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Why is inventory valued at the lower of cost and net realisable value, and how does the valuation affect profit?

Value inventory at the lower of cost and net realisable value and explain its effect on profit

A focused answer to the O-Level Principles of Accounts outcome on inventory valuation. The lower of cost and net realisable value rule, the prudence concept, and the effect of inventory value on gross profit.

Generated by Claude Opus 4.88 min answerUpdated 2026-06-06

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The answer
Examples in context
Try this

What this dot point is asking

SEAB wants you to value inventory at the lower of cost and net realisable value and explain its effect on profit. The central insight is prudence: inventory is not written up to a hoped-for selling price, but it is written down if it cannot be sold for at least its cost, so neither the asset nor profit is overstated.

The answer

The rule

Inventory is valued at the lower of cost and net realisable value (NRV):

Cost - what the business paid for the goods (including carriage inwards to get them in).
Net realisable value (NRV) - the expected selling price less any costs still needed to sell them (for example repairs or selling costs).

Take whichever is lower for each line of inventory.

Why prudence

If goods can still be sold for more than they cost, they stay at cost (we do not record a profit before the sale). If they can only be sold for less than cost (damaged, out of fashion, obsolete), they are written down to NRV, recognising the loss now. This is the prudence concept: anticipate losses, do not anticipate profits.

Value each line separately

The lower of cost and NRV is applied to each line (or category), not to the inventory as a whole. A profit expected on one line cannot be used to hide a loss on another.

Effect on profit

Closing inventory is deducted in cost of sales, so its value directly affects gross profit:

Inventory valued	Cost of sales	Gross profit
Too high	Too low	Overstated
Too low	Too high	Understated

Because this year's closing inventory is next year's opening inventory, an error reverses: an overstatement this year becomes an understatement next year.

Worked example

A shop has three product lines at the year end. Line X: cost $\$ 5,000 $, NRV$ \ $6,000$ . Line Y: cost $\$ 4,000 $, NRV$ \ $3,200$ . Line Z: cost $\$ 2,000 $, NRV$ \ $2,000$ . (a) Value the inventory. (b) If gross profit was drafted using cost of $\$ 11,000$, state the corrected gross profit effect.

Step 1: Value each line at the lower figure

Line X: lower is cost $\$ 5,000 $. Line Y: lower is NRV$ \ $3,200$ (written down $\$ 800 $). Line Z: equal,$ \ $2,000$ .

Step 2: Total the inventory

Correct inventory $= 5\,000 + 3\,200 + 2\,000 = \$ 10,200$.

Step 3: Compare with the draft

The draft used total cost $\$ 11,000 $; the correct value is$ \ $10,200$ , a write-down of $\$ 800$ (the loss on Line Y).

Step 4: State the profit effect

A lower closing inventory ( $\$ 10,200 $instead of$ \ $11,000$ ) raises cost of sales by $\$ 800 $, so gross profit **falls by$ \ $800$ **. Prudence has recognised the likely loss on Line Y this year, rather than carrying the goods at an unrealistic value.

Examples in context

Example 1. Last season's stock. A clothing shop holds coats that cost $\$ 8,000 $but, now out of season, will sell for only$ \ $5,000$ after a markdown. The coats are written down to their $\$ 5,000 $NRV, recognising the$ \ $3,000$ likely loss this year. Carrying them at cost would overstate both the asset and profit, which prudence forbids.

Example 2. The two-year wash. A firm overstates closing inventory by $\$ 2,000 $, lifting this year's profit. Next year that figure is the opening inventory, raising cost of sales and cutting profit by$ \ $2,000$ . Over the two years the effect nets to nil, but each year on its own is wrong, which is why an accurate count and valuation matter.

Try this

Q1. A line of inventory cost $\$ 3,000 $and has an NRV of$ \ $2,500$ . State the value used and the concept. [2 marks]

Cue. Use the lower figure, $\$ 2,500$ (NRV); the concept is prudence.

Q2. Closing inventory is overstated by $\$ 1,000$. State the effect on this year's gross profit. [1 mark]

Cue. Gross profit is overstated by $\$ 1,000$, because cost of sales is understated.

Q3. Explain why inventory is not valued at expected selling price. [2 marks]

Cue. The profit on a sale is not earned until the goods are sold; valuing at selling price would record profit early, breaching prudence.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original6 marksA business holds three lines of inventory at the year end. For each, the cost and the net realisable value (NRV) are: Line A cost

\

4\,000

, NRV

4\,500

; Line B cost

\

3\,000

, NRV

2\,200

; Line C cost

\

1\,500

, NRV

1\,800

. (a) State the value of each line for the accounts. (b) State the total inventory value and name the concept applied.

Show worked answer →

(a) Each line is valued at the lower of cost and NRV:

| Line | Cost $\XKATEXDISPLAYTOKEN0XEND | Value used$ $$ |
| --- | --- | --- | --- |
| A | 4,000 | 4,500 | 4,000 (cost lower) |
| B | 3,000 | 2,200 | 2,200 (NRV lower) |
| C | 1,500 | 1,800 | 1,500 (cost lower) |

(b) Total inventory $= 4\,000 + 2\,200 + 1\,500 = \$ 7,700$. The concept applied is prudence (do not overstate assets or profit).

Markers reward valuing each line at the lower figure (note B is written down to $\$ 2,200 $), the$ \ $7\,700$ total, and naming prudence. Lines must be valued individually, not in total.

Original5 marksA business wrongly valued its closing inventory at

\

12\,000

when the correct figure was

9\,000

. Explain the effect of this overvaluation on (a) this year's gross profit, and (b) next year's gross profit.

Show worked answer →

(a) Closing inventory is deducted in cost of sales. Overvaluing it by $\$ 3,000 $makes cost of sales **too low**, so this year's **gross profit is overstated** by$ \ $3\,000$ .

(b) This year's closing inventory becomes next year's opening inventory, which is added in cost of sales. An overstated opening inventory makes next year's cost of sales too high, so next year's gross profit is understated by $\$ 3,000$.

So the error reverses: profit is overstated this year and understated next year by the same $\$ 3,000$, though over the two years combined the total is unaffected.

Markers reward this year's gross profit overstated, next year's understated, and the link through opening inventory.