This article on finding the most profitable franchises was written by Daniel Slone, our contributing franchise reviewer.

While I normally evaluate the pluses and minuses of specific franchises, comparing specific brands is actually the end stage of the selection process. Lots of homework and legwork should have already gone into the preceding stages.

Now, it is perfectly natural that most prospective franchisees are concerned with finding the most profitable franchise opportunity available to them. While profitability should by no means be the sole criterion for evaluation, there is also no reason to leave money on the table when choosing from among several franchises that suit you.

For that reason, I want to examine some of the financial considerations that should guide your assessment of the monetary potential of different franchise brands. There are three factors that carry the most weight in the financial evaluation of franchise opportunities: revenue, cost, and net profit.

Risk vs. Return, Cost vs. Income, and Franchise Profitability

In investing, the basic tradeoff is between risk and return.

Low-risk investments (U.S. government debt being the premier example) yield relatively low rates of return (under 2 percent at times in the past year for Treasury notes) while higher-risk investments normally produce correspondingly higher rates of return (to stay with the bond example, “junk” corporate bonds are around 6 percent right now, although the Federal Reserve’s monetary stimulus has distorted the spreads in those returns somewhat).

Stocks have the potential to produce substantially higher returns by comparison but may produce smaller returns or even significant losses.

Buying a franchise concept typically carries a similar tradeoff between cost and net profit (income). A heavy-hitting QSR concept like McDonald’s will probably produce significant profits, but buying one—if you can even secure a franchise in your desired market—is a very expensive proposition.

Aside from high costs, McDonald’s requires new franchisees to make a down payment of 40 percent of the cost of a new restaurant with the remaining balance financed for no more than seven years.

While the company does not discuss cost estimates on its website, I can tell you from my own experience with other QSR brands that building a new restaurant from the ground up will take a minimum of $750,000 to $1 million, even if you only lease the land, and McDonald’s requires high-visibility, high-traffic sites that command premium prices whether purchased or leased.

Converting an existing building—assuming it meets the franchisor’s real estate standards—is not much cheaper. So before even considering things like inventory or operating capital, there are some high financial hurdles to leap.

At the other end of the spectrum are some basic service franchises that can be relatively cheap to purchase and establish but that will produce correspondingly limited revenue.

I have worked with such a system, and we sold franchise rights to entire metropolitan areas. At the time (this was the early 2000s) a well-established franchise in a moderate-size city along the lines of New Orleans, Jacksonville, or Orlando would produce about $150,000 a month in revenue, and that was with a fairly substantial staff of commission-compensated technicians. (Given that an entire city was producing 150K monthly when we operate single restaurants that do that much, in relative terms that’s “low revenue”–and most markets did significantly less.)

Such service franchises often represent the opportunity to “buy a job,” as the saying goes, but that expression is typically viewed more negatively than it should be. Some people exploring franchising want the opportunity to work for themselves, to personally benefit from their own efforts rather than benefitting someone else. There is absolutely nothing wrong with this, so long as it is aligned with your personal goals and motivations for buying a franchise.

If, on the other hand, you want to be able to put good management in place and spend your days on the golf course or enjoying your particular preferred leisure activity (a few years down the road after you’ve built the business, mind you), one of these relatively low-revenue franchises is not going to support your lifestyle unless you have several markets.

Revenue vs. Gross Profit

Revenue tends to be a big number, and some people allow themselves to be dazzled by those big numbers. At the end of the day, however, you should pay more attention to gross profit than to revenue.

Back in the day (I decline to say how far back in the day) I was in store-level management for a privately-held Southeastern retail grocery chain. We did about $1 billion a year out of 100+ stores. A billion dollars isn’t chump change even today (unless you’re the U.S. government and spending other people’s money), and back then it was certainly dazzling to me as a young department manager.

The important addendum to that, however, was that at the time net profit margins in retail grocery were about 1 percent. Now, 1 percent of $1 billion is still $10 million—not bad when you’re a family-owned company with no shareholders clamoring for dividends—but it’s a lot less impressive than $1 billion.

I jump ahead of myself a bit since this discussion relates to gross, not net, profit, but I want to make clear that impressive-sounding numbers—some of which may be thrown at you by franchisors—can quickly come down to earth once all the facts are in hand.

Gross profit is simply revenue minus cost of goods sold (COGS) or (more commonly in service businesses) cost of sales (COS). Different companies will put different items into cost of sales, but the accounting rule of thumb is that all costs directly attributable to sales should be included. Clear as mud, I know, to say nothing of redundant, since that’s just what “cost of sales” implies.

In the retail trade the main component of COGS is the wholesale cost of merchandise. A manufacturer will include the cost of raw materials and in some cases the wages of its manufacturing workforce. A business-to-business wholesaler would probably include the compensation paid to its salesforce along with its direct COGS. A supplier of an intangible like software would use the salaries of its engineers and coders and any other development costs.

You see the point. Consider the franchise’s business model and what inputs are required, and also whether the franchisor has paid special attention to COGS.

For example, in reviewing Jimmy John’s one of the positives I noted was that the brand has a commendably streamlined menu, among other things using only provolone cheese. This might seem silly and trivial, but it’s not. Offer four different cheeses on your sandwiches, and that’s four blocks of cheese you’ve got to buy and have on hand, even if only two people a day choose one of them.

This consideration ties directly into another important financial issue: the amount of inventory you’ll need to carry. Inventory is the lifeblood of businesses that require it. Unfortunately, it also represents money tied up and at risk of “shrink”—that polite term for theft, loss, damage, and spoilage.

As such, a business model that minimizes inventory requirements—or eliminates them altogether or nearly so—will be less capital-intensive and less expensive to establish.

From Gross Margins to Net Margins

The dollars that remain after gross margin is calculated are the ones that do everything else. “Everything else” can be a long list and includes things like administrative labor, professional services (accountants and lawyers), insurance, taxes, fees, permits, office supplies, travel expenses and fuel, and all the myriad “oh by the way” services and supplies that go into running a business.

Since we are discussing franchises, don’t forget that a royalty and in most cases some form of advertising fund contribution will also be required. And somewhere in there after all those things are covered is your money—the net profits.

Keeping that number at the very bottom of the income statement a respectable size can be a real challenge. I’ll take an industry sector with which I’m extremely familiar—quick-service restaurants (otherwise known as “fast food” to nearly everyone outside the industry)—and offer some generalized numbers.

Depending on the brand, COGS will run from 30 to 35 percent. Labor is usually between 20 and 25 percent (a far cry from the 14 to 15 percent benchmarks we had back when I was a store-level manager in the QSR business—yes, I did that, too). Royalties vary, but 5 percent is typical. Advertising fees vary much more, but in the franchised restaurant business you can figure on 4 percent and be glad if you pay less but not surprised if you pay a bit more.

Take the middle-of-the road numbers for those items, and already we’re at 65 percent. We haven’t paid for rent, insurance, utilities, repairs and maintenance, administrative costs, or any of the miscellaneous services and supplies from alarm systems to uniforms yet. Oh, and if you have any debt, that has to be serviced, too.

Given how quickly we ate up almost two-thirds of our revenue, it should be clear that the remaining 35 percent could go just as fast.

For a restaurant doing a million dollars a year, the difference between a 3 percent net margin and an 8 percent net margin is $50,000. If you’re a multi-unit operator with five stores, that’s $250,000; for ten stores, $500,000.

That’s where your management skills come into play. Shaving a couple of percentage points off food cost and a point off labor and a point or two off of everything else equals that 5 percent.

Yes, the more revenue you have to work with, the easier it generally is, but in a business with tight gross margins even volume won’t help much because your expenses scale up with your revenue.

Strength (and Profitability) in Numbers

If you are really focused on franchise opportunities for the money (as opposed to having lifestyle-oriented or other goals as your top priority), you’ll want to work toward either multiple units of the same franchise or ownership of multiple franchise brands.

While some diversification is a good idea, it’s better if you can stay within the same general industry because it will help keep your overhead down, and because too many concepts frankly become distracting.

Multi-unit ownership will obviously increase revenue, but it’s more than that: You should be able to increase your net profit margins as well.

Operating a business has variable costs—the ones that increase or decrease in proportion to sales, like COGS, direct labor, and general liability (normally based on revenue) and workers’ compensation (based on wages) insurance coverage.

There are also certain fixed costs—expenses that don’t vary much regardless of scale. The rent on your administrative office (assuming the “office” isn’t your spare bedroom) is an example; until you own enough units to need more space, it’s not going to change.

Most non-variable costs are, strictly speaking, semi-fixed. Utilities will vary a little bit based on how much business you’re doing, but if you run a retail store or a restaurant the doors have to be open and the lights on whether you’ve got 20 customers, one customer, or none.

A better example is your administrative labor. If you hire someone to handle your bookkeeping, he or she can handle one store, five stores, or ten (and probably more), so within the practical limits of their workload your administrative labor costs won’t change as you add units, yet you’ll have more revenue to cover them.

Conclusion

Choosing a franchise is about a lot more than the money you can make. It’s about having a business that suits your lifestyle goals, your interests, and your skill set—although nearly every franchisor will train you in their operations system, so don’t worry about venturing into something new as long as you’re confident you’ll enjoy it.

It’s also, frankly, about how much money you have (and can borrow if necessary) and what limits that may place on the types of franchises available to you.

But within those constraints, it only makes sense to seek the most profitable franchises available.

Consider revenue and what the likely maximum is without significant expansion of the business. (This is especially important for a service franchise in which you’re going to do the work yourself—how much can you reasonably expect to make before you have to hire employees?)

Consider gross margins and how much control you have over them. For example, does the franchisor require you to buy some or all inventory or supplies from it, or do you have the flexibility to seek better pricing wherever you can find it? (In large systems there may also be a franchisee co-op that provides purchasing power.)

Finally, look at what will be left after cost of sales to cover your remaining expenses and what sort of net margins you can make. Your projections should always include best case, worst case, and middle-of-the-road versions, and always be conservative in projecting revenue and generous in projecting expenses.

Is that net profit number in line with your financial goals? If not, how many units would it take to get there?

Don’t be discouraged, by the way, if you want multiple units but there’s no way you can afford to commit to an area development agreement right out of the gate. There are other ways to grow your unit count—but that is the topic of another discussion entirely.

To read more articles from Franchise Chatter on the financial performance representations of some of the most profitable franchises, click here to subscribe.