Long Term Planning and EBITDA

At the depth of the Great Recession, I was approached by a client for assistance with refinancing his loan portfolio.  Today, the business is flourishing and cash flow is strong.  In any long term planning project (e.g. a five year plan), I recommend taking the viewpoint of the banker.

Successful long term planning for growth involves a clear corporate vision with respect to high level goals and the road map to achieve these objectives.  Investors and bankers are interested in the company’s track record, the economic conditions, local trends, competition and other factors which impact the success or failure of the venture.

Whether your growth plans begin with digging out of a hole or launching a new venture from scratch, you can benefit by thinking like a banker. A favorite metric used to evaluate a business plan is EBITDA (i.e. earnings before interest, taxes, depreciation and amortization).
The earnings figure used is typically Net Income (the bottom line). To arrive at EBITDA (see illustration below), any interest expenses, income taxes, depreciation expenses and amortization expenses are added back to net income.

EBITDA = E + I + T + D + A

E = Net Income

I = Interest Expense

T = Income Taxes

D = Depreciation Expense

A = Amortization Expense

A struggling business may need to refinance in order to weather tough economic times.  EBITDA analysis helps the bankers determine a business’s ability to meet loan payments.  Since the bank will replace current loans with the new facility, the interest expenses paid during the year are added back to net income.  A company reporting a net loss generally has no income tax so the impact in the formula is zero.  Neither depreciation or amortization expenses eat cash so adding back these two numbers shows the bank how much cash is available to make loan payments.

A losing company can have positive cash flow if they have significant net fixed assets. There are many issues involving the quality of fixed assets which have an impact on negotiations. Before approaching a bank for a new loan, it is wise to sell any fixed assets which do not have a positive impact on earnings potential. The cash raised in the sale of these non-essential assets will reduce the amount of the loan required.

Evaluating the sale of a fixed asset helps to understand how your profit and loss statement and balance sheet work together to produce cash. The sale price often is less than the book value of the asset. Let’s use the sale of a delivery truck as an example.

In our example, the company has decided to eliminate the unprofitable delivery service. The vehicle has no use. If the book value is $15,000 and we are offered $12,000, we would book a loss of $3,000. This produces $12,000 in positive cash flow and reduces earnings by $3,000.

Generally, the transaction will not be repeated since the truck is gone and we do not intend to replace the vehicle. The $3,000 loss should be noted so the bank may see the one time nature of the transaction. They will correctly eliminate these transactions from their analysis of future cash flow potential. We have reduced our cash required by $12,000 with no negative impact on our ability to borrow.

The key to success in making these decisions is the evaluation of the ability of any fixed asset to generate future cash flows.

Many companies delay closing an unprofitable unit because they worry about the impact on current earnings. This short sighted approach will impair future cash flow. The closing of a store which is bleeding cash will be treated as a non-reoccurring transaction. There may be additional expenses required such as penalties to break lease commitments and real estate commissions.

The depreciation and amortization expenses of any unit on the chopping block should be used to analyze the loss on the profit and loss statement. If the depreciation and amortization exceed the net loss, the store is still producing positive cash flow. Otherwise, the store is bleeding cash and is a candidate for closure.

Future earnings and cash flow will improve once any losing units are eliminated. These transactions are always shown as one time losses due to the closure of the store. In general, you go to a bank to finance the investment in fixed assets needed to achieve financial and operational objectives.

Clearing the dead wood is seen as a positive by anyone making a decision on your loan application.

In summary, cash flow is not the same as net income. The EBITDA formula helps to measure the cash flow available to meet loan payment obligations. Think like a banker. You can reduce the amount you need to borrow, improve your chance to make payments on a timely basis, and allow yourself to focus on positive activities by evaluating the quality of your fixed assets.

Professional Recipe Model - POS System Review

The key to using a recipe model to control usage is the link to the POS System.  Menu item counts provide the volume information for calculating ideal usage and for menu analysis.  Advanced menu engineering requires menu item counts to determine popularity.

POS Systems are designed to handle the revenue cycle including sales (by category, item, day-part, revenue center and server), cash, credit card charges, house account charges, gift card transactions, sales tax collected and server tips.  A typical POS System will have many modifiers to handle customer preferences, extras, substitutes, add-ons, call liquor, take out orders, portion size and special requests.

Every PLU (Product Look Up) code in a POS System with a selling price is required in order to tie Z reading for actual sales to the calculated sales figure (sales price in the recipe model and imported menu item counts).  In addition, there are many other PLU codes of interest.

Guest orders may include a double shot of liquor, extra cheese, the special of the day and other important information for inventory usage calculations.

Make sure the POS System is properly setup to track inventory.  Many times the focus is on cash control.  For example, a PLU code with a description DOUBLE and a selling price of $4 is a red flag item.  Frequently, the POS System does not capture the counts by brand of liquor.  The DOUBLE code may include shots of vodka, gin, tequila, etc.  Many brands of liquor can be impossible to track due to the use of a generic DOUBLE key.

The special of the day may always be recorded using the same PLU code.  This would eliminate the ability to track food usage in any operation with a high volume of special sales.

POS Systems are often under-utilized.  Any operation with salad bar or buffet sales can benefit from tracking pans of prepared items.  Setup a PLU code for every possible pan of food in the system.  Many times, a restaurant spends the time needed to account for every slice of bacon sold in the a la carte menu and ignores the buffet control.  An entire pan of cooked bacon can leave the kitchen with a verbal request.

In general, a professional recipe model will require additional work for the POS System database team.  This exercise will also provide the operations team with valuable information.  The insight gained will pay for the costs to update the POS database.

Professional Recipe Model - Technology Considerations

The success of any professional recipe model project rests on the ability to match your data flows from the POS system and the vendor ordering systems to your cost control solution. Once you have the model complete, the systematic use includes imports of menu item counts from the POS system. In addition, you'll want to export purchase orders to your suppliers. Many suppliers allow imports from their order guide (with current price data), and ad hoc purchase orders (entered directly online).

Choose a software system with tight integration to your POS system and vendor ordering systems. In addition, many people use Excel spreadsheets to handle inventory, butcher yields, competitive bids, menu analysis and order guides. Excel integration is a major plus for any cost control software.

I have two deal breakers when selecting the best solution. The system needs to have the capability of negative quantities in recipes and invoices. You will need to handle substitutions, returns and other common items which require a negative quantity. In addition, flexible units of measure with unit conversion factors is essential. At a minimum, you will need units of measure for purchasing (e.g. case), production (e.g. can or gallon) and one or more recipe portion units. Try to purchase a system with the flexibility needed to handle your operating environment.

Once the essentials are checked off and you have a short list, there are capabilities which can save time in the routine use of the solution. Template management tools allow you to design shopping lists (order guides), inventory count forms, vendor bid lists, transfer forms and production worksheets. Handheld unit integration is also a plus. Rather than focusing on bar code scanning capability, give preference to units which handle the forms. These handheld units allow users to complete the forms on the spot. When the unit is synced or the file is emailed, no further data entry is needed.

Before you make your final decision, determine the level of support you will need. The main benefit in building a professional recipe model is the business intelligence gained during the database build phase. You will have many important questions. In addition, the technology issues which will surface often require a certified network technician.

Professional Recipe Model - Introduction to Sub-Recipes

Preliminary Work Required

Professional recipe models provide a positive return on investment in a short time and offer flexibility for future changes. Initially, the project team should spend time and effort gathering and organizing critical information. The focus is on key items (most popular menu items and options and the ingredients used in producing these items).

This project is data intensive. Gather a POS menu item sales recap report for a 90 day period, quarterly (90 day) tracking reports from all major vendors, hard copy menus, inventory count forms, kitchen prep work forms, line setup layouts and all batch recipes.

In addition to POS reports and tracking reports, a comprehensive list of all food and beverage suppliers, food and beverage category lists, menu item category lists (preferably from hard copy menus) are essential. Any reports which can be exported to a CSV or spreadsheet file will save time.

Sub-Recipes and Key Item Yields

Identify key items (both menu items and raw ingredients) and key activities (all butchering, trimming and prep work which impact yields). If you use ranking reports, the key menu items and raw ingredients will be found on the first page of the report. These key items will represent a high percentage of menu item sales or overall food cost. The meat, seafood, poultry and produce items require yield intensive prep work. All prep work used to convert untrimmed raw product into recipe ready ingredients falls in the key activity group.

Recipe costing depends on standard recipes calling specific ingredients with well tested standard yields. Building adequate flexibility into a professional recipe model requires a thorough knowledge of sub-recipes. These sub-recipes are used to handle prep work, mise en place, stocks, sauces, butchering, trimming, cleaning and mixes. The sub-recipes used for prepping key items (generally meat and seafood) have the greatest impact on the entire recipe model.

Ideally, a large sample should be used for determining standard yields. If you butcher a beef short loin for T-Bone steaks, a 80% yield may be achieved using 10 boxes of meat. Some of the boxes may only yield 76% and others may yield 84% (by weight). Tracking actual yields against standards is an excellent control feature. An operation could achieve an above average food cost result if the yield is poor in a given period.

A beef short loin is used to produce steaks. In this operation, we produce steaks for 2 people (40 ounces) and single person steaks (20 ounces). Typically, the short loin cut produces Porterhouse, T-Bone and Strip steaks. When building a recipe model, we require sub-recipes for each steak variety (Strip Steak, Porterhouse Steak and T-Bone Steak).

In our example (see table below), we will assume all steaks are 40 ounces each and the standard yield for the entire 25 pound short loin piece is 8 steaks (2-Porterhouse, 3-T-Bone, and 3-Strip). This assumption may be changed to fit any given operation. The sub-recipe for T-Bone Steak would reflect the standard 80% yield. If we produce 40-ounce steaks from a 25 pound short loin (80% yield), our expectation would be 8 steaks.

If the actual short loin yield was 85%, we would still produce 8 40-ounce steaks and the extra trim would be used in ground beef and stew meat. We could experience a poor yield when butchering a short loin. If the yield was 76% on a 25 pound piece, we would not be able to cut 8 40-ounce steaks. Our yield would only be 7 steaks plus extra trim. We want the sub-recipe to red flag these poor yield short loins.

Some recipe model architects decide to use below average yields in their sub-recipes. Their goal is to have near zero variances in future reports. For example, they could make the short loin yield a weak 76% in the sub-recipe. Using the poor yield will produce fewer unfavorable variances in future reports. Savvy operators should welcome these variances. We don't want a standard yield which would allow 4 of every 100 short loins to disappear without an alarm going off in the reporting system.

Standard yields will allow us to forecast purchase requirements, track portion control, identify poor yield pieces and expose theft. Determining the standard yields on key items is the most important work in building a solid professional recipe model.

Food Cost Formula Questions

Regardless of your business model, the food cost calculation is the same:

Food Cost = Beginning Inventory + Purchases - Ending Inventory

If you look closely at the formula, you will find your cost is closely related to purchases.  The purchase cycle involves purchase orders, competitive bids, packing lists, invoices, par stock levels, shopping lists, etc.  Only invoices should be included in the purchases each month.

Finding the inventory value is simple and complex.  The simple part involves an accurate count.  We have two levels of complexity in our industry.  The perishable nature of food guarantees a declining value as product ages.  The most costly event in a kitchen involves freezing a protein item with a high cost per pound.  It's better to buy it frozen at the start if portion control is a challenge in your operation.

The second level of complexity involves the preliminary preparation of meat, seafood and produce.  Trimming and butchering activities need to be standardized.  Using a standard yield %, it is possible to assign the correct value to prepped items.  For example, a prime steak purchased for $10/pound may have a yield of 80%.  The cost per servable pound is $12.50.  This is the cost to use on the inventory sheet in calculating the extension.