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Student Study Notes - Chapter 7 Factors Affecting Menu Pricing  Perhaps no area of hospitality management is less well understood than the area of pricing food and beverage products. Some of the most common factors affecting menu prices include one or more of the following: Factors Influencing Menu Price 1. 2. 3. 4. 5. 6. 7. 8. 9.          Local Competition Service Levels Guest Type Product Quality Portion Size Ambience Meal Period Location Sales Mix Local Competition. The price a competitor charges for his or her product can be useful information in helping you arrive at your own selling price. Service Levels. As the personal level of service increases, costs increase and thus prices must also be increased. Guest Type. A thorough analysis of who your guests are and what they value most is critical to the success of any restaurant's pricing strategy. Product Quality. You should select the quality level that best represents your guests’ anticipated desires as well as your own operational goals, and then price your products accordingly. Portion Size. The effect of portion size on menu price is significant. It will be your job to establish and maintain strict control over portion size. Ambiance. Prices may be somewhat higher if the quality of products and ambiance also support the price structure. Meal Period. In some cases, diners expect to pay more for an item served in the evening than for that same item served at a lunch period. Location. A location can be a good for business or bad for business. If it is good, menu prices may reflect that fact. If a location is indeed bad, menu prices may need to be lower. Sales Mix. Sales mix has the most influence on a manager’s menu pricing decisions. Sales mix refers to the frequency with which specific menu items are selected by guests. 1 Assigning Menu Prices   There should be a clear and direct relationship between a restaurant’s profits and its menu prices. Menu item pricing is related to revenue, costs (expenses), and profits by virtue of the following basic formula that you learned in Chapter 1: Revenue - Expense = Profit It is important to understand that revenue and price are not synonymous terms. Revenue refers to the amount spent by all guests, while price refers to the amount charged to one guest. Thus, total revenue is generated by the following formula: Price x Number Sold = Total Revenue    The economic laws of supply and demand state that, for most products purchased by consumers, as the price of an item increases, the number of those items sold will generally decrease. Conversely, as the price of an item decreases, the number of those items sold will generally increase. For this reason, price increases must be evaluated based on their impact on total revenue and not on price alone. To illustrate the relationship of pricing to total revenue, refer to Figure 7.1, which illustrates the possible effects of this price increase on total revenue in a single unit. Increasing prices without giving added value can result in higher prices but, frequently, lower revenues because of reduced guest counts. Guests demand a good price/value relationship when making a purchase. The price/value relationship reflects guests’ view of how much value they are receiving for the price they are paying. Go Figure! Assume that Sofia wants to raise the price of cheesecake sold in her downtown delicatessen. If she raises the price by 50 cents, how can she calculate the number that must be sold to keep her revenue constant? Sofia can use the following computations. Current Number Sold X Current Price = Current Revenue To calculate the number of newly priced cheesecakes that must be sold to maintain Sofia’s current revenue she makes the following computation: Current Revenue New Price = Number That Must Be Sold The actual results she achieves will depend largely on the price/value relationship her customers perceive regarding the higher priced cheesecake. 2 Marketing Approaches to Pricing    The prices of the items sold on a menu can represent a variety of concepts. For example, when Ruth Chris, the famous New Orleans steakhouse restaurant group, sets the price for a steak on its menu, it seeks to tell its customers, “Come here for quality!” When Wendy’s selects items for its 99 cent menu, it seeks to tell customers “Come here for value!” In a sales approach to marketing, the goal is to maximize volume (number of covers sold). Increased customer counts should result in maximized total operational revenues. This approach works best when service levels are limited, the products sold are easily produced, and the cost of providing the product can reliably and consistently be controlled. Other managers, usually in full-service restaurants, use the marketing philosophy of maintaining your current competitive position relative to the other restaurants in your market that target the same customers as you. Restaurateurs utilizing this approach feel that guests are primarily price conscious and will not pay “more” for the menu items at their restaurants than they would pay at competitive restaurants. Cost Approaches to Pricing   Another approach, which the authors believe is the best way to examine menu pricing, is to view it primarily from a cost approach to pricing. The best methods used by restaurateurs to set prices consider an operation’s costs and profit goals when determining menu prices. Currently, the two most popular pricing systems are those that are based upon:  Food cost percentage  Item contribution margin Food Cost Percentage  The formula for computing food cost percentage for a restaurant is as follows: Cost of Food Sold Food Sales = Food Cost % 3  This formula can be worded somewhat differently for a single menu item without changing its accuracy. Consider that: Item Food Cost Selling Price  The principles of algebra allow you to rearrange the formula as follows: Item Food Cost Item Food Cost %   = Item Food Cost % = Selling price This method of pricing is based on the idea that food cost should be a predetermined percentage of selling price. When you use a predetermined food cost percentage to price menu items, you are stating the belief that food cost in relationship to selling price is of vital importance. See Go Figure! in the text for an example of this. A second formula for arriving at appropriate selling prices based on predetermined food cost % goals can be employed. This method uses a cost factor or multiplier that can be assigned to each desired food cost percentage (see Go Figure! in the text): 1.00 Desired Item Food Cost % = Pricing Factor  A factor table for desired item food cost percentages from 20% to 45% is shown in Figure 7.2. Go Figure! A factor, when multiplied times the item’s cost, will result in a selling price that yields the desired item food cost percentage. The computation would be as follows: Pricing Factor x Item Food Cost = Selling Price Item Contribution Margin   Some managers prefer an approach to menu pricing that is focused on an item contribution margin, defined as the amount that remains after the food cost of a menu item is subtracted from that item’s selling price. Item contribution margin, then, is the money that “contributes” to paying for labor and other expenses and providing a profit. 4  Some restaurateurs refer to item contribution margin as item gross profit margin (selling price minus item food cost). This term is sometimes used because it employs the same calculation as gross profit margin on the income statement (food sales minus food cost). Go Figure! The item contribution margin is computed as follows: Selling Price – Item Food Cost = Item Contribution Margin The selling price is calculated as follows: Item Food Cost + Desired Item Contribution Margin = Selling Price  Managers who rely on the contribution margin approach to pricing do so in the belief that the average contribution margin per item is a more important consideration in pricing decisions than food cost percentage. Food Cost Percentage vs. Item Contribution Margin    For the average managerial accountant, understanding the use of food cost percentage, item contribution margin, or a combination of both will enable him or her to arrive at appropriate pricing decisions. Pricing should be viewed as but an important process with an end goal of establishing a good price/value relationship in the mind of your guest while achieving profits for your operation. It is important that the menu not be priced so low that no profit is possible or so high that you will not be able to sell a sufficient number of items to make a profit. Menu Price Analysis   The best method of analyzing the profitability of a menu and its pricing structure should simply seek to answer the question, “How does the sale of this menu item contribute to the overall success of my operation?” Menu analysis involves marketing, imaging, sociology, psychology, and many times, the manager’s emotions. Guests respond not just to weighty financial analyses, but rather to menu design, the description of the menu item, the placement of items on the menu, their price, and their current popularity. 5    The menu analysis methods that have been widely used each seek to perform the analysis using one or more of the following important operational variables:  Food cost percentage  Popularity (sales mix)  Contribution margin  Selling price  Variable costs The most popular systems of menu analysis (shown in Figure 7.3) represent the three major philosophical approaches to menu analysis. The items and information related to menu items’ cost, selling price, contribution margin, and popularity are compiled in a Menu Analysis Worksheet (refer to Figure 7.4). These figures can be used to illustrate the matrix analysis of food cost percentage and contribution margin, and goal value analysis. (See Go Figure! in the text to see how the rows of the Menu Analysis Worksheet are calculated.) Matrix Analysis  Matrix analysis is essentially an easy method used to make comparisons among menu items. A matrix allows menu items to be placed into categories based on their unique characteristics such as food cost %, popularity, and contribution margin. Food Cost Percentage     Matrix analysis that focuses on food cost percentage is the oldest and most traditional method used. Until the mid-1980s, it was overwhelmingly the single most popular method of evaluating the effectiveness of menu pricing decisions. When analyzing a menu using the food cost percentage method, you are seeking menu items that have the effect of minimizing your overall food cost percentage, since a lowered food cost percentage leaves more of the sales dollar to be spent for other operational expenses. A criticism of the food cost percentage approach is that items that have a higher food cost percentage may be removed from the menu in favor of items that have a lower food cost percentage but may also contribute fewer dollars to overall profit. To analyze a menu using the food cost percentage method, menu items must be segregated based on the following two variables:  Popularity (number sold)  Food cost percentage 6 Go Figure! To determine average popularity (number sold) of menu items, the total number of items sold is divided by the number of items on the menu. In this case, the computation is: Total # Sold Number of Menu Items = Average # Sold To determine the average item food cost percentage, the average total food cost is divided by average total sales. The computation is: Average Total Food Cost Average Total Sales    = Weighted Average Food Cost % With an average popularity of 100 covers sold per menu item per week, any item which sold more than 100 times would be considered high in popularity, while any item selling less than 100 times would be considered low in popularity. Similarly, with an overall average food cost of 35%, any menu item with a food cost percentage above 35% would be considered high in food cost percentage, while any menu item with a food cost below 35% would be considered low. The food cost percentage matrix to analyze these variables follows: Popularity Food Cost %      Low Square 1 High High Food Cost %, Low Popularity Square 3 Low Low Food Cost %, Low Popularity High Square 2 High Food Cost %, High Popularity Square 4 Low Food Cost %, High Popularity See Figure 7.4 for sample data which can be used to create the actual matrix. In matrix analysis, each menu item inhabits one, and only one, square. When developing a menu that seeks to minimize food cost percentage, items in the fourth square are highly desirable. They should be well promoted and have high menu visibility. The characteristics of the menu items that fall into each of the four matrix squares are unique and, thus, should be managed differently. Each of the menu items that fall in the individual squares requires a special marketing strategy, depending on their square location. These strategies can be summarized as shown in Figure 7.5. The food cost percentage method is fast, logical, and time tested. If you achieve too high a food cost percentage, you run the risk that not enough money will remain to generate a profit on your sales. Again, however, you should 7 be cautioned against promoting low-cost items with low selling prices at the expense of higher food percentage items with higher prices that may contribute greater gross profits. (For a discussion of this, see Go Figure! in the text.) Contribution Margin      When analyzing a menu using the contribution margin approach (also widely known as menu engineering), the operator seeks to produce a menu that maximizes the menu’s overall contribution margin. Each menu item will have its own contribution margin, defined as the amount that remains after the food cost of the item is subtracted from the item’s selling price. Contribution margin is the amount that you will have available to pay for your labor and other expenses and to keep for your profit. A common, and legitimate, criticism of the contribution margin approach to menu analysis is that it tends to favor high-priced menu items over low-priced ones, since higher priced menu items, in general, tend to have the highest contribution margins. Over the long term, this can result in sales techniques and menu placement decisions that tend to put in the guest’s mind a higher check average than the operation may warrant or desire. To analyze a menu using the contribution margin method, menu items must be segregated based on the following two variables:  Popularity (number sold)  Contribution margin Go Figure! In Figure 7.4, to determine average popularity (number sold) of the menu items, the total number of items sold is divided by the number of items on the menu. In this case, the computation is: Total # Sold Number of Menu Items = Average # Sold To determine the weighted average item contribution margin, the average total contribution margin is divided by the average # sold. The computation is: Average Total Contribution Margin Average # Sold = Weighted Average Item Contribution Margin   The contribution margin matrix is developed along much the same lines as the food cost percentage matrix. The contribution margin matrix to analyze these variables follows: Popularity 8 Contribution Margin High Low        Low Square 1 High Contribution Margin, Low Popularity Square 3 Low Contribution Margin, Low Popularity High Square 2 High Contribution Margin, High Popularity Square 4 Low Contribution Margin, High Popularity See Figure 7.4 for sample data which can be used to create the actual matrix. Again, each menu item finds itself in one, and only one, matrix square. Using the contribution margin method of menu analysis, it is desirable to have as many of the menu items as possible to fall within square 2, reflecting high contribution margin and high popularity. A manager would seek to give high menu visibility to items with high contribution margin and high popularity when using the contribution margin approach. Each of the menu items that fall in the four squares requires a special marketing strategy, depending on its location. These strategies are summarized in Figure 7.6. The selection of either food cost percentage or contribution margin as a menu analysis technique is really an attempt by the foodservice operator to answer the following questions:  Are my menu items priced correctly?  Are the individual menu items selling well enough to warrant keeping them on the menu?  Is the overall profit margin on my menu items satisfactory? Some sophisticated observers feel that neither the matrix food cost nor the matrix contribution margin approach is tremendously effective in analyzing menus. Because the axes on the matrix are determined by the average food cost percentage, contribution margin, or sales level (popularity), some menu items will always fall into the less desirable categories. Eliminating the poorest items only shifts other items into undesirable categories. For an illustration of this drawback to matrix analysis, see Go Figure! in the text. One answer to address complex questions related to price, sales volume, and overall profit margin is to avoid the overly simplistic matrix analysis and employ a more effective method of menu analysis called Goal Value Analysis. Goal Value Analysis   In 1995, at the height of what was known as the value pricing (extremely low pricing strategies used to drive significant increases in guest counts) debate, goal value analysis proved its effectiveness. Essentially, goal value analysis is a menu pricing and analysis system that compares goals of the foodservice operation to performance of individual menu items. It uses the power of an algebraic formula to replace less sophisticated menu averaging techniques. 9            The advantages of goal value analysis include ease of use, accuracy, and the ability to simultaneously consider more variables than is possible with twodimensional matrix analysis. Both the food cost percentage and contribution margin approaches to menu analysis relate to the actual costs of food and beverages. Today, the cost of labor is likely to exceed that of food and beverages in many restaurants. In such a situation, how logical is it to utilize a menu analysis system that is based upon food costs or contribution margin alone, and that ignores labor costs? Goal value analysis evaluates each menu item’s food cost percentage, contribution margin, popularity, and, unlike the two previous analysis methods introduced, includes the analysis of the menu item’s nonfood variable and fixed costs as well as its selling price. The total dollar amount of fixed costs does not vary with sales volume, while the total dollar amount of variable costs changes as volume changes. An example of a fixed cost is manager salaries, and an example of a variable cost is hourly wages. Returning to the data in Figure 7.4, we see an overall food cost % of 35%. In addition, 700 guests were served at an entrée check average of $16.55. If we knew the overall fixed and variable costs, we would know more about the profitability of each of the menu items. One difficulty, of course, resides in the assignment of nonfood variable costs to individual menu items. The majority of nonfood variable costs assigned to menu items is labor cost. The variable labor cost of preparing many dishes is very different. For analysis purposes, most operators find it convenient to assign nonfood variable costs to individual menu items based on the overall restaurant’s nonfood variable costs. Total variable costs are all the costs that vary with sales volume, excluding the cost of the food itself. Those variable costs are computed from the income statement. If they account for 30% of the total sales, a variable cost of 30% of selling price would be assigned to each menu item. Having compiled the information in Figure 7.4, the algebraic goal value formula can be used to create a specific goal value for the entire menu, and the same formula can also be used to compute the goal value of each individual menu item. Menu items that achieve goal values higher than that of the overall menu goal value will contribute greater than average profit percentages. As the goal value for an item increases, so, too, does its profitability. The overall menu goal value can be used as a “target” in this way, assuming that the average food cost %, average number of items sold per menu item, average selling price (check average), and average variable cost % all meet the overall profitability goals of the restaurant. 10  The goal value formula is as follows: A × B × C × D = Goal Value where A = 1.00 – Food Cost % B = Item Popularity C = Selling Price D = 1.00 – (Variable Cost % + Food Cost %)  Note that A in the preceding formula is actually the contribution margin percentage of a menu item and that D is the amount available to fund fixed costs and provide for a profit after all variable costs are covered. Go Figure! Using 30% for variable cost % and the average/ weighted average numbers from Figure 7.4 for # sold (100), selling price ($16.55), and food cost % (35%), the formula can be calculated to compute the goal value of the total menu as follows: A ×B ×C (1.00 – 0.35) × 100 × $16.55 ×D = Goal Value × [1.00 – (0.30 + 0.35)] = Goal Value × 0.35 = 376.5 or 0.65 × 100 × $16.55 According to this formula, any menu item whose goal value equals or exceeds 376.5 will achieve profitability that equals or exceeds that of the overall menu.    The computed goal value is neither a percentage nor a dollar figure because it is really a numerical target or score. (See Figure 7.7 for an example of the goal value data needed to complete a goal value analysis.) Refer to Figure 7.8 for the results of the goal value analysis. Should items that fall substantially below the overall goal value score be replaced? The answer, most likely, is no if the manager is satisfied with the current target food cost percentage, profit margin, check average, and guest count. Every menu will have items that are more (and less) profitable than others. Many operators develop and promote items called loss leaders. A loss leader is a menu item that is priced very low, sometimes even below total costs, for the purpose of drawing large numbers of guests to the operation, while their fellow diners may order items that are more profitable. 11              The accuracy of goal value analysis is well documented. Used properly, it is a convenient way for management to make decisions regarding required profitability, sales volume, and pricing. Items that do not achieve the targeted goal value tend to be deficient in one or more of the key areas of food cost percentage, popularity, selling price, or variable cost percentage. In theory, all menu items have the potential of reaching the goal value. Refer to Go Figure! in the text to see an example of goal value analysis of a menu item. This item did not meet the goal value target. Why? There can be several answers. One is that the item’s food cost % is too high. This can be addressed by reducing portion size or changing the item’s recipe since both of these actions have the effect of reducing the food cost % and, thus, increasing the A value. A second approach to improving the goal value score is to work on improving the B value, that is, the number of times the item is sold. This may be done through merchandising or incentives to service staff for upselling this item. Variable C, menu price, can also be adjusted upward; however, adjustments upward in C may well result in declines in the number of items sold (B value)! Increases in the menu price will also have the effect of decreasing the food cost % and the variable cost % of the menu item (and increasing the contribution margin). An easy way to determine the effects of changes made to goal values is to use an Excel spreadsheet. Sophisticated users of the Goal Value Analysis system can modify the formula to increase its accuracy and usefulness even more. Goal value analysis will also allow you to make better decisions more quickly. Anytime you determine a desired goal value and when any three of the four variables contained in the formula are known, you can solve for the fourth unknown variable by using goal value as the numerator and placing the known variables in the denominator (see Figure 7.9). To illustrate how the data in Figure 7.9 can be used, see Go Figure! in the text. Goal value analysis is becoming increasingly linked to break-even analysis because of their mathematical similarities (see Chapter 9). In addition to the ability to analyze multiple cost variables simultaneously, goal value analysis is valuable because it is not, as is matrix analysis, dependent on past operational performance to establish profitability. It can be used by management to establish future menu targets. An illustration of this concept can be seen in Go Figure! in the text. Each item on next year’s menu should be evaluated with the new goal value in mind. Actual profitability will be heavily influenced by sales mix, so all pricing, portion size, and menu placement decisions become critical. Remember, however, that a purely quantitative approach to menu analysis is neither practical nor desirable. Menu analysis and pricing decisions are always a matter of experience, skill, and educated predicting because it is difficult to know in advance how changing any one menu item may affect the sales mix of the remaining items. 12