This is the second post in the series on auditproofing your restaurant from an unfair audit. Most restaurants and bars with weak internal controls (almost all independent establishments), will be audited by the Canada Revenue Agency (CRA) or a provincial tax authority using an indirect audit approach. In most cases, this approach will be the mark-up method, which seeks to project the sales level that was likely to have been generated based on the amount of alcoholic beverages purchased by the establishment. As we have seen in other posts, this audit method involves making a number of assumptions about the operation. Determining what these assumptions should be, can be quite complicated.
Instead of spending the time to develop accurate assumptions for each establishment (which would be the fair method of auditing), the auditor relies on rules of thumb. Basically, these are averages of metrics observed at similar establishments or annual averages based upon the restaurateur’s answers to questions during the initial interview.
Let’s look at one of the key assumptions auditors make.
The Sales Mix
Each restaurant will have its own sales mix, which is simply the percentage of each category of menu items, such as liquor, wine, beer and food. The sales mix may be relatively consistent from one year to the next, or there could be significant changes, if there has been a strategic change in the business operations (new patio, new bar, renovation, new chef, new menu, etc…) Where there have been significant changes to the restaurant, it is important to ensure that the auditor takes these into account when determining the average sales mix for each year.
Not only will there be a sales mix of major categories of menu items, there will be a sales mix of sub-categories within the major categories (martinis, 1 oz shots, 1.5 oz shots, etc…) These sales mixes can also change from year to year.
So, we want to know how the auditor determines the sales mix for each year of the audit. Typically, the auditor will work backwards to determine the estimated sales mix, based upon the actual purchases of alcohol in each category and certain assumptions regarding the mix of sales in sub-categories. Armed with estimated average sales prices and average portion costs, the auditor is able to calculate average markups for each category (and sub-category), for each year. Care must be taken to properly allocate the change in inventory each year, for each category of alcohol.
Why is this important? The determination of the sales mix can have a significant impact on the projected sales, because the margins in the various categories and sub-categories can be quite different and each category of inventory has its own “theft profile“.
In my first post on auditproofing, I briefly discussed checking the accuracy of each menu item’s categorization. While we could re-sort all of the menu items into appropriate categories, using a program like Excel, this would be time-consuming, subject to error, and require additional audit work to determine that the re-sorted report is accurate. Auditors don’t like Excel reports, because it is difficult to determine whether they have been manipulated. Consequently, we want the POS system to provide accurate sales and inventory usage figures, directly, without any re-categorizing. This will also save a lot of time preparing analyses during the year.
We will be preparing several POS reports on an ongoing basis. It is important that they be consistent from one period to the next, because we are going to summarize them for each year that is to be audited. We will be analysing the sales mix for all categories and for key sub-categories within each period and for the entire year. Before the auditor conducts the initial interview, you will know all of the sales mixes that are relevant to your restaurant for the entire audit period. Not only that, you will know them to a very high degree of accuracy.
In a future post, we will be looking at gross margins and how we document the variance between the expected margin and the actual margin. We will be looking at all categories and major sub-categories, and we will be looking at changes over time. This is another reason why we need the categorization of menu items to be consistent throughout the audit period.
To put this post’s topic in perspective, the sales mix among the categories (and within major categories) is a key component of the mark-up method, used by auditors to project sales for a restaurant. If we know the actual sales mix figures and they can be supported, before the auditor arrives, the auditor will be compelled to adopt these assumptions in the audit analyses. It is one less assumption that might lead to an error in the auditor’s analyses.