McDonalds: The Impact of Higher Labor Costs

“I’m not in the food business- I’m in the human resources business”.

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That was a comment made to me by a McDonalds franchise owner 10 years ago. The comment has stuck with me. Fast food restaurants have constant turnover in staff. That issues requires a huge investment in hiring, training, evaluating- and sometimes firing- staff. So what happens financially when you increase the hourly rate of pay across the board?

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McDonalds hourly rate increase

McDonalds recently announced an hourly rate increase for its workers. As stated here, the raise only applied to the 1,500 McDonald’s-owned restaurants in the US. The raise does not applies to franchise-owned stores, which make up 90% of the restaurants and most of the workforce in the US.

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The franchise relationship

In a franchise, an investor- referred to as a franchisee- purchases the right to use the McDonalds brand and operate a restaurant for a period of years. Page 45 of the McDonald’s 2013 Annual Report explains the arrangement. The franchisee pays an initial fee and annual royalties, based on a percentage of sales. So, your royalties are an additional expense on the franchisee’s income statement. The agreement is typically in force for 20 years.

Wage pressures on profit

McDonalds defines margins as sales less operating costs. In 2013, company-owner restaurants saw a 2% decrease in margins, due in part to higher labor costs. The article explains that the company will increase wages to “more than $10 an hour by the end of 2016- up from $9.01 currently.” To keep things simple, call it an 11% increase in labor costs. Consider the impact of that increase on the financials.

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Profitability and cash flow

The firm’s 2013 consolidated income statement states that payroll and employee benefits account are 17% of sales. Now, this report includes both franchise-owned and company-owned stores. This line item includes wages for management- as well as benefit costs that are not payroll. But the schedule does give you a sense of how much of each sales dollar goes toward paying employees.

Assume that, if wages increase by 11% (from $9 to $10), the entire line item of payroll and employee benefits increases by the same percentage. Payroll and employee benefits would increase to 19% of sales. Again, not a perfect comparison- but you get the idea. A restaurant would spend 2% more of every sales dollar on employee costs.

 

Higher payroll costs also affect cash flow. If your costs increase by 2%, you need 2% more cash every two weeks to make payroll- everything else being the same. Instead of plowing 2% of your cash generation into business growth, you have to use it for payroll.

All of this is food for thought. Carefully consider the long-term impact of a pay scale increase on your profitability and cash flow.

 

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