Food Profit Margins

Rudyard Kipling described prostitution as the world’s oldest profession. Clever but of course not true. The world’s oldest occupation is hunting or farming food – because before food there was nothing worth getting paid with.

Food the business actually comes in multiple parts. Producing it, moving it to the person who wants to eat it, and making it super tasty. Each of these earn a profit margin. This blog is going to tell you what these margins are and why. And its going to tell you what the hottest food start up is right now.

Food profit margins

Image: Michael Stern

Pizza The Hut

Let’s start with that exceptional business: Pizza delivery.

Exceptional for the Franchisor that is.

Your typical local cheesy dough store sells their pizza for twice the price they pay for the ingredients. Most of the difference gets blown on staff and rent. But they actually make a respectable profit margin of five cents on the dollar.

I choose this as my jumping off point because it shows a variety of dynamics. Firstly, unless you have a Michelin star, you probably don’t make much on what you sell. Five cents are honest to God above average in the food business. Maybe if you are the go to place to eat with a three month waiting list, you can get fifteen cents, but you should really plan on less than five.

But this low profit margin leads you on to the best thing about selling food. Your customers are generally trying to solve their hunger problem three or more times a day. If you are good you can stamp out your five cents like a printing press.

Pizza delivery is also actually one of the most evolved forms of business in food. It is an area where people have figured out how to split most of the profit from the food itself.

To explore that split let’s check out Papa Johns.

How does papa johns make money

Image: Keith Allison

Franchising Your Way to Success

Imagine a franchisee selling $20 in pizza, deep fried jalapenos and coke. The ingredients cost $10. They blow $7 to turn flour and cheese into pizza and getting it to your door. That leaves $3.

However, before you get too excited, Papa Johns International charges the franchisee almost $2 for royalties and marketing. They are taking ten cents and leaving you the franchisee with five cents on the dollar.

Operating profit margins on a PJ store is not really fifteen cents on the dollar, because most of their ten cents is getting spent on a head office, product development and marketing. The fact is most PJ stores that they operate themselves only make five or six cents on the dollar.

Franchising is the splitting of the local, in the kitchen and front of house hard work, from the national, big brand hard work. It is carefully boxing the making of the pizza, miles away from the creating the name recognition and consistent quality control.

As a franchisee, you might sell 900-1000 pizzas a week, which works out as $1k profit on $20,000 of weekly revenue. Our hypothetical store owner is making $50k a year, which ain’t bad being your own boss. But you put in a lot of capital and then worked your ass off for it.

That’s the upfront capital and hard work Papa Johns has managed to AVOID. Their return on capital is up the chimney and beyond the roof.

Pizza franchise profit margins

Image: Denise Kreb

Maybe the best way to explain this is by imagining you have decided to flip condos. In this planet bizarro, Papa Johns have persuaded the bank to lend to them zero percent down. The bank is paying for the condo 100%. Oh and if the condo goes down in price its all the banks problem too. Its a cut of the upside and none of the downside.

Papa Johns Business Model

  • Create a globally recognizable brand.
  • Ensure consistent quality.
  • Get franchisees to pay the cost of rent and employees.
  • Get franchisees to buy ingredients from them.
  • Collect 9% of sales for themselves, part of which they spend on marketing and product development.

According to a survey by Franchise Business Review, the average franchisee earns a profit of $66k a year. However, the big earners are skewing this mean. Over half of all franchisees surveyed are making LESS than $50k a year. At the other end one in fourteen are pulling down a cool quarter of a million dollars.

You ever read how seven out of ten drivers think they’re above average? That’s us. We’re all sitting there saying “If I were franchising I’d be making $250k!” But don’t doubt the phenomenal amount of smarts and hard graft it takes to get there.

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Costs

I am not going to give you a bunch of clichéd advice like location, location, location, or don’t hire your friends and family. You can read that somewhere else, and maybe you don’t get a choice.

Here’s an insight. Your landlord, and especially if they are a professional real estate investment trust (REIT), is after half your net cash flow. If you’re lucky, they will only want two fifths, but generally it is half. They figured out that asking for more than this makes you move locations, and asking for less means you won’t.

In that $20 pizza order example, your landlord wants $3.50. More than 3 times the $1 the guy doing all the work, and taking all the risk, ends up with.

Another insight is that McDonald’s, Starbucks, hell even Wells Fargo…they all choose to build more stores than an area needs. Seriously they would make more money with less stores – If they didn’t have competitors. The number of McDonald’s are being dictated by the number of Burger King’s. Location x3 is critical to a new business because people are lazy. The more competitors they have to walk past to get to you, the less likely they are to walk in.

These big players have scale. The unfortunate reality for everyone else is industry level margin suppression.

You ever go into the burger joint opposite Grand Central Station? Afterwards did you complain, that place is just for tourists. Every seat full for an over priced burger. Here are their skewed incentives: they don’t need to make the food any better to fill the store. In fact their incentive is to make the food worse – that’s one of the few ways for them to boost their profits, since their seats and covers are fixed.

Salad profit margins

Image: Salad for tourists, Nate Steiner

My last point is more of a joke than an insight. I knew some family friends who ran a Chinese Takeaway. The guy drove a pimp black Mercedes. My brother expressed some jealousy regarding this beautiful car. The guy laughed. He said that there was a tax inspector almost permanently parked outside his shop. When they saw his kids walk out, they would go up to them and ask these teenagers how many customers came in on a typical day. They would ask if they ordered a side of rice or vegetables.

My family friends were fiddling their taxes like crazy, as you can do when half your revenues are in cash. But that doesn’t make it easy because the IRS knows what your shop should be pulling down. His greed flashed red on a computer and in the end he paid up.

From Farm to Food

Let’s take a look at the bigger picture. Farmers grow corn and chicken. They make food. According to the US Department of Agriculture, median farm income in 2015 was $80,000. They made more than your typical franchisee. But again, they work damn hard for it. This has had a big run up compared to the $60k in income they averaged back in 2010, because food prices have run up and land supply is largely fixed.

There are many people who argue there isn’t enough food to feed everyone. They make the case that people in China and developing countries are going to eat more and more meat and that means less and less food to go around.

Here’s a factoid on this. China already eats half the pork in the world. They really like their pig! And even crazier to me, Americans eat almost half the beef they did in the seventies!

How does pounds of meat make money

Image: US per capita consumption of meat in lbs, NPR

Food prices aren’t running up because of sky rocketing population. It runs up because of the cost of oil. The proportion bounces around but it isn’t hard for half the cost of the chicken you buy in Kroger to be oil. That is gasoline to drive chicken feed to the farm, and gasoline to drive the chicken to the abattoir. And that is oil to make the plastic packaging.

Getting Food To Your Fridge

Wrap up the corn and the chicken, and stick it on a shelf in Kroger. Do that a hundred million times a week and you can see why delivering food is a military operation. The cost of the merchandise to Kroger is 78 cents on the dollar. After rent, staff and marketing, they are only taking 2 cents in profit.

Business gets bigger yet their margins are razor thin. Oftentimes, the industry you are in dictates your margins. In the supermarket business, you make 4 cents if you are great and zero cents if you are having a tough year. And this is all because you’re selling largely standardized products against sharp and aggressive competitors.

Kroger profit margins

Image: Andrew Albosta

What the supermarket model is doing is getting the customer to pick the food up from the warehouse. Except of course it is the discounters who show you what the inside of a warehouse looks like.

A discounter like Aldi, who hail from Germany, can make 5-6 cents on the dollar. Nobody has figured out a way to deliver quality food cheaper to the consumer than a discounter.

One model I’m going to highlight are the convenience store chains like Seven Eleven. You would think it is even more competitive than supermarkets, there are more of them right! But they are not. Each store only has to compete with the store down the block. Two convenience store chains decide to have a price war. All one has to do to protect its chain profits is to create a price firewall. Only the stores that are next to a competitor have to cut prices. The rest of the group’s stores can stick to whatever price they want. Other than that the rent relative to revenue is key. They have got to be paying the right rent for the location.

Getting You To Their Table

Let’s have a restaurant cook that corn and chicken into a meal. Offer seats and persuade you to come to them. Restaurants come in all shapes and sizes but the competitive environment is always a bunfight. The average restaurant makes 3 cents on the dollar.

Convenience stores compete with the one down the block. Every restaurant is competing with every other restaurant, fast food joint and supermarket in town.

David Chang of Momofuku claims that in New York he’s selling $28 worth of ramen for $17.

How do restaurants make money

Image: Paul Keller

How is that possible? Mr Chang is saying that only viral restaurants make money. Your restaurant is hot and you are rich. Conversely though the majority of restaurants and their owners are like the PJ franchisee, paying the bills and earning a salary that’s pretending to be a profit.

David Chang is objecting to the industry profit margins that are being forced on to his world class restaurants.

I often come across the question, is it better to go work in Wall Street or to join a start-up. Finance pays everyone extremely well. Start-ups are high risk and high return. But for every Zuckerberg or Gates making it big, there are nineteen others who burn multiple years for nothing except the memories.

Food is even worse. There are no Zuckerbergs or Gates in food. Rather there are great restaurateurs like David Chang complaining that he should be making more money. Maybe the difference is that there are fewer unhappy wealthy restaurateurs compared to other industries. Lots of people start restaurants because that is their passion. Because it continues to be one of the best ways to be your own boss.

Chain, Chain, Chains

A top restaurant could be making fifteen cents on the dollar. Maybe even more. But you are playing a volume game so you decide to capitalize on your success and open other restaurants. You make more money but ultimately you lower your average margins.

The current state of the art in food chains is Chipotle. They often earn 10-11 cents on the dollar.

How does chipotle make money

Image: Andrew Blight

Chipotle’s Business Model

  • Use a limited list of ingredients. Pick one of five carbohydrates (rice or taco), choose one of five meats, and then personalize it with your choice of beans, sides and condiments.
  • Fit out each store in the same modern style. Stainless steel everything means it is cheap to furnish and cheap to clean.
  • Serve people quickly. The quicker the queue moves the more they can print their $3 in profit per burrito.
  • Flip the pricing discussion on its head: Instead of leading downwards on price, they come in competitive but then announce, if they find a better beef, or a better bean, they will use that instead and raise the price.

Less ingredients translates into less inventory, less cash invested and less cost. Everything at Chipotle that needs to be cooked is already cooked. That makes service super fast.

Given the low margins, raising prices on food is hugely powerful, if commonly impossible. Think of it this way, if you are making three cents on the dollar, and you raise your price from $1 to $1.01, you have just boosted your dollar profits by a third.

Turn these numbers into store numbers, and four cents instead of three is comparable to $66,000 instead of $50,000 in profits – and just by putting your prices up by one per cent.

Volume businesses have phenomenal operating leverage, both up and down.

Food Start Ups

More recently we have seen an explosion of food start-ups. People want to try new things. And rent is just too high.

As an overview, think of a premium takeaway [delivery] as an old business model with four elements that make a circle.

Build a reputation (A) -> Take Orders (B) -> Cook Food (C) -> Deliver Food (D) -> Back to (A)

Similarly think of Restaurants as an old business model with three elements.

Build a reputation (A) -> Cook Food (B) -> Provide a nice place to eat food (E) – > Back to (A)

Takeaway delivery tends not to do (A). Takeaways are dominated by food that the average person considers interchangeable: pizza, chow mein, and curry.

Many of the disruptive start-ups arriving on the scene are trying to carve up these business models into their component parts.

Food start up margins

Image: Basher Tome

Deliveroo wants to do (A+B+D) where people visit their website, put in their orders, pass them on to their restaurant partners, and then send guys to collect and deliver. They’re leaving the cooking, and the rent, to the guys already cooking and renting.

Schlep and Fetch want to only do Delivery (D). It’s a specialist logistics company.

Just Eat want to build a reputation (A) and take orders (B). It is similar to GrubHub. It is worth drilling into these two further, because they are not really food businesses at all, they are software companies.

Marketing Cost Versus a Cost of Doing Business

It is a bit of a cheat to call a software company a food business, but they illustrate a great point. The line between getting new customers and servicing existing customers can be frighteningly thin.

Right now, Just Eat is making 14 cents on the dollar and GrubHub is at 16 cents. These are the special kinda start-ups that are making a profit today.

Imagine you are a small restaurant that is doing better than the industry. And somebody comes along and says hey I can get you new customers!

So you say SURE!

How does GrubHub make money

Image: Alexis Finch

Just Eat and GrubHub are asking for a 10-13% cut. GrubHub’s average order in 2015 was $28. The commission was 13.5% so they took $3.80 of that. That works out at 53 cents in profit per order.

Doesn’t sound too bad a cost for a new customer.

After a while you discover that more and more of your regular existing customers are using these guys to order stuff they used to call you up for. Originally, each new order that came in, you made $1 while they made 50 cents.

But as they start taking 10% of all your revenues you realize they are killing your business. Now they are making $1 while you are losing 50 cents on EACH order.

Your regular customers pay your rent and costs. So new customers are incrementally valuable. But when your whole business has a new 10% cost – its time to start investing in a reputation (A) outside of GrubHub.

These business models are unsustainable unless they become monopolistic. Just Eat and GrubHub can only survive if their website become the destination for diners and away from their platform you are stuck with nobody.

This has arguably happened in Denmark, where Just Eat channels 90% of all online orders. This could do with more research, but it is likely that it is small restaurateurs that suffer and are pushed out of business, driving orders to bigger, more competitive kitchens.

That 10% cut has to come from somewhere.

In other markets, I would expect a Groupon style peaking in these businesses. Groupon was a huge success when they promised new customers and vouchers to everyone. When small businesses realized that these deals were toxic, Groupon were obliged to shrink their ambitions. Companies will pay anything for new customers, but the budget for servicing existing ones is pretty damn low.

That’s why we end up on hold for half an hour calling up the cable company.

The Netflix of Food

Netflix is not a perfect analogy for meal kit delivery. But subscription is what I am getting at and it is powerful.

How does hello fresh make money

Image: SITS girls

My wife and I have been a member of Hello Fresh in the past. Blue Apron and Plated are the established firms in America. Our personal experience of Hello Fresh was of tasty recipes and a politely insistent sales force. Hello Fresh hails from Berlin Germany, and delivered 4m meals a month in 2015.

The similarities between these start ups and the Indian dabbawala, where a quarter of a million lunch boxes are dispatched every day across the city of Mumbai alone, are incredibly stark. It speaks to a point my reader Ryan has made in the past, which is that some of the best new innovations really do come from the oldest business models around.

However there is the twist that these meal kit services encourage people to cook.

Decades ago, there was a story about a cake mix company that was unsuccessful until they changed their recipe from “add water, mix and bake” to the wildly different “crack an egg, mix and bake”.

The egg element was surprisingly powerful. It made people feel like they were baking and not just being lazy. There is a massive market for people who enjoy cooking but dislike shopping.

Advantages of The Meal Kit Business Model

  • They take advantage of the multiplier effect around meals. When you hear 4m meals you think wow, as you should do. But subscribers are a fraction of that. The deal we tried was 3 meals in a box in a week, so 12 meals a month. I estimate that in 2015 Hello Fresh had 200-300k active members. I can’t imagine many of these people go to the same restaurant 12 times a month – unless it is their office canteen.
  • Meal Kits allow control over costs. The recipes are written in advance against a pre-agreed price. They can choose which type of steak to deliver. Seriously, even airline food would be a good business model if only it were safe to have real stoves on a plane!
  • Lower rent. Remember how your landlord wants half your net cashflow. They have less ability to take that from you if you can base yourself far away from your customers.
  • Differentiation between standard and premium meal packages. Restaurants find this extremely difficult – they try with “today’s specials”, but mostly people choose what they want. Meal boxes can sell themselves like 32GB and 128GB iPhones – feel free to pay more for better!
  • The customer default is to carry on with the boxes. It is an annuity to the company.
  • And that just emphasizes how great subscription is. You sign someone up and they give you a nice predictable cashflow. Why they may even ask you to pay in advance so you fund their business too!

Meal Kits have turned food into a Netflix subscription. It is a particularly special innovation. However, the good news for entrepreneurs is that food is constantly evolving and continues to surprise and delight. How else could we have new concepts like Huel or Soylent – pure nutrition virtually taste free.

What’s the business model of ultra-nutritious replacement food?

It is not to replace good food; it is to replace bad food. Except of course, for a small minority who include it in their master plan to live forever.

I eat whatever my wife is in the mood for, so I’m a terrible person to ask where food is going to go next. But the opportunity is there, absolutely no doubt about it. Food trends can’t help rising and changing.

I’m an affiliate partner with Blinkist. This is an app I use every day to read short summarized non-fiction and I cannot recommend it highly enough.

Yuen Lo

6 Comments

  1. Extremely insightful and well written piece!!! There are certain careers/businesses that have a sort of romantic allure, attracting many, who later discover that running the actual business is actually not lucrative and requires too much effort. Examples include running a bed and breakfast or as the author discusses running a restaurant. As a counselor, I run into many people who have gone into jobs/careers, having paid high prices for college degrees, that are not making the wages needed to live a comfortable middle-class lives. On the other hand, I have met many people who make lots of money but spend it all as fast as they can, building no long-term wealth. In the end, what I encourage all of the young people I work with is to conduct deep level research on their career interests so that they do not commit the next 30-40 years of their lives to a unfulfilling future. Then I also impart the importance of personal finance management so that they will build wealth instead of burn through it. Thanks again for wonderful article!

  2. Thanks for this insightful article.
    Being your own boss is a big thing right now, and for good reason.
    The key thing is that you at least know what you are getting in to.
    This is extremely important and your post goes a long way into educating the food startup people.

  3. Ryan – really interesting comment. People really struggle to grasp what is important to them, today and in the future. Good to know you are there to help them.
    Giancarlo – yes we all dream of being our own boss. The media can be as emotional as the people looking for advice sometimes, so I’m happy to add some clarity in amongst the noise. Thanks for your support!

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