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  • Writer's pictureRyan

The Future of Restaurants (Pt. 5)

Updated: May 10, 2019

This week we'll re-start our exploration of different business models.

If you're curious and want to read more, here are the business model posts so far:

For the fifth installment, we'll dive into restaurants.

Running a restaurant is a tough business. Labor and food costs typically run at least 60% of sales. And then you have rent and miscellaneous expenses.

Plus, there is so much competition. Just drive into any strip mall and you're bound to come across a few restaurants. To compound the problem, competing against a chain like Subway or Chipotle is difficult because of their economies of scale.

For instance, McDonalds has 37,855 global locations. More specifically, 93% of those are owned and operated by franchisees. This is key.

McDonalds typically owns the building and the land but then brings a franchisee onboard to run the operations. This benefits the company in two ways. First, franchisees cover the monthly costs of the mortgage which helps McDonalds gain equity in the real estate over time. Second, the company hauls in royalty fees from overall sales. McDonalds cut is typically 13% after including all fees.

This franchisee system allows McDonalds to reap big profits. The company's profit margins are about 40% compared to Chipotle's of 10%. The reason for the discrepancy is that Chipotle owns and operates all 2,504 of its stores.

Interestingly, McDonalds only operates 266 more stores than Chipotle despite having 37,855 locations. All the rest are under franchisee agreements.

There are trade-offs to both strategies. McDonald's asset-light business model clearly results in radically higher margins. However, it has less control over the operations of the restaurants. While there are strict guidelines that a McDonald's franchisee must adhere to, it is tough to continuously monitor 35,085 locations globally.

On the other hand, Chipotle has to put up the money to build out stores and it doesn't receive high-margin royalties. But it does have full control over its operations. This is why Chipotle's store-level margins are better at 22% than McDonalds' at 17%.

Even if you're a big chain, the business is still tough. Chipotle's growth petered out because of the big E.coli conundrum. The company couldn't blame a rouge franchisee for its health safety since it operates all of its locations.

Another tough issue for restaurants is employee retention. Turnover is typically sky-high and therefore, productivity suffers because new employees must be trained. Most fast-food employees are seasonal workers or young adults looking for temporary work. This is an area where chains have another advantage.

Think about it. If you own a mom-and-pop restaurant, there is likely no upward career progression. A hired waitress will not be thinking she is going to run the place one day. But a chain provides the opportunity for a waitress to eventually manage a store and possibly move into upper management. This is crucial for employee retention, which drives profitability in the long run. In other words, the rich just keep getting richer.

Let's zoom out and tie this all together from the point of view of a someone looking to start their first restaurant.

Off the bat, you need a location. Well, honestly, if I were to start a restaurant, I'd create an MVP (minimum-viable-product). I couldn't find out if it's possible to get on the DoorDash/UberEats platforms without a physical presence, but if it is, then I'd rent out a kitchen and drive all the customer traffic through those delivery platforms. You could cut costs on labor and leasing a building and that would probably compensate for the delivery commission fees.

The real value-add of this strategy would be testing your product. It would almost be similar to agile software development. Iterate on the product before going all out.

Once you have some market acceptance of your product (food) then you could spend the money on leasing a building. It could be a way of de-risking the process.

In fact, this is actually what is happening. Travis Kalanick, the guy who started Uber but got pushed out, is now working on a venture called Cloud Kitchens. In China specifically, so much food is ordered online that restaurants can now just rent out kitchen space without the need for a fully physical building.

This could drastically change the dynamics of the restaurant industry. Imagine a physical restaurant being like a physical book. Most people still read physical books but there a large proportion that only read digital ones. It could be the future of restaurants. Some people may only have food delivered, especially as economies of scale reduce costs. As more customers order food from a delivery platform like GrubHub, costs will be driven lower.

Picture a delivery guy picking up food from Panda Express but then he gets another order from the Subway next door. He can save time and reduce the costs of the process which can be passed through to end-consumers.

This could be a big shift in how restaurants are operated. But it could create even more surplus in competition. The fixed costs would be reduced and effectively, anyone who makes a good meal could create an online restaurant.

Obviously physical restaurants will not go away. But this could be a fascinating paradigm shift in the restaurant industry.

In the "old world" you'd have to lease a building, hire a chef and employees, set up the décor, create the cooking infrastructure (ovens, grills, sinks), and actually make the food.

The up-front costs are big so you'd likely be running at a loss for a few years. It's similar to the airline industry. Big up-front costs and tons of competition = tough economics.

All in all, if you're looking to make a lot of money, starting a restaurant might not be the easiest way to go about it. Big chains have big advantages over smaller players and competition abounds. However, the current industry may be changing as we know it. Once again, the internet is wreaking havoc on a familiar business model.


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