Contractor Investments: Look the Gift Horse in the Mouth

With low interest rates and the Federal Reserve’s easy money policy, the major food service contractors have been more generous in offering financial investments to potential college and university clients.

 In Clarion Group college food service projects, we've seen recent seven-figure investment offers to college clients where the apparent profitability to the contractor doesn’t merit such large sums. Clearly, the contractors are seeing a return on investment (ROI) that’s not apparent to the client.

 A food service contractor needs a 20% ROI – total annual profit – to justify a large investment.  That means for a $1 million investment, its annual profit must be at least $200,000 a year for five years.

A minimal profit for the contractor is about 8% – 5% to cover its general and administrative expenses and 3% net, pre-tax profit. It would take $2.5 million in annual sales to generate an 8% rate of profitability to cover a $1 million investment.

 Some contractors have offered investments that on the surface don’t come close to yielding a 20% ROI.  Their actual profit is far above 8% or whatever profit margin they show to their clients on their budgets and financial statements.

Recent Clarion Group reviews of college food service financial statements indicate where the additional profit comes from. There are at least three principal areas:

Vendor rebates: Contractors no longer deny that they receive rebates and discounts from their vendors.  An audit by the New York State Attorney General found contractors were withholding rebates equal to 14% of purchases from state university and public school clients. Other documents we've reviewed indicate the rebates may be as high as 18% of purchases.

A $2.5 million dining service might have a 35% food cost and 4% paper/disposables cost, about $975,000.  At 14% of these purchases, the contractor's rebates are $136,500.

Wage-related taxes, benefits and insurance: Contractors typically charge between 30% and 40% of direct payroll (salaries, wages, overtime and paid time off) on their operating statements.  A college administrator may not question this cost because the college’s own payroll tax and benefits package may run as high as 40% to 50% of payroll. 

The food service contractor’s actual cost is about 25% to 27% of payroll, sometimes less.  The contractor retains the difference as part of its profit.  Low-wage food service employees often can’t afford their share of the cost of the contractor’s health insurance; young employees don’t think they need insurance, and some have a spouse with better coverage.   Typically, half or fewer of full-time hourly employees – and none of the student or other part-time employees – accept the company’s benefits package.

A $2.5 million sales, dining service's direct salaries and wages cost may be about $850,000.  If the contractor charges 30% of payroll, but has an actual cost of 25%, its indirect profit is about $42,500.

Liability insurance: Contractors typically charge between 1% and 1.8% of total sales for liability insurance, although their actual cost is about 0.5% of sales; up to 0.8% for small contractors, Clarion financial reviews have found.  What that's worth to the contractor?  At 1.5% of $2.5 million in sales, the insurance charge is $37,500.  A large contractor's actual cost at 0.5% of sales is $12,500, leaving $25,000 in the contractor's pocket, an undisclosed 1% of sales.

Altogether, the contractor in this example has generated about $204,000 in profits not visible to the client -- some 8% of sales --  in addition to the profit shown on the operating statement.

 The trap: Contractors typically ask for five- to ten-year contracts when they make an investment, and sometimes longer, if the investment is large.   This may seem like a minor consideration when the college is seeking the investment dollars, but it can prove to be disadvantageous. The operating contract will require the college to refund the undepreciated balance of the investment if the contract is terminated by either party for any reason before the contract term has expired.

 If a college that accepted a $1 million investment, depreciated over a 10-year contract and by the fifth year, the college is dissatisfied with the operation of the campus food services, it must pay back $500,000 to terminate the contract.  The college may not have the resources to make such a repayment.

 Colleges should be cautious about asking for or accepting large investments from food service contractors.  Their services may not live up to the promises they made to secure the contract. Measuring the value of food service contractors by the size of their investment offers shuts out the smaller, but often more capable, regional and local food service companies from consideration.

Clarion Group works with colleges and universities, corporations and institutions to improve the quality and cost-effectiveness of their food service and hospitality services and in the competitive selection of food service providers.  For information about Clarion and the value we can bring to your organizations, contact Tom Mac Dermott, FCSI, president, 603/642-8011 or Angela Phelan, senior vice president, 609/619-3925 or e-mail us at info@clariongp.com.  We look forward to hearing from you.