The Unit Economics of social distancing

How viable is reduced capacity

There is a good piece this morning in the Irish Times — here. In it, a group of restaurant owners are interviewed about the reality of opening up in social distancing and it’s enlightening in a number of ways. This is just a short note on one element.

A common theme is a reality that many businesses, from hairdressers to cafes, are facing. At the moment they are closed and making significant losses or/and building up significant deferred debts. This is a balance sheet disaster waiting to happen — but it isn’t my main focus here (more on that soon).

My main focus is on the unit economics of social distancing. There has been a lot of talk in recent days about re-opening and some of the language kind of jars with me. Often you see something like this “Hospitality business will open up in mid-summer”. The operative word here being ‘will’. Nobody, bar the owners themselves, seems to be asking ‘can they afford to?’. As Caroline Boyle, of Salamanca, says in the piece itself:

“Our capacity will be dramatically reduced. Safety is paramount, for our staff and our customers. We will have to redo the entire layout. With lower capacity, restaurants will not be viable on their own without some sort of support”

So what are the unit economics of opening under social distancing? It all comes down to fixed costs. These costs are typically around 20% of turnover. They cover things like rent, rates, insurance, and licences, etc. Currently, as these businesses are in lockdown, these costs continue to accrue and are turning into significant debts. But, understanding their impact will also be important under social distancing.

Leaving cert business studies flashback

Take for example a barber charging €10 a haircut & doing 1,000 cuts a week. This is a busy outfit and will turn-over €10,000 over the seven days. They will also typically have around €2,000 in fixed costs.

On every one of the thousand cuts they do, they will pay out around 60% in the cost of goods, wages, utilities, etc and another 13.5% in VAT. So, they make around €2.65 on every cut. Then using that money they pay their fixed costs and take a wage. If fixed costs are 20% of turnover then they need to do 754 cuts a week to break-even (75% of normal footfall)— and everything after that is pre-tax profit.

Similarly, a restaurant with 100 covers a day at €20 a cover will turn over €2,000 and have fixed costs of around €400. On a €20 meal, the margin after variable costs and VAT is about a fiver. This means they need 80 covers to break-even (or 80% of normal capacity).

So — in a world of social distancing where capacity could be reduced to 30% or less — re-opening isn't viable without help. Infact, for many small businesses, it isn’t viable to open unless footfall is going to be around 80% of their pre-Covid normal. This won’t happen any time soon. Infact, it could be 2021 before we see a return to that kind of normal.

But if fixed costs can be reduced, then operating at lower capacity is viable. This has to be a permanent reduction rather than a deferral as no low-margin business can afford to take on debt to cover permanent losses. So, unless there are a lot of generous landlords out there, the State is going to have to play a role.

Reduce fixed costs by a quarter our barber can open at 56% of capacity. Halve them and he can open at 37%. If social distancing requires a 25% capacity then no-one is viable without a reduction of two-thirds in their fixed costs.

In the end, a broad re-opening won't occur when the lockdown is lifted, it will only occur when it is viable. And as it stands, it won’t be for many.