The Service Charge Infused Dining Experience

It looks like integrity is no longer on the menu

Bill of Fare

How does a $125 round trip airline ticket cost $225? A $20 seat charge and $30 bag fee per leg of travel. How does a $20 entree cost $24.99? A 20% service charge and $.99 on-line ordering fee. Welcome to the new service charge-infused dining experience.

A growing number of restaurants are adding service charges to the menu. Of those adding service charges, it varies from 3% to 22%. Some states, such as Minnesota, require that all such obligatory service charges be duly noted in 18-point font on all presented menus and placards. (Minnesota Statutes section 177.23, subdivision 9). In the statute, restaurants must give "clear and conspicuous notice" that the service charge is not a gratuity, thus the funds go to the house, and it is a sales taxable event.

Service charging restaurants typically issue an additional statement explaining the purpose of the add-on fee. They describe the mandatory service charge as a “wellness fee,” “a living wage fee,” or a “sustainable environmental fee.”  Whatever the restaurant calls the service charge, CPA's, the IRS, and sales taxing authorities call it revenue.

The service charge fee explanation is simply a marketing gimmick. Restauranteurs know that a good menu item description means a higher price. A bacon cheeseburger with a side of fries is a $15 menu item. But 60% ground sirloin beef burger with applewood-smoked bacon and Tillamook cheddar cheese served with truffle oil infused, sea salted French fries is $18 all day long. For Restaurant operators, getting the marketing verbiage dialed in is the difference between break even and profit. So too when adding a service charge to the menu. How the service charge is marketed will determine whether customers will "buy” the additional revenue stream slight-of-hand.

The math doesn't lie

Let's look at two scenarios for charging a customer for a bacon cheeseburger with a side of fries. 

Option one is straight up $15 plus sales tax:

 Cheeseburger and fries - $15

 10% sales tax - $1.50

 total receipt - $16.50

Option two pricing with deceptive service charge:

Cheeseburger and fries- $12.50

20% service charge- $2.50

Subtotal- $15

10% sales tax – $1.50

Total receipt- $16.50

In both above scenarios, the restaurant received $15 in revenue for the menu item and the taxing authorities received $1.50 in sales tax. However, the service charging restaurant marketed their menu item at $2.50 less than the competition. This is simply a marketing ploy. It is the selling of a menu item infused with a service charge.

The one trick pony

For restaurants that adopt the service charge model, it generally only fixes a revenue problem once. Believe me, I have sympathy for restaurant operators regarding mandated expenses that must be absorbed into their business model. Healthcare costs, competitive wage pressures, local ordinances and the highly fluctuating commodity market certainly make producing restaurant menu pricing for profit a difficult task. Restaurants that opt for the service charge fix is a one-off endeavor. Shifting to a percent service charge business model to absorb the above cost scenarios can only happen once. In my above scenario, solving a revenue problem with a 20% service charge allows the operator to keep the hamburger at $12.50 only one time. As the business continues and additional price pressures mount, eventually the restaurant operator either must raise the service charge percent to keep the hamburger at $12.50 or start raising the base menu price. Thus, the operator is back in the price adjustment game but now manipulating both menu price and service charge percentages.

Dynamic price warning

There is a growing trend in the restaurant industry toward the use of dynamic pricing. We are familiar with dynamic pricing when purchasing airline tickets. Dynamic pricing changes the price of a round trip ticket based on customer demand. The travel industry bit hard on fees and service charges to competitively market their airfares with these not-so-subtle add-on costs. Consumers are aware of these charges and mentally add them into the cost calculation when booking an airline ticket. The travel industry is now using algorithms that are constantly assessing customer demand and adjusting airline prices accordingly based on that real-time data. To that point, airline carriers have realized the first leg of a journey can be discounted because every traveler's destination is an emotional purchase. With “the hook set” on the destination the return flight cost is elevated as customers must return home. Airline travelers accept that airline travel pricing strategies are a game. And like pulling the handle on a slot machine, sometimes they win a good fare and sometimes they don't. Increasingly, because of dynamic pricing, the airline industry has conditioned travelers to have no loyalty to the airline they select. Many travelers, especially if flying on their own dime, will jettison loyalty miles for the cheapest fare.

Sadly, this dynamic pricing strategy is creeping into the restaurant industry. Adding service charges is one way that is occurring. But I have witnessed additional dynamic price scenarios whereby menu prices are adjusted for online orders versus in-house. Menu prices are also adjusted for high-peak volume versus slower times. Mostly, I fear that the propensity for service charges will expand, and restaurants will start affixing additional fees for desired reservation times or tables. This will not be good for our industry, and it will certainly limit customer loyalty. Instead of restaurants utilizing a “happy hour” discounted menu items to attract customers to low volume time slots, dynamic price increases during high-demand time will certainly create "unhappy hour" price modeling.

Can technology save your mortal soul?

No matter what the service charge-infused menu description is, no matter how fervently one attempts to deceive themselves and their customers as to its purpose, the service charge is revenue. Not food sales revenue nor bar sales revenue, just revenue. Although some may play a financial trick by applying the service charge to labor and benefits expenses or simply as an offset to overhead, when reporting it to both the IRS and sales taxing authorities, it is revenue. If, on the Income Statement, the service charge is posted as revenue, an operator will see it reflected in a true Cost of Goods Sold percentage, however, the prime expense categories of food and alcohol will report COGS percentages sans service charge inflated sales.

Technology can cure this deception. My father was a restaurant man opening his first restaurant in 1969. The industry was more forgiving in those days because of laissez-faire regulations, low overhead costs and generous profit modeling. Simply managing gross labor and COGS percentages to a desired metric was sufficient and the on-time, on-demand data that we currently have access to was but a “Buck Rogers” futuristic dream to him.

Today, however, through many affordable platforms, restaurant operators have access to up-to-the-minute sales, labor, and profit-modeling metrics. Flow of inventories into menu costing programs yields theoretical versus actual cost of goods sold. Menu mix analysis provides operators with revenue producing racehorses as well as highlighting profit eating dogs. Being profitable now, as well as being up front to our customers about true menu costing, is simply a matter of understanding overhead and its relationship to the cost of goods sold. Once that has been established, setting a retail menu price for desirable profit is merely an exercise of middle school mathematics.

For the love of my industry and all the wonderful people that show up each day with smiles on their faces and the desire to serve, I beg that the restaurant industry use technology to solve profit woes instead of utilizing the simple, yet deceptive, fix of writing service charge-infused menus or worse yet, adopting dynamic price modeling. I am sure airline carriers, who truly care about their customers and loyalty, wish they could put their industry’s service charged-infused fare structure genie back in the bottle. Do not let the hospitality industry go down that same path. It takes sophisticated algorithm-calculating software systems to create deceptive dynamic price models. Why not use that same technology to honestly calculate proper menu prices based on commodity and overhead costs?

Essentially, what restaurants that add a mandatory service charge, especially one billed for the purpose of building better work environments, are saying to their employees is, we are deceiving our customers so that we can pay you and honest wage. I don’t know about you, but that just doesn’t pass the swirl and sniff test. In fact, that bottle was vinegar from the very beginning.

Bruce Nelson is a restaurant CFO and author of “Restaurant Management, The Myth, the Magic, the Math.” The book is available on Amazon, Kindle, Audible or at brucelnelson.com. The overhead pricing strategies described in this article are methodically presented in the book.