The Future of Craft Beer - Part 2: Profitability

I’ve always found profitability and cost control to be one of the more sensitive conversations to have with folks in craft beer…but there’s reason for it.

Many of the early craft breweries established counterculture brands that rebelled against the commoditization and cost cutting of macro beers. So it’s normal that if we now talk about seeking more profit or cost cutting in craft it feels uncomfortable, because to many craft was built on attacking others for doing exactly this.

But that is a misconception. Craft was built on putting the consumer first, understanding what they wanted, and taking the risk that if you build it, they will come. Early craft brands weren’t attacking macro brands for cost cutting in general, but for taking cost cutting too far, at the expense of the consumer.

How global brewers are villainized by craft is a little bit like judging an iceberg by what is visible. We only see the tip of the iceberg: we’ve tried the beer and seen the ads. As lovers of beer, consumers and authenticity, that is more than enough to know that it’s not for us, but we also shouldn’t be na?ve enough to ignore what lies underwater.

Heineken as a brand is now worth USD7.6 billion(1). AB InBev grew from a regional Brazilian brewery to the largest brewery in the world in under 20 years. That may not define success to you, but you can’t accomplish that without being really good at many things. We need to gain insight into those strengths, and which can help at a time craft needs to evolve from high growth to a more mature market.

Today I wanted to share one of those strengths; a simple tool I witnessed which you will see opens some crucial discussions we need to have: Margin Pool Analysis.

Margin Pool Analysis

Let’s say you’ve brewed a 5% Pale Ale in Keg at a cost of ￡0.40 per pint (excl. duty) which someone will buy in a pub for ￡6. In this example, before reaching that drinker, the beer will be purchased by a wholesaler, then a pub, and ultimately the lucky drinker. That pint that costs ￡0.40 to make and is sold to the Drinker for ￡6 delivers ￡5.60 in total margin. Margin Pool is the analysis of where that full margin goes. Before reading on, take a guess on who takes the most margin from that ￡5.60?

The Pub. On a 70% wet led margin (ex VAT), a common target in the trade, the Pub takes ￡3.50 of margin, or 63%. Ok, who takes the 2nd largest margin amount?

The Government. Through VAT and Duty, the government takes ￡1.44, or 26% of the margin. This calculation will vary significantly based on your hLpa. For this calculation I have estimated a brewery at 1000 hLpa (about 20khL).

The Brewery is 3rd, with ￡0.39 of margin or 7%.

And then the Wholesaler, assuming a 18% margin will have ￡0.27 of the margin, or 5%.?

To state it bluntly, as a brewer you are receiving less than 10% of the margin created by the beer you make in this route-to-market example. That doesn’t necessarily mean your partners in the margin pool don’t deserve their cut. We’re selling more than just beer, we’re selling experiences. The venue, staff, beer freshness, serve, and more all play a key role in the experience the drinker is buying into.

However, at a time where breweries need to become more profitable to ensure the sustainability of craft, we can’t ignore the fact that that profitability may already be there.

I can feel the pitchforks and torches gathering in response to where this is headed, so let me clarify. What I am not suggesting is that you set out a plan to steal margin from your partners, because I can unequivocally say that you, and UK craft beer overall would be much worse off without them.

However, there are now more than enough breweries and beers out there to supply wholesalers and bars if you step away from some volume in those channels. In fact, for many breweries the challenge is getting listed and/or pushed by those partners. So, for a brewery to consciously work towards moving from say 10% of their beer sold direct through their own channels, to say 30% won’t affect their partners’ margin, or break the ecosystem, as long as they don’t start undercutting their partners. And if in doing so, that brewery can become stronger financially, then they’re in a much better position to support their wholesale and bar partners who at this time also need it.

To give one practical example. In the current climate, it’s very hard for wholesalers and bars to turn away significant volume-based discounts and listing fees from macro brands or craft brands owned by global breweries. If they choose to turn down such an offer and list an independent brewery, sticking to their values and supporting independent craft is going to cost them at a time when margins are razor thin. As mentioned in part 1, the average operating profit of 5 of the largest independent craft brewers in the UK is 0.2%(2). We can’t really expect independent breweries in their current form to just open the wallet and match those big brewery offers because there isn’t much in that wallet.

The system is broken. However, if we allow those breweries to build profitability, then that gives them a better chance to compete with those big money deals, and thus better financially support their trade partners. It can become a win-win for independent craft. Something has to change, and change will be uncomfortable, but we need to keep an open mind.

Now of course, this is just one route-to-market example. Complete this analysis for your main channels and have a discussion about what actions, if any, you want to take to increase your share of the margin pool. While the opportunities to build profitability will differ across brewery types and sizes, to initiate the conversation I’ve focused below on the 3 areas which I believe can have the largest impact.

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Open More Bars

If you have or can obtain the capital, open bars.

Let’s take that margin pool example and let’s say that drinker is buying the beer from a bar you own. Just like that, you’ve gone from earning 7% of the margin pool, to 74% (less any transport costs to your bars).

Let’s say the only beer your brewery sells is that 5% Pale Ale on keg through the wholesaler & pub route to market from the example. If you currently sell 20% of your volumes through your own bars now, and you increase that to 50%, you’ve just increased your total brewery margin by 15% without having to grow the brewery or make any cost reductions.

Ok, that’s not exactly true because by opening bars you are taking on additional costs such as rent, salaries, and utilities. But from experience I am confident that in the current environment, there is not a more profitable, sustainable way to sell your beer than through brewery owned bars if they are done right. Not to mention the cash flow of selling to yourself is about as good as it gets.

In the first piece, I mentioned that as the US market saturated, brewery openings began to slow. However, the slowdown was not consistent across all brewery types. Taprooms, defined by the Brewers Association as a brewery that sells 25% or more of its beer onsite and does not operate significant food service, has grown almost 350% ahead of all other brewery types combined. Yet despite that, taprooms maintain the lowest closure rate of all brewery types(3). So, if we once again use our ability to look into the future of craft through our friends in the US, optimising the margin pool, and specifically selling beer to drinkers yourself through bars & taprooms, has been a successful response to the market saturating in the US.

But the impact this can have in the UK is even bigger. For one, duty rates are considerably higher in the UK than in the US, so there’s less margin for the breweries and more of a need to make up that margin elsewhere in the margin pool. Secondly, the recent duty changes and the ongoing discussions on return schemes show that the government is going to incentivise on trade growth while bringing more cost & risk to packaged sales than ever before. Selling to yourself in the On Trade fits perfectly into this clear policy direction.

I know this strategy isn’t new, it’s just that the time to do this has never been more needed or accessible.

Price Bailey recently reported that 620 pubs in the UK entered insolvency in the past 12 months, a dramatic 68% increase over the previous year. The staffing impacts of Brexit combined with the increased costs of seemingly everything, debt burdens, and some consumer behaviour changes lingering from the Pandemic are, unfortunately, making this one of the most challenging times for pubs ever.

No one wants this to be the case; not only is having pubs thriving the best thing for craft beer, but more importantly, it just sucks to see folks we know going through this. However, it’s not an easy time for breweries either, and the current cost climate is making it such that operating a pub sustainably becomes significantly more feasible if you can sell beer to yourself. Additionally, due to the scale of closures, landlords want to bring in tenants with strong brands and, more than ever, are willing to negotiate premiums, rent, capital contributions and more. Great deals are out there.

I’m not suggesting it’s easy to run a bar. It brings a lot of new challenges that aren’t things experienced in a brewery. We have close relationships with our bar customers, and we know how good the best ones are at what they do. But this is a challenge worth taking on. There is no better way to strengthen brand affinity with current fans, and attract new ones, than the frontage outside and unfiltered brand experience inside of your own bar; and there is currently no more sustainable, profitable way to sell the beer you make.

Pay as little to the Government as Possible

On August 1st, the new duty rates and calculations came into place, so it’s a perfect time to really understand duty calculations and how it may shape your strategy and the future of craft beer. While our options to improve margin and profitability through the Government are limited, there are some interesting conversations to be had:

Do you actually want to grow?

Due to the way duty works in the UK, one of the quickest ways to erode margin and profitability is growth.

Based on the margin pool example discussed earlier on, for most breweries above ~8,000HL, the government will take more margin from beer through duty and VAT than the brewery will. Due to the size of the government’s take of the UK beer margin pool, it plays a significant role in shaping the landscape of beer.

And one of the biggest implications is that the duty rate disadvantages breweries that are looking to scale to compete with global brewers.

For the following, assume all breweries in the example have an average ABV of 5% for duty calculations. If you are a 2,000HL brewery, your main duty rate will be about 52% less than a global brewer. That is a significant discount that has been instrumental in incentivising the growth of craft beer. At that rate you can make some decent margin. At 5,000HL the discount is 46%; still solid.

But once you get to 10,000HL the discount on duty falls to 35%. by 30,000HL it’s become only 15%. At 50,000HL it’s 6%. Therefore, by the time you get to 50,000HLs you are almost paying the same duty rate as a global brewer, and clearly at that size you cannot obtain the same commercial negotiating power, scale efficiencies, or availability of capital for production efficiency projects…not even close.

So life can be good staying small and focusing on building a strong brand and efficient operation that can churn a good profit. And life is good at scale because you have a distinct advantage of scale over small brewers. The government is incentivising and protecting those business models. But the UK duty model is currently designed in a way that ‘crossing the chasm’ and growing from small to big becomes incredibly difficult, and an area you don’t want to hang in for too long.

I’m not saying don’t try and scale. In the current climate a lot of breweries will need to slow growth ambition due to the increased cost of stimulating demand, expanding a brewery, and debt. It’s actually a good time to go hard at growth, but only if you have the funds to back it up, a dialled in brand, and a brewery or business model that is cost efficient and able to handle the squeeze on margin that growth will bring.

But most breweries don’t have that.

While in the past it was often the path of least resistance to add a tank and ride the wave of growth, now that we see saturation in the market and a challenging cost environment, we really need to be deliberate in those decisions. For many, the best decision may be that instead of that tank, it’s time to invest in a strong, profitable brewery that isn’t chasing growth for now.?

The ABV of your focus brand(s) matters more than ever:

Make sure your focus beer is at an ABV you’re comfortable to scale it with.

As of August 1st, the average ABV of a brewery along with total HL production will be used to define your duty rate. In the past if you had a focus beer that had a higher ABV of say 6.5%, the duty impact of that beer would be limited to the HL production of that beer. Now, the HL production of that beer will affect the duty rate of your entire brewery.

Let’s say you have a higher ABV focus beer so instead of a 5% average ABV for your brewery, you are at 6%. Your main duty rate for the brewery will now be, on average, 3.5% higher than the 5% average ABV brewery if your volumes are equal. This impact is amplified for breweries between 5,000 – 40,000 HL, where the main duty rate will be on average 4.4% higher.

In the previous section we saw that a 5% ABV brewery has only a 6% discount on duty vs. a global brewer once they reach 50,000 HLs, however, if that brewery has an average ABV of 6%, their discount hits 6% almost 10,000 HLs earlier, by 41,000 HLs. So, not only does the duty model create a scale challenge for smaller brewers, but that challenge is amplified if you’re trying to achieve that scale with a higher ABV focus brand.

If you are looking to scale, ask yourself what your focus consumer really wants, and whether focusing on a lower ABV beer, or an ABV change would impact their experience. With the recent duty change, even better if you think you can scale a focus brand at 3.4% (but more on that in Part 3). If you want to effectively cross the scale chasm the duty model imposes on the industry, cost conversations like this will be crucial.

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Reduce your Costs

Publicly traded, global breweries are typically ‘blue chip’ businesses. Delivering reliable, stable earnings for investors reigns supreme…but business is unpredictable.

These businesses have powerful processes, tools and experienced people creating forecasts that predict sales volumes and price, but if the last three years have proved anything, it’s that you never know what’s going to happen. However, the last main P&L lever is the one they have almost total control over: costs.

If their financial plan doesn’t get to the desired profitability, cost cutting can improve that. If there is a gap between profitability actuals and budget, cost cutting can fill that gap.

Having tight control over costs can be as important to these businesses as innovation is to craft, so as we build cost control into our breweries we can learn a lot from them.

However, their dependence on cost cutting as a counterbalance to underperformance is a slippery slope. The need for cuts can come urgently, and the required cuts can be deep. They try and make the decision that will prevent any negative impact on consumers and long-term results, but in some cases it’s unavoidable.

I explain all this because as we make cost control a daily conversation within our breweries, we should absolutely look to those with more experience to help shape how to do this right for craft. In short: Agree realistic forecasts, plan ahead, put the consumer first, and start by reducing or eliminating costs that have no impact on the beer experiences of your focus consumer. These are what I’ve called ‘no impact’ costs, and they take two forms: general and brand specific.

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General No Impact Costs

These are costs that will have no impact on the beer experience of any consumer, regardless of brewery.

The ideal state here is that you map all your cost points in your business. A cost point being either where you spend money, or where there is an activity that influences the cost of production. For instance, procurement of raw materials or sales trade tools are obvious cost points, but so is the fill height of a can, or transfer volume from FV to BBT.

Mapping all of that for your business can sound daunting, and may be a medium term goal, ?but the important thing is just to start in a way that has the highest impact for you without distracting you from other focuses in the business. Maybe just map what you believe to be the top 10 cost points, or you could focus on one area of production, like brewing, to start. As you map cost points, you want to identify as many no impact costs as possible and go hard at eliminating them.

Consumers don’t care about whether the CO2 in beer is purchased or recovered for free. Similarly, it won’t change their perception of you if you optimise the variability of can fill heights, reduce the number of labels you have to write-off at the end of a run, standardize hop dumps per brand, propagate your own yeast, or have your 4 packs automated vs. manually packed.

Some of these areas may require capital to achieve, but a lot won’t. Empower your team to find these opportunities, bring in expertise to help if need be, speak to other breweries. In a time where we’re looking to improve profitability, there is no better place to start than identifying and eliminating costs that add no value.

Brand Specific No Impact Costs

As a brewery, ask yourself this: Who would miss you if you didn’t exist?

It’s not a critique if you cannot answer the question, or you aren’t satisfied with your answer.

After the pioneers opened the floodgates of craft beer, on the whole, the collective movement was more meaningful to consumers than the specific brands within it. Those that were interested in craft beer were seeking similar things: local, authenticity, creativity, and innovative flavours. That was where the growth was, so a lot of breweries naturally developed their version of that. Trying to carve out a unique position, or focus consumer, was risky, and potentially limiting.

But as growth slows, yet number of breweries continue to increase, there is now risk in not carving out your own position or focus customer.

This is an important topic that I will touch on in part 3 on innovation, but I have introduced it here because it forces us to distil down who our focus consumer is. And most likely when we do that, we’ll recognise that we’re spending money in ways that aren’t actually meaningful to that consumer. These are brand specific no impact costs because while they may be important to some consumers, they aren’t to those you are choosing to focus on.

As an example, for breweries that have a focus on consumers seeking highest ‘perceived’ quality, festivals, collaborations, Untappd and social media influencers can play a crucial role in building and maintaining that reputation amongst the more hardcore craft fanbase. Double down on this. Put your spend behind pushing quality even further and educating people about why your quality is the best, and if you need more margin, you’re better off raising your price than risking any quality perception.

But for most breweries your focus consumer isn’t concerned about whether you’re the top rated at something; they probably don’t even know where to look for the rating. There are approximately 100k users of Untappd in the UK, or less 0.2% of the above 18 population, and most of them are not highly active. The thickest, hazy beers are great for ratings, but if you’re making them for your focus customer who isn’t actually seeking them, they are a very costly substitution.

Take yields for example. Big, hazy beers often mean low yields. There are craft breweries in this country with yields below 70%, and there are some as high as 95%. For every can, bottle, keg or cask you produce above your current yield, all you are paying for is the duty and the container. The beer is free. While the impact will be different by brewery, any additional can, bottle, keg or cask will mean you’ve produced that beer at 20-40% less cost. This is without a doubt one of the best ways available to you to improve margin, IF it’s right for your focus consumer.

So, ask yourself who would miss you if you didn’t exist? Make sure you have an answer you are comfortable with, seek to understand as much as possible about that consumer, and make the beer and deliver the beer experience that is right for them.

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I don’t think there is a single person in craft beer that wouldn’t prefer to have discussions about growth and how we work together with our partners to help each other out and share the upside. However, we also cannot ignore the need for sustainable profit levels, or the impacts of such things as the UK duty model. This part of the evolution of craft will be most uncomfortable, but we need that thicker pie. And don't worry, part 3 of this project is all about a topic we love: innovation.

Stay tuned.

As I mentioned in the intro, this is not intended as an instruction manual full of infallible opinions and solutions. Some parts you will agree with, some parts you may disagree with, some parts may not be relevant for your challenges or goals. The goal is to start what I believe to be a crucial conversation, one that will hopefully continue with industry friends over beers, in your offices or breweries, and in the comments section of this post. So, what do you think?

Footnotes

(1)???Ibisworld; (2) Companies House; (3) Brand Finance 2023 annual report