Operating margin for a quick-service-restaurant franchisee in the US

Quick-service-restaurant (QSR) brands such as McDonald’s, Domino’s Pizza are franchisors that allow qualified individual investors to operate stores using their brand names and operational formula in general. These investors become franchisees. So, roughly in the US, how much is the margin for franchisees?

I looked at Domino’s Pizza’s latest annual report and came up with some estimations.

Besides franchising out stores, Domino’s Pizza also runs some owned restaurants by themselves. Self-owned restaurants provide a great reference to pitch future investors and test out new technologies and operational practices. How big is operating margin for the brand’s self-owned stores?

Source: Domino’s Pizza

Cost of sales for US company-owned stores in 2019 was about $346 million while revenue was $454 million. That put operating margin at around 24%. Even though each franchised store will have a different cost structure, it’s reasonable to assume that is a good starting point to look at this issue. However, 24% is just operating margin for the brand without any cost related to the franchise agreement. Here is how Domino’s Pizza describes its franchise agreement:

We enter into franchise agreements with U.S. franchisees under which the franchisee is generally granted the right to operate a store in a particular location for a term of ten years, with an ability to renew for an additional term of ten years. We have a franchise agreement renewal rate of approximately 99%. Under the current standard franchise agreement, we assign an exclusive area of primary responsibility to each franchised store. Each franchisee is generally required to pay a 5.5% royalty fee on sales as well as certain technology fees. In certain instances, we will collect lower rates based on certain incentives.

Our stores in the contiguous United States currently contribute 6% of their sales to fund national marketing and advertising campaigns (subject, in certain instances, to lower rates based on certain incentives and waivers). These funds are administered by Domino’s National Advertising Fund Inc. (“DNAF”), our consolidated not-for-profit advertising subsidiary. The funds are primarily used to purchase media for advertising, and also to support market research, field communications, public relations, commercial production, talent payments and other activities to promote the Domino’s brand. In addition to the national and market-level advertising contributions, U.S. stores generally spend additional funds on local store marketing activities.

Source: Domino’s Pizza

Essentially, there are three main expenses from a franchise agreement: a fixed upfront fee, a monthly royalty fee of 5.5% of sale and a contribution of 6% to the national marketing and advertising campaigns. First of all, a fixed upfront fee which can easily be more than $20,000 is a significant sum that can generate interest in another investment opportunity. However, for the sake of simplicity, let’s ignore that. Second, a franchisee will have to pay a 5.5% haircut every month to the brand, which lowers the margin from 24% to 18.5%. Additionally, there is also a required contribution of 6% of sale to the fund for marketing and advertising purposes. Now, there are two ways to look at this: whether Domino’s Pizza’s definition of “cost of sales” already consists of marketing and advertising expenses that are on top of the fund.

If it does, then franchisees’ operating margin, after the royalty fee, may stay at 18.5%, even though it’s entirely possible that each store may run additional activities on their own dimes. However, it’s worth noting a couple of more things:

  • Some franchisors lease lands/buildings to franchisees with margin on top of their own expenses. It means that franchisees’ operating margin will take another small hit
  • Franchisors like Domino’s Pizza also sell supplies and ingredients to franchisees at profit. Even though there is a profit-sharing scheme, Domino’s Pizza still stands to make around 6-11% margin, implying another hit to the margin of franchisees

We believe our franchisees voluntarily choose to obtain food, supplies and equipment from us because we offer the most efficient, convenient and cost-effective alternative, while also offering both quality and consistency. Our supply chain segment offers profit-sharing arrangements to franchisees who purchase all of their food for their stores from our centers. These profit-sharing arrangements generally offer participating franchisees and Company-owned stores with 50% (or a higher percentage in the case of Company-owned stores and certain franchisees who operate a larger number of stores) of their regional supply chain center’s pre-tax profits. We believe these arrangements strengthen our ties to and provide aligned benefits with franchisees.

Source: Domino’s Pizza

In sum, I used only Domino’s Pizza as an example in this post, but it’s the standard formula across QSR brands. Read any publicly available annual reports and you’ll see that. Some franchisors have higher operating margin for their owned stores (Domino’s Pizza is among the ones with the highest margin) than others. Some may require a lower royalty fee rate than others. However, I don’t think QSR franchisees have a great operating margin. It’s true that they can raise prices to make up for additional expenses compared to the expenses of franchisors’ owned stores. Nonetheless, given a cut-throat competition in the QSR industry and Food & Beverage in general, they can only increase prices so much before losing customers.

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