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Figuring out cost is easy. It's what a firm paid. Firms normally use cost as the value for inventory.
There's a problem though. Sometimes the value of items drop substantially. Think about a new computer. When it's first manufactured, it's worth a lot. A couple of years later, it's barely worth anything, because it's obsolete. Recording its value at its original cost no longer makes any sense.
When the cost drops below the market value, firms should downgrade its value to the market value (when using LIFO or retail inventory methods).
Unfortunately, figuring out what the market value is can be challenging. Firms first need to compute three values:
- Replacement Cost - How much it would cost for the firm to buy
- Net Realizable Value - How much it would sell for minus the cost to complete the sale (shipping and handling, commissions, etc.)
- Net Realizable Value Minus Normal Profit
So if it could be one of the three, which one should be chosen to represent the market price?
The one in the middle (the median). Arrange the three values from least to greatest, and pick the one in the middle.