Internal Controls for Fun & Profit

I confess, the title of today’s post was the best I could come up with to try and make internal controls sound interesting.  Truth is, the mere mention of internal controls makes most accountants’ eyes glaze over.  While they may not be “fun”, they certainly are profitable.  I’ll be writing extensively on the topic in the future, because the lack of effective internal controls will eventually destroy otherwise sound businesses.  It’s a tough task, but I will try to keep the discussions practical and avoid theoretical, technical details.

Internal controls are the backbone of your operations.  They help ensure that things get done the way they are supposed to and help ensure the accuracy of your financial reports.  They include both preventive and detective controls.  Whether you know it or not, you already have some internal controls in your restaurant.  The question is how good are they?

Preventive Controls

Like the name suggests, these controls are designed to prevent errors and unwanted activities.  We lock up alcohol stock to prevent theft.  We require a manager’s authorization for voids and comps, to prevent their inappropriate use.  The kitchen cannot prepare a plate without a food order having been rung-in.  In short, these are the rules and procedures put in place to help ensure that only the right things get done.

All controls have a cost, in terms of time and/or money.  There is a tradeoff between the benefits achieved with the controls and the cost of putting the controls in place.  As a result, most businesses will not have “perfect” preventative internal controls.  Theft and errors will always be a problem, which leads us to the other kind of controls…

Detective Controls

Once we realize that unwanted activities and errors can occur, even with strong preventive controls, we would like to be able to find out whether they have occurred.  Then, we can correct the situations in the future.  We do inventory counts and reconcile the physical quantities with the balances we think we should have on hand, to determine whether there has been theft (or errors in recording transactions).  We reconcile bank and supplier accounts, to detect errors in the recording of transactions.

Many controls will serve a dual purpose.  Installing CCTV cameras to detect theft and other unwanted behaviour will also have a preventative effect, as the employees know there will be a greater chance of being caught.  Rigorous cost control procedures serve the same dual purposes.

Moving Forward

As I mentioned in an earlier post, even though restaurants are “small”, they are quite complex businesses, requiring the same types of controls that much larger companies employ.  Our job is to find a practical, yet effective, system to ensure operations run smoothly and profitably.

I’ll be writing several articles about the key control areas in restaurants.  I’m going to keep them short, so I’ll bring today’s discussion to an end.  But I would like you to think about the controls you have in your operation.  Here are a few questions to get you started.

1. How do you ensure that all sales are accurately reported and recorded in the accounts?
2. How do you ensure that all sales receipts are actually received (and recorded)?
3. How do you safeguard restaurant assets?
4. How do you ensure profitable transactions?
5. How do you minimize your expenses?

The list could go on, but the point of this exercise is to get you to realize that you do have internal controls.  Future posts will examine their effectiveness and how you can make practical improvements to increase your profitability.  Today’s post may not have been fun, but I guarantee it will be profitable.

Do You Have a Sales Tax Expense?

On this blog, I mainly talk about controlling costs in restaurants.  When we look at sales taxes that restaurants pay, we rarely consider them to be ”costs”.  Sales taxes are considered “trust” taxes.  Restaurants, retailers and other businesses that charge sales taxes are really collecting them on behalf of the government.  This means that sales taxes are not revenues and the remittance of sales taxes is not an expense.

So, it should be obvious that restaurants don’t have sales tax expenses.  However, many restaurants do have sales tax expenses!  I’m going to tell you how.

In a perfectly honest, trustworthy world, restaurants would collect the proper amount of sales tax from customers and remit it to the tax authorities on time.  Unfortunately, we don’t live in a perfect (or an honest) world.  Some restaurateurs use tax receipts to fund their operations (usually out of necessity).  Others fail to report all of their legitimate sales and the sales taxes collected on those sales.  It’s called skimming and it has been around for at least as long as we have had sales taxes.  Most tax authorities estimate that about 50% of all restaurant operators “cheat” on their tax commitments.

If you don’t pay your taxes on time, you will be penalized and charged interest.  The penalty and interest becomes an expense of the restaurant.  But that’s not all.  If the government finds that your restaurant has not remitted all the taxes that it collected from customers, it will be reassessed for the tax, together with penalties and interest.  The difference in this case is that the restaurant may not have actually collected any sales tax from a customer!  Huh?  How can that be?

To understand this very common situation, you need to understand how tax auditors verify whether restaurants have reported all of their sales and sales taxes.  First of all, tax authorities “know” restaurateurs cheat on their taxes.  They also know that restaurants generate cash sales which can be skimmed from the till.  The tax auditor only needs to estimate the likely amount of sales and taxes that were skimmed from the restaurant’s sales, in order to issue a reassessment for the unreported tax, penalties and interest. 

It all goes wrong for the restaurateur, if the auditor estimates higher sales and sales taxes than the restaurant actually generated from customers.  Unfortunately, this is a very common occurrence.  Unless the restaurant can prove that the auditor’s estimate is wrong, the assessment will stand and the phantom taxes will have to be paid (plus penalties and interest).  This can be a very significant cost to a restaurant – even ones that are run by completely honest restaurateurs.

Try to disprove the tax auditor’s estimate is a very difficult task, especially when you try to do so after the fact.  There are effective ways to minimize the possibility of these unfair tax assessments, but it requires the restaurateur to be proactive and gather ongoing evidence to support the restaurant’s margins at all times.   If you need any further incentive to get on top of your restaurant’s margins, this is it.

To learn more about government tax audit tactics and how to “audit proof” your business, visit my sister blog for a comprehensive source of information crucial to your bottom-line and maybe even your survival.  While this information is written from a Canadian perspective, identical audit approaches are employed in the U.S. and many other international jurisdictions.  If you have any questions, please leave a comment or send me an email.  All enquiries are held in the strictest of confidence.

Restaurant Cost Percentages

I’ve been scouring the net for useful information on a variety of topics related to restaurant cost control.  I have to tell you that it is a pretty discouraging task.  The vast majority of the web sites and blogs offer very little useful information for a restaurateur who wants to manage his or her operations better.  Many blog articles are far too simplistic to be of any use.  It is a waste of time reading (or even scanning them)!  Others  offer a huge number of articles, videos and templates, but usually require you to sign up as a “member” (i.e. customer).  A quick review of their offerings suggest that you are not likely to get your money’s worth.  A few sites offer advice that is, well, wrong.  I hope to correct this deficiency, with an ongoing series of blog entries on this site.  In the mean time, you might consider Joe Dunbar’s blog, Food Cost Control.  Joe’s blog is one of the best I’ve come across so far.  Maybe I have a soft spot for his site, because he’s so analytical!

Today’s topic is restaurant costs.  More specifically, the  cost of sales figures.  Most of the bloggers, consultants and web sites focus their articles on the percentages.  “If your food cost percentage is more than 1.5% higher than the ideal, you have a problem.”  That type of thing.  This is bad advice.  Period.  Try as hard as you like, you simply cannot bank percentages.  The only important figure is your gross margin dollars. 

When I first got started in this business, armed with a background in accounting, I was more than a bit surprised to learn that many restaurateurs did not understand this concept.  Most chefs were confused, too.  Certainly, it is not as bad as it was back then, but I still find it necessary to explain the difference between percentages and dollars of gross profit.

Before I get into more complex and useful discussions about cost control and menu engineering, it is essential that we fully understand this concept.  I’m going to simplify the analysis to demonstrate the concept with numbers.  Let’s say a restaurant has only two menu items – a steak that sells for $40 and has a cost of $16, and a pasta dish for $15 with a cost of $3.  The steak has a 40% COS and the pasta has only a 20% COS.  If 10 guests come in and all order pasta, your COS percentage will be 20%.  If they all ordered steaks, the percentage would be 40%.  Which scenario would you prefer for your restaurant?

If you look only at the percentages, you would love to have all of your guests choose the pasta (20% vs. 40% food cost).  If you are more interested in profit (or at least paying the bills), you would prefer the steak eaters.  Ten orders of steak will generate $240 of gross profit [($40 - $16) x 10 = $240].  The pasta only generates $120 of gross profit.  The point is that it is the gross profit dollars per plate that matters, not the percentage of profit that each generates.

While many restaurant meals tend to have similar food cost percentages, several higher priced meals will tend to have a higher food cost percentage.  Steaks, rack of lamb and lobster are prime examples, where most restaurants charge a high price but have a high food cost percentage for the plate.  The same concept applies to wines.  Restaurants can have high mark-ups on lower priced wines, but generally have much lower mark-ups on the very high end wines.  We still love to sell the higher end wines, because they bring in more dollars of profit.

It should be clear that you need to look only at the gross margin dollars generated by each menu item.  If you insist on trying to compare gross margin percentages each period, you need to consider the sales mix.  Only with the sales mix will you be able to determine what the cost of sales percentage should have been.  Then you can compare your actual percentage with the “should have been” (or ideal) percentage.

How the HST Will Affect Your Prices & Margins

Recently, the Canadian Restaurant and Foodservices Association (CRFA) published three calculators to help restaurateurs determine the effect of the new HST, effective July 1, 2010, on their prices.  The calculators cover wine, spirits and beer.  I’ve included the links, below.  Perhaps a short note is necessary to help you use them properly.  They are set up for “typical” value, medium and premium priced examples.  Unfortunately, you aren’t able to change the net cost figures, but they will give you an idea as to the effects on your prices and the price that your customers will be paying come July. 

In order to use the calculators, you need to change the Licensee Margin figures for the Current and New price regimes.  When I looked at the calculator for wine, I found that it used a 246% margin for the medium wine.  In other words, a wine costing $14.85 would be sold for $51.38.  Not very likely.  If you sell your wine for 2.5 times cost, use 150% as your margin percentage (250% – 100% cost = 150%).  Under the New column, the calculator does not always use the same margin as under the Current column.  I doubt very many restaurants are planning on reducing their margins in July, so I would use the same margin before and after the HST changeover.

Here’s the good news:  The current 10% RST sales tax on alcohol sold in a restaurant is effectively being reduced by 2% when the combined HST rate on alcohol becomes 13%.

When we’re dealing with a government, when there’s good news, undoubtedly there is some bad news too.  In order to make up for the shortfall in liquor taxes, the LCBO will be raising prices.  Based on these calculators, it appears that wine prices will be rising 3.5% – 4.5%, spirits about 4.2%, and beer 3.7% – 5.5%.  Even though consumers will get a 2% break on sales taxes, the effect of restaurant markups on the increased purchase costs will ensure that most consumers will be paying more after June, 2010.

Based on these figures, beer prices shouldn’t rise more than about $0.10 per bottle.  Martini prices will probably increase about $0.50 and typical bar shots and cocktails about $0.25.  Low end wines will probably increase about $1.50 per bottle, and high-end wines about $6.00. 

Even though these cost changes are relatively small, the effect of volume means that you will need to adjust your selling prices for all alcoholic menu items on July 1, 2010.    Here are the calculators.  If you have any problems using them, ask your questions in a comment to this post or email me directly at bartaxca@gmail.com.

Wine Calculator

Spirits Calculator

Beer Calculator

Wine Cost Control

Wine inventory is different from food inventory in one very important aspect.  Wine turns over a lot slower than food.  In other words, it stays on the shelf longer.  While food must be sold quickly, or it perishes, wine often improves with age.

The size and composition of a wine list depends on the type and style of restaurant.  Higher priced, fine dining restaurants tend to have larger wine lists and include higher priced wines, while casual dining restaurants feature a smaller selection of reasonably priced labels that appeal to a larger audience.

We usually categorize wines by varietals, countries and price, and often show the wines by-the-glass separately.  This is helpful for the customer trying to make a selection, but it is much less useful to the owner/manager.  There are at least four different categories of wine, and each has its own unique profit profile and implications for analyzing costs.

Pourable Wines

Two words:  Spoilage and Over-pouring.

Most restaurants provide a reasonable selection of wines that are offered by-the-glass, especially those operations that have a separate bar.  The customer benefits by being able to try new wines, without having to buy the whole bottle, and individuals in a party are not locked in to drinking the same wine. 

Cocktails and glasses of wine are similar, in that they both involve a serving of alcohol from a bottle.  The difference is that the remaining contents of the wine bottle start to spoil as soon as the bottle is opened.  Such wines have a much higher spoilage factor than wines that are only offered by the bottle.  As the number of wines by-the-glass increases, the spoilage increases.  All open bottles of wine should be re-corked quickly and consideration should be given to employing a wine keeping system to minimize spoilage.

Offering higher priced wines by-the-glass can be risky.  These wines  tend to be ordered less often than the lower priced glass offerings.  More open bottles will become tainted.   The amount of wine that remains unsold from each bottle will tend to be higher, and of course, the cost of the tainted wine will be higher.  Often, an excellent alternative to offering high priced wines by-the-glass is to offer half-bottles instead.  Most patrons that choose high priced glasses of wine are not price conscious.  It is a fairly easy up-sell to move them to a particularly good half-bottle, which often sells for about twice the cost of a good glass of wine.  It can be an especially good choice if two people wish to enjoy the same wine.  This concept allows the restaurant to improve its wine offerings without suffering high spoilage costs.

Each pourable wine has a “recipe” for serving.  It is a simple one, but it is still a recipe, expressing the portion as 5 or 6 ounces of a particular wine.  I generally don’t generalize, but in this case I will.  All bartenders over-pour wines by-the-glass.  Maybe not every single one, but on average, they all over-pour.  Your job as the owner or manager of a restaurant is to minimize the amount of over-pouring.  You do this through proper training and strong supervision. 

Many restaurants sell a high volume of wines by-the-glass.  A small amount of over-pouring results in very significant losses over the course of a year, and these losses fall straight to the bottom-line. 

These wines tend to have similar gross margin percentages, so mix changes will not have much of an effect on margins for this category.

Regular Wines

Customers like variety, so they have as many choices as possible.  While these wines do not involve losses from over-pouring, there is a greater potential for theft, as they sit on the shelf for a longer period of time.  Many of these lower volume bottles are more likely to be “corked” or otherwise tainted, especially if they are improperly stored.

The owner/manager needs to balance the customer’s desire for selection with the inventory cost.  Each wine added to the wine list requires an investment in the stock of wine.  Many wines, especially those purchased from agents, must be purchased in case lots.  If you’re lucky, a case will only  be six bottles.  Most are in cases of 12.  These types of wines, with costs ranging between $10 and $25 per bottle involve an investment of $120 to $300 for each wine on the list.  Given the number of varietals, countries and price ranges, the inventory cost can be very significant, and with a greater number of wine bottles comes a higher risk of theft.

These wines tend to have similar mark-up percentages, so changes in the sales mix within this group will not affect overall margins significantly.

Premium Wines

Many wine lists include a few higher priced wines that appeal to well-heeled clientele and wine aficionados.  These are important for attracting and keeping such clients, but again, they come at a high cost.  These wines can involve individual inventory investments in the hundreds of dollars.  Such wines are more likely to become tainted, because they will sit on a shelf for much longer periods than will the regular wines.

Corked wines may be returned to the vendor for credit, but “cooked” wines (tainted from improper storage) are your cost and can take a hit out of the bottom-line.  If one bottle of wine is tainted through improper storage, there are likely many more that were stored nearby.  One mistake can have a very large cost.

These wines will have a wide range of mark-up percentages.  Generally, the higher priced the wine, the lower the mark-up percentage.  However, investment wines that enter the wine menu may have higher mark-up percentages.  Measuring the theoretical wine cost for these wines requires that the sales mix be taken into account. 

Investment Wines

These wines are similar to the premium wines, except that they are purchased for ageing.  The expectation is that the wines will improve with cellaring and become rarer commodities, which will command higher prices and greatly enhanced profit margins. 

The higher priced the wine and the greater importance of ageing means an even larger investment in wine storage.  Typically, these wines require a constant, climate-controlled environment.  Failing to maintain a proper storage environment may turn a potentially great wine into expensive vinegar. 

Some of these wines are held in storage for years before becoming drinkable.  It is especially important to maintain proper security, so that there is no “shrinkage” during the ageing process.  These wines will be included in the inventory, but will not have any impact on the wine gross margin until they start selling, at which time they should be treated like premium wines.

 

The Bottom-line

Grouping all wines together to analyze mark-ups will not be particularly useful.  Spoilage and over-pouring in pouring wines will be hidden by the volume of bottle sales.  Changes in the sales mix of all categories and within the premium wine sub-category will distort the mark-up percentage from one period to the next.  If you don’t take the sales mix into account, cost problems are likely to go unnoticed and continue to be problems.  Investment wines should be excluded from the cost analysis until they are put on the wine list and made available for sale.

Coupon Accounting

When the economy went into a tailspin, a lot of restaurants experienced an alarming drop in sales.  Not only were guests spending less, fewer were dining out and those that were, dined out less often.  Pretty much every restaurant that I knew saw their sales drop by a minimum of 20% – some as much as 40%.  Understandably, this put severe pressure on the bottom-lines of a lot of restaurants. 

Restaurateurs were willing to do just about anything to bring a customer in the door.  Many began offering coupons, some for the first time.  Done properly, coupons and other discounts can be a valuable marketing tool, but too often they seriously harm the restaurant’s brand.  Today’s article is not about whether they are useful.  Instead, I want to talk about how we account for discounts and what it means to our analysis of costs.

Basically, there are two ways to account for discounts:  Deduct them from sales or show gross sales and the discount as a promotional expense.  The generally accepted method is to show sales net of all discounts.  This is the method used to calculate sales taxes.  In fact, this may be the required accounting treatment when preparing your annual financial statements, but as the owner, it may not be the best way to look at discounts when making decisions about your business.

Why?  Since most coupons relate to food sales, this increases the chef’s food cost percentage, even when there has been no change in the chef’s ability to control costs.  Food costs will appear to be out of line with past standards and pressure will fall on the chef to fix the problem, especially if the coupons are accepted for a considerable period of time.  I have seen a lot of poor decisions made by normally smart restaurateurs, when this happens.  Portion sizes are reduced.  Lower cost ingredients are used.  Quality suffers.  Regular customers notice the consistency problem and come in less often, or stop visiting your restaurant all together.  The potential customers you bring in with the promotion don’t come back, because the value-proposition isn’t really  there.

Where the discounts are available to all customers (all of the time) or the discounts are continuously used to attract new customers, it is appropriate to use the net selling prices in the calculation of margins and take appropriate action to improve margins.  In these situations, the entire business model will need to be re-considered.  Lower margins will require higher volumes to make the same profit as before.

However, where the use of coupons and discounts is intended to be a short-term promotional effort, I prefer to analyze margins using the usual, or standard, selling prices.  This maintains the proper food cost (both dollars and percentage of sales) and separates the promotional effort, directed at increasing sales, from the production function.  Ideally, the financial statements should disclose gross (standard) sales and discounts, to arrive at a net sales figure.  A separate spreadsheet should be used to analyze the restaurant’s margins and support smart decisions.

The Bottom-line

Discounts can be used effectively, but when they “cause” poor decisions to be made, they can quickly destroy a strong brand that has been carefully built over a period of years.  Owners need to be aware of this issue and modify their analysis of margins to properly understand what is going on.

Welcome to the Canadian Restaurateur Blog!

I’ve been involved in the restaurant business for over 20 years, both as a chartered accountant advising restaurateurs and as an owner operator.  I started this blog to help restaurateurs improve their operations with practical information.  While I have advised a variety of different restaurant operations from fast food to fine dining, my focus is mostly in the area of licenced, full-service restaurants. 

Despite being “small” businesses, restaurant operations are surprisingly complex.  They offer a wide variety of products, using hundreds of ingredients, purchased from numerous suppliers.  The product mix needs to have some uniqueness to distinguish one restaurant from the multitude of competitor operations.  There are huge number of small sales from a team of changing salespeople.  Many of the products are “manufactured” and the prices of many ingredients change frequently.  Manufacturing needs to be closely matched to sales, because many of the ingredients are perishable, yet sales volumes are notoriously difficult to forecast.  Restaurants must comply with a variety of laws and regulations covering virtually every aspect of their business.  All this, and we haven’t even touched on how restaurants attract and retain customers.  Finally, there are several catastrophic risks that need to be managed every single day. 

The complexity of restaurant operations means that there is no shortage of topics to discuss!  As an accountant, my specialty is cost control, and you will find a wealth of practical advice to help you better manage costs in your restaurant.  The recent economic downturn has made effective cost control the single most important aspect of operating a successful restaurant.  My experience is that very few restaurateurs establish and maintain effective control over their costs.  My hope is that this blog will motivate more owners undertake this very important activity. 

My sister blog, Canadian Restaurant Tax Advisor, provides a comprehensive source of information about restaurant taxes and how to prevent unfair tax audit reassessments.  If you haven’t visited this site, I strongly urge you to take advantage of this valuable source of information that could save you thousands of dollars.

I’ve started a Linked-in Group for Canadian restaurateurs to discuss important issues.  You can join by visiting Linked-in and searching for “Canadian Restaurateur”.

I welcome your comments and questions.