Lower of Cost or Net Realizable Value (LCNRV) is a conservative accounting rule that dictates how a company must value its inventory. Think of it as a mandatory reality check for a company’s stockroom. The principle is simple: inventory must be recorded on the balance sheet at either its original historical cost or its net realizable value (NRV), whichever is lower. Why the long face? This rule, a cornerstone of the accounting principle of conservatism, prevents companies from carrying inventory on their books at a value higher than what they could realistically get for it. This is crucial because it stops businesses from inflating their assets and, by extension, their profits. If a company’s inventory of last year's smartphones or bell-bottom jeans is now worth less than what they paid for it, LCNRV forces them to acknowledge that loss now, not later when they finally sell it for pennies on the dollar.
For a value investor, LCNRV isn't just boring accounting jargon; it’s a peek behind the corporate curtain into a company's operational health and management's grip on reality. Frequent or large inventory write-downs can be a flashing red light, signaling potential problems such as:
Ultimately, an inventory write-down directly hits the financial statements. It increases the cost of goods sold (COGS), which shrinks gross profit, net income, and a company's book value—all critical metrics for a value investor’s analysis. A consistent need to apply LCNRV suggests a business that is struggling, not thriving.
To understand LCNRV, you need to know its two key components: “Cost” and “Net Realizable Value.” The company compares these two figures for its inventory and chooses the lower one.
“Cost” is the original price the company paid for the inventory. But it's more than just the sticker price. It includes all the expenses required to get the inventory ready and in place for sale. This can include:
Companies use different methods to track this cost, such as FIFO (First-In, First-Out) or weighted-average cost, which will be detailed in the footnotes of their financial reports.
NRV is the estimated selling price of the inventory in the normal course of business, minus any costs needed to complete, sell, and deliver it. It’s the net cash a company realistically expects to pocket from selling that item.
Let's imagine a fashion retailer, “Trendy Threads Inc.” They have a warehouse full of floral shirts that cost them $40 each to produce. Unfortunately, plaid is the new floral. They estimate they can only sell the shirts on a clearance rack for $35. To do this, they’ll spend an average of $2 per shirt on marketing and sales commissions.
Now, Trendy Threads Inc. must apply the LCNRV rule to its floral shirt inventory.
The rule says to pick the lower of the two. In this case, the value is $33. The company must “write down” the value of each shirt from $40 to $33. This difference of $7 ($40 - $33) is recognized as a loss on the income statement in the current period, typically by increasing the Cost of Goods Sold. If they have 1,000 such shirts, that's a $7,000 hit to their profit right away. This adjustment ensures the company’s assets aren't overstated and that the income statement reflects the economic reality of its inventory situation.
As an investor, you're a detective. The LCNRV rule gives you important clues if you know where to look.