Answer to Pricing Puzzles – Restaurants Charging Fee for Sharing

I tweeted a series of pricing puzzles. This series is my interpretation of what the answers could be. Do not treat them as absolute answers. Alternative explanations are possible.

There are two parts to this question.

  1. Why do restaurants charge a fee for sharing?
  2. Why do they charge two different prices based on what is shared?

It is safe to say that those willing to share are most likely couples and they likely pay for it from the same shared budget. For everyone else, those not sharing budgets, the question of sharing does not even come into play.

A restaurant’s goal is to maximize spend per table.  Their wait-staff are essentially the sales team trying to generate more sales per table during the period it was occupied.

So when customers share, it cuts (almost in half) the spend (and hence profit) per table. To discourage customers from doing so, they make the price of the single entree look a little more unattractive by adding the split fee. This is second degree price discrimination. With the split fee, customers may see higher value (consumer surplus) when they order two vs. one.

For those who still want to share for any number of reasons including limiting portions, even with added fee sharing will provide higher consumer surplus and the restaurant gets to recoup profit.

Why charge different split fees? Price discrimination done right. If you charge one split fee, you might as well charge two.

Should they do it? What about customer backlash?

To repeat my earlier point, this is a limited segment that will share food. The rest won’t even notice the split fee.  So by all means do it as this is money that flows straight to bottom line. However they should consider their customer mix and capacity utilization.

What does this mean to you as a Tech Product Manager?

I do not recommend you following in the restaurant’s footsteps. Start with the customers and their needs. Consider how your webapp is being used by your customers.

  1. Do they share login?
  2. From what budget are they paying for it?
  3.  Is there value for them in keeping separate logins?
  4. Do they want to keep their Netflix video queue/history or Evernote clip archive separate?
  5. Do they consume your limited capacity without adding to revenue?

My recommendation: Instead of trying to tack on split fees, make the price of adding second (or third) user attractive that most will do it.  (Like SurveyGizmo did)


Follow up on two short sells I recommended

It is not difficult to make predictions in a down market. In May  I made calls on two stocks, CROCs Footwear and Ruby Tuesday Restaurants. They both had just released their Q1 earnings and I made a call by spending some time with their 10-K and their proposed strategy. While 3 months is a short time to check back, a quick view of their current market prices justify the short call.

RT is now trading at $5.8 down 21%  from $7.35
CROX is now trading at  $8.25 down 30%  from $11.81

Compared to this S&P 500 is at 1283.6 down 8.1% 1397.68.

So not all weakness in these two stocks are due to market downturn. Motley Fool’s Tim Hanson called Crox attractive at current prices. But given  the red flags in their accounting it is good to stay out longer.

Will the Oil Shock Lead to Unbundled Services?

When I was visiting Sweden I found it shocking that they charged me 4 Kroner for a 8oz glass of tap water. As I traveled a bit more in Europe I found this common practice of restaurants charging extra for things that in US we take for granted. Sitting at a table has a surcharge, bread has a surcharge, water too. I compare this to a sign that I saw outside a Hot Dog stand near UC Berkeley, “All toppings always free”, this captures the characteristic of US restaurants.

These are not really free, restaurants here use bundled pricing. The problem with this bundling is some of the added items are valued below cost by the customers and hence the restaurants do not reap the advantages of bundling.

Now in US, as the food and fuel prices keep increasing, restaurants are finding it hard to keep their margins. All these free toppings and additions that are “always free” add to the cost with no relief through higher pricing. Until now they have not passed on much of the supplies cost increases to their customers in the form of higher prices. It is not that it is difficult to keep changing prices (economists call this the menu costs).

Restaurant owners are wary of customer reaction and competitor moves. There may also be lingering doubts on whether we are experiencing a temporary price shock or the higher prices are here to stay. If the businesses and the public are convinced that is is the latter, then the cost increases will flow into prices.

However, an acceptance of increased prices does not mean the demand will stay the same. There are substitutes, eating at home and packing lunch from home. So restaurants may still be reluctant to increase prices. That leads us to unbundled pricing. Should the US restaurants do costing right (do not price items below their cost)? Should they price the food items at its current levels and start charging for service, water, bread, toppings, paper napkins, plastic ware etc?

It is not clear to me.

Customers may not value some of the items included in the bundle but will consider these essential to support the main product they are buying. If customers do not value something by itself, they also will not be willing to pay it. So charging a quarter for toppings may find fewer takers. While the costs will go down, I am not certain if the demand for the main product will remain steady.

It is definitely worth experimenting at a smaller scale before unbundling the whole burrito.

Restaurants on a Downward Spiral

I listened to J. Carlo Cannell of Cannell Capital LLC speak about his Investing Strategy, “Selling Short: Controversial Black Magic”. He agreed to let me share some of the broad themes from his lecture.

His thesis is,

“it is more difficult to pick a stock and go long than it is to pick an absolute loser. What do any one analyst or stock picker know more than the rest combined? On the other hand there are industries that perpetually weak and all businesses in that segment someday go out of business. Find one such weak industry segment and find the worst loser in that segment and short it. Look for signals like, unknown auditors, bad reps for their C level officers, lawsuits, labor union, dealings with Governments. Do not short a stock based on valuation, the market always will move against the valuation call as the company manages earnings through complicated schemes. Look for the real duds.”

Once such industry is Restaurants, Carlo has considerable experience and knowledge about this segment.

“There are no barriers to entry, customers are fickle with no switching costs, employees steal from the business, from money to food carted out through the back door and for a food service business most of its profits come from liquor sales. In the data, from 1983 to 2005, the stocks shrank -8.7% CAGR. Once a restaurant hits the downturn, it is not suddently going to turnaround. People who left for the next cool place are not going to come back. Given enough time every restaurant will go out of fashion and will go out of business.”

I asked him specifically about the Ruby Tuesday case and its current investment of $50 million to improve the lights and upholstery. He replied, ” people did not leave because of bad lighting, just by changing they are not going to come back. May be they have done some EBIDTA calculations that show a positive outcome”. But as I discussed last time, at their projected growth rate of 3%, $50 million investment is not a positive NPV project.

Finally, given this loss making characteristic of restaurants, should anyone open a franchise?
” If you are the first one to get franchise for an geographic area and your plan is to roll it out, make money in 2-3 years and sell it off, then yes”. The corollary is, it is not usually a good option to buy a franchise from a previous owner. You have to ask, why are they selling and will you be able to find another buyer who will buy this from you at a higher price.

That said, I am in no hurry to short Ruby Tuesday. I am a simple indexer.

Slowing Restaurant Sales

The problem with products like food and drinks and with food service business is scalability. There are only a limited number of people in the market. The current slowdown in restaurant business has its roots in how the market grew at faster rate than the population growth. National Restaurant Association says that the number of restaurants grew at a more than two times the rate of population growth during the period 1990 to 2006. The total market size increased from $239 billion (nominal) to $550 billion (nominal). This implies two stylized facts:

  1. The average sales per restaurant has remained constant over this period.
  2. An average meals consumed outside the home per person increased as well.

The current economic slowdown will lead to people cutting their additional meals outside home. An average restaurant that saw near zero growth will now see its sales drop. With increase in marginal costs due to food prices increase and the increase in operational costs, restaurants are getting squeezed from revenue side and the cost side.

For franchise owners, there is no relief from the franchise fees despite falling sales and rising costs since the franchisees pay a percentage of the sales.

For family owned and operated restaurants, the impact is going to be worse, since the costs are much higher and the operations are geographically concentrated.

This calls into the question the notion of making a comfortable living by owning a franchise or a family restaurant let alone running a business