Inventory Accounting 101 for Restaurants and Bars

For most restaurant and bar owners and managers, the enjoyable part of the job revolves around delighting customers in the front of house. There are not many hospitality professionals who enjoy accounting and crunching numbers in the back office. But while accounting is often best left to an accountant or bookkeeper, it's important for restaurant and bar operators to understand inventory accounting. This post will give an overview of the different inventory accounting methods, followed by recommendations that can help you improve your operations and have a better handle on the business' cashflow.

Getting a handle on inventory counts

Before we dive into valuing inventory, let's start with knowing how much inventory you have on hand. Most restaurant and bar veterans will be familiar with the traditional physical inventory count. Once a month (or sometimes more or less often) you walk around, counting every bottle, can and keg, writing down on a sheet of paper or typing into a spreadsheet the count of each item. This is called a periodic inventory. You only know your true, actual inventory counts at specific points in time.

Alternatively, there is what's called a perpetual inventory system. In a perpetual system the inventory on hand is known at all times. However, because the inventory is not physically counted, the inventory on hand is a theoretical value. It's the amount you should have on hand based on your purchases and POS sales. Even when using a perpetual inventory system, it's important to perform periodic physical inventory counts to reconcile your theoretical counts with actual counts.

Shortly, I'll come back to best practices and recommendations for which system you might want to use and when, but first let's cover inventory valuation.

The different ways to value inventory

While inventory value may not seem exciting, understanding it is one of the most important things to running a profitable beverage program. Why is inventory value so important? Inventory is usually the largest current asset of the business. All of that liquid gold, sitting in boxes in a storage room, or half empty behind a bar somewhere, that's a big part of the business' worth. And how you put that inventory to work can be the difference between big profits and going out of business.

There are two important points to keep in mind about inventory value:

• The value of your items are changing over time and generally, that value is decreasing. The longer you hold inventory, the less value it has, until eventually, it could be worthless if the products go bad. Cash is king and holding on to a lot of inventory is a slow march to your financial death.
• Money tied up in inventory could often be put to better use growing your business than it is sitting on shelves. Don't think of all your inventory as just the cost of doing business. Sure, some of your inventory is... you need to have enough inventory on hand to sell to customers and make them happy. But think of how you could improve your business if you had an extra $25k, $50k, or $100k in cash.

There are many different accounting methods for valuing inventory, but I'm really only going to cover the two most commonly used in restaurants and bars. To calculate the value of inventory we need to multiply the quantity we have on hand of a product times the cost of the product. We then add this up across all our products to get our total inventory value. Where inventory valuation methods differ is in what number we use for the product cost.

The most common and easiest method to use is the average cost or weighted average cost. Average cost is just how it sounds, you take the total cost of what you have bought and divide by the quantity that you bought. You don't worry about the price fluctuations from your vendors during that period of time, it is averaged out. For example, if you bought the first 5 bottles at $10 each and the second 5 bottles at $20 each, for the purpose of valuing inventory we consider each bottle remaining to be worth $15 (the average of $10 and $20).

Alternatively, you can use an accounting method that better tracks the flow of costs as they change. For this industry, the best method for tracking cost flows is called First In, First Out, or FIFO for short. Another way to say it is you are tracking the costs for products as they change in chronological order. Using the previous example of buying 10 bottles, in FIFO we don't consider all bottles to be worth $15 over time. We paid two different amounts for the same bottles and as inventory is depleted (sold), our FIFO cost changes. When we haven't sold any bottles, our FIFO cost is $15, but as soon as we sell any that changes. Let's say we sell 2 bottles and are left with 8. The resulting FIFO cost is ($10+$10+$10+$20+$20+$20+$20+$20) / 8 = $16.25. Notice that to calculate that we assume that the two bottles we no longer have are the ones we paid $10 for, since we bought those first.

So when would you use one over the other?

The decision is a trade-off between accuracy and complexity. There is no right answer or required method. The most important thing is to remain consistent. Consistency not only gives you a better long-term picture and allows you to make better decisions, it is also most likely encouraged by your taxing authority. In the United States, the IRS mostly doesn't care what method you use, as long as you don't jump back and forth. If you do change it, more complex adjustments are needed, which is why the IRS even has a form (IRS form 3115) to notify them that you have changed inventory valuation methods.

Considerations for bar inventory accounting

Every bar or restaurant will be different. There are many variables at play that will help inform what inventory accounting processes and calculations to use.

• Total beverage sales
• Amount of inventory carried
• Resources available (staff, bookkeeper, accountant)
• Skill set of management
• Simplicity vs. accuracy tradeoff
• Technology (inventory and purchasing software, POS system, etc...)

Let's return to how to count inventory, as that is also a main driver of the decision. I frequently speak with owners or managers who want to put in perpetual inventory systems. After all, it sounds great to always know your exact inventory on hand and it would be fantastic to have less labor counting bottles. The problem lies with the complexity of maintaining an accurate and highly automated perpetual system.

Problem #1: "Garbage in, garbage out." Your depletion data is only as good as the data you are putting into your POS system and inventory tracking system you are using. Is every employee ringing up every sale accurately? With the correct liquor? The correct modifiers? Do you have options for the thousands of drink variations a customer might request? Probably not.

Problem #2: Bartenders don't pour perfect pours. They are humans, not robots. When you use a perpetual inventory system, you are making an assumption that every pour is perfect. Every shot is 1 oz, every wine glass pour is 5oz. If there is 5.5oz left in a bottle, is your bartender going to save that last half an ounce of wine in the bottle? Nope. I'm sorry, but I'll take an imperfect human bartender over a perfect robot bartender any day.

These and other issues make maintaining a perpetual inventory system difficult. Problem #2 above is actually valuable for measuring variance or leakage of your beverage program, but that topic is covered in other posts, here we are concerned with inventory accounting. You might be asking yourself, why is any of this relevant to the accounting method used? How is the way I know my counts on hand related to how I calculate its value?

The reason is that in order to use FIFO, you must have some level of perpetual inventory. You don't necessarily have to use a real-time perpetual system connected to your point-of-sale, but you must account for usage and purchases over time. Meaning, for FIFO it's not enough to just know you bought products between two dates, you have to know on what dates you bought how much. Then do that same thing for every product in your inventory. For that reason, using FIFO is extremely time-consuming and often impractical to do without software.

Recommendations for bar inventory accounting

Let's cut to the chase, what do I recommend? Having worked with hundreds of restaurants and bars over the past decade, here's my two cents...

Frequency - For the large majority of establishments, taking a full inventory once per month is the right amount. However, I also recommend doing a partial inventory weekly. A partial inventory means you don't count all of your different products, you just focus on your high-volume products. In that way, you can make more informed purchasing decisions so you don't have too much-sitting inventory (or go out of stock). A weekly partial inventory can be done in less than half an hour.

Counting Method - No matter what, you should be doing a physical inventory count at least once per month. The question is really, should you implement a perpetual inventory system? And for a large majority of establishments, my recommendation is no. You'll typically spend more time and effort than it's worth. The theoretical counts for many items won't be that accurate and you may not even end up saving any time.

In my experience, perpetual inventory does work better for establishments that have a larger share of sales from packaged alcohol products rather than pours. And by that I mean, if most of your sales are bottles of wine, bottles or cans of beer, instead of draft beer and mixed drinks, perpetual inventory will be a better fit. It's easy to deplete one bottle or one can. It's harder to accurately deplete 16oz from a 15.5gal keg or all the exact liquor amounts from a long island iced tea.

Inventory Valuation - Based on what I've recommended already, you may think the right way to go is using an average cost instead of FIFO. It's more simple, faster, and easier. All true, but that's in a world where software doesn't exist. FIFO is more accurate and better accounts for cost variations, which is important to track for most bars and restaurants. Luckily, the software does exist, which makes using FIFO just as easy and the same amount of effort as using an average cost.

That's what Backbar is for... to save you time and provide you with more accurate data. And that's why we use FIFO at Backbar. We do all the complex calculations and number crunching for you, so you can focus on delighting customers. Best of all, Backbar is free forever, so there are no increased expenses to using a better accounting method.

If you are going to do inventory in a spreadsheet, stick with using the average cost. It's easy enough to set up the formulas in Excel to multiply a single cost times the quantity. But there's no reason not to use software such as Backbar to be more accurate, especially when it also saves you time counting inventory and placing orders.