Restaurant Economics 101

Part 1: A Flawed Model

Ever wonder why your favourite restaurant, that was always packed, and where you could never get a table, suddenly closes its doors due to financial reasons? You don’t need to be an economist to understand that something just doesn’t add up.

Every so often, you cross paths with a headline such as: “restaurants are a tough business”, “restaurants operate on tight margins”, or “it’s so hard to turn a profit in this industry.” You get the idea. What piqued my curiosity, was why we haven’t dug deeper than these simple hyperboles?

Why do restaurants struggle so hard to make money!?

First off, running any small businesses is tough; that goes without question. Limited access to capital and reduced economies of scale are clear obstacles, defied at every turn by the desire to put love into your product or service and share it with the world. So it doesn’t matter what you are selling, independent retail in particular is tough.

Additionally, restaurants have a whole host of unique issues to consider, among them having to manage perishable goods, pay exorbitant utility bills, and operate during unusual hours. If you are further interested in the unique life of a chef, my team and I have taken a deeper dive into a number of themes through a project called The Last Service, launching this spring.

Ultimately, restaurants are using a flawed economic model to manage their dining rooms.

Simply put, unlike most businesses, restaurants not only have fixed costs and variable labour costs to consider, but they fail to acknowledge that they are operating with a fixed capacity. Due to this finite physical constraint, there is an upper limit to their revenue.

So why do restaurants charge the same price for the best table at 7PM on Saturday as they do for the worst table at 5PM on a Monday? It’s a question I have been contemplating for some time, which we will unpack in the next segment.

Now, fixed capacity isn’t a phenomenon exclusive to restaurants. Where it is found elsewhere, you will discover a significant difference: dynamic pricing, a pricing strategy also referred to as surge pricing, demand pricing, or time-based pricing, in which businesses set flexible prices for products or services based on current market demands.

Hotels, concert halls, airlines, and sport arenas all have fixed capacity, but you wouldn’t find yourself paying the same price for first class or court side, as you would for the nosebleeds or the middle seat next to a crying baby on a transcontinental flight.

Put into practice, this means restaurants should be charging for sections, tables, and times based on peak demand, vanity, and pure desirability. When people want something, they will pay for it. Within the restaurant industry, they have simply never been asked to pay for it. You don’t ask, you don’t get. It is a literal ‘free for all’, where competition for the best space at the best time truly carries no value.

Dynamic pricing, a pricing strategy also referred to as surge pricing, demand pricing, or time-based pricing, in which businesses set flexible prices for products or services based on current market demands.

So why do restaurants charge the same price for the best table at 7PM on Saturday as they do for the worst table at 5PM on a Monday? It’s a question I have been contemplating for some time, which we will unpack in the next segment.


Part 2: A Revised Model

As a server paying my way through a degree in economics, I’ve observed many guests compete for the best tables by trying to slip a bill at the host stand. Meanwhile my owners were struggling to make more than 3% margins. What I observed is certainly not a unique phenomenon in an industry that fails to accurately value its coveted real estate.

Framing a meal in terms of what it really is, an experience in a dining room that has finite real estate, is the first step in shifting perceptions and understanding the economic opportunities. Not only could one table be more desirable than another, but certain time frames are more popular, which yet again disrupts supply and demand on a daily basis. To a consumer, this is an important distinction over simply raising food prices across the board, which is not without its own justifiable backlashes.

Restaurants in North America face two issues: consumers’ skewed perception of food prices and elasticity of demand.

Simply raising food prices has proven to be a constant recipe for financial disaster, because restaurants in North America face two issues: consumers’ skewed perception of food prices and elasticity of demand, which refers to how sensitive a consumer is to the price of a good. The more elastic a product is the more consumers react to price increases. Restaurants suffer from high elasticity, meaning that consumers will go somewhere else or not at all if they perceive the price is too high. Inversely, products like medication are highly inelastic. Consumers will pay whatever is asked of them.

Why are North American restaurants faced with these issues? Well, North Americans pay the lowest food prices per capita in the world. This was the intended outcome following a very long and well documented history of coordinated government agricultural policies enacted since the 1960s during the green revolution. Despite the benefits of efficiently feeding an entire population through subsidized industrialized farming, inherently it has led to a massive misunderstanding of the real cost of quality food.

Without defining your offering as an experience to a highly price sensitive consumer, the perceived value of your food prices can spiral towards the lowest common denominator. In a competitive market, where each individual business has no control over prices and the products are subject to elasticity of demand, a business’s prices must rise and fall with the market regardless of the costs, which can often lead to a race to the bottom or in the case of a restaurant negative profit regardless of being busy.

Restaurants should begin to view their dining rooms in terms of differentiated tiers of real estate and frame their offerings as experiences.

So all of this brings us back to how a restaurant can and should price their dining room. Restaurants should begin to view their dining rooms in terms of differentiated tiers of real estate and frame their offerings as experiences. In a market where 63% of millennials seek experiences over goods and services, restaurants will quickly flip the script on their profitability issues by joining the rest of the economy with modern pricing mechanisms.

This all leads me to my final point: there should not be any stigma directed towards restaurants for wanting to make money! In the final part, let’s take a look at how we can continue to support these important cultural hubs in our communities.

Part 3: A Brighter Future

Before Covid, there was a general thought that restaurateurs were wealthy. Although some are, many of those made their money before becoming restaurateurs. Most restaurants are actually owned by individuals who worked their way up through the industry and scraped together enough money to start their own place.

Oddly, despite this long and well deserved road to ownership, most newly minted owners are very afraid to talk about the financial goals of their business. Their success is always framed in terms of how many meals they can cook for a local charity or the suppliers they support. This is a beautiful collective attribute and one that has personally kept me in admiration of my peers. Restaurants, however, should not be afraid to make hay while the sun shines and be proud of it! As we all know, there are many days that the sun is just not shining.

The goal of any business is to maximize profit. Profit maximization does not mean overcharging or trying to rip off your customer, it’s about ensuring that marginal cost does not exceed marginal revenue. For restaurants, determining this equilibrium can be tricky. On a busy Friday and Saturday night, a restaurant’s marginal revenues certainly exceed the marginal costs. But what about that lunch seating on a Monday? You still have to bring in staff, keep the lights on, and pay the rent. So how can a restaurant maximize its profits on a weekend and minimize its losses any other day of the week? By matching the price of a product or service to the utility of your customer, an opportunity presents itself.

Utility refers to the value or usefulness that a consumer perceives a product or service has. Simply put, how happy does it make your customer? Everyone has a different utility curve, meaning that everyone places a different value on a product and thus, are willing to pay different prices for the same product or service. When a business is able to properly determine and leverage the utility curves of its customers, both benefit: the customer receives and pays exactly what they want and the business earns an accurate profit.

For restaurants, this once again supports the need to differentiate table real estate and to better match the utility of their customers. Not all diners are created equal; some love to flaunt their status and would gladly pay $100 for the best table in the house, while others are extremely price sensitive and would simply move up their reservation time to take advantage of a discount, enabling a restaurant to flip the table again.

When we are in the business of pleasing our guests and creating the best possible guest experience, why are we not truly putting that into practice?

Covid has presented the restaurant industry with an opportunity to make significant and major changes to how a dining room can generate profit. Every major industry that is faced with the limitations of fixed capacity, has applied some form of dynamic pricing as a means to adjust supply and demand across different utility curves, allowing customers to determine what value they are willing to assign to a product or service, and in turn, pay for it. For the first time, a collective understanding of the challenges restaurants face, in addition to new technological solutions that can help restaurants assign dynamic pricing to their coveted real estate, restaurants should not squander this opportunity to make some profit. Our communities will surely benefit from it.

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