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Restaurant Owners–What Are Your Numbers Really Telling You?

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Successful restaurant owners are focused on providing high quality food at reasonable prices and with very good service.  This is obviously a very important focus for restaurant owners.  Successful restaurant owners also know that there is a numbers side to the business—how profitable is the restaurant?

It is helpful for restaurant owners to know how their financial numbers look compared to their competition.  When restaurant owners compare their numbers to industry norms, interesting questions tend to arise.  They begin to take closer looks at certain aspects of their restaurants to make sure they are operating the restaurants as profitably as possible.

Our firm has access to real-time databases and we were able to gather information on privately held restaurants in Michigan with sales of $1 million and under.

We found the following information (percentages of sales):

Average Cost of Food    42.57%

Average Gross Profit      57.43%

Payroll                              22.22%

Rent                                  5.92%

Advertising                       4.16%

Example: JoJo’s Restaurant has the following Profit & Loss Statement:

Sales                      $1,000,000

Cost of Food               600,000  (60%)

Payroll                        280,000  (28%)

Rent                           100,000  (10%)

Advertising                   50,000  (5%)

There are some things to note:

JoJo’s cost of food is slightly higher than the average.

This can be caused by:

  • Underpricing the competition
  • Paying higher food costs than the competition
  • Buying higher qualify food than the competition
  • Inventory walking out the back door
  • High inventory waste or spoilage
  • Over-portioning
  • Inventory being eaten by the owners/employees and it’s still being counted as food cost expense

JoJo’s cost of labor is higher than the competition

This can be caused by:

  • Scheduling too many employees during shifts
  • Paying employees a higher wage/salary
  • Employees are moving slowly
  • Having too few employees and paying some employees overtime
  • Employees clock in early and clock out late

Going through the numbers on a regular basis may not be the most interesting thing to do, but it will reveal things about your restaurant that could surprise you.

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New IRS Rule on Tips Frustrates Restaurants

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Beginning in 2014, the IRS is changing the way restaurants treat service charges they add to customers’ bills.  A service charge is usually a

Restaurant billrequired tip amount that restaurants add to the bill of large parties. For example, a restaurant may add a 18% required tip to a bill of a party of 10 or more people.

Restaurants are currently treating service charges as tips and not as wages.  By doing this, they are leaving it up to the employee to report the service charges as income (i.e., some of these service charges may go unreported by employees).  Restaurants are also claiming the tip tax credit on the amount of FICA taxes they are paying on service charges.  The tip tax credit can be a substantial tax benefit for restaurants.

The IRS issued new guidance in 2012 that is taking effect January 1, 2014 that will require restaurants to treat service charges as wages, and not as tips.  By doing this, restaurants will be required to track the service charges paid to employees (and not rely on the employee reporting the service charges as tips).  Restaurants will also have to withhold taxes from the service charges.

Additionally, treating the service charges as wages will affect the hourly wage earned by employees.  Finally, since the service charges are classified as wages, the FICA taxes paid on service charges will no longer qualify for the tip tax credit.

There is a way to avoid service charge treatment.  To be classified as a tip, and not as a service charge:

  • the payment must be made free from compulsion
  • the customer must have the unrestricted right to determine the amount
  • the payment should not be the subject of negotiation or dictated by employer policy; AND
  • generally, the customer has the right to determine who receives the payment.

Example:  Euro Restaurant automatically adds an 18% gratuity to bills of parties of 10 or more.  On the bill, the tip line is automatically filled in with an amount equal to 18% of the food and beverage charge.  Euro Restaurant distributes the service charge to its wait staff and bussers.  The service charge will be treated as wages because:  the payment was made under compulsion because it was required, the customer did not have the right to determine the amount, the payment was dictated by employer policy, and the customer did not have the right to determine who would receive the tip.

A technique some restaurants are using to avoid the service charge treatment is to suggest (and not require) tip amounts.

Example:  Asia Restaurant does not require a service charge to bills of large parties, but they do suggest either a 15%, 18%, or 20% tip amount.  The tip amount at each percentage level is listed on the bill.  Customers are free to use any of the suggested tips, tip based on their own rate, or not tip at all.  Under these circumstances, any amount the customers fill in the tip line will be treated as tips and not as wages.  This is because:  the payment was not made under compulsion—the restaurant only suggested a tip amount.  The customer was free to determine what amount would be tipped.  The payment was not dictated by restaurant policy. 

It is expected that most restaurants who charge a required service charge will stop doing so and instead only suggest tip amounts.

 

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How a Restaurant Should Evaluate Its Menu for Profit & Customer Satisfaction

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Once a restaurant decides which food items to serve on its menu, it’s important that the menu items be monitored and evaluated on a regular basis.  This helps the restaurant owner respond to changes in customer demands and to changes in food prices.

Restaurant owners typically change their menu items and prices based on gut feelings as to how profitable and popular menueach item is.  However, there is a more accurate way to evaluate menu items to increase a restaurant’s profits while keeping customers thrilled with the selection.

This process focuses on the profitability and popularity of each menu item.  It makes sense to divide the food items into categories such as appetizers, entrees, desserts, alcoholic beverages and nonalcoholic beverages.  This makes sense because a menu item should only be replaced by another menu item in the same category (for example, you would only replace a poor performing appetizer with another type of appetizer, and not with a dessert).

At a minimum, menu items should be evaluated each time the menu is reprinted.

Overview of the Menu Evaluation System

The steps in evaluating menu items are:

  1. Calculate food costs for each food item
  2. Determining the sales price of each food item
  3. Calculate contribution margin by unit (sales price of the item minus the cost of the item)
  4. Multiply the contribution margin by the number of food items sold per week
  5. Rank menu items by:
    1. Profitability
    2. The number of food items sold during a week
  6. Evaluate menu items
  7. Adjust menu selection

When ranking menu item, the restaurant owner uses his experience and judgment to rank each item separately for profitability and popularity.

Example:  JoJo’s Restaurant has six entrée items.  It grades these entrée items based on profitability and popularity based on the following information:

   

Entrée 1

 Entrée 2 Entrée 3 Entrée 4 Entrée 5

Entrée 6

A

 Sales Price (Step 2)

$18

 $16 $13 $12 $11 $10

B

 Food Cost (Step 1)

$6

 $5 $4 $4 $5

$5

C

 Contribution Margin (Step 3)

$12

(A – B)

 $11 $9 $8 $6

$5

D

 Units Sold per Week

120

 

 115 100 80 120

70
 

Total Contribution Margin (Step 4)

 $1,440 (C * D) $1,265 $900 $640 $720

$350
  Profitability Grade (Step 5a)

A

A

B

C

B

D
  Popularity Grade (Step 5b)

A

A

B

C

A

C

 

JoJo’s management based the profitability grades based on the following total contribution margins:

  • Above $1,000 per week:                          A
  • Between 700 & $1,000 per week:              B
  • Between $500 & $700 per week:               C
  • Under $500 per week:                             D

JoJo’s based the popularity grades based on the number of items sold per week as follows:

  • 115 units and above:                                      A
  • 90 to 114 units:                                             B
  • 75 to 89 units:                                              C
  • Below 75 units:                                              D

How to Evaluate Menu Items According to Profitability and Popularity Rank

Two decisions can be made very quickly.  First, items that scored an A for both profitability and popularity should obviously be kept on the menu.  Second, items that scored a D for both profitability and popularity should be dropped from the menu.

Popular but Unprofitable

If a menu item is popular, but unprofitable, the restaurant owner may:

  • Substitute side items with lower costing side items
  • Reduce the portion size to reduce cost
  • Raise the price of the item
  • Use lower costing food items

However, the restaurant owner must make sure that these changes will not greatly affect the popularity of the item.

Profitable but Unpopular

Here, the restaurant owner may:

  • Encourage waitstaff to recommend these items to customers
  • Offer specials on these items to get customers to try the items so they will purchase the items at a later date at full price

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How the IRS Audits Tips

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Employees who receive tips must report them as income on their tax returns.  To make sure employees are taxed on their tips, they must report their tips to their employers so their employers can withhold taxes and report the tips on the employees’ Form W-2s.

tips

Each year in February, large restaurant owners must report their employees’ tips to the IRS on the Annual Tip Income Report.  This report shows the IRS how much in tips the employees are reporting.  If tips are less than 8% of sales, then the IRS requires the employer to increase total tips to equal 8% of sales, then allocate those increased tips to their employees (generally based on hours worked or sales made by each tipped employee).their tips to their employers so their employers can withhold taxes and report the tips on the employees’ Form W-2s.

It should be noted that the IRS usually expects tips to be greater than 8% of sales, so making sure that tips equal 8% of sales will not provide complete safety from an IRS tip audit.

When auditing tips, the IRS will estimate actual tips by looking at the tip percentage on credit card slips.  Unlike tips on cash sales, restaurants have records of charged gross receipts and the related charged tips.  The IRS can look at the tip rate on charged sales, and then apply that tip rate to total cash and credit card sales.

Example: The employees at Bob’s Restaurant report very little tips on their tax returns.  The IRS decides to perform a tip audit at Bob’s Restaurant.  The IRS reviews the credit card charge slips and determines that credit card tips are 12% of credit card sales.  The IRS will take this 12% and apply it to total sales (cash and credit card sales) to estimate total tips earned. 

If Bob’s Restaurant has $800,000 in total sales, the IRS will estimate tips at $96,000 (12% multiplied by $800,000 sales).  If Bob’s Restaurant’s employees only reported $80,000 of tips, then Bob’s Restaurant would have to allocate $16,000 of additional tips to its employees ($96,000 IRS determined tips less $80,000 employee reported tips).  Bob’s Restaurant would have to amend payroll tax returns, its income tax returns, issue corrected W2s to employees (who would have to amend their personal returns), and pay payroll taxes on the increased tips plus penalties and interest. One silver lining is that the restaurant owner can claim a tip tax credit on the additional FICA taxes paid.

As you can see, this would be a complete mess.

Fortunately, restaurant owners have at least a couple defenses:

  • They can argue that customers who pay cash generally tip less than customers who charge
  • If the restaurant has separate areas, an overall tip rate calculated by the IRS may be adjusted downwards for areas that have less business activity

The following are some techniques that restaurants can use to encourage higher tip reporting rates:

  • Discuss the employee’s tip reporting responsibility at regular staff meetings
  • Require employees to enter tips into the POS system at the end of each shift
  • Send waitstaff with low tip percentages through additional training (if the waitperson is providing poor service, his low tip rate could be affecting the restaurant’s overall tip rate.  This employee would need more training or be let go).

 

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How to Calculate Overtime for Tipped Employees

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Background on Minimum Wage Rules for Tipped Employees

The current minimum wage in Michigan is $7.40 per hour.  The Michigan Minimum Wage Law covers tipped employees age 16 and over.  Under Tipped Employeethis law, employers may pay tipped employees $2.65 per hour if tips received by the employee plus the $2.65 hourly rate equals the minimum wage of $7.40.  Thus, employers may pay tipped employees $2.65 per hour provided that reported tips per hour equal at least $4.75 (so the total hourly rate is $7.40).  This $4.75 reduction in the minimum wage is referred to as the Tip Credit.

How to Calculate Overtime for Tipped Employees

When calculating overtime for tipped employees it is important to note that the hourly rate being multiplied by 1.5 is the minimum wage of $7.40 and not the reduced wage of $2.65.  The tip credit then reduces the overtime pay rate.

Example:  Jimmy’s Restaurant has a waiter who works 50 hours in a week.  The waiter’s pay rate is $2.65 per hour and the employee earns $250 in tips for the week.  The overtime pay rate is calculated as:

Minimum Wage:              $7.40

Times 1.5:                   $11.10

Less Tip Credit:            ($4.75)

Overtime Pay Rate          $6.35

The waiter’s gross pay is:

40 hours at $2.65 standard rate:               $106.00

10 hours at $6.35 overtime rate:                $63.50

Reported Tips:                                        $250.00

Total Gross Pay                                       $419.50

A common mistake is to simply take the $2.65 minimum tipped wages and multiply it by 1.5.

Calculating Overtime When Employees Have Different Pay Rates

When employees have different pay rates during a pay period (e.g., a waitress also works as a hostess), a weighted average pay rate must be calculated.  This average pay rate is then used to calculate the overtime rate.

Example:  Jimmy’s restaurant has a waitress who makes $2.65 per hour as a waitress and $8 per hour as a hostess.  She earned $200 in tips.

She has the following hours during a week:

Waitress:               40 hours at $2.65

Hostess:               30 hours at $8.00

 

Step 1: Calculate Weighted Average Pay Rate:

40 hours at $7.40                              $296.00

30 hours at $8.00                              $240.00

Total                                               $536.00

Divide by 70 hours                           $7.66 (this is the weighted average pay rate)

 

Step 2: Calculate Overtime Premium

Divide Average Rate in Half                     $3.83

Overtime Premium                             $114.90 (30 hours of overtime times $3.83                                                                    overtime premium)*

*The employee has already been paid 70 hours at the average standard rate of $7.66.  This calculation adds the overtime premium to gross pay.

 

Step 3: Reduce Gross Pay by the Tip Credit

Less Tip Credit                                 ($190.00) ($4.75 Tip Credit times 40 hours worked                                                                     as a waitress)

 

Step 4: Add Reported Tips

Reported Tips                                    $200.00

 

Her total gross pay is:

40 Hours at $7.40                             $296.00

30 Hours at $8.00                             $240.00

Overtime Premium                           $114.90

Reported Tips                                    $200.00

Less: Tip Credit                                ($190.00)

Total Gross Pay                                         $660.90

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

 

Special Rule for Deducting Restaurant Smallwares

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Business owners who buy assets that have useful lives longer than one year usually cannot immediately deduct the costs of these assets.  The costs have to be deducted over a number of years through depreciation.

Luckily for restaurant owners, there is an exception that allows restaurant owners to immediately deduct the costs of smallwares in the year they are purchased and used.

What Are Smallwares?

Smallwares include the following items:

  • Glassware
  • Flatware
  • Dinnerware
  • Pots and pans
  • Table top items
  • Bar supplies
  • Food preparation utensils and tools
  • Storage supplies
  • Service supplies
  • Small appliances that cost $500 or less individually

This Provision Helps Other Food Services Businesses, Too…

This provision applies to corporations engaged in the business of preparing food and beverages to customer order for immediate on-premises or off-premises consumption.  In addition to restaurants and cafeterias, this provision also applies to caterers, mobile food servers, bars and taverns, and food or beverage services located in grocery stores, hotels and motels, amusement parks, theaters, casinos, country clubs, and similar social or recreational facilities.

Watch Out for These Traps

There are two situations where an immediate deduction will not be available and the business owner will have to deduct the costs of smallwares over a number of years.  The situations are:

  • When the smallwares are purchased before the business begins operations.  In this situation, the smallwares are treated as start-up expenses.  Start-up expenses of up to $5,000 can be deducted the year business operations begin.  Excess start-up expenses are deducted over 15 years.
  • When the smallwares are purchased and stored, rather than put to immediate use.  In this situation, the smallwares are treated as inventory and become deductible when they are put to use.

Example:  Janson Family Restaurant will open to the public in July 2013.  Prior to its opening, it buys $10,000 of smallwares.  Later during 2013, it buys $5,000 of additional smallwares.  During 2014, it buys an additional $4,000 of smallwares.  Finally, during the last week of 2015, it buys $10,000 of smallwares, but keeps them in storage until 2016.

Janson Family Restaurant can deduct the costs of smallwares as follows:

  • The $10,000 of smallwares purchased before opening are treated as start-up expenses.  It can immediately deduct $5,000 and deduct the remaining $5,000 over 15 years.
  • The $5,000 of additional smallware purchased in 2013 after the restaurant opened are fully deductible in the year of purchase
  • The $4,000 of smallwares purchased during 2014 are fully deductible in the year of purchase
  • The $10,000 of smallwares purchased during 2015 must be recorded as inventory in 2015 since the smallwares aren’t being used.  The $10,000 will be fully deductible in 2016 once they are used.

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.