Budgeting in an Expense Economy: Cutting Costs Might Include Cutting Underperformers

Now that we are freshly off the annual rite of late fall--the annual budget process--it might be a good time to consider how it could be done differently next time around. Conceptually, the budgeting process for franchise companies is pretty simple: pick some revenue numbers that build off the previous year's performance and do the same for expenses.

For franchisors that have an established book of business in the form of franchised unit locations, the process is pretty simple on the revenue side because revenues are largely driven by royalties. Royalty revenues are far less sensitive to changes in economic conditions than the sales activity they are based on because royalties are always a relatively small percentage of sales levels (even less so if royalties are based on some fixed determinant). While unit fee income is a bit harder to predict in this economy, for established franchisors it is the smaller component of total revenues, and therefore a poor budget forecast of fee income has less of an effect on the year's operations.

The much bigger challenge is with expenses. In a down economy, franchisee operations are more stressed and in need of greater franchisor support. At the same time, franchisor profitability is under pressure because total franchisor revenues are unlikely to be expanding by historical percentages, if they are growing at all. This creates a challenging conundrum for franchisors: keep expenses down or provide more resource support to a franchisee community that very likely needs it.

Digging out the data

The difficulty in choosing between the two is a lack of good information. It would be much easier if we could measure the financial long-term impact of changes to training levels or field staff support. Those activities are significant franchisor expenses. What would that financial impact be? For starters, how much does it cost, in dollars and/or human capital, for a franchisor to help an underperforming franchisee either achieve at least average performance or get out of the system?

Before I address that question, a quick side note regarding the decision to get a franchisee out of the system. I have concluded from several decades of management that some under-performing employees are never going to get to average, let alone to greatness, and I'm doing them no favors by allowing them to have a career of under-performance. I have found that they are generally better off with an exit strategy, voluntary or not. I think the same applies to some franchisees. Sometimes it just doesn't work, and no amount of support and patience will allow them to look back years later and feel good about the outcome.

Now back to the questions. The issue in franchising is that we simply don't know what the differential costs are to a franchisor between a high-performing franchisee and a poorly performing one. So we really can't answer those questions. And if we can't, how do we know whether we are setting budgets and allocating resources correctly? I'm pretty sure that if we could quantify the cost of an under-performing franchisee, we could establish a better connection between the type of franchisee the development department finds, the training provided, the level of field support needed to achieve acceptable performance, and the amount of time and money spent on compliance and legal functions.

Making it work

How would all this work? It should be pretty easy to separate franchisees into two types: those who will become above-average performers and those who will become below-average performers. Today it isn't easy to determine how much more the underperformers cost but what if the data were available? An above-average performer might get to opening 2 months sooner, to cash flow break-even 3 months sooner, and to profitability 4 months sooner--and in doing so, perhaps require less training and field support. If we knew the dollar and human capital differences, it might help guide the development function to identify franchisees who represent more long-term (and perhaps even short-term) profitability to a franchisor.

For those who think this is just an interesting theory, check back with me in 2 years. It's coming. Many publicly traded companies have found the answer, and in so doing have significantly boosted earnings and stock performance. They've recognized that this economy is not a revenue economy, but an expense economy.

In franchising, green shoots are revealing themselves. Franchise Update Media Group has lead generation survey information. The IFA is assembling some generalized operational benchmarking survey data. And FRANdata has been developing detailed benchmarking capabilities over the past few years, such as the annual franchisor compensation studies. (Do you know how salaries have changed in the past 12 months? That seems like a good data input for operational budgets.)

There are 3,500 franchise brands with untapped data points of information. There are brands that are best in class, perhaps not in all franchise-specific functions but certainly in some. Sorting through them and coming up with data points and associated metrics won't be easy, but it will be necessary. It's already under way.

Darrell Johnson is president and CEO of FRANdata, an independent research company supplying information and analysis for the franchising sector since 1989. He can be reached at 703-740-4700 or djohnson@frandata.com.