Theoretical Costs of Sales
vs.
Actual Costs of Sales

by Thomas K. Hill, CHAE, CHTP

Thomas Hill, CHAE, CHTP, is the controller for OGC Restaurants, L.L.C. OGC owns and operates nightclubs in Dallas, Texas.

    For years, the hospitality community has measured the financial performance of the business by the percentages generated at the end of each month. At the weekly staff meetings, the end of the month meetings, or whatever meetings are being held where there is a financial discussion, percentages are "thrown" around the table. But, by looking at percentages, have we looked at the business as fully as we could?

    In a financial training class with a group of restaurant managers in the early stages of training, a question was thrown out to the group. How do you manage liquor costs? One trainee was very quick to say, "tell my bartenders and waitresses to push the well drinks because they have the lowest percentage of costs."

    In the corner, the area manager’s head drops. He has just spent the whole morning discussing how to build liquor sales. And the answer was to upsell! We should change our waitstaff from being order takers to sales people. But for this particular trainee, he already was percentage driven.

    You have just taken a new position as the controller of an establishment in a different segment of the industry. Is a 12 percent cost too low?

    You are the financial analyst for a chain of restaurants in the city. Every restaurant has the same menu with the same retail prices. You have worked with the food and beverage suppliers to get the same low prices for all of the restaurants. Therefore, food cost percentages will be the same...or will they?

    Every month you have to explain your food costs to the club’s board of directors. How do you explain why you have not achieved a 34 percent food cost? Club ZZYYXX down the road always runs 34 percent.

    Percentages are great tools. But, by themselves, percentages do not show the whole picture. If we do not manage percentages, how do we manage? What are the alternatives?

    For the purpose of this article, the discussion will center on the beverage menu and its costs. Each item on the menu does not have the same percentage of cost as the other items. Beer costs are different than wine costs. The sales mix of the different categories determines the final beverage cost, and every restaurant or club will have a different mix of sales. Table I shows a menu of beverage items, the retail prices, the costs dollars, and the costs percentages.

    Given these percentages of costs by menu item, what should the cost of sales be? It all depends on how much is sold of each. The newer point-of-sale systems are great for tracking this information. To add to the complexity, you want to charge more at night than during the day.

TABLE I

Recipes

    Recipes are needed in order to develop the costs for the menu. Does your beverage operation have standardized recipes for all the drinks? A recipe may be as simple as one ingredient, i.e. 8 ounces of draft beer.

    Recipes serve multiple functions. They provide a training tool for the new bartender, as well as for the most experienced bartender who needs to know how the drinks are to be made in your establishment versus his previous one. This means that every time your guests return, they will have their favorite drink made the same way as the last time.

    There are a number of programs on the market that can store recipes. Inventory items are entered and recipes are built from the inventory. Some programs are sophisticated enough to handle batch recipes within recipes. For instance, a recipe to make margarita mix in bulk is used as an ingredient in the final recipe for a margarita.

    The great selling point of these programs is the integration. As the inventory prices are updated, the recipe costs are updated as well. For those not ready to invest in a program dedicated to recipe costing, worksheet models or database programs can be used.

Theoretical Costs

    The theoretical costs of sales can be defined to be the "perfect" cost. Every drink was made exactly according to the recipe. There was no theft, waste, or overpour. Also, every drink was correctly recorded on the point-of-sale system. Things happened exactly as you knew they would when the doors were opened for business.

    Theoretical costs are calculated by multiplying the number of each menu item sold by its retail price, and its menu costs. This will produce the aggregate sales dollars and costs dollars for each item. If your recipe program has the interface capability to accept units sold, this is a major time-saver. If not, a spreadsheet can be built such as the one in Table II.

    As shown in Table II, the theoretical cost of beverage sales is 21.6 percent. This is the number that should be compared to the actual cost of sales, (beginning inventory + purchases – ending inventory +/– adjustments). If your establishment permits free pouring, then you would allow for more overpour than if your establishment uses a metered liquor system.

    Under this plan, it is the variance to theoretical that becomes the key number to watch. If each month your variance is .5 percent, and all of a sudden it spikes to .75 percent, there is something to investigate.

    Management wants an 18 percent cost of sales because they know another club runs that. Here is the documentation to show why 18 percent is not a feasible number. Something will have to change in order to achieve 18 percent. Increase prices? If your market will bear it...why not? Decrease costs? Can costs be reduced while still producing a product that is acceptable to the guests?

TABLE II

Gross Profits

    Gross profit is the level of profitability after the cost of sales and represents the dollars available to pay labor and other expenses. Sales – Cost of Goods Sold = Gross Profit. It should be considered hand in hand with cost of goods sold.

    Management can push the sale of those low-cost items, generating a good percentage of costs. The bartenders can do well, pouring according to the recipes throughout the month so that variance to theoretical costs is better than anticipated. But, there is still a departmental loss.

    Table II shows that 2,350 beverage were items sold for the month. What if the wait staff was able to get one-fourth of the guests that bought...

    The end result would be a theoretical beverage cost that is 1.6 percent higher. But is that bad? Of course it is bad. Higher percentages of expenses are always bad! What is the effect to the big picture? Table IV shows the summary of Table II and Table III.

    The bottom line is that there are $545 more to be used to pay the fixed costs. The number of drinks poured did not change, and there were no additional labor costs to incur these sales dollars. Also, no additional rent or depreciation is to be taken into consideration, only dollars that could flow to the bottom line.

    Is 12 percent liquor costs too low? After determining the theoretical liquor costs, it was found that 12 percent was too high. The theoretical cost was 8.9 percent. The club’s managers only thought they were running good numbers.

    Percentages have their places in the scheme of financial and operation management. Percentages provide benchmarks to managing the business. The key is to give percentages the importance that they deserve. Percentages represent key indicators or benchmarks; however, ultimately it is the dollars that are taken to the bank, not the percentages.

TABLE III

TABLE IV