Two years ago, St. Paul-based Punch Neapolitan Pizza’s strategic initiative to raise wages struck many in the industry as a stunt. Since then, though, the nine-unit chain has raised wages further, and the effort has been much chronicled and lauded, including by President Obama during his 2014 State of the Union address. The raises have been cited as a socially responsible template for an industry that has long relied on low wages and weak benefits. They also have been cited by critics to paint the rest of the industry as exploitive of its labor force.

From 2014 to 2016, Minnesota restaurants will have been hit with a 31 percent increase in minimum wage plus the impacts of the Affordable Care Act (ACA). Recently the city of Minneapolis proposed—then temporarily withdrew—a series of labor regulations that threatened changes in scheduling obligations and benefits costs.

Are times good enough for the hospitality industry to pay more? Americans are eating out like never before. A recent Bloomberg report indicated restaurant spending now outstrips grocery purchases in the U.S. Despite that, Minnesota eateries are crying uncle.

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Local developers and industry insiders cite a host of negative effects, including national chains that won’t locate in the state and local operators postponing expansion plans. One of them is Blue Plate Restaurant Group CEO David Burley (Freehouse, Lowry, Longfellow Grill). Wary of the next shoe to drop, he notes “I love doing business in Minneapolis. But how do you forecast out three years right now?”

Punch’s contrarian approach has been repeatedly cited to refute arguments like Burley’s, yet much is misunderstood about Punch’s wage initiative and its broader applicability to the local restaurant trade. And despite media reports and the suggestions of labor advocates, the effort has not made Punch more profitable, nor was it ever about social justice.

“I’m a do-gooder,” says Punch founder and co-owner John Sorrano. “A do-gooder for Punch.”

Higher wages as growth strategy

“We did decide to prioritize employees over profits, but that’s a small part of the story” says Punch co-owner John Puckett.

In 2013, when it was still hiring some employees at minimum wage, Punch decided to set an entry wage of $10 an hour (now $11), nearly $3 hour over Minnesota’s minimum wage.

What Punch embarked on was far more than a wage initiative. It was a rethinking of the company that required higher wages as a means to that end. “The core principles translate to any business,” says Puckett. “Are you willing as an owner to make the investment?

“We’re making a $3 million to $4 million investment in wages to deliver a commensurate increase in the quality of what we do. It is a lot of work. You have to create systems to measure your success.” Punch now carefully tracks everything from food quality to cleanliness to customer feedback.

The motivation was to solidify the quality of Punch’s food and service and position Punch for growth, stability and increased returns. “We look at it as a 10- to 20-year process,” says Sorrano. “We’re trying to build a great company.”

Puckett decided Punch could not build the type of company they wanted without stabilizing its labor base: “Two years ago we were having trouble attracting people and experiencing unacceptable levels of turnover.”

But Punch had flexibility because “we don’t have shareholders,” says Puckett.

That’s relevant because “training employees is very costly,” says Jenny Nyquist, Punch’s vice president of operations. But she is quick to remind that “turnover is costly. The waste involved with untrained employees is costly.”

Puckett and Sorrano’s wage initiative was rooted in a study of leaders in retail and hospitality. “Only two restaurant companies [Pal’s and Mighty Fine Burgers] have won the Malcolm Baldrige National Quality Awards,” says Puckett, “and what characterizes them is that they have incredibly low turnover and high sales per unit. It takes a low-turnover workforce to run that success.”

Punch Neapolitan Pizza Stores: 9

(Eagan in development)

Expansion targets: Ridgedale area, Vadnais Heights, Edina, Roseville

Annual revenue:

$2 million/store

Unit cost: $1 million to build

Given the growing conversation about living wages, the question is whether what Punch is doing is broadly applicable or if Punch is a high-profile outlier.

Privately held Punch’s unit profitability “is still as healthy as anyone in the industry,” says Puckett, of an industry where a 10 percent margin is considered solid and 5 percent more typical. But Punch has little in common with the bulk of locally owned eateries, which primarily employ tipped employees. Only one of its nine units has servers who are tipped, while the rest operate in a mode that the industry calls “fast casual.”

Fast-casual operates with a fraction of the employees of traditional restaurants and with substantially smaller real estate footprints, according to Gary Karp, executive vice president at food/restaurant analyst firm Technomic Inc. Punch says it outperforms most restaurants in this sector—doing $2 million in average unit volume in a niche where half that would be considered solid. (Technomic estimates Punch earns $1.63 million per unit.)

That’s important because “you need an incredibly craveable product” that allows revenues well in excess of average. Puckett and Sorrano believe that ace in the hole allows them to add labor overhead with little risk.

“You can’t make that kind of investment,” says Puckett “on a typical $700 million [in annual unit revenue].” He says Punch’s outsize success has given it the flexibility to make the investments in labor and systems.

And it doesn’t hurt, Puckett adds, that “our customer base likes that we are treating employees well.”

Cue the best practices

There was a time when Punch was run by the instincts of its co-partners. “We used to be all gut and do it our way,” says Sorrano. “But we’ve come to believe that you can’t grow [number of stores] to double digits and do it that way.”

The company believes the key is instituting best practices to improve quality, systematize operations and deliver consistency to customers. “We’ve studied Costco and In n’ Out Burger—category leaders,” says Puckett. “We’ve found they are also leaders on compensation.”

Punch has created defined pathways for career and income growth within its stores. This allows employees to work toward promotions and Punch to provide numerous layers of opportunity for evolution.

They are also leaders in training and believe in old-school apprenticeship. “At In ‘n Out you can’t start as a manager,” says Puckett, “so we’ve established an eight-level system” employees progress through (see graphic, above), and a training regimen called Punch University.

“It’s designed to move people on that path,” says Sorrano, “which is why we’ve gotta grow.”

The results have satisfied Puckett and Sorrano, despite uneven revenue trends (see chart, below) and a hit in profitability. “Our quality of employee is significantly better than [those of] our primary competition,” Puckett says. The downside is “we’re running 17 percent higher in labor cost. . . . The cost [of paying people more] hits immediately, but the savings take time.”

Over a barrel on overhead

If most fast-casual restaurants could not sustain Punch’s wages, what does that say for the full-service tip-based model, the most common independent restaurant format? Substantial full-service restaurants employ two to three times the staff as a fast-casual restaurant and have seen wages rise by a third since the state started raising minimum wages.

Technomic’s Karp says many full-service restaurateurs are trying to adjust their concepts “to try to get into the fast-casual space.”

“We will have less full-service casual restaurants,” adds Blue Plate’s Burley. “You will have to get used to standing in line to order and never seeing a server after your food is delivered.“

For restaurants that stay the course, “all of us our going to have to take price increases,” says chef and restaurateur Scott Foster, who co-owns Nova Restaurant Group, which operates five restaurants in the west Twin Cities suburbs and Rochester. But Burley says price hikes are fraught with risk for operators like Blue Plate that market a value proposition. “I don’t think of fast-casual or quick service as our competition, but our guests are starting to,” he says. “Five Guys has a damn good burger. Is mine worth two times as much?”

Blue Plate’s profitability has been squeezed because “our labor and benefits are running 41 percent [of overhead, up from 38 percent in 2013], the highest it’s ever been.” This is a refrain heard repeatedly from restaurateurs trying to hit a 30 to 35 percent labor benchmark, but watching it creep up and up.

One high-volume restaurateur that caters to a business clientele but did not want to be identified notes, “I’m already charging $10.95 for bacon and eggs. People won’t pay more.” And wage pressures are not likely to abate. One much-discussed initiative is a $15 minimum wage, already in place in Seattle and San Francisco. “I wouldn’t object to a $15 minimum wage with a tip credit (lower base wage for tipped employees),” says Burley. “That would stabilize casual dining.”

The alternative is a fundamental change in the restaurant matrix. Burley, an Australian native, notes that in his homeland “restaurants are far more expensive, and as a result people don’t eat out as much.”

What the American restaurant wage and benefit environment buys diners is convenience. We are the land of the all-day restaurant, lavishly staffed to offer quick service and consummate flexibility. Continued increases in overhead could drive restaurants to a more European model, with limited meal hours, small footprints and less staff.

For now, operators are treading cautiously, and many aren’t expanding. “Absolutely it’s delayed our next project,” says Burley. “When Minneapolis started talking about the big scheduling and benefit changes, we had a deal done in Northeast; I had hired an architect. We pulled the plug on it.”

Foster has a more optimistic take. “The only way to win in this environment is to grow sales. My mindset is not to cut back, but try to do better.

Still, this ambition is rooted in a precarious paradigm: “If you can’t do $4 million to $5 million revenue per [full-service restaurant] in the current environment, you can’t make money or justify” growth, says Foster’s partner Pat Woodring. “It’s grow or die.”

This article is reprinted in partnership with Twin Cities Business.