French Fry Arguments and the Kraft Heinz Split

I love McDonald’s French fries.

They’re the best fries, bar none. I even love the way the grease accumulates in the bottom of the bag. People may argue the point, but I’m right. Reminds me of growing up…

Of course, you also need Heinz ketchup, and some Kraft Macaroni and Cheese to go with it. Kraft and Heinz make dozens of the products I grew up with.

A merger of the two companies 10 years ago seemed to make sense. They both make food products for the masses, and a merger could allow the combined firms to find synergy and cost savings.

But it hasn’t worked.

The Kraft Heinz split is a great illustration of gross profit, net income, and the components that comprise each.

Gross profit is defined as:

• Revenue - cost of sales = gross profit

When you think “revenue”, think “sales”. Cost of sales includes direct labor, direct materials, and other spending that can be traced directly to producing a product (or providing a service).

Gross profit does not equal net income. Here’s the formula for net income:

• Gross profit - operating expenses = net income

Operating expenses are costs that cannot be directly traced to producing a product or providing a service. Home office costs, such as leases, insurance, and professional services (for accountants and lawyers) are operating expenses.

Try CPA Exam Flashcards Free

When companies merge, there’s often an opportunity to get cost savings through better use of machinery and equipment. Kraft produces salad dressings and barbecue sauce, while Heinz makes ketchup, sauces, and other condiments.

Why not use the same machinery and equipment to make both products? If Heinz owns a machine that operates 1,200 hours a year, maybe the combined business gets 1,600 hours a year out of the machine.

Packaging, shipping, and marketing can all become more efficient. Sounds good, right?

Another point: The combined companies buy more (a lot more) raw materials from suppliers. They can demand lower prices based on higher volume.

The result?

Cost of sales declines, and gross profit increases (assuming the same level of revenue).

Customer preferences can have a huge impact on sales, and customer tastes may change quickly.

As the Wall Street Journal reports:

“Demand for some of Kraft Heinz’s core products—from Lunchables to Capri Sun, macaroni and cheese and mayonnaise—has weakened. Kraft Heinz has been working to reshuffle its portfolio and invest in healthier products more in line with consumers’ changing preferences…

It has also tried in recent years to sell off some of its underperforming brands like Oscar Mayer and Maxwell House, to no avail.”

If revenue falls faster than the cuts to the cost of sales, gross profit will decline.

The gross profit formula shows that a lower cost of sales after a merger can benefit a company, but larger declines in revenue can reduce gross profit.