Economic Outcome Analysis, Case Study Example

Introduction

Andy’s Parties, a local business that offers theme parties at their Party Center, is owned by a local businessmen.  The local businessmen is considering whether it should expand Andy’s Parties. There are two potential ways to expand the business: 1) Expanding existing outlets to offer more parties in local areas; 2) Franchising the brand to different owners that would accomplish the same goal of expansion, but at a different price. This paper will examine the main costs and benefits associated with both strategies to come to a conclusion.

Expansion Analysis

Revenue

If Andy’s Parties wants to expand its presence through leveraging internal resources, the main comparison of interest is: the projected investment for building new infrastructure, training new staff, and increasing advertising versus the expected gain in revenue from the expansion. Because the revenue side will drive whether the expansion ultimately works or not, the following assumptions for revenue projections:

• Number of parties: The number of increased parties above the existing baseline was set at 50; the number of parties increases 10 per month. This incremental rise is based on one main reasons: 1) An expansion means that additional capacity will come on gradually This is particularly true for the training aspect of the budget: new party trainers will take time to scale up activities.
• Average Revenue per party: The avenue revenue per party figure was taken directly from financial information: $385 per party. One may rightly argue that the average figure should initially be lower during the time of expansion and that all parties are not necessarily the same size- I kept the figure because it was used to calculate Andy’s margin pre-expansion activities.
• Average cost per party: The estimate for the average cost per party was calculated from the financial information provided. That is, I took the total costs related to labor and supplies and divided that number by the total number of parties (385). The number used for the average cost per party was $200.

Costs

I then made the following estimates for the costs that would be involved in the expansion:

Table 1: Expansion-related investment and costs

Overall, the expansion related costs are $120,000.  Based on the average revenue of party that increases over time with the number of parties, the break-even point of expansion occurs in roughly month seven of the proposed expansion.

Franchising Analysis

Franchising presents a different potential value proposition for Andy’s Parties.  Indeed, while the case for expansion is really looking at when the anticipated increase in revenues will offset the investment in training and advertising, the case for franchising rests on the value of franchisee fees, and their ability to grow the business, with a less onerous burden on the current owner of Andy’s Parties to invest.  Indeed, although franchising has the opportunity to increase revenue over the long-run, it also has less risk for the current owner of Andy’s Parties.

Revenue

The main revenue for franchising is based on the ability to find, sell, and collect revenue from franchisees. Because I did not have extensive data for the party market in the local area, I made conservative estimates for the growth of franchising: I estimated that 2 franchises would be sold per month; the fees derived from the franchisees would be $10,000 for the franchise fee and $5,000 for the royalty.  These fees were based on market prices.

Costs

Due to the nature of franchising versus expansion, Andy’s would face more costs than investments

Table 1: Franchising-related costs

There are a number of cost categories associated with franchising. Legal fees are expected to be an ongoing expense related to franchising: this is because each time a franchise transaction is completed, there will be associated legal fees. Operation manuals are considered to be a one-time expense: although more manuals may ultimately need to be printed, this should cover the amount that needs to be distributed over the upcoming year.  Perhaps the most important expense for the firm in pursuing franchisees is the training fee.  The training fee will go to training  of the new franchisees- the ability to make money off franchising in the future will be directly related to the level of preparedness among franchisees; thus, the amount spent ($50,000) is considered to be worth it.  Finally, a modest advertising budget is established to initially help out franchisees; once franchisees have established their own business, one expects that amount to decrease over time.  The current level is set at a high enough price that it should provide substantive help for fledgling franchisees, while also offering a support level high enough to incentivize them to sign on.

Franchise Versus Expansion Analysis

The question of whether to expand or franchise comes down to two different considerations. The first analysis involves financial projections that will be provided below.  The second and equally important analysis, however, deals with the potential risk around the numbers.  While a full-blown sensitivity analysis is not possible with the current data, several qualitative factors should be considered before the financial analysis.

Expansion of Andy’s Parties through increased investment is likely more risky than the franchise route; the reward is also likely greater.  This is because expansion takes more up-front investment without the guarantee of income.  The positive side to this risk is that there is also a greater potential upside from the investment as the business owner would have a claim to the income.  Franchising would offer less risk to the business if the expansion fails; indeed, the company’s only up-front costs would involve legal services (which could be purchased on a case-by-case basis) and printing costs for the manuals (which also could be handled on an as needed basis).

Table 2:  Projected Party Earnings

The above analysis shows that franchising is likely the better option for Andy’s Parties over the long-run.  Although some of the assumptions embedded in the franchise assumptions are more aggressive than the expansion, overall the breakeven point for expansion would be in month 8 versus month 3 for franchise. There is also another consideration: Although franchising might get Andy’s Parties paid back quicker, a combination of receiving franchising fees and royalties up front rather than on the back end for expansion, this analysis only goes out for one year.  The timeline is thus biased in favor of the franchising option that returns capital quicker, but does not necessarily give the investor a better return over the long-run.

 Conclusion

Overall, the best option for Andy’s Parties over the short-run is to pursue franchising.  This option holds less and better risks over the long-term compared to the expansion option.  It should be noted, however, that if the timeline was expanded, expansion would likely be the better option.

References

Blair, R & Lafontaine, F. (2010). The Economics of Franchising. Cambridge: Cambridge University Press.

Klien, B.  (1994). The Economics of Franchise Contracts.  Available at: ssrn.com

Krugman, P. (1986).  Microeconomics. Boston: Wiley Press.

Mankiw, G. (1998).  Practical Economics.  Boston: Harvard