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By Debra Weinryb
As a restaurateur, your success relies on sourcing quality ingredients at sustainable prices. Inventory costing methods can help keep your expenses in check. After all, you want to be able to keep creating recipes that your customers love, without breaking the bank.
Yet the average restaurant spends between 20-40% of its expenses on food – that takes up a large portion of cash! This is also a reason why you should consider following restaurant inventory best practices.
With an effective inventory costing method, you will be able to ensure you can keep up with your spending habits and save money for so many other important operational expenses – like labor, rent, utilities, marketing, and advertising.
To help you get started, we’ve broken down inventory costing methods into easy to understand concepts with real-life examples, covering topics such as:
Ready to stay on top of costs when purchasing and selling new products? Let’s get started.
Inventory costing is when companies assign a cost to products. These hidden costs can include fees such as storage, administrative costs, or market fluctuation. For a restaurant, these costs may include the cost of kitchen or storage space, the cost of money such as debt or interest, or the cost of waste, such as spoiled and damaged foods.
Cost is a major part of restaurant inventory management. It can help restaurant owners stay on top of their expenses and assist in determining how much of a product they should carry. This helps ultimately restaurateurs decide on margins – the revenue they will make after paying the cost of goods sold (COGS).
There are many reasons why a restaurant could experience low levels of profit, but the cost of food is often a major factor. That’s why it’s important to understand the concepts of inventory (purchases) and the costs of goods sold – they are actually very different!
Let’s take a closer look.
Inventory is your products – the food and drinks that have been bought but not yet sold to customers. For restaurants, this could be fresh meat, frozen food, fresh produce, beer or liquor bottles, soda cans, or any product that can be bought and resold to customers. They can be sold on their own, or mixed with other ingredients to complete a dish.
The Cost of Goods Sold (COGS) is the cost of the products that were already sold to customers. This includes the cost of what goes on a plate, or in a mixed alcohol drink that is being served. COGS is usually calculated over a week or monthly time period.
Since the profitability of your restaurant is calculated using the cost of goods sold, it is also important that the value of your inventory is as accurate as possible. So how do you determine the cost? To do this, you’ll need to know how much each product is worth.
Thankfully, there are a few options to help restaurateurs determine the cost of goods sold, and we’ve outlined each of them below:
First In, First Out refers to the valuation method of selling the oldest inventory you own first. As a result, the value of your remaining inventory will be based on the most recent inventory you purchased.
This method is most popular among restaurant owners because it reflects how the industry works in real life. For example, a coffee shop would use its older beans first to keep its remaining stock fresh.
To calculate your Cost of Goods Sold (COGS) using the FIFO inventory method, you’ll need to figure out the cost of your oldest inventory. Then, multiply that cost by the amount of inventory sold.
For example, let’s say Bob’s Bistro buys and resells bottles of wine. Here is what it’s been costing Bob to build up his inventory since his restaurant opened:
Let’s say Bob wants to calculate the cost of goods sold in the first quarter of the year at the beginning of April. Bob has sold 90 bottles so far.
The COGS formula is:
(Amount of Units Sold) x (Price Paid Per Unit) = Cost of Goods Sold
90 x $20.00 = $1,800
Since Bob is using the FIFO inventory costing method, he will use the oldest cost of $20.00 per bottle in his calculation.
With the FIFO inventory method, purchases at the end of a sales period have no effect on the cost of goods sold or net revenue. This leads to several pros and cons:
Last-In, First Out refers to the valuation method of selling the newest purchases added to your inventory first. As a result, the value of your remaining stock will be based on the oldest products you purchased.
The LIFO inventory method is especially useful when inventory costs are on the rise, like during inflation. This also means the cost of sale will be higher when more expensive items are sold first. In addition, less taxes will be paid if profit is lower, which can lead to significant savings overtime.
Since most restaurants are looking to sell their oldest stock first, the LIFO method is not usually the preferred choice. But, in some circumstances, it can be used to make your restaurant look more profitable. For example, it could be used in a presentation to show how your business runs. It’s also important to note that this method is only legal in the United States.
In order to calculate your COGS (cost of goods sold) with the LIFO inventory method, you’ll need to determine the cost of your newest inventory. Then multiply this amount by the total amount of inventory sold.
It looks like Bob didn’t choose the best time to start selling bottles of wine. After all, the cost of his inventory started increasing month over month, as shown in the ‘Price Paid’ column for February and March. Instead, Bob now chooses to use the LIFO method, so he will use the price it cost him to buy bottles in March.
Bob’s calculation for COGS is as follow:
90 x $80.00 = $7,200
Since Bob is using the LIFO method, he uses the most recent cost of $80 per bottle in his calculation. Since his costs of goods sold are high, he will get a lower tax rate. The 210 bottles that haven’t been sold will count as inventory.
With LIFO, inventory purchases at the beginning of a sales period have no effect on the cost of goods sold, or net revenue. This leads to several pros and cons:
The weighted average inventory costing method (WAC) is a happy-medium between FIFO and LIFO. It uses the average cost per product, instead of the cost of the oldest or newest products. This means that all of your inventory items will have the same valuation, regardless of when, or at what cost, they were purchased.
To calculate WAC, divide the total cost of your goods available for sale by the total number of units in your inventory. This will give you the weighted average cost per item.
WAC = (Total Cost of Goods Available for Sale) / (Number of Units)
Let’s use Bob’s example to calculate his WAC (weighted average cost):
The total cost of inventory purchased by Bob is $14,500. The total number of units in inventory is $300.
To determine the WAC, divide $14,500 by 300 to get the average weighted cost per unit, which is $48.33.
To find out if the weighted average inventory costing method (WAC) is right for your business, consider the following pros and cons:
Should you choose FIFO, LIFO, or WAC for your restaurant inventory costing methods? They are all commonly used methods for valuation, but your business should pick one based on what compliments your reporting preferences and management style.
After choosing your inventory costing method, the easiest way to keep track of your product costs is by using a point of sale system that links up with your back office software. This will ensure your inventory valuation is always up-to-date and accurately reflects your restaurant’s financial practices.
Debra is the Content Marketing Specialist at TouchBistro, where she writes about the latest food and restaurant industry trends. In her spare time, Debra enjoys baking and eating together with family and friends. Her favorite creations include chocolate cake with Italian meringue buttercream, mile-high lemon meringue pie, and fresh naan with tahini sauce.
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