The "C"

I am amazed at how little some coffee luminaries know about the "C", how it functions, the factors that impact it and what strategies are useful in protecting your company from price spikes. The "C" is the widely accepted commodity price for Arabica coffee sourced from any of 19 approved countries and traded as contracts on the New York Mercantile Exchange.
The extreme lows of the "C" experienced in the recent past caused an expansion of coffee consumption and the introduction into many new markets at very low costs. The low market price acted as a disincentive to growers to plant more crops and expand capacity. As consumption surpasses production, the price naturally rises. This is not a new story, but a fact of life when playing commodities.

There are many things that separately and concurrently effect price moves in the "C". Traditionally most feel that scarcity or supply concerns are the main market mover. If you listen to news reports or read blogs all the talk is about increased consumption in developing nations plus China, Russia and India. While this does have some impact, there are other things at play which are pushing coffee higher.

As the world struggles to exit from the great recession, every developed country has injected borrowed money into their economies to boost economic activity and employment. This, along with ridiculously low interest rates is the perceived magic bullet for most economies. The thing about super low interest rates is that anyone with money to invest is not looking to place it where they can expect 0.25% on bonds. The lack of interest in the American Bond market leads to the US dollar weakening...when no one wants to buy what you're selling you reduce the price.
The result of a lower USD is that all commodities get an instant bump every time the dollar drops because the commodities and the "C" are priced in USD. For fun just watch how the USD behaves against major currencies, and watch what happens to commodity prices on the same day.

Equity markets over the past decade have not performed in a rational way, with two extreme bubbles forming as a result of irrational exhuberance attached to tech companies in the 90's, and a housing bubble collapsing the market most recently. This has caused people with money to look for actual things to purchase, rather than stocks. Commodities are things that people don't need advanced degrees in math to figure out. They are things where prices behave in a rational way in reactions to real world inputs that you can read about and understand. When the weather in Brazil is bad, the price goes up. When there is trouble in the middle east oil supply chain, the price of oil increases. No accounting scandal is going to bring down the value of your investment in any commodity.

The thing with the "C" is almost no one actually takes delivery of coffee purchased on the market although the final settlement of the contract can result in delivery. The coffee is purchased as a contract with a set delivery date in the future. As the delivery date nears, it is normal for the purchaser to role the contract into a new one with the appropriate adjustments to the account made at the time of the rollover.
An individual can participate in the commodity market in one of several different ways including Non-discretionary account, a Managed Account or Commodity Pools. The important thing to understand is most participants have no intention of ever taking possession of coffee, they are simply trading futures in the hope of making profit.

FYI: There is another cost attached to commodity trading referred to as Contango. This is a universal term which encompasses storage, insurance, loss etc.

For coffee, a typical contract is 37500 lbs, or one container of coffee. A savvy investor in coffee would be required to only put down a small deposit on the value of the contract, typically 5%. If the "C" is trading at $2.75, the value of the contract is $103,125.00 and 5% of that is $5156.25. If the price moves up 10%, then the contract is now worth $113,437.50 , a profit of $10,312.50 on a small investment of $5156.25. This example clearly demonstrates the power of leverage in commodity trading is an incredible draw for those with discretionary dollars to invest. Conversely, if the price drops, the investor will receive a "margin call" requesting more money to cover the daily losses if the value of the contract has dropped more than 50% of the initial investment.

There are many factors which indicate to me that the price is not about to drop in any significant way in the near term.
1. The American Dollar is weak and getting weaker. Printing money always results in inflation and a devalued currency, both working against a reduction in the price of coffee. The US is not likely to increase interest rates (raising the USD) which would stifle any recovery.
2. Supply is something that can take up to 3 years to address. Trees planted this year, won't produce anything this year or next and so we are stuck with the supply we have, or less if there is a natural weather event.
3. Emerging economies are doing quite well, and those that are disengaged from the American market are doing even better. Any growth in coffee consumption in those countries is not likely to wane, and put more pressure on the "C".
4. Commodities as a group of investments are doing remarkably well, and yielding excellent returns for investors, something that encourages new participants. The excellent liquidity in the "C" also benefits more participants as contracts trade at high volumes with many eager buyers and sellers. The ability to apply leverage when trading coffee makes it an attractive play when there is still room to move up.
5. Total coffee consumption is relatively inelastic to price spikes on a macro level. The real pain will be felt on a store level where individual customers will make rational choices based on price and quality. As the price at your favourite shop increases, customers will search for strategies to reduce the impact either by reducing their numbers of visits, or choosing a slightly cheaper option with more perceived value.
6. As I stated in a previous post, compared to a classic hedge like Gold, coffee has actually lost about 38% of it's value over the past 10 years leaving a lot of room to move up.

I hope this provides a little information for all to consider. Remember, there are many things in play in the coffee market which are driving prices higher. Here is an excellent source for further information on trading commodities

Raison D'etre

Raison d'etre is a french phrase which literally means "reason to be", or what do you want to be.
This is perhaps the most important question you can answer when deciding to start a coffee business. There are many different answers and motivations that all impact your decision making once your business is up and running. Admittedly I get focussed on financials, but I also run a business that roasts and serves Fair Trade Organic coffee, composts everything ourselves, sources our power from renewable resources, donates dollars and hours to many local charities and causes, and attempts to be responsible members of our community. I want to list some different motivations along with how that choice will impact your business going forward.

1. Passion: this term is perhaps the most overused word in coffee, which I typically reserve for teenaged girls dreaming of werewolves and vampires battling for their affection. For me passion implies a short attention span and a short career in coffee. Someone who describes themselves as passionate is likely looking to seek out the newest trends and adopt them quickly. This strategy will by necessity incur much higher training and capital costs and unless that is replaced with much higher sales, a lower profit margin. Try using LOVE instead of Passion. See how it fits? Love remains even when your business is a little saggy, needs improvement and even annoying. (Just ask a married person) You never give up on a love...ever! A company founded on a love of coffee in my mind is much more likely to endure the vagaries of the market, and will likely be seen by the owner as a long term life's work and not a passionate whim.

2. Sustainable: this term may be the second most overused word in coffee. It is usually applied to companies that are attempting to benefit community, farmers, employees, the environment and any other number of beneficiaries you can think of. As I mentioned in my prelude to this post, my company would probably fall quite easily into this category but with an important caveat...you can't be sustainable if your business is not financially sustainable. YOU CAN'T BE SUSTAINABLE IF YOU'RE NOT FINANCIALLY SUSTAINABLE! You can't help anyone if you're business is insolvent in a year.

3. Owning a coffee shop looks like fun!: Everyone who visits a cafe, (especially a great one) thinks they would love to own one just like it. There is something very appealing in picturing yourself in a pleasing, bustling environment, surrounded by intellectuals, students, film makers and musicians. The reality is that you don't get to choose your customers (my customers happen to fit the examples, good for me) they choose you. Cultivating a cafe culture requires countless hours of work, which is interrupted by plugged toilets, stock shortages, employee absenteeism, and lack lustre sales. If you think owning a coffee shop looks like fun and you have a passion for coffee, beware. Instead you'd be better off Loving coffee and thinking owning a coffee shop looks like a lot of work.

4. I want to teach people about great coffee: There are some incredibly knowledgeable folks out there who have a ridiculous amount of information bidding it's time inside their cranium, looking for an excuse to make an appearance. Giving, well meaning, awesome teachers, terrible business people. Unless your business IS teaching people about coffee in a classroom/lab area, this is a bad reason to start a coffee business. Here's a little anecdote to show you the pitfalls of taking on the role of single handedly changing your local market. Several years ago my company was supplying a local health food store with organic coffee. We tried to introduce CO2 Organic Decaf because I thought it tasted better than Swiss Water. The owner (not the brightest bulb) couldn't get it through his head that CO2 wasn't a chemical, but a gas that we expired about once every 10 seconds. Every time we delivered the CO2 Decaf, I would have the same conversation and he'd be grumpy. Then I came up with the perfect solution...I started selling him the Swiss Water that I thought didn't taste as good, and he was happy. There is an old saying in coffee that goes like this: Q How should I drink my coffee? A The way you like it. Guiding customers to make the better choice is a great strategy, telling them how to drink it is a terrible one.

5. I'm a great barista and I want to run my own shop: I happen to think all committed baristas should own their own shops. As a barista, you should be fully acquainted with the less than glamourous side of espresso, if not the paperwork side. You are one of the main reasons I'm taking the time to write this blog. While your skills behind the cash register and espresso machine may be impeccable, the money is made in the back office. Leverage your skills by attracting other quality baristas, and step back to learn the business side of cafes. Know your break even...cold. You should be able to recite your daily, weekly and monthly break evens, and massage your costs to yield desired results once your are familiar with your expected revenues. For goodness sake, take time to read my pointers on negotiating a lease, and managing your capital costs before you even consider writing a business plan. Remember Love, hard work, good intentions, community, education and skills all factor into a successful start up cafe.

Coffee Pricing Part II

I wanted to add an interesting update to provide some context for the current coffee market price.
In my last post I indicated that the differentiation between the coffee price valued in USD, and that of Canadian and Euro was the effect that a weak American dollar had on the market. Certainly there has been an increase in the "C", but at least 30% of that can be attributed to the fact that the "C" is valued in USD.
As an interesting bit of information, I've figured out the Price of Coffee in Gold for each of the time periods, to determine how coffee has performed against the standard measure of hedged value versus world currencies.
In 2001, one ounce of gold equalled 376.53 lbs of coffee.
In 2005, one ounce of gold equalled 365.60 lbs of coffee.
In 2010, one ounce of gold equalled 496.24 lbs of coffee.
Today, one ounce of gold equals 518.10 lbs of coffee.

From 2001 to present, the price of coffee stated in terms of gold has fallen 38%. Even at the extreme low price of 2001, coffee was worth more in real value, than it is today at relatively high priced "C".

This is relevant because Gold is perceived to be the measure of secure wealth in the world. Currencies pre-1971 were backed up by vaults filled with the stuff as security against the value of the dollar. The US no longer holds near enough gold to guarantee it's currency value, and instead issues promises to pay. Recent events has made those promises increasingly suspect, which makes gold more valuable versus a declining USD. Pricing coffee versus Gold clearly shows us that although the price is relatively high versus USD, against a standard measure of value like gold, it has actually lost value in the past 10 years, even when comparing a $0.71 market of 2001 to today's $2.76.

Coffee "UN" Common

This is a little off my normal topics of finance and costing but no less relevant to my target reader. My target reader is a barista who wants to own their own shop one day, a family run shop trying to get better, the great majority of shops who serve great coffee every day but lack some technical knowledge, advice and resources to get them there.
For those of you who aren't aware, an association has been launched at the TED Conference in Palm Springs California where the self appointed "creme de la creme" of coffee invite each other to share a space and inform the attendees on how coffee should be experienced. Admittedly I have not witnessed this personally so judging the relative importance of what they are sharing is a mystery, but I believe it is safe to say it is less an educational exercise and more a self promotional one. *I'm sure there'll be a slick black and white video released soon that will shed more light for those of us not attending, so keep an eye out for it!
The reason this is relevant to my target reader is I want to warn you of the pitfalls of believing this is how you build a successful business and make money in coffee. Certainly there is an imperative to constantly draw attention to yourself when you compete for customers in London, Los Angeles or New York City, but not so much in middle America or Canada. Thinking that being part of a self congratulatory "security council" with a veto on who is relevant and who is dismissed will lead to distraction and ruin.
The blurring of lines between some SCAA/Barista Guild executives and the relentless self promotion is becoming hard to ignore, neither of which serve the community as a whole but alienate the supportive base of both organizations. Maybe an unintentional consequence, but a real sentiment felt by thousands of companies who are getting the message "you're not important", but renew anyway.
The main point I want to get across is that it's ok to be a great operator in rural Maine, middle Kansas or Winnepeg Manitoba. The value of what you are bringing to the Specialty Coffee Industry is relevant to all the companies like you, and you are managing to do it without alienating and diminishing your peers. Good on you!

Coffee Prices From a Different Perspective

This is a subject I have been interested in for a long time but lacked a forum to develop any ideas. I have been curious about the spasms in the Commodity price for coffee and how currency fluctuations effect both the producers and the consumers. Recently anyone in the coffee business can't ignore the heights that the "C" has climbed, closing today at $2.7170. The thing that started me thinking recently is the fact that economics in the world have changed and drastic measures are currently being taken to get a handle on the catastrophic events caused by the Sub Prime mortgage market and access to easy credit. The American Federal Reserve reaction to the events was to increase money supply through stimulus initiative which both increases economic activity and reduces the value of the American Dollar. Any American who has travelled extensively in the past decade or so has seen their spending power erode when they convert their greenbacks to local currencies. Here in Canada very recently we were accustomed to receiving $0.65 US for every Canadian Dollar we exchanged. At today's market close I would receive $1.03 US for every Canadian Dollar I exchange. When I examined the relationship of the Euro to the USD I found a similar relationship.
I began to think that although there has been an increase in the "C", that a decent portion of that increase was actually a weakening of the USD. Think of it this way, if I am purchasing coffee with money that is worth less, the price of the coffee must increase. I decided to create a chart to visually represent the relationship of the American, Canadian and Euro to the "C" price for the years 2001, 2005, 2010 and Present.

Graphically the important thing to notice is how the pitch of each graph differs. Notice the strength of the USD in relation to the other currencies in 2001, and how it's value relative to the others has reduced. Looking at the Canadian and Euro lines, both follow a similar trajectory which probably follows the actual increase in the commodity price. When we look at the USD line, it clearly has a greater pitch than either the CDN or Euro. In fact, that increased pitch begins as early as 2001 for both comparisons. If we were to extend the lines out a year, the price gets increasingly steep for Americans, and less so for the rest of the world. I did take some time to examine the British Pound, but the Pound is a mess largely due to the same factors which are affecting the USD. I know there are some Aussies and Kiwis out there reading so when I get some time I'll poke into those currencies as well and maybe throw gold into the mix.
Important Additional Note: I spent a few minutes looking at what the "C" would look like if the USD had maintained the relative price levels versus both the Canadian Dollar and the Euro circa 2001 to see what the "C" price would look like today.
If the Canadian dollar was still worth .65 USD, then the "C" would be priced at $1.7585 USD today.
If the Euro was still worth 1.05842 of a USD, then the "C" would be priced at $1.86 USD.
These numbers would indicate that the difference between $2.7170 and $1.86-$1.75 USD is the impact the depreciation of the American Dollar has had on the "C" or between $0.85-$0.97 USD.

Negotiating a Lease Part 3

I wanted to continue to post on topics which will materially benefit potential cafe owners and especially baristas hoping to own their first shop. I can't think of any topic which is more important to the success of a coffee shop than negotiating your lease. I have already posted a couple of times with some helpful hints, but believe the spreadsheet I have created will greatly benefit coffee shop owners and arm them with the same tools landlords have in their arsenal.
Basically the spreadsheet measures the landlords costs and income related to the lease, and the tenants potential costs related to the lease. When a tenant enters asking price and other inputs they should be able to determine how much room the landlord has to negotiate which ultimately benefits the tenant (good guys). There are some terms which I should explain in more detail.
NPV is short form for Net Present Value. Net Present Value is the total value of the lease added, then each year multiplied by a factor related to the expected rate of inflation. This factor is available from a Net Present Value table similar to the one following.

The reason NPV is useful is it represents a value today to the tenant and conversely the landlord. On the landlord's side we would make the factor the expected rate of inflation plus the desired return. The difference between the tenants and landlords NPV is the negotiating room.

If you would like a copy of the spreadsheet, please let me know through the comments and I'll email it to you. In the interim I'll try to figure out how to make it available for download. Try entering numbers from listings of commercial space from online listings in your area and get a feel for the numbers landlords use to skew deals in their favour. I have made the calculations assuming a constant rate of inflation of 4% which may need to be adjusted over time. The key of this whole exercise is to realize that the landlords have these tools and they understand them fully in order to determine how to make you pay as much as possible. Get tough, learn everything you can about how your landlord thinks, and save yourself tens of thousands of dollars. Commercial Real Estate agents are reluctant to share these numbers with you since effectively their compensation is based on getting you to pay as much as possible as well, but ask your agent to prepare a similar breakdown for you. Let me know whether this is useful or not.
Good luck.

Manual Brew Costing Part III

Hello again and welcome to my third in what may end up being a long series on manual brew costing. Think of it in the same way you do when one variable in espresso changes, there's several solutions which all work, but one perfect solution which takes several attempts to reach.

From my last post "Manual Brew Costing Part II" I came to the conclusion that Batch Brewing and Manual Brewing are perfect substitutes, ie a normal customer would be just as happy if he received one instead of the other at the same price and time. We can argue all day whether one tastes better than the other, but for the sake of progress, I'm assuming a customer would choose a Manual Brew over Batch Brewing if:
1. They had more time to spend
2. They were willing to pay more for their coffee
3. They were convinced the cost of 1 and 2 was worth it in the cup.

So I will repeat the equation I formed to describe this transaction:

Demand for Coffee = Batch Brewed + Manual Brewed/Higher Price and Wait Time

The denominator of Higher Price and Wait Time reduces the number of Manual Brewed Coffees sold and does not affect Batch Brewed Coffee.

I next concluded because they are perfect substitutes, there exists the possibility of eliminating one and shifting all volume to Manual in order to attempt to achieve labour efficiency. The new equation would look something like this:

Demand for Coffee = Manual Brewed/Price + Wait Time

This is effectively the same sort of equation which would describe any transaction. You could substitute any good into it and it would describe most pretty well. The reality is any espresso bar has many imperfect substitutes in the form of tea, espresso, juice, hot chocolate, cappuccino etc, which all serve to tempt the customer away from Manual Brewing with various degrees of effectiveness. I claimed that eliminating Batch Brewing in my last post could potentially eliminate the drag Price and Wait Time had on the demand, but there are other choices which also serve to tempt the customer. For this reason, the denominator must remain as a drag on Manual Brew Sales.
All coffee shops operate in highly competitive environments, so much so that we often look for any competitive advantage available in order to differentiate ourselves from our nearest competitors. The reality is that coffee is (wait for it) not a necessity, but a luxury good. Stop cringing, I drink way more coffee than most, but it isn't water, diapers or medication.

The degree with which demand fluctuates with price is determined by the Price Elasticity of Demand which is defined by the following equation:

Price Elasticity of Demand = Percentage Change in Quantity Demanded/ Percentage Change in Price

Including this into our Demand equation it becomes:

Demand for Coffee = Manual Brewed Coffee/Wait Time + Batch Brewed Coffee + Price Elasticity of Demand

Since most coffee shops operate in highly competitive environments, one where customers are very aware of your prices and your competitors, we can deduce that the elasticity is relatively high for coffee on an individual level. A high elasticity means in practical terms, that if you raise your prices 10%, you will experience a greater than 10% drop in quantity of sales. If you lower your price by 10%, you will experience a greater than 10% increase in quantity of sales. There does exist factors which can buffer the effects, such as customer brand loyalty, relatively cheap purchase, increased perceived value derived from marketing efforts, captive customers related to store location etc, but generally this relationship of price to volume is pretty sound. Anyone who would argue that the elasticity of demand is neutral is effectively claiming that they can raise their pricing while remaining galvanized against a negative customer reaction, which if it were true, we'd be witnessing $10 cups of coffee on every corner.
I do want to point out that on a macro or market level, demand is relatively inelastic, meaning increases in prices don't appear to negatively effect the whole coffee market. We are currently testing C market prices not seen in over a decade and demand has not waned, perhaps because of the elastic nature of micro choices keeps the prices competitive for the individual.

Finally, if we can agree that coffee is a highly competitive product, and possesses a high elasticity of demand, then the rise in pricing will negatively effect sales volumes at a greater percentage rate than the price increase itself. Further, since Manual Brewing will always incur higher portion costs than Batch brewing, the price should always be higher than Batch Brewed. If the price is higher and the wait time is longer, then the volume will always be less than Batch Brewed even if we completely eliminate Batch Brewed coffee as an option. Instead customers will either seek out alternatives within your shop, or go elsewhere. If the volume is less than Batch Brewed Coffee, then the possibility of achieving labour efficiency is hobbled and Manual Brewing becomes a drag on profitability.