This morning I read an article regarding the rising costs of food and how restaurants will respond. In the article former server Charles Ferruzza finds a pair of local restaurant owners who say they will refuse to raise prices to compensate for the increase in costs. The owners discuss absorbing the costs themselves or reducing portion sizes to keep prices constant. While I am certain no owner was eager to have an article written about their pending price hike, there is another side to this story. The difference in priorities between an independent owner and corporate shareholders is something that explains a great deal about the restaurant industry.
Independent restaurant owners directly profit from the money spent at their restaurants. They have the autonomy to determine what is best for their restaurants long term. Maintaining profitability in the long term is more important than immediate profits. They determine how much of the profit they take as income and how much is reinvested into the restaurant. If they are convinced that foregoing short term profits is better for the long term profitability of the restaurant, they can proceed in that manner. This in reality is the owner offering to subsidize the guest’s meal to keep them returning. For the individual owner of a profitable restaurant, this short term hit can be seen as a long term investment in the restaurant.
When a restaurant becomes a corporation the priorities change considerably. Corporate restaurants rarely have only one owner to answer to. Instead they answer to shareholders who own stock in the corporation. This can be a handful of investors in a privately held corporation or thousands of individual and institutional investors who own stock in a company publicly traded on one of the stock exchanges. The priorities for these investors, the true owners, are maintaining stock prices and dividends. Profits of the corporation are divided equally amongst the shareholders and paid out as dividends. These dividends provide incentive to own the stock and keep stock prices high.
The determination of how much profit a corporation should earn is made a third party. Major brokerage houses and investment firms assign analysts to study corporations. A quick look at the investor relation page for Darden shows 29 different analysts who watch their stock. These analysts make projections called earnings estimates. These estimates on revenues and profits are the guidelines corporations target for each quarter. Failing to meet these estimates can reduce stock prices considerably as shareholders sell. Exceeding these estimates creates excitement among shareholders and inspires more people to want to buy the stock which will raise the price per share.
Because of the need to meet these forecasted estimates, corporations are unable to simply forego some profits as independent owners are able to. A price spike on a particular commodity (milk, beef, chicken, etc) that occurs during a quarter must be immediately accounted for. This need to respond immediately can be achieved in a number of ways. A corporation may choose to begin buying lower quality products to compensate for a price increase in another commodity. They may cut back on the costs of supplies the restaurant uses. They can also cut back on salary positions on the restaurant or store level to achieve cost savings.
In the extended recession we now face most of these steps have already been taken. Restaurants are operating on tighter margins than ever before. Cost cutting has already achieved a level that it is noticeable to the guest. Additional spikes in the cost of commodities are leaving the officers that manage corporate restaurants with very few options. We have reached a point where they must decide whether price increases or closing underperforming stores will best help them maintain profits without jarring investor confidence.
Oddly enough this is the point where independent restaurant owners feel relief. If a corporation closes underperforming locations, the independent restaurants will gain some of the remaining customers. If a corporation chooses to raise prices, it provides coverage to the independent restaurant owner to do the same. As I discussed in relation to chicken wings in a previous post, prices are more determined by the perception of value rather than the actual costs of the product. When the corporations they compete with increase prices, the independent owner will either see an increase in value oriented customers or be able to raise their prices without as much backlash.
In the restaurant industry, prices are more dependent on the competition than the commodities. The large corporations set the standard to which all others must comply. It is the need to produce returns for shareholders that keep the corporations in check. The consumer benefits most directly from this competition during an economic downturn. They also suffer from a mild form of collusion during times of prosperity when aspirational dining becomes in fashion. Understanding the forces in play behind the scenes helps both the employee and the consumer realize the pressures faced by both independent and corporate restaurants.
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