Lower of cost or net realizable value: when inventory is worth less than it cost

Inventory is normally carried at what it cost. But goods can lose value on the shelf: a product goes out of fashion, a newer model arrives, or the costs of selling it climb. When the amount a business expects to get back falls below cost, the inventory is written down. This page explains the rule, works through a five-item example, and shows how to build the schedule in a spreadsheet.

The rule in plain English

A balance sheet should not show an asset at more than the business can get out of it. For inventory, the amount it can get out is the net realizable value, or NRV: the estimated selling price minus the costs to complete and sell the goods. Costs to sell include things like sales commissions, packaging and shipping to the customer. If the goods need finishing work before they can be sold, that cost is subtracted too.

The rule is simple: value each item at whichever is lower, its cost or its NRV.

• If NRV is above cost, the item stays at cost. The expected profit is not recorded until the goods are sold.
• If NRV is below cost, the item is written down to NRV. The loss is recorded now, in the period the value fell, not later when the goods are sold.

This is one-sided on purpose. Accounting recognizes expected losses early and expected gains only when they are earned. Inventory is never written up above its cost just because it could be sold at a profit.

Notice that NRV is not the same as the selling price. An item can have a selling price above its cost and still be worth less than cost once the costs to sell are taken off. Those are the items that are easiest to miss.

Worked example: five items at year end

Bluebird Veterinary sells a small range of retail goods from its front counter. At year end it has five items in stock:

The selling price and costs to sell are per unit. For each item, work out NRV per unit, take the lower of unit cost and NRV, and multiply by the units:

Three items are comfortably above cost and stay at cost. Two are not:

• Ceramic mugs sell for $5.00, already below their $8.50 cost. After $1.25 of costs to sell, each mug nets only $3.75.
• Candle sets look fine at first: they sell for $20.00 and cost $18.50. But $2.75 of costs to sell brings NRV down to $17.25, which is below cost.

The write-down

At cost, the five items total $13,973.00 (128 × $23.50 + 42 × $38.00 + 44 × $37.75 + 305 × $18.50 + 243 × $8.50). The lower-of-cost-or-NRV value is $12,437.50. The difference is the write-down:

Candle sets: 305 × ($18.50 − $17.25) = $381.25
Ceramic mugs: 243 × ($8.50 − $3.75) = $1,154.25
Write-down: $13,973.00 − $12,437.50 = $1,535.50

The entry reduces Inventory and records the loss. Many businesses charge it to Cost of Goods Sold; others use a separate loss account so it can be seen on its own. Either way, the credit goes to Inventory:

After the entry, Inventory shows $12,437.50, and the candle sets and mugs carry their new, lower values into next period.

Item by item or as a whole?

The rule can also be applied to the inventory as one group. Then you compare total cost with total NRV. Bluebird's total NRV is $17,323.50, well above its $13,973.00 cost, so on that basis there would be no write-down at all. The healthy items hide the losses on the mugs and candles.

That is why item by item is the usual starting point: it is the most cautious, and its value is never higher than the whole-inventory value. Some businesses group similar items together. Whatever grouping is used, gains on one group never offset losses on another.

How to lay it out in a spreadsheet

Put one item per row, rows 4 to 8: the item name in column A, units in B, unit cost in C, selling price per unit in D and costs to sell per unit in E. Then add three formula columns and a total:

• F4 takes the costs to sell off the selling price. This is the step that catches items like the candle sets.
• G4 uses MIN, which returns the smaller of its arguments. It picks cost or NRV automatically, so you never have to decide row by row.
• H4 turns the per-unit value into a dollar amount for the row.
• H10 adds the five rows to give the inventory figure for the balance sheet.

Write F4 to H4 once, then fill them down to row 8. The references are relative, so each row uses its own units and prices.

To work out the write-down, compare totals rather than per-unit values. Add a total cost column, =B4*C4, and a total NRV column, =B4*F4, then take =MIN(G4,H4) of the two in a third column. Total each column in row 10 with SUM. The write-down is total cost minus the total of the lower amounts, for example =G10-I10. For the inventory as a whole, compare the two totals instead: =MIN(G10,H10), and the write-down on that basis is total cost minus that.

A useful check: the write-down can never be negative. If yours is, the formula is comparing the wrong totals.

Common mistakes and how to avoid them

These are the mistakes our exercises check for.

Ignoring the costs to sell

NRV is what the business will actually net: selling price minus the costs to complete and sell. Using the selling price alone makes every item look more valuable. In the example, the candle sets would stay at their $18.50 cost, the mugs would be valued at $5.00, and the total would come out at $13,122.50 instead of $12,437.50.

Taking the higher value

The rule takes the lower of cost and NRV, never the higher. Using MAX instead of MIN writes the profitable items up to their NRV and gives $18,859.00, more than the goods cost. Inventory is written down when its value falls, but it is never written up above cost.

Working the write-down out from total NRV

Subtracting total NRV ($17,323.50) from total cost ($13,973.00) gives a negative figure, −$3,350.50. That mixes up the items above cost with the items below. Items worth more than cost stay at cost, so they cannot offset the others. The write-down is total cost minus the total of the item-by-item lower amounts: $1,535.50.

Using the item-by-item total for the whole-inventory basis

When the rule is applied to the inventory as a whole, compare total cost with total NRV directly. Here that gives $13,973.00, not the item-by-item $12,437.50. The two bases are meant to give different answers; that is the point of comparing them.

Where this fits in the inventory cycle

The lower-of-cost-or-NRV test comes at the end of the year, after the cost of ending inventory is known. In a periodic system that cost comes from the count, priced with a cost flow method such as FIFO, LIFO or weighted average; see periodic inventory and cost of goods sold. In a perpetual system it comes from the running inventory record, adjusted for any shrinkage found at the count, as in supplies and inventory shrinkage adjusting entries. The write-down is a separate step: shrinkage is goods that are missing, while a write-down is for goods that are there but worth less.