Question

As a recently hired MBA intern, you are working in a consulting capacity to provide an analysis for Al Dente's Italian Restaurant. A financial income Statement is presented below: Sales $2,698,000 Cost of sales (all variable) $1,557,563 Gross Margin $1,140,438 Operating expenses: Variable $277,975 Fixed $213,675 Total operating expenses: $491,650 Administative expenses (all fixed) $564,375 Net operating income $84,413 This income statement presents the sales, expenses and pre-tax operating income for a local eating facility. At Al Dente, the average meal cost for lunches and dinners are $20 and $40 respectively. Al Dente serves both lunch and dinner 300 days per year and serves twice as many lunches as dinners.

5. In order to increase NOI, the owner of the restaurant is considering adjustments to the quality of food ingredients currently used. Rather than using premium ingredients, use of average quality ingredients would reduce the cost of food by 15%. The owner proposes to not change the current meal pricing. As the consultant, prepare a memo to the owner that presents the pros and cons of this change in operations. What are the potential impacts on revenue, costs, and net operating income may result from this change? The owner does not want to see a decrease in net operating income. Could the owner make this change and absorb a decrease in customers, and how would you demonstrate numerically to support your analysis? What other factors or consequences of this decision should the owner consider besides the financial impact of the change?

Answer 1

In the existing scenario where the restaurant uses premium quality ingredient for preparing its meal, the net operating income is $84,413. If the restaurant shifts to average quality ingredient for preparation of its meals, the cost of meal shall reduce by 15%. Assuming that this change does not affect other expenses and revenues, the net operating income shall increase to $318,047. The calculation in the current scenario and proposed scenario is shown in the table as follows:

Particulars	Current scenario	Proposed scenario
Sales	$         2,698,000	$            2,698,000
Cost of sales	$         1,557,562	$            1,323,928
Gross margin	$         1,140,438	$            1,374,072
Operating expenses:
variable	$            277,975	$                277,975
fixed	$            213,675	$                213,675
Total operating expenses	$            491,650	$                491,650
Admin exp	$            564,375	$                564,375
NOI	$              84,413	$               318,047

Keeping other factors constant, the net operating income (NOI) shall increase by the same amount of reduction of $233,634 in cost. Consequently, the NOI reflects an increase of 277% over the existing scenario.

However, the shift from premium quality to average quality ingredient shall cause reduction in the number of customers having meals at the restaurant. It is imperative change in type of ingredient shall impact the taste and quality of the meal. The change is highly likely to cause issues at the end of regular customers especially during lunch hours. The change may cause them to switch to other restaurant.

Based on the fact that lunch meal is priced at $20 and dinner at $40 and the number of lunches served are twice as compared to dinners. On evaluating this information, it is derived that approximately 224 lunches and 112 dinners are served by the restaurant on a daily basis. It is apparent that the restaurant might be able to increase the NOI despite reduction in the number of customers but decline in one customer shall have a drastic impact on its revenues and consequently on the operating income.

The advantage of the proposed plan is that it is expected to increase the NOI by a substantial rate. The fact that reduction in quality of ingredient does not impact other expenses is a favorable factor for the restaurant. Hence, the proposed change shall enhance the profitability of restaurant in a significant manner and provide high return for the short-term. Another advantage of the proposed change is that since the cost reduction is significant, the restaurant shall be profitable despite decrease in the customer volume.

On the other hand, the proposed change may cause a significant decline in customer volume. With the fall in customers, the number of meals served will decrease and consequently, the revenues shall fall. The fall in revenues shall decrease the operating income steeply. Hence, from a long-term perspective, the change is not beneficial for the restaurant. The degradation in the quality of ingredient shall affect the quality of meal which shall affect the reputation of the restaurant. Negative reviews by the customers and food critics shall deflect the prospective customers. Loss of prospective customers may have an adverse affect on the profitability of the restaurant. This is due to the fact that over the period of time, all operating expenses will increase. If customer volume does not increase at the same pace, the restaurant may face steep decline in the profit.

In conclusion, it can be stated that the proposed plan is highly profitable for the restaurant. However, from the long-term perspective, the change may cause loss of customers and brand value in the market.