Financial Mathematics Text

Thursday, January 30, 2014

McDonald's and Wages

There's a considerable amount of debate revolving around the minimum wage and the vast number of workers in the US that earn a very low wage. I'm personally of the view that the growing inequality in the US in which the top 1% (and 0.1% which looks even worse) have been taking a larger share of the income.

A good portion of the talk has concerned fast food workers of which McDonald's is the largest and most focused on.  Today I want to take a practical look at McDonald's and wages.

McDonald's Workers Disconnect

One of the biggest problems is how many of the rich and even middle class seem to lack an understanding of the conditions of those on the low end. A good example is a hypothetical budget put out by McDonald's:

The monthly budget, amongst other things, assumes that the worker can work two jobs earning \$2,060 per month in net income. This works out to about 70 hours a week.

Actually getting that many hours working fast food is probably not easy. Fast food businesses often have needs for a large number of employees during certain periods of the day (e.g. lunch time business) while having less of a need during other hours. This results in many work shifts only being around 2-4 hours. See this interview from Forbes with a worker who only gets 20-30 hours per week.

Picking up hours at a fast food job often requires a significant amount of flexibility. This works quite well for students during the summer time but it's not really the kind of job an adult with a family can make due with. I don't see how realistic it is for someone with kids to be able to pick up two of these jobs in order to work 70 hours a week (and manage every other aspect of their life.)

The expense side of this budget is also quite unrealistic. For more details, see Yves Smith's critique of the budget here.

Three Party Relationship

One thing that I think many commentaries seem to miss is that there are at least three parties in the McDonald's - worker relationship. Many focus on the low wages of McDonald's employees and the billions in annual profits that McDonald's makes. But there's actually a third party in all of this: franchisees.

McDonald's contracts with franchisees who ultimately front capital and operate restaurants. This complicates the relationship a bit and that complication is often ignored. Ultimately, it's the franchisees that are responsible for hiring and paying workers.

McDonald's makes its money by collecting various fees from the franchisee which are often a percentage of sales. So whatever analysis one uses, I think it's essential to consider this more complex relationship. Any "solution" to the problem will require all three parties working together.

McDonald's Franchisee Financial Position

Today I want to take a quick look at what the franchisee's financial position looks like. I was actually curious how much franchisees actually make.

Janney Capital Markets has collected an "average" income statement for a McDonald's franchisee (see here). Of course as the saying goes, YMMV. I've entered this into a google spreadsheet (which you can save to your drive and modify as you see fit). Here's what it looks like:

In the first column I have Janney Capital Markets' figures. In the second column I have my own adjustments.

My goal was to, more or less, retain the same (unlevered) return on invested capital. I assumed the initial investment required  was \$1.5M (again, YMMV).

My assumptions include an increase in prices of 7.25%, an increase in wages of 25% (someone making \$8 per hour would now make \$10) and insurance costs of \$60,000 (essentially providing \$2000 per year insurance for 30 full time employees).

There are problems with my assumptions. I didn't take into account how that would effect taxes. I also assumed that prices can be increased by 7.25% without any reduction in output. There are a few problems with this:

1) An increase in the price of value menu items would likely not occur. That \$1 price tag is an important psychological anchor. So other prices would have to be increased by more than 7.25%.

2) As a result of (1), some customers would switch from the higher ticket items to value menu items.

3) McDonald's might lose sales volume in other ways due to price increase.

Concessions from McDonald's?

Now it might be possible for McDonald's corporate to make concessions. For example, many franchisees are "simmering" over rental costs. The article points out that some franchisees are paying 12% of sales versus historical levels of 8.5%. Based on Janney Capital Markets' figures, "rent and fees" amounted to 14.5% of sales.

I don't know the economics of that situation but that may be an area where McDonald's could make concessions.

McDonald's may be able to cut its royalties in other areas to allow franchisees to pay workers more. In addition, they may be able to help with insurance subsidies to workers.

Concluding Thoughts

There are a number of very real concerns here. Here are a couple:

1) Would higher wages reduce employment?

The idea here is that the higher wages would make various technologies profitable to implement to reduce labor costs. For example, ZeroHedge recently posted this technology: Smart Restaurant.

2) Are higher wages appropriate for McDonald's workers?

The criticism (and I think it's a bit misguided but there is a worthwhile point of consideration in spite of that) is that these are entry level jobs that perhaps do not deserve higher pay.

Where the criticism is misguided, I think, is that it assumes these are all entry level workers (young, unskilled, etc) which is not necessarily the case. Some are college graduates who cannot find other work. Others are workers displaced from other fields (e.g. manufacturing) in which they may have other skills but there simply isn't any jobs available.

Furthermore, it's assumed that we need these types of jobs so that unskilled employees can gain skill. This latter "myth" someone will have to explain to me; I have hard time believing an HR manager saying, "Oh, I see you worked a year a McDonald's; we're always looking for former McDonald's employees." Perhaps I'm mistaken. No doubt there are skills to be learned (food handling, cash handling, customer service, cleaning, etc) but I don't see how that translates into a stepping stone to a better paying job. (If I'm wrong, feel free to educate me.)

Where I think the criticism has merit is that we have a number of people who may be more capable but are stuck in McDonald's employment because there are no opportunities for them. In a sense, their skills and abilities and potential are being underutilized by society as a whole.

In any case, I wanted to give this whole McDonald's wage discussion some direction. I think asking the right questions and looking at some hard data is important if real change is to take place.

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