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Individual Case Assignment

Chipotle Mexican Grill’s Strategy in 2018: Will the New CEO Be Able to Rebuild Customer Trust and Revive Sales Growth?

Arthur A. Thompson The University of Alabama

Headed into August 2015, Chipotle (pronounced chi-POAT-lay) Mexican Grill’s future looked rosy. Sales and profits in the first six months of 2015 were at record-setting levels, and expectations were that 2015 would be the company’s best year ever. But a series of events occurred over the next five months that alarmed customers, drove down sales at Chipotle restaurants, and proved frustrating for Chipotle top executives to fix.

• In August, a salmonella outbreak in Minnesota sickened 64 people who had eaten at a Chipotle Mexican Grill. The state’s Department of Health later linked the illness to contaminated tomatoes served at the restaurant.

• In August, 80 customers and 18 employees at a Chipotle Mexican Grill in Southern California reported gastrointestinal symptoms of nausea, vomiting, and diarrhea that medical authorities and county health officials attributed to “norovi- rus.” Norovirus is a highly contagious bug spread by contaminated food, improper hygiene, and con- tact with contaminated surfaces; the virus causes inflammation of the stomach or intestines, leading to stomach pain, nausea, diarrhea, and vomiting. After the reported food poisoning, the restaurant voluntarily closed, threw out all remaining food products, and sent home the affected employ- ees. Employees who tested positive for norovirus

remained off duty until they were cleared to return to work. County health officials also inspected the facility on two occasions and rendered passing grades, despite finding several minor violations. The restaurant reopened the following day, and no further food poisoning incidents occurred.

• In October, 55 people became ill from food poisoning after eating at 11 Chipotle locations in the Portland, Oregon, and Seattle, Washington areas. Medical authorities attributed the illnesses to a strain of E. coli bacteria typically associated with contaminated food. Most ill people had eaten many of the same food items, but subsequent testing of the ingredients at the 11 Chipotle restaurants did not reveal any E. coli contamination. (When a restaurant serves foods with several ingredients that are mixed or cooked together and then used in multiple menu items, it is difficult for medical studies to pinpoint the specific ingredient or ingredients that might be contami- nated.) State and federal regulatory officials reviewed Chipotle’s distribution records but were unable to identify a single food item or ingredient that could explain the outbreak. Nonetheless, out of an abun- dance of caution, Chipotle management voluntarily closed all 43 Chipotle locations in the Portland and Seattle markets, pending a comprehensive review of

CASE 12

Copyright ©2019 by Arthur A. Thompson. All rights reserved.

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the causes underlying the food contamination and a check of whether any of Chipotle’s food suppliers were at fault. Chipotle management worked in close consultation and collaboration with state and federal health and food safety officials (including personnel from the Centers for Disease Control and Prevention, the U.S. Department of Agriculture’s Food Safety and Inspection Service, and the U.S. Food and Drug Administration) throughout their investigation of the incident and also launched a massive internal effort review of the company’s food preparation and food safety procedures. These internal actions included:

1. Confirming that more than 2,500 tests of Chipotle’s food, restaurant surfaces, and equipment all showed no E. coli.

2. Confirming that no employees in the affected res- taurants were sickened from the incident.

3. Expanding the testing of fresh produce, raw meat, and dairy items prior to restocking restaurants.

4. Implementing additional safety procedures and audits, in all of its 2,000 restaurants to ensure that robust food safety standards were in place.

5. Working closely with federal, state, and local gov- ernment agencies to further ensure that robust food safety standards were in place.

6. Replacing all ingredients in the closed restaurants. 7. Conducting additional deep cleaning and sanitization

in all of its closed restaurants (followed by deep clean- ing and sanitization in all restaurants nationwide).

Meanwhile, the Federal Drug Administration sought to identify a cause for the outbreak. The FDA’s investigation revealed no ingredient-related cause and no evidence that particular suppliers were the source of the outbreak. Ultimately, no food item was identified as causing the outbreak and no food item was ruled out as a cause, although fresh produce was suspected as the likely cause.

After health officials concluded it was safe to do so, all 43 restaurants in the Portland and Seattle mar- kets reopened in late November 2015, roughly 6 weeks after the incident occurred.

• Later, it was confirmed that at least 13 people in nine other states became infected with the same strain of E. coli linked to the Chipotle restaurants in Oregon and Washington states.

• In early December 2015, five people in three states— Kansas (1), North Dakota (1), and Oklahoma

(3)—became ill after eating at Chipotle Mexican Grill restaurants. Studies conducted by the Centers for Disease Control and Prevention (CDC) determined that all five people were infected with a rare strain of E.coli different from the infections in Oregon, Washington, and nine other states. However, investigators used sophis- ticated laboratory testing to determine that the DNA footprints of the illnesses in the Midwest were related to those in the Portland and Seattle areas.

• In mid-December 2015, about 120 Boston College students became ill after eating at a Chipotle Mexican Grill near the campus, an outbreak that local health officials attributed to a norovirus. Health officials also tested students for E. coli infections but the tests were negative.

Extensive reports of the last three incidents in the national media took a toll on customer traffic at most all Chipotle locations. The average decline in sales at Chipotle locations open at least 12 months was a stunning 14.6 percent in the fourth quarter of 2015, causing Chipotle’s revenues in Q4 2015 to be 6.8 percent lower than in the fourth quarter of 2014. The company’s stock price crashed from an all-time high of $758 in early August 2015 to $400 heading into 2016.

2016 aND 2017—GROWING FRUsTRaTION IN ReVIVING saLes aND ResTORING CUsTOMeR TRUsT IN THe CHIPOTLe BRaND In January 2016, the CDC announced that the prior food contamination and food safety issues at Chipotle were “over.” Chipotle management followed up by finalizing plans to install comprehensive food safety procedures at all Chipotle restaurants and establish Chipotle as an industry leader in food safety. In February 2016, Chipotle shut all of its restaurants for a period of four hours to conduct food safety training for all store employees. That same day, in an effort to get customers back into its stores, Chipotle offered a free burrito to anyone who signed up on its website. Recognizing that the task of rejuvenating customer traffic at its restaurants would not be easy, Chipotle

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any Chipotle in the United States or Canada just for playing.

• On Halloween, from 3 p.m. to closing at all Chipotle locations, customers dressed in costume could buy $3 burritos, bowls, salads, or tacos.

• All active duty military, reserves, national guard, military spouses, retired military with a valid U.S. military ID, and veterans with ID were offered a special buy-one-get-one-free with the purchase of an entrée from 3:00 p.m. to close on Veterans Day.

In addition, in October 2016, Chipotle began an “Ingredients Reign” advertising campaign highlight- ing its carefully selected ingredients and reinforcing Chipotle’s commitment to sourcing, preparing, and serving only the very best ingredients. The campaign featured a series of animated stop-motion short films shown in movie theaters across the country and also distributed through various online, digital, and social media outlets. In addition, the company used indoor and outdoor advertising with content showcasing the company’s obsession with fresh ingredients.

But the results of all these efforts to revive cus- tomer traffic were disappointing. Average sales at Chipotle restaurants in 2016 dropped to $1.87 million, 22.9 percent below the 2015 average of $2.42 million. Chipotle’s revenues dropped from $4.5 billion in 2015 to $3.9 billion in 2016, despite the opening of 240 new restaurants. Net income plunged 95 percent, from $475.6 million in 2015 to $22.9 million in 2016.

Chipotle’s performance in 2017 was better, but far from comforting to top management or shareholders. Revenue rose 14.7 percent to almost $4.5 billion, fractionally below the amount for 2015, but with 400 more restaurants in operation than in 2015; net income rose to $176.3 million. Average res- taurant sales climbed 3.9 percent to $1.94 million, but were still almost 20 percent below the 2015 aver- age. Exhibit 1 presents recent financial and operating data for Chipotle Mexican Grill.

At the end of November 2017, Chipotle Mexican Grill announced that Steve Ells, chair- man and CEO—and the founder of the company in 1993—would relinquish the title of CEO and become executive chairman following the comple- tion of a search to identify a new CEO. Ells rec- ommended the change in his role to the company’s Board of Directors, indicating it would “allow me to focus on my strengths, which include bringing inno- vation to the way we source and prepare our food.

management launched a series of marketing efforts and incentives to entice former and new customers to dine at Chipotle restaurants. For example:

• In March, Chipotle introduced a new online game called Guac Hunter—a digital photo hunt where players saw a series of two images that looked similar and had to spot the differences before time runs out. During a specified 11-day period, play- ers were rewarded for their keen eyesight with a mobile offer good for a free order of chips and guacamole at any Chipotle in the United States and Canada.

• In May, teachers, faculty, and school staff with a valid school ID received a free burrito, burrito bowl, salad, or order of tacos with the purchase of another menu item at all U.S. Chipotle loca- tions from 3:00 p.m. to close in honor of Teacher Appreciation Day.

• All nurses who showed a valid ID were rewarded with a special buy-one-get-one-free promotion on June 8.

• In June, chorizo sausage was introduced as a meat selection.

• A national advertising campaign featured Chipotle’s carefully selected ingredients and its longstanding commitment to sourcing, preparing, and serving only the very best ingredients.

• In July, Chipotle initiated a three-month pro- motion called Chiptopia where customers were rewarded with a free entrée on their fourth, eighth, and eleventh visit and purchase of paid entrée within a given month; customers who registered for the program in July earned a free chips and guacamole with their first entrée purchase.

• Families were offered a free kid’s meal with the purchase of an entrée on Sundays during the month of September.

• Also in September, high school and college stu- dents with a valid ID received a free fountain soft drink or iced tea with any in-store entrée purchase.

• In October, Chipotle introduced a new online game that allowed players to test their memory skills by matching up real Chipotle ingredients while being careful not to select the imposters (added flavor or added color cards). Anyone who played the game received a limited time mobile buy-one-get-one-free entrée offer redeemable at

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EXHIBIT 1 Financial and Operating Highlights for Chipotle Mexican Grill, 2011–2017

In millions of dollars, except for per share items

Income Statement Data 2017 2016 2015 2014 2011

Total revenue $4,476.4 $3,904.4 $4,501.2 $4,108.3 $2,269.6 Food, beverage, and packaging costs 1,535.4 1,365.6 1,503.8 1,421.0 738.7 As a % of total revenue 34.3% 5.0% 33.4% 34.6% 32.5% Labor costs 1,206.0 1,105.0 1,045.7 904.4 543.1 As a % of total revenue 26.9% 28.3% 23.2% 22.2% 23.9% Occupancy costs 327.1 293.6 262.4 230.9 147.3 As a % of total revenue 7.3% 7.3% 5.8% 5.6% 6.5% Other operating costs 651.6 642.0 515.0 434.2 251.2 As a % of total revenue 14.6% 16.4% 11.4% 10.6% 11.1% General and administrative expenses 296.4 276.2 250.2 273.9 149.4 As a % of total revenue 6.6% 7.1% 5.6% 6.7% 6.6% Depreciation and amortization 163.3 146.4 130.4 110.5 74.9 Pre-opening costs 12.3 17.2 16.9 15.6 8.5 Loss on disposal of assets 13.3 23.9 13,194 6,976 5,806 Total operating expenses 4,206.6 3,869.8 3,737.6 3,397.5 1,919.0 Operating income 270.8 34.6 763.6 710.8 350.6 As a % of total revenue 6.0% 0.9% 17.0% 17.3% 15.5% Interest and other income (expense) net 4.9 4.2 6.3 3.5 (0.9) Income before income taxes 275.7 38.7 769.9 714.3 349.7 Provision for income taxes (99.5) (15.8) (294.3) (268.9) (134.9) Net income $ 176.3 $ 22.9 $ 475.6 $ 445.4 $ 214.9 As a % of total revenue 3.9% 0.6% 10.6% 10.8% 9.5% Earnings per share Basic $ 6.19 $ 0.78 $ 15.30 $ 14.35 $ 6.89 Diluted 6.17 0.77 15.10 14.13 6.76 Weighted average common shares outstanding Basic 28.5 29.3 31.1 31.0 31.2 Diluted 28.6 29.8 31.5 31.5 31.8

Selected Balance Sheet Data

Total current assets $ 629.5 $ 522.4 $ 814.6 $ 859.5 $ 501.2 Total assets 2,045.7 2,026.1 2,725.1 2,527.3 1,425.3 Total current liabilities 323.9 281.8 279.9 245.7 157.5 Total liabilities 681.2 623.6 597.1 514.9 374.8 Total shareholders’ equity 1,364.4 1,402.5 2,128.0 2,012.4 1,044.2

Other Financial Data

Net cash provided by operating activities $ 467.1 $ 349.2 $ 683.3 $ 682.1 $ 411.1 Capital expenditures 216.8 258.8 257.4 252.6 151.1

Restaurant Operations Data In thousands of dollars

Restaurants open at year-end 2,408 2,250 2,010 1,783 1,230 Average restaurant sales $1,940.0 $1,868.0 $2,424.0 $2,472.0 $2,013.0 Average annual sales increases at restaurants open at least 13 full calendar months 6.4% (20.4)% 0.2% 16.8% 11.2% Development and construction costs per newly opened restaurant

$ 835 $ 880 $ 805 $ 843 $ 800

Source: Company 10-K reports, 2015, 2016, and 2017.

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In July 2018, Chipotle once again had a food safety lapse; this foodborne illness outbreak sick- ened over 600 customers at a restaurant just out- side of Columbus, Ohio. Health officials attributed the problem to bacteria that formed when certain food items were left out at unsafe temperatures. Upon learning the cause, Chipotle top management immediately announced it would launch retraining of all its restaurant workers nationwide the follow- ing week. While the company’s stock price dropped about 7 percent on news of the incident, it recov- ered quickly since customer traffic at Chipotle res- taurants nationwide was largely unaffected and the company’s future performance seemed to be on the upswing remained amid reports that the company was testing a number of new menu enhancements, perhaps to include the addition of a new breakfast menu and earlier opening hours.

CHIPOTLe MeXICaN GRILL’s eaRLY YeaRs Steve Ells graduated from the Culinary Institute of America and then worked for two years at Stars Restaurant in San Francisco. Soon after moving to Denver, he began working on plans to open his own restaurant. Guided by a conviction that food served fast did not have to be low quality and that delicious food did not have to be expensive, he came up with the concept of Chipotle Mexican Grill. When the first Chipotle restaurant opened in Denver in 1993, it became an instant hit. Patrons were attracted by the experience of getting better-quality food served fast and dining in a restaurant setting that was more upscale and appealing than those of traditional fast- food enterprises. Over the next several years, Ells opened more Chipotle restaurants in Denver and other Colorado locations.

Ells’ vision for Chipotle was “to change the way people think about and eat fast food.” Taking his inspiration from features commonly found in many fine-dining restaurants, Ells’s strategy for Chipotle Mexican Grill was predicated on six elements:

• Serving a focused menu of burritos, tacos, bur- rito bowls (a burrito without the tortilla), and salads.

• Using high-quality, fresh ingredients and classic cook- ing methods to create great tasting, reasonably-priced

As we work hard to restore our brand, I believe we can capitalize on opportunities, including in areas such as the digital experience, menu innovation, delivery, catering, and domestic and international expansion, to deliver significant growth.”1 A three- person search committee that included Steve Ells and two directors was formed to identify a new leader with demonstrated turnaround expertise to help address the challenges facing the company, improve execution, build customer trust, and drive sales. As of early February 2018, no new CEO had been announced.

During 2017, there were two more incidents of food poisoning at Chipotle restaurants that were widely publicized. In July, a crowd-sourced web- site, Iwaspoisoned.com, indicated that 133 persons reported becoming ill after eating at a Chipotle res- taurant in Sterling, Virginia, a Washington suburb. Chipotle promptly closed the restaurant for a “thor- ough sanitization” and reopened it two days later. In December, there were reports of sick employees and customers at a Chipotle restaurant in Los Angeles. Chipotle alerted local health officials, held the employees out of work, and instituted heightened pre- ventative procedures. Local health officials promptly began an investigation, inspected the premises, and were pleased with the operations. The restaurant remained open. Both incidents spooked investors, triggered immediate declines in the stock price, and reignited concerns over whether Chipotle had fully resolved its food safety issues.

In announcing Chipotle’s 2017 financial results in February 2018, Steve Ells commented on the com- pany’s ongoing efforts to regain the confidence of customers and restore the appeal of dining at one of Chipotle’s 2,400 locations:

During 2017, we have made considerable changes around leadership, operations, and long-term planning and it is clear that, while there is still work to be done, we are starting to see some success. 2018 marks the 25th anni- versary of Chipotle, and I am encouraged by the dedica- tion all of our guests and employees have to this brand. Our focus this year will be to continue perfecting the din- ing experience, enhancing the guest experience through innovations in digital and catering, and reinvesting in our restaurants. We are making good progress on our search for a new CEO who can improve execution, drive sales and enable Chipotle to realize our enormous potential.2

Ells further indicated that management expected sales increases in 2018 at restaurant locations open at least 13 months would be in the low single digits.

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and constant improvement. He pushed especially hard for new ways to boost “throughput”—the number of customers whose orders could be taken, prepared, and served per hour.3 By 2012, Ell’s mantra of “slow food, fast” had resulted in throughputs of 300 cus- tomers per hour at Chipotle’s best restaurants.

From 2011 through 2015, Chipotle’s revenues grew at a robust compound average rate of 18.7 percent. Net income grew at a compound rate of 19.4 percent, due not only to sales increases but also improved operat- ing efficiency that boosted profit margins. Growing customer visits and higher expenditures per customer visit drove average annual sales for Chipotle restau- rants open at least 13 full calendar months from $1,085,000 in 2007 to $2,424,000 in 2015. The aver- age check per customer ran $8 to $10 in 2011-2015.

CHIPOTLe MeXICaN GRILL IN 2018 Going into 2018, Chipotle operated 2,363 Chipotle Mexican Grill restaurants in 47 states and the District of Columbia, plus 24 in Canada, 6 in England, 6 in France, and 1 in Germany. In addition to the 2,000 Chipotle locations, the company had experimented with transferring its Chipotle model for Mexican food to other cuisines over the past seven years and currently operated a small fast casual pizza chain called Pizzeria Locale that had seven res- taurants in four states, and one burger-fries-shakes restaurant called Tasty Made, giving it a total of 2,408 restaurants. In 2017, Chipotle decided to aban- don its efforts to use high-quality, fresh ingredients and classic cooking methods to create great tasting, reasonably-priced Asian dishes; all 15 ShopHouse Southeast Asian Kitchen restaurants opened from 2011 through 2016 were closed after determining that devoting further efforts to perfect the ShopHouse concept and invest capital to expand the number of ShopHouse locations was not justified in light of the current difficulties being encountered in reviv- ing sales and growth at its core Chipotle Mexican Grill business. The Tasty Made location was closed in March 2018, because two years of finetuning and tweaking of operations failed to produce satisfactory revenue-cost-profit economics. Chipotle manage- ment planned to open between 130 and 150 addi- tional restaurants in 2018, all of which were expected to be Chipotle restaurants.

dishes prepared to order and ready to be served 1 to 2 minutes after they were ordered.

• Enabling customers to select the ingredients they wanted in each dish by speaking directly to the employees assembling the dish on the serving line.

• Creating an operationally efficient restaurant with an aesthetically-pleasing interior.

• Building a special people culture comprised of friendly, high-performing people motivated to take good care of each customer and empowered to achieve high standards.

• Doing all of this with increasing awareness and respect for the environment and by using organically- grown fresh produce and meats raised in a humane manner without hormones and antibiotics.

In 1998, intrigued by what it saw happening at Chipotle, McDonald’s first acquired an initial own- ership stake in the fledgling company, then acquired a controlling interest in early 2000. But McDonald’s recognized the value of Ells’s visionary leadership and kept him in the role of Chipotle’s chief executive after it gained majority ownership. Drawing upon the investment capital provided by McDonald’s and its decades of expertise in supply chain logistics, expand- ing a restaurant chain, and operating restaurants efficiently, Chipotle—under Ells’s watchful and pas- sionate guidance—embarked on a long-term strategy to open new restaurants and expand its market cov- erage. By year-end 2005, Chipotle had 489 locations in 24 states. As 2005 drew to a close, in somewhat of a surprise move, McDonald’s top management determined that instead of continuing to parent Chipotle’s growth, it would take the company public and give Chipotle management a free rein in charting the company’s future growth and strategy. An initial public offering of shares was held in January 2006, and Steve Ells was designated as Chipotle’s CEO and Chairman of the Board. During 2006, through the January IPO, a secondary offering in May 2006, and a tax-free exchange offer in October 2006, McDonald’s disposed of its entire ownership interest in Chipotle Mexican Grill.

When Chipotle became an independent enter- prise, Steve Ells and the company’s other top execu- tives kept the company squarely on a path of rapid expansion and continued to employ the same basic strategy elements that were the foundation of the company’s success. Steve Ells functioned as the com- pany’s principal driving force for ongoing innovation

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although some items were prepared from fresh ingre- dients in area commissaries. Kitchen crews used clas- sic cooking methods—they marinated and grilled the chicken and steak, hand-cut produce and herbs, made fresh salsa and guacamole, and cooked rice in small batches throughout the day. While the food prepara- tion methods were labor-intensive, the limited menu created efficiencies that helped keep costs down.

Food preparation methods at Chipotle’s restau- rants were overhauled in late 2015 in response to the food contamination incidents. The goal was to develop an industry-leading food safety program uti- lizing the assistance and recommendations of highly respected experts. Components of the new program included:

• DNA-based testing of many ingredients to evalu- ate their quality and safety before they were shipped to Chipotle restaurants.

• Changes to food preparation and food handling practices, including washing and cutting some produce items (such as tomatoes and romaine let- tuce) in central kitchens.

• Blanching of some produce items (including avo- cados, onions, jalapenos, and citrus) in each res- taurant before cutting them.

• New protocols for marinating meats. • Utilizing the Food and Drug Administration’s

Hazard Analysis Critical Control Point (HACCP) management system to enhance internal controls relating to food safety.

• Instituting internal training programs to ensure that all employees thoroughly understand the company’s newly imposed standards for food safety and food handling.

• Offering paid sick leave to employees to reduce incentives for employees to work while sick.

• Implementing stricter standards for food prepara- tion, cleanliness, and food safety at all of the com- pany’s restaurants.

• Strengthening efforts to ensure that the company remained in full compliance with all applicable federal, state, and local food safety regulations

Quality Assurance and Food Safety Chipotle’s quality assurance department was charged with establish- ing and monitoring quality and food safety measures throughout the company’s supply chain. There were quality and food safety standards for farms that grew

Menu and Food Preparation The menu at Chipotle Mexican Grill restaurants was quite limited—burritos, burrito bowls, tacos, and salads; plus soft drinks, fruit drinks, and milk—the drink options also included a selection of beers and margaritas in all locations except those where serv- ing alcoholic beverages was prohibited. Menu vari- ety was achieved by enabling customers to customize their burritos, burrito bowls, tacos, and salads in dozens of different ways. Options included five dif- ferent meats or tofu, pinto beans or vegetarian black beans, brown or white rice tossed with lime juice and fresh-chopped cilantro, and choices of such extras as sautéed peppers and onions, salsas, guacamole, sour cream, queso, shredded cheese, lettuce, and tortilla chips seasoned with fresh lime and salt. In addition, it was restaurant policy to make special dishes for customers if the requested dish could be made from the ingredients on hand.

From the outset, Chipotle’s menu strategy had been to keep it simple, do a few things exceptionally well, and not include menu selections (like coffee and desserts) that complicated store operations and impaired efficiency. While it was management’s prac- tice to consider menu additions, the menu offerings had remained fundamentally the same since the addi- tion of burrito bowls in 2005, tofu Sofritas (shred- ded organic tofu braised with chipotle chilis, roasted poblanos, and a blend of aromatic spices) as a meat alternative in 2013 and 2014, the addition of chorizo sausage as a meat option in 2016, and the 2017 addi- tion of queso (made of aged cheddar cheese, toma- toes, tomatillos, and several varieties of peppers). So far, the company had rejected the option of opening earlier in the day and offering a breakfast menu.

The food preparation area of each restaurant was equipped with stoves and grills, pots and pans, and an assortment of cutting knives, wire whisks, and other kitchen utensils. There was a walk-in refrigera- tor stocked with ingredients, and supplies of herbs, spices, and dry goods such as rice. The work space more closely resembled the layout of the kitchen in a fine dining restaurant than the cooking area of typi- cal fast food restaurant that made extensive use of automated cooking equipment and microwaves. Until the food contamination and food safety incidents in Q4 2015, all of the menu selections and optional extras were prepared from scratch in each Chipotle location—hours went into preparing food on-site,