We begin today with some McDonald’s math.

We do so because of recent votes to raise the minimum wage to $15 per hour in California and New York. It is a boneheaded idea. It shows the degree to which labor and its political supporters do not understand simple economics nor the knock-on effects a radically higher minimum wage has on the very people it’s supposed to help.

But first the math…

The service sector runs on thin profit margins. Consider that a typical McDonald’s generates about $2.5 million a year in sales, and labor costs eat up roughly 20% of that, according to a San Diego consultant who has worked with Mickey D’s franchisees. Subtract all the other costs — utilities, food commodities, rent, insurance, etc. — and those franchisees typically see a net profit of about 6% when all is said and done.

Here’s the math:

Sales: $2,500,000

Labor: $500,000

All the other stuff: $1,850,000

Net Profit: $150,000

Now, let’s see what happens when wages rise by 67%, which is what a $15 hourly wage represents in New York:

Sales: $2,500,000

Labor: $835,000

All the other stuff: $1,850,000

Net profit: -$185,000 (That’s a negative.)

When your profit margin is 6%, a 67% increase in labor means a $335,000 increase in a commodity cost. More than enough to wipe out your profit as a restaurant owner and thrust you deeply into the red.

Honestly, why stay in business?

Well, because you need a job, of course. But you won’t have a job very long if your eatery is hemorrhaging money. So, what do you do?

No Matter What … Workers Lose

Let me digress for a moment to address a school of thought that claims higher wages do not reduce employment — a school of thought hanging its belief on a 1992 study by Princeton econ professor Alan Krueger. He examined the impacts on fast-food employment when New Jersey raised its minimum wage, and found that the rate of employment growth did not differ from neighboring Pennsylvania, which had not raised the minimum wage.

Ipso facto, the wage-hike supporters insist, a $15 hike today will have no discernable impact on employment either, and any argument to the contrary is just a ruse by the 1% to once again screw the 99%.

Insert Price Is Right “you lose” music here…

There are two very significant problems labor glosses over or conveniently disregards:

  1. A $15 wage for the lowest-skilled worker means that managers who were earning $15 to $17 will suddenly — and rightly — demand much more, to maintain the pay gap with their subordinates. That cost trickles all the way up to middle management.
  2. Labor is nothing more than a commodity — no different, really, than ground meat or cheese slices. And when commodity prices rise significantly, management has choices to make to preserve profit margins: Find a cheaper alternative or raise the price of your product.

Some argue that producers should simply accept lower margins so that workers can earn a living wage. That’s a pretty picture of pink unicorns, though entirely naïve. As the math shows, higher wages turn profits to losses in businesses with thin profit margins. So businesses either shut down (workers lose), they replace workers with technology (workers lose) or they raise the price of their products (workers lose).

Businesses certainly don’t want to close. And though they will raise prices (eroding the purchasing power of the very people a minimum wage purportedly helps), they can’t easily raise prices to the degree necessary in the current economy.

Technology is the answer … which gets us back to why those preaching the gospel of Alan Krueger’s 1992 study are way off the mark (not to mention that Krueger’s study was ultimately discredited).

Killing the Economy

Technology today is no comparison to the technology of 25 years ago. Back then, there was no way to physically replace a fast-food worker. As an eatery owner, you might make your workers more efficient with certain pieces of hardware or cash-register software. But you still needed workers.

Today, workers are expendable.

Electronic order-entry kiosks that accept credit and debit cards obviate the need for cash registers and, thus, cashiers. Burger-making machines that will soon begin appearing (and which produce perfect burgers consistently) will soon obviate the need for back-of-house fry cooks. Soon enough, a single techie with an Internet connection and some well-positioned webcams will be able to efficiently manage a fleet of McDonald’s while working on a laptop in a Starbucks.

Labor has won what it considers a seminal victory in New York, California and a few individual cities that have been pushing up local minimum wages. It will, however, be labor’s greatest mistake. Labor has ultimately priced itself out of a job, and that will come back to haunt all of us in ways both economic and social that not many people are thinking about today … but that’s a topic for another day.

Until next time, good trading…

Jeff D. Opdyke
Editor, Frontline Investor

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