5 Best Inventory Valuation Methods to Optimize Your Business!

In the business world, managing stock inventory is the key to success. Imagine a restaurant constantly running out of essential ingredients during peak hours or, conversely, overstocking supplies to the point where many go to waste. 

Such situations not only cause financial losses but can also harm a business’s reputation. Therefore, understanding inventory valuation methods is crucial to ensuring smooth and efficient operations.

In this article, we will explore different inventory valuation methods you can apply to your business.

Understanding Inventory Valuation

Inventory valuation is the process of determining the value or cost of goods owned by a business at a given period. In the context of a restaurant or food business, this means assessing raw materials such as meat, vegetables, spices, and other ingredients before they are used or sold. Accurate valuation helps determine the cost of goods sold (COGS) and ensures that financial reports reflect the actual condition of the business. In MYOB, inventory valuation utilizes specific methods that can be chosen according to business needs.

Importance of Understanding Inventory Valuation

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Knowing the exact value of inventory provides several benefits:

• Cost Control: By knowing the value of inventory, businesses can identify areas where costs can be reduced without compromising quality.
• Accurate Pricing: Precise valuation ensures that selling prices cover all costs, maintaining profit margins.
• Waste Prevention: Monitoring inventory helps businesses avoid excessive purchases that could lead to waste due to expiration.
• Better Decision-Making: Accurate inventory data helps management make strategic decisions, such as when to order more supplies or reduce certain stock levels.

Read more: How to Tackle Food Waste in the Culinary Business

Types of Inventory Valuation Methods

Every business has different characteristics, and so do the inventory valuation methods used. Here are the five most commonly applied methods:

1. FIFO (First In, First Out)

The FIFO method assumes that the first items purchased are the first to be used or sold. In a restaurant setting, this means that raw materials bought first will be used first. This approach is highly effective for perishable products, such as fresh produce, as it helps prevent waste due to expiration.

Additionally, in situations where raw material prices tend to rise, the FIFO method can result in a higher ending inventory value since newer (and more expensive) items remain in stock.

One of the advantages of the FIFO method is its ability to reflect the most recent prices for remaining inventory, making it more relevant for financial recording. It also helps reduce the risk of expired goods, making it ideal for industries such as food and pharmaceuticals that rely on products with limited shelf life.

However, FIFO also has a drawback: it can lead to a higher cost of goods sold when raw material prices increase. This can impact business profit margins, especially during inflation or significant raw material price hikes.

2. LIFO (Last In, First Out)

Unlike FIFO, the LIFO method assumes that the most recently purchased items are used or sold first. In the food industry, this method is less common as it is not suitable for perishable ingredients. However, in certain situations, such as when raw material prices are decreasing, LIFO can help reduce tax burdens due to higher COGS.

The advantage of this method is its ability to lower tax burdens when raw material prices rise, as higher COGS can reduce taxable income. However, LIFO also has some disadvantages, including not reflecting the latest prices for remaining inventory, which can make financial reporting more challenging. Moreover, this method is not suitable for industries handling perishable or limited-shelf-life products, such as food and pharmaceuticals.

3. FEFO (First Expired, First Out)

The FEFO method prioritizes the use of raw materials based on the closest expiration date. In the culinary business, this approach is crucial to ensuring that the food served remains high quality and safe for consumption. Ingredients such as dairy products, fresh meat, and ready-to-eat meals have a limited shelf life, so they must be used before expiration to prevent waste.

Implementing the FEFO method helps reduce raw material waste and ensures more efficient operations. Additionally, FEFO supports compliance with strict food safety standards, especially for businesses in the restaurant, catering, or processed food industries. For this method to be effective, raw material storage must be well-organized, ensuring that items with the nearest expiration dates are placed in easily accessible positions and used first.

4. WAC (Weighted Average Cost)

The WAC method calculates the average cost of inventory to determine the cost of goods sold. With this method, each inventory unit is assigned the same value, meaning that the total cost of all raw material purchases is divided by the total number of available units. This approach is relatively simple and provides a more stable cost estimate, especially when raw material prices fluctuate.

The WAC method offers several advantages, such as minimizing the impact of price fluctuations on financial reports and being easy to implement due to its stability. However, it also has drawbacks, including not always reflecting the most recent market prices and being less accurate if raw material prices change drastically.

5. Specific Identification

The specific identification method evaluates each unit of raw material or product based on its original price. In the culinary business, this method is more suitable for high-value and limited ingredients, such as wagyu beef or truffles. With this approach, each ingredient can be recorded at its exact cost, leading to more accurate profit calculations.

The advantage of this method lies in its high level of accuracy in recording inventory costs. However, since it requires detailed record-keeping and a strict inventory system, it is less suitable for restaurants or businesses that use large quantities and a wide variety of raw materials. Typically, this method is more commonly applied in high-end culinary businesses that sell exclusive products with high market value.

Read more: First In First Out: A Stock Management Method to Reduce Waste in the Food Business

Conclusion

Choosing the right inventory valuation method is essential for ensuring efficient business operations and accurate financial reporting. Whether it’s FIFO, LIFO, FEFO, WAC, or specific identification, the choice should align with your business characteristics and market conditions. Each method has its advantages and disadvantages, making it crucial to select the one that best suits your business needs.

Simplify inventory management with ESB Core, an ERP system that automates inventory management, COGS calculations, stock movements across branches, and stock-taking. Equipped with the most comprehensive financial reports, you can monitor your business in real-time, anytime and anywhere. Consult your business needs now!