04/15/2015 12:02 pm ET Updated Jun 15, 2015

Happy Workers, Happy Meals: The Strategic Case for Higher Wages at McDonald's


McDonald's, the chatterbox tells us, is on its last legs. The food is bad, or at best, unfashionable. Everybody now eats at Chipotle. Moreover, it pays its employees so badly that, at least for liberals, eating there is unconscionable. The bad food, on some level, reflects bad politics (echoing a common feeling about Walmart). McDonald's is, in this view, the food equivalent of Walmart, but without the market power. Goodbye, good riddance.

Despite the inevitability of its fall, McDonald's is still an extraordinarily successful company--at least globally. Between the company-owned and the franchisee-owned stores, McDonald's still sells $88 billion a year in McProducts. Last year its corporate revenue was twice as high as either Yum! (Taco Bell, Pizza Hut) or Starbucks. Chipotle, its supposed replacement, was only one-seventh its size. With over 400,000 employees and 36,000 restaurants worldwide, it is a global phenomenon.

In the U.S., however, growth has stalled. Since 2004, McDonald's has sold more in Europe than in the United States--and that gap continues to grow. Last year, Chipotle's revenues grew 28%, Starbucks grew 11% and even Yum! grew by 1.5%. McDonald's fell by 2.4%.

In the last few years, McDonald's has tried to reposition itself with an upmarket strategy to compete with "fast casual" chains and to differentiate itself from other fast food. While still delivering the "Dollar Menu," it has experimented with other offerings to lure back more affluent consumers. In the last year its new offerings have focused on "food quality" with the hope, as it wrote in its governmental filings, of "transition[ing] products to a higher price point when appropriate." McCafe offers a $1 alternative to that $4 Starbucks. The recent antibiotic-free chicken and hormone-free milk, echoing Chipotle, are intended to appeal to the customer suspicious of chemically-laden animal products.

The strategy has failed. Whereas Walmart has few competitors, fast food restaurants are everywhere. If McDonald's can no longer differentiate itself on price or quality, it needs a bold strategy--or it will go out of business. McDonald's smart move will be to compete on profits--not by cutting prices, but by raising wages.

McDonald's, while short on growth, has plenty of profit. Last year, worldwide, the EBITDA margin (the earnings out of every dollar of sales) for McDonald's was 35%. For Starbucks, Chipotle, and Yum! it was only about 20%. For such a big company, that extra 15 cents out of every dollar of sales is huge. McDonald's can raise wages, take the moral high ground, and still make more money than the other guys. Perhaps it can even persuade those Starbucks yuppies to try its McCafe. Its competition can't follow. The wage increase won't be able to be replicated elsewhere.

The American branch of the McDonald's corporation, however, will not be taking the hit--the franchisees, who own 89% of all American locations, will.

Historically, the franchise model kept labor relations at arms-length from the McDonald's corporation. Franchises received business training and supply chain access from corporate, but they ran their locations like independent small businesses. For many would-be entrepreneurs, the franchise is the surest path to ownership. While independent restaurants usually fail, brand-name fast food chains usually succeed. While the corporation has always provided helpful guidance--Hamburger University!--on how to run the franchises, it has left wages and hours to the owner's discretion, just to keep a clear distinction between franchisor and franchisee.

Those boundaries, because of worker and legal activists, are beginning to break down. Since last summer, the National Labor Relations Board and McDonald's have been battling over whether the employees at franchises are actually jointly employed by the McDonald's corporation and the franchisee. Most importantly, workers across the country have been organizing against McDonald's like they have against Walmart. Unlike Wamart, which owns all of its locations, most golden arches are privately owned. Unlike Walmart, franchisees can't just close up shop and move across town. Workers at McDonald's franchises have actual power.

Corporate, then, has a choice: fight the workers or join them--against the franchisees. This summer McDonald's plans to raise wages a dollar above minimum wage and, over the next year, to see that wage rise above $10. The catch is that the McDonald's corporation can only do this at the stores that it owns directly. McDonald's workers at the franchise locations will not automatically get a pay raise. Pressure will, no doubt, be brought to bear on franchisees to match the pay raises, since corporate profits won't be affected. Franchisees could refuse, but to do so would to lose the good will of consumers.

The dirty secret is that higher wages, even at those 11% of restaurants owned by the corporation, will not substantially affect corporate's revenue. In 2014, about half ($4.35 billion) of McDonald's corporate revenue came from sales in its own restaurants and about half ($4.30 billion) came from franchise revenue. Consider McDonald's own restaurants, the ones getting the pay raises. Of that $4.35 billion, $3.60 billion gets paid out in food & paper ($1.4b), wages & benefits ($1.25b), and occupancy ($0.942b). If McDonald's increases its wages from the national minimum wage of $7.25 to $10, then it should, if benefits go up at the same rate, decrease its labor costs to $1.72b--costing it about $470 million. But with all that revenue from its franchisees, it will still earn a staggering $2.3 billion.

The franchise fees, unlike McDonald's profits, are based only on how many hamburgers a franchisee sells, not how much it costs to sell them. In the most recent franchise agreement, McDonald's corporate took, in additional to other fixed fees and royalties, 4% of a franchisee's gross sales. If wages go up at a McDonald's, the franchisee will still have to pay the same share of profits to corporate. While McDonald's corporation might be able to handle the wage increase, the franchisees, whose margins are much tighter, might not.

Critics might claim that McDonald's has an incentive to prop up profits at the franchises, since if profits fall, then no one will open more McDonald's. But in most markets, good new locations are rare. Only in states, like Texas, that have dynamic suburban growth, are new locations opening up. Rhode Island, for instance, had no new McDonald's open last year. McDonald's only path to growth is by increasing in-store sales, not adding more locations.

Labor rights has become a consumer issue and McDonald's has an opportunity to rebrand itself as the friend of workers, albeit at the cost of franchisee profits. McDonald's, if it wants to survive in the U.S., would be foolish to do otherwise. A few failed franchisees is a small price to pay for rejuvenating what is perhaps the most signature American brand--and saving all those other franchisees. High wages will be a way for it to shine, providing not just a happy meal, but a happy worker.