The Gross Profit Trade-Off in Food Businesses
What is Gross Profit?
Gross profit in the food industry is the product of two important expenses: labor & cost of goods (food cost). In restaurant parlance, this is often referred to as a “prime” and it is almost universally agreed that it should be kept around 50%. This is outdated thinking.
Food service has changed a lot in the past 5 years and so has the cost structure that supports it. Sure, most businesses are still largely driven by these two costs, but labor costs are rising at a faster rate than raw material. Most new food businesses pay their employees more than minimum wage in order to hire and retain better quality candidates.
How Do Rising Labor Costs Impact Gross Profit?
Do rising labor costs mean that gross profits inevitably shrink? Not if businesses become more efficient. The “Gross Profit Trade-Off” is this: if you can become more efficient through strategic capital expenditures, or otherwise reduce COGS to compensate for higher labor costs then you can still achieve the same if not improved gross profits.
I recently worked with a company that operated in a competitive labor market in a high cost of living city. The unemployment rate was a little over 1% and most competing businesses were starting employees at $13/hour, well above the state’s minimum wage. In order to even attract candidates, the company had to start employees at this base wage level, but they really wanted to be able to offer a starting wage of $15/hour so that employees weren’t constantly lured away by higher paying competitors (in this market notably, Whole Foods was ½ mile away and as an Amazon company had begun paying all employees at least $15/hour).
They wanted to know if they should sacrifice gross profits and commit to higher labor costs under the reasoning that this was the new way the industry would operate. Essentially, they were ready to accept that increasing labor costs couldn’t be avoided and therefore that decreases in gross profits also couldn’t be avoided.
I encouraged them to look at the situation differently: what if there was a way to pay higher wages in order to attract and retain quality workers while maintaining or growing gross margins? Did an increase in one automatically mean a decrease in the other?
To explore the possibility that we could “save” gross profits, we went process by process through their operations and looked at all the places that we considered to be “high-touch” meaning that the process required a high amount of labor hours and considered if it could be eliminated, automated, or partially automated. We came up with a laundry list of ways to eliminate the need for “unnecessary touch” or labor hours. Then we assigned each of these potential changes a cost; some had zero cost or would even produce positive cash flow (like the elimination of unnecessary tasks) and others could be undertaken only at considerable expense (like an IT systems upgrade).
Investing in Efficiency "Saves" Gross Profit:
By working through this analysis we were able to choose a handful of processes we wanted to change in order to increase efficiency and therefore reduce the amount of labor hours needed to run the company’s operations. Through this reduction, the company was able to pay employees more while also increasing gross margin. In this case the “Gross Profit Trade-Off” allowed us to “save” gross profits by investing in expenditures that would reduce the dependency on labor and that would reduce COGS both through operational efficiency.
The “Gross Profit Trade-Off” is a powerful tool that can eliminate 1-for-1 thinking in your business; each dollar spent doesn’t have to come from directly from a dollar somewhere else, instead if the dollar is invested in the proper areas it can actually result in many more dollars available for additional expenses in the right areas, more to the bottom line, or in most cases both.