The primary reason for the franchise arrangement is the increased net profit for the franchisee in using the franchiser’s name, logo, brand, or trademark. The franchiser charges an upfront fee called a Franchise Fee, monthly Royalties, in some agreements a License Fee and Marketing/Advertising minimums. These additional costs to the franchisee are paid to use the franchiser’s name. So how much does it really cost the franchisee to use the name, logo, brand, or trademark?
This article uses the contribution margin formula to evaluate the additional sales required for each of the four costs associated with owning a franchisee. The cumulative total is evaluated for the potential franchisee to discern how much more work is involved before the first marginal dollar is generated on the bottom line to end up in the pocket of the franchisee. Remember the primary purpose of the franchise relationship is making additional dollars for the franchisee for using the franchiser’s name, logo, brand or trademark. This article is detailed and will follow several steps in analyzing the costs associated with owning a franchise. Each section is designed to aid the reader in evaluating the costs associated with owning a franchise. I suggest that with each section, you enter your information into a spreadsheet and the final summation will be calculated for your particular situation at the end of this article. Finally, if you are still having trouble with this, contact me via e-mail, dave (use the standard symbol) businessecon.org. It usually takes me a day or two but I do respond. Give me the particulars and I’ll insert the information into my spreadsheet and we’ll talk.
The first term for a franchisee to understand is ‘contribution margin percentage’. This is the raw percentage of the net sale (Sales less discounts, coupons, and returns). For additional information in understanding this term, read: Definition of Contribution Margin. For the purpose of this article, I am going to compare two sub shops.
Two sub shops in the same shopping center are competing with each other. One is a national chain franchise (your store) and the other is a local Mom & Pop store. Both stores sell similar sandwiches and sides. The Mom & Pop have sales of around $340,000 per year with a contribution margin of 37%. From that contribution margin, the owners make around $48,000 a year in net profit. So for the purpose of the Mom & Pop store, their financial profit and loss statement looks similar to this:
Gross Sales $365,000
Discounts, Coupons & Returns (25,000)
Net Sales $340,000
Cost of Goods Sold 214,200 (Food, Labor, Supplies, Drinks)
Gross Profit $125,800 37% of $340,000
Overhead 77,800 (Rent, Utilities, Phone, Insurance, etc.)
Net Profit to the Owners $48,000
From the above example, the Gross Profit is the dollar amount of the Net Sales less costs for food, drink, supplies, labor and other direct costs to serve the sub sandwich. If your store is similar in size and similar requirements, then you too must generate at least $125,800 of profit to offset the similar overhead costs and end up with a similar net profit.
This article will illustrate how much more in net sales you must generate to offset the additional costs associated with owning a franchise. Remember, there are four additional costs with owning a franchise and they are 1) The Franchise Fee (entrance fee), 2) The Royalty (a monthly percentage of sales or net sales depending on the agreement), 3) Licensing Fee and 4) Marketing/Advertising minimums or costs (usually a percentage of sales). For an understanding of these costs, read Franchise Agreement Terminology .
If you are trying to evaluate your franchise, the franchiser should have historical information identifying the contribution margin percentage from net sales. This is your starting point in following this analysis in evaluating your personal situation.
For the owner of the national franchise store to earn the same bottom line amount of $48,000, we must make some assumptions to complete this exercise.
- The Franchise Fee is $25,000 and is amortized over seven years (Read: What is Amortization? for a better of understanding of this business concept).
- Royalties are 6% of Net Sales
- Licensing is $1,000 per year
- Marketing and Advertising is 4% of Gross Sales
The following sections identify the respective franchise agreement cost and illustrate how to monetize the cost in additional sales.
The Franchise Fee is an upfront cost paid by the franchisee for the right to enter into an agreement with the franchiser. In effect, it is compensating the franchiser for generating the legal documents and complying with federal and state laws.
Often this fee is more than $10,000 and rarely more than $50,000.
The fee is recovered over the life of the agreement via amortization. In most situations, a period of seven years is used to recover the fee unless the contractual agreement is less than seven years. If less than seven years for the contractual period; then the fee should be amortized over the lesser period of time. In most businesses, the amortization is divided equally over the amortization period. For this fee, I am assuming seven years for a $25,000 fee. So, the annual amount to recoup is equal to $3,571.
As a franchisee, you must understand that this amount of money is to reimburse you for your initial outlay for this agreement. It is a return on your initial capital investment into this franchise. The Mom & Pop competition did not have to pay this fee. Therefore, you must generate this additional amount via marginal dollars from the contribution formula.
If the contribution margin is 37% of net sales, and you must generate an additional $3,571 per year, then the formula is as follows:
Additional Net Sales = $3,571 divided by 37%
Another way to look at the math is in the financial statement format:
Net Sales $349,653 ($340,000 Mom & Pop + $9,653)
Cost of Goods Sold @63% (from above) 220,281
Franchisee Contribution Margin 129,372
Amortization of Franchisee Fee 3,571
Contribution Margin = Mom & Pop $125,800 *$1 Rounding Error
It is actually worse. Because you sold more product to pay for the up-front franchise fee, you must pay the royalty percentage and the marketing/advertising fee on the additional sales. Combined, these two line item fees add up to 10% of net sales. But this 10% must be net of the associated costs of sales or 63% (cost of goods sold as a percentage of net sales in the above Mom & Pop financial summary). So to cover the royalties and marketing/advertising costs, the additional sales must be divided by 72.97% or one minus 27.03% (.10/.37 cost of goods sold rate). So the correct formula is as follows:
Additional Net Sales = $3,571 divided by 37% divided by [one minus 27.03% or 72.97%)
= $9,653 divided by .7297
This is the additional net sales required to reimburse you for one year’s worth of amortization of your up-front franchise fee. So, right now, the Mom & Pop store only needs gross sales of $365,000 and your franchise needs at least $378,229 to end up in the exact same financial condition on the bottom line.
Here is the math in financial statement format:
Gross Sales $378,229
Discounts, Coupons, & Returns (25,000)
Net Sales $353,229
Royalties/Marketing at 10% of Additional Net Sales 1,323 *$13,229 * 10%
Cost of Goods Sold @63% of Net Sales 222,534
Contribution Margin for Franchisee $129,372
Less Cost of Amortization of Franchise Fee 3,571
Contribution Margin to Match Mom & Pop $125,800 *$1 Rounding Error
I will go further and argue that in addition to the amortization value of the franchise fee, you should also compensate for the cost of the associated capital you used at a reasonable rate of return on that capital borrowed (whether you borrowed it from yourself or from family) of 7%. Therefore, to cover the first year, an additional interest value of $25,000 times 7% equals $1,750.
So in the aggregate, you will need to have a contribution margin of $3,751 plus the $1,750 or $5,501 to make you whole again (put you back in the same financial condition prior to the agreement). Therefore using the formula from above, your additional net sales required to generate additional net contribution margin of $5,501 equals $20,375.
Here is the math:
Net Additional Sales $20,375
Royalty/Marketing/Advertising 2,038 10% of Net Additional Sales
Cost of Goods Sold at 63% of Net Sales 12,836
Contribution Margin $5,501
This number decreases each subsequent year due to interest on a lower unamortized value. So in year two, the franchisee only needs to cover the $3,751 of amortization of the franchise fee plus interest of 7% on the remaining unamortized balance of $21,249 ($25,000 – $3,751 – year one of amortization). This equals $3,751 plus interest of $1,487 or $5,238. So; net sales in year two needed to cover the franchise fee and interest equals an additional $19,401.
To check your math, the difference between the two years of additional net sales equals $974. This $974 means a royalty and marketing/advertising fee of 10% or $97. The cost of food and beverage associated with the $974 is 63% or $614. Therefore the remaining contribution margin is $263 ($974 less $614 CGS & $97 royalty/marketing). This is the difference in the amount of interest needed between the start year and the second year of business ($1,750 in year one and $1,487 in year two).
Over the seven year period, the additional sales required drops from the year one amount of $20,375 to the final year amount of $14,867.
You may think that this is a lot of additional sales needed and you are right. Think about this for a moment, assuming you are open 360 days a year, the per day amount of additional sales to cover just this one franchise cost equals $46. If you sell your sandwiches for $6 each and the customer spends on average $7 in your store per visit, you will need an additional 8 customers per day over the Mom & Pop store. This may seem unrealistic already, but wait until you see how many more customers per day you need to cover the royalty percentage.
In general most franchisers charge a royalty percentage on all sales. Many of the contracts charge a percentage on a sale value prior to discounts or coupons. So it is important for the franchisee to understand his franchise agreement prior to signing the agreement. Many franchises require franchisees to participate in monthly discount programs such as BOGO’s (Buy One Get One Free) or national discount periods for certain products. In addition, some franchisers require the royalty payment based on the gross sale before any coupon reductions. For the purpose of this franchise agreement cost, there is no assumption of a discount on the sale so in effect; gross sales will equal net sales.
The royalty percentage in this situation is 6% of the net sale. To compare required sales, the franchisee needs to have an additional 6% in sales. But this additional 6% of sales has food and labor costs too at 63% ($214,200 divided by the net sales of $340,000 from above) So the final additional amount required is 6% divided by .37 (one minus the 63% food, labor, beverage & supplies cost) or 16.22 %. So, required net sales for the Mom & Pop is $340,000, therefore for the franchisee, he will need sales of $405,825 [$340,000/(one minus 16.22% or 83.78%)]. To end up on equal footing, the franchisee must sell an additional $65,825.
At $7 per customer and using a 360 day year, you will need an additional 26 customers per day to cover the royalty percentage at 6%.
Here is the math:
Required Contribution Margin in Dollars $125,800
Required Sales $405,825
Royalty at 6% 24,350
Cost of Goods Sold (@63% of net sales) 255,700
Contribution Margin in Dollars **$125,775 *Matches Mom & Pop Store
** Error rate of .1% due to rounding ($25 over $405,825)
In some franchise agreements, the franchiser charges a license fee or some other charge to use the logo, trademark, or copyright. This fee is assessed because it is possible that the franchiser has to pay some third party for the right to use the trademark, logo, patent, or copyright in the franchise system. In rare situations, the franchiser is merely a clearinghouse or territorial controller for the franchise network and therefore, this fee pays for the territorial grant. Do not confuse this with a governmental license to operate. Some state commissions do charge a franchise license fee or business license. This is strictly a franchiser franchisee issue and is defined in the franchise agreement.
For the purpose of this article, the annual license is $1,000.
This means that as the franchisee, you will need to earn an additional contribution margin of $1,000 to pay this fee. Using the 37% contribution margin, this means net sales must increase $2,703. To complicate matters, do not forget that you must pay royalties/marketing on the additional sales. Therefore, the sales must equal $3,704 (refer to the formula in the Franchisee Fee Section above) to cover the royalties on the sales and contribution $1,000 of margin at a 37% contribution rate. Here is the math:
Required Additional Contribution Margin $1,000
Additional Net Sales $3,704
Royalties/Marketing (10% of Net Sales) 370
Cost of Goods Sold at 63% of Net Sales (1-.37) 2,334
Additional Contribution Margin $1,000
Using the customer analysis as above, you will need an additional 1.5 customers per day to cover the license fee.
The marketing/advertising rate has significantly less contribution to your store than the cost associated with the fee. You are in effect helping the franchiser promote the franchise name and the return on the investment is not there. The franchiser reaps more benefit from the marketing/advertising than the franchisee. If anything, it helps to sell the franchising program more than anything else.
Most contracts carry about a 2% national campaign fee. It covers the website, internet marketing, national and regional advertising via television or radio. The fee allows for develop of campaigns including coupon types and prepaid cards. In addition to the national fee many franchise agreements get into local affiliate advertising. In simple terms, you are paying an additional amount to participate in a regional or community wide advertising program.
A typical business gets themselves listed in the yellow pages; and this is an advertising cost customarily found in overhead. For this article, it is assumed that your sandwich shop is using the same programs and campaigns as the Mom & Pop shop. The 4% fee is strictly a franchise agreement cost.
The fee formula was included in the Franchise Fee section above and the License Fee section. So the question is: How much more in sales do we need to cover the existing basis of $365,000 of gross sales plus the additional $65,825 of sales associated with the royalties? Remember, this marketing/advertising percentage is based on gross sales and not net sales.
So let’s break this down into two parts. Part one is the original $365,000 of gross sales. The 4% marketing/advertising rate (M&A %) is after the cost of goods sold component. Therefore, the 4% M&A rate must be divided by the contribution rate of .37. So the percentage to use is 10.81% to cover the M&A requirement. This part means that we will need $39,459 of additional sales before royalties. Using the formula in the franchise fee section above, we need to divide this by the 72.97% factor. Therefore, the final additional gross sales needed are $54,076. Let’s put this in financial summation:
Gross Sales ($365,000 + $54,076) $419,076
Discounts, Coupons, Returns (25,000)
Net Sales $394,076
Royalties @ 6% 3,245 (Only on the marginal sales amount of $54,076)
Marketing @ 4% on the Total 16,763 (Remember, the rate is on Gross Sales)
Cost of Goods Sold @63% 248,268
Contribution Margin $125,800 *Equals the Mom & Pop Shop
Part Two covers the additional sales associated with the royalty formula from above. Notice that we needed an additional $65,825 in sales to cover royalties for the sandwich shop. This is net of the associated M&A issue. The 4% M&A would require an additional sales volume of $9,752. This is 4% of 65,825 divided by the contribution margin of 37% divided by the franchising royalty fee rate divisor from above of 72.97%. Formula = $65,825*.04/.37/.7297. We need $9,752 of sales to cover the additional M&A amount on the royalties. Here is the math in financial statement format:
Additional Sales Needed to Cover M&A Associated With Royalties $9,752
Royalties @6% on marginal sales of $9,752 585
M&A @ 4% of combined total ($65,825 + $9,752) 3,023
Cost of Goods Sold @ 63% on marginal sales 6,144
Contribution Margin -0-
The reason for a contribution margin of zero is because our goal is to cover the cost of the marketing/advertising fee on the royalties from above. But to do this, we need sales and those sales have royalty fees too.
Combined, we need additional sales of $63,828 ($54,076 to cover the marketing/advertising fee associated with the initial sales of $365,000 and $9,752 to cover the costs of marketing/advertising on the royalties for the net sales of $340,000).
So, how many more customers do we need to cover the costs of M&A? We will need an additional 25.33 customers per day to pay for the marketing/advertising cost of the franchise agreement.
Conclusion – Franchise Costs
If you haven’t figured it out yet, you are paying royalties on monies earned to cover the cost of the franchise fee, the licensing amount and the marketing/advertising costs. In addition, you must pay marketing/advertising costs on the needed sales to pay for the franchise fee, the royalties, and the licensing amount. It is referred to as circular math. But to grasp the entire picture, let’s look at the problem in its entirety.
Your contribution margin must be greater than the Mom & Pop to cover the licensing fee of $1,000 and to reimburse you for the up-front cost of the franchise fee. In addition, you will want interest on that franchise fee. So, your contribution margin must be as follows:
Contribution Margin of Mom & Pop $125,800
Licensing Fee 1,000
Franchise Fee Amortization 3,571
Interest on Franchise Fee @7% of $25,000 1,750
Your Required Contribution Margin $132,121
Using the information from the above sections, additional sales required equals the following:
Sales Required to Cover Franchise Fee $13,229
Sales Required to Cover Interest on Franchise Fee 7,146
Sales Required to Cover Royalties 65,825
Sales Required to Cover M&A 63,828
Sales Required to Cover License Fee 3,704
Total Additional Sales $153,732
In financial statement format:
Gross Sales ($365,000 + $153,732) $518,732
Discounts, Coupons, and Returns (25,000)
Net Sales 493,732
M&A at 4% of Gross Sales 20,749
Royalties @ 6% of Net Sales 29,624
Cost of Goods Sold @63% of Net Sales 311,051
Contribution Margin $132,308
Contribution Margin Required to Cover All Costs $132,121
Difference is $187. I’ve tried several times to figure out where it is coming from but I can’t get it close because most likely it is related to the rounding to two digits on my divisors used above and using large numbers associated with sales causes this error at the end of the day. $187 isn’t going to break the bank when we are talking about $518,732 of sales. Someday when I have an extra four hours on my hands I’ll go to the third digit in my divisor and see if that is the reason.
Anyway, notice that total sales must be at least $153,732 greater than the Mom and Pop to have the same contribution margin in dollars to cover overhead and have the exact same profit as the Mom and Pop shop. At $7 per customer and utilizing a 360 day year, we are talking about 61 more customers per day as follows:
Customers to Cover Franchise Fee & Interest 8
Customers to Cover Royalties 26
Customers to Cover M&A 25
Customers to Cover Licensing 2
Total Customers to Cover Franchise Agreement Costs 61 PER DAY!
Let’s think about this for a minute, you need 135 per day just to reach the same level as the Mom & Pop shop and as a franchisee you will need an additional 61 customers per day or around 196 customers per day.
Go back to the introductory paragraph. What is the primary reason to have a franchise?
To have an increase in the net profit, you will need at least 197 customers per day. The franchiser is saying that he can increase your average customer count by at least 62 per day to cover the franchise costs and to BEGIN to add to the bottom line on your financials. That is about a 45% increase in the number of customers coming into your store to eat a comparable sandwich as the Mom & Pop in the same location.
Do you really think this is true? Now look at the real costs of a franchise agreement. Sixty-one more customers per day will generate a lot more stress on the owner in exchange for no monetary gain. Do you want to gamble that using a franchise name will bring in 45% more customers per day over the Mom & Pop. To make matters worse, this is just to get to the point where you can begin to earn some money off the use of the franchise name. Given the nature of the risk, I find this highly unlikely. If anything, I would argue that the Mom & Pop can easily make this difficult just by serving a decent sandwich with a good old fashion smile and a ‘Thank you’.
So if you are considering going into business via the franchise method, evaluate the true costs first. If you have any questions or need help in evaluating your situation, contact me via the comments section below. I’m here to help you. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.