In this article, I’ll explain the concept of the contribution margin related to the sale of alcohol over other types of refreshments. Then I’ll explain the concept of the ratio of cost of alcohol to the revenue it generates. Finally, I’ll explain why you want to monitor this ratio and what factors affect the ratio. This way, you can better understand the reason to monitor this part of your operations regularly and compare this ratio to the standard and the current trend.
We have all heard of ‘Function over Form’ and how some folks prefer ‘Form over Function’. Well, in business, ‘Form over Function’ is critical in determining profitability. To understand contribution margin, let’s first discuss form and function.
When a customer walks in the door, they are there to eat a meal. In addition to the meal, the customer will desire a refreshment of some sort. The refreshment is a function of business. The type of refreshment is the form in this situation. Will the customer drink water? Will he order a soda? How about a beer? Maybe he’ll order wine or a mixed drink. If he orders a soda, how much is the sale?
For the sake of this article, let’s use $2.00 for the price of the soda. What are the associated costs for this form of refreshment? Well we know we have to provide the syrup, carbonated water, ice and a straw. In addition, there are some shared costs associated with preparing the drink. You have the soda fountain dispenser, the ice maker, costs to maintain the soda lines (required cleanouts etc.). I’m not going to get involved in the minutia of soda prices and other direct costs. For our case; restaurants serving about 20 ounces of soda, the cost is around 58 – 62 cents. So for the purpose of accounting, the contribution margin is the revenue generated from the sale less the direct and indirect costs to deliver this form of refreshment. The contribution margin for a soda is around $1.38 ($2.00 less $.62).
Now let’s look at the contribution margin associated with a beer. Assume you sell the beer to the patron for $3.29. This is a draft beer, so let’s think about the associated direct and indirect costs. First we have the keg of beer itself, refrigeration, the beer tap costs, gas to propel the beer, spoilage and that darn doily we put the glass on top of for looks. There is a lot involved in the core costs including domestic beer or international brew. Lager or light also affects the costs. But to illustrate the contribution margin issue, I’m using a general average to illustrate this business concept. For this article, the beer costs for a pint (16 ounces) is $1.42. The contribution margin is the revenue (sales price) less the costs. In this case, we have a contribution margin of $1.87 ($3.29 less $1.42).
Which would you rather have, a $1.87 or $1.38 as your contribution margin for the sale of refreshment? There is 49 more cents for the beer sale over the soda sale.
How much is the margin for a mixed drink? Typically, mixed drinks sell for more than $6.00 each and the costs to deliver the product (assuming mid-range liquor quality) are in the $2.50 to $3.00 range. This includes the alcohol, the mixer, ice, vegetable/fruit wedges and any other auxiliary items. For a mixed drink, the contribution margin for the drink is in at least $3.00.
So as a restaurant owner, the customer’s preferred form of refreshment is critical to your bottom line. Look at this chart to see the contribution margin value of one form of refreshment over another:
Form Sales Price Costs Contribution Margin
Water $0.00 $.14 $-.14
Soda 2.00 .62 1.38
Beer 3.29 1.42 1.87
Mixed Drink 6.00 3.00 3.00
Look at the numbers, there is a $1.13 more in contribution margin for the sale of a mixed drink over a beer. You do this 2,000 or 2,400 times in a year, you are talking about adding $2,200 to the bottom line. To sell a mixed drink over a soda the same number of times, you can figure on an additional $3,000 in your bank account at year end. So it is important to understand the concept of the contribution margin for refreshments and more specifically, alcohol. Now that you understand contribution margin and its value, let’s take a look at alcohol ratios.
From above, we know that alcohol contributes greatly to the overall profitability in a restaurant. Now we need to understand the concept of alcohol ratios. First off, what is the math to calculate a ratio? Simply stated, a ratio is one variable (in our case cost) in relation to another variable (sales). Simple put:
Costs of Alcohol Divided By Sales of Alcohol
Now we need to agree on what the costs are, the sales are easy to determine; but what about the costs? Remember from above, I said that the costs include the alcohol itself, the costs to deliver (tap system, ice, mixers, etc.) and the maintenance of the fixed assets used for the control of the alcohol. But for the purpose of this formula, let’s focus on the one item that has the greatest impact on overall cost – ALCOHOL. In addition, it is the one item that we need to control or the whole formula gets whacky.
In general, beer is about 25 to 35% of the sales price. Mixed drinks have alcohol costs of 18 to 20% of the sales price. So how do you calculate this cost? The easiest method is to tally the total direct costs of product sold at the end of the accounting period, typically on a monthly basis. Simply add up all the tickets for beer purchases in one column and the alcohol purchased in a second column. Retrieve your sales for these items from your restaurant software and you have all four items needed to determine alcohol ratio. If you desire the aggregated value, add both beer and mixed drink sales together and divide into the total costs. I would encourage you to separate beer from mixed drinks for several reasons, but mostly because the contribution margin is significantly different between the two forms of refreshment.
Now you have your alcohol ratio for both beer and mixed drinks. Now what?
Well, you need to monitor this ratio from one accounting period to the next. Actually, you need to monitor it weekly if not daily. This depends on your volume but if you are selling more than $1,200 a day in alcohol sales, I would suggest a daily monitoring.
Monitoring and Factors Affecting Ratio
So why do you want to monitor this ratio? How important can this truly be in this business? Well first off, let’s do a little math to find out. Assume your aggregate (combined beer and mixed drinks) ratio is 26%. If you are a typical national franchise restaurant like a TGI Fridays or an Applebees, then your average annual sales associated with alcohol is around $430,000 (18% of sales). If your ratio of alcohol is 26% then your corresponding costs are approximately $111,800. Your direct contribution margin is $318,200. Now, let’s see what happens if this ratio increases to 27.5%. Now your direct costs are $430,000 times .275 or 118,250. The annual difference in cost between a 26% direct cost ratio and a 27.5 direct cost ratio is a loss of $6,450. That’s greater than $500 a month or around $125 per weekend.
More importantly is the fact that if you don’t monitor the ratio, then there is a good possibility the ratio will exceed 30%. At thirty percent, the additional cost is more than $1,700 per month, over $450 over a week. The reason the ratio goes up is due to many factors. The following is a short list of those factors that negatively affect the ratio (causes it to increase), decreasing your contribution margin:
- Inattention to the details with bartenders – basically the bartenders fail to properly charge the customer for their respective drinks reducing the revenue side of the equation which forces the ratio higher. Sometimes it is a lack of rotating the stock or allowing too much gas in the beer dispensing system generating more foam (waste). Improper drink preparation causing the consumer to return the drink because “… it’s wrong.”
- Double Shots – double shots are the worst enemy in the bar tending business. Typically bartenders do double shots without charging in hopes the patron tips higher. I’ve seen it a lot. Your typical shot costs around $1.00 in core costs to the restaurant owner. Imagine this happening 10 times per night, 360 days per year. There goes $3,600. What if this were on the higher quality alcohol like Grey Goose or Scotch Whiskies? Now you are talking about $2.00 to $3.00 per extra shot in value. It adds up!
- Poor Pours – similar to double shots, poor pouring of liquor adds to the overall costs of alcohol. Actually it is worse than you realize. If a patron gets an extended pour on his drink, the cost for that one drink increases about 20% costing you around $.25 to $.30 more. But this isn’t the whole truth; the customer may have hit his buzz off that additional alcohol over 2 drinks and decides not to purchase the third drink. So not only did you lose 50 cents for the extended pours but now you lost and additional $3.00 of additional contribution margin from the failure to sell the third drink to that customer. Total cost to the bottom line: $3.50! For ONE customer. Imagine if this happens 1500 times per year?
Each of the above examples adds to the overall cost of alcohol over a period of time. As the owner, you would begin to see these additional costs within a week, two weeks at most assuming a reasonable volume of sales. It is your job to monitor the overall consumption of alcohol. Here are some suggestions to help you:
- Separate beer and mixed drinks in your formulas and have a ratio for both. Monitor them separately.
- Invest in a professional dispensing system – this is a great tool if you have sales in excess of $400,000 per year in alcohol sales. In effect, it eliminates the double shots and poor pour issues. It also holds the bartenders accountable for their attention to the details. Most of these systems cost less than $10,000 and will typically earn that money back within a year.
- Inventory worksheets – use this method to measure the overall consumption at a more personal level. Each day tag the keys with simple colored dots (a different color per day) and the bottles of liquor too. All liquor bottles should be tossed into their own separate trash can for management review daily. In effect, you inventory not only what comes into the restaurant, but inventory what leaves! By using simple spreadsheets you can calculate the daily volume consumed in the restaurant and in turn determine the overall sales for beer and mixed drinks.
- Web Cam – simple to install and just watch what your bartenders do at night. How much do they pour? Are they paying attention to the details etc. Simply monitoring their activity and letting them know you are doing this will reduce your cost lowering your ratio significantly.
- Dummy patrons – have a friend or two visit your establishment every now and then. Put the bartenders through the test. Have them watch what they do and get them to temp the bartender for additional alcohol.
The overall secret is to monitor regularly and control that cost ratio. This will minimize your cost to what should be the standard for your restaurant. Monitoring this ratio and comparing to the standard will eliminate additional costs and save you money in the long run. Remember, it is about making a great profit and alcohol is the number one profit center in a restaurant due to its high contribution margin.
Summary – Alcohol Costs
It is essential for the restaurant owner or manager to understand the contribution margin related to alcohol over regular forms of refreshment. This signifies the value you should place on monitoring the cost of alcohol in your establishment. The key to this is to determine the correct ratio for your establishment and compare that ratio from one period to the next. This could be daily if you have huge volumes of sales or weekly for average establishments. But the goal is to monitor regularly and compare. Determine an adjustment point and make corrections to what is going on when you hit that correction point. Monitor what is going on in the bar and don’t be afraid to conduct regular training with the staff. They too need to understand the value of what they do in keeping the restaurant open in and in business. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.