limited worldwide chicken supply, combined with continued high demand, drove prices upward. Beef prices have also been higher in the past year due to U.S. restrictions on Canadian imports in the
wake of incidents of "mad cow" disease in Canadian cattle herds. Weather is also a factor, especially when severe conditions limit the growing season or crop quality. This happened in 2004, when
hurricanes in some parts of the United States damaged tomato crops and drove prices higher. Unlike many other restaurants, we decided not to limit our use of tomatoes (and not to pass the cost
increase on to customers). These and other cost increases negatively affected our margins in 2004. Similarly, hurricanes Katrina and Rita in the fall of 2005 have resulted in higher
short-term chicken prices and higher diesel prices, which may affect our suppliers, causing them to increase the price of other ingredients.
We try to minimize the volatility of our food expense by working closely with our suppliers and using a mix of forward, fixed and formula pricing protocols. Under forward pricing
protocols, our suppliers and we agree on prices for the ingredients or other raw materials that they sell to us at specified times in the future (possibly weeks or months in advance). Whether
the price goes up, down or remains stable over the period, we pay that agreed-upon price at the time we make our purchase. Under fixed pricing protocols, we agree a fixed price with our
supplier for the duration of that protocol. Under formula pricing protocols, the prices we pay are based on a specified formula related to the prices for the goods; for example, prices may be tied to
the spot price for the ingredient or raw materials in the commodities market on the date of purchase. Though we do not have long-term supply contracts or guaranteed purchase amounts, our
pricing protocols with suppliers can remain in effect for periods ranging from one month to a year, depending on the outlook for prices of the particular ingredient. We also sometimes buy supplies at
current market or "spot" prices.
also tried to expand, where necessary, the number of suppliers for our ingredients and other raw materials to assure supply and freshness and mitigate pricing volatility. Our focus
on "food with integrity" has constrained our sourcing flexibility to some extent. We've been careful in expanding that initiative so that we don't outpace available supply. Some of our ingredients
come from small farms that have facilities that must comply with federal or industry standards for classification as natural, and they may face economic or other limits on their growth. We believe
that consumers' increasing concern about where and how food is raised, environmental management and animal husbandry will foster demand for these foods, which will in turn attract the interest and
capital investment of larger farms and suppliers. That said, we understand that we'll continue to be at the forefront of this trend and must balance our interest in advancing "food with integrity"
with our desire to provide great food at reasonable prices. If our focus resonates with consumers, it should improve our sourcing flexibility, although we'd expect that these kinds of ingredients and
other raw materials will remain more expensive than commodity-priced equivalents for some time to come.
and packaging costs, while smaller than food costs, are also a significant portion of these costs. McDonald's relationship with Coca-Cola has helped us contain our
beverage costs and as long as we are a consolidated subsidiary of McDonald's, we expect to continue to have that pricing advantage. See "Risk FactorsRisks Relating to Our Business and
IndustryAs we increase our independence from McDonald's, we may face difficulties replacing services it currently provides to us and entering into new or modified arrangements with
existing or new suppliers or service providers." Food, beverage and packaging costs also include freight costs, which can be higher than those of some of our competitors in part because we rely
primarily on perishable ingredients rather than on processed food products. These costs have also been affected by higher diesel prices that have in some cases resulted in the imposition of surcharges
on the delivery of commodities to our distributors, which they have generally passed on to us to the extent permitted under our arrangements with them.
Labor costs are the second-largest component of our expenses, and represented 32.5% of total revenue in 2002, 29.8% in 2003, 29.6% in 2004 and 28.5% in the first
nine months of 2005. Labor costs