Franchising Economics

A primary concern when considering investing in a franchise is franchise economics. There are many facets to this topic, but we will only undertake to examine the four primary concerns here. This article will provide a simple overview of how to think about the financial side of any franchise concept you may be interested in joining.

In franchising, as with any business, there are four critical components of financial concern: revenue, costs, capital expenditures, and income. All of these must be evaluated in order to understand any franchise opportunity under consideration. For a more detailed analysis of the financial picture of any franchise opportunity, seek the services of a professional franchise advisor.

Franchising Economics: Revenue          

Revenue is the amount of gross sales you produce through your business. The total revenue you are able to generate, or expect to generate, is the most critical factor when determining the potential or estimated long-term cash flow of the franchise opportunity.

Some franchise opportunities provide multiple products and/or services through which to multiply revenue, while others may offer more limited options. Of course, the more opportunities to make money, the better. Think of a fast food franchise compared to a computer repair services franchise. The fast food outlet would have approximately 30-40 products for sale; the computer repair service may have five or six service options.

A sound franchise opportunity should also provide a robust marketing plan that you can follow in order to locate and grow a solid customer base. Great franchises provide not only a time-tested plan, but also deliver support, marketing collateral, and other help to assist you as you grow your business.

During the discovery phase with a prospective franchise, be sure to ask questions like:

• How much annual sales does the parent company generate?
• How much does the average franchise generate?
• How long did it take the average franchise to reach that level?
• What are the key performance indicators (KPIs) of the business?
• How easy/difficult was it for them to manage these KPIs?
• How supportive is the parent company to help them increase franchise sales?

The answers you get to these questions will inform you about the quality of the franchise and give you an idea of the overall revenue picture.

Franchising Economics: Cost Structure                      

Costs, or the franchise cost structure, are the cash expenditures you incur as you manage and grow your business. These costs include personnel, marketing and advertising, product costs, rent, and utilities. These are, of course, the segment of franchising economics you want to keep as low as possible in order to maximize your income/ROI.

Other costs are those determined by your parent company, and they can include one-time startup fees, monthly royalties, advertising fund dollars, training funds, and other related costs. Typically, you pay the parent company a certain percentage of your gross revenue for these items. Many of these costs are fixed; therefore, your cost management efforts will primarily be directed at the other, more fluid expenses.

Franchising Economics: Capital Outlays               

It is important that you not overlook this crucial part of franchising economics. Capital outlays are large expenses that you must spend out of your franchise revenue to maintain the business. This could be initial store construction, store remodeling, equipment purchases and upgrades, parking lot maintenance, working capital, or anything else necessary to keep the physical location in good order.

As a general rule, these capital expenditures occur every three to five years. Therefore, they are large expenditures, sometimes averaging around 3-5% of total annual revenue. So, as you calculate the numbers as part of evaluating any potential franchise opportunity, be sure to budget for these items.  

Franchising Economics: Income

After assessing a number of working franchises from a parent company, including the three franchising economics factors we have discussed above, you should be able to gain a good idea of what your income can be as the owner of a similar franchise. Owner’s earnings are the profits that will accrue to you as the owner. This may differ somewhat if you plan to operate the franchise as the manager or hire a staff manager to oversee operations.

Franchising Economics: Return on Investment (ROI)

Now that you have examined the cash flow of the potential franchise (revenue minus costs and any capital expenditures), you are now in a position to determine if this franchise investment is the right one for you. A general rule of thumb is to take the average of your expected cash flows for the next three to five years and divide by the initial investment to buy your franchise.

For example, if the average cash flow generated from a franchise is expected to be $1,500,000 annually. The upfront investment is projected to be $500,000. Therefore, your return on the investment (ROI) would be 33%. Another way to view this investment is the payback period. In this example, if you earn 33% ROI ($1,500,000/$500,000), you would get all your money back in three years.

These are only brief explanations of the main categories of franchising economics, to give you a broad picture of how to evaluate franchising opportunities. For more exacting examinations of any potential franchise, contact us at Franchise Guardian. Our experienced advisors are happy to answer your questions.