Chapter 36 — Exercises

Work these in order; they are graduated. Items marked with a dagger † have worked solutions in the answers appendix. Bring a calculator and a blank sheet — several of these are P&L problems and the lines have to foot.

A standing instruction for every item in this set: wherever an exercise asks you to evaluate a real franchise opportunity, the correct final step is always "have the FDD and the franchise agreement reviewed by a franchise attorney before signing anything or sending any money." None of these exercises, and nothing in this chapter, is legal advice.

A. Recall and definitions

36.1 In one sentence each, state who the customer is, what the product is, and where the revenue comes from — first for a franchisee, then for a franchisor.

36.2 What is a Franchise Disclosure Document, how many numbered items does it contain, and what is the minimum period the FTC Franchise Rule requires between furnishing it and the prospect signing or paying?

36.3 † A franchised unit does \$1,480,000 in gross sales. Its Item 6 fee schedule is: royalty 5.0% of gross sales; advertising fund 2.5% of gross sales; local marketing minimum 1.0% of gross sales; technology and online-ordering fee \$1,400 per month; loyalty program fee 0.25% of gross sales. Compute the total annual fee load in dollars and as a percentage of sales. Then state how much of it sits below the operating lines as royalty and ad fund, and how much sits inside other operating expense.

36.4 Define protected territory, and list four common carve-outs that limit it.

36.5 † Build the complete operating statement for a franchised unit from these rates. Revenue \$1,340,000. Food and paper 29.5%. Labor, all-in, 28.0%. Occupancy 7.5%. Other operating 11.5%. General and administrative 2.0%. Royalty 5.0%. Advertising fund 2.0%. Report: prime cost in dollars and percent; operating profit before franchise fees; operating profit after franchise fees; and the share of pre-fee operating profit consumed by the fees.

36.6 Why is a royalty not part of prime cost, and why does that make it more dangerous to an operator rather than less?

36.7 Using the unit you built in 36.5 (operating profit \$194,300): the total investment was \$845,000, funded with \$295,000 of the operator's own money and \$550,000 of debt carrying \$87,200 of annual debt service. A market general-manager compensation for the work the operator personally does is \$72,000. Compute (a) the pre-tax cash to the owner-operator and (b) the true economic return on the operator's equity, as a percentage.

36.8 Name the six FDD items this chapter says to read first, and state the single question each one answers.

B. Applied reasoning

36.9 † An independent restaurant earns 14.2% operating profit on \$1,720,000 of revenue. The owners are approached about converting to a franchise brand that charges a 6% royalty and a 2% advertising fund. Incremental sales at this restaurant carry a 42% contribution margin before fees. Compute (a) operating profit in dollars and percent immediately after conversion, assuming no change in sales, and (b) the permanent sales lift, in dollars and as a percentage, required to restore the original operating profit.

36.10 A franchisor's Item 19 makes no financial performance representation. Give two reasons a sound system might make that choice and one reason a weak system would. Then describe, concretely, the three things you would do next — and say which FDD item makes each of them possible.

36.11 An Item 19 discloses: 96 outlets in the representation; the system has 271 franchised outlets; average gross sales \$1,655,000; median gross sales \$1,470,000; 39 of the 96 (40.6%) attained or exceeded the average; highest \$3,610,000; lowest \$742,000. (a) What percentage of the system's franchised outlets are described? (b) What does the 40.6% tell you about the distribution? (c) What is the ratio of highest to lowest, and what does that ratio imply about what actually drives unit performance? (d) Which figure would you build a pro forma on, and what would you stress-test it at?

36.12 Read this sentence from a constructed Item 19 and list everything it excludes: "The following figures reflect the average gross sales of company-operated outlets that were open for at least 24 months as of the fiscal year end and that are located in markets where the brand has at least four outlets." Then say why a prospective franchisee should be especially careful with a company-operated representation.

36.13 † (Engineer this promotion.) A franchisor mandates a systemwide value item at \$7.49 with a plate cost of \$3.05. The unit's comparable regular item sells at \$11.99 with a plate cost of \$3.60. Over one month at this unit the promotion cannibalizes 1,100 units from the regular item and adds 800 genuinely incremental units. The royalty is 5.0% and the advertising fund is 2.0%. Compute: contribution margin and food cost percentage on each item; the net monthly effect on sales; the net monthly effect on contribution; the annual effect on each party. Then state, in one sentence, what the result tells you about how royalties align the two parties' incentives.

36.14 Explain why a fast-casual format can typically carry a 5–7 point royalty while a chef-driven full-service format usually cannot. Ground your answer in the two P&Ls compared in §36.6, not in generalities.

C. Cost it, price it, schedule it, read it

36.15 (Cost this.) An Item 7 estimated initial investment shows a low of \$512,000 and a high of \$806,000, of which the "additional funds — 3 months" line is \$45,000 at the low end and \$70,000 at the high end. Your own bottom-up forecast says the unit will need \$58,000 of operating cash in month 1, \$41,000 in month 2, \$27,000 in month 3, and \$12,000 in month 4 before revenue covers costs. (a) What reserve does your forecast actually call for? (b) What is the shortfall against the Item 7 high estimate? (c) Restate a realistic total investment figure. (d) Which chapter of this book built the tool you just used?

36.16 (Price this.) You operate a franchised unit. The system's approved supplier raises the price of the core protein by 14%, moving your plate cost on the signature item from \$4.20 to \$4.79. The menu price is \$13.49 and it is set by the system; you may not change it. (a) What happens to the item's contribution margin and food cost percentage? (b) List, in priority order, the four things you can actually do about it inside the agreement, and identify which FDD item governs each one.

36.17 † (Read this P&L and find the leak.) Here is a franchised unit's annual operating statement. The system's published benchmarks are food and paper 30.0%, labor 27.0%, prime cost 57.0%.

(a) Compute prime cost in dollars and percent, and operating profit in dollars and percent. (b) Identify the leak and quantify it in dollars. (c) State what operating profit would have been at system benchmark prime cost. (d) Name one cost line on this statement that the operator genuinely cannot fix, and say why.

36.18 (Read this P&L, second pass.) Using the same statement as 36.17: the unit's Item 19 median for its format was \$1,286,000. This unit did \$1,152,000. Before you touch a single cost line, what does that gap tell you, and what are the three things you would check first?

36.19 (Build this schedule to a labor target.) A franchised unit's system staffing guide sets an all-in labor target of 27.0% of sales. Next week's forecast is \$22,150. The all-in hourly labor rate (wages plus payroll taxes plus benefits) averages \$19.40. One salaried manager costs \$1,250 per week all-in. How many *hourly* labor hours may be scheduled? Then state what you would do if the forecast came in \$2,000 light on Wednesday morning.

36.20 (Cost this.) The franchise agreement requires a remodel to current brand standards at year seven. The specification, when it arrives, prices at \$168,000. Over the seven years, what annual amount should the operator have been setting aside, ignoring interest — and where on the P&L or the cash forecast should that reserve have lived? Which chapter built that tool?

36.21 (The other side of the table.) A franchisor has 24 franchised units at an average unit volume of \$1,080,000, charges a 5.5% royalty, opened 5 units this year at a \$42,000 initial fee, and spent \$1,520,000 running the franchisor business. Compute: total revenue; operating profit; the result on royalties alone; the per-unit gap between royalty received and system cost consumed; and initial fees as a percentage of total revenue. Then state what a prospective franchisee should conclude from Item 21 if these were the audited numbers.

36.22 Using the same franchisor: assume the fixed core of the cost base is \$960,000 and the remainder scales at roughly \$23,300 per unit. At what unit count does royalty revenue alone cover total cost, assuming the same AUV and royalty rate? Show your reasoning.

D. Judgment, writing, and ethics

36.23 A prospective franchisee is told the territory is "a two-mile radius, exclusive." Write the five questions you would put to the franchisor in writing before accepting that description, and say what a bad answer to each one would look like.

36.24 A franchisee's protein supplier — an approved source under Item 8 — ships three consecutive cases out of spec. The franchisee's instinct, honed over fifteen years, is to pull the item and buy from a local purveyor for two weeks. Explain exactly why they cannot, what the agreement most likely requires instead, and what a good operator does with the situation.

36.25 † (Write the memo.) You are a prospective franchisee. Item 19 discloses an average for freestanding drive-through units only; you are evaluating an in-line site. Write the written request you would send to the franchisor. It must do four things: request the written substantiation for the existing representation; request an FPR (or an explanation of its absence) for the format you are actually buying; document a specific verbal figure a development representative gave you, with date and speaker; and confirm the date on which the FDD was furnished to you. Keep it under 300 words and keep the tone professional — you may end up in business with these people.

36.26 (Write the policy.) You are the founder of a three-unit group considering franchising. Draft the one-page internal decision memo that scores your concept against the six-step systems test and states a recommendation. Be specific about which tests you fail and what each remedy would cost the concept.

36.27 (Ethics.) You are a franchisor with 14 units. Your audited statements show that initial franchise fees are 31% of your revenue and that royalties alone do not cover your cost base. A candidate arrives: enthusiastic, likable, financially qualified on paper at the low end of your Item 7 range, with no restaurant operating experience of any kind and no manager identified. Selling this franchise makes your quarter. What do you do, what is the argument on each side, and what does your answer imply about how much capital a franchisor entity needs?

36.28 (Ethics, from the other chair.) A departed franchisee on the Item 20 list tells you on the phone that they signed a confidentiality clause as part of their exit and "can't really get into it." What have you just learned, what do you do with it, and what would you now go re-read in the FDD?

36.29 A chef with a well-known local name agrees to let a friend open a restaurant using the chef's name and recipes. The chef provides a week of training and a spec sheet, tells the friend how the kitchen should be run, and takes \$2,000 a month. The document is titled "Brand License Agreement." Analyze this arrangement against the three-element test in §36.9, state the risk plainly, and say what should have happened first.

36.30 (Judgment.) Two operators, identical in skill and capital. One buys a franchised unit at 13.5% operating profit; the other opens an independent projected at 16.8%. Five years later, which one is more likely to be able to sell their business, and why? Then name the circumstance in which the answer flips.

E. Synthesis and the Business Plan

36.31 Rank the seven growth instruments in Figure 36.6 for a specific operator you invent in three sentences (capital available, experience, concept maturity). Defend the top choice and the bottom choice.

36.32 Chapter 35 concluded that Bellwether's second-location test says "not yet." Chapter 36 concludes that franchising says "no." Explain, in a paragraph, why those are different answers rather than the same answer stated twice — and name the one asset that would move both.

36.33 † (Business Plan extension.) Write the Growth Appendix subsection "Franchising — assessed and declined" for the Bellwether plan. It must contain: the buy-side comparison with numbers; the systems-test score with a one-line justification per test; the fee arithmetic showing what 16.8% becomes and what sales lift would be required to recover it; and the seven conditions that would have to be true, with an honest note about what conditions 3, 4, and 5 would cost the concept. Do not state or imply any financing outcome — that belongs to Chapter 40.

36.34 (Business Plan extension.) Now do the same exercise for your own concept, real or planned. Score it against the six systems tests, compute what your projected operating margin becomes under an illustrative 5% royalty and 2% advertising fund, and compute the permanent sales lift you would need to break even on it. Then write the two-sentence honest conclusion.