The new ‘restaurant math’ of Seattle’s $15 an hour minimum wage is starting to ‘break the system’

From Mark Perry.

"For its Notable and Quotable item today, the WSJ featured a short excerpt from the much longer article “Seattle’s $15 Minimum Wage is Driving My Restaurant Out of Business.” That article originally appeared on the EcomCrew website a few weeks ago, and was written by Seattle restaurant owner Grant Chen about his struggles to stay in business as he faces a 61% increase in his labor costs from Seattle’s $15 minimum wage initiative. As I’ve mentioned before on CD, the $15 an hour minimum wage law isn’t really ultimately “a political problem as much as it’s a simple math problem,” as Anthony Anton of the Washington Restaurant Association explained the situation. And Grant Chen and other Seattle restaurateurs like Brendan McGill (owner of Hitchcock Restaurant and Hitchcock Deli) are finding out that the new restaurant math of Seattle’s $15 minimum wage is breaking the system.

As I point out in the Venn diagram above, a 61% increase in wages from $9.32 to $15 an hour is like imposing an annual tax on restaurants of $11,360 per full-time employee. If you understand that a $11,360 tax per employee (and $113,600 in higher labor costs for every 10 employees) would drive many restaurants out of business, you’ll understand why the “new restaurant math of a $15 minimum wage” is making Grant Chen’s restaurant unprofitable, and why it is driving him out of business.

Here are some excerpts below from Grant Chen’s article about the new “restaurant math” in Seattle. He starts with some basic restaurant economics:

Most people think that restaurants are some type of hugely profitable enterprise. The reality is that restaurants are “profitable” but are usually paying back loans or trying to recoup initial costs of building out the restaurant. The breakdown of expenses is usually along these lines:

• 25-40% food cost
• 30-35% employee wages
• 15-25% rent plus utilities

If you add up the low side, it equals 70% expenses, leaving 30% profit. If you add the high side all up, it actually equals 100%, leaving little profit. If you’ve ever wondered why the steak or lobster costs so much at the fancy restaurant in downtown, it’s because the margins are thin and expenses are high. Famed Seattle restaurateur Tom Douglas stated that his profit margins were 5% and he has some of the most popular restaurants in Seattle.

For this reason, buying or building a restaurant is a form of gambling. You put a huge amount of money up front and hope to make your initial investment back in about three to five years (if you’re lucky). That means for those years, even if everything goes according to plan, you can not make money if something happens at the end of the third year. As it stands, most restaurants fail during the first or second year, because they can’t get enough traction or repeat customers during this incubation period or they simply run out of cash. It’s a risky business, because you have to generate immediate cash flow, otherwise your business is burning through cash keeping your rent paid, the ovens on and servers to stand around doing nothing.

Grant then discusses the restaurant math of a 61% increase in labor costs:

As of January 2016, Seattle’s minimum wage is $13 an hour, which represents a 40% increase in our labor cost from the prior hourly wage of $9.32. This puts our expenses over 100% [of sales revenues], but we’re trying to offset it with price increases of 10% across the board and cutting hours by about 10% as well.

The difficulty in increasing prices is that 5 minutes away, the Seattle city boundary ends, which means that we are competing with restaurants that don’t need to charge extra. If our customers don’t run away, we anticipate a slight loss or ideally, a break even year. Most other restaurant owners we’re talking to are all in the same boat of trying to raise prices without upsetting customers and digging into profits to make it work. Those with sit down service can at least go from a tip system to service charge system, at the risk of alienating their best servers. So far, customer complaints have been fairly muted, with the occasional mention, but we usually just tell them that it’s the side effect of minimum wage.

To put things into perspective, the average American household in 2013 spent almost $3,000 or 6% of their budget on gasoline at $3.50 per gallon. If you take an overall 20% increase in restaurant expenses and apply an equivalent increase to a gas budget of 6%, it would be the equivalent of $11.70 per gallon gasoline prices. This is the type of shock that restaurant owners are facing.

Come next year, when minimum wage of $15 an hour goes into effect, it will be a 61% increase in our labor cost, which will bring our total expenses to well over 120% [of sales revenue]. This is when the real economics experiment begins, when we can no longer cut hours and have to raise prices by another 20% just to break even. Will customers balk at this price or will the general lift in wages throughout the city enable people to afford to pay more while eating out?

I really don’t know, but we’re all going to find out soon enough.

Note: I’d add some of my own restaurant economics here and point to the economic reality that a 20% increase in Grant’s menu prices won’t generate a 20% increase in sales revenues unless the demand for his food is completely inelastic, a totally unrealistic assumption. Given any normal assumptions about the price elasticity of demand for restaurant food and accounting for the reduction in the number of meals served following price increases, it’s highly likely that there is no increase in menu prices that will generate a 20% increase in Grant’s sales revenue.

Grant ends by discussing how higher government-mandated labor costs have forced him to operate now as a “private charity” as he anticipates the inevitable closing of his restaurant:

This will be a complete loss of savings and retirement money that we put into the restaurant. Rather than being “rich old white guys,” we’re young, minority entrepreneurs. Two of us just became proud fathers last year and another is about to have his first this year. The final kick is that since the mass exodus from the retail space, commercial leases almost always require a personal guarantee. In the event that we the tenant cannot pay the bills, the guarantor and their personal assets (read: our homes) are on the hook. This means that even with a failing business, we would be better served continuing to bleed money instead of letting the landlord come after us, short of negotiating a buy-out or other arrangement.

When we eventually close the restaurant, we’re going to be laying off a team of extraordinary employees. They are hard workers and I respect all of them and they deserve the increase in pay. I simply wish I could continue paying them while making a living myself. As it stands, we’re more or less operating a private charity now.

Bottom Line: It’s unlikely that Grant Chen’s situation operating a restaurant in Seattle today is in any way unique. It’s probably a pretty typical example of the new “restaurant math” that all restaurants in Seattle are now facing. If the typical restaurant makes a profit margin of 5%, there’s just no way that most restaurants can possibly survive a 61% increase in labor costs. In the end, it’s about math, not politics. And the restaurant math of a $15 an hour minimum wage is an arithmetic for restaurant failures, not restaurant survival. Apparently that math is already starting to “break the system.”"