Best Inventory Valuation Methods For Your Restaurant

Inventory

 

Inventory management is so critical if you want to run a profitable restaurant. A restaurant’s profitability is calculated using the cost of goods sold, so it is important that your calculated inventory value be as accurate as possible. This is where the inventory valuation method comes to surface. Choosing the right method can make the process of valuation and managing your inventory easier and reflect better profitability.

 

Inventory valuation Methods

As a restaurant owner you have only three options to evaluate your inventory:

  • First-in, First-out (FIFO)
  • Last-in, First-out (LIFO)
  • Weighted Average Cost (WAC)

 

Now the question is what is the best method to go for? Keep reading to find out…

First-In, First-Out (FIFO)

This technique is used by most restaurants. 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.

FIFO is the best inventory valuation method for restaurants because it decreases waste and preserve freshness.

As we can imagine, inventory in a restaurant has a short demand cycle. At restaurants, goods purchased earliest with the nearest expiration date will be consumed first to avoid spoilage. That is why restaurants prefer FIFO as it matches the actual flow of food in the kitchen.

Why FIFO?

In an inflationary environment where costs continue to rise, using FIFO will allow the older, lower-priced goods to leave first and the more expensive, newer goods to be kept as inventory.

The conclusion is a lower cost of goods sold and higher net income.

One more added value of FIFO is that managers can access real-time inventory counts and depletion instantly through restaurant management software.

The only drawback when using the FIFO method is that there is often a mismatch between costs and revenue since older and often lower costs are associated with current revenues.

Last In, First Out (LIFO)

LIFO is not commonly used in restaurants. LIFO values inventory on the assumption that the goods purchased last are sold first at their original cost. So, the oldest goods usually continue to remain as ending inventory. Many goods would expire before being used. That is why this technique is typically used 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. A higher cost of goods sold will ultimately yield lower restaurant profit margins and net income.

FIFO 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.

Weighted Average Cost (WAC)

With this method, 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.

It can be represented mathematically like this:

WAC = (Total Cost of Sitting Inventory) / (Number of Units)

This technique is more popularly used in situations where it is impossible to determine the cost of a single item because they are so integrated and commoditized. When comparing WAC to FIFO and LIFO, the WAC technique generates a valuation between that of FIFO and LIFO. Using WAC, the value assigned will represents a cost between the first and last purchased items.

Pros and Cons Summary

Method Pros

Cons

FIFO

  • Used by most restaurants
  • 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
  • Mismatches revenue and costs
  • Yields higher income taxation

LIFO

  • Matches revenue and cost
  • Good for non-perishable items, like restaurant swag
  • Good for when prices are fluctuating
  • Yields lower income taxation
  • Yields lower net income
  • Not a good indicator of EI value
  • Banned by IFRS and restricted by GAAP

WAC

  • Good when single item cost is impossible to determine
  • Calculation is Fast and simple
  • Assumes all items are identical

FIFO, LIFO, and WAC are all accepted methods for valuation, but 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.

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