Many restaurant owners and managers do not understand the difference between their fixed and variable costs. The problem with defining fixed and variable costs in a restaurant relate to their connection with sales. In addition, reasonable assumptions have to be made in order to delineate between fixed and variable costs in the food service industry.
This article will explain the difference between fixed and variable costs in a restaurant, provide examples of both and educate the reader on proper analytical procedures to create baselines for improvement. The best tool to use to set baselines is the feedback loop method of business operations. It will help to maximize profit and reduce overall stress for owners and the management team.
In general, most readers have been taught or believe that the variable costs are really only two items in a restaurant. The first is food costs and the second is labor associated with producing and serving the meals. Once you are done reading this article, you will discover that variable costs are actually broader in scope than just these two basic costs.
Furthermore, many small business owners believe that if labor and food are variable, the remaining costs must be fixed in comparison. This is not necessarily true especially as the restaurant’s volume of sales increase and more costs begin to accumulate. Before going into details, a short definition of each of the terms used is provided to remind the reader of their meaning.
Fixed Costs – those cash costs paid each month whether one patron or 30,000 patrons are served. A perfect example relates to costs associated with occupancy. These include rent, insurance and property taxes.
Variable Costs – the technical definition relates to those costs that fluctuate (generally increase) as the volume of sales increase. The most common identifiable cost in a restaurant is food cost.
Mixed Costs – a derivative of both fixed and variable expenditures as one single cost; in the restaurant industry a good example is the water bill. In general, this monthly bill has a fixed required payment whether the restaurant washes dishes or not. Think of the standard account fee. The variable element of the water bill is the actual consumption of water. The fixed element is spread over the volume of water consumed so the price per gallon decreases as the volume of water consumed increases.
Sunk Costs – costs incurred to get into the restaurant business yet have no real ongoing costs as the restaurant serves patrons. A good example relates to restaurant equipment. The owner paid for this equipment upfront prior to opening. Therefore, the cash paid is ‘Sunk’ or gone. The only way to get it back is to either earn it back using the equipment or sell the equipment.
Accrual and Cash – the form of financial presentation related to actual costs associated with business operations. In a restaurant business, the most common presentation format is accrual due to the nature of receiving payment from the customer upon service. Very few if any restaurants use the cash basis of accounting because there are no real tax advantages related to this presentation format. However, when discussing fixed and variable costs, the standard protocol relates to actual cash expenditures.
The following sections explain the respective fixed and variable costs in a restaurant and the relationship to both accrual and cash basis analysis.
The key to understanding fixed costs in a restaurant is its relationship to the accrual form of accounting. There are actual cash fixed costs and accrual fixed costs. Yep, it seems weird, you are probably saying to yourself that this guy is crazy. Well, bear with me and let’s explore this concept. In a typical profit and loss statement for a restaurant, the presentation format looks a little like this:
Costs of Meals:
Staff Labor ZZ,ZZZ
Sub-Total Meals ZZZ,ZZZ
Gross Profit (Margin) ZZ,ZZZ
CC Discounts Z,ZZZ
Office Ops ZZZ
Taxes & Licenses Z,ZZZ
Professional Fees Z,ZZZ
Sub-Total Expenses ZZ,ZZZ
Operational Profit ZZ,ZZZ
Sub-Total Cap Costs ZZ,ZZZ
Net Profit $Z,ZZZ
Those costs in the ‘Cost of Meals’ section (commonly referred to as the Cost of Goods Sold) are typically variable in nature (explained in more detail below). As an example, the cost of alcohol only goes up as you prepare drinks which are then included in sales. Thus, the definition associated with cost of meals is variable (they change with volume of sales). The costs in the expenses section include both fixed and variable types of costs. The fixed costs are those costs whereby you write actual checks for each month or on a regular basis. The most obvious ones include occupancy, communications (phone system, internet etc.), marketing, insurance, and licenses. Typically taxes are only paid if you generate sales or pay employees (payroll taxes).
Notice that these cash payments are done on some form of a recurring basis. That is the primary attribute of a cash based fixed cost. Notice how this is clarified? The expense is cash based? Now let’s talk about those non cash based fixed costs, or appropriately stated as accrual based fixed costs. These types of costs occur on a regular basis too. The exception though is that they are an accounting generated cost and the most common one is depreciation. If you need a better understanding of depreciation, there are several articles on this website; please review the following:
- Depreciation – This is Weird Accounting
- The Various Forms of Depreciation
- Accelerated Depreciation – An Explanation
- Small Business Tax Depreciation – Section 179
In the ‘Capitalization Costs’ section of the Profit and Loss Statement, small business owners want to know what are the costs associated with setting up the company when it started out. In the restaurant business this includes the equipment, kitchen construction, initial utensils and kitchenware, the dining room furniture, fixtures, signage and the initial menus. All of these are referred to as fixed assets. Please do not confuse fixed assets with fixed costs; they are not the same thing.
These fixed assets are depreciated via accrual accounting entries and posted to the profit and loss statement as depreciation. In addition there are some intangible costs that are amortized over a period of time. All accrual based fixed asset costs and intangible costs relate to a sunk cost customarily paid out during the initial start-up of the restaurant. The Capitalization section is merely recapturing an allocated share using accrual accounting. Therefore, these fixed costs are a non-cash based fixed element of the P&L.
What about the interest in that section? Well, this one is interesting in that it is a recurring monthly item, but it is a fixed cost that is cash based. More importantly, this illustrates something that is important for the small business owner to understand, just because it is a cash based fixed cost, doesn’t mean it stays the same value from month to month. When the equipment was purchased, many restaurants borrow money to complete the purchase or build out of the kitchen. The loan is paid back monthly but the interest on the loan varies from month to month depending on the principle balance remaining. This means that although the cost is fixed, it can vary from period to period.
OK, now that the two forms of fixed costs (cash and accrual based) have been explained, let’s go onto variable costs.
The technical definition for variable costs are those costs that change with the change in sales. The obvious ones in the restaurant industry are the food and staff. The staff includes everyone from the hostess through the dishwashers. The chef, waiters and busboys; everyone that participates in getting that patron served food and refreshments; all of them are considered staff. The entire staff’s payroll is variable in nature. If you didn’t have the customer, you wouldn’t need them to provide the service, so their costs do change with the volume of sales.
In addition, any associated costs with the service pool are also variable in nature. This includes payroll taxes, benefits and training. Notice now the definition for variable cost is beginning to go beyond the traditional definition of just food and labor?
Now let’s go back up to the profit and loss statement above. Those costs in the Cost of Meals section are all variable in relation to serving food. Even supplies (napkins, table clothes, etc.) are variable. But, in the expense section of the profit and loss statement, only a few of the costs are variable. The first one that often happens relates to how the payment from the customer is processed. Every restaurant has to pay discount fees to process credit and debit cards. This is referred to as ‘CC Discounts’. If a customer didn’t use the card, there would be no variable expense. Thus, this expense is in direct correlation to a volume issue which is the basis of the definition of a variable expense.
Other variable expenses include maintenance because maintenance is a function of volume. If nobody showed up at the restaurant, how much maintenance and cleaning would the operation experience? Very little, maintenance increases as the restaurant is used more by customers.
Now, let’s talk about some of the marginal items such as utilities? Utilities are mixed in nature. Some of the utility costs exist as a regular recurring monthly fee. Think of this, before you even have your first customer of the day, you have to turn on the lights, heat up the grill and go into the freezer (which runs 24/7). Therefore, this electrical aspect of each monthly bill is fixed in operation. It’s when the customer comes in that we turn up the grill and cook their food. This marginal use of energy is variable. So what do you call this particular expense?
Well, to be honest with you, it is referred to as ‘Mixed’ in nature. But it is only analyzed or reviewed in detail when an owner has a very large bill like in the 10’s of thousands per month related to this cost. Other than this rare situation, these types of mixed costs are customarily treated as fixed. The reason is that it is more akin to fixed than to variable therefore classified as fixed. This goes for other types of expenses with similar attributes:
- Professional Fees
- Office Operations
- Management Salaries/Wages and the Associated Benefits
Thus, in the expenses section of the profit and loss statement the following few items are customarily classed as variable:
- CC Discounts
The key to these expenses is that they fluctuate greatly with the volume of sales in the restaurant. The other expenses tend to remain relatively stable or flat and are indifferent (low correlation) to volume.
One more interesting tidbit, one of the more interesting fixed costs tends toward a mixed costs status. This is ‘Occupancy’. In many mall leases, the lease for the space has a fixed component and a variable component. Often the clause will read that the minimum monthly rental payment is X dollars and then there is a percentage of sales charge in addition to the flat amount. Therefore, in a typical month, the rent paid can vary several hundred dollars. In general, most business owners still call this a fixed cost because the variance isn’t significant enough to warrant breaking the cost out into the two components. Remember, fixed costs can vary from month to month as illustrated above; but, they tend towards a fixed value than a variable value.
Basic Analysis of Fixed and Variable Costs in a Restaurant
So why does all of this matter?
Remember, restaurants are in business to make a profit. As an owner you need to understand the relationship of these costs to generating profit. What you want to do is to identify each cost on the profit and loss statement as either fixed or variable. In general, the fixed costs will not significantly change (they can change as described above) from one accounting period to another. However, variable costs should have a high correlating relationship to sales. This is where the value of having this ratio comes in handy in determining productivity and profitability.
As an owner of a restaurant, you want to establish a baseline or a value of what are the variable costs for total sales. It will take several accounting periods to determine this ratio. Even then, this ratio may change related to seasonal or particular holidays. Once you have stored up enough data, then you can begin to compare current activity against what you believe should be the normal operational ratio. As an example, let’s look at 6 months of variable cost ratios for an Italian style restaurant:
The owner reviews this ratio and determines that the better than average in February relates to Valentine’s Day as the volume of sales increased significantly and the staffing costs remained stable. In May, both Mother’s Day and college graduation (the restaurant is near a college) activity again generated a significant increase in sales and the staff was able to manage without bringing in additional help.
In July the ratio jumps to more than .60. Why do you think this happens? Well, you can use your experience and deduce that staffing costs remained relatively level while the volume of sales decreased due to summer activity. Remember, this is summer time and that nearby college is not in session.
This helps management realize that in the following summer, they either release some of the staff or force staff members to take vacation during this period. This should help to reduce the variable cost of operations and keep the ratio in line with what is considered reasonable or normal.
Another positive attribute of understanding your variable cost ratio is determining the break-even point for operations. Let’s assume that the total fixed cost for this restaurant is $21,000 per month. How much in sales does the owner need to cover those fixed costs (break-even)? Well, let’s do some Algebra:
Sales Volume needed to cover $21,000
Therefore the formula is Fixed Costs Dollars Needed = The Contribution Margin per Sale (Contribution Margin is Total Sales less Variable Costs) Times Sales
Therefore $21,000= (1 – .56 which is the average variable cost ratio) Times Sales
Therefore $21,000 = .44 of Sales
Therefore $21,000/.44 = Sales (Divide both sides by .44)
Therefore the Restaurant Needs $47,727 of Sales to Cover $21,000 of Fixed Costs
Let’s work this from the cost analysis format:
Variable Costs @ .56 26,727
Fixed Costs Contribution $21,000
Now you can see the value of understanding the relationship between the two types of costs. It is essential to monitor and create an acceptable baseline and work towards improving the financial performance of the restaurant. Let’s prove this. Suppose the owner could improve the variable costs by really controlling staffing needs so that the variable costs decrease to .53. How much improvement is generated using the above example? Let’s see:
This is the exact tool the major restaurants use to generate improvements in financial performance. There are other tools and tricks, I don’t cover them here, but there are articles on this website that go into more detail. Act on Knowledge.
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