Journal of Hospitality Financial Management e Professional Refereed Journal of the Association of Hospitality Financial Management Educators Volume 24 | Issue 2 Article 5 11-14-2016 ACTIVITY-BASED COSTING IN THE RESTAUNT INDUSTRY: WHAT’S PAST IS PROLOGUE Carola Raab William F. Harrah College of Hotel Administration, University of Nevada, Las Vegas, NV Dina Marie Zemke William F. Harrah College of Hotel Administration, University of Nevada, Las Vegas, NV Follow this and additional works at: hps://scholarworks.umass.edu/jhfm is Refereed Article is brought to you for free and open access by ScholarWorks@UMass Amherst. It has been accepted for inclusion in Journal of Hospitality Financial Management by an authorized editor of ScholarWorks@UMass Amherst. For more information, please contact [email protected]. Recommended Citation Raab, Carola and Zemke, Dina Marie (2016) "ACTIVITY-BASED COSTING IN THE RESTAUNT INDUSTRY: WHAT’S PAST IS PROLOGUE," Journal of Hospitality Financial Management: Vol. 24 : Iss. 2 , Article 5. DOI: 10.1080/10913211.2016.1239488 Available at: hps://scholarworks.umass.edu/jhfm/vol24/iss2/5 brought to you by CORE View metadata, citation and similar papers at core.ac.uk provided by ScholarWorks@UMass Amherst
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Journal of Hospitality Financial ManagementThe Professional Refereed Journal of the Association of Hospitality FinancialManagement Educators
Volume 24 | Issue 2 Article 5
11-14-2016
ACTIVITY-BASED COSTING IN THERESTAURANT INDUSTRY: WHAT’S PAST ISPROLOGUECarola RaabWilliam F. Harrah College of Hotel Administration, University of Nevada, Las Vegas, NV
Dina Marie ZemkeWilliam F. Harrah College of Hotel Administration, University of Nevada, Las Vegas, NV
Follow this and additional works at: https://scholarworks.umass.edu/jhfm
This Refereed Article is brought to you for free and open access by ScholarWorks@UMass Amherst. It has been accepted for inclusion in Journal ofHospitality Financial Management by an authorized editor of ScholarWorks@UMass Amherst. For more information, please [email protected].
Recommended CitationRaab, Carola and Zemke, Dina Marie (2016) "ACTIVITY-BASED COSTING IN THE RESTAURANT INDUSTRY: WHAT’SPAST IS PROLOGUE," Journal of Hospitality Financial Management: Vol. 24 : Iss. 2 , Article 5.DOI: 10.1080/10913211.2016.1239488Available at: https://scholarworks.umass.edu/jhfm/vol24/iss2/5
brought to you by COREView metadata, citation and similar papers at core.ac.uk
ACTIVITY-BASED COSTING IN THE RESTAURANT INDUSTRY: WHAT’S PAST ISPROLOGUE
Carola Raab and Dina Marie Zemke
William F. Harrah College of Hotel Administration, University of Nevada, Las Vegas, NV
ABSTRACT. Restaurant managers often do not have a comprehensive understanding of all ofthe costs involved in operating a successful restaurant, leading to inaccurate, and potentiallyunprofitable, menu item pricing. One trend in cost analysis is to explore techniques used inother industries, including activity-based costing. A body of work exploring the application ofactivity-based costing in the foodservice industry has gradually evolved. A review of previousresearch on activity-based costing in various restaurant segments validates it as aconsequential approach that is capable of reducing waste, preserving employment, andproducing maintainable profitability in the restaurant industry.
INTRODUCTION
The restaurant industry is a challengingbusiness. Today’s restaurant customers areincreasingly sophisticated regarding food andservice quality. Restaurant managers facenumerous difficulties in achieving ongoingprofitability. Profit margins are usually relativelylow, leaving no margin of error for operatormistakes (LeBruto, Ashley, & Quian, 1997;Taylor & Brown, 2007). Restaurant managersare also often challenged by marketing andfinance tasks (Raab, Mayer, Shoemaker, & Ng,2009). Most restaurants’ marketing activitiesconsist of promotions to increase sales volume,such as discounting menu prices, often resultingin increased volume but decreased profitability.Overreliance on discounting and other pro-motions gradually erodes the restaurant’sfinancial position, leading to the restaurant’sgoing out of business. A primary driver of thisdownward spiral is that restaurant managers donot have a comprehensive understanding of allcosts involved in sustaining a successfulrestaurant (Raab & Mayer, 2007).
Identifying variable costs, such as food cost,is fairly intuitive for novice restaurant owners,
who use them to set menu item prices.However, they often overlook the effect ofoverhead costs, even failing to account for laborcosts associated with food and beveragepreparation and service. This is a primarycontributor to restaurant failure. More experi-enced food and beverage operators account foroverhead costs when setting menu prices andperforming breakeven analysis. A current trendin cost analysis is to explore techniques fromother industries, such as manufacturing, toimprove the accuracy of cost identification.Onesuch technique is activity-based costing (ABC).
A body of work exploring the application ofABC in the hospitality industry has graduallyevolved. The technique has been demon-strated in a wide variety of foodservice andhotel applications (Pavlatos, 2009). However, itis appropriate at this point in ABC’s evolution tolook at past restaurant ABC research, its effecton traditional ABC theories, and its potentialfuture effect on the restaurant industry. Thestudies discussed here illustrate how ABC canbe applied in different restaurant segments andhow this application complements traditionalmethods in manufacturing.
Address correspondence to Carola Raab, William F. Harrah College of Hotel Administration, University of Nevada, Las Vegas, 4505S. Maryland Pkwy, Box 456021, Las Vegas, NV 89154, USA. Email: [email protected]
Color versions of one or more of the figures in the article can be found online at www.tandfonline.com/uhfm.
The Journal of Hospitality Financial Management, 24:133–146, 2016
Copyright q International Association of Hospitality Financial Management Education
Overview of Cost Allocation and Pricingin the Restaurant Industry
The restaurant industry commonly uses thecontribution margin approach to establishmenu prices. This process sets a menu item’sselling price on the basis of a desired foodcost percentage. The expectation is that thedifference between a menu item’s price andfood cost will cover overhead costs (such aslabor costs, marketing costs, utility costs), alongwith taxes and profits (Raab & Mayer, 2004).Once selling prices are set, operators onlychange prices if variable costs (specifically, foodcost and beverage cost) change, but theyrarely actually analyze their menu items forprofitability.
Managers often find it difficult to identifythe reason why their restaurants lose money.If the selling price is based solely on variablecosts, the menu prices might not result inprofitability, because management has animprecise knowledge of total menu item costs(variable cost plus overhead costs). A menuitem price may be low, with a low food cost,but could be labor-intensive to prepare, thusincurring high overhead costs that must beintegrated into the selling price.
Previous research established that, in highlycompetitive markets, prices cannot be set solelyon the basis of variable costs. Researchersapplied ABC as an alternative approach
(Annaraud, Raab, & Schrock, 2008; Ben HadjSalem-Mhamdia & Bejar Ghadhab, 2012;Raab, Hertzman, Mayer, & Bell, 2006; Raab,Mayer, Ramdeen, & Ng, 2005; Raab, Mayer, &Shoemaker, 2009; Raab, Shoemaker, & Mayer,2007). For an overview of past research, pleaserefer to Table 1.
What Is ABC?
ABC is a theoretical approach that providesmanufacturing and service firms with a bettercomprehension of their costs, greatly enhancingtraditional contribution margin approaches(Cooper & Kaplan, 1988a; Kaplan, 2000;Rotch, 2000). ABC’s major advantage overother costing methods is its ability to trace themost expensive overhead costs to individualproducts and not to merely allocate them.
One condition that makes companies goodcandidates for applying ABC is a diversity ofresource consumption, where product andresource consumption are not correlated withtraditional cost allocation methods. Thischaracteristic is certainly present in thefoodservice industry. For example, each menuitem utilizes different types and amounts offood and preparation time.
Advantages of Applying ABC to theRestaurant Industry
Today, overhead expenses represent abouthalf of all restaurant costs. Labor costs,
TABLE 1. Summary of Activity-Based Costing in the Hospitality Literature
Author(s) Year ABC application and setting
Raab and Mayer 2004 Explored the use of ABC in the U.S. restaurant industryRaab, Mayer, Ramdeen, and Ng 2005 Applied ABC in a Hong Kong restaurantRaab, Shoemaker, and Mayer 2007 Demonstrated the application of ABC in a fine dining restaurantRaab, Hertzman, Mayer, and Bell 2006 Incorporated ABC into a menu engineering analysisRaab and Mayer 2007 Applied ABC menu engineering to a buffet restaurantAnnaraud, Raab, and Schrock 2008 Applied ABC in a quick-service restaurantVaughn, Raab, and Nelson 2010 Application of ABC to a support kitchen in a casinoRaab, Mayer, Shoemaker, and Ng 2009 Activity-based pricing applied to a Hong Kong restaurantRaab, Mayer, and Shoemaker 2009 Exploratory study that used an ABC/CM profit factor
comparison approachVaughn, Raab, and Nelson 2010 ABC applied to a support kitchen in a casinoBen Hadj Salem-Mhamdia and Bejar Ghadhab 2012 Combined value management and ABC in a Tunisian restaurant
Note. ABC ¼ activity-based costing; CM ¼ contribution margin.
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considered a part of the restaurant’s overhead,usually make up the largest proportion oftotal cost. However, overhead costs are rarelyconsidered when product prices are estab-lished, which are usually calculated strictly as afunction of cost of goods sold, plus a percentagefor markup (LeBruto et al., 1997; Taylor &Brown, 2007).
ABC traces overhead costs to individualmenu items, enhancing managerial decisionmaking. Given that overhead costs represent alarge share of total costs, assigning this cost toindividual menu items is beneficial, especiallyfor marketing tasks such menu pricing andpromotional activities, to ensure profitability.
ABC also assists in pinpointing profitablemarket segments by identifying true menu itemcosts. At present, restaurant managers often donot understand the differences in profitabilitybetween each customer segment because theydo not know the actual profit margins of theirmenu items. ABC helps management deter-mine which menu items are truly profitableand also helps identify who the most profitablecustomers are by tracing these products to thecustomer. Thus, marketing dollars can be spentmore efficiently by targeting the most profitablecustomer segments.
Another advantage of the ABC method isits inherent emphasis on activities, which canimprove the service production and deliveryprocess. A deep understanding of productionactivities allows better control of labor costswithout decreasing the level of serviceprovided to the customer. This assists inreducing organizational waste and servicedelays, improving customer and employeesatisfaction, operational efficiency, andcooperation between back-of-the-house(BOH) and front-of-the-house (FOH) oper-ations. A more efficient, process-orientedorganization should achieve increased laborproductivity, thereby decreasing labor costsdirectly and indirectly.
The remainder of this article reviewsABC’s theoretical basis and its basic principles.The article then traces the evolution of ABCthrough the application to different restaurantsegments.
ABC Theoretical Framework
In the past, economists have embraced theidea that only marginal (variable) costs shouldbe considered to set prices and fixed costsshould be ignored as sunk costs, which arethen arbitrarily allocated. However, all costsare ultimately variable (Cooper, 2000). ABCassumes that overhead is not consumed inproportion to the number of units produced(Cooper and Kaplan, 1988a; Kaplan, 2000;Cooper, 2000; Horngren, Datar, & Foster,2007). Activities are traced to the actualproduct that triggered the activity, permittingassignment of costs to the product itself (Cooper& Kaplan, 1991, 1992; Horngren et al., 2007;McNair, 2007).
ABC has been used extensively in manu-facturing to track direct overhead costs toindividual production items. As product linesexpand, overhead commitments increase tosupport product diversity (Cooper & Kaplan,1988a; Cooper & Kaplan 1991; Horngrenet al., 2007). Cooper and Kaplan (1988a)established ABC to assist manufacturingmanagement to understand indirect costs on aper unit basis (O’Guin, 1991), and Cooper andKaplan (1988a) demonstrated that ABC aug-ments contribution margin analysis. The mostrecognized benefit of ABC is the insight intomanaging the activities that lead to undistrib-uted costs (Cooper, 2000). Consequently, ABCleads to a very good estimate of undistributedcosts on a per-unit basis. Managers can estimatetotal costs per unit in a way that is not possiblewith contribution margin-based cost analysis.
The Evolution of ABC in the RestaurantIndustry
Characteristics that make an operation acandidate for ABC include “diversity ofresource consumption, products and resourceconsumption not correlated with traditional,volume-based allocation measures” (Rotch,2000, p. 68). These characteristics describethe foodservice industry, which Kock (1995)recommended as fertile ground for combiningABC with more traditional restaurant-basedapproaches. Thus, researchers applied ABC
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to several restaurant segments, including finedining, buffet, quick service, and casinosupport kitchens (Annaraud et al., 2008; Raab& Mayer, 2004; Raab et al., 2005; Raab et al.,2006; Raab et al., 2007; Raab & Mayer, 2007;Vaughn et al., 2010). A step-by-step guide toapplying ABC is provided in the Appendix.
State of the Industry. Raab and Mayer(2004) surveyed comptrollers and managers ofthe top 100 restaurant firms in the UnitedStates to explore the potential for applyingABC in restaurants. They inquired about therespondents’ knowledge of ABC theory and theuse of ABC in their restaurants. The resultsshowed that ABC was not applied in the top100 U.S. restaurant companies. In addition,respondents stated that they were aware ofthe concept but did not know how to apply itand suggested a need to enhance traditionalcontribution margin approaches.
Buffet Restaurants. Raab and colleagues(2005) applied ABC to a buffet restaurant inHong Kong. The researchers traced labor anddirect operating costs to the buffet entrees andallocated the rest of the costs to a facility-sustaining cost pool (see Figure 1).
Traditional ABC methods had to be alteredto calculate ABC costs for the buffet. First, a billof activity for each customer had to beconstructed because FOH activities werehomogeneous for each customer. True resourceconsumption was only found in the BOH,which was then reflected in an additional bill ofactivity per buffet entree containing only thefood costs and BOH batch-level cost for the
item. The results revealed that the restaurantwas losing HK$33 on each buffet dinner sold.
A menu engineering approach for buffetswas then developed, applied first to variablecosts and then to the established ABC cost.Raab andMayer (2007) discussed this approachin detail, examining whether the combinedmethod provides new insights about true menuprofitability. The combination resulted in a newapproach that allows for accurate managementdecisions regarding what items to include inthe buffet menu, which is an especially usefultool for unprofitable operations. The authorsobserved that, contrary to restaurants in otherparts of the world, labor costs in Hong Kongwere relatively low, while facility-sustainingcosts such as rents were relatively high,diminishing the effectiveness of the ABCanalysis.
Fine Dining Restaurants. Raab andcolleagues (2007) then tested Raab andcolleagues’ (2005) model in a fine diningrestaurant in the United States. Although thestudy also traced labor and direct operatingcosts to dinner entrees, the nature of thisrestaurant segment allows for one bill of activityper menu item, which is quite different fromthe aforementioned buffet restaurant.
Other characteristics also differed from theHong Kong example. First, labor costs tend tobe higher and occupancy costs are lower in theUnited States than in Hong Kong. Therefore,tracing labor to individual products is moreproductive than in the Hong Kong. Facility-sustaining costs are also generally lower in the
FIGURE 1. ABC model for buffets (adapted from Cooper & Kaplan, 1988a).
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United States, which should allow for a lowallocation value (total facility-sustaining costs/number of units sold). However, in this case, therestaurant sold a low volume of entrees, leadingto a relatively high allocation value. This distortedthe ABC calculation, although it did reflect thebusiness situation accurately. In addition, theresearchers observed that, for both restaurants, itwas not efficient to trace direct operating costs;they thus concluded that the model should bealtered to include these costs in the facility-sustaining cost pool (see Figure 2).Ultimately, theresults confirmed that ABC feasibility in estab-lishing overall menu profitability.
ABC Plus Menu Engineering. The con-tribution margin-based menu engineeringmodel for buffets and fine dining was thentransformed into an ABC-based menu engin-eering model, by replacing food cost with totalcost—activity-based cost (Raab, Hertzman,Mayer, & Bell, 2006; Raab & Mayer, 2007).Both approaches were applied, and the resultswere compared. The traditional menu engin-eering analysis showed a positive overallcontribution margin for the menu, but theABC approach revealed a negative overalloperating profit. Understanding the true costswould not have been possible using traditionalcontribution margin-based menu engineeringmethods alone. The effort required to applyABC in a restaurant is worthwhile to compre-hend menu profitability.
Quick Service Restaurants. Annaraudand colleagues (2008) adapted the modeldisplayed in Figure 2, for a quick-service
restaurant in Southeastern United States. Therevised model included a utility cost pool, andutilities (e.g., electricity, water, and natural gas)were successfully traced to individual menuitems for the first time. A single activity centerwas used (see Figure 3), given that FOH andBOH activities are indistinguishable in thisrestaurant segment, which provides little or noFOH service. A comparison of contributionmargin results and ABC outcomes confirmedissues central to traditional manufacturing ABCliterature—that traditional methods yield mis-guided cost information and product prices.Here, only two menu items showed positiveoperating profits. This study confirms that ABCis a superior method for establishing overallmenu profitability and that managementdecisions will improve dramatically if showndiffering results from a contribution marginanalysis and an ABC approach.
Price Sensitivity. Raab, Mayer, Shoe-maker, and Ng (2009) incorporated ABC in aprice sensitivity analysis for a buffet restaurant.Combining the pricing and costing activitiesresulted in an activity-based pricing model forrestaurants. The integrated approach proved tobe superior by incorporating the customers’price perceptions and the total cost per buffet.This study demonstrated that either methodby itself would have not been sufficient tounderstand the restaurant’s total profitabilitypicture; ABC’s effectiveness is magnified whencombined with pricing data.
Profit Factor Analysis. Raab, Mayer, andShoemaker (2009) tested for differences
FIGURE 2. ABC model for restaurants (adapted from Raab, Mayer, Ramdeen, & Ng, 2005).
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between contribution margin and ABCmethods, using the model displayed in Figure4, which incorporated a profit factor analysis,introducing another dimension of relativeprofitability to the ABC research. The studytested four hypotheses and found no significantcorrelation between the contribution marginand ABC methods, which suggests that they arevery different methods. These findings supportprevious ABC research, indicating that ABC is asuperior method in general, simply because itincludes all costs.
Support Kitchens. Vaughn, Raab, andNelson (2010) tested the ABC approach in abakery support kitchen in a casino-resort’shotel; the support kitchen provides bakedgoods to all of the foodservice outlets in theproperty and does not have any FOHoperations. ABC methods were again com-pared with traditional allocation approaches,applying Raab and Mayer’s (2007) model to
test whether traditional allocation methods thatare based on food costs yield incorrect resultsand should be eliminated. The results showedthat ABC methods can be applied successfullyin support kitchens, with immense impact.Without the benefit of the ABC analysis,restaurant managers for individual food andbeverage outlets received an unfair share of theoverhead and did not have appropriate costinformation for bread products. Major changeswere incorporated at the property followingthe study’s recommendations, where itemsthat were previously outsourced were nowproduced in-house, and some items that wereproduced before were now outsourced.
Value Management. Ben Hadj Salem-Mhamdia and Bejar Ghadhab (2012) extendedABC research by testing whether an ABCapproach combined with value managementcan improve menu profitability. The studyused the ABC/value management method in
FIGURE 4. ABC model for Baker support kitchen (adapted from Annaraud, Raab, & Schrock, 2008).
FIGURE 3. ABC model for quick-service restaurants (adapted from Cooper & Kaplan, 1988; Raab, Mayer, Ramdeen, & Ng, 2005).
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a Tunisian restaurant to obtain the best value,using customer satisfaction and total productcost. The study specifically broadens Raab,Mayer, Shoemaker, and Ng’s (2009) research,which merged ABC and price sensitivityanalysis. Data were collected using directobservations of restaurant activities to calculateABC and menu item earnings, and a ques-tionnaire was administered to determinecustomer satisfaction.
The study showed that the ABC/valuemanagement approach yields different resultsthan traditional menu analysis. Ben HadjSalem-Mhamdia and Bejar Ghadhab calculatedearnings per menu item and, at the same time,evaluated customer satisfaction for each item.The authors concluded that the study con-firmed the results from previous ABC research,specifically stating that ABC is a feasible way ofproduct costing.
IMPLICATIONS
ABC has evolved over time to create avariety of tools to help both foodservicemanagers and hospitality scholars gain a greaterunderstanding of the full range of costsassociatedwith providing a restaurant’s product.
Theoretical Implications
Traditional ABC systems work effectively inadvanced manufacturing environments, whichshifted from labor-intensive to capital-intensiveconditions, and make traditional methodsof overhead allocations on the basis of directlabor hours obsolete (Cooper 2000; Cooper &Kaplan, 1991, 1992). When ABC is applied to amanufacturing setting, the greatest opportunityfor productivity improvement can be achievedby concentrating on batch and product-sustaining activities (Cooper & Kaplan, 1991).
In contrast, the best chance of improvingrestaurant productivity is through enhancing alllevels of activities, because manual labor isstill a crucial part of restaurant production andservice processes. Technological advancesthat dramatically impacted the manufacturingenvironment have not yet happened to thesame extent in restaurants. Therefore, the
restaurant industry can profit from ABC theoryby focusing on unit-level activities with thesame intensity that traditional theory suggestsfor batch and product-sustaining activities. Thecost structure of restaurants also differs fromother industries by classifying direct labor as apart of overhead costs, while direct labor in themanufacturing industry is classified as a variablecost that can be assigned to individual productswithout the application of ABC. Restaurantscan benefit greatly from the application of ABCby tracing labor costs, along with food andbeverage costs, to individual products.
Next, Cooper’s (1989) two-stage ABCprocess is applicable to restaurants, givensome modifications. O’Guin (1991) suggestedthat ABC systems designed for the manufactur-ing industry should be as simple as possible.The studies discussed in this article observedthat ABC systems for restaurants must be simpleto make them easy for restaurant managersto understand and feasible to implement. Forexample, the model that proved to be mosteffective in restaurants is one with only twocost pools, labor and facility-sustaining (seeFigure 3). In addition, traditional ABC theory(Cooper & Kaplan, 1991; O’Guin, 1991;Turney, 1991) suggests establishing numerousactivity centers for complex manufacturingstructures, while in restaurants, activity centerscan simply be identified as FOH or BOH.
Traditional ABC theorists suggest that aprocess value analysis should be performed toidentify the value of all activities. However,processes are difficult to standardize in therestaurant industry because of the industry’slabor-intensive nature. In general, a largepercentage of activities in the restaurant industryare non–value-added, which may explain whyrestaurants traditionally have high labor costsand low profit margins. Even though most non–value-added activities cannot be eliminatedor automated in restaurants, as recommendedby traditional ABC theory (Cooper & Kaplan,1991), a process value analysis is crucial toidentify how these activities can be conductedmore efficiently or outsourced.
Next, traditional ABC theory suggests thatoverhead costs should be traced to individual
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products as often as possible to gain preciseknowledge about product costs (Cooper &Kaplan, 1991). In restaurants, it is most efficientto trace labor costs to menu items and toallocate the rest of the overhead cost. This isparticularly true for North American restau-rants, where labor costs are, in general,relatively high. The ABC model shown inFigure 2 works best in North America whenspecifying only two cost pools. In Asia, laborcosts are lower and occupancy costs, such asrent, are higher. Occupancy costs are facility-sustaining costs that require allocation, makingthe system less efficient. Restaurants with lowbusiness activity (i.e., low production volume)have high allocation values. Managementshould evaluate high allocation values andconduct what-if analyses to estimate allocationvalues at different business levels and takeaction to increase business. However, facility-sustaining costs were low in most locationstested in the previous literature, and thereforecould be allocated accurately. The phenom-enon of fluctuating allocation values also differsfrom traditional theory.
Bills of activities suggested by traditionalABC theory (Cooper & Kaplan, 1988b) must bemodified, depending on the restaurant seg-ment’s characteristics. For example, two bills ofactivities were needed for a buffet restaurant—one per customer and one containing onlyBOH batch-level activities and food costs forthe buffet item (Raab et al., 2005).
Next, some of the studies reveal apotentiating effect that occurs when combiningABC and other theories or methods, such ascombining ABC with price sensitivity,menu engineering, or value management. Forexample, ABC in restaurants provides infor-mation about non-value added activities andpromotes waste elimination. Moreover, ABCdelivered total cost information that promoteslow-cost and high-quality product designs andinformation about desired target markets.Vaughn and colleagues (2010) found that ABCaids in accurate make-or-buy decisions in asupport kitchen. Most important, the researchshows that ABC in restaurants facilitates properpricing strategies and profitability information,
crucial for restaurants’ survivals in a hypercom-petitive market.
Managerial Implications
ABC techniques yield several implemen-tation challenges for restaurant managers, butalso provide enormous opportunities for robustmenu costing and overall profitability. First,separating overhead costs into homogenouscost pools and their assignment to activitycenters reveal exactly where major overheadcosts occur, a fact often not clearly observed bymost managers. Managers can then use processvalue analysis to improve non–value-addedactivities, which should assist in reducing laborcosts. Processes that do not add value need tobe eliminated or reengineered.
Managers can further use ABC/menuengineering analysis to reevaluate whichmenu items to retain or improve and whichitems to reprice, according to market conditionsand customer demand. Managers shouldconcentrate on market segments that purchasethe most profitable items; all unprofitable menuitems should be eliminated, except for itemsthat are priced low for promotional purposes.Most of the ABC analyses in the previousresearch revealed some menu items thatwere not profitable; every time a restaurantsells these items, it loses money. Managementneeds to examine these items to increaseprices, or rework the recipe to reduce theABC basis.
THE FUTURE OF ABC
The research on ABC in various restaurantsegments validates ABC as an innovativemethod to assist restaurants in achievingprofitability. Even though ABC in restaurantshas been the topic of 11 studies discussed inthis article, it is unknown how many restaurantsactually apply ABC.
We have discussed ABC with restaurantmanagers, who say, “ABC can’t be done,because we’ve never done it before and wedo not know how.” These managers say thatthey are aware of the concept of ABC butdo not implement it and mostly still use
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contribution margin approaches to costingand pricing (J. Yedlin and D. Woods, personalinterviews, January 6, 2016). Others mentionthat they partially apply ABC by assigning directlabor costs to individual menu items (Raab &Mayer, 2004).
A review of the recent practices of thetop 100 revenue producing restaurant firmsin the United States revealed that sometop-producing restaurant chains, such asMcDonald’s and Pizza Hut, do use ABC tocapture true costs and to enhance the valuechain of their operations (Sadderman, 2015;“SCA Case Study McDonalds,” 2013). Giventhat ABC is particularly useful in determiningunit labor costs, more restaurant firms can beexpected to follow suit. Once managers andemployees comprehend the true benefits of anABC system, they can manage the restaurantand execute tasks in a profitable manner whiledelivering value to the customer, improvingthe business’ sustainability.
There is also a clear need to combineABC in with other management systems. Forexample, Noone and Griffin (1997) suggestedthat combining revenue and cost data can yieldcrucial information about the customer andproduct mixes and can enhance profit max-imization in general. Huefner and Largay(2008) emphasized the importance of costs instrategic pricing decisions, and Burgess andBryant (2001) proposed that costs must beidentified to support revenue managementdecisions. Even though revenue managementfocuses on pricing, profitability, and thereforecosts, must be considered. Cost cutting isoften applied to enhance profitability inrestaurants. However, cost cutting has its limits,and revenue growth is necessary to achieveprofitability (Huefner & Largay, 2008; Mass,2005). Even though ABC is not a cost-cuttingmethod, it provides an excellent estimate ofoverhead costs for individual menu items and isa suitable complement to revenue manage-ment methods.
Many restaurants have applied revenuemanagement-type practices (Kimes, Chase,Choi, Lee, & Ngonzi, 1998), but theseapproaches are at best tactical and consist
mostly of some sort of discounting approach.Restaurants generally have low variable costsand relatively high fixed costs, making themcandidates for revenue management methods.Some overhead costs, such as labor andutilities, are not strictly fixed costs but have avariable portion that fluctuates with salesvolume. Discounting without knowing over-head costs per unit can be, and often is,detrimental to restaurants. Combining ABCwith revenue management methods is essentialfor demand-based pricing in restaurants.
The future of ABC will be its amalgamationwith other established management methods,such as revenue management. Future researchshould reinvestigate restaurant managers’knowledge and use of ABC, and should applyABC to measure the impact of sustainablepractices on costs and restaurants’ profitability.Disseminating the benefits of ABC andimproving the education process will alsospread awareness and use of this technique tostrengthen the restaurant industry’s perform-ance and profitability.
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APPENDIX. APPLYING ABC IN THERESTAURANT INDUSTRY
This appendix provides a step-by-step guide to implementingactivity-based costing (ABC) in a foodservice operation.
PHASE 1: IDENTIFY AND COLLECT DATA;PERFORM CONTRIBUTION MARGINMENU ENGINEERING
Step 1
The first step in the ABC process is meeting with managersand employees to explain the ABC concept and its benefits. Thisdiscussion should include how to determine the objectives ofimplementing ABC. Potential objectives include tracing overheadcosts to menu items and establishing correct menu item costs.Production processes need to be improved by identifying andreducing non–value-added activities.
Step 2
Next, the restaurant’s current pricing method for menuitems must be determined. Then select which menu items toanalyze. At this time, the concept of menu engineering should beexplained.
Step 3
Identify the processes to obtain the necessary data toconduct menu engineering, for example, monthly total salesnumbers and food cost for each menu item. The method forobtaining cost information from the General Ledger should alsobe discussed.
Step 4
Using the data gathered from Step 3, conduct contributionmargin menu engineering.
PHASE 2: DESIGN THE ABC SYSTEM
The next phase is to design the ABC system for a restaurantoperation. Appendix Figure 1 represents a generic restaurant ABCmodel adapted from Cooper and Kaplan (1988).
Step 1
The restaurant’s activities must be identified and flow-charted. Each step is labeled as either value-added or non–value-added. Here, only activities that actually produce the product orprovide service to the customer are value-added (Raab & Mayer,2004). Major activities in the restaurant industry includepurchasing, receiving, storing, preparing food, cooking, cleaning,setting up dining room, seating customers, taking orders,ordering, serving food and beverages, maintaining tables, cashingout customers, and communicating with customers.
Step 2
Activity centers are then created, which are established bycombining homogenous processes. For most restaurants, activitycenters are created separately for the FOH and the BOH areas.Each area’s activities can be combined into activity centers, suchas back of the house (purchasing, receiving, storage, preparationand cooking) and front of the house (seat people, takereservations, take orders, order on the POS system, serve foodand beverages, make beverages, table maintenance, cash outcustomers, customer communication, set tables, set side stations,fold napkins, polish silver).
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Next, examine overhead costs in the general ledger.Separate overhead costs into homogeneous cost pools.Homogeneous cost pools are a collection of overhead costs forwhich cost variations can be explained by a single cost driver,where related accounts sharing a common purpose arecombined. For example, wages and employee benefits can becombined in an account called “costs of personnel,” which will beassigned to activities using a single cost driver (hours worked inFOH and BOH).
In Figure 1, restaurant overhead costs are displayed as part ofthe cost pools derived from the general ledger. According to the2002 Uniform System of Accounts for Restaurants, overhead costsinclude salaries and benefits, direct operating expenses, musicand entertainment, marketing, utility service, general andadministrative expenses, repair and maintenance, security,insurance, landscaping, and occupancy costs.
Step 4
On the basis of the two-stage model shown in Figure 1, thenext step involves assigning overhead costs to activity centers.In restaurants, one overhead cost pool can be “cost of personnel,”which includes the total costs of all wages and all employeebenefits. This cost pool is assigned to a department (e.g., FOH orBOH) by determining how much of it is incurred by eachdepartment. The cost driver “numbers of hours spent”incorporates the hours spent on all phases of producing food.To trace this cost to the activity center “back of the house,” allpersonnel costs incurred for the BOH are divided into theexpected action of the activity center, that is, the average hoursworked in food production. Assuming the total cost for the foodproduction-related staff is $10,000 per month, and the foodproduction staff worked 1,600hr per month, the pool rate equals$6.25 per hour worked ($10,000/1600 hr).
This pool rate is applied in the second stage of the costingprocess to determine howmuch of the “cost of personnel” is usedby each individual product (menu item). The same procedure isconducted for the FOH.
Other overhead pool costs are classified as facility-sustainingcosts, where no cost drivers can be determined. These types of
overhead costs cannot be traced to the product by means ofactivity centers, and are allocated bymeans of some arbitrary base,such as the number of items sold during the time period analyzed.
Step 5
The next step is to establish second stage cost drivers bydividing the total costs of each activity center (FOH and BOH) intocost driver pools. Activities are hierarchical, and unit cost driversenable activities to be grouped into four categories: unit-based,batch-related, product-sustaining, and/or facility-sustaining.
Unit Cost Drivers. These occur any time a unit isproduced; they are directly related to the number of unitsproduced. The number of employee hours and units of utilitiesused are unit-based cost drivers applicable to the restaurantindustry. For example, each time a guest orders a meal, laborhours are consumed by unit activities, such as taking the orderand preparing and serving the meal. Utilities (electricity, naturalgas) are used to produce the meal, and a unit-based driver is usedto measure the units of utility used per meal cooked.
Batch Cost Drivers. Examples of batch activities in arestaurant are kitchen line setup and purchasing supplies. Thenumber of setups and the number of times supplies are orderedare considered batch cost drivers. Batch drivers are not used intraditional cost systems but are appropriate in restaurants.
Product-Level Drivers. These signify resources con-sumed by product-level activities that sustain products in thecompany’s product line. Examples of product-level activities inthe restaurant business include establishing and maintainingspecifications, recipe testing, and expediting food production.
Facility-Sustaining Activities. This final category containscosts that sustain a company’s general processes, such asaccounting, marketing, property taxes, security, and landscaping.
Step 6
Assigning cost driver pools to products. Each of the costdriver pools has its cost assigned to products using a second-stagecost driver unique to each cost pool. A cost driver pool is assignedto products on the basis of the number of cost driver units itconsumes. The overhead cost applied to the product is calculated
APPENDIX FIGURE 1. General ABC model for restaurants (adapted from Cooper & Kaplan, 1988).
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by multiplying the number of cost driver units with the cost poolrates established in Step 4.
Using the restaurant industry example, the pool ratecalculated for the activity center food production was $6.25 perhour worked. The activity center is now deconstructed into thedifferent levels of activities. For example, to produce menu items,unit-based cost drivers will be applied for time spent to prepareand cook a menu item and the kilowatt-hours of power used todo so. However, other levels of activities need to be considered.For example, batch-level activities, such as line setup andpurchasing, and product sustaining activities, such as recipecosting and establishing and maintaining specifications, must beconsidered. The amount of resources consumed for each productis measured and listed in a bill of activities.
Measuring Units of Resources Consumed by Products.Observation and interview methods can be used to measure theunits of resources consumed by a product. Observers and/orinterviewers will learn how long it takes to perform each activityand how many employees are performing it. For example, in arestaurant, an observer can learn how many people set up thecooking line in the BOH and how long it takes to do so. A cost permenu item can be established by dividing the total labor cost bythe amount of time used to set up the line. Assuming two cooksset up the line every day and it takes 1 hr, the cost for each menuitem per setup can be calculated as follows: $6.25£1 ¼ $6.25(cost pool rate £ number of units used) and $6.25/50 (number ofmenu item) ¼ $0.13. This means that the bill of activities shouldinclude 13 cents as setup costs incurred in the BOH.
Other resources that need to be considered to establishproduct costs are unit-based drivers, such as the number of unitsof power and labor hour units that are used to prepare a particularmenu item. The time spent on labor hours to prepare the item isobtained by observation or interviews with the food productionstaff. For example, if the item takes 2min of prep work and 10minto cook, the total amount of labor applied to the menu item is12min. To determine the unit-based labor costs, the pool rate of$6.25 established earlier is divided by 60 to establish the cost perminute ($6.25/60 ¼ $0.10). Therefore, the unit-based labor costfor this item equals $1.20 (12min £ $0.10 ¼ $1.20).
The product-level cost is established in the following way:First, assuming interviews reveal that 10hr per month are spent onrecipe testing, this activity has a total cost of $62.50 a month (costpool rate £ 10hr). To establish the cost per menu item, the totalcost is dividedby the total average number ofmenu items sold eachmonth. Assuming an average of 3,000 items are sold per month,the cost per item equals $0.03 ($100/3,000 ¼ $0.03).Whilemanymanagers may consider these low costs to be immaterial, and maynot be considered on their own, these small incremental costs maybe significant if all product-sustaining costs are considered.
The same procedure is used to estimate the cost ofexpediting. For example, if the restaurant employs two full-timeexpediters working 160 hr per month, the cost equals $1,000 (i.e.,160hr £ $6.25/hr) and the average cost per menu item for theseproduct-sustaining costs equals $0.33 ($1,000/3,000 items).
Step 7
Bills of activity. ABC costs calculated for products are usuallycondensed into bills of activity. The bill lists each cost and activityassociated with a product occurring in each activity center. Thebill may also include information about the value of an activity.A bill of activity considering only the cost traced from the“personnel cost” cost pool for the BOH establishes the followingcosts for a particular menu item:
Total resources consumed by one menu item, as traced fromthe personnel cost pool based only in the BOH activity centerfood production, equal $1.69 ($1.20 þ $0.13 þ $0.36). Thesame procedures are applied to assign all other overhead costpools (e.g., utility costs), except for facility-sustaining costs(accounting, general and administrative expenses, insurance,security, landscaping, direct operating costs, occupancy costs, anddepreciation) that must be allocated arbitrarily, similar totraditional methods. For example, the total value of the facility-sustaining cost pool can be divided by the total average number ofmenu items sold per month and then applied to each menu item.If the total facility-sustaining cost is $15,000 per month and 3,000menu items are sold, the cost per item equals $5.00, whichmeans that each menu item will have added $5.00 to its bill ofactivity. In addition, food cost is added to each menu items’ bill ofactivity and the sum of all costs of all levels of activities (unit-level,product-sustaining, batch-level, and facility-sustaining costs) plusthe item’s food cost will then establish ABC cost for the menu
APPENDIX TABLE 1. Bill of Activity for Filet Mignon
Back of housePreparation 2 0.074 $0.15Cooking 5 0.074 $0.37Cleaning 1 0.074 $0.07Total 8 0.074 $0.59
Total unit-level activities 12.65 $1.43Batch-level activitiesFront of houseSetting up 3.2 0.18 $0.58Cleaning 1.59 0.18 $0.29Administrating 3.83 0.18 $0.69Total 8.62 0.18 $1.55
Back of housePreparation 7.2 0.074 $0.53Cleaning 0.5 0.074 $0.04Total 7.7 0.074 $0.57
Total batch-level activities 16.32 $2.12Product-sustaining activitiesFront of house administrating 2.55 0.18 $0.46Back of house administrating 3.21 0.074 $0.24Total product-sustaining
activities5.76 $0.70
Facility-sustaining activities 1 unit 5.02 $5.02Food costs 1 unit 9 $9.00
Total cost $18.27
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item. An example of a complete bill of activity for a full-servicefine dining restaurant is displayed in Appendix Table 1.
Step 8
ABC menu engineering is conducted. ABC menu engineer-ing uses a process similar to contribution margin menuengineering. The major difference between the two is that ABCmenu engineering is based on the ABC cost and evaluates eachmenu item on the basis of operating profit (Price – ABC Cost)instead of only looking at contribution margins, as per traditionalcontribution margin menu engineering analysis.
Step 9
Process and organizational improvement. The results of theABC analysis are used to improve the menu and the organization
as a whole. Managers can use this information to reevaluatewhich menu items to retain and which items to reprice accordingto market conditions and customer demand. The informationshould be shared with the employees to conduct activities in amore efficient manner.
The data collected should be updated routinely whenoverhead costs change, and menu items should be repricedaccordingly. Management may concentrate on market segmentsthat purchase the most profitable items. Last, all menu itemsthat are unprofitable should be eliminated, except for items thatare priced low for promotional purposes. Processes that do notadd value need to be eliminated or reengineered. Onceemployees and management comprehend the potentialopportunities of an ABC system, they can manage the restaurantand execute tasks in a profitable manner while delivering valueto the customer, and adding to the sustainability of theorganization.
