mcdonalds-business-model

McDonald’s Heavy Franchised Business Model In A Nutshell

McDonald’s is a heavy-franchised business model. In 2021, over 56% of the total revenues came from franchised restaurants. The long-term goal of the company is to transition toward 95% of franchised restaurants (in 2020 franchised restaurants were 93% of the total). The company generated over $23 billion in revenues in 2021, of which $9.78 billion from owned restaurants and $13 billion from franchised restaurants. 

McDonald’s origin story: from the McDonald Brothers to Mr. Ray Kroc

As explained on McDonald’s website “Dick and Mac McDonald moved to California to seek opportunities they felt unavailable in New England.” In 1948 they launched Speedee Service System featuring 15 cent hamburgers. As the restaurants gained traction that led the brothers to begin franchising their concept until they reached nine operating restaurants.

A native Chicagoan, Ray Kroc, in 1939 was the exclusive distributor of a milkshake mixing machine, called Multimixer. In short, he was a salesman.

He visited the McDonald brothers in 1954 and was impressed to their business model which led to him becoming their franchise agent. He opened up the first restaurant for McDonald’s System, Inc., until in 1961 he acquired McDonald’s rights to the brother’s company for $2.7 million.

Ray Kroc, died on January 1,4 1984, all the rest is a legend.

And indeed, while most people associate McDonald’s with the Ray Kroc story, in reality, McDonald’s was founded in 1940 by Richard and Maurice McDonald, with the first restaurant being a BBQ stall in San Bernardino, California.

Ray Kroc, in fact, leveraged the McDonald’s brothers’ “Speedy Service System” to initially scale the operations of the restaurant chain. In fact, this process was developed by the McDonald’s brothers (what we would later call “fast food”) which was an incredible process development able to provide an improved product at a faster pace.

This stall was eventually sold to businessman Ray Kroc, who opened the first McDonald’s franchise in 1955 and made the company what it is today.

Indeed, McDonald’s now has close to 39,000 restaurants in 119 countries. While it remains a highly successful franchise, shifting consumer preferences pose the most serious challenge to the company moving forward.

As the story goes McDonald’s started to use a franchising model to grow its restaurant business, and it became over the 1960s a giant in the restaurant business (or real estate depending on the perspective). 

The speedy system itself represented the application of the manufacturing process to the restaurant business. Later another important building block was added. 

The franchising model really became widely applied during the 1920s and 1930s in the restaurant business. As new physical communication networks (in the US the Interstate Highway System) enabled people to move long distances with their cars. 

Later on, Ray Kroc would apply in its most aggressive form the franchising model (different formats already existed centuries before) to McDonald’s existing operation to create one of the most scalable restaurant businesses in the world. 

Franchising combined with a product delivered differently (the “speedy system”) made up a whole new experience, that made it a new business model: the heavy franchised McDonald’s business model.

Is McDonald’s a franchising? You bet, and a heavy one!

Approximately 93% of the restaurants at year-end 2020 were franchised, including 95% in the U.S., 84% in International Operated Markets, and 98% in the International Developmental Licensed Markets.

mc-donalds-franchised-restaurants

This makes the heavily franchised model run at 93% total capacity, compared to McDonald’s long-term goal of 95%.

As specified in its annual reports “McDonald’s is primarily a franchisor and believes franchising is paramount to delivering great-tasting food, locally-relevant customer experiences and driving profitability. Franchising enables an individual to be his or her own employer and maintain control over all employment-related matters, marketing, and pricing decisions, while also benefiting from the financial strength and global experience of McDonald’s. However, directly operating restaurants is important to being a credible franchisor and provides Company personnel with restaurant operations experience.”

To further understand the main features of McDonald’s business model, it’s worth looking into the three main categories of business models that revolve around franchising and one that moves beyond it. 

franchising
Franchising is a business model where the owner (franchisor) of a product, service, or method utilizes the distribution services of an affiliated dealer (franchisee). Usually, the franchisee pays a royalty to the franchisor to be using the brand, process, and product. And the franchisor instead supports the franchisee in starting up the activity and providing a set of services as part of the franchising agreement. Franchising models can be heavy-franchised, heavy-chained, or hybrid (franchained).

In the spectrum of franchising business models, the FourWeekMBA research has identified three main categories of franchising:  

Heavy-franchised

McDonald’s is the classic example of heavy-franchised. In fact, McDonald’s has found a balance, which made it able to have a large percentage of restaurants franchised, thanks to the fact McDonald’s secures the land or the rental contract of the land, therefore the franchisee, even if an “independent restaurateur” is locked into McDonald’s growth plan.

On the other hand, McDonald’s keeps a small percentage of owned restaurants primarily for product development, for the development of new workflows, and for experimentation. When things work out at these stores, these same strategies might be applied back to the other franchised restaurants. 

Hybrid or franchained

franchained-business-model
In a franchained business model (a short-term chain, long-term franchise) model, the company deliberately launched its operations by keeping tight ownership on the main assets, while those are established, thus choosing a chain model. Once operations are running and established, the company divests its ownership and opts instead for a franchising model.

Coca-Cola is the classic example of franchained, as the company uses a hybrid strategy, where it first keeps tight control over newly established operations (especially in foreign countries). Once those operations have been successfully established, Coca-Cola transforms them into franchises.

Yet it keeps a stake in the franchising business afterward, so that, even if the franchisee is independent, it’s still tied to the mother company. 

Heavy-chained

starbucks-business-model
Starbucks is a retail company that sells beverages (primarily consisting of coffee-related drinks) and food. In 2018, Starbucks had 52% of company-operated stores vs. 48% of licensed stores. The revenues for company-operated stores accounted for 80% of total revenues, thus making Starbucks a chain business model.

The classic example of a heavy-chained company is Starbucks. While Starbucks still leverages on franchise stores (what the company calls “licensed stores”) in reality, it operates the majority of its stores. 

And in the long run, Starbucks’ vision is to chain them all. This is what the FourWeekMBA research has labeled as heavy-chained. 

How do McDonald’s partnerships work?

As specified in its annual report “under McDonald’s conventional franchise arrangement, franchisees provide a portion of the capital required by initially investing in the equipment, signs, seating, and décor of their restaurant business, and by reinvesting in the business over time. The Company generally owns the land and building or secures long-term leases for both Company-operated and conventional franchised restaurant sites. This maintains long-term occupancy rights, helps control related costs and assists in alignment with franchisees enabling restaurant performance levels that are among the highest in the industry.

In short, the model is pretty smart. McDonald’s keeps control over the land and or long-term leases to leverage its market position to negotiate deals. At the same time, this kind of deal serves as an alignment between the company and its franchisees.

What are McDonald’s segments?

At the qualitative level the segments can be organized into four main ones:

  • The U.S., as of 2018 represents still the most significant market.
  • International Lead Markets include Australia, Canada, France, Germany, the U.K., and related markets.
  • High Growth Markets that comprise markets with high growth potential include China, Italy, Korea, the Netherlands, Poland, Russia, Spain, Switzerland, and related markets.
  • Foundational Markets & Corporate, the remaining markets in the McDonald’s system, most of which operate under a primarily franchised model.

As of 2017, the U.S., International Lead Markets, and High Growth Markets accounted for 35%, 32%, and 24% of total revenues, respectively.

Who are McDonald’s key partners?

McDonald’s business model is based on three key players. Franchisees, suppliers, and employees are the piece of the puzzle of McDonald’s successful business model.

  • Franchisees are entrepreneurs that at a local level allow McDonald’s to expand rapidly while keeping a global focus
  • Suppliers across the globe guarantee McDonald’s ability to operate at a high level
  • The continuous training of employees across the over thirty-six thousand restaurants around the world allows McDonald’s to perform at full speed

What management metrics McDonald’s uses to assess its growth?

Any organization has a set of management ratios and metrics to understand and assess the growth of the business.

McDonald’s looks at the following metrics:

  • Comparable sales and comparable guest counts: the percent change in sales and transactions, respectively, from the same period in the prior year for all restaurants, whether operated by the Company or franchisees, in operation at least thirteen months, including those temporarily closed
  • ROIIC: calculated by dividing the change in operating income plus depreciation and amortization (numerator) by the cash used for investing activities (denominator), primarily capital expenditures
  • Free cash flow: defined as cash provided by operations minus the capital expenditures 
  • Free cash flow conversion rate: defined as free cash flow divided by net income, are measures reviewed by management to evaluate the Company’s ability to convert net profits into cash resources

McDonald’s velocity growth plan in action

McDonald’s has launched and developed a velocity growth plan based on three pillars:

  • Retain the customers they have
  • Regain the customers lost by improving the taste and quality of food, enhancing the convenience, and offering strong value
  • Convert casual customers to more committed customers with coffee and snacks

They also identified three accelerators, intended to drive growth:

  • Digital by re-shaping interactions with customers
  • Delivery by bringing the McDonald’s experience to their homes
  • Experience of the Future in the U.S. which consists of a set of new technologies within the restaurants to enhance efficiency and improve the experience

Why is McDonald’s’ transitioning to a heavy franchised business model?

The transition to a more heavily franchised business model is part of the long-term company’s strategy. In fact, the rent and royalty income received from franchisees provides a more predictable and stable revenue stream with significantly lower operating costs and risks.

In a way, it is almost like McDonald’s is introducing a subscription business model, where franchisees pay a fixed amount each month. That makes McDonald’s income more stable over time.

Also, the operating and net income coming from franchising operations makes it easier for the company to grow its profitability.

Understanding the company-operated business model vs the franchised-based business model

McDonald’s business model has a double soul. On the one hand, when it comes to its operated restaurants, we can still call McDonald’s a restaurant business when it comes to franchised restaurants McDonald’s looks way more like a commercial real estate company.

Understanding the function of company-operated restaurants

Directly operating McDonald’s restaurants contributes significantly to our ability to act as a credible franchisor. One of the strengths of the franchising model is that the expertise from operating Company-owned restaurants allows McDonald’s to improve the operations and success of all restaurants while innovations from franchisees can be tested and, when viable, efficiently implemented across relevant restaurants. Having Company-owned and operated restaurants provides Company personnel with a venue for restaurant operations training experience. In addition, in our Company-owned and operated restaurants, and in collaboration with franchisees, we are able to further develop and refine operating standards, marketing concepts and product and pricing strategies that will ultimately benefit McDonald’s restaurants.

As highlighted in the 2018 financial reports, company-owned restaurants are important for a series of reasons:

  • Credibility as a franchisor: how can you teach others how to run a restaurant if you don’t run it yourself?
  • Experimentation: company-owned restaurants enable McDonald’s to test things quickly, and roll out only when they have proven to work on the company’s owned restaurants to the franchised restaurants.
  • Training: company-owned restaurants also act as training venues for franchised restaurants.
  • Innovation: as McDonald’s has full control of its owned restaurants it can freely innovate, and bring these processes to other franchised restaurants. So that processes can be reviewed and improved periodically
  • Control: the company-owned restaurants guarantee complete control of processes, innovation, and standards that can be applied elsewhere.

Understanding the economics of the franchised business model: a $41 billion-dollar commercial real estate company

As reported on McDonald’s financial statements:

Revenues from conventional franchised restaurants include rent and royalties based on a percent of sales along with minimum rent payments, and initial fees. Revenues from developmental licensees and affiliate restaurants include a royalty based on a percent of sales, and generally include initial fees upon the opening of a new restaurant or grant of a new license. Fees vary by type of site, amount of Company investment, if any, and local business conditions. These fees, along with occupancy and operating rights, are stipulated in franchise/license agreements that generally have 20-year terms.

Therefore, a good chunk of the revenues coming from McDonald’s franchisees comes from rent and royalties.

As further explained in McDonald’s financial statements:

Under McDonald’s conventional franchise arrangement, the Company generally owns the land and building or secures a long-term lease for the restaurant location and the franchisee pays for equipment, signs, seating and décor. The Company believes that ownership of real estate, combined with the co-investment by franchisees, enables us to achieve restaurant performance levels that are among the highest in the industry.

mcdonald's-real-estate-commercial-property

Source: McDonald’s financial statements 2021

To have an idea of how big is McDonald’s real estate business, as of 2021 the company reported over $41 billion in property and equipment (without counting accumulated depreciation and amortization), which makes it a mammoth commercial real estate owner.

This commercial real estate portfolio, well places McDonald’s among the largest real estate companies in the world!

Key highlights from McDonald’s business model

  • McDonald’s uses a heavy franchised business model. As of 2018, the company had 93% of total restaurants as franchising.
  • Its long-term target is 95% of franchised restaurants worldwide.
  • Even though revenues have decreased since 2013, it’s important to understand this is part of the transition to a heavy-franchised business model.
  • Indeed, according to McDonald’s financial reports in 2018 Franchised margin dollars represented about 85% of the combined restaurant margins in 2018, about 80% in 2017, and about 75% in 2016.
  • Therefore as McDonald’s business model primarily shift toward a heavy-franchised model we might expect this effect of reduced revenues and increased margins.
  • That is also due to how revenues are reported for each segment
  • Although company-operated restaurants have higher revenues compared to franchised restaurants, they contribute less to the company’s gross margins and net income.
  • It’s important to understand the key difference between McDonald’s company-owned restaurant business model vs the McDonald’s franchised restaurant business model.
  • McDonald’s can be considered a restaurant business in the McDonald’s company-owned side of the business.
  • However, it can be considered a mammoth commercial real estate company on the franchising restaurant side of the business. Indeed, in 2018, McDonald’s reported a cost of over $37 billion in property and equipment, which makes it one of the largest commercial real estate companies on earth.

Summary of the McDonald’s business model

  • McDonald’s operates a heavy-franchised business model, where most stores are franchisees. 
  • This strategy enables McDonald’s to amplify at maximum its distribution.
  • McDonald’s keeps control over the land leases on top of which new restaurants are built. In this way, it can keep control (without having a take in it) of the standards for franchised restaurants. 
  • Keep small numbers of operated stores for product development, workflow development, experimentation, and testing, before rolling things up at scale 
  • McDonald’s combines the Speedy System (operational efficiency), which today is amplified through the use of automation, combined with franchising operations for larger distribution, and a small set of operated stores for product development and innovation. All the while, controlling the lands on which McDonald’s are built so that while franchisees are independent, they have still to adhere to McDonald’s standards. 

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