A detailed look at one restaurant's books.

RENT

"Is the problem really that the rent is too high? Or is it that you rented the wrong apartment"

FOOD COSTS

"High menu prices don’t always mean higher profit"

TAX & MISCELLANEOUS

PROFIT MARGIN

"They were left with 427,178 rmb profit ... not much different than if they had just taken that money to China Merchant’s"

THE "THEY USED TO BE BETTER" THEORY

"In Shanghai, the real estate market is young and volatile. Landlords' motivations don’t always seem like rational economic decisions"

BACK TO THE PROFIT MARGIN

LABOR

A CONCLUSION

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Let’s pull the curtain back on a restaurant. Not the one that reveals the kitchen -- open kitchens, so 1990s. The one that hides the important stuff: money. A generous and uncommonly transparent restaurant owner recently gave me his 2014 financial statement, a detailed profit-and-loss spreadsheet broken down by month, and then gave me the permission to share it publicly. There’s no obvious motive to believe it’s not true, as you’ll see from the measly profit. (On second thought: tax is an obvious motive. Low revenue = less tax liability. But judging from the average daily revenue, the number of seats, and my estimate of what it costs to eat there, it seems believable).In fact, the owner is happy that restaurant is just surviving. That is despite the fact that he’s worked like a dog for the last four years; that he is just about to pay back the two million rmb initial investment; and that his lease comes up next year, leaving him about 12 months to make a profit. (A theoretical profit, as we’ll see later).Though he doesn’t care one way or the other, I’m not going to name this place. Let’s call it Ristorante Italiano. It’s a small spot in Xuhui. And while it’s not completely representative of many successful restaurants in Shanghai (none are), it’s a good jumping off point to talk about money. Let it also be a cautionary tale to every friend with a restaurant daydream. Remember, there are more than 100,000 restaurants in Shanghai, according to Dazhong Dianping , and this -- Ristorante Italiano, a money trap, a cost puzzle -- is a good outcome. P&L 101. This is a long one. Time to dive in!First up, everyone’s favorite scapegoat:The cost varies over the course of the year, but that is mostly due to late fees. The fact is that Ristorante Italiano’s lease is 88,000 rmb per month for a space of just more than 100 sqm. These things are quoted in Shanghai as the price per square meter per day; Ristorante Italiano is at just under 30 rmb psm per day. And while the owner cries that these are shopping mall prices but he’s not in a shopping mall and doesn’t get the same foot traffic, a more useful way to look at this figure is as a percentage of revenue. In 2014, Ristorante Italiano took in a little under seven million rmb from customers and turned over just more than a million rmb to the landlord. The actual numbers work out to 16%.Now, I don’t own a restaurant in Shanghai but over the course of the last month, I have talked to almost ten people who do. They and their restaurants are both Shanghainese and foreign, some are small and independent, some are homegrown chains, and one was a massive operation with 1,800 employees and more than 500 million rmb in annual revenue. If you’ve ever had a smoothie in Shanghai, you know them. I also talked to owners and real estate agents in New York and London, to establish a baseline. What I found: Shanghai rents are expensive, in terms of rent-to-revenue. New York and London rarely go above 10% and many cities operate well below that. But! Ristorante Italiano might be giving a larger slice of the pie to the landlord than if they were in New York, but that is completely, totally, unremarkably normal in Shanghai. All of the owners I spoke with considered the 15% zone to be standard. Some pay more. More than one owner told me 20% was the ceiling. So, Shanghai: expensive. But in Shanghai, expensive is normal, and Ristorante Italiano’s rent is unremarkable.One other point I want to make before we continue the lecture. Rent is often held up as the boogeyman when a restaurant circles the toilet, or gets flushed completely. That is retardedly simple. Wrong concept (Russian doughnut and pirogis), poor operations (i.e, your food sucks, your service staff are champion phone-starers), inaccurate sales forecasts (you thought you’d have a million customers a night; in reality, you have two), an imbalance between volume and how much each customer pays, and just plain old business mistakes are all in the mix too. Think about it this way: If you make 20,000 rmb a month, and you rented an apartment for 18,000 rmb a month, you are going to be hurting. But is the problem really that the rent is too high? Or is it that you rented the wrong apartment / don’t make enough money / didn’t marry the right person? Next!This is what you are talking about when you wonder why a Caprese salad costs four times the price in China than it does in Rome. The standard for food cost in the West is anywhere from 25% to 40% of total revenue, or even higher if you are at a fine-dining place. (High menu prices don’t always mean higher profit.) This one is hard to compare for a variety of complex reasons, including but not limited to the type of food/cuisine (pizza is a low cost/high margin food), the location (a common ingredient in Italy can be a premium one in Shanghai), the attentiveness of the cooks to food waste, the negotiation skills of whoever does the buying… But we have to start somewhere, so let’s start with this: Ristorante Italiano had a 36% cost in 2014.Now, that includes food and beverage, and a restaurant makes a whole lot more on that bottle of water or wine than they do on your steak, but again. Let’s call it 36% for comparison’s sake. On the high side. The owner sees this as the most frustrating part of the P&L puzzle. He buys buffalo mozzarella from Italy, at ten times the price he’d pay in Rome (says he), and his beef comes from Australia. He insists it’s the food quality that keeps the customers happy, and he doesn’t see how to cut costs without sacrificing quality. If only more owners in Shanghai thought like this! On the other hand, his mozzarella cost is serious but that’s offset in part by things that are cheaper here than they would be in Rome. Vegetables, for example.I wondered if maybe the high number just reflected a reality that cooking Western food in China means paying through the nose for imports, so I went back to my cabal of owners. One Shanghainese restaurant confirmed my theory (they have a food cost around 25%, and quality is good); another disproved it (they pay around 40%, and are not stupid). The Western owners? Eh. They don’t want to be paying 36% but see how it can happen. So while Ristorante Italiano would benefit from shaving a couple of percentage points off that figure, they are still mostly normal. (Despite all of this and despite asking the owner directly, I never figured out the mystery of why they charge almost 100 rmb for a simple aglio e olio pasta, made with dried De Cecco pasta -- or many of their other prices.) Onward.None of these items are as notable as the above two categories, but they do make for a couple Shanghai cocktail party factoids. In addition to business tax, did you know there is also a “river tax”? Ristorante Italiano squeezed 3,420 rmb out of their bank account for it in 2014. Or that Sherpa’s takes a cut not just from the person ordering from their couch but also from the restaurant? The men in orange made 68,106.10 rmb for delivering pizzas and pastas from this place in 2014. Do a little mental math -- how many restaurants on Sherpas ? -- you will wish you were Mark Secchia , Lead Sherpa. But these and other little things (pest control, business cards, paper towels, buying new chair coverings, taxis fare for your staff when they finish after the metro closes) are the fixed costs of the restaurant business, and there’s not a (legal) way around that.This is where things start to diverge for Ristorante Italiano and the truly successful restaurants in Shanghai. Over the course of 2014, Ristorante Italiano took in 6.84 million rmb, or enough to stay in The Peninsula’s Grand Deluxe River Suite (11,100 rmb per night) and have dinner at Ultraviolet (6000 rmb per person) every night of the year. After all the costs, however, they were left with 427,178 rmb, or 6%. Just enough for three nights in The Peninsula’s Presidential Suite . In strict return on investment terms, that’s not much different than if they had just taken that money to China Merchant’s or some other Chinese bank and put it in a simple investment.Lest that six-figure number seem big to you, think about it this way. There are three investors in Ristorante Italiano, including the owner / manager I keep referring to. That means the 427,178rmb is split three ways: 142,392rmb. Divide by 12 months: a bonus of about 11,700rmb per month. A bonus that the owner / manager will never see. The initial two million rmb investment in the restaurant has to come out of this profit (less depreciation costs, which are factored into the profit and loss sheet, and appear to be about 500,000 rmb over the restaurant’s five-year lease), and only now, after almost four years, has that been paid off. But the lease is only five years, a common term in Shanghai, leaving just one year where the profit might actually go into someone’s pocket. But then! That is just one year left on the lease: come 2016, Ristorante Italiano will either renew the lease but at a higher cost (which means our owner needs to start saving this little bonus to help offset the coming increase in rent) or Ristorante Italiano will move (which means our owner needs to start saving this money to pay for decorating a new restaurant in a new location).I’ve thought a lot about this situation and it’s led me a working theory for why restaurants seem to get worse over time. (Contrary to the popular thinking that a new restaurant needs time to find their feet and they get better as they age, I find that most Western restaurants in Shanghai are best when they first open -- when the owner is present, enthusiastic, and eager to make a good impression -- and then they go downhill as they slide into autopilot, and my theory starts to kick in. Opening is exciting. The day-to-day grind is not.)New York and London think that five-year leases are crazy. They operate on 10-year leases at a minimum and in London, sometimes up to 20 or 25 years. The long lease terms allow the owners to make their investment back without unreasonable pressure, stabilize their operations, build a brand, and then profit from their hard work. In Shanghai, the real estate market is young and volatile. Landlords aren’t usually willing to commit their property to a single operator for ten years (who knows what the real estate market is going to look like in ten years?), and their motivations don’t always seem like rational economic decisions. For these and other reasons, five-year lease terms are common in Shanghai.But think about that from a restaurant owner’s perspective. That means you have five years to get in, decorate, stabilize, pay off your investment and then try to make some money. It’s a highly accelerated schedule and it puts a ton of pressure on the owner to pay their investment off as quick as possible so they can get to the part of the business where they actually make some money. Most owners I spoke to said they try to pay back their investment in the first 18 to 24 months, leaving them 24-36 months to profit.But what happens when you, the owner, realize in Month 16 that things aren’t going as you expected, and at this rate, you are either not going to make your investment back in time to profit, or not going to make it back at all? Time to start cutting costs. That expensive skilled chef -- thanks but see you later. That fresh whole salmon flown in from Norway -- is anyone really going to notice if you switch to something cheaper? The complicated recipe that requires a bunch of ingredients and an inordinate amount of time -- shortcut! Follow this slash-and-burn theory to the bottom, and it’s not so hard to see how reprocessed oil (di gou you) becomes an economic, not an ethical, choice among the least scrupulous owners. Now, clearly this is a simplified theory of a complex chain of decisions, but I’ve run it by a few owners, and haven’t been shot down yet, so there you have it: my “they used to be better theory”.Compare Ristorante Italiano’s 6% to my owners circle. These restaurants are winners in this game, keep in mind, but their profit margins vary from 20-30% depending on month (except the high-end Shanghainese place, whose margin was chopped in half when the government turned the expense account faucet off). Over the course of a year, these successful places are making a 20-25% profit margin. One could argue that it’s a math distortion: the percentage looks high only because the actual numbers are small. At small restaurants, it might be true. But at others, where revenue is measured in tens or hundreds of millions of rmb, that is heavy money. Twenty, twenty five percent is unheard of in London or New York, or most anywhere else really, where owners hope -- wish -- for something around 10%. So how does this work? Where is the secret sauce that turns high rent into high profit?The simple truth is that people are cheap in China. Even if labor costs have gone up by about 40% in the last couple of years as new labor laws have come into effect and wages rise, and even if employers have to pay "social benefits", and even if they give their workers free housing in a company dorm (which the company rents; totally common). Even then, labor costs in Shanghai top out around 25%.At Ristorante Italiano, it’s slightly higher at 28%, a conscious decision by the owner to pay above market salaries in exchange for loyalty. That includes his own 30,000rmb salary, for being there every day, lunch and dinner, and helping in the kitchen as well. (Adding foreign chefs, whose salaries are around 25,000rmb -- if they’re good -- messes up the math, hence their relatively infrequent appearance at small restaurants.)In the West, labor costs and food costs are by far the biggest money pits, way more than the rent. New York and London face labor costs of 30% and higher, and in the US, that’s often with the de facto outsourcing of this cost to the customer, via tips.And therein is the big lesson in a Shanghai profit-and-loss sheet. Rents might be expensive in Shanghai -- but the rewards? The rewards can be high. If you get it right.Now for a little prevaricating. This conclusion assumes a narrow goal: making money. There are many others: a passion for food, a love of hospitality, wanting to get some status ("hey baby, let’s go eat at my restaurant tonight"), money laundering. It also sets profitability as the measure of achieving this goal. In many ways, Ristorante Italiano is successful. The grapevine told me that within a month of opening, the investors thought the place was doomed. Rent too high, space too small, chefs too expensive. Four years later, they are still around, they have not lost money, the owner is his own boss and he’s not a desk jockey. The ship is still floating. It has a loyal customer base, and while the restaurant is not so special to me, it is certainly special to the owner and a couple hundred of you in Shanghai. Seventy percent of the customers are regulars, according to the owner, and they come at least once a week. Money can’t be the only concern for the other two investors -- by that measure, they would have been better off gambling with Austen Morris. Ristorante Italiano makes a group of people happy.Unfortunately, happiness won’t pay your rent or mortgage, buy you health insurance or an education, or take you on vacation to San Sebastian. I’m of the opinion that sweating blood for four years to keep a neighborhood restaurant afloat -- not profitable, not a drain, definitely a cash trap -- is a steep price to pay.The owner is just nearing his payback on the initial investment, his lease is coming up and his profits exist primarily on paper -- it looks like he’ll walk away with a niche reputation, all the costs of opening, designing and decorating a new restaurant in a new location (assuming he finds/wants one) and not much more. And for that? "I am thankful," he told me. "So many Italian places open every day but my customers come back to me."Class dismissed!