We have been living in a very low inflationary environment for the past decade, courtesy of both the U.S. Federal Reserve and the coordinated international effort of other central banks. While there are many good outcomes from this monetary policy, one of the drawbacks has been the lack of pricing power. Whether B2C or B2B, companies have had difficulty raising prices. In franchising, this has put greater emphasis on expense controls.
A companion of reducing costs is reducing initial investment levels. One way to increase return on capital is to require less and try to find ways to achieve the same expected return. So, based on the idea that franchisors are being pressured to find new ways to take costs out of unit operations, we should have seen the cost of opening a franchise declining, or at worst remaining flat, in the past 5 to 10 years. At least that is a reasonable theory. Is it true?
To find out, we analyzed initial investment levels for more than 1,100 franchised brands in the past few years. A preliminary look at the data reveals a picture that is contrary to what we expected.
|Avg. Initial Investment||2016||2019*||% Change||CAGR|
|* Adjusted for inflation using 2016 as a base year|
On average, franchises are getting more expensive. Between 2016 and 2019, the average nominal initial investment among all analyzed brands grew by a total of 22.5%, while the CPI grew by a total of 6.4%. To put that in perspective, over the past 4 years, annual inflation was about 2.1%, while the nominal cost of opening a franchise grew at triple that rate with a CAGR of 7% per year. Adjusting for inflation, the median cost grew by 14.6%.
While dramatic, that is not the whole picture. A key to understanding this is to look at investment strata. The table shows the average initial investment shown with minimum and maximum costs. Both boundaries have not grown equally. The maximum value paid by franchisees has gone up substantially more than the minimum. As a result, the median initial investment has been skewed by the higher limit. A key driver is physical location cost, and the implication is that as rental and real estate levels have risen, footprint sizes have not adjusted downward to compensate.
The values shown in the table vary depending on the size of the business. Franchises that require more equipment, training, and complicated computer systems have greater than proportional cost increases relative to less complex brands. By bracketing investment levels, our original hypothesis is shown to be partially correct. The real costs of opening a franchised business are actually declining for average investment levels less than $1 million. In fact, 57% of all brands analyzed had overall declining real costs.
Despite recent events that might increase costs (e.g., higher equipment prices resulting from trade wars), franchisors are indeed focusing on reducing costs in their initial franchise package. We believe that the growing number of brands with detailed FPRs is allowing prospects (the majority of whom are experienced multi-unit operators) to assess profit margins as well as sales-to-investment ratios.
Top-line unit revenue may drive royalties for franchisors, but it is not the end game for franchisees. Our research suggests that competition among brands for better operators is pushing franchisors to find ways to lower costs and increase returns.
Across industries, the data paints a mixed picture. The initial investment paid by franchisees has changed dramatically in some industries and not much in others. The graph shows investment levels across 30 industry groupings.
The demographic influences revealed through changing consumer demand have given some sectors more flexibility to offer larger-format unit offerings. That shows itself in sectors such as child-related and lodging. But shifting consumer demand trends have taken away flexibility in other sectors, particularly those with retail footprints. Competition from new brands in more mature sectors likely contributes to downward pressure on investment levels.
The conclusions drawn from this analysis start with one that is contrary to expectations. Sectors with higher investment levels are getting even more expensive. However, across the entire business model there are more franchise brands with decreasing investment levels than increasing ones. This is particularly true in mature sectors, and especially in retail.
*This co-authored piece from FRANdata CEO, Darrell Johnson, and Research Analyst, Luis Despradel, originally appeared in Franchise Update on March 31, 2020. You can view the original publication here.