Restaurant operators are faced with margin pressures unlike any ever experienced. Food costs and Labor costs constitute a majority of the restaurant cost structure usually in excess of 60% of revenues. Experienced operators have weathered commodity challenges from seasonal produce spikes to longer term cycles in proteins. Spikes cause pain. Cyclical changes can often be readily met with changes to menu pricing, portion sizing, or new product development.
Labor markets can have their own cyclical behavior. Labor markets, by their very nature impacts each rural, urban, metropolitan and regional area differently. In a free market, wages increase to induce labor into the market when demand exceeds supply. Wages fall when labor is too plentiful. A natural cycle. For each additional hour of labor expended, or added, that hour must generate revenue in excess of its associated costs. The marginal utility of labor must exceed its price, or less labor will be used. When labor costs are raised, less productive, or marginal, labor is priced out of the market. Therefore, less labor is desired. Capital investment in labor alternatives; equipment, software or hardware technology, becomes more attractive.
Changes in Labor pricing when dictated by government fiat are sustained, not cyclical. Political authorities on a political agenda interfere with the natural cycles of labor. Over the last 100+ years a legislated minimum wage, by various state and federal authorities have skewed labor markets. Today, efforts to legislate a minimum wage increase for hourly employees are accelerating in both city and state venues. Once established, minimum prices for labor do not fall in response to market pressures; i.e. an excess of labor supply. The price of Labor includes decreed changes to benefits as well as minimum wages. Sick leave, mandatory family leave, overtime rules, healthcare, etc. all impact the marginal cost of labor. As the cost of labor rises, usage naturally drops. Usage in this case is measure by the employment labor pool and its corresponding measures, various unemployment rates, which rise.
In the past, minimum wage increases priced the less productive employees out of the workforce; even when the minimum wage was below the market-induced prevailing wage rate. The increases currently being contemplated are 50%, or higher, than current levels of the federally mandated minimum wage. An increase of this magnitude is not benign. The result will be higher unemployment as marginal labor is priced out of the labor market.
Pros and cons for Interfering in the Free Market for Labor
The arguments for increasing labor prices are controversial at best. Supporters claim that raising minimum wages will provide a “living wage”. However, a majority of people earning a minimum wage live with parents in middle, and upper, class families. Many union contracts are tied to the minimum wage, so as minimum wages increase, the result is that wages throughout the economy and in many industries also climb. As wages rise, other prices will rise as the higher costs are managed, reducing the buying power the minimum wage increase was designed to address in the first place.
In addition, those members of society who are less productive due to a lack of education, abilities, training, etc. become unemployed, increasing the rolls of the needy. These workers (voters) will be told that the reason they are unemployed is the fault of business, not the result of the fiat dictates of government. These same people will be offered government services by a government which ostensibly provides for the well being of the individual, thereby increasing centralization of its own power.
Prices of goods and services must rise in response to each increase in the minimum wage. The cycle begins anew. The impact passes through the economy raising all prices, and decreasing the labor pool available to work productively at that wage. Prices increase to restore balance. As that “living wage” cycles through the economy, prices of goods and services must return to the same relative levels, or investment and economic growth slows and then, stops. Meanwhile, the under-educated, and low skilled have been priced out of the market, ensuring more enrollees for government help. They are trapped in a never-ending cycle of humiliation and poverty. Without the self-respect that is earned by a job done well, and, well done.
Real World Results
Recent activities, particularly on the West Coast provide laboratories for us to study and learn from in order to better prepare for what is happening on a much wider scale. Local minimum wage actions in Seattle, are in the implementation stages, and provide an excellent look into how well various strategies play out. California has recently taken large increases in minimum wages as a state as well.
Seattle raised minimum wages to $15 per hour in June 2014, phased in over 7 years. The previous minimum wage rate, as mandated by the State of Washington, was $9.32. The first increase in Seattle took effect in April 2015 to $11 per hour, an 18% increase. The second took place on January 1, 2016 to $12 per hour, a net 29% increase in 18 months. Since April 2014, the unemployment rate in the Seattle/Tacoma SMA, as measured by the Bureau of Labor Statistics, moved from 3.0% to 4.4% in February 2016, hitting a high of 4.7% in January 2016. As one would expect, the labor force increased by 1.9% (37,600 people), attracted by the promise of higher wages. But unemployment went up by 30,000, as businesses realized that the higher priced labor did not contribute in excess of their cost. Net, net the labor pool got bigger and more of them are unemployed.
Response by Restaurant Operators
As experienced restaurant operators, we know the buttons to push and the levers to pull to make adjustments for minimum wage. Even the most experienced operators among us have never faced the wave of regulatory actions in the form of the ACA, coupled with aggressive movements to raise minimum wage to as high as $15 per hour. These actions are either happening now or are in the planning stages state by state, and in some cases, have reached national proportions.
In fact, the very experience that breeds confidence in our ability to “weather the storm” could be our biggest weakness in the face of what is happening now. We have never seen anything of this magnitude, and our “toolboxes” are not going to be up to the challenges we are about to face. Fortunately, there are mechanisms available for us to respond to these challenges. Unfortunately, there is not a lot of time to react. The time is upon us!
Responses to minimum wage hikes have typically involved menu price hikes to cover the additional costs. Consumers expect some level of price increases over time, although few are actually aware that minimum wage increases are often the actual drivers of menu price increases. This lack of understanding by consumers and employees alike leads to the problem’s persistence. Many leading industry figures have taken to the print media, the lecture circuit, the airwaves, and to our elected representatives to explain the issues to them. We should continue to support them.
Real World Solutions for the Individual Operator
In the past, a modest increase in menu pricing would offset increases in the minimum wage. Historically, the balance of the wage increase has been absorbed in either, or both productivity improvements, and/or product degradation (either food quality or portion size). These choices may, or may not have had a positive impact on the business. Price increases beyond the consumer’s ability to pay and food quality degradations are likely to negatively impact sales, traffic and profitability. Improvement in the labor productivity measurements may have been unintentional and negatively impact service levels expected by consumers. Most often the improvements were a function of holding the line on control systems; often, a percentage of sales allocated to labor to ensure operating ratios remain constant.
So the current tools in responding to an increase in minimum wages are as follows:
- Raise menu prices
- Reduce portion sizes
- Lower quality of ingredients
- Increase control systems for labor productivity
- Reduce labor pool.
These tools work in balance when changes are nominal. For example, a minimum wage move from $6.90 per hour to $7.50 is an 8.6% hike in minimum wage, but a combined 1.5% increase in menu prices and a 2.3% productivity improvement covers the increase. This analysis assumes no change to customer traffic as a result of the higher prices. If hourly labor costs were 24% of sales and productivity improves by 2.3%, then labor costs, adjusted for menu price increase and minimum wage is now 25.1%, but, the gross dollar profit remains the same, so life goes on.
However, the productivity improvement came from a 2.3% reduction in actual hours worked by the hourly employees. So they got a raise, but now work fewer hours. And, the prices of the goods they buy went up also. Or, assuming the number of hours worked per employee remains constant, that is a reduction in the number of people employed by 2.3%, an unintended consequence of raising minimum wage. In a firm with 100 people, two, maybe three people just lost their jobs. The restaurant’s profitability has remained the same in dollar terms, but has shrunk an estimated 170 bps in terms of margin.
The Game Changes
As long as the magnitude of minimum wage hikes is “reasonable” and happens infrequently enough, the consumer can accept these increases as “normal” or within the range of the consumers’ expectations, the game works without major disruption. The game changes however, when the increases are significantly larger and more frequent. In California, the minimum wage went from $8 per hour in June of 2014 to $10 per hour in January of 2016. That’s a 25% increase in 18 months. Offsetting this rate of wage increase with a combination of price and productivity is a lot more difficult than more modest increases.
This 25% increase would require some combination of price increase and productivity improvement to offset the cost to the operator. In order to limit the productivity increase to the same 2.3% in the prior example, prices would have to increase by 5.3%. The real damage occurs when the menu price increase negatively impacts customer counts, the wage increase becomes impossible to offset with price alone. Units with marginal sales have to close. Unit counts begin to drop and the real damage to employment occurs. Entire restaurant teams are unemployed – often as many as 100 or more per restaurant.
So, to limit the price increase to our prior example of 1.5%, the resulting improvement in productivity would have to be an estimated 15.0%. Again, this leads to either a significant reduction in the hours utilized, or number of employees. So instead of employing 100 people, the restaurant now employs only 85. The resulting degradation in service style, or effectiveness, is also likely to lead to customer dissatisfaction and traffic erosion. When significant traffic declines occur, the unit is even more likely to close.
Recent activities, particularly on the West Coast provide laboratories for us to study and learn from in order to better prepare for what is happening on a much wider scale. As noted above, local minimum wage actions in Seattle, are underway. California has taken large increases in minimum wages as a state as well. Both of these laboratories provide an excellent look into how well various changes to operating strategies may play out.
In one Bay Area municipality, the minimum wage was raised from $8 per hour to $14.40 per hour in the same 18 month period that the state of California increased from $8 to $10. We were able to get information from four operators of upscale casual dining operations located in close proximity to one another in the bay area; all waterfront properties, and all with sales in excess of $4 million annually.
Three of the four took menu price increases that reached into double digits, reasoning that they were in an area that was very desirable and frequented by tourists who are, by their nature, unable to make independent price comparisons, and therefore be less sensitive to price increases. The fourth restaurant limited its price increases to only 3.5%. If the 4th restaurant had limited its price increase to 1.5% as in our previous examples, the productivity gains required would have to be on the magnitude of 40%+. As expected, the three restaurants with large price increases were rewarded with traffic declines between (8%) and (17%). Two of these three restaurants now experience negative cash flow. Sustained negative cash flow will likely negatively impact the number of employees utilized, and the number of hours each employee is needed. More than likely, these three units will shutter their doors, eliminating approximately 100 jobs each.
The unit with more a more moderate approach increased their traffic by just over 9%, a dramatic improvement. By reducing hours, productivity improved a whopping 5%. Even with sales averaging $100,000 per week, ($5.2 Million annually), and traffic and productivity improvements, the increased cost of labor completely eliminated profitability for this restaurant. To survive, this restaurant will likely have to continue to raise prices, reduce hours and jobs and negatively impact the consumer experience relative to other nearby restaurants that are not impacted by the mandated changes. And, eventually close. The impact on the employee is negative; the cumulative impact on the economy even more negative.
The simple fact that our old tools no longer work should not come as a surprise. Changes of this magnitude to these costs completely alter old assumptions about what margins are achievable and under what conditions. In order to survive in this new world new approaches are going to be necessary which we will discuss in our next post.
The preceding information is the work of NRCP. It cannot be copied, or reproduced without the express written consent of NRCP.
National Retail Concept Partners, LLC is a full-service consultancy based in Denver, CO. working with a variety of industries, including the automotive, retail, restaurant and hospitality industries. Partners Larry DeVries and Dean Haskell wrote the preceding post. These recurring posts can be accessed at their LinkedIn profiles. NRCP recently shared its labor optimization success at the Restaurant Finance Conference. The partners can be reached by email at firstname.lastname@example.org and email@example.com. Mr. DeVries is based in Denver, Colorado and Mr. Haskell is based in Nashville, Tennessee.