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The impact of rising commodity prices on franchise restaurants

A major topic of conversation in the restaurant industry over the past 18 months has been the continued rise in commodity prices, especially for proteins. In 2012, beef prices rose 9.9 percent and chicken prices had a double-digit increase. These trends have continued in 2013, with the beef price pressure continuing a trend that started in 2010.

Annual change in wholesale commodity prices

 200820092010201120122013
Beef5.4%-7.1%10.4%15.3%10.1%0.3%
Poultry3.9%2.1%1.5%-1.4%11.2%4.8%
Pork-1.9%-11.0%23.3%12.5%-3.9%3.1%
Milk5.7%-13.3%12.7%11.8%-2.4%4.2%
Cheese10.8%-20.0%9.6%14.0%-0.2%4.6%
Corn42.2%-23.4%10.6%72.3%5.0%-4.7%
Wheat54.0%-32.6%7.5%42.5%-1.3%1.3%

Source: BLS 2013 YTD as of 10/13

Cost of goods (COGs) are a significant driver of restaurant profitability. With price changes lagging the daily fluctuations in commodity prices, a dollar increase in cost is one less dollar that goes to the bottom line.

The financial impact of COGs can be most easily seen by looking at a performance quartile range. According to GE Capital’s proprietary SmartChartTM tool, an analytical repository of financial performance on more than 11,000 restaurants throughout the U.S., the average sandwich chain had a COGs margin of 31.5 percent compared to 31.7 percent margins for QSR as a whole. Performance in the segment, however, varied from 29 percent to 34 percent.

Using average sales volume of $1.2 million as a baseline, it’s easy to see the potential impact of COGs fluctuations. Operations could move from the highest quartile (worst performers) to average, a move of 250 basis points, if $30,000 per year per store is added to the bottom line. And if COGs rise, the operator has the same bottom-line impact as if operations deteriorate.

But an interesting thing happened amid the changes of the past several years. Operational results did not, in fact, take the financial hit from commodity prices that might have been expected. Or, perhaps more correctly, restaurant operators have been able to manage the increasing costs. Year-over-year performance data shows EBITDA and EBITDAR margins were essentially flat in the QSR sector.

Looking more closely at COGs, we see a similar story. Costs did not increase as a percentage of sales in 2011 and 2012; they stayed at approximately 32 percent. So how have restaurants been able to manage through the cost pressure? Price. QSR same store sales were up 3.8 percent in 2012 while traffic only increased approximately 1 percent, meaning that roughly 3 percent of the increase came from price.

But the important thing to remember is, as COGs are about 1/3 of sales at a restaurant, a 1 percent increase in price covers a 3 percent increase in COGs. Therefore, although the major proteins had cost increases in 2012 in excess of 10 percent, the 3 percent price increase, coupled with other inputs that didn’t rise as dramatically, meant operators were able to maintain profitability in 2012 and 2013 year-to-date.

The industry’s success in 2012 in mitigating increasing commodity costs likely bodes well for COGs going forward. While we certainly don’t have the ability to predict commodities with any real accuracy, the major restaurant commodities have been outpacing inflation since 2008; year-to-date trends, although still increasing in price, have moderated compared to 2012. Because price increases tend to be sticky, the efforts from 2012 to maintain margin should be able to hold and any reduction to COGs should drive bottom-line growth.

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