Domino’s Pizza Inc. (DPZ) did not invent the pizza, and The McDonald's Corporation (MCD) did not invent the burger. Yet, these fast food chains have become billion-dollar global businesses. Despite health concerns about the possible negative impacts of fast food, the quick-service, ready-to-eat, drive-through restaurants continue to be on a path of growth. Thanks to the franchise business model, these brands have successfully expanded and can now be found even in remote parts of the globe, reaching out to even the tier-II and tier-III cities in developing countries like China and India.

This article discusses the franchising business model of the fast-food chain restaurants, their profit potential, business requirements, and long-term sustainability. (For more see: When Is A Franchise The Right Investment For You?)

The Franchise Model

A franchise usually involves one party (the franchisor) giving controlled rights to the other party (the franchisee) to use the franchisor's trademark, brand name, system, and other tools necessary for a defined business purpose, as agreed upon in the franchise contract. The franchise model provides a well-described, step-by-step blueprint for running the business. The franchisee not only has to abide by the set terms and conditions to run the business, but is also required to pay the necessary franchisee fee and the royalties to the franchisor for using the franchisor's trademark.

The franchisee fee is usually paid upfront or as an advance at the start of each term. The royalties are ongoing charges, and are generally based on specific numbers like total sales. There are other contributions that may include fee towards advertising, staff training, audit, and surveillance.

Why do people drive to McDonald's, when they could just as easily pick up a similar burger at a cheaper price from Joe's Burger stand just two blocks away? One main reason is the assurance of the same taste, quality, and ingredients, whether they buy the cheeseburger at a McDonald's outlet in California or at the one in Michigan. That’s the power of an established brand. (For more, see: How McDonald's Makes its Money?) The brand has a value, and the brand owners capitalize on it by offering franchises. This model offers multiple benefits to the franchisor: business expansion for the brand, full control on the business through dictated terms to the franchisee, and a steady flow of income in the form of franchise fees and royalty payments, while using other people’s money and efforts.

The franchisee benefits by gaining better success and selling potential by using a reputable brand; receiving assistance with a quick setup and training; and having a proven business model, large-scale advertising, and even easy funding based on a recognized brand name.

The Fast-food Franchise Business

Fast-food franchises have many specific requirements. Most of them are for the franchisee, as directed by the franchisor. The initial setup cost may be very high, and beyond the upfront franchise fee, the real estate cost also requires a lot of money, followed by costs towards setup, equipment, inventory, transportation, and labor. Here is a breakdown of major costs and expenses:

  • Fast-food restaurants perform better if they are front-facing establishments, preferably on the main-roads, major junctions, and prominent tourist places. They should have sufficient space for dining area, a provision for a driveway and/or parking space. Such requirements significantly increase the cost towards real estate for the franchisee.
  • A franchisor may also impose a minimum size requirement for a mandatory dining area for each franchisee restaurant, leading to larger size requirement for the establishments.
  • To avoid business interruptions due to relocation, the franchisors prefer locations which are self-owned by the franchisee. Rentals may need assurance of long-duration lease agreements.
  • Franchisors like McDonald's and The Wendy’s Company (WEN) may sell their own company-owned stores to the franchisee at their fixed rates.
  • The geographical territories are also defined for business operations within the franchise agreement. Two outlets of Domino’s Pizza in a suburb will have clearly defined delivery areas for each. On one hand, this helps to prevent conflicts between the two franchisee firms; on the other hand, it limits the business potential for each.
  • The franchisor may impose a mandatory provision for offering home delivery, which requires manpower, resources, and associated costs. These costs may increase further to meet assurances like “Delivered hot in 30 minutes, or its free!”
  • To retain their unique taste and recipe secrets, most fast food franchisors provide their own custom ingredients to the franchisee. Being perishable food items, they need timely transportation due to shorter life spans of the ingredients. Costs towards frequent transportation of such frozen food and content may be shared, or may need to be borne completely by the franchisee.

For example, McDonald's requires “a minimum of $750,000 of non-borrowed personal resources to consider you for a franchise,”—and that is only towards the down payment of acquiring a restaurant. Entrepreneur magazine broke down the basic investment costs for a McDonald's franchisee:

  • Total Investment: $1,000,708 - $2,335,146
  • Franchise Fee: $45,000
  • Term of Franchise Agreement: 20 years, renewable.

Beyond the usual terms and conditions of a franchise agreement, franchisees also must adhere to state-defined regulations for food standards. This is the sole responsibility of the franchisee, although the franchisor may offer assistance in establishing required adherence procedures.

Most administrative and maintenance tasks need to be performed at odd hours, which underscores the intensive and engaging work on part of the franchisee. For example, cleaning of the overhead water tanks, servicing of the air conditioners, or shampooing of carpets. Such tasks are often outsourced, but supervision is mandatory to ensure quality adherence.

Management of inventory, labor, and resources; customer service; and handling local challenges and risks are the sole responsibility of the franchisee. Failure to handle these efficiently gives franchisor an option to pull out anytime. These requirements significantly increase the initial cost of setup for a fast food franchise. The bigger the brand one is trying to associate with, the higher the initial cost. 

The Franchisee Profile

To ensure successful a partnership, franchisors prefer a franchisee with prior experience running restaurant business. Although there are no strict criteria for education, a degree or diploma in business management, marketing, or hospitality management is an added plus. Such educational experience coupled with experience improves the potential for success because of assets like an understanding of local needs that can drive the types of promotions (coupons, newspaper ads or fliers) to attract more customers, or the ability to analyze offerings by local competitors.

Taking on a franchise requires a significant amount of dedicated effort, especially during the initial days of setup. It is common to observe franchisees putting in 90-100 hours per week in their newly opened stores. Their responsibilities include supervising every aspect of their business, including inventory management, storage requirements, adherence to quality standards, food preparation, staff hiring and training, customer service, record keeping, local advertising, and restaurant management. The franchisor may help with a few of these functions, such as training new hires, food preparation, and procedural setup.

The Profit Potential

Although precise figures of profit margins are difficult to get, inputs gathered from franchisee discussion forums indicate that profit margins range between 6% and 9% for the established fast food brands. The location of the restaurant directly impacts its turnover. Additionally, fast food franchisors may have their own custom tiered margin sharing structure, such as generating $500,000 in sales may qualify for 7% profit potential, while crossing the $1 million mark may result in 10% margins.

The 6% net profit on the lower side may sound small, but on $1 million in sales, which is easily achievable with reputable brands, it translates into $60,000. And a franchisee can benefit from owning multiple restaurants. Imagine having three stores, each having $2 million worth of revenue, which qualifies you for a 10% margin—that is a $600,000 net profit.

Sustainability

Not all is rosy, however, even with the top global brands. Like every business (proprietary, partnership, or contracted), the franchise model has its challenges. Due to declining sales and drop in profits, the industry leader McDonald's recently announced closure of 700 stores across the US, China, and Japan. Though this is a fraction of its more than 32,500 franchisee worldwide, this still indicates restaurant-specific challenges. The franchisees were unable to meet the expected sales targets. (For more, see: The Outlook for McDonald's.)

Unrelated to the above news, other reasons for closure of franchise relation may include non-compliance on part of the franchisee, change in terms by the franchisors, change in geo-political situation in the region, or simply the decision of franchise to close the restaurant for reasons such as retirement, a profitable sell-off of property, or even a move to another franchisor for higher profits. (For more, see: Top 7 Franchise Dangers - Slideshow.)

An alternative to taking on a high-cost franchisee is to purchase the desired fast food company's stock. It eliminates all operational overheads, but instead of running your own restaurant, you are taking a bet on the overall company, which includes the combined performance of all its restaurants. (For more, see: How To Analyze Restaurant Stocks?)

The Bottom Line

Before embarking on such ventures like a fast food franchise, one needs to conduct thorough research and planning, and arrange for sufficient capital. A franchisee is often at disadvantage as he is pitted against strong brands, putting him in a "no-say, all-abide" situation. His success as a franchisee leads him only to monetary gains, and enhances the brand value of the franchisor. Failure hits him monetarily and leaves him without any brand or intellectual property of his own. Like every venture, the high-cost, high-engagement fast food franchise option should be planned with a forward-looking multi-year approach, including clearly defined exit strategies. (For more, see: Most Affordable Fast Food Chains.)

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