In carrying out this dual mission, the exchanges operate retail stores, similar to department stores, and provide a host of other services and specialty stores, including furniture stores, florist shops, barber and beauty shops, optical shops, liquor stores, and fast-food restaurants. The sales occurred at about 2,200 food outlets operated by three military exchanges—the Army and Air Force Exchange Service (AAFES), the Navy Exchange Service Command (NEXCOM), and the Marine Corps Community Services (MCCS). The Indirect Method Has Been More Profitable for the Exchange Services

Our analysis of fiscal year 1998 and 1999 financial data showed that the indirect method of operating name-brand, hamburger restaurants provided greater profitability than the direct method. This was true regardless of whether the restaurants were grouped and analyzed by sales volume, restaurant type (stand-alone or part of a food court), or location (continental United States or overseas). We also projected that if new name-brand, hamburger restaurants were to be built, the indirect method would result in a higher return on investment over a 20-year period. Investment Analysis Projected That the Indirect Method Would Provide a Greater Return on Investment if New Restaurants Were Built

In addition to our profitability analysis of fiscal year 1998 and 1999 financial data, we performed a 20-year, cash flow analysis for a capital investment in a new name-brand, hamburger restaurant. The exchange service provides the capital for building and periodically updating the restaurant, assumes all financial risks of operations, and generally pays the name-brand company an annual licensing fee and a royalty or commission on its annual sales. Under the direct method, these issues fall primarily with the exchange service. In general, each exchange service has adopted the operating method that it believes best fits its particular circumstances. As a result, the exchange services have not always had a compelling reason to analyze the financial and operational benefits of the two operating methods. Recommendation for Executive Action

To properly weigh profitability and other factors in selecting operating approaches for name-brand, fast-food operations on military installations, we are recommending that the Under Secretary of Defense (Personnel and Readiness), in conjunction with the secretaries of the military services, revise the Department’s name-brand, fast-food policy by incorporating a standard methodology that considers both profitability and other factors to be used by the exchange services to identify the most appropriate method for operating fast-food restaurants, including criteria to approve deviations from any preferred operating method specified in the revised policy guidance, and   clarifying how the instruction on public-private ventures affects the policy. The ability of a restaurant to recover these costs will depend on the expected profitability of the restaurant as well as financial and operational risks associated with the restaurant’s operations. License agreement

A term for the legally binding agreement between a franchisee and a franchiser. Profitability

Refers to economic earnings for the direct method of operation or net profit for the indirect method of operation and is expressed as a percentage of restaurant sales. Under the indirect method, profitability represents the revenues (sales commissions, signing bonuses, and licensing fees) received from the name-brand company less the exchange service’s overhead costs.
What GAO Found

The military exchange services operate a wide range of retail activities, such as department stores, florist shops, barber and beauty shops, gas stations, and restaurants. Hamburger restaurants represent a major segment of the exchange services' name-brand, fast-food sales. The exchange services use either a direct or an indirect method to operate these restaurants. Under the direct method, the exchange service enters into a franchise agreement with a name-brand company to sell its product on a military installation. As the franchisee, the exchange service builds and operates the restaurant and directly employs and trains the personnel. In turn, the exchange service receives all of the revenues and profits and usually pays the company a licensing fee plus a percentage of the restaurant's sales. Under the indirect method, the exchange service contracts with a name-brand company that, in turn, builds the restaurant and either operates it as a company restaurant or provides a licensed operator. The company or its licensed operator hires, trains, and pays the restaurant personnel and usually pays annual fees and commissions to the exchange service on the basis of restaurant's sales. Under this agreement, the exchange service receives a percentage of the restaurant's annual sales; annual licensing fees; and, in some cases, a signing bonus or minimum guaranteed commissions. GAO's analysis of fiscal year 1998 and 1999 financial data from the Army and Air Force Exchange Service and the Navy Exchange Service Command showed that the indirect method of operating name-brand hamburger restaurants was more profitable than the direct method, regardless of the restaurants' sales volume, restaurant type (free-standing or part of a food court), or location. GAO's investment analysis projected that if new name-brand, hamburger restaurants were to be built, the indirect method would provide a greater return on investment over a 20-year period. Other factors important in choosing between direct and indirect methods include financial and operating risks, customer service issues, employment opportunities for military dependents, and management control of a restaurant's operations. Although the Department of Defense's (DOD) policy on name-brand, fast-food restaurants establishes preferences for when the direct and indirect methods should be used, it does not provide enough guidance or criteria to determine which method to use or when it is appropriate to deviate from the policy. Also, DOD has not been actively involved in monitoring compliance with the policy. As a result, the exchanges have, over time, adopted operating philosophies and business models they believe best suit their particular circumstances.