The role and importance of franchising

It is now widely accepted that franchising plays an important role in furthering the development of modern business. Franchising as a business concept is fully established in the USA, indeed nowhere else is it actually found to be developed so intensively in a number of industry sub-sectors comprising of food, non-food, financial and other service businesses¼ˆBeilock, 1998¼‰. Even outside the USA growth rate of franchising is impressive. As far as Europe is concerned, franchising made its first appearance as early as 1929 in France and has been on the increase ever since.

Franchising is already well known and has an increasing role in national economies, being also assisted by divestment programs in the state and publicly owned enterprises. In some developing countries, franchising has been adopted by national governments as one of the strategies for faster economic development and is considered a major tool for providing faster job creation and new incomes (Clarke, 1997). Various research studies have identified that the failure rate of businesses using franchising is generally lower than those of the “conventional” startups. However, it has also been proven that the development of franchising depends on the overall economic circumstances and that its growth can be significantly impacted by the performance of the economy as a whole. It should be also be pointed out that the failures in franchising are possible and that franchising is not “a panacea” to cure ailments (Huszagh, 1992).

All these issues highlight the need to understand the benefits as well as limitation in using franchising as a tool to open business. It is also vital to identify which measures and tools should be used and how, for facilitating and promoting franchising with a purpose of optimizing its benefits. It is also important to understand the ways to build up franchising into a successful business into an overall economic development (Preble, 1995).

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1.2 The growth of franchising (from book )

Franchising as a legal or marketing concept was not new when its wide use commercially started to develop in the late 1940s and 1950s, principally in the USA as well as in other countries. Nevertheless, it is a concept which remains misunderstood by many despite its widespread use. Franchising is not an industry it is a method of marketing goods and services which knows almost no boundaries in terms of business categories (Quinn, 1999). Franchising has proved over many years in the UK, as well as I the rest of the developed world and in many developing countries, that it is a viable method of distributing goods and services which can have positive influence on economic development by its contribution to the establishment of new businesses and job creation. There has been a gaining in momentum, resulting in a rapidly expanding use of this marketing method (Sang havi, 1998).

In examining the growth of franchising one must start in the USA as not only is it the cradle of modern franchise development, but also it is the largest market place for franchising systems and until recently provided the bust statistics. It is undoubtedly the largest exporter of franchising systems despite the great advances which have been made in other countries, notably Canada, Japan, Australia, France, Germany and the UK. Franchising in some form exists in over 140 countries and that number will continue to grow (Lincoln & Guba, 1985).

When one bears in mind that it was only in the 1950s that franchise systems began to develop in large numbers the growth rate in the USA has been impressive. According to the Franchising in the Economy (1998), whose publication by the US Department of Commerce has now been discontinued: “franchising sales of goods and services in more than 509,000 outlets were expected to reach $640 billion in 1988, about 7% higher than a year earlier and about 91% over the level of sales at the start of the 1988s. Employment in franchising, including part time workers, will probably reach 7.3million by the end of 1998” (Frazer & Weaven, 2004).

Product and trade name franchising, which typically include automobile and truck dealers, petrol filling stations and soft drink bottles, have achieved a growth in sales despite the reduction in the number of outlets. Almost the whole of the reduction is attributed to the closure of petrol filling stations. The publication shows sales of 72 billion in 1972 from 262,100 establishments compared with sales of responsible 281 billion in 1988 from 140,820 establishments. Business format franchising has been responsible for much of the growth of franchising in the USA since 1950. The publication shows sales of 17.9 billion in 1972 from 189.640 establishments compared with 118.8 billion in 1988 from 368,458 establishments- a rise of 6,62 times in sales and 1,94in establishments (Levitt, 1983).

Also a survey of franchise associations conducted by Arthur Anderson in 1995 there are then 3000 franchisors in the USA, with 250,000 franchisees. The USA and Australia are the main countries in which government sponsored statistics have been available but there are statistics available from other countries, which vary from the professionally prepared in (Quinn, 1998). The information shown in table 1 appears to be the best available and indicates the level of franchising activities in some of the major economic markets in 2003.

1.3 An over view of franchising development in China (from internet document)

Franchising first emerged in China in the late 1980s. In 1987, KFC’s first Chinese outlet was opened in Beijing, the capital city of China.

Franchising industry in China experienced a period of disordered development in the early days. In the poor legal environment, some franchisers conducted substandard business or even defrauded franchisees of money (Ackerman, 1994). In some cases, franchisees delayed payments to the franchisers or infringed on their intellectual property rights.

In 1997, the Ministry of Internal Trade established the first Chinese franchise law, the Regulation on Commercial Franchise Business, which included guidelines on such issues as trademarks, copyrights, and intellectual property protection. A lack of specific provisions in the 1997 version governing foreign direct franchising allowed relatively few major international companies to have significant franchise businesses in China. Although many of these international brands such as 7-Eleven, McDonald’s, KFC and Pierre Cardin, normally do business through franchising, in China foreign franchising was still a grey area before the new rule was published (Micjael, 2000).

Because franchising typically does not involve investing in equities, the Chinese Government used to put less focus on such business. But the government came to find that franchises are a good business model for China to help solve its job problems and its scattered private capital. China’s capital markets are underdeveloped and franchising is one method that allows the assembly and concentration of capital from a wide capital base through investment in franchises. China has a great number of qualified potential Chinese franchisees with strong sources of funding. Franchising makes up for the commercial inexperience of the Chinese franchisers by linking their investments to completed training within a well-tested operating system (George, 2002).

The new Regulation on Commercial Franchise, announced by the Ministry of Commerce on December 30th 2004 and which took effect on February 1, will stimulate business in terms of its scale and standardization. The new regulation for franchises, to replace the 1997 measures concerning administration of commercial franchising, defines more clearly the way foreign brands operate franchise businesses in China. The new rule should help build a sound legal environment and invite additional foreign franchisers into doing the local business.

The franchising model, which allows people with limited capital to enter an established business, is well suited to a developing economy. China’s infant franchising industry is set to enter a rapid but orderly development stage after the new Regulation of Commercial Franchise takes effect (Patton, 2002).

1.4 Main Figures Related to Franchising Industry in China

With potentially the largest consumer market in the world and an accelerating economy, China is hailed as one of the most important consumer markets of the

21st century. China’s GDP expanded by 9.3% in 2004, the best among the world’s biggest economies. According to the estimation of State Information Center, the Chinese retail sector will grow at a stable speed of 8 to 10 percent from 2005 to 2010 and the retail amount of social consumption will exceed RMB 20 trillion in 2020. This increase in consumption is why many enterprises are eying China’s profitable franchise market. Large numbers of foreign franchisers are either operating in China or giving serious consideration to doing so.

China currently has 1,900 franchise systems, with 82,000 outlets, growing 49% annually. Nearly 60 industries have applied for franchise operations, including traditional sectors of catering, retailing and individual services, as well as some newly developed fields of education, commercial services, family services and automotive care. In terms of the number of franchisers, the catering industry leads by 35%, while retailing accounts for 30%, laundry 10%, and auto sales, care and leasing 3%. Nearly half of the top 100 restaurant companies are utilizing franchise business models, and their business earnings significantly surpass those of independently operated companies.

Though China has the most franchise systems in the world, the scale of their operations is relatively small. Each system in China has an average of 43 outlets, compared to more than 540 in the United States. There is a great deal of potential for further growth, but now the franchising business only accounts for 3 percent of China’s total retail sales, starkly behind the 30 percent in the United States.

Although not big in scale, the franchise sector has witnessed rocketing success in China. Its sales growth hit 40% on average in the last several years, far more than the 10% annual growth of national consumer goods.

1.5 research Objectives, questions and scope

The following are the objective of this study.

To indentify the critical factors of franchising business and the franchising systems.

To find out the new opportunities of franchising business in China.

To indentify the success strategies which are using currently face on China’s franchising industry.

Based on the above objectives, the research questions are given below:

What are the critical factors influence of franchising business and how the franchising system operating?

Which are the success strategies using currently in China’s franchising industry?

What are the new opportunities in China’s franchising market?

Scope:

This study have identified as relating to franchise system successes point. The main factors include franchisee satisfaction (Johns, Paswan and Strutton, 2004; Morrison, 1997), franchisor power (Dahlstrom and Nygaard, 1999; Lim and Frazer, 2004), the franchisor/ franchisee relationship (Clarkin and Swavely, 2003; Nathan, 1996), communication (Anderson and Narus, 1990; Frazer, 2004), franchisor support (Frazer, 2001; Pilling, 1991), franchisee entrepreneurial ability (Dandridge and Falbe, 1994; Frazer, 2004), and franchisee selection criteria (Jambulingam and Nevin, 1997; McCosker, 2000). This research examines these issues in relation to franchise unit success. A greater understanding and appreciation of the issues involved may result in a better utilization of the scarce resources of franchisors and franchisees and allow for the development of processes which will result in improving the likelihood of success of individual franchise unit.

Chapter 2 Literature Review

2.1 The concepts of franchising

The essence of franchising is capitalizing on both the economies of scale associated with large systems and the benefits derived from small. Localize operations. The franchise entrepreneur, as the creator, builder, and guardian of a unique business format, is responsible for efficiently managing a complex system of independent business owners (Onkvisit & Shaw, 1987). Of the many types of management issues faced by franchisers, perhaps one of the most difficult is defining the appropriate boundaries of their format, i.e. maintaining the required level of uniformity for the system to obtain economies of scale, while avoiding the danger of stifling efficient local market adaptation (Kaufman and Eroglu, 1998).

Studies of franchised systems suggest that franchise owners are more motivated than branch managers or non-franchised businesses, as they are effectively self employed but face less risk than occurs in this latter form of ownership. Coupled with this, franchisee turnover tends to be lower than branch manager turnover incomparable businesses (Levitt, 1983). It should be pointed out that many entrepreneurs who start their own conventional small business in order to preserve their independence find in reality that this independence is whittled away by various external constraints to a fraction of what was originally anticipated. Every existing and potential entrepreneur who is thinking about becoming a franchisee should first undertake self-evaluation of his/her suitability as a potential franchisee in comparison with starting and managing an entirely independent business (Rubin, 1978).

For example, if he/she is too autonomously minded, he/she may need to think hard before entering into such commitment, as the price to join a well-established franchising system is “subordination compliance” to the already existing rules and conditions determined in the operating manuals as stipulated in the franchise contract. The decision by prospective franchisee to “buy into a franchise system” is not enough; he/she has to be also selected by the franchisor, especially well established ones, who are particularly concerned about the suitability of those wanting to join the system in terms of their resources and capabilities, personality, professional background and experience, family background and even health condition. These issues are equally applicable to single entrepreneurs as well as to SMEs.

Franchising has been defined as a “type of business arrangement in which one party (the franchiser) grants a license to another individual, partnership or company (the franchisee) which gives the right to trade under the trade mark and business name of the franchiser” (Clarke, 1997). This form of franchise system is commonly found among fast-food service restaurants such as A&W, KFC, and McDonald’s; among oil companies and their petrol retailers and expanded rapidly in the country. It is also used selling cars, pharmaceutical, specific products or services and educational services.

On the other hand, such business format franchising has been described as a form of “business cloning” (Hoffman and Prebles, 1993). As Hoffman and Prebles (1993) advocate, business format franchisers seek to have franchisees replicate in their local community an entire business concept, including product or services, trade name and methods of operations. Franchisees are provided with details of the franchiser’s trade secrets, as well as everything else necessary to establish a previously untrained person in their own legally separate business, running it with continuing advice and support on a predetermined basis for a specific period of time (Clarke, 1997). Furthermore, the franchiser also normally provides the franchisees with information systems, through training programs and a detailed operation manual so that “each franchisee operates within the franchiser’s corporate image, offering customers consistency in product and or services. Consistency day in day out from every location in the network is expected” (Clarke, 1997). The franchiser’s control over the franchisees’ activities may extend over products sold, price, hours of operations, condition of plant, inventory, insurance, personnel and accounting and auditing (Rubin, 1978).

Franchising has become increasingly popular because, if it is properly managed, it is mutually beneficial to both parties. Franchising may be seen as a business relationship, where by a franchiser must depend on the franchisee to undertake some action on the franchiser’s behalf (Dant and Nasr, 1998). In a franchise system, franchisers must depend on their franchisees to run their businesses efficiently. In return franchisers not only offer their support and advice in the form of information system, training and an operational manual, but they also monitor their activities to ensure that the reputation of the franchises system is not being damaged in any way by the activities of any one of them (Rubin, 1978). It is therefore, in the interest of both the franchisers and the franchisees to optimize their efforts to make the franchise a success.

In considering the pace of development of franchising as a means for establishing small and medium businesses, one must also examine the reasons why the franchise system was an attractive proposition to companies seeking to expand a particular businesses format. In terms of control and profitability, the decision to franchise a new business concept not, at first sight seems the ideal way to achieve growth (Jain, 1989). However, as has been noted, the franchiser is able to keep his capital investment relatively low in comparison with acquisition methods of business expansion. By utilizing the capital and hard work of the franchisees, the franchiser is able to generate profits from a relatively low cost base. The decision to franchise will often be justified by the successful working relationship between the franchiser and the franchisee (George, 2002).

There are a number of disadvantages to business format franchising which can affect both the franchiser company and the franchisee. As with any form of business, friction can occur between the parties to a contract. In franchised systems, however, since the franchiser is largely devolved from the daily operation of the business, lack of communication between the parties can frequently be the cause of the problems. Close attention to the nature and spirit of the franchise agreement will often prevent occurrence of disputes in an effective franchising formula (Sang havi, 1998).

2.2 The various elements of franchising

Business format franchising is the process of licensing the rights and obligations to copy a unique retail positioning that profitably serves a need for a viable customer segment (Kaufmann and Eroglu, 1998). It may contain products and/or service and may or may not be location-specific. Including the support systems to implement and operate it, the format typically also involves access to sources to supply, as well as specified equipment and detailed operating instructions. Overall, therefore, the business format is comprised of various elements that manifest four distinct components: product/service deliverables benefit communications, system identifiers, and format facilitators (Anderson, 1984).

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Product/service deliverables are those elements sometimes referred to collectively as the concept, and reflect the unique features of the format franchise. For example, a key product/service deliverables for a particular franchise may be the quick preparation of consumers’ income taxes. The product/service deliverables also include differentiating features, such as a unique menu and the quality of the food in a restaurants franchise, or the convenience of being able to have our oil changed seven days a week in an automobile service franchise (Beilock & Wilkinson 1998). To sum, the product/service deliverables are the collection of features that comprises the franchise format and defines its unique competitive niche.

Benefit communicators are those elements referred to quality, durability, and elegance are other examples of attributes that are not readily observable or measurable by consumers. It also should be noted that the benefits implied and the form of such implications vary across format types (Caves & Murphy, 1976). For instance, clean uniforms in a fast-food outlet suggest cleanliness in the preparation and handling of the food, whereas clean uniforms in an automotive service center imply care and professionalism.

System identifiers are the set of visual and auditory elements i.e. the trademark or logo that also includes color schemes, and characters (McDonalds) among others. While format facilitators are the policies and procedures that form the foundation both for format’s efficient functioning into the operation of the total system. These would cover a wide spectrum such as equipments, layout and design, as well as financial reporting requirements, royalty payment procedures, and data collection. This is the most critical element because it defines the organization, operation and governance of the franchise system.

Another encouraging factor to consider this business format franchising is the advantage of costs and the benefits of standardization. One of the primary motives for standardizing across markets is the desire to reduce cost. These cost savings are scale of economies due to purchasing (Douglas and Wind, 1987), marketing (Buzzell, 1968; Onkvisit and Shaw, 1987), and research and development (Buzzell, 1968), as well as savings due to easier implementation and management of programmes. As organization go into international market, cost minimization is also an important rationale for standardization across domestic market. Therefore, a standard format is effective in reducing cost relates to monitoring. However, the central concern of the operations function in franchising systems is quality control and the ability of the franchiser to identify poor performance by franchisee. Again standardization takes it form to ensure quality assurance to the customers’ satisfaction and possibly minimize the cost.

Standardization also permits image continuity and stability across markets (Jain, 1989; Levit, 1983). Within the context of formal franchising, a consistent image is obtained through close adherence to the system’s rules and standards by all franchisees and the unequivocal of all franchisees to the system (Kaufmann and Oroglu, 1999). In fact this image represents the total expected reinforcement that a consumer associates with patronizing the outlets, consumers’ experience and rewarding, but importantly, consistent image.

2.3 The theory from marketing concept

2.3.1 Capital Theory

A common explanation for the franchising of independent firms, rather than reliance on expansion by wholly owned subsidiaries is that franchising is a method used by the franchisor to raise capital (Carson, Gronhaug & Perry, 2001). Thus, it is argued, the franchisor is able to expand his business more quickly than would otherwise be the case.

A consideration of this argument in the light of modern capital theory quickly indicates that it is fallacious. A franchisor will own outlets in many areas; a franchisee will in general own only one or a few outlets in some area. Thus, the investment of the franchisee will be much riskier than the overall franchise chain a risk averse franchisee would clearly prefer to invest in a portfolio of shares in all franchise outlets, rather than confining his investment to a single store (Daft, 2002).

This means, essentially, that the franchisee will require a higher rate of return on his capital if he is required to invest in one outlet rather than in a portfolio, conversely, the franchisor, by forcing a relatively large risk on the franchisee, will himself earn a lower rate of return (Jain, 1989). This argument thus appears to make sense only if we assume that franchisors are more risk averse than franchisees. But since franchisees commonly invest a large share of their assets in acquiring the franchisee, it is unlikely that this will be the case.

Let us make the strongest possible care for the capital market argument. Assume that franchisors are unable to use normal capital markets for expansion. Therefore also assume that they want to rely on their store managers for a source of capital. Even in this case, the franchisor would do better to create a portfolio of all outlets and sell these shares to his managers. This would diversify risk for the managers, with no capital effect on the franchisor. Thus, it is clear that capital market arguments do not explain franchising (Preble, 1995).

2.3.2 Agency Theory

Agency theory is concerned with exchanges involving delegation of work by one party (principal) to anther (agent) (sharma, 1997). A central assumption of agency theory framework is that the interests of principals diverge from that of agents. As a result of this assumption, agents might misrepresent information concerning their skills and effort. According to agency theory, these problems can be mitigated through either residual claimancy, or monitoring (Shane, 1996a). Residual claimancy aims at aligning agents’ incentive with those principals. Monitoring, on the other hand aims at providing principals the information concerning behavior of agents (Eisenhardt, 1988).

Residual claimancy

In the context of franchising, the agency premise is that is likely to be greater goal divergence between franchisors and hired managers than between franchisors and franchisees. This is because franchises have stronger incentives for maximizing the present value of their franchises (Alchian & Demsetz, 1972). Franchisee effort is assumed to be more self-enforced relative to that of a hired manager on the basis of the argument that “producing outputs at lower costs is in the interests of residual claimants because it increases their net cash flows”. Under a franchising contract, franchisees bear the undiversifiable residual risk tied to their particular units, and therefore, the cost and benefits of franchisee actions that affect the value of their individual units are capitalized onto their own shoulders. The moral hazard of sub optimal efforts is less threatening in the case of franchisees than in the case of hired managers (Shane, 1996). Because franchisees are residual claimants, they do not have the incentives to shirk on efforts. The hired managers, however, do not have to burden the cost of actions such as shirking because they are typically promised fixed pay offs, though some variable payments are possible. Therefore, franchisors incorrect lower monitoring costs in operation than in company owned units run by hired managers (Bates, 1998)

Monitoring

Norton noted that franchising is an institution to “circumvent the entrepreneurial capacity constraint” (Norton, 1988). Norton emphasized that the growth and the size of firms are constrained by monitoring problems. Focusing on the monitoring function of the entrepreneur, Norton cited Alchian and Demsetz (1972): “entrepreneur is monitor whose principal task is to assure that all hired factors of the firm provide their promised level of service to minimize “shirking”(Norton, 1988). An entrepreneur has to spend more time in monitoring as the firm grows. The problem of monitoring is not solved by delegating this critical function to the hired managers because then, the monitors will have to be monitored. Franchising, however, mitigates the problem of shirking. By setting the incentives of the owner manager (franchisee) of local unit in such a way as to be compatible with those of the franchisor, the latter can be relieved of incentives by according franchisees the status of residual claimants in a franchising contract. Franchisee cannot afford to shirk monitoring because that would reduce their revenue from the detected shirking than would a hired supervisor because the franchising contract can be terminated in the event of the breach of the contract. Thus, franchising, by substituting owner managers (franchisees) for the hired supervisors, permits larger systems without the high monitoring costs of large firms that do not franchise.

Brand and capital

Franchisors have to weigh, however the saving in the monitoring cost against the contract cost ad the possibilities of free riding by franchisees (Brickley &Dark, 1987). The presence of brand name capital can lead to the opportunistic behavior of free-riding. Brand name capital: (a) lead to customer belief that each unit in a retail system provides the same levels of quality and (b) potentially reduces the ability of customers to detect differences in the quality of service received from different unites of retail system. Therefore, anticipating the spillover benefits from those units whose franchisee do not shirk on the input quality, a franchisee, especially in a low repeat purchase location, has an incentive to behave opportunistically. That is, in the presence of brand name capital, a franchisee shirking on quality would likely b able to free ride without losing business, especially if the location is characterized by low repeat purchase probability (Caves & Murphy, 1976).

A franchisor must incur monitoring costs to detect and prevent shirking, free-riding, and potential under investment by franchisees so that the brand name capital of the system is not diluted. Such costs are, however, absent in the case of company owned units run by hired managers because they do not have similar economic incentives to shirk on quality (Anderson, 1984). Thus, the disadvantage of potential shirking, free-riding, and under investment inherent in franchising, and the associated higher monitoring costs to avoid these disadvantages, explain the presence of company owned units in a franchising system.

Goal conflicts in franchising

Although residual claimancy and monitoring are promising mechanisms to redce agency problem (Eilsenhardt, 1988; Jensen, 1983; Shane, 1996), their potential effectiveness in the context of franchising is unequal. Dante and Nasr (1998) have emphasized that the alignments of incentives, through residual claimancy, is difficult to achieve because there are differences in the perspectives of parties involved in franchising. These differences lead to basic conflicts even when incentive alignment is attempted. The conflicts arise from the differences in priority, time perspective, and form of earning (Table 3). We argue that these differences are less acute in a dyad involving a franchisor and a multi-unit franchisee than in a dyad involving a franchisor and a single-unit franchisee. This follows from the fact that a multi-unit franchisee has greater system-specific investment relative to a single-unit franchisee. Therefore, the perspectives of the multi-unit franchisee concerning brand name and time will be better aligned with franchisor relative to the alignment between a single-unit franchisee and franchisor concerning the same issues.

2.3.3 Trust as Relationship

It has been observed and the literature on franchisee- franchisor relationship has also taken to a note of the fact that franchisees have more incentive and tendency to “free ride”. They tend to take advantage of the positive effects of others investments, such as product quality and advertising, while minimizing investment of their own (Brickley, 1991).

Studies have also shown that franchisors even tend to terminate the franchise agreement unilaterally in an unfair manner. The level of trust between the franchisee and franchisor it may be important, however, that the commitment must be more demonstrated than told (Micjael, 2000).Therefore, both the parties must walk the talk in order to consciously build a strong level of trust between the two.

Trust