Probably the most frequent questions we are asked relate to peer group comparisons and what can be done to improve profitability. Many of you know the fundamentals of operating your restaurant, but may not really have had the opportunity to grasp the concepts of fixed and variable costs and their respective impact on your operations, your profitability, and your cash flow. If you do not understand the differences between fixed and variable costs, you have a minimal chance of succeeding.
I do frequently use the phrase "Sales cure all evils," which means that if you have sufficient sales you can do many things wrong and still survive, but few of you will experience this level of sales. So for the rest of you out there, this article is intended to share the basic principles of fixed and variable costs and contribution margin in a format that should enable you to know what your economic reality is now, what you can do about it, and what the changes you implement will mean.
Before you can go much further you must understand that break-even calculations are not a science. They are merely estimates of outcome. A break-even calculation is critical to your operations, but to do one with exacting measure you need a computer to analyze data in more detail. So we make several generalizations in order to get to an answer that is useful, meaningful, has relevance to your operations, and is reasonably accurate for the intended purpose.
To explain a little further for those of you who challenge this perspective, what are true variable costs? What are true fixed costs? The only true fixed costs that I know are rent and debt service. Everyone considers things such as utilities, bank charges, insurance, taxes, telephone, uniforms and so forth as being fixed costs, but they all have variable components. When have you ever received a utility bill that was exactly the same every month? The same theory holds true for variable costs. We generally categorize labor, advertising, food costs, and delivery expense as variable costs. Here too is another example of not being 100 percent accurate in terminology and facts. For example, is labor truly variable? I dare say that you have a minimum amount of labor regardless of the volume of your business. This is the fixed component of your labor costs. But for ease of calculation and the presumption that everyone will do a respectable level of sales to reach a point that labor can be considered a variable, everyone treats labor as variable.
We also have another term to define, Contribution Margin, which is merely 100 percent minus the total of your variable cost percentages (not dollars). You then take your total fixed costs and divide by the contribution margin percentage to arrive at your Break-Even point. By the way, break-even is defined as the point at which sales cover all costs. An interesting point to make here is that once break-even is reached, the contribution margin on incremental sales goes to your bottom line. I wish it were that simple when in fact in theory your contribution margin should improve as sales increase, but in some cases it actually erodes. For your analysis purposes you should assume that sales above break-even have a contribution margin to your bottom line.
A further definition of variable costs are the costs that must be incurred in producing your product. Maybe the best illustration of variable costs is to look at rent. Rent is a fixed cost, (assuming that your rent is not a percentage rent). You have the same rent expense regardless of your sales volume, regardless if you are open seven days a week, regardless if you are open for lunch, late, or open for holidays. Rent is generally due monthly, on the same day of the month and is generally a cost that follows you if the business fails. In contrast, variable costs are those costs that go into your product, such as food. Without food, what product do you have? What about labor? It takes labor to prepare the product, it takes labor to interact with the customer, and it takes labor to deliver the product, whether the delivery is in the store or at the customer's address. Another contrast, variable costs are generally only incurred if you have a sale. Yes, you have food spoilage, yes, you have labor to operate the business, but in its truest form, you only use variable costs if you make a sale.
We have included a Break Even calculator example to further your understanding. We have created this template in Excel and will be more than happy to send this to you if you send me an email request at firstname.lastname@example.org. If you broaden your understanding of fixed and variable expenses and the related contribution margin, you are well on your way to improving your cash flow. Remember: Cash is King!