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Core Elements in the Franchise Business Model – Part One

Core Elements in the Franchise Business Model – Part One

Executive Summary
While all successful franchise systems are built on the foundation of a successful retail (or other) business model, not all businesses are appropriate for franchising.
This paper discusses (in a number of parts) some of the elements that must be present for a business model to be appropriately adapted for growth through franchising.  Those elements include, among others:
•    Adequate profitability levels for the retail business to support the ongoing costs of operations as a franchise system at all relevant levels.
•    Financial and emotional attractiveness of the concept to potential franchisees.
•    Probability of successful development of system-wide brand value.
•    Replicability and adaptation of the business model to varying market environments.
•    Ease of operation by unit-level managers without excessive training requirements.
•    Ease of assuring appropriate levels of operational control over retail-level units.
•    Personal and business requirements for success as a franchisor, aside from business model considerations.
    This part addresses the first of those elements; required profitability levels.

Profitability of the Underlying Retail Business
Of course, no one experienced in franchising would recommend franchising a concept that did not have a proven track record (or reasonable prospect) of profitability at the retail level.  
To do so would be a disservice to both the company planning to be a franchisor, since franchise concepts possessing profitable retail business models are far more “saleable” than non-profitable ones and can support higher royalty levels than those which are not, and the potential franchisee, who hopes to operate a profitable business and one that provides an appropriate rate of return on his or her investment.
Of equal importance, the very nature of franchising arguably requires a higher level of profitability at the retail level than a similar non-franchised business.
Here’s why:
By definition, a franchise business model involves at least two levels in the distribution chain:  the retail-level unit and the franchisor.  (Note that in some systems a third, intermediate level, may also be involved, imposing additional costs.)
Each of those levels has its own associated overhead, G & A and related costs, all of which need to be supported by the cash flows generated by operation of the system.
So, in a franchise distribution model, some or all of the costs at the franchisor-level must be provided for by cash flows received from the franchised (retail) unit level.  (For purposes of this analysis, we’re putting to one side franchisor revenues from units owned and operated by the franchisor, as well as revenues from sales of franchises, and focusing on the operating costs and revenues of the franchised system.)  In effect, those franchisor revenues are (a part of) the franchisee’s costs.
In most franchise systems, those revenues/costs are paid by means of a royalty; in some systems equivalent amounts may be paid in connection with mandatory or other purchases of products or services from the franchisor and/or its affiliates, but in either event those costs must be borne by the franchisee.
In addition, the franchise arrangement may impose other costs on the franchisee, such an mandatory contributions to an advertising fund, required local advertising expenditures, regular upgrades of the business premises, insurance requirements, etc.
These costs may be absent (or may not be as large or may be deferred for a longer time) in the case of a non-franchised unit.  After all, a McDonalds franchisee makes regular and substantial royalty payments to the franchisor; an independent hamburger stand does not.
So, in a well-designed and well-managed franchise system, the advantages of franchising to the franchisee (brand identity, savings through volume purchases, access to superior retail locations, etc.) will be reasonably anticipated to be reflected in increased revenues and profit levels for most operators, thereby justifying, from an economic standpoint, the greater costs involved in being part of a franchised chain.
And that means that in the analysis of whether a concept is appropriate for franchising, attention must be given to the question of whether, given anticipated greater costs at the unit level, the unit level business model generates sufficient cash flows and profit levels from typical operating units to make the business model operate satisfactorily for both the franchisor and the typical franchisee.

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