What You Will Learn
Understand the four main inventory costing methods restaurants use and how each affects your profits and taxes. This guide helps you pick the right method and offers simple strategies to manage inventory costs and reduce waste.
What Are the Main Inventory Costing Methods for Restaurants?
Overview
Running a restaurant isn't just about cooking great food - it's also about keeping track of your costs so your business can stay healthy. One of the biggest challenges restaurant owners face is managing food inventory and knowing exactly how much it costs to use that inventory. This is where inventory costing comes in.
Inventory costing is simply a way to figure out how much the food and drinks you use in your restaurant actually cost you. This helps you understand your profit better and set prices that keep your business running. In fact, studies show that restaurants lose about 4% to 10% of their revenue due to food waste and poor inventory management. That's a big hit to your profits!
There are several methods to calculate inventory costs, but the most common ones are FIFO, LIFO, Weighted Average, and Specific Identification. Each method values your inventory differently, and that can change how you see your profits and expenses.
The Basics
Before diving into the different ways to cost your inventory, it's important to understand what an inventory costing method actually is - and why it matters.
At its core, an inventory costing method is the way you assign a dollar value to the food and drinks you use in your restaurant. When you buy ingredients like vegetables, meat, or beverages, they come at different prices and times. Inventory costing methods help you decide which cost to use when figuring out how much your food really costs during a certain period.
Why is this important? Because the way you count the value of your inventory affects your Cost of Goods Sold (COGS) - which is how much it costs you to make the dishes you serve. COGS directly impacts your profit. If you don't track it properly, you might think your restaurant is making more money than it really is, or worse, lose money without realizing it.
Here's a simple example - Imagine you buy 10 pounds of chicken at $3 per pound one week, then 10 pounds at $4 per pound the next week. When you use 15 pounds to make meals, how do you figure out what those 15 pounds cost? Do you count the cheaper chicken first? The more expensive? Or do you take an average price? The answer depends on which inventory costing method you use.
Each method values your inventory differently, and the choice can impact your financial reports, taxes, and even how you price your menu items. Some methods match better with how food actually moves in your kitchen, while others might help you save on taxes during times of rising prices.
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FIFO (First In, First Out)
FIFO stands for First In, First Out. This method assumes that the first ingredients you buy are the first ones you use. In other words, you use your oldest stock before the newer stock. For most restaurants, this makes a lot of sense because it matches how food should be handled in the kitchen to keep everything fresh and safe.
Think about it this way - when you get fresh vegetables or meat, you want to use the oldest batch first so it doesn't spoil. FIFO encourages this natural flow by making sure your accounting reflects how you actually use your inventory.
From a money perspective, FIFO means the cost of the oldest items is recorded as the cost of goods sold (COGS) when you prepare your meals. The newer, often more expensive stock stays counted as inventory on hand.
Why does this matter? Because food prices usually go up over time. If you're using the FIFO method during times of rising costs, your older, cheaper stock is recorded as your expense first. This typically results in a lower COGS and shows a higher profit on paper.
However, this doesn't mean your restaurant is suddenly making more money - it's just how the costs are recorded. The inventory on your shelves may be worth more because you bought it at a higher price recently.
Using FIFO is also good for tax purposes because it often reflects the actual flow of inventory, and many accounting standards recommend or require it. Plus, it's easier to manage practically since it matches the idea of using food before it spoils.
Here's a quick example -
- Week 1. Buy 10 lbs of chicken at $3 per lb.
- Week 2. Buy 10 lbs of chicken at $4 per lb.
- When you use 15 lbs of chicken, FIFO assumes you use all 10 lbs bought at $3 first, then 5 lbs at $4.
So your COGS would be - (10 x $3) + (5 x $4) = $30 + $20 = $50.
In short, FIFO aligns well with how restaurants actually use inventory, helps keep food fresh, and provides a clear, simple way to track costs.
LIFO (Last In, First Out)
LIFO stands for Last In, First Out. It's the opposite of FIFO, meaning you assume that the most recently bought inventory is used first. So, when you use ingredients in your kitchen, the newest stock is counted as being used before the older stock.
This method doesn't always match how food actually moves in most restaurants. For example, you probably wouldn't want to use fresh produce before the older vegetables because the older ones might spoil first. That's why LIFO is less common in the restaurant world.
However, LIFO can be helpful from a financial and tax point of view - especially when prices are rising. Because LIFO assumes you use the newest (usually more expensive) inventory first, your Cost of Goods Sold (COGS) will be higher. When your expenses go up, your reported profit goes down, which can lower your taxable income and save money on taxes in the short term.
Let's say food prices are going up fast. Using LIFO, your restaurant will count the higher-cost ingredients as being used first, which means you show higher costs and lower profits on your tax reports. This can be an advantage if you want to reduce your tax bill.
However, there are some downsides. LIFO might not give you the clearest picture of your actual inventory costs because it doesn't match how food physically moves through your kitchen. Also, many countries do not allow LIFO for accounting purposes (for example, it's not accepted under international accounting rules known as IFRS).
Weighted Average Cost
The Weighted Average Cost method takes a different approach from FIFO and LIFO. Instead of assuming you use your oldest or newest stock first, it calculates an average cost for all the items you have on hand. This means you treat every unit of inventory as if it costs the same amount - the average price of everything you've bought.
This method is especially useful for restaurants that buy large quantities of similar items frequently, like a busy cafe or bar. For example, if you regularly order coffee beans or bottled drinks at different prices, the weighted average smooths out the ups and downs in price and gives you a consistent cost to use when calculating expenses.
Here's how it works - imagine you buy 10 pounds of potatoes at $2 per pound and later buy another 10 pounds at $3 per pound. Instead of choosing the oldest or newest price, you add the total cost ($20 + $30 = $50) and divide by the total pounds (20 lbs). The weighted average cost per pound is $2.50. So, when you use any potatoes, you count them as costing $2.50 per pound.
Using weighted average can make inventory tracking easier, especially if your restaurant uses many ingredients with fluctuating prices. It also avoids the problem of having a very low or very high cost showing up in your reports, giving you a more balanced view of your spending.
One thing to remember - weighted average doesn't match the physical flow of food like FIFO does, but it works well if you want simple, steady numbers to guide your pricing and financial decisions.
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Specific Identification
The Specific Identification method stands apart from FIFO, LIFO, and Weighted Average because it tracks the exact cost of each individual item in your inventory. Instead of using a general rule, you assign the true purchase price to every item you use or sell.
This method is ideal for restaurants that deal with high-value or unique products. Here's why -
1. Precision for Expensive Items - If your restaurant sells pricey bottles of wine, specialty cheeses, or rare cuts of meat, Specific Identification lets you know the exact cost of each item. This accuracy helps you calculate true profits for every dish or bottle sold.
2. Accurate Cost Tracking - You get a clear picture of your Cost of Goods Sold (COGS) because you're tracking individual items instead of using average or assumed costs.
3. Best for Limited Inventory - This method works well when you have a small number of expensive or unique items that are easy to track individually.
However, there are drawbacks for everyday use
4. Not Practical for High Volume - For most restaurants handling large quantities of common ingredients like produce, canned goods, or meats, tracking every item separately is time-consuming and complicated.
5. Better for Specialty Items - Restaurants with busy kitchens and frequent deliveries usually find FIFO or Weighted Average simpler and more efficient.
Specific Identification is useful when exact cost tracking matters most mainly for expensive or unique inventory. For most restaurants, other inventory costing methods are more practical and manageable.
How to Choose the Right Inventory Costing Method
Choosing the right inventory costing method can feel confusing, especially with all the different options available. But understanding what fits your restaurant's needs can help you manage costs better and make smarter financial decisions.
Here are some key points to consider when deciding which method to use -
1. Your Type of Restaurant and Inventory Flow - Think about how your kitchen operates. If you use ingredients quickly and in the order they arrive (like fresh produce or meat), FIFO usually fits best. It matches how food moves in your kitchen and helps keep track of freshness.
2. Inventory Complexity - If you have a lot of similar items purchased at different prices - like a bar with many types of liquor - Weighted Average can simplify tracking by giving you a steady cost across all items.
3. Tax and Financial Goals - Some costing methods can affect how much tax you pay. For example, LIFO can lower taxable income when prices rise, but it may not reflect how your food moves in reality. Always check with your accountant or financial advisor before choosing a method for tax purposes.
4. Technology and Tools You Use - Inventory software can make tracking easier. Some systems automatically support FIFO or Weighted Average, so check what your software offers and how much manual work you want to do.
5. Your Comfort Level - It's okay to feel overwhelmed by accounting terms. Choose a method that you understand and can manage without stress. Remember, the goal is to have accurate data that helps you run your restaurant better.
In the end, the best costing method is the one that fits your business, is easy enough for you to use consistently, and gives you the information you need to control costs and make informed decisions.
Make Inventory Work for You
Inventory costing methods might seem complicated at first, but understanding them can make a real difference in how you run your restaurant. By choosing the right method, you gain clearer insight into your food costs, reduce waste, and make smarter decisions about pricing and ordering.
Remember, consistency is key. Whichever method you choose, stick with it so your financial reports stay accurate and useful. Don't hesitate to ask for help from a financial professional or use technology that simplifies inventory tracking.
Managing inventory well isn't just about numbers - it's about running a smoother, more profitable kitchen and keeping your customers happy with fresh, quality food.
If you're ready to take control of your inventory costing and improve your restaurant's financial health, consider using Altametrics. Their powerful platform is designed specifically for restaurants, helping you track inventory, manage costs, and make data-driven decisions - all in one easy-to-use system.
Learn how Altametrics can simplify your inventory management and boost your restaurant's profitability by clicking "Request a Demo" below.
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Frequently Asked Questions
Which inventory costing method is best for most restaurants?
FIFO is often best because it matches how food is used in kitchens - older items are used first to reduce spoilage. However, the right method depends on your restaurant's specific needs.
How does FIFO affect my restaurant's finances?
FIFO assumes you use the oldest inventory first, so during rising food prices, it usually results in lower Cost of Goods Sold and higher reported profits.
How do I choose the right inventory costing method?
Consider your restaurant's inventory flow, complexity, tax goals, available technology, and your comfort with managing the method consistently.
What role does technology play in inventory costing?
Inventory software can automate costing calculations, track usage in real time, and reduce errors, making it easier to maintain accurate inventory costing.
