Reporter's Notebook

Rising costs have hurt McDonald's franchisees' profits

Over the past decade McDonald’s has done an admirable job adding new products and dayparts to its menu in a long run-up of its average unit volumes. Even after a tough 2014, the average McDonald’s is still going to take in about $2.5 million in revenue, roughly $1 million more than Wendy’s and twice the average Burger King.

But, it seems, the additional products haven’t quite been as profitable as you might imagine.

In a presentation to analysts last week, McDonald’s executives said that the chain’s locations have had an average sales increase of $770,000 over the past decade. That’s good. The average store has basically added the equivalent of a good-volume sandwich shop in 10 years.

Yet cash flow, those executives said, has increased by $70,000 over that time. That’s only about 9 percent, which is surprising because in theory all of those added products and menu items should be more profitable. 

In general, a restaurant’s second $1 million in revenue should be more profitable than the first $1 million, because the fixed costs don’t increase. Labor should be more efficient, too.

“Those added sales dollars should be extremely profitable because they’ve already covered their fixed costs,” said Richard Adams, a former McDonald’s franchisee turned consultant.

Part of the issue is McDonald’s franchise model. The company controls its franchisees’ real estate, and operators pay rent based on a percentage of sales, rather than a fixed amount. So as their volumes go up, so go their rent charges and thus the profitability of that second $2 million. In most systems, rent is a huge fixed cost.

But it also suggests that rising food costs have hurt operators’ bottom lines at a time of high food inflation. Beef costs, in particular, have been a problem the past couple of years, and McDonald’s uses a lot of beef. Cheese and pork have been a problem this year, too.

Indeed, CEO Don Thompson explained to analysts that “costs have been accelerating at a much more rapid pace” and that a couple of years ago, “cash flow would have been higher than that.”

Some note that McDonald’s reliance on discounting to get customers in the door has played a role, too.

The company uses a lot of everyday value discounts, with its Dollar Menu and its Extra Value Meals. And while the company has taken steps to address those costs — increasing prices for some items, for instance, re-labeling the Dollar Menu the Dollar Menu and More — it’s still tougher to make a profit when ground beef rises 10 percent a year and your system serves a lot of low-cost products.

Adams also suggested that pressure from the company on franchisees to increase kitchen staffing to improve service has increased labor costs and also hurt the profitability of those new items.

Regardless, the cash flow numbers demonstrate the pressures operators have been under the past couple of years as that sales growth stopped. And it can help explain their growing unrest.

During Janney Capital Markets Analyst Mark Kalinowski’s last survey of McDonald’s franchisees in October, 28 of 32 operators said their outlook was “fair” or “poor.” And 27 operators said their relationship with the franchisor was either “fair” or “poor.” A sales decline and diminished profit tends to have that impact.

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