31 January 2014

Example of Operating a Business and Impact on Raising Labor Costs

I keep hearing from some in the news commentary world that raising the minimum wage doesn't really have any bad impact. Basically during this big promo of the President's, to raise it from $7.25 to $10.10. That rising costs of labor, in the absence of rising sales (read: during weak economic times like now), won't cause business owners to find ways to recoup the lost profits. In my view, that's just fantasy, irrespective of whatever Princeton study they want to cite.  (But it is a popular vote-getter or poll-booster.)

Below, is a real-world example walk-through of business expenses, using a generic restaurant business. It’s lengthy, but maybe informative for those who are not business owners and don’t think about this stuff every day.

But before that, just some basic facts, because there's a lot of spin out there. The current minimum wage is $7.25/hr. Using the CPI Index, adjusting for inflation, it has averaged $7.13 since its inception in 1938. So it is in line with inflation, as defined by the CPI index. (I have my beef with CPI being a good gauge of inflation, but that’s another battle.)

The current poverty level for individuals is about a $15 thousand annual income. Adjusted for inflation, it has always been $15 thousand. ~$7.13-7.25/hr, 40 hours per week, 52 weeks per year is ~$14.8-15 thousand annually.

So minimum wage has been historically designed to cover you up to the poverty level. It is not presently lagging. It is in line.  To say that wages have been flat, “when adjusted for inflation”, as they have for the past few decades before the effects of the financial crisis is to say that wages have increased at the same rate as inflation.

Having said that, from 1961 through 1979, minimum wage was somewhere in the zip code of ~$9/hr, adjusted for inflation. In other words, it provided almost ~$4 thousand more annually in today’s dollars over the poverty level during that time. That's what the Administration is advocating presently - a minimum wage that offers more than the poverty level.

I am not judging. I am not saying it is too low or too high. I am actually for raising it, but only when the economy is stronger. Benchmarking a raise in the minimum wage when say, unemployment declines to a certain level. That way everybody wins. Lower incomes get a raise; and businesses have more profits from higher sales to pay them, continue to expand and still compensate owners for their risk-taking.

But most importantly, it incentivizes all of us to come up with ways to improve the economy, rather than instead to come up with ways to simply offer greater reward for doing nothing more than what you are already doing. The latter being the bane of all heretofore class struggle.

In my view, if we want to fight stagnant wages, we need to encourage public-private partnerships to incubate nascent technologies and grow them into 21st Century industries and markets that will pay a higher wage.  We need to invest in education to align it to preparing our workers for those industries.  Part of that fight involves checking what has been runaway education inflation.

Our wages are low, because we keep trying to compete too often in markets that, now places like China, Brazil, India, the Philippines are developing more and more skilled labor that is still willing to work for half or less what the average American might.  That international pressure – available only when markets are free to source labor at the best price – I believe is the single largest pressure on all our incomes in the past few decades.  And that is an inevitable free market force, as lesser nations grow in wealth and offer a more skilled, yet still cheaper source of labor.

Not a weak union.  Their only argument is for protectionism really, which runs antithetical to healthy markets and ultimately just sickens domestic industry v. foreign competition.  See how much better our auto industry is, now that we abrogated through their financial crisis bankruptcies all those way-over-market benefits packages, negotiated decades ago by the then-stronger unions?

Not evil big business.  They are operating freely as market animals, sourcing the best possible labor at the best possible price available globally.  S&P 500 operating profit margins right now are about 15%, a few points higher than the average of the past few decades.  But it just came out of being a few points below that through the financial crisis.  So they are basically historically in line right now.
Real-world example of operating business results (using a generic restaurant in the US, based upon my experience doing diligence on thousands of operating companies over the years):
A little background - in the US, restaurant sales represent about 4% of GDP and employ about 10% of the workforce.  About half of all dollar-food sales in the US are through restaurants.  All of us have had the experience of being a patron – so it’s a familiar business model to use as an example.

Restaurants are the perfect window into the small businesses that drive the US economy, and the classical debate between lower income earning employees v. their risk-taking entrepreneurial owner-employers.  Restaurants are the typical American Dream, as 80% of them are started by people who began at near minimum wage working in that industry.  So today’s low-wage employee is highly likely to be tomorrow’s restaurant owner.

[For the following discussion, please refer to the tables at the end.]

Average annual sales for a restaurant in the US is about $700 thousand per unit.  The cost of food and liquor ranges ~25-35% and ~18-25% of sales, respectively.  In the sample income statement (below) I arrive at a 26.4% cost of sales for our generic restaurant, which assumes that food is 55% of sales and costs 30%; liquor is 45% of sales and costs 22%.

That leaves $515 thousand gross profit to pay for everything else to operate.  Most of everything else is the cost of labor and the cost of occupancy.  I’ll do labor last because that’s the punch line, although it is typically a restaurant’s largest operating expense.

First, cost of occupancy.  Take an average 2,500 square foot tenant establishment, where 20% is utility (kitchen, storage, office, eg.).  That leaves 2,000 square feet for patrons.  The more successful restaurants generate ~$500-600 per usable square foot.  The typical “Mom and Pops”, more like ~$350 (which equals our $700 thousand sales example).

Rent ranges from ~$25-45 per square foot on average across the nation right now (but can be over $80 in wealthy urban areas).  Let’s use $35.  That’s $88 thousand annually in rent (which is triple net, including landlord property taxes, etc., as is standard nowadays).  Electric, gas and water utilities for premises like this might consume about ~4-5% of sales in this current environment.  I’m using $30 thousand, or 4.3%.

So that’s $118 thousand of fixed occupancy costs to take away from $515 thousand in gross profit.  That leaves $398 thousand.

Now there’s the repair and maintenance - or replacement - of all the various equipment, furniture and fixtures.  One stove might cost ~$4-10 thousand to replace.  One refrigerator, freezer or dishwasher, ~$3-6 thousand each.  Ice bins, POS systems, sinks, prep tables, exhaust systems ~$1-3 thousand each.  If you want to have TVs for entertainment, a number of large screens could quickly add up to $10 thousand or more.  Chairs, tables, booths, dishware…

A typical 2,500 square foot place is going to easily have $80 to $120 thousand of stuff (likely higher).  Purchased by the business owner with their own savings.  That depreciates (depending on what it is) every three to seven years to almost $0 salvage value.  So depreciation expense - the proxy for the cost of replacement - on $100 thousand of stuff then will be somewhere around ~$20 thousand per year in this example.  That’s before repair and maintenance, which can easily add up to another several thousand per year.  Let’s call that $5 thousand.

Now that leaves $373 thousand in profit available.  There is a good-sized list of other stuff that restaurants pay that absolutely adds up to a number.  Liability insurance, permits and licensing on something like this could be $5-7+ thousand per year.  Credit card fees, if you assume 60-80% of sales are with credit cards can be $9-12 thousand on $700 thousand sales (Visa/Mastercard costs the merchant ~1.8-2% of charged sales, AmEx ~3-4%+; not to mention the tip is usually in that).  Trash collection, security monitoring, cable/satellite (if you have TVs are several thousand dollars a year), linen cleaning (super-expensive, which is why you don’t often see tables clothes or linen napkins) and the general expenses like phone, professional fees… all of that can very easily be another ~4-7% of sales all added up.  I am using $32 thousand, or 4.3% of sales.

That basically covers everything other than the cost of labor.  Almost all of that other than cost of sales is 100% fixed.  Meaning, no matter who does or does not walk through the door, you are paying that nut no matter what.  So we are now left with $339 thousand of that original $700 thousand to pay for the cost of its employees and hopefully have something left over for the business owner that is taking all the risk investing in and operating the business.

A place like this might have a chef at $15/hr, an assistant cook at $9.50/hr, a prep cook at $8.50/hr, and a couple busboy/expos at $7.50/hr.  It might also have a bartender and maybe three servers for a total of four tipped hourly employees.  The average of all 50 states and D.C. for minimum wages paid by the employer to tipped hourlies in the food service industry, adjusting for an allowable tip credit, is $3.85/hr.  Add to that a manager to keep everyone honest and have someone for the patrons to yell at, and that’s possibly another $40 thousand to payroll annually.  Making certain assumptions then (see Table 1 below) all that labor adds up to $245 thousand annually.

But we’re not done on the cost of labor.  The employer owes a contribution of payroll taxes on the base pay, plus all their declared tips.  In my example, this is another $28 thousand expense.  Add a little for workers’ comp, and total cost of labor here is $275 thousand, or 39.3% of sales.

In this example, that leaves $65 thousand of operating profit available to the owner.  That’s 9.3% of sales, which is low in the context that the more successful units can generate 12-25%.  But, as most restaurant costs are fixed, that greater success really comes largely from having a brand that brings in higher traffic and allows you to charge higher prices for the same slop.

In this example, cost of labor is at the higher end as a % of sales (40%) and can be as low as mid-20%.  But that involves serious labor cuts that can eat into quality of service and possibly sales as a result, and/or the owner assuming certain roles (manager or bartender for example) to cut labor.

So here’s the whole point.  This example uses the national average of $3.85/hr for a restaurant to pay tipped hourlies (or more, as the restaurant must cover any shortfall if their declared tips don’t get them to minimum wage).  Pretend instead it had to operate in a state where those costs were mandated by the government to be a lot higher.  CT for example where I live, requires that tipped hourly food servers be paid $5.69/hr, and bartenders $7.34/hr.  If I rework Table 1, plugging in those numbers, total cost of labor is now $308 thousand.

That’s $33 thousand higher labor costs annually.  With no additional sales coming through the doors, now the owner of the business is only earning $32 thousand.  The person taking all the risk and all the headache of running a business is now earning about what her assistant cook is making.  Which is kind of out of whack.  And in a business, where a $3 reduction in average check or ~7-9 less patrons per day can wipe out all profits to begin with, just the whiff of the government suggesting that they will have to pay more for labor, will already chill hiring decisions.

Forced by the government to pay everyone more on the same amount of sales, what do you think the owner is going to do?  Of course they’re going to cut hours or full-out let people go.  They sure-as-shinola aren’t going to take on another employee.  And all of that will now start eating into sales and quality of service.  Compromising the viability of the business.  So they also do what most restaurant owners do when they start to panic in the face of reducing profits – raise menu prices.  Which drives people to the place next door that didn’t.  Which just sends them quicker into a loss situation.

The President is currently pushing raising the minimum wage by $2.85 from $7.25 to $10.10.  If we raised all of this labor in this example by the lesser of $2.85 or to the $10.10 threshold, that now makes the total cost of labor $337 thousand.  That basically wipes out all profit to the owner in this example.  And now the busboys are making what the assistant chef and prep cook makes.  You think the kitchen isn’t going to be griping about wanting more than the busboys?

As the owner makes adjustments to recoup lost profits, all of that adds up to a reduction of work opportunity for employees, coming from the very thing that the government did trying to help them in the first place – raising minimum wages in the absence of improved sales for the business.

The counter-point suggests that that extra coin in workers' pockets is a direct stimulus to the economy.  And it is.  Just in nominal terms.  When demand is not strong enough, the ultimate effect is just an increase in the price of everything, without an increase in output or real growth - read, staglation.

So to conclude, if you want to raise this place’s cost of labor by ~$60 thousand without it having a negative repercussion on work opportunity for its employees, then do it as the restaurant is making at least $60 thousand more in profits.  And none of this is to support only the business owner and blame the employee.  It's a relationship, where both the employee and employer have legitimate positions.  The employee should be able to work full time and not live in poverty.  The employer is risking capital – often their life savings – and deserves a significant compensation incentive for the risk during their successful years.


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