets records a 15,000 pound write-down expense on the income statement. This exercise ensures investors and managers see a realistic asset value, avoiding inflated profits that do not match current market realities.
Watch out
Common mistakes.
- Comparing the original cost against the original expected selling price instead of the net realizable value, which ignores the actual costs required to sell the items.
- Failing to reverse write-downs if market conditions improve in subsequent accounting periods, though under US GAAP this is restricted, it is permitted under IFRS.
- Applying the rule to total inventory in aggregate rather than evaluating individual items or logical categories, which can mask significant losses on specific products.
Questions
People also ask.
How often do we need to check our inventory value?
Companies typically review inventory values at the end of every reporting period, such as monthly, quarterly, or annually, depending on how fast their stock moves and how volatile their market is.
What happens to my taxes when I write down inventory?
Inventory write-downs generally increase your expenses for the period, which reduces your net profit and can lower your taxable income for that year, though local tax rules vary on deductibility.
Can I increase the inventory value back up if market prices recover?
Under International Financial Reporting Standards, you can reverse a write-down up to the original cost if market conditions improve. Under US GAAP, reversals are not permitted once a write-down is recorded.
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