When it comes to running a profitable restaurant, much of what you need to know lies in your restaurant inventory management. In fact, the financial health of your business largely depends on the goods held in stock.
The profitability of a restaurant is calculated using the cost of goods sold, so it's important that your calculated inventory value be as accurate as possible.
But let's be honest - no one really likes to do their 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?
As it turns out, restaurant owners actually have a few options here. These include:
- First-in, first-out (FIFO)
- Last-in, first-out (LIFO)
- Weighted average cost (WAC)
Keep reading to find out which inventory costing technique is right for your business.
First-In, First-Out (FIFO)
The majority of restaurants operate according to the first-in, first-out principle of inventory valuation.
This technique, often referred to as FIFO, assumes that the goods purchased first are the goods sold first. As a result, the remaining inventory consists of the most recent purchases and is accounted for at the good’s current cost.
To preserve freshness and avoid waste, FIFO is the obvious inventory costing method choice for restaurants.
The first-in, first-out method is best for cases where inventory has a short demand cycle or is perishable, just like in the foodservice business. At restaurants, chefs will use the ingredients purchased earliest with the nearest expiration date in order to avoid spoilage. Foodservice businesses therefore tend to prefer FIFO as it matches the actual flow of food in the kitchen.
Why Use FIFO?
As costs continue to rise, restaurants find themselves in an inflationary environment. For those using the first-in, first-out method, however, the financial hit is minimized. FIFO directs restaurants to use the 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 valuation methods, first-in, first-out is the most reliable indicator of inventory value for restaurants. Since inventory measured this way corresponds with its original cost, the calculated value of remaining goods is most accurate. Managers even can access real-time depletion and inventory counts instantly through modern restaurant management software.
One thing to consider with this method, however, is that there is not always proper revenue and cost matching. With FIFO, older and often lower costs are calculated with current revenues, resulting in some misassociation.
Last In, First Out (LIFO)
Last-in, first-out (or LIFO) is another technique used to value inventory. Although not commonly practiced - especially in restaurants - this method offers a reverse approach to FIFO with its own benefits.
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 continue to remain as ending inventory. Many foods would expire before being used under the LIFO system, and 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 not even be sold under the LIFO model.
Should Restaurants Use LIFO?
In a word: no.
A higher cost of goods sold will ultimately yield lower restaurant profit margins and net income. The only real benefit to this inventory costing method is that businesses will face a reduced tax burden because of their smaller profit.
Also, unlike FIFO, the last-in, first-out method does not always provide an accurate valuation of ending inventory. Since the oldest goods tend to be stored repeatedly as inventory, a significant portion will likely become obsolete before use.
Another thing to keep in mind is that when it comes to financial accounting, LIFO is usually not the preferred method as it is banned by IFRS (the International Financial Reporting Standards) and has restricted use according to GAAP (Generally Accepted Accounting Principles).
Weighted Average Cost (WAC)
Depending on the goods, FIFO and LIFO may not be viable options for inventory valuation. An alternative and generally accepted method is weighted average costing, or WAC. With this technique, the goods 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)
For example, maybe you want to lump your soft drink inventory together for more convenient calculations. Perhaps some of the cases are $24 for 24 soda 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.
This method is more popularly used in situations where it is impossible to determine the cost of an individual item because they are so integrated and commoditized. 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
- Good for items that have a short demand cycle or are perishable
- Matches actual flow of goods
- Good indicator of EI value
- Yields higher net income
- Used by most restaurants
- Mismatches revenue and costs
- Yields higher income taxation
- Good for non-perishable items, like restaurant swag
- Good for when prices are fluctuating
- Yields lower income taxation
- Matches revenue and cost
- Yields lower net income
- Not a good indicator of EI value
- Banned by IFRS and restricted by GAAP
- Fast and simple to calculate
- Good when individual item cost is impossible to determine
- Assumes all units are identical
While the FIFO, LIFO, and WAC are all accepted methods for valuation, restaurants should select the one that best fits their reporting and management styles. The easiest way to monitor your products is by using back office software that links with your point of sale system and provides live tracking of your inventory whenever you need it.
Inventory valuation is an extremely useful and powerful tool for restaurant management, but if not done properly, can have costly consequences.