In 2003, Amy Chan and Steve Lee formed a partnership to start an Internet cafe in Portland, Oregon. For many years, Amy and Steve had worked as freelance writers. They enjoyed bringing their laptops to local coffeehouses to complete their writing projects. Having an endless supply of good strong coffee at their disposal helped them to stay focused on their work. Over time, they began to daydream about owning their own cafe. Although Portland already had many great coffee shops, Amy and Steve felt that none of them catered well to freelancers like themselves. More and more, people in Portland seemed to be doing their work in informal settings. Everywhere they turned, twenty- and thirty-somethings were sipping lattes while conducting business deals on cell phones. Amy and Steve sometimes wondered if anyone worked in a traditional office anymore.
We Can Do Better
As much as they enjoyed Portland's cafe culture, they felt that a fatal flaw compromised each of their favorite coffee spots. One was too loud. Another had uncomfortable chairs and tables that weren't well suited for laptop users. Their particular favorite, The Magic Bean, only had three electrical outlets, which meant that only that many laptops could be plugged in at one time. Just a handful of the coffee shops in downtown Portland offered high-speed Internet access at that time. Amy and Steve felt that they could do a better job of running a cafe that catered to the needs of freelancers. They made a list of everything they would want in a cafe, and then asked their freelance friends for additional feedback. The two partners resolved that, in their cafe, customers would be able to enjoy high-speed Internet access; laser printers; a soundproof, quiet room; and comfortable, up-to-date work stations. To attract their target market, Amy and Steve decided to name their business the Portland Freelancers' Cafe.
They spent $10,000 up front installing superfast T1 Internet lines. They imported a $7,000,
top-of-the-line espresso machine from Italy. To make the cafe look sleek and modern, all of the furniture was custom-designed for the space, as were the curved metallic ceiling and wall panels. Installing the soundproof interior room was more costly than they had anticipated. Their equipment costs totaled $25,000. At $500 per month, they had negotiated a good deal on their rent, so they figured that they could afford to splurge on these other features.
The cafe's start-up investment totaled $100,000. This included a $ 10,000 cash reserve. Amy and Steve contributed a combined $20,000 from their personal savings. Steve's brother invested another $20,000, in exchange for a 20 percent equity stake. Amy's mother wrote a check for $ 10,000, which she gave to the partners as a gift. Also, Amy and Steve received a $50,000 loan from Amy's uncle. The partners agreed to pay back the loan with interest at an annual rate of 12 percent.
Because so much money was needed for start up, Amy and Steve tried to cut costs by hiring a local high school student, who agreed to work 1 00 hours per month for an hourly wage of $10. It soon became apparent to frustrated customers, however, that none of the staff, including Amy and Steve, knew how to solve the technical problems customers encountered with the computers and printers. Amy and Steve tried to find a permanent technical-support person, but computer experts were in high demand at the time, and the partners felt that they couldn't afford to pay a competitive salary.
Business Troubles Brew
Before starting their business, Amy and Steve assumed that revenue would come from two primary sources, food and beverage sales and computer/Internet services. Together they had calculated two economics-of-one-unit analyses, one for each of the two sources.
Amy and Steve's EOU
The partners originally assumed that the average customer would spend $6 at the cafe and that $2 of this revenue would be generated by food and beverage sales. The remaining $4 would come from the sale of computer and Internet services. They believed that the business could be very successful if they did well selling computer services. After all, they could charge customers $4 for an hour of service that would only cost them 45 cents to provide. In comparison, food and beverage sales would not be nearly as profitable. For every $2 of lattes and muffins sold, they would pay $1 in direct costs. Amy and Steve built a 5 percent manager's commission into their EOU, even though they did not yet have the funds to hire a manager. They wanted to account for this cost because they did plan to hire a manager at some point in the future, and the commission would be a real cost of doing business. It was time for Amy and Steve to examine both revenue streams together.
In Hot Water
When the Portland Freelancers' Cafe first opened, Amy and Steve were encouraged by how busy things seemed. The cafe was buzzing with customers and they received some positive reviews in the local papers. They expected to lose money at first, but figured that, in a few months' time, the business would become profitable. After three months, they had a major shock when they realized that this was not happening. What went wrong?
Changes in the Environment
Initially, Amy and Steve's customers willingly paid $4 an hour to use the computers and highspeed Internet connection. However, soon after the grand opening, wireless Internet service became available throughout the Portland area. Within two months, the cafe's customers no longer wanted to pay to go online. They put pressure on Amy and Steve to become a wireless hot spot. This meant that Amy and Steve would have to foot the bill of providing free Internet service. The partners carried out some research and learned that it would cost $300 to purchase the basic equipment for wireless Internet connectivity, plus an additional $30 per month in service fees. They had counted on charging their customers for Internet access and now it looked like they would have to pick up the tab. They wondered how they could pay for this unexpected cost and also make up the lost revenue. On the other hand, they feared that the Portland Freelancers' Cafe would not be able to compete unless they adapted to changes in the market.
Amy and Steve's EOU Revisited
Three months after they opened the cafe, Amy and Steve discovered that their monthly unit sales of computer services had been cut by more than half. In their first month, they had sold 1 ,500 units, but by month three they were only averaging 600. They worried that this number would only continue to decline. The cafe was holding steady with its food and beverage sales-in fact, the monthly units sold had climbed steadily from 4,500 units in month one to 5,000 in month three. Customers were enjoying the cafe's free wireless service. This feature created a situation where people would stay longer and order more coffee. But even with increased sales of cappuccino, the overall finances of the operation were not improving. In looking at their economics-of-oneunit analysis of food and beverage sales, the partners could see that their gross profit per unit for food and beverage sales was only 90 cents. Even if they sold 5 ,000 food and beverage units per month, they would still only be earning $4,500 in gross profit. In the scheme of things, this was not very much money-not nearly enough to cover the monthly fixed costs of $8,332.
An Uncertain Future
One year into their venture, Amy and Steve began to seriously doubt their decision to start the Portland Freelancers' Cafe. In hindsight, they realized that they knew a lot about being customers but running a state-of-the-art coffee shop was a lot harder than they had imagined. By the end of the year, the Portland Freelancers' Cafe was on the verge of going out of business. Take a look at the cafe's financial statements in and then analyze why this happened.
Case Study Analysis
1. Evaluate the economics-of-one-unit analysis that Amy and Steve conducted and then answer the following:
a. Amy and Steve assumed that, for every $6 in sales, $4 would come from selling computer-related services. Calculate what percentage of their total sales revenue per unit this $4 represents.
b. For every $2 in food and beverage sales, Amy and Steve assumed that their COGS per unit would be $1. Calculate the markup percentage.
c. For every $4 in computer services sales, Amy and Steve assumed that their COGS per unit would be 25 cents. Calculate the markup percentage.
2. List three things that Amy and Steve should have considered doing to adapt to the changes in the environment after their customers no longer wanted to pay for Internet services and expected the cafe to provide free wireless connection.
3. Evaluate Amy and Steve's income statement for their first month of operation:
a. Is the cafe operating at a profit or a loss?
b. How many units above or below breakeven were sold?
4. Amy and Steve decided to take on a $50,000 loan to finance their start-up investment. Each month they are paying $ 1,469 in interest charges. Look at their total monthly fixed costs. What percentage of their total monthly fixed costs does this $1 ,469 represent?
5. What is the debt-to-equity ratio of the Portland Freelancers' Cafe?
6. Look at each section of the cafe's cash flow statement. Based on what you see, write a memo highlighting three reasons why this business is not succeeding.
7. Review the cafe's balance sheet. Explain why the net value of the cafe's property and equipment has decreased from $80,000 in month one to $64,000 by year's end.