Duff Ave Retail Signs in Ames, Iowa, April 2022. Credit: Christopher Gunnon / Iowa State University

From McDonalds to Marriott, 7-Eleven to Ace Hardware, we are surrounded by franchises. They are the dominant retail model in the United States, and their success has been based on franchisors developing a network of franchisees who use their own resources to open and operate regular stores.

But Stephen Kim, a professor of marketing at Iowa State University, says focusing only on growth misses a great opportunity to understand how franchises become profitable.

“There’s another aspect, which is termination,” Kim said.

Termination of a contract with a franchisee is the ultimate form of enforcement, which is rarely announced, he explains. Franchisors typically use this latter measure in an attempt to maintain uniformity and protect their brand when franchisees repeatedly violate or deviate from chain standards. Kim gives the example of a pizza shop that saves on quality ingredients; rubber cheese can damage the reputation of the restaurant chain, leading to loss of customers and revenue.

But severing ties with the franchisee also carries costs for the franchisee, including the risk of litigation, the possibility of upsetting customers and other online franchisees, and an immediate drop in royalties, which are usually 5-7% of the franchisee’s sales.

To better understand these trade-offs and how the termination affects the franchise’s long-term profitability, Kim is leading a study that digs up four-year data from more than 6,000 chains in South Korea. Results already available in Journal of Managementfound that the profitability of franchisors decreased immediately after termination, but essentially recovered in two years.

Researchers also found that young, fast-growing chains benefited more from terminating contracts with wayward franchisees than mature, slow-growing chains.

“For younger chains, termination could have a spillover effect. It signals to other franchisees at the beginning that they must follow the rules, otherwise they may suffer the same consequences, “said Kim. “For mature chains, there is a greater chance that franchisees have already established their way of doing business.”

Advantages and disadvantages of being a franchisee

In their article, the authors cite previous research that found that 9-10% of franchisees’ contracts were terminated, which raises the question: why take a risk as a franchisee at all?

Kim says the biggest benefit is that the franchisee can start a business using a model that has already been established and tested. They face lower risks and start-up costs compared to starting their own independent business and benefit from brand recognition and chain marketing.

But people may feel closed when they can’t try something new or make a change to suit local tastes.

“Often people who want to run a franchisee want to be their own boss, but they find that there are very strict procedures and rules that the franchisor wants to follow. They realize they don’t have that much freedom,” Kim said.

Data collection and analysis

One of the reasons researchers decided to analyze franchises in South Korea is that it is easier to access data than the United States. The South Korean government requires every franchisor operating in the country to submit annual reports to the country’s Fair Trade Commission, which the government then compiles and makes publicly available online.

To understand how terminating franchisees affected performance over several years, researchers focused on profitability (return on assets) rather than profit. Kim explains that profit is determined by the size of the franchise, while profitability is an indicator used to determine the scope of a company’s profit in relation to the size of the business. Profitability captures more nuances and accurately reflects the impact of termination on the success of the franchise.

Researchers also examined whether “adding a franchisee” and “customer mobility” alleviate or exacerbate the effects of dropping a franchisee’s contract.

They found that adding franchisees (ie the rate at which franchisors sign new contracts to add more stores) reduces the negative effect of termination on the chain’s profitability, while customer mobility shows no noticeable effect. Customer mobility refers to the degree to which someone regularly visits different retail outlets of the same chain. For example, customers who go to many different McDonald’s stores can expect more uniformity from someone who dines in one place.

Kim says future research may be able to break the link between the termination of the franchisee and the high and low mobility of customers.

Although data from this study comes from franchises in South Korea, researchers say the findings are relevant in the United States and may help inform franchisors as they make decisions about growing or downsizing their business.

Sunguk (Sam) Min of California State University Long Beach contributed to the study.

How franchisors can use the ambiguity in the contract to their advantage

More information:
Stephen K. Kim et al., Termination of franchisees: does it improve the franchisor’s performance? Journal of Management (2022). DOI: 10.1177 / 01492063221088507

Provided by Iowa State University

Quote: In franchising, playing hard early can support the long-term benefits (2022, May 13) derived on May 13, 2022 from

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