Understanding product costing and gross margin analysis is critical to running any business. Managing your gross margin (the profit produced by your product) and product costing is a balancing act. Not paying attention to these areas can be wasteful and costly. Cutting costs too much can reduce quality, which often will result in lower sales and a loss in customers. Understanding how to manage product costs while still delivering a great cup of coffee can help you increase profitability.

In a specialty coffee shop, the majority of sales comes from beverages. When managing these costs, it’s important to remember that making espresso is still an art, and a certain amount of waste is to be expected in delivering that perfect drink.

Keep in mind:

• When your shots aren’t pulling correctly, you will have to recalibrate the grind. This leads to expected waste.
• Customers sometimes change their minds as the drink is being made. This leads to anticipated waste.
• When there is a little bit of milk left in the steaming pitcher, dumping the milk and not re-steaming it is a sacrifice worth making.
• When a customer orders an odd number of shots, sometimes the extra shot is poured down the drain for the sake of quality.

Also remember that too much waste could be due to poorly trained baristas or theft. Too little waste may mean that you’re selling poorly made drinks, which can lead to a long-term sales decline.

Make sure you’re focusing on factors that will help you manage your business. Trying to understand which condiments a customer is using with specific beverages will only take up a lot of your time and yield few results. Remember that condiments are used in every type of beverage. One simple way of allocating the cost of condiments is to take all your condiment usage for the month and simply divide it by the number of drinks you sold that month. For example, if you used $500 in a month and sold 10,000 drinks, you should allocate $0.05 worth of condiments to every drink sold.

You should also avoid over-analyzing sales of decaf versus regular and the overall use of milk types (whole, nonfat, etc.). Using an average cost of coffee and an average cost of milk will save you a lot of time, and you’ll still be able to understand your margins. You can’t control your customers’ requests on these items and you aren’t charging them for these decisions, so it probably isn’t worth the time of a small-business owner to analyze these too closely.

A point-of-sale system can be a great tool in understanding your beverage costs. Most POS systems will allow you to enter in your component costs (milk, coffee, sugar, cups, etc.) and your recipes. Using this information, the POS system will calculate what your theoretical usage should be every time you sell a beverage. This information can be used to establish how much waste you’re experiencing by looking at your beginning and ending inventories. The following equation will help you determine your waste:

Beginning Inventory + Product-Related Items Purchased -Theoretical Usage - Ending Inventory = Waste

Once you’ve discovered your beverage costing, you can use this information to better manage your business. One important number to understand is gross margin. Again, this is the profit you’re making solely from your product. Understanding your gross margin allows you to understand how much money you have to spend on labor, rent, marketing and any other expenses that occur. Gross margin is often measured as a dollar amount and as a percentage of sales. Looking at gross-margin dollars allows you to understand how many dollars you have to spend on the rest of your business. Examining gross-margin percentage allows you to understand how much incremental margin will be gained with every additional dollar spent.

To calculate gross margin dollars, subtract product cost from the retail price of a beverage. This also can be calculated on all beverages or other products by taking total sales for a category and subtracting the costs. To calculate gross-margin percentage, divide the gross margin by the sales.

Gross Margin $ =
Retail Price - Product Cost

Gross Margin $ =
Sales-Cost of Goods

Gross Margin% =
Gross Margin $ / Sales

Once you determine your gross margin by product, you can start making decisions that affect your profitability. You can use this information to determine:

1. Correct retail pricing. Do your prices accurately match the sizes you have?
2. Sales mix by units. This will help you understand which drinks are most popular from a customer’s perspective.
3. Sales mix by dollars. This helps you determine which drinks are bringing in the most revenue.
4. Margin mix. This can reveal which drinks are most profitable and, conversely, which drinks aren’t worth carrying.
5. New menu items. When developing a new drink, a theoretical cost can be built to determine pricing and profitability.
6. Product cost also can help you in understanding inventory as well as negotiating with vendors.
7. Understanding your product profitability can be used in determining which products to push and promote and also help in determining how much money you can spend on a promotion.

Understanding total sales and margin will help in decisions involving labor, incentives, occupancy, marketing and other expenses. Sales and gross margin are really the starting blocks for managing the rest of your business.