What Is Cost of Goods Sold
Cost of Goods Sold (COGS) represents the direct expenses required to produce or purchase the products your franchise unit sells. This includes raw materials, inventory purchases, packaging, and direct labor tied to production. It excludes indirect costs like rent, utilities, marketing, and franchise fees.
COGS in Franchise Evaluation
When evaluating a franchise opportunity, COGS is critical because it directly affects your unit economics and profitability. The FDD (Franchise Disclosure Document) Item 19 often contains financial performance representations that show average unit volumes (AUV) and operating expenses. COGS typically represents 30-50% of revenue depending on the business model, though this varies significantly by industry. A quick-service restaurant might show COGS at 28-32% of sales, while a product-based franchise could run 40-60%.
During due diligence, you need to understand whether the franchisor controls COGS through approved suppliers. Many franchisors require you to purchase from designated vendors or approved distributors. This protects brand consistency but also affects your margins. Some franchisors negotiate volume discounts with suppliers, then pass those savings to franchisees. Others mark up supplier costs, creating an additional revenue stream. Item 19 financial statements should disclose COGS, but you should ask franchisees directly about actual costs versus what the FDD projects.
How COGS Connects to Franchise Structure
- Franchise fees: Royalties (typically 4-8% of gross revenue) and advertising fund contributions are not COGS. They're operating expenses deducted after gross profit is calculated.
- Territory rights: Your exclusive territory affects COGS indirectly. A well-defined territory with lower competition may allow you to negotiate better supplier pricing due to higher volume commitments.
- Renewal terms: Long-term franchise agreements (10+ year terms) give you leverage to negotiate better supplier agreements and lock in COGS predictability.
- Franchisor obligations: Review whether the franchisor is required to maintain supplier relationships, provide price caps, or guarantee certain cost levels during your franchise term.
Calculating and Monitoring COGS
To calculate COGS, use this formula: Beginning Inventory + Purchases - Ending Inventory = COGS. Track this monthly, not just annually. Most franchise systems require you to report revenue weekly or monthly, making it easier to spot COGS increases immediately. If your COGS creeps from 35% to 40% over six months, you need to address supplier contracts or operational waste before it kills profitability.
Request detailed COGS breakdowns from franchise references. Ask what percentage they spend on ingredients versus packaging, labor versus materials. This gives you realistic benchmarks beyond what Item 19 might show. Some franchisors publish COGS guidance by quarter to help franchisees plan. Others keep this data proprietary, which should raise questions about transparency.
Common Questions
- Does the franchisor profit from my COGS purchases? In many systems, yes. Some franchisors have supply company subsidiaries or rebate agreements with vendors. This isn't inherently bad, but you should know about it. Ask in Item 19 disclosures whether the franchisor or related entities receive payments from suppliers.
- Can COGS change during my franchise term? Yes, unless your agreement specifies price caps. Commodity-based franchises (coffee, ingredients, packaging) see COGS fluctuate with market prices. Build 5-10% contingency into your financial projections for COGS increases.
- How does COGS affect my cash flow? If you pay suppliers upfront but collect payment from customers on credit, COGS creates a cash timing gap. This is especially important in B2B franchise models. Understand your payment terms (net 15, net 30) before signing.
Related Concepts
Gross Margin is calculated by subtracting COGS from revenue. It shows the percentage of each sales dollar available to cover operating expenses and profit. A Profit and Loss Statement breaks down revenue, COGS, gross profit, and all operating expenses to show your net income, making COGS a foundational line item in understanding unit profitability.