Final answer:
In LIFO inventory costing, market is defined as the current replacement cost affected by demand and supply, and may not always be equivalent to the cost of production. Understanding average total cost is crucial for businesses, as it is a determinant of profitability.
Step-by-step explanation:
In applying the lower of cost or market method to LIFO inventory costing, market is defined as the current replacement cost, not exceeding the net realizable value nor less than the net realizable value minus a normal profit margin. This method requires a comparison to be made between the historical cost and the market cost as defined. If the market cost is lower than the historical cost, the inventory is written down to its market cost to reflect the loss in value of the inventory. This approach helps ensure that the inventory is not overstated on the balance sheet.
The concept of market in this context is influenced by demand and supply, which set market prices rather than the cost of production. This can result in situations where goods are sold below the cost of production, for instance during a going-out-of-business sale or when there is an excess supply driving market prices down. In such cases, the market price can fall below the average total cost of producing the goods.
As a practical matter, understanding how to calculate average total cost is important for businesses as it impacts profitability. We calculate average total cost by taking total cost and dividing it by total output at each different level of output. If a firm's average cost of production is lower than the market price, then the firm is typically profitable.