About that McDonald’s Minimum Wage and Prices Competing Maths

Leave the kid (ok, Finance Research Assistant, Arnobio Morelix, from University of Kansas ) alone for his math on effect of wage increase on McDonald’s prices. He did his math based on labor costs reported by McD in its SEC filings and said,

7.1 percent of the fast-food giant’s revenue goes toward salaries and benefits. … Thus, if McDonald’s executives wanted to double the salaries of all of its employees and keep profits and other expenses the same, it would need to increase prices by just 17 cents per dollar, according to Morelix.

But he is blamed for not considering the fact most of labor is in the books of franchisees,

By contrast, the small business owners that actually operate McDonald’s locations are spending about a third of their income on employees. Using Morelix’s own methodology, this means prices would actually increase by 32 cents on the dollar if labor costs doubled, or an extra $1.28 for your Big Mac.

And this article goes on to say,

Morelix’s estimate also ignores the fact that price increases reduce restaurant sales–requiring even higher prices on the remaining customers to maintain the assumed profit line

Actually both the methods are wrong. They are wrong on two fronts – costing and pricing.

Cost Analysis Errors

Let us not forget that the numbers reported in financial statements are for investor purposes as mandated by SEC. These are reported in aggregates, truthfully (mostly), but done in a way not to make it easy for competition to understand the cost structure. Do not expect the cost per unit number (marginal cost) for each product to be broken down and reported for competition to see.

McD has a large product mix that spans the spectrum from premium to basic. Its margins (gross and contribution) on premium priced products are most likely higher than that from basic products. A moment’s reflection will convince you that labor cost does not change with product mix or number of units sold. So it should be treated as a fixed cost of operating the franchise vs. marginal cost on each unit sold.

Price Analysis Errors

Both these analyses assume and do math using cost based pricing. That is you add up all your costs, distribute the costs among units sold, tack on a markup and voila you have price. Customers are not buying your products to defray your costs. See this article on ridiculousness of cost based pricing.

Had McD set prices thusly then it is true that increasing prices will result in lower sales (demand schedule), hence fewer units to distribute the costs on, hence higher per unit cost allocation, hence even higher price, …. death spiral.

Pricing comes before costs. A marketer will first find out what the different customers are willing to pay and set a price that maximizes their profit at given cost structure. If innovations or off loading cost components help reduce costs they will lower prices as long as the incremental profit from new sales is more than the lost profit from decreased per unit profit.

McD wants to get its products into the hands of as many customers as possible. They as the brand owner gets to set prices. They set prices (using whatever demand schedule they uncovered) and try to make those prices at costs that deliver profits. With franchise model it works a bit more in their favor – they set prices and let the franchisees worry about making a profit at those prices after covering their total costs.

If the franchisees see their current sales is not enough to make a profit, after paying McD its due (franchise service fee , rent, marketing expenses and materials cost to McD), labor costs, investment costs and all other operating costs they may decide to either quit and do something else or look for ways to squeeze other costs. For instance they could force McD to reduce the service fee, rent or materials costs.

If McD sees drop in gross sales because franchisees see an unprofitable business they may either set higher price point thereby catering to fewer customers or change product mix. Note that I did not say price increase but said, “set higher price point“. There is a huge difference. The former means passing on cost to customer while later means deciding to let go some customers who are not willing to pay the higher prices.

If McD should change the product mix they may choose to opt for premium products, different service and better experience. That product strategy will require a different labor that demands higher wages but franchisees may willingly pay those wages because of better profit from new product mix.

A marketer decides to drive down prices to reach as many customers as possible because they can still maximize profits at those prices by driving down costs. If they were not allowed to drive down costs (by artificially passing on to others) they will choose to set higher price points and serve a different segment vs. serving all.

Finally an important point Ron Shevlin makes about businesses and price increases,

Yes they would have as I wrote previously on this topic.

There you have it. Costs have nothing to do with pricing and paying living wages does not mean costs are being passed on to customers.

On the same note when a business says they are passing on Obama care costs in each slice of pizza you buy you should question it.

Correlation Causation Confusion

Here is a quote from today’s Journal’s opinion piece on minimum wage increase:

Study after study reveals that there are long-term career benefits to working as a teenager and that these benefits go well beyond the pay that these youths receive. A study by researchers at Stanford found that those who do not work as teenagers have lower long-term wages and employability even after 10 years.

What the study found is a correlation, but WSJ uses it to imply causation – not working as a teenager leads to getting lower long-term wages and employability. But isn’t is it possible that there is an underlying cause for both these observed characteristics (omitted variable bias)? Is it possible that the same reason that led to unemployment as a teenager is driving low-wages and employability in later years?

On the other hand, for those with high wages and employability is working as a teenager  just one tool? Would they have used any other means equally effectively to achieve what they want?

Correlation does not imply causation. The Stanford study was an observation, not a controlled experiment where they randomly selected teenagers, assigned them randomly to working and non-working groups and then years later look at their earning potential.

This is not the first time the Journal is pushing causation based on correlation. You can find more such causation confusion from WSJ here and here.