mcdonalds

Carnegie ConsultingStrategic Solutions for Business

Improving Customer Satisfaction andPreserving the McDonald’s Brand

Prepared for:

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______________________________________________________________________________Carnegie Consulting

425 N. College Ave. s Claremont, CA 91711-2-

Table of Contents

Executive Summary ......................................................................3

Company History...........................................................................3

Internal Rivalry...............................................................................3

Substitutes and Complements ......................................................5

Entry ..............................................................................................6

Buyer and Supplier Power ............................................................7

Strengths, Weaknesses, Opportunities and Threats ....................9

Financial Outlook.........................................................................13

Strategic Analysis: Improving Store Performance ......................14

Conclusion...................................................................................17



Executive Summary

Competition for fast food customers is fierce. For the purposes of this report, we discuss thefast food industry, focusing on the Southern California region. The Southern California regionwas selected specifically for two reasons: First, Southern California often acts as a bellwetherfor food trends nationwide. Second, inter-brand competition is especially intense in SouthernCalifornia because of the variety and high concentration of restaurants. Because of thisstructure, internal rivalry among fast food establishments has a tremendous effect onrestaurant profitability. Similarly, substitute goods are plentiful and growing in popularity, andtherefore represent a threat to current and future earnings. Entry does exist; however it isusually limited to the local level, decreasing its power. Both buyer power and supplier powerare low in the fast food industry. Our analysis of the fast food industry can be summarized inthe following chart:

Summary of Five-Forces Analysis of the Fast Food Market

Force Threat to Profits

Internal Rivalry High

Entry Low to Medium

Substitutes and Complements Medium

Supplier Power Low

Buyer Power Low

Improving QSC and offering competitive prices are necessary steps for McDonald’s customerretention and brand reputation. Carnegie Consulting therefore recommends that McDonald’spare down its menu size in an effort to improve quality, lower labor costs, and reduce waittime. Further, we encourage McDonald’s to consider devolving some menu decision powerto local restaurants in an effort to create efficiency gains and maximize profits using localarea knowledge. McDonald’s corporate management has taken some important andmeaningful steps towards improving QSC at McDonald’s restaurants, but we believecorporate management has not properly evaluated the long-term effect of underperformingrestaurants. We therefore urge that stronger action be taken to monitor franchises andenforce McDonald’s QSC standards.

Company History

Richard and Maurice McDonald opened the first McDonald’s restaurant in 1948 in SouthernCalifornia. Ray Kroc, the founder of the McDonald’s Corporation opened his first McDonald’sin Des Plaines, Illinois in 1955. In the 1950s franchising consisted mostly of assigninggeographic territories in exchange for fees. Kroc believed that the idea of geographicmonopolies with multiple outlets operated by a single owner undermined the controlMcDonald’s could exert over franchisers. Rather, he assigned only one franchise at a time,thus ensuring consistency in each store’s output. By 1956 there were 12 McDonald’sRestaurants, and by 1960 there were 228.



Ronald McDonald was created in 1963. A testament to McDonald’s amazing marketingpower, Ronald McDonald is now the second most recognizable character in the world (afterSanta Clausi). Other famous creations include the Big Mac in 1968, the popular EggMcMuffin in 1973, and the Happy Meal in 1979.

In 1965 McDonald’s stock went public and it was added to the S&P 500 in 1985. Since itsinitial offering the stock has split 12 times (most recently in 1999). 100 shares in 1965 wouldhave cost $2250, but by now would have grown to 75,000 shares worth $2.8 million.McDonald’s reigns supreme as the largest food-service retailer in the worldii. 1970 markedthe first international expansion of McDonald’s (into Costa Rica). Since then 3500restaurants have been added in Japan and 164 in Africa. Restaurants were opened inRussia and China in 1990. By 2000, McDonald’s was present in 118 countriesiii.

Currently, 80% of McDonald’s restaurants are franchises, with licenses costing around$45,000 per outletiv. In 2000, income from franchising fees totaled to $63.7 million.Beginning in 1956 McDonald’s also began to purchase real estate, which it leases tofranchisees. Today McDonald’s owns the land at approximately 40% of its restaurants. Thishas had the duel effect of increasing both McDonald’s wealth and its control over itsfranchisees.

Despite its previous rapid growth and innovative product development, today some analystsview the future of McDonald’s with an increasingly skeptical eye. Lately the company hasbeen affected by many adverse developments. A mad cow disease outbreak in Japandramatically slowed sales in all of Asia. Though the company believes it will recover,significant resources must be expended to reassure customers of McDonald’s beef safety.Also abroad, implacable political and ideological resistance to McDonald’s presence remainsstrong in many countries, and the resulting bad publicity is a real threat to brand image bothdomestically and abroad. Domestically, low customer satisfaction ratings have been thefocus of management’s efforts, and it is still unknown whether management’s plans will besufficient to reverse the loss of customers. Labor issues have been plaguing manyMcDonald’s (and other fast food establishments) as well. A booming economy has madelow-cost labor scarce, and this puts upward wage pressure on McDonald franchises. Trendsaway from unhealthy food are also adversely affecting McDonald’s, although it is unclearwhether this represents a permanent shift away from fast food. Further, because manydemand characteristics vary by geographic region, McDonald’s has had difficulty directinglocal marketing campaigns effectively.

Overall, McDonald’s has had a storied history, and has overcome numerous problemsequally as vexing as those it encounters today. But today’s problems are real, and they areserious. Carnegie Consulting believes that through the implementation of the plan we presentin this report, McDonald’s will be able to recover its market share and delight its customerswell into the future.

Internal Rivalry

McDonald’s competes in the fast food market. The product in this market is food; either ameal or a snack, individual or family-size. McDonald’s Standard Industrial Classification



(SIC) number is 5812-10. Competitors are other restaurants selling quick, made-to-orderfood, including but not limited to burgers, fries, pizza, fried chicken, sandwiches and tacos.National rival food chains can be grouped in the following categories:

a) Burgers: McDonald’s, Burger King, Wendy’s, Jack in the Box, Carl’s Jr. / Hardee’sb) Pizza: Round Table, Domino’s, Little Caesar, Papa John’s, Pizza Hutc) Chicken: Kentucky Fried Chicken, Popeye’s Fried Chickend) Mexican Food: Taco Belle) Healthier Alternatives: Quiznos, Subway,f) Regional brands: Baja Fresh, In-N-Out, Del Tacog) Local establishments: Any non-national rival restaurant.

This report which is prepared for corporate McDonald’s will focus on the first five of thesecategories. Store or regional managers should deal with competition from localestablishments.

McDonald’s has 34.7 percent market share in the U.S. hamburger/sandwich chain market,and 43.0 percent in the U.S. fast food hamburger chain market.v Under the first marketdefinition, close rivals are Burger King with 15.8 percent, Taco Bell with 9.6 percent, Wendy’sInternational with 9.5 percent, and Subway with 5.9 percent.vi We calculate the HH-Index as1,722 for the hamburger/sandwich chain market.vii This is the “numbers-equivalent” ofapproximately six firms of equal size. Participants in this market engage in intense productand price competition. Marketing efforts emphasize product and price simultaneously (e.g.,“$1.99 flame-broiled Whopper”). Historically, competition has been so fierce that each fastfood restaurant is forced to offer at least one hamburger selling for less than $1.

Not surprisingly, there has been no history of cooperative pricing. Raising prices tends just toencourage greater marketing efforts emphasizing low prices at other chains. Prices atcorporate chains cannot be adjusted quickly or unobservably – but prices can be adjustedfaster in chains with franchise-models. It is difficult for firms to retain brand loyalty becausecustomer switching costs are low. It is not difficult for an unhappy customer to frequent adifferent restaurant chain. Customer loyalty is weakest in the burger group of the fast-foodmarket because products are relatively undifferentiated. There is the highest degree ofproduct differentiation between the non-healthy and healthy groups.

Because the industry is moderately capital intensive but does require location-specificknowledge, most fast food chains are franchisee operated. Franchising also helps overcomeserious agency problems that would exist if McDonalds owned and operated its own retailoutlets. The franchisee pays McDonald’s a fee that is usually a percentage of monthly salesrevenue; in this way McDonald’s shares risk with franchise owners, since the fee is low ifsales are poor and increases when sales grow. In exchange, the franchiser provides rawmaterials, brand reputation, advertising, training, guidelines and other forms of assistance.

Growth in the industry has been aided by shifting consumer-dining habits. An increasingnumber of households have either two working adults or a single working head of household,and this means less time to prepare meals. That plus rising incomes means more and moreAmericans are eating outside the home and on the road.



Firms in the mature fast food restaurant industry has been diversifying in order to offer agreater variety of choices for customers. In this mature industry, restaurant operators havechosen to grow by acquisition rather than internal development, and this has lead toconsolidation. For example, the Hardee’s chain, popular along the East Coast, was acquiredby Carl’s Jr. as part of its Eastward expansion. Robust expansion in the industry,accelerated by the popularity of co-branded units in airports, stadiums, entertainment parks,hardware stores, and other locations, has also increased capacity. However, continuedgrowth and store openings have hurt some franchisees that have experiencedcannibalization of sales.

Substitutes and Complements

Substitutes

Substitutes to the fast food industry include sit-down restaurants, convenience stores,specialty-food retailers and cooking at home.

Major Chains:a) sit-down restaurants: Applebee’s, Olive Garden, TGI Friday’s, Denny’s, Chili’sb) convenience stores: 7-11, AM/PM, Circle K, gas station martsc) specialty-food retailers: Starbuck’s Coffee, Dunkin Donuts

Consumers have many options to choose from when dining. The food products available atconvenience stores offer the closest substitute and the most significant threat. Manyconvenience stores offer sandwiches, burgers and hot dogs at prices often below those offast food establishments. The fast food customer is generally looking for convenience andvalue; although convenience stores lack drive-thru service, they do provide inexpensive andquick meals and snacks. Convenience stores cater to the late-night customer and are evenmore attractive to someone with limited time when they are paired with gas stations.

Specialty-food retailers are relatively good substitutes for the snack portion of the fast foodbusiness, but these establishments rarely offer meals. Patrons of espresso shops aregenerally looking for higher quality and do not mind the higher prices. The good is oftenmore than just a cup of coffee – the purchase price includes atmosphere and a place tosocialize with friends.

Sit-down restaurants are not a very close substitute to fast food. Again, the restaurantproduct bundles service and ambiance with the food product – the fast food consumerusually does not want to spend the time and money necessary for these additional amenities.For customers who choose to dine in the fast food restaurant, however, these sit-downrestaurants offer a reasonable product substitute.

Cooking at home is a viable alternative to fast food for consumers who spend a good portionof their time at home. The majority of fast food purchases, however, are made on the gowhen returning home to make a meal would be inefficient. In general, there has been agrowing trend toward eating outside the home; thus, many households lack the food, time,and tools which would make cooking at-home a convenient alternative.



Complements

Complements to the fast food industry include businesses that are partnered with fast foodrestaurants. Examples include gas stations, discount retailers, airports, mall retailers andsports stadiums. On a long road-trip, most people would prefer making only one stop for gasand food rather than two. Hence, the appeal of a combination McDonald’s / gas station isstrong. Customers at a discount retailer appreciate low prices and they are able to pick updinner while they run an errand after work. Airports, malls and sports stadiums all produce acollection of captive consumers for the fast food industry. McDonald’s, for example, haslocations attached to Chevron gas stations and locations within Wal-Mart stores, HomeDepot stores, Disneyland, and in malls and airports.

Entry

Barriers to entry to become a national fast food chain are substantial; entrants must spendlarge amounts on marketing to increase awareness and establish brand recognition. Anentrant would have to expend considerable resources to match existing marketingcampaigns. However, considering the stiff price competition and low customer loyalty in theindustry, advertising expenses are probably less of a barrier to entry in the fast food industrythan in many other consumer industries. At the local level, some barriers to entry may existbecause fast food restaurants, in particular, depend on having a good location. The maincriteria for choosing a location are customer traffic levels and convenienceviii and incumbentsmay have an advantage if they are already located in a desirable spot. In general, the localbarriers to entry in the fast food industry are low, as fast food restaurants have relatively lowfixed cost start-up expenses

There are two facets of entry into the quick-serve, fast food market: either entry by existing,national fast food chains into new locations or by smaller, regional and local quick-serverestaurants. The fast food market is an intensely competitive market and entry increasescompetition, which reduces companies’ margins and restricts growth.

Entry by large chains generally takes one of two forms. One type of entry is geographicalentry – that is, the firm may be diversifying geographically. For instance, Carl’s Jr. is locatedprimarily in California and the Southwest. Recently, however, it has been growing andentering new markets, as newly acquired Hardee’s restaurants are outfitted with the Carl’sJr.’s menu items and its trademark star. Also, there is room for many existing firms to opennew locations in markets where they already compete. If McDonald’s is used as a baselinefor when one chain has saturated a market, it becomes evident that other large fast foodchains can have significant growth in units without cannibalizing existing locations (assumingthat fast food customers are loyal to just one type of restaurant).

Chain U.S. Units at End of 2001McDonald’s 13,099Subway 12,254Burger King 8,064Pizza Hut 7,927Taco Bell 6,746Wendy’s 5,455



KFC 5,364Dairy Queen 5,058Domino’s Pizza 4,818Arby’s 3,153Sonic Drive-In 2,175Jack-in-the-Box 1,634

Source: Standard & Poor’s Industry Survey: Restaurants, March 7, 2002.

Large firms can also pursue another type of entry. Since convenience is essential to the fastfood industry, many firms are opening new restaurants in areas not traditionally associatedwith fast food. Fast food can increasingly be found in countless locations outside of thetraditional units, from retailers such as Home Depot and Wal-Mart to food courts in shoppingmalls.ix

The other important type of entry is by smaller, regional or local quick-serve restaurants.These firms make up a significant portion of the restaurant industry as a whole. Includingboth full service and quick serve restaurants, 43.9% of the entire market or $113.2 billion inannual sales, comes from small chains or independents.x Furthermore, small operators runnearly seven out of every 10 restaurants.xi Though these numbers are for the industry as awhole, it seems reasonable to assume that the small restaurant operator is an influentialplayer in just the quick-serve market. Examples of these types of firms would be aneighborhood deli or a small hole-in-the-wall ethnic restaurant offering low prices and quickservice coupled with a relatively plain décor. The barriers to entry that exist for a smallerquick serve restaurant are relatively low. The fixed costs associated with starting up arelikely lower for a small independent company than for a large national chain as theinvestment required to create a uniform dining experience across all units does not exist.Moreover, a smaller firm may enjoy advantages in training and employee loyalty that wouldreduce their operating costs. As annual labor turnover in the fast food industry as a whole isabout 96%, employee training and length of employment are important for quick serverestaurantsxii.

However, even though barriers to entry in local markets are low in the fast food industry,entry by smaller firms is not necessarily as important an issue for large chains as iscompetition between those firms. This is due to two factors. First, small restaurants are alocal problem. The success of local chains or restaurants affects each region independently.Therefore, it is local competition that concerns franchise owners and regional managers.Also, it is more difficult for large firms to compete directly against smaller firms withadvertising and price promotions. Thus, Wendy’s is a larger threat to McDonald’s than thelocal burrito stand. Wendy’s market share in the quick-serve sandwich sector rose to 10.2%in 2000 from 9.6% in 1998. During the same period, McDonald’s share fell to 34.4% from35.0%.xiii While entry by local restaurants is a concern for large firms, entry and competitionwith other large firms represents a greater threat to the large firms’ bottom line.

Buyer and Supplier Power

Supplier Power



Supplier power is a measure of the power of suppliers to extract economic rents from the fastfood industry. Suppliers to the fast food industry include food suppliers, labor, and equipmentsuppliers. The most common food inputs to the industry are soda, beef, potatoes, dairyproducts and vegetables. Many food suppliers have commonly-known brand-names, suchas Kraft, Coca-cola, Pepsi, Tyson Foods and Carnation – fast food chains try to gain orenforce a reputation for quality by using popular brand inputs. Once a fast food chain hasestablished a relationship with a brand-name supplier (e.g. McDonald’s always serves Coke),the supplier gains some power because repeat customers expect these products. Moreimportantly, however, the supplier is dependent upon the fast food industry because itcomprises a large percentage of its sales. Suppliers’ potential power is also weakenedbecause they want their brand name associated with major fast food chains. This givescorporate McDonald’s tremendous power over its franchisees. Additionally, McDonald’stremendous size gives it leverage over all their input suppliers.

The meatpacking industry is typical example of McDonald’s power. The fast-food/meatpacking alliance has led to a consolidation of the meatpacking industry. In 1968, forexample, McDonald’s bought from 175 local beef suppliers; today they buy from five.xiv

During that same period, a rancher’s share of the retail beef dollar fell from 63 cents to 46cents.xv Even with substantial concentration of the industry, the beef producers retain lowsupplier power. This trend may be reversing, however, as beef slaughter in the United Stateshas decreased rapidly. In 1996 7.3 million cows were slaughtered, while this year only 5million are expected to be slaughteredxvi. Thus, McDonald’s has recently been forced to turnto foreign beef markets to ensure supply. This could be problematic for two reasons: First, itmay result in an increase in supplier power. Second, with mad cow disease fearsMcDonald’s will have to be test its meat and convince customers of its safety.

Food suppliers have some supplier power because of the possible threat of forwardintegration, carried out already, for example, by PepsiCo’s previous ownership of Pizza Hutand Taco Bell. Although there are no available substitute inputs for food, supplier power isdoubtless limited by the large number of potential suppliers and the homogeneity of theirproducts.

Because fast food chains have such vast purchasing power (or conversely because supplierpower is so low) they are often able to encourage major changes in how food inputs areproduced. When McDonald’s wanted to begin producing chicken nuggets in the 1980’s,Tyson had its contract growers switch to big breasted birds.xvii

Labor and equipment inputs are of secondary importance to the fast food industry.Equipment inputs include food preparation and order-processing equipment (e.g. cashregisters, computers). Because these are only purchased every few years and the fast foodindustry is the major buyer of these products, equipment supplier power is fairly low. Theprimary labor pool for fast food/restaurant services are non-unionized , part-time people age16 – 24.xviii Without years of experience and education, these workers do not have manyemployment alternatives. The restaurant industry is also increasingly using automation toincrease productivity and decrease their dependence on labor.

Buyer Power



Buyer power measures the power of those who buy products from the fast-food industry.Buyers in the fast food industry have little buyer power. Because buyers are individuals andfamilies, the purchasing volume of any individual buyer is very low. Buyers are notconcentrated – the fast food market serves the majority of the US population. However,because of many available substitutes to fast food, buyers possess some power.Alternatives such as cooking at home or going to a sit-down restaurant, however, lack theconvenience and quickness of fast food – anyone looking for a prepared meal on the go willbe a captive consumer for the industry.

Individual franchisees similarly have little buyer power over corporate McDonald’s.McDonald’s calls the shots when drawing up the terms of franchise contracts.

Strengths, Weaknesses, Opportunities and Threats

Strengths

Brand Recognition and Customer Base

McDonald’s is one of the world’s most recognized brands. It is the largest restaurant chain inthe United States:

Restaurant Name Number of Units Total US SalesMcDonald’s Restaurants 12,804 $19.572 billionSubway 12,253 $3.800 billionBurger King 8,326 $8.542 billionPizza Hut 7,927 $5.000 billionTaco Bell 6,746 $5.100 billionWendy’s 5,095 $5.757 billionNote: These are the numbers of “McDonald’s” stores. These do not include sub-brands, such as Chipotle Grill.

Source: Technomic Information Services “Top 100 Chain Restaurant Companies.” 2000.

It’s continual community rebuilding efforts, such as the Ronald McDonald House, haveestablished it as a philanthropic organization with strong community ties. Additional brandstrength is built through the Ronald McDonald characters and menu items such as the HappyMeal and Big Mac. On top of this, McDonald’s benefits from years of successful relationshipswith its many franchisees, many of who operate several McDonald’s stores.

Franchise System

McDonald’s was the first to capitalize on the franchise system. Nearly 85% of McDonald’srestaurants are franchised, and each restaurant earns a higher per-store income than do anyMcDonald’s competitorsxix. Thus, investors have an incentive to perform well and openmultiple stores, and there always remains an incentive for entrepreneurs to help expand thecompany’s location base with relatively low risk for McDonald’s Corporation.

International First Mover Advantage

By aggressively pursued international opportunities McDonald’s has secured an earlyfoothold in many countries and has begun building the goodwill and community bonds it



enjoys domestically. These may become invaluable as competition from other restaurantchains increases.

As previously noted, people in some parts of the world have been resistant to McDonald’s,viewing it as a symbol of American hegemonic culturexx. McDonald’s CEO Jack Greenbergbelieves that angry allegations should not be taken too seriously. Because McDonald’sworks inside regional economies (e.g. with local farmers and marketing agencies),Greenberg believes that anger at McDonald’s is misplaced and not particularly widespread.He states that McDonald’s is “an amalgamation of local businesses owned by localentrepreneurs.”xxi Further, Greenberg believes that McDonald’s strengthens local culture anddoes not erode it.xxii Thus, misplaced anger at McDonald’s will likely subside in the upcomingyears.

Weaknesses

Customer Loyalty and Customer Satisfaction

Fast-food is a fickle industry. Consumer switching costs among fast-food restaurants arepractically nothing. Therefore, to retain its business McDonald’s must deliver a qualityproduct to every customer. Fortunately, this weakness is endemic in the industry, andtherefore any other faltering restaurant chains similarly risk losing customers to McDonald’s.

Because of low levels of service, however, McDonald’s is at risk of damaging its customerbase. Below is the table of customer satisfaction scores for fast-food restaurants:

Restaurant Name Satisfaction Index ScorePapa John’s 78Domino’s Pizza 73All Others 73Wendy’s 72Pizza Hut 71Little Caesar 70Taco Bell 66Burger King 65Kentucky Fried Chicken 63McDonald’s 62Source: American Customer Satisfaction Index, 2002.

When one McDonald’s performs poorly it generates a negative externality on other franchisesand on the McDonald’s brand. Therefore, it is important that corporate McDonald’s assurethat each restaurant provide the high levels of service.

The franchise system is intended to reduce agency problems, by tying the success of thefranchise owner to that of the franchise. In theory, this means that corporate McDonald’sdoes not need to micromanage each individual franchise owner. However, since individualfranchise owners have incentives to shirk on product and service standards withoutexperiencing the externality they impose on all of McDonalds, corporate McDonald’s mustinstitute monitoring systems to detect such shirking and to insure that standards aremaintained. (For more on this, see the Strategic Analysis section.)



Over-Centralization

Nearly 85% of McDonald’s restaurants are franchised. Lately many of these McDonald’sfranchise operators have become increasingly unhappy with corporate McDonald’s decisions.These franchise operators claim that McDonald’s is failing to respond to the geographicallyspecific varied needs of local market segments, Last year, for example, an association of560 Southern California McDonald’s operators wrote an angry letter regarding the company’spolicies, stating that, “There is a battle for customers currently raging among competitors andMcDonald’s is not keeping pace.xxiii” These franchisees claimed they were being undercut bylow prices of rivals and that corporate McDonald’s was not responding appropriately to thedifficulties presented in the marketplace. Although the company then instituted a 99-cent Big-Mac deal, the decision came too late to satisfy many operators. This example illustrates thepotential dangers of over-centralizing operations. Slowly, McDonald’s is moving decision-making capabilities back to the regional level in an attempt to respond to this concern.

McDonald’s is on the horns of a dilemma. On the one hand, McDonald’s would like to ensureconsistency by centralizing decision making. On the other hand, some power must be residewith regional operators so they can compete against local establishments. CarnegieConsulting believes that McDonald’s plans to hire regional managers is a step in the rightdirection. It may become necessary, however, to further devolve power if the problems facedby franchise owners are not resolved.

Danger of Cannibalized Growth

McDonald’s restaurants generate very high annual sales. The average McDonald’s outletgenerates $1.6 million in sales, compared with $1.2 million at Jack in the Box, and $1 millionfor Carl’s Jr. Nevertheless, same store sales figures for McDonald’s are not growing at a ratecomparable to its competitors. Rather, same store sales numbers are lagging. This may bean effect of cannibalized growth. That is, increasing numbers of McDonald’s stores may beeating into the sales of already existing franchises. Further, with the acquisition of otherbrands, such as Chipotle and Boston Market, McDonald’s is further exposing itself to internalcompetition. Chipotle, for example, grew restaurants at 181% in 2000, while only growingsales at 116%xxiv.

Opportunities

Cross and New Branding Opportunities

McDonald’s is steadily expanding its brand name and expertise to many new ventures.McDonald’s cafes can be seen in airports. McDonald’s has moved into the fresh-Mex marketwith an acquired stake in Chiptole Mexican Grill. The recent purchase of Boston Marketgives McDonald’s a presence in still another market segment.

Cross-branding opportunities are also now being pursued. McDonald’s can be found inWalMart, Home Depot, Disneyland, and merged along side Chevron gas stations. DeliveringMcDonald’s food to shoppers is becoming easier and easier for the shopper.

International Opportunities



International growth remains one of the most exciting opportunities for McDonald’s. Nearlyone-third of total sales during the last year came from Europe, and McDonald’s hopes toincrease its presence there even more. Aroma Café coffeehouses have opened in the U.K.have been fairly successful as well.

Although sales have slowed in Asia following an outbreak of Mad Cow Disease, marketingcampaigns are well underway to dispel any fear regarding McDonald’s beef (which comesfrom Australia, not Japan where the disease was detected). Following similar scares inEurope it took nearly a year in some markets for full recuperation. Once confidence isrestored, a resumption of growth in Asia is to be expected.

Likewise, marketing in Europe has been somewhat hampered recently by the adoption of theEuro currency. Price-based marketing (such as the “Under a Euro Menu”) have not beensuccessful. The company believes that as consumers become more comfortable with thenew currency and its value, price-based marketing will once again become very effective.

Menu Alterations

McDonald’s is continually updating and refining its product selection. Recent menu additionsinclude items such as the Parmesan chicken sandwich and the creation of a McValue menu.The McDonald’s menu features more than 20 items priced under $1. The McValue Menuhas been particularly successful, according to company executives and local McDonald’smanagers. The company has plans to roll out further menu innovations, which will includesuch products as the Chicken Selects (breaded chicken breast strips) and a Grilled ChickenFlatbread Sandwich. Both of these products should help raise overall store margins. TheParmesan chicken sandwich has also been a successful addition. The average purchasetotal for a customer ordering this sandwich was around $7, much higher than average.xxv

There is always a risk that McDonald’s will add new items too quickly. In order to ensure thatthe products are adopted fully and served properly, the company has slowed menu additionsfrom four, down to two items a quarter. McDonald’s hopes this will address service issuessurrounding the addition of further menu items. For more on menu alterations, see theStrategic Analysis section.

Menu decisions are l made at the corporate level. As discussed previously, this can createdifficulties for individual owners. For example, one franchise owner explained that in one hisMcDonald’s, located where there is a higher ethnic minority concentration, he sold manymore Big Macs and far fewer chicken sandwiches. Pricing and menu item selection thatmight help him capitalize on this fact, however, remain beyond his control, much to hisfrustration.

Threats

Healthier Alternatives

One possibly serious threat to McDonald’s ongoing dominance in the fast food industry is atrend toward food alternatives healthier than fast food. This may turn out to be a major threatfor McDonald’s in the long-run. This trend is easily observable in the Southern Californiamarket where healthy alternatives to French fries and burgers are abundant. Rubio’s, Baja



Grill, Quiznos, and Au Bon Pain all offer menus with substantially healthier fare. Outside ofSouthern California this trend is still evident. The international growth of Au Bon Pain andBoston Chicken are examples.

Competition From Other Fast Food Restaurants

Competition also exists from other fast food restaurants domestically and internationally. Thefast food market is intensely competitive domestically, with McDonald’s, Wendy’s, BurgerKing, and Carl’s Jr. (among others) fighting for a share of a saturated market. McDonald’smust be especially alert to price competition from these other venders. The value menus thatthese establishments commonly employ to compete on price with McDonald’s have beencountered by the recent unveiling of the McValue Menu. Although not McDonald’s first valuemenu, this is the company’s first serious attempt to reverse customer losses caused by rivals’low prices. Rather than lower prices (that is, enter into price competition against otherchains), the McValue menu aggregates lower price menu items into one location. Whetherthis offering will suffice to allay concerns of price competition remains to be seen.Regardless of the McValue Menu’s success, the need for its invention is indicative ofincreasingly fierce inter-industry competition which presents a definite threat for McDonald’sin the future.

Financial Outlook

For the fiscal year ended December 31, 2001 McDonald’s revenues grew 8% to $14.9 billion,net income fell 15% to $1636.6 million and EPS fell 12% to $1.25 in constant currencies.The increase in revenues was driven by restaurant expansion, which was partly offset byreductions in same store sales.xxvi Additionally, McDonald’s recorded a $200 million specialcharge which was due to streamlining operations by reducing the number of divisions andregions, enabling the company to combine staff functions and improve efficiency. In addition,McDonald’s introduced a variety of initiatives domestically designed to improve customers’restaurant experience, including accelerated operations training, restaurant simplification,incentives for outstanding restaurant operations and an enhanced national restaurantevaluation system.xxvii A low current ratio of 0.81 combined with a cash-debt coverage ratioof 0.21 may indicate some financial issues; however, these are beyond the scope of thisreport.

Analysts’ forecasts of 2002 EPS range between $1.45 and $1.53, averaging $1.49. For 2003the EPS forecasts are even more ambitious ranging between $1.53 and $1.68 with anaverage of $1.62. As a result of these high EPS estimates, many analysts rate the stock a“Buy.”

ANALYSTS’ OPINIONS# of Ratings % of Total 1 Month Prior 3 Month Prior

Buy 7 39 6 5Buy/Hold 2 11 2 2Hold 6 33 7 6Weak Hold 1 6 0 0Sell 1 6 1 1No Opinion 1 6 0 0Total 18 100 16 14



Even though the stock price has fallen over the last year, many analysts are still enthusiasticabout the company. Recently McDonald’s has begun to address what many analysts see asits biggest problem, low scores on quality, service and cleanliness (QSC). A McDonald’smystery shopper initiative coupled with increased training and a simplification of systems willlikely lead to improved QSC scores (See Strategic Analysis section for more.). As a result,most analysts seem optimistic that McDonald’s will improve its performance and recaptureits lost market share .

Over the last year, McDonald’s stock has tracked and slightly outperformed the S&P 500,while it has significantly under performed peer companies in the restaurant industry.

Strategic Analysis: Improving Store Performance

Customer satisfaction scores must improve if McDonald’s is to compete effectively againstother fast food restaurants. However, because McDonald’s competes in a mature industrywhere price competition is fierce, any initiatives undertaken must also reduce costs.Carnegie Consulting therefore has derived a two-part strategy designed to simultaneouslylower costs and provide incentives to improve service.

Menu Reduction and Control

Menu changes create many problems for restaurateurs (See Appendix A for a SampleMcDonald’s Menu). Physical changes be made to update menus. Workers must beinformed about new items, how they are prepared, and their price. In theory, new menuitems should increase customer satisfaction by providing greater variety. However, atMcDonalds, the pleasing effect of variety is mitigated by the bad effects increased variety hason prices and on quality of service.

A more extensive menu means that more items must be ordered by managers, complicatingtheir work and increasing the probability that some items will not be available for customers.Further, greater variety means employee actions become less routine, which lowers marginsby increasing the amount of labor that is put into each prepared item. Finally, more varietymeans that additional menu items may not be cooked properly. Having fewer productsencourages “learning by doing,” increasing the likelihood that each product will be madeproperly. By making production more routine, food can be provided by fewer employees,either increasing store margins or allowing for other service issues to be addressed morefrequently (e.g. cleaning restrooms). Further, a small menu selection can be assembledmore quickly by the person at the cash register, thereby decreasing customer wait time(which would also have a positive impact on customer satisfaction).

In a recent analyst conference call, management acknowledged the service difficulties itcreates by introducing so many new products every month. They pledged to slow menu itemgrowth to only 2 items per month. This reduction is a step in the right direction, but it is ourrecommendation that McDonald’s seriously reconsider reducing the scope of its menu anddecentralizing some decision making power about menus.

Across the Board Reductions



Carnegie Consulting recommends that McDonald’s pare back its offerings in order to achievethe benefits of specialization. Over the years, the scope of McDonald’s menu scope hasincreased as McDonald’s has striven to grow same store sales. The product proliferation hasbeen overdone. For example, McDonald’s burgers include the Mac Jr., the Cheeseburger,the Double Cheeseburger, the Big Mac, the Big Mac with Cheese, the Big N Tasty and theQuarter Pounder. On top of this plethora of burger offerings, which alone seem sufficient toconfuse customers and workers alike, typical offerings also include several chickensandwiches (fried or grilled, served on a bun or with flat bread), several types of chickennuggets, fish sandwiches, fries, onion rings, a range of breakfast items (e.g., Egg McMuffin),a salad bar, a number of desserts, and other offerings, such as the new Chicken FajitaRollup. This is not to mention coffee, milk, and a number of soft drinks. These are only coreofferings. New offerings appear and disappear regularly throughout the year. (For example,the McRib sandwich was just removed from the menu after one month.)

McDonald’s should reduce its menu offerings to improve its customer satisfaction. Althoughany menu reduction will result in some dissatisfaction from customers expecting a certainitem the costs of menu simplification will be far outweighed by the benefits. A majority ofMcDonald’s profits come from very few of its offerings, according to franchise owners towhom we spoke (the company does not disclose exact margin information). Therefore,McDonald’s should focus on its high margin items and its high volume items, eliminatingitems that have a low margins and low volume.

The short-term impact of a menu reduction on overall sales may be negative. The decisionto reduce the menu is, however, in the best long-term interest of the company. This is aneasy way to please customers by (1) simplifying the menu and thereby the ordering process(2) making sure each order is made correctly and (3) making sure each order is filled quickly.

Corporate strategy consists of establishing the boundary between what a company will doand what it will not do. McDonald’s has been attempting too much.

An Alternative Approach: Local Menu Decisions

As we have noted before, McDonald’s must balance the desire to have consistent products ateach restaurant nationwide against the benefits serving differences in tastes by allowingsome local autonomy to franchise operators. Until now, McDonald’s has chosen to centralizemenu control for the sake of consistency. Using this approach, a customer knows that everyMcDonald’s will have the same selection. Additional benefits to uniform menus are thatmarketing costs are lower and distribution is simplified by delivering uniform products.

Centralized menu control (currently at the regional level) has its benefits, but it also createsmany difficulties. Treating every McDonald’s menu identically may have been optimal whenthe restaurant focused on burgers and fries, but now that the menu is so diverse thatrequiring identical menus is counterproductive. Further, supply chain managementtechnology is advanced enough so that delivering different products to different stores will notbe excessively expensive.

Under this program, corporate McDonalds will delegate some but not all authority toindividual franchises for determining the menu. Certain items will be required offerings (a



price special being heavily marketed, for example). Outside of the set of “core” menu items(the core will be determined by corporate McDonald’s), franchise owners can choose to carryor not carry the remaining McDonalds approved products. By requiring certain items toappear on the menu, marketing campaigns will still be effective. These required items will bethe most popular items that already generate the bulk of corporate and franchise sales andprofits. This means that consumers traveling from one McDonald’s franchise to another willnot notice an appreciable difference in menu as the core menu would be availableeverywhere. Advertising will also continue to be effective because it will still tout McDonald’sas a great place for value and service. Advertising can also still focus on individual itemsfrom the core menu.

If managers and franchise owners can choose which non-core menu items they want tocarry, they can enhance their profits. McDonald’s already allows franchisers to select theirphysical location based on first-hand knowledge of the local environment. The concept hereis similar: local franchise owners are more acutely aware than corporate McDonald’s of howtheir franchise product needs differ from the core menu. Different items appeal to differentdemographics and different product competition can exist in different markets.

Allowing individual restaurants too much latitude may lead to problems. For example,granting pricing power, which we do not recommend, may lead to inter-McDonald’s pricewars. However, the negative effects of letting each McDonald’s decide which items it wantsto carry are small and surmountable. Letting each McDonald’s eliminate certain items wouldmean that labor costs would be lower, prices could be lower, and product quality andcustomer satisfaction would certainly be higher. Essentially, we believe that allowing eachMcDonald’s to determine its menu scope would allow for greater profitability and customersatisfaction.

Agency Problems

An agency problem is created whenever incentives are not aligned between an owner and anemployee. Individual franchisees have incentives to not offer optimum quality and service inmany instances, instead preferring to offer low cost (and therefore lower quality and service)products. For example, imagine a McDonald’s on the side of a freeway in a desolate area.Customers at this McDonald’s are usually travelers, who will eat there once and never again.The owner of this McDonald’s, knowing that the majority of his business is non-repeatbusiness, does not care if the customers are pleased. Rather, the owner can spend less timetraining his workers or hire fewer workers to clean the restaurant in an effort to maximizeprofit. Unfortunately, this profit maximization creates an externality for other franchises andfor corporate McDonalds by damaging brand reputation.

In order to deal with agency problems from a store-specific level, corporate management hasinstituted a number of new initiatives. The focus of these initiatives is to improve Quality,Service, and Cleanliness (or QSC, as management refers to it). For example, a mysteryshopper program is now in operation and corporate management’s benefits (the inspectorsand enforcers of franchise standards) are tied to how well each individual store performs.Similarly, a new 1-800 complaint number will help the corporate offices identify whichMcDonald’s locations are in need of improvement. Once identified, teams of QSC expertswill meet with local store managers to help them improve their performance.



McDonald’s corporate management has found that higher QSC scores are tied to betterfinancial performance. It is therefore believed that increasing levels of QSC will improve theeach restaurant financially, and therefore McDonald’s stores collectively will benefit if QSCimproves. The success of these programs will depend on the energy and diligence thatcorporate McDonald’s brings to monitoring and enforcing its QSC standards. DuringMcDonald’s most recent profit report conference call, financial analysts expressed concernsregarding how management plans to deal with consistently underperforming restaurants.Although special QSC teams will be deployed to underperforming restaurants, McDonald’shas no intention of undertaking more drastic methods for improving performance. Thisbothered many of the analysts, and for good reason.

Poor franchises impose a serious negative externality on the McDonald’s brand. With aneutral and objective set of evaluative tools (the 1-800 number and the mystery shopperprogram), the onus is now on corporate McDonald’s to ensure that QSC standards are met.Several steps may be taken by McDonald’s. The new a management training program for in-store managers may help solve problems based on lack of knowledge and experience. Inmore serious cases, however, revoking the franchise and installing new franchise ownersmay be necessary. Corporate McDonald’s must vigorously enforce QSC standards topreserve the value and reputation of the McDonald’s brand.

Conclusion

Improving QSC and offering competitive prices are necessary steps for McDonald’s customerretention and brand reputation. We therefore suggest that McDonald’s pare down its menusize in an effort to improve quality, lower labor costs, and reduce wait time. Further, weencourage McDonald’s to consider devolving some menu decision power to local restaurantsin an effort to create efficiency gains and maximize profits using local area knowledge.McDonald’s corporate management has taken some important and meaningful steps towardsimproving QSC at McDonald’s restaurants, but we believe corporate management has notproperly evaluated the long-term effect of underperforming restaurants. We therefore believestronger action must be taken to monitor franchises and enforce McDonald’s QSC standards.



Appendix A – A McDonald’s Menu



i http://www.mcdonalds.com/corporate/info/history/index.htmlii http://www.mcdonalds.com/corporate/info/history/index.htmliii McDonalds 2000 Annual Reportiv “A Recipe for Riches.” Foreign Policy. May / June, 2001. pg. 33.v Market Share Index – Restaurant Industry, US Business Reporter, http://www.activemedia-guide.comvi Market Share Index – Restaurant Industry, US Business Reporter, http://www.activemedia-guide.comvii Market Share Index – Restaurant Industry, US Business Reporter, http://www.activemedia-guide.comviii Standard & Poor’s Industry Survey: Restaurants, March 7, 2002.ix Standard & Poor’s Industry Survey: Restaurants, March 7, 2002.x Standard & Poor’s Industry Survey: Restaurants, March 7, 2002.xi Standard & Poor’s Industry Survey: Restaurants, March 7, 2002.xii Standard & Poor’s Industry Survey: Restaurants, March 7, 2002.xiii Standard & Poor’s Industry Survey: Restaurants, March 7, 2002.xiv http://progressivefarmer.com/issue/0501/fastfood/default.aspxv http://progressivefarmer.com/issue/0501/fastfood/default.aspxvi “McDonald’s Tests Imported Beef.” Associated Press. April 2, 2002.xvii http://progressivefarmer.com/issue/0501/fastfood/default.aspxviii Restaurant Industry Profile, US Business Reporter, http://www.activemedia-guide.comxix Techmonic Top 100 Chain Restaurant Companiesxx “McAtlas Shrugged.” Foreign Policy. May/June 2001. pg.26xxi “McAtlas Shrugged.” Foreign Policy. May/June 2001. pg.27xxii “McAtlas Shrugged.” Foreign Policy. May/June 2001. pg.27xxiii “McDonald’s Looking For a Break.” Ballon, Mark. The Los Angeles Times. December 15, 2001. Part 3, page 1.xxiv Technomic Spreadsheetxxv McDonald’s Q1 Investor Webcastxxvi http://www.mcdonalds.com/corporate/press/financial/2002/01242002/index.htmlxxvii http://www.mcdonalds.com/corporate/press/financial/2002/01242002/index.html

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