Why does eating out cost so much more than cooking at home?
Does scanning the menu at your local charming Italian restaurant ever make you ask: if I can knock together some spaghetti with tomato sauce at home for about $4 in ingredients, why on earth is it listed on the menu for $20? These restaurant owners must be making a killing! you and your dining companion might exclaim in outrage over digestifs at the cocktail bar across the street, or heaven forbid, in the lines of a Yelp review, furiously scribbled on your Uber ride home.
Well if the pasta grannies are fleecing us so effectively, why do about 30% of all restaurants fail every year? And why do full-service restaurants expect to earn something like 4% profit as compared to, say, 15% for software developers, or 13% for our good friend Chipotle? Surely making a fivefold profit on a plate of noodles should add up to a bit more cash flow security. Are these restaurant owners as incompetent as they are greedy?
To answer these questions, let’s dive into some extremely fun Accounting for Dummies: Foodservice edition.
Prime numbers
In many businesses, the link between dollars in and dollars out can be somewhat indirect, and stretch across weeks and months. It’s difficult to say how much money an IT department made for a company, despite the fact that it would obviously have a difficult time functioning without it, for example. A development cycle for a new product can last years, and involve numerous distinct contributions across organizations in ways that don’t obviously connect to the revenue that product ultimately brings in, like HR and facilities teams.
Costs and revenue in hospitality, on the other, are by and large fitted hand in glove. You buy a bottle of wine, pay somebody to open it, and collect payment for services rendered.
As such, the industry standard for accounting is a method known as Cost to Revenue Ratio. Every expenditure is measured not as dollars per se, but as a percentage of top line revenue. You take the $50 you charged for that bottle of wine and divvy it up between the bartender, the landlord, the liquor company, and so on, until hopefully there is a little something left to take home.
For context, when building a business plan for a restaurant, you would typically build the projected P&L along the following lines.
Occupancy: rent and associated fixed costs 10%
Prime cost: labor and ingredients 60%
Other fixed costs 15%
Total costs 85%
Net profit!(...?) 15%
There is a lot of nuance collapsed in these line items, but here we’ll be focusing on the elephant in the room, Prime Cost. This covers your variable costs, labor and ingredients (aka Cost of Goods Sold or COGS), which map more or less directly to the ups and downs of the business. Want to sell another bottle of wine? You’re going to have to buy it, pay somebody to open it, etc etc. As such, prime cost is where the most levers exist for management to pull when it comes to managing profitability.
Bear in mind as well that while it is industry standard to make the objective a balance sheet that leaves a 15% rate of profit, actually achieving this is extremely uncommon, as evidenced by the 4% number cited above. This projection is basically the gold standard that every burger joint and crab shack is aspiring to, and would rest easy if they landed on that mark.
Steak and pie
Understanding restaurant economics in terms of percentages of revenue is important because there is a foundational decision that restaurants must make on a daily basis: how do I price my menu? Since prime cost includes both labor and COGS, there exists something of a teeter totter effect; an intensive dish that has a high labor cost will often make the most sense when it uses cheap ingredients, and vice versa.
A classic example would be to compare the business models of a steakhouse and a pizzeria.
Even in our Great American Beeftopia, a dry-aged 20oz slab of prime rib is a very expensive ingredient to put on a plate. Steakhouses often run a food cost as high as 40%, leaving them a scant 20% to budget for labor.. Fortunately, chop shops also tend to have simple menus, where everything other than the steak is simple to prepare in large batches. One cook on a grill station can pump out dozens or hundreds of mid-rare striploins with scoops of creamed spinach in a dinner service. The front of house needs are light as well, because the menu is easy to navigate, never changes, and guests already basically understand what they want and how to order it.
Pizza, on the other hand, uses relatively cheap ingredients such as flour, canned tomatoes, and scant amounts of cheese. However, it requires many steps in production, hours of proofing and shaping, and each and every pie must be carefully shaped and cooked by expert hands, often in a single temperamental oven that can cook maybe a few pies at a time. Even wood-burning subway-tiled pizzerias with lots of evocative Italian buzzwords on their menus can run food costs as low as 15%, enabling them to shift the necessary dollars into labor.
So why the expensive spaghetti? Let’s look at how these percentages translate into menu prices.
While in recent times, dramatic inflation in raw ingredient costs has grabbed headlines, the reality is that at least in SF, over the last decade or so, the ever-tightening noose of staff scarcity has so heavily shifted the conversation to labor that food costs have become less and less essential as a driver of profitability. While your neighborhood Italian joint may have once budgeted a food cost as high as 30%, which balanced acceptably in a world of abundant workers and poverty wages, it is increasingly common to aim for food cost in the 20% or lower range, and hand over those precious percentage points to the labor budget.
While it has been a long walk to get here, the pricing strategy is actually quite simple: taking the 20% number, you calculate the COGS of a single portion of food or glass of wine, and multiply that by 5. Half an avocado costs you $0.75 at wholesale? You need to charge $3.75 for a side of avocado to recoup your COGS.
A whole Rocky’s Air Chilled chicken at the time of this writing costs just over $7 at wholesale. By the time you’ve roasted and trimmed a half bird, which you plate lovingly alongside some Star Route baby parsnips and buttery mashed potatoes drizzled with white wine thyme jus, you might be looking at a cost per plate of $8, meaning you can’t really get away with charging anything less than $40 for your chicken entree.
Scrooge McRestaurateur
Well there you go, you might say, making a killing in the restaurant industry is simple: buy stuff for a dollar, and sell it for five, go home and swim around in your lake of krugerrands.
Let’s remind ourselves: if by charging a five-times markup, a restaurant manages to maintain its prime cost at 60%, and the rest of their P&L perfectly meets all benchmarks, they might earn as much as a 15% rate of profit, but more realistically are lucky to find themselves in the single digits, or less than half the average yield of the S&P500.
Step out of the abstract realm of spreadsheets and put yourself in the shoes of a small but successful neighborhood restaurant owner. A quaint bistro with a couple dozen seats, a handful of staff in the front and back of house, and a decent neighborhood following. As the owner, you are your own general manager, and are basically always there, on your feet, doing your books, manning the bar, bussing tables, interviewing new hires, taking out the trash. You are on call 24/7 for employees calling out sick, vendors chasing late payments, and constant equipment breakdowns.
Let’s say the top line annual revenue of this charming trattoria is $1.5 million. 4% of that is $60,000, so for all of that sweat equity, a diligent restaurant operator could easily find themselves taking home less than half of the local median income, and consider themselves lucky to do so.
Perhaps you’ll reflect on this next time you’re sipping Fernet across the street after sharing a candlelit bowl of radiatore in lamb ragu and a juicy glass of Vermentino, and find a different one of society’s ills to commiserate over.
