A First-Timer’s Guide To Inventory Costing and Management

Most restaurant owners go into the restaurant business because creating delectable foods and delighting customers is their passion. However, no matter how good your food is or how exceptional your customer service is, they might not be enough to help you turn profitable if your inventory costing and management procedures are not streamlined and automated. 

For a restaurant business to be successful and lucrative, it should efficiently manage its inventory. The profitability of your restaurant is primarily determined by your inventory. 

Restaurant inventory management comes down to how you manage the finances of your restaurant. This involves four things: how much the menu item is sold for, what it costs to make it, how frequently your restaurant places new purchase orders, and what product is wasted in their respective quantities. 

As an owner or a manager, if you have ever had to ‘86’ a menu item, you would realize the importance of having an adequately stocked inventory. 

Traditionally, restaurants had to manually make the ingredients or menu items unavailable in their POS system or online ordering menus. No matter how well-prepared you are, 86-ing menu items are unavoidable in the restaurant industry. 

However, such high-value risks can be mitigated by preparing and establishing good inventory processes within your restaurant from the beginning.

The average restaurant burns 20-40% of its revenue on food. That’s why it is imperative that restaurant owners adopt an effective inventory costing system to keep up with other expenses such as rent, labor, and maintenance while still turning a profit. 

Inventory costing can be used to guarantee that restaurants are following sustainable financial practices.

 

Inventory Costing

Inventory is one of the most significant financial KPIs that a restaurant should track. As inventory is generally one of a restaurant’s major assets, the cost of goods sold is an important part of both financial and tax reporting processes.

The process of allocating value to inventory, and hence to the cost of items sold, is known as inventory costing. Though all inventory costing entails assigning a value to products sold, there are a few common costing strategies to consider, including:

1. First-In, First-Out (FIFO)
2. Last-In, First-Out (LIFO)
3. Weighted Average Cost (WAC) 

While there are various methods to manage inventory, figuring out what works best for your business is key. Let’s explore a few inventory costing methods with suitable examples below. 

Inventory Costing Methods

First-In, First-Out (FIFO)

To reduce food waste, product spoiling and expiration, most restaurants follow the First-In, First-Out (FIFO) principle.

The FIFO system is a method of storing and rotating food. The food that has been in storage the longest (“first in”) should be the first to be used (“first-out”) in a FIFO system. 

This strategy aids businesses and households in keeping their food storage orderly and ensuring that food is consumed before it spoils. First In, First Out is an effective approach that should be part of every food service establishment’s standard operating procedure and normal practice for food supervisors.

As a result, the restaurant’s remaining inventory is made up of the most recent purchases and is valued at the current cost of the item. This is the most popular approach for calculating restaurant inventory costs since it’s accurate, dependable, and simple to calculate. 

FIFO mirrors the regular movement of products in a restaurant. Modern inventory management software allows managers to see real-time depletion and inventory counts in real-time.

For example: Because fresh food has such a short shelf life, it is usually sold on a first-come, first-served basis. As a result, the oldest products, or those that were originally brought into the store, are usually the first to sell. 

Let’s say, a restaurant purchases 10 kilos of apples today, and 10 kilos of apples the next day. They should aim on finishing the apples purchased the previous day (first in, first out) in order to prevent potential food waste and spoilage. 

Some of the most commonly used FIFO practices include 

1. Organizing products based on their use-by dates
2. Placing high-priority items in visible and easily accessible places 
3. Stocking new supplies behind existing supplies 
4. Ensuring stock items are in good condition and well within their expiration dates 

FIFO can go a long way to ensuring the freshness of your restaurant’s food and is one of the most common safety practices in the restaurant industry. 

PROS:

1. FIFO is simple and easy to understand. Even staff with no accounting knowledge will have an easy time determining what products should be consumed first. 
2. Because the cost of the inventory being sold is determined by the most recent cash flow of purchases to be used first, the FIFO technique saves money and time when estimating the exact cost of the inventory being sold.
3. Food enterprises can use FIFO to cycle through their stock and keep it fresher. Employees who keep track of how much time food spends in storage are proactive about safeguarding food safety and freshness.
4. FIFO stops food from being pushed to the back and overlooked. 
5. FIFO helps restaurants track how quickly their stock is being used.

CONS: 

1. Organizing and tracking products in a busy kitchen can be difficult.
2. When using FIFO, older and generally cheaper costs are added to current revenues, which can lead to some inaccurate correlations.
3. This method results in higher profits during periods of inflation, resulting in higher income tax yielding. It may also result in higher cash outflows as a result of tax penalties.
4. It may present a distorted picture of inventory expenses when restaurants match most previous purchases with most current sales, as this would inflate earnings and provide skewed information in times of hyperinflation.
5. If the materials/commodities acquired have variable pricing patterns, FIFO will not be a suitable metric, since it can result in grossly misinterpreted profits for the same period. because different costs of the same goods over the same period are recorded.

Last-In, First-Out (LIFO)

In contrast to the FIFO method, the Last-in, First-out (LIFO) technique of inventory valuation assumes that the last expenditures for purchased items or direct supplies are the first costs charged against revenues.

In simpler terms, the last-in, first-out inventory valuation is based on the assumption that the last-purchased items are sold first at their original price. The oldest commodities are normally kept as ending inventory in this circumstance. 

Because many food items and goods can expire before being used under the LIFO system, this method is typically utilized with non-perishable commodities.

According to the LIFO approach, when the price of items rises, the newer and more costly commodities are used first. This raises the overall cost of items sold while leaving cheaper, previously purchased goods in inventory, which may not be sold at all.

For example: When a restaurant stocks up on canned food, but continues to purchase fresh ingredients, it follows the LIFO method. Rather than using the older canned goods, the staff use newer inventory instead. However, LIFO is generally not used for perishable items as they will spoil under this method. 

When using the LIFO costing method, the restaurant must record the inventory item’s original purchase price when it is used, even if the value of the item decreases over time. Price inflation reduces profit margins, resulting in lower taxes.

PROS: 

1. LIFO method lowers taxes due to reduced profit margins
2. Always reflects current revenue with current costs 
3. Useful for stacking and storing non-perishable food in the sequence in which it is received. Staff have easier access to newer items, which saves them time.

CONS:

1. LIFO is actually prohibited as an accounting practice by the IFRS (International Financing Reporting Standards)
2. This strategy results in a greater cost of goods sold, resulting in lower profit margins for the restaurant.
3. LIFO does not always result in an accurate ending inventory valuation. The oldest commodities are frequently retained as inventory, and there’s a chance that a large number of these will expire before they are used.

Weighted Average Cost (WAC) 

The Weighted Average Costing method considers the average unit cost of inventory items rather than the oldest or newest reported prices.

WAC users take a basic average of their inventory value, regardless of purchase date, and then execute a final inventory count at the conclusion of their accounting month. The restaurant can compute the cost of ingredients at that time by multiplying the average cost per item by the final inventory count.

The WAC technique is great for restaurateurs who want to streamline their record-keeping while purchasing fresh ingredients and finished goods in large volumes. Take the total cost of ingredients and divide it by the number of units available to determine the WAC of your total inventory.

While weighted average costing is advantageous for purchasing goods with minimal price variations, it can be disadvantageous when sourcing materials with substantial price fluctuations as it will be difficult to arrive at a fair, average cost.

PROS:

1. WAC is faster and easier to calculate. It can be done using this formula 

WAC = (total cost of sitting inventory) / (number of units)

2. Allows restaurants to calculate COGS in cases where determining the cost of individual items is hard due to fluctuation in prices.

CONS:

1. One of the biggest drawbacks of WAC is that it assumes all goods in the inventory are identical, which is rarely the case. 

The Bottom Line

FIFO provides a more realistic value for ending inventory on the balance sheet during periods of inflation. On the other hand, net revenue increases due to inventory values and increased net income might result in higher taxes.

Using LIFO during periods of inflation results in a balance sheet ending inventory number that is substantially lower than what the inventory is genuinely worth at current prices. This results in lower net income due to a higher cost of goods sold (COGS). The findings with weighted average cost are somewhere between FIFO and LIFO.  

FIFO, LIFO, and WAC inventory costing methods are all widely accepted, but restaurants should choose the one that best suits their accounting needs. 

The simplest approach to keep track of your products is to use an inventory management system that connects to your point of sale system and gives you an accurate picture of  inventory in stock whenever you need it.