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Successful franchise systems depend, among other things, upon a win-win philosophy. Both franchisor and franchisee need to make a fair profit by working together. This philosophy has to be reflected in the design of the cost structures of the franchise.

If franchisees fail to be profitable, then the system will quickly become unattractive for all concerned. If the franchisor fails, then the franchisees will find themselves left without the support they need.

The key question for anyone in business (or looking to get into business) must therefore be: 'At what point does this business start to become profitable?' This is called the break-even point, and is one of the most fundamental tools in managing your business.

GROSS PROFIT & NET PROFIT

Nobody goes into business to make a loss. Profits allow the business to grow, and produce the rewards for the owner's investment of time and effort. Profitability is the goal for us all.

There are two stages that occur in profit in business – the Gross Profit stage, and the Net Profit stage – and both are clearly shown on a basic Profit & Loss account in Table 1. With a clear understanding of these, calculating break-even becomes simple.

Gross Profit

Gross profit is the profit that is made from the pure trading activity of purchasing goods at one price from suppliers, adding value, and selling them at a higher price to customers. The gross profit figure does not allow for any of the fixed running expenses of the business – the costs you would have whether you were making any sales or not, such as rent, power, equipment or whatever.

Gross profit is therefore the measure of the efficiency with which you convert inputs (such as material and labour) into returns - sales of products or services at a particular price.

The gross profit can be expressed in dollar value by the following equation:

Gross Profit

= Sales - Direct Cost of Sales

The Direct Costs of Sales are those costs which can be directly associated with the sales that were made – eg, the cost of buying the product, the cost of processing it for sale, and the cost of any percentage-based franchise fees or marketing levies.

When sales rise or fall, the dollar value of these direct costs will also rise or fall in unison with the sales. For this reason, these costs are also known as variable costs.

Gross Profit Margin

The gross profit is most usually expressed as a percentage of the sales figure, called the Gross Profit Margin, or Gross Margin. The gross margin shows, quite simply, how good the owner is at making money from trading.

In the case of a franchise which sells products, the maximum gross margin for each product is set by the trading discount given by the franchisor or other suppliers. Any business will have a range of different products with different gross margins, and these all form part of the overall sales mix.

For example, in the fast food business a basic hamburger will have a relatively low gross margin, while chips and carbonated drinks will have margins perhaps twice as high. Increasing sales of burgers will reduce the overall gross margin; increasing sales of chips will increase it. It is the job of the franchisor to create the right mix of products to ensure that a franchise will succeed in the marketplace; the franchisee's challenge is to achieve the maximum achievable gross margin on each sale and keep fixed costs to a minimum.

Beyond the basic margins on each product set by the franchise system, enhanced gross margins can be achieved by selling service. If the margin generated on services is higher than the product margin, selling more service relative to product will lift the overall margin. For instance, a garage owner makes a small margin on supplying a new part, but a much larger margin on the service involved in repairing an existing part.

The gross margin is one of the most important performance indicators in business, and is the main controllable influence affecting the break-even point. In every franchise, the gross margin can be forecast quite accurately. Franchisors should have considerable experience across multiple outlets to draw on in making their forecasts, and should also be able to provide the franchisees with figures showing what is achievable and what is being achieved by others in the system for comparison.

Such comparisons are both an incentive and a safeguard for the franchisee. A failure by a business to achieve the expected margin is a signal that something is wrong. Common causes of gross margin erosion are unrecorded sales or discounting, unrecorded owner's drawings, theft of goods or cash, incorrect pricing, and unchecked short delivery of goods from a supplier. In production type franchises, such as food or printing, inefficient use of materials and high levels of wastage are major culprits.

Net Profit

Net Profit is the residual amount left from the gross profit after running expenses have been deducted. In other words:

Net Profit

= Gross Profit - Fixed Costs

Fixed costs are the running expenses or 'overheads' of the business. These are all the other costs which are incurred just by having the franchise business set up and operating, and are not related directly to the sales figure.

Typically these costs include things like rent and power, the fixed level of franchisee drawings and staff wages, equipment and vehicle purchase or lease, and fixed (ie. flat rate) franchise service fees. They are called fixed costs because they remain constant rather than varying with the level of sales. Financing costs such as interest or loan repayments also need to be included under this heading.

Failure to generate enough gross profit to cover the fixed costs will result in an operational loss. While this is not immediately life-threatening to the business – and indeed is common in the early days of most franchises – it is an undesirable result. Continuing losses lead eventually to a cash-flow crisis, insolvency, and possible business failure.

BREAK-EVEN

The point at which the sales achieved are high enough to generate the gross profit necessary to cover the fixed costs is called the break-even point. At this point, the gross profit exactly equals the fixed costs and the net profit is nil.

Knowing the break-even point is a critical piece of information for both franchisee and franchisor.

Because it is the Gross Profit Margin that determines the relationship between sales dollars and gross profit dollars we can calculate the sales required to achieve break-even in any particular business by using a simple formula:

Break-even (Sales Level)

= Fixed Costs ÷ Gross Margin

For example, a franchisee with annual fixed costs of $150,000 and a gross margin of 60% would have a break-even sales target of:

150,000 ÷ 60%

= $250,000 sales p.a.

(see Table 2)

If the franchisee were to consider hiring an extra staff member on a wage of $25,000, we would get a new break-even of:

175,000 ÷ 60%

= $291,666 sales p.a.

In other words, the new employee would have to enable the company to generate an additional $41,666 sales per annum in order to pay their way.

This process is useful for evaluating any fixed cost purchase decision. If the franchisor were to suggest an extra levy of $5,000 per franchised outlet to fund a special advertising campaign then the extra sales required by this franchisee just to cover the extra costs would be:

5,000 ÷ 60% = $8,333

Now let's look at a franchisee in the same system who is achieving a higher gross margin - say 70% (in my experience, a range of 10% in gross margins is not uncommon). With a higher margin, the breakeven point is significantly reduced. From the examples above:

150,000 ÷ 70% = $214,285 sales per annum

175,000 ÷ 70% = $250,000 sales per annum

($35,715 additional sales)

5,000 ÷ 70% = $7,143 extra sales required

Not only do high gross margins enable you to reach break-even more easily, but once you pass break-even point the profits are thicker and juicier. In the diagrams below, the steeper sloping line is the revenue line and the more gently sloping line is the total cost line (fixed costs plus variable costs). Where they cross is the break-even point.

The first business has low gross margins – it is returning meagre profits after break-even, and requires more volume. In contrast, the second business has strong gross margins – it reaches break-even more quickly, and starts to show strong profits immediately afterwards.

RETURN ON INVESTMENT

I mentioned finance payments under 'Fixed Costs', but in order to get into the business almost all franchisees will also have invested their own capital. Since this would otherwise be earning interest at the bank, a further recommended practice is to calculate a required rate of return (RRR) on the invested capital and add this figure to the fixed costs before doing the break-even calculation.

The RRR is dependent on the riskiness of the venture, which should be lower in a franchise than in a stand-alone small business – perhaps as low as 20% as compared to 30-33% (see my previous article in Franchise New Zealand Volume 7 Issue 1).

So if the franchisee has $150,000 of capital invested in the business and the required rate of return is 20%, then another $30,000 per annum will be added to the fixed cost. This represents the profit required by the franchisee to cover his investment risk.

Continuing with the previous example and using the fixed costs level of $175,000, adding $30,000 of required profits gives a new calculation of:

$205,000 ÷ 70%

= $292,857 sales p.a.

To make the breakeven figure more relevant to everyday business operations, it is common to bring the figure down to a monthly, weekly or even daily target, eg:

$292,857 sales p.a.

= $5632 per week

If this franchisee wants to cover all their costs including his or her drawings and the cost of invested capital, then the business must generate sales of $5632 per week.

This process breaks the sales task down into manageable chunks, enables a franchisee to monitor performance faster and identify trends earlier, and is comprehensible by franchise staff if shared with them (sometimes a good motivator, especially if combined with an incentive scheme).

TRADING UNPROFITABLY

A business may trade unprofitably for some time without any noticeable problems, because the shortfall in revenue is being made up out of the initial funds the franchisee invested in the business (the owner's equity).

This fact can lull the unsuspecting franchisee into a false sense of security, but the longer a lack of trading profit goes unchecked – or worse, unnoticed – the more likely it is that the business will slip suddenly into a life-threatening cash flow crisis.

The issue is so critical to survival that you must have profit information in real time. Two points are worth noting here. First, waiting for your annual accounts to be processed by your accountant before you find out about profits or losses is not good enough – you need monthly financial reports. Second, the best real time measure you can have is your break-even target. If you achieve that every week, you're making a profit – miss it and you're running at a loss.

If the financial reports show a trading loss, you need to know why. Is it temporary or cyclical? Can the situation be quickly remedied? Is it a sales, pricing or cost control problem? Franchisees should involve their franchisors at an early stage in identifying the cause and taking corrective action.

PROFITS, CAPITAL & GOODWILL

Profits not only provide the payback on all the franchisee's hard work – they also build the ultimate value of the business in a very significant way. When a business is sold the financially sound method of valuing the business is by capitalising the net profit. The extent by which the capitalised value exceeds the asset value is classified as 'goodwill' and represents a tax-free capital gain for the seller (see previous article).

If, however, over a period of years low profits have been generated, then the capitalised valuation of the business will be less than the asset value. If this is the case the seller will not only miss out on any tax-free capital gain in goodwill, but will also suffer a loss on the book value of the assets.

KEY POINTS

Franchisees and franchisors are well-advised to pay a great deal of attention to the measurement and monitoring of break-even points. Franchisors could usefully include the calculation of break-even in their training programmes, and ensure that franchisees remember to update break-even targets as their businesses grow.

Ideally, franchisors will produce a break-even calculation form for franchisees to use and return. This will provide a basis for benchmarking. To make sure figures are comparable, franchisors will need to see break-even calculations both before and after personal drawings.

To use break-even calculations as a tool to help your business, the basic points to remember are:

1. Monitor your gross margin monthly. Fight hard to get it high, and then protect it - erosion of the margin indicates mismanagement of some kind.

2. Fixed costs should be minimised and controlled tightly. Monitor and focus monthly on the top 20% (dollar value) of fixed costs.

3. Know your break-even point, and recalculate it at any change in fixed costs or gross margin.

4. Use the break-even calculation in your decision-making on new staff or other expense evaluations.

5. Use the weekly break-even target to monitor your profit performance regularly.

6. Use a monthly financial reporting system to give you accurate and regular profit performance results.

7. Always include a proper income for the franchisee as one of the fixed costs which must be covered in the breakeven calculation.

8. Include the cost of capital in your calculation. This depends on your required rate of return.