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Size and Risk Management

The next section of the FRPT relates size of the system to risk. Generally, the larger the system becomes, the larger are the economies of scale, the lower the costs, the higher the profits, and therefore the less risky is a franchise opportunity. For example, when a system has only four units, the media exposure and brand awareness that are generated—and that subsequently reinforce themselves over time—are entirely different from the exposure and brand strength of a system that has reached 1,000 units. When a significant size is reached, signals of strength and consequently reduced risk are sent to the market. These are real factors of lowered risk for the franchisee. As the next exercise demonstrates, these lowered risk factors not only increase the income but will also lower the discount rate for the franchisee. Total number and market placement of outlets is indicative of consumer acceptance and power in the marketplace. Profitability drives the need and motivation to grow a system, and growth makes profitability more feasible because of economies of scale. It is a virtuous economic cycle.

The FRPT links multiple market presence and market share as defining criteria for measuring market size. For example, a system that has 100 units spread across the country does not have the same market presence as a system that has 100 units in one geographic region. The concentration of outlets tends to create marketing economies of scale and increases administrative efficiency. Therefore, the system with dominant market share in a number of markets is the least risky.

Most franchisors make an attempt to operate stores. Some have proven to be quite good store operators. Radio Shack has 2.5 times as many company-owned stores as franchised stores.[3] It pushes out geographically from its headquarters until the monitoring costs become too high or until it simply wants to grow faster than its available capital allows, and then it sells more franchises. Keeping in mind that the per-unit development cost for each new unit is identical for franchisor and franchisee, you must consider the capital requirements of the franchisor. For example, developing four corporate-owned units could be capital-prohibitive in comparison to developing one corporate unit and franchising the other three. In the former case, the required investment for development could be so high as to retard growth, whereas in the latter, the increase in cash flow may very well enable further expansion more quickly. Therefore, the franchisor seeks to implement franchises as a means of leveraging the concept and franchisee capital—a fundamental underpinning of franchising. TIP 3-2 illustrates the principle of balancing capital needs in a growing franchise system.

Tip 3-2 Theory into Practice: Risk Management—An Intelligent Growth Strategy[a]

Panera Bread is an interesting, relatively new franchise. Originally based in Saint Louis and called Saint Louis Bread Company, it expanded to 20 company-owned stores between 1987 and 1993. Panera used St. Louis to discover the nature and extent of its economies of scale, to create brand awareness in a large, single market, and to refine its service delivery system. After making numerous enhancements to the concept, the company began to franchise. By early 2003, Panera had over 400 stores and $350 million in revenue. It currently has franchisee commitment for over 700 new outlets.

Panera’s is executing a classic franchise strategy. It used its capital to build out the market surrounding its headquarters, perfected the concept, then used franchisee capital to create explosive growth. Panera has balanced its ability to grow company-operated restaurants with its available capital. But by using franchising, it has been able to accelerate growth 250 percent, as shown in the table below.

YearU.S. FranchisesCanadian FranchisesForeign FranchisesCompany-Owned

[a] http://www.panera.com

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