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Advantages of Franchising with Examples

by Suleman
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Introduction

There are more and more people heading away from conventional job-related jobs and searching for prospects for self-investment in these tough recessionary times, where work is difficult to come by. Franchising is one of the most enticing opportunities for self-investment, especially because it offers the ability to buy into a corporation that is already well established and has a defined market. This article contrasts two investment prospects for franchising in order to analyse which will be more valuable from the point of view of an investor. Quiznos, a fast food sandwich outlet that provides franchising options with an upfront cost of just $5000, is believed to be the largest. The other franchise is Pitapit, which requires an upfront expenditure that is even more costly, i.e. $255,614 in order to open. For the purposes of this forensic report, the time span is 10 years and all expenditures and profits are measured over a duration of 10 years in order to draw a decision as to what will be the right business option for an individual over a long-term period.

The Benefits of Franchising

                Franchising offers five distinct advantages, which are listed below;

  • Branding
  • Advertising
  • Name recognition
  • Reputation
  • Support

Branding is one of the first benefits of franchising, in which a franchisee who acquires a stake in the organisation is willing to provide a strategic branding that has a strong business effect. In turn, taking up a franchising option such as Macdonalds, for example, suggests that the business is now well established to the public; as a result, every potential franchise will have the benefit of drawing buyers from the organisation who have already been exposed to prior advertising attempts. Since buyers are now acquainted with the brand name, they are likely to take advantage of the company’s services. A prospective business owner will be confronted with the challenge of making the organisation a familiar entity in the industry in the absence of a licence, which would take time and resources.

Advantages of Franchising with Examples

Franchising’s second gain is linked to the aforementioned. Advertising may also be one of the more costly parts of operating a company and recruiting clients, for a franchise, all advertising is taken care of by the franchise owner and the franchisee just needs to compete with customers from their own local region. Therefore, being a franchisee often ensures that the corporate name is a known one and it will automatically be important for the new company franchisee to draw on a recognisable brand name in the marketplace.

Similarly, a franchisee will still gain ties to the franchise’s prestige. Under the case that there is a successful franchise, reputation and has not been adversely affected by  lawsuits, the very name would be enough to ensure that the franchisee gains form that good name in terms of gaining access to a wide customer base.

                Lastly, entering into a franchise arrangement means that the franchisee is able to gain access to specialised training from the head office of the franchise. When a franchisee enrols for a business arrangement, training is provided on all aspects including technology, business activities, and collections . Online support and training is available on an ongoing basis, in order to ensure  the continued success of the franchisees.

The Research Problem

                This research proposal examines two different franchises. The first is Quiznos, a fast food franchise where the initial investment is low, i.e., $5000; however the monthly royalties to be paid are 50% of all revenues received. The second is a Pita franchise where the initial investment is substantially higher, i.e., $255,614, but the monthly royalties payable from the revenues is only 6%.  Both of these franchises are assumed to be located in the United States, in order to provide a common background market against which to assess the viability and profitability of the two business options. The objective of this research study is to determine which of these two franchises is likely to be more profitable in the long run, over a ten year period. The research questions which are posed are as follows:

  • How long would it take for each of the two franchises to be opened and to start generating revenues?
  • Which of the two franchises is likely to have higher profits after ten years?

Literature Review

                Michael (2000) defines the franchising system as “an organizational structure governed by a contract  between a parent company – the franchisor, and a local outlet – the franchisee, established to sell products or services under the parent’s trademark.” (at pp 497).  One of the biggest drawbacks in constituting and starting up a new business is the element of uncertainty that is involved.  When a person seeks to be his or her own boss by starting up a business,  advisers may need to be recruited, such as a solicitor, accountant  and a banker; yet despite the involvement of all these professionals, there is still no guarantee that the business will succeed.  Where franchising is concerned however, someone else has already done all of the ground work that is needed to establish the business. (franchisedirect). As a result, this saves a great deal of time and legwork for the new business owner, while also saving on the business expenses incurred to hire professionals

                The business theory that best explains franchising is agency theory, which explain how to organize relationships in which one party determines the work which another party takes up.(Shane 1998: 697). Martin points out that franchising is an important way for companies to raise capital, especially in the context of expansion plans (Martin, 1998:954). Franchising allows a franchisor the opportunity to exploit economies of scale in expanding into a large number of outlets in heterogeneous locations and by exploiting such economies of scale,  a franchisor can shed risky locations where profit potential is low and retain the more profitable locations as company owned outlets.

                In the context of fast food outlets in particular, Kalnis and Mayer (2004:1716) have carried out a case study on Texan pizza franchises. They have come to the conclusion that most of these units tended to be more profitable and benefitted from the franchisee’s own local knowledge and congenital experience of the area rather than from distant experience, which did not prove to be beneficial.  When the franchisee had local experience, it helped to reduce failure rates.

                The legal problems associated with franchising generally tend to fall into three categories: (a) misrepresentations made by franchisors to potential franchisees about how the franchise operates (b) restrictions placed by the franchisors on the sources of supplies or services that are purchased by the franchisees , which is referred to as a tying agreement  and (c) the complexities of the termination procedures in the franchise agreement.  Where a tying arrangement is concerned, this means that when a franchisee is purchasing  a product, s/he is also obliged to purchase a range of products and services that go along with it, which may not strictly be needed but provide additional revenues for the franchisor.

Comparison of The Financial Benefits of The Two Different Franchises

                The Pita Pit franchise has locations all over the United States, especially concentrated in the states on the east and west coasts.  The idea behind formulation of this franchise was to provide a healthy fast food alternative, as opposed to fattening burgers ad pizza. PitaPit came up with Lebanese style lean pita which was filled with lean, grilled meats and healthy vegetables, cheese and sauces (www.pitapitusa.com).  According to Rasmusson, reporter for the Bonne County Daily Bee, fast food from a Pitapit provides the opportunity to enjoy wholesome fast food that does not automatically translate into gaining weight by eating foods rich in fat, such as those offered by other franchises like Macdonalds  (Rasmusson, 2010).  Additionally, Pitapit  Pitapit is also the only food outlet that stays open long hours; for example on weekends, it stays open up to 3 am. This would translate into increased costs of operation in hiring staff to man the counters , as well as in ensuring that adequate food supplies are available to satisfy the demands that arise.  

                Most fast food firms fall within the category of perfect market competition, which is demonstrated by the following characteristics (a) large number of buyers and sellers (b) homogenous products  and (c) easy entry into and exit from the market.  The market demand and supply conditions will influence the prices which can be charged for the food products. Moreover, the extent to which a customer feels satisfied with the food product which is being offered is likely to make a difference in terms of the willingness of the customer to even pay a higher price, if necessary. For the sake of this project, the fast food franchise which is assumed as the first business opportunity is Quiznos, which is a sandwich outlet.(quiznos). The Quinzos franchise was started in Denver, Colorado, based upon the bold idea that food should taste good and should also taste different. The franchise has three major selling points (a) they dare to be different, i.e, they toast their sandwiches (b) quality, i.e, they supply quality meats and (c) every order is custom made, to suit the specific customer’s preferences.

                The Quinzos franchise has been praised as having some of the best fast food in the industry and the parent franchisor spends $90 million on its marketing budget. (franchisesThe franchisor has also received top rated rankings at no: 1 in terms of its service and has even found a place among the top 30 of all restaurant chains.  Although a Quinzos franchisee would thus be well supported in terms of active advertising and promotion carried out by the head office and also enjoy the business generated by its top rankings for quality, there are also some issues identified  against the franchisor. Quiznos was accused by several franchisees of racketeering, because it made it mandatory for franchisees to pay higher process for food and supplies at highly inflated rates, while at the same time mandating that the food items be sold at low prices through the Quiznos store outlets. As a result, the lower retail prices resulted in the franchises proving to be an unprofitable venture.

                In computing the costs associated with the running of a franchise, costs and expenses must be taken into account. In this connection, the following information is provided.The initial purchase price to acquire the respective franchises is different.  Where Pitapit is concerned, a general idea of costs that might be involved has been provided by the franchisor on its website.  The costs are split up as follows, into two columns, one offering the lower cost version while the other provides the higher cost option and both of these differ in terms of their investment by a sum of $120,279. (source: www.pitapitusa.com)

LOW HIGH
Initial Franchise Fee $20,000 $25,000
Initial Rent and Security Deposit $2,400 $10,000
Opening Cash $500 $1,000
Leasehold Improvements $59,865 $138,979
Business License $200 $2,500
Insurance $1,500 $4,500
Initial Start-up/Printing Pkg $1,500 $2,000
Legal and Accounting Fees $500 $2,500
Initial Furniture, Fixtures, Equipment Package and Signage $73,535 $87,600
Opening Advertising $500 $1,000
Staff & Management Training Expenses $1,000 $3,200
Uniforms $1,000 $1,500
Initial Inventory Package $5,000 $8,000
Total Initial Investment $167,500 $287,779
 Additional Funds (for 3 months) $25,050 $30,900
 Local Advertising 1% of gross sales of the restaurant
Total Investment $192,550 $318,679

Of the aforementioned, it can be found that the amount of cash that has been estimated, which an investor would be required to have in order to start up the Pitapit franchise is $192,500. This figure however also requires a three months worth of additional funds to also be held. This is quite important, so that the business does not run out of steam once it has started; every business has an initial warm up period where it is unlikely to have many customers to bolster revenues and it would need to supplement its funds requirements from its own reserves of cash. Assuming however, that (a) this three month security fund stash is ignored  (b) leasehold improvements are kept to a  minimum of $10,000 and (c) costs for furniture, packaging, etc are also lowered to about $50,000, this would bring the bare minimum amount required to start up a franchise to about $94,100. The start up costs for the Pitapit franchise amount to at least $20,000 for the franchise name itself, hence other base minimum costs would definitely hike up the prices.

It may be noted from the above table that the initial franchise fee is itself $20,000, as compared to $5000 with Quinzos, which has a special offer for potential franchisees to purchase certain stores across the country for as little as $12,500 total start up costs, with additional financing assistance to be provided by the Company itself. The actual costs for starting up a new Quiznos franchise are listed below and it must be noted that by opting for the purchase of the franchise with the lower down payment option, it may become necessary to factor in the interest costs that an investor is likely in order to compensate for a given time frame, depending upon what time frame is agreed to. Since the initial duration of a Quiznos franchise is for 15 years, it will be assumed that a loan for the balance amount of investment over and above the sum of $12,500 will be paid by the investor by securing a loan from the franchisor.

In so far as Quinzos is concerned, the actual costs incurred in order to purchase a Quiznos franchise is an initial minimum amount of $70,000 and a minimum net worth of $125,000. The basic cost of the franchise itself is however , lower than that required for Pitapit, i.e, $20,000 as opposed to $25,000 for Pitapit. In order to ensure that its franchisees succeed, the Company also initially provides a self study program that a franchisee can peruse at home. This is followed by an 18 day training period in a regional training store and finished off with 6 days of training at the Quiznos  University headquarters at Denver.  Through the provision of such extensive training, the chances of success that a Quiznos franchisee is provided with are much higher. Finally, before the franchisee can actually commence operations, the Quiznos competency test needs to be passed and the one-time cost for passing this test ranges between  $185,450 and $264,950.

Projected Revenues

To adjust for a particular time period, arises out of its sale of food, although the sale of drinks would also contribute to the gross revenues. Average food prices at Pitapit, for individual products such as meat and vegetable pita are in the range of $5 to $6 each. Speciality pitas cost between $6 to $7; beverages and snacks cost on an average between $2 to 3 (www.ordering.bigholler.com).  It appears likely that there will be a high volume of food sales during the meal times, i.e, thrice a day; there might also be a time of high sales during the evening and another one during the midnight hours, when the franchise gets its share of truck drivers and people working on night shifts into the store to grab a meal. On the basis of this, an assumption may be made that on average, one store outlet is likely to sell about 700 ordinary units and 50 special units. On this basis, the ordinary units would generate a revenue of $4200 for the ordinary units and $350 for the special units. Assuming that about 750 drinks on an average are purchased in a day, this would pull in a revenue of $2250. Thus, the total revenue for a day would be about $6800 per day.

  Assuming an average number of four workers in every store, with three being paid the minimum wage of $6 per hour for 10 hours from 7 AM to 5 PM and two workers being paid the night time wage of $8 per hour for  10 hours from 6 PM to 3 AM in the morning, the total wages to be paid in a day just for the labour used in the store amounts to $340 in a day. The salary for a manager would also need to be added, which can be estimated at an average of $24,000 per year or roughly $76 per day, bringing the total wages payable for the entire day to about $420. The net revenue per day taking the wages into question and deducting them from the net taking is likely to be about $6300. Additionally, the cost of perishable food items paid daily can be estimated at about $700 and coupled with the daily share of non perishable items which may be purchased on a monthly or weekly basis, an average amount of $1000 may be set aside per day for  miscellaneous expenses such as food, electricity and similar expenses.

Assuming an average revenue amount of $5200 per day to account for some days when the sales volumes may be very low, this would result in a gross yearly revenue of  $1,872,000 with the number of days being taken into account being 360 rather than 365, in order to make some allowance for days when the fast food outlet might remain closed for one reason or the other. It must be borne in mind that on the whole, the Pitapit franchise is likely to generate higher revenues because it stays open during the nights as well, thereby it may generate a much higher volume of business per day.  Thus, on the whole, the gross revenue for a year is likely to be approximately in the range of  1.8 million dollars, while the investment in the first year is approximately $200,000 only, which is about 1/10th of the revenue that is gained.

The franchise would still pose a profit in the first year, even if the volume of sales was assumed to be only half of what was assumed earlier, i.e, just 350 ordinary pitas and 25 special ones. This would produce a gross revenue of $0.9 million dollars, leaving a net profit of about $6,000,000. For purposes of this estimation, the net profits are assumed to be about $500,000 per year, hence over a time period of ten years, the franchise is likely to generate very high profits in the range of $5,000,000. Allowing for depreciation, potential recessionary slumps, further franchise fees and adverse changes in the market, a safe projection can still be made for the future of an income of at least  $4,000,000, based upon these low intakes. This forecast is centred on an understanding that market conditions are not likely to change so drastically that they cause a sharp drop in revenues and impact upon the business. Based upon the actual projections of $1,872,000 for a period of ten years and making some allowance for unexpected contingencies, etc, a safe estimation may still be made of an income  of about $18,600,000.

In the case of the Quiznos franchise, the average price of its premium beef and chicken sandwiches ranges from $6 for the smaller sizes to $9 for the larger units. Where sandwiches are concerned, the smaller serving portions of flatbread cost about $5 while the larger portions cost about $8, with salads ranging from $4 to $7.  Since the franchise does not stay open into the late hours of the night, a slightly lower sales volume is assumed, i.e, about 600 units in total being sold in a day.  An average price of $6 per unit is taken as the norm and this pulls in gross revenues for a day at about $3600. Added to this would be the amount spent on drinks by customers, i.e, about $2000 per day. Hence, a total daily revenue of about $5500 will be estimated. Using similar approximate figures for wages for the workers as stated above in the case of the Pitapit franchise,  the wages paid per worker would be $6 for work rendered from 7AM to 5 PM, i.e, 10 hours and $60 plus a further $8 for another two hours per worker, i.e, $16 per worker.

Assuming there are three workers totally , working in shifts, the total wages payable works out to $228 per day and adding an average amount of  $700 per day for miscellaneous expenses such as food and electricity works out to total expenses of $928 per day, works out to a net taking of about $2600 per day. Assuming an average daily revenue input of about $2200 per day after taking daily expenses into account, this produces an income of $792,000 per year, which in turn can be projected forward over a ten year period to about $7,90,000.  Against this figure of income  of $792,000 for the first year, the initial investment expenses for the first year work out to $70,000, while the cost of entry for Quinzos competency test would work out to about $200,000, bringing the total costs to about $300,000. This brings the net revenues to  $492,000. For subsequent years, the competency test expenses would not occur,  hence the net revenues would be in the region of about $700,000. Taking depreciation and other investments into capital assets, as well as the potential for swings in the market, etc , it can still safely be projected that the income that could be attained over a ten year period would be as follows: $492,000 + (9 X 700,000) = $492,000 +$6,300,000 = $6,792,000.

Where Quinzos is concerned however, an investor also has the option of buying the franchise for a low down payment of $12,500. To allow individuals to buy into the franchise in an attempt to, the franchisor has recently reduced its upfront costs for those who already have some restaurant experience to $5000 (www.finance.yahoo.com). If an investor opts for the low down payment investment option, wherein s/he pays only $12,500 initially rather than $300,000, there would be a balance amount of  $287,500 which would need to be taken on loan. If this loan is provided at an average interest rate of about 6.5%,(businessweek), then this results in an interest rate change of approximately $186,875, thereby  producing an amount of about $474,375 which would need to be repaid over the ten year period. Taking this figure into account for the ten year projection, the figure of $6,792,000 would need to be reduced  by this amount, producing net revenues of about $6,317,625.

On this basis, the following comparison can be drawn:

       PITAPIT        QUIZNOS
Initial Investment 192550 255450
Minimum down payment 94100 70000
Alternative down payment options 50000 12500
5000
Interest charges (at 6.5%) 92675 186875
Plus Capital repayment 235225 474375
Average daily revenue 5200 2200
Average yearly revenue 1872000 792000
Net ten year revenue 18,600,000 679,200

                Based on the details above, it can therefore be noted that Pitapit appears to be the better franchise to invest in on the whole. In the first place, the initial investment is on the whole lower, because the  Pitapit franchisee would not be required to pay out large amounts to pass a competency test. Secondly, it must also be noted at the outset that because the initial costs of investing in Quiznos, especially with the requirement to pay such a large amount for the competency test,  are so high, it would automatically be a disadvantage for any investor who would need to arrange a loan to cover the high costs. Quiznos is offering loans for potential franchisees to purchase the franchise for a low down payment, however in both cases – Pitapit and Quiznos, investors who opt for this option would find themselves paying out a much higher amount in terms of interest charges and capital repayments, which would cut into the profits.

                Another advantage offered by the Pitapit franchise is the longer hours of opening, because this means that there is greater scope for increased sales during the night, at a time when other fast food outlets are likely to be closed.  Quiznos would have the advantage in that because of the significant amount of training that is provided to a potential franchisee through the competency test,  it may be possible for the franchisee to start off the business with fewer employees and no managers being used.   Net revenues over the long term may be significantly improved once the initial high investment charges are recovered. It must also be noted that the Quiznos franchise is supported by extensive advertising and support from the franchisor, which may produce higher volumes of sales than have been projected. On the whole, Quiznos would not be a better investment in the short term, and it may be necessary for the franchise to continue for several years before it is pulling in enough revenues to generate the high levels of profit of the Pitapit franchise.

Conclusions

In terms of assessing the promotional aspects,  there are some similarities between both the franchises. Despite the actual food product being different, i.e, in the cast of Quinzos, it is sandwiches while in the case of Pitapit, it is pita bread,  both franchises offer their customers quality of meat and the option of putting together their own combinations .  Quinzos stands out in that it offers its customers sandwiches made with toasted bread, which help to set it apart from other sandwich shops, and the franchise also offers soups and salads.  Quinzos is also distinct in that it is an organization that strictly practices corporate social responsibility. The website of the Company details how it seeks to ensure compliance with all regulations, to ensure that food is ethically sourced. Moreover, the Company also has other compliance measures in place, such as mandating the exclusion of child labour and practising non discrimination in recruitment policies. The franchisor also requires periodic inspection and audit to be carried out  by its franchisees, in order to ensure that the necessary  compliance measures are being instituted. All of these are likely to considerably improve Quiznos’ customer base.

In arriving at a conclusion about which franchise would be better, it may safely be concluded that Quiznos is the more expensive option on the whole and would require a much longer period before it is able to generate high level profits. The potential for sustained growth and increasing income is however better than it is with Pitapit, because of the support provided by the franchisor. As already pointed out in the literature review,  the relationship between the agency and the franchisee will impact upon the profitability of the enterprise.  In the long term, Pitapit will not be able to enjoy the benefits of such advanced support and its success or failure will depend to a large extent upon the franchisee’s knowledge of the local area and its ability to provide quality and services that are appropriate to that setting.

The option of taking loans to meet the initial investments may be considered by potential franchisees of both Pitapit and Quiznos. In this instance, Quiznos would offer the more attractive option, because of the lower down payment which is involved.  When bolstered by the fact that interest charges on the loan and other expenses may well be justified in the long term when the sheer name and reputation of the franchisor proves to be an aid in the business, it may provide the potential for a steady and high source of long term income, once the initial heavy investment blocks have been surmounted.

 Investing in the Pitapit franchise may be more suitable for an investor who is looking for a franchise that would start generating strong profits as quickly as possible. In the short term, this franchise is definitely preferable to Quiznos, but the lack of training would be a significant deterrent. Without an adequate support system from the franchisor in terms of training on various aspects of business, as well as extensive advertising, Pitapit franchisees will need to rely on a much narrower outreach to the consumer market. They would also have to cope with the potential pitfalls that would be associated with entering a business without a strong base of support and training. For those investors with a shrewd business sense and those who have a strong local knowledge, a local franchise is likely to be successful. But a franchisee who succeeds in one particular area because of local knowledge and decides to buy another franchise after experiencing some success could find some difficulties because the same local knowledge would not be applicable there.  On the other hand, a Quiznos franchisee who finds success in one local area would be able to open another one in a different area and be as successful without too many problems, because the training received earlier can be applied elsewhere. Hence, Pitapit franchisees are lacking in that they do not have the benefit of this training; as a result, the initial high costs for the competency assessment  at Quiznos may well be justified.

Another factor that needs to be taken into consideration is the current recessionary market. While a food franchise provides a good business investment, the high initial costs are likely to prove to be a deterrent for the Quiznos buyer. Even in the instance that a small down payment option is selected and the balance taken on loan, it would still mean that a potential investor would have heavy payments to make and would be responsible for such payments in a recessionary environment, where volumes of food sales cannot be guaranteed. If the investor is able to ride the initial period of uncertainty and heavy expenses however, s/he is likely to benefit in the long term. Although the income projections which have been presented earlier show Pitapit making a higher proportion of revenues over the ten year period,  this balance would shift as the years move along further. As many of the heavy initial investments for Quiznos are paid off,  the franchise would benefit from potentially much higher sales than Pitapit due to the franchisor’s advertising and reputation for quality and also offer the scope for expansion into more outlets. In view of the current recessionary climate however, it does appear that the best long term prospects are offered by  Pitapit, if the franchisee purchases one in a local area s/he is familiar with.

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