When it comes to running a profitable restaurant, a lot of what you need to know comes down to the way your restaurant manages inventory. Many times, the financial health of your business is dependent upon the goods you have in stock.
But let's be honest: No one really likes doing inventory. That's why there are inventory costing methods. When you stick to one, it can help make the process of managing and costing inventory easier — and more profitable.
Inventory Costing Methods
So, what's the best inventory costing method to determine the cost of goods sold in your restaurant?
You actually have a few options here:
- First-in, first-out (FIFO)
- Last-in, first-out (LIFO)
- Weighted average cost (WAC)
Keep reading to learn about each of these inventory costing techniques and figure out which makes the most sense for your business.
First-In, First-Out (FIFO) Inventory Costing
The majority of restaurants operate according to the first-in, first-out (FIFO) principle of inventory valuation.
This technique assumes that the goods you purchase first are the goods you use (and sell) first. As a result, your remaining inventory consists of your most recent purchases and is accounted for at the goods' current cost.
The first-in, first-out method is best for businesses where inventory has a short demand cycle or is perishable, which is most prominent in the restaurant industry. Chefs and back-of-house staff will use the ingredients purchased earliest, with the nearest expiration date, in order to avoid spoiling or wasting inventory. FIFO makes sense because it matches the actual flow of food in the kitchen.
Why use FIFO?
As inventory costs continue to rise — and with the potential for inventory shortages and disruptions in the food supply chain due to the COVID-19 health crisis — restaurants find themselves in an inflationary environment. But for those using the first-in, first-out method, the financial hit is minimized. FIFO directs restaurants to use older, lower-priced goods first and to leave the (theoretically) more expensive goods as inventory.
Altogether, this adds up to a lower cost of goods sold and higher net income.
FIFO in restaurants
Of all inventory valuation methods, first-in, first-out is the most reliable indicator of inventory value for restaurants. Because this method corresponds inventory with its original cost, the calculated value of remaining goods is most accurate. Managers can even access real-time depletion and inventory counts instantly through modern inventory management software.
One thing to consider with this method is that revenue and cost matching don't always match up. With FIFO, older and often lower costs are calculated with current revenues, resulting in some incorrect correlations.
Last In, First Out (LIFO) Inventory Costing
Last-in, first-out (LIFO) is another technique used to value inventory, but it's not one commonly practiced, especially in restaurants.
Last-in, first-out values inventory on the assumption that the goods purchased last are sold first at their original cost. In this scenario, the oldest goods usually remain as ending inventory. Under the LIFO system, many food items and goods would expire before being used, so this method is typically practiced with non-perishable commodities.
When the price of goods increases, those newer and more expensive goods are used first according to the LIFO method. This increases the overall cost of goods sold and leaves the cheaper, earlier purchased goods as inventory, which may end up not even being sold under the LIFO model.
Should restaurants use LIFO?
The short answer is no.
The higher cost of goods sold brought on by the LIFO model and will ultimately yield lower restaurant profit margins and net income. Also, unlike FIFO, the last-in, first-out method doesn't always provide an accurate valuation of closing inventory. Since your oldest goods tend to be stored as inventory repeatedly, a significant portion will likely become obsolete before you can use them.
And as it relates to financial accounting, LIFO is also banned by the International Financial Reporting Standards (IFRS). More on this from Investopedia: "As IFRS rules are based on principles rather than exact guidelines, usage of LIFO is prohibited due to potential distortions it may have on a company’s profitability and financial statements. In principle, LIFO may create a distortion to net income when prices are rising (inflation); LIFO inventory amounts are based on outdated and obsolete numbers, and LIFO liquidations may provide unscrupulous managers with the means to artificially inflate earnings."
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Weighted Average Cost (WAC) Inventory Costing
Depending on the inventory items, FIFO and LIFO may not be viable options for inventory valuation. An alternative and generally accepted method is weighted average costing (WAC).
According to Investopedia, WAC is "most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit. This is frequently the case when the inventory items in question are identical to one another. Furthermore, this method assumes a store sells all of its inventories simultaneously."
With the WAC technique, the inventory items receive the same valuation regardless of when and at what cost each was purchased. Instead, the total cost of items in inventory is divided by the number of units to yield the weighted average cost per unit.
Mathematically, that looks like this:
WAC = ( Total Cost of Sitting Inventory ) / (Number of Units)
Here's an example: Maybe you want to lump your soft drink inventory together for more convenient calculations. Perhaps some of the cases are $24 for 24 bottles, but you also choose to buy a more premium drink that costs $36 for 24 bottles. Assuming you buy the same amount of cases for each price point — say, 10 at the $24 price and 10 at the $36 price — your WAC per beverage case is $30, or $1.50 per bottle.
In comparison to the techniques above, the weighted average method generates a valuation between that of FIFO and LIFO. The value assigned in this case represents a cost between the first and last purchased goods.
Inventory Costing Methods: Pros, Cons & Summary
While FIFO, LIFO, and WAC are all accepted methods for inventory valuation, you should select the one that best aligns with your reporting and management styles. The easiest way to monitor your products is by using back office software that integrates with your point of sale system and gives you live tracking of your inventory — whenever you need it.
Inventory costing is an extremely useful and powerful tool for managing an important piece of your restaurant's finances, and keeping a close eye on it will help you maintain the financial health of your business.