Financial Issues In The International Hospitality Industry Commerce Essay

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Franchising has grown rapidly in the last decades and contributes a large share of profit for the service sector, especially for the restaurant sector and has attracted a wide a variety of researchers. To identify whether profitability is increasing with an appropriate proportion of franchised restaurants and company-owned restaurants, this study investigated firstly the profitability of franchised and non-franchised restaurants and secondly the effect that company-owned restaurants would have on the profitability of the franchising system. This study is demonstrated through the application of juxtaposing the two main theories of franchising, agency theory and resource scarcity theory. Using data from McDonalds and Vapiano enables the exploration of whether franchising has an effect on the profitability of franchised or non-franchised restaurants. The results of this study showed that firstly franchised restaurants had higher profitability than non-franchised restaurants due to the support of the head office and secondly the combination of both franchised restaurants and company-owned restaurants contributes to profitability increases. The results lead to several recommendations regarding the profitability of franchised and non-franchised restaurants concerning entry barriers, competition and profit margins.


This essay critically analyses the effect franchising has on the profitability of restaurant firms and financial issues concerning the profitability of franchising will be discussed. Firstly, this essay will examine the existing theories and literature of Franchising regarding agency theory and resource scarcity theory. Secondly, it will compare the profitability of franchised restaurants and non-franchised restaurants. Thirdly, the effect that a proportion of company-owned restaurants would have on the profitability will be evaluated. Finally, through these arguments a set of recommendations will be developed related to the appropriate proportion of franchised restaurants and company-owned restaurants regarding their profitability. Additionally, there is an upcoming profitability ´effect` on franchising when comparing unmixed franchised restaurant with company-owned franchised restaurants.

Franchising is a business practice and occurs when an individual person or a company (the franchisee) use another company's (the franchisor) business model, where they receive a royalty fee and an agreed percentage of the sales from the franchisee or independent operator (Cunill, 2006). Caves and Murphy (1976), as cited in Sorenson and Sorensen (1991: 713) suggest that "[f]ranchising appears particularly common among chains-including restaurants, hotels, and small business services […] entrepreneurs license the chain's business concept: the right to use its brand name and access to its marketing strategies, organizational routines and operating manuals". It is common practice to offer the latter effective methods of marketing such as promotional techniques, pricing structures, product information, distribution methods and critical information regards competitors, their customers and the independent operator itself (its history, key success factors, culture and future) (Carney and Gedajlovic, 1991). Thompson (2004: 31) states that the "[s]hared use of the brand name", which is "an asset owned by the franchiser", "creates an obvious potential for cost-saving quality reductions by the franchisee with consequent externality effects elsewhere in the franchise chain". Dant and Kaufmann (2003), as quoted in Watson et al. (2005: 26) add that "franchisees bring to the franchise system not just financial capital, but also a knowledge of geographic locations and labour markets, and their own managerial labour" and that after all, one could say that "they represent an efficient bundled source of financial, managerial and information capital".

The services economy sector has undergone a transformational change as supply and demand, competitive landscape and the customer's greater consumer power and decision-making ensures that service providers such as restaurants must maintain profitability to remain competitive within the market. Within the restaurant industry it's common place to observe both franchised and company-owned outlets which are known as the franchise proportion (Lafontaine, 1992). Kaufmann and Dant (1996) remark that companies actively try to control the ratio of franchising outlets to that of company-owned in order to retain a balance of ownership, control and profitability.

Agency Theory and Resource Scarcity Theory related to the motivation of Franchising

The use of franchising has predominantly been explained by agency theory and resource scarcity theory (Aliouche and Schlentrich, 2009; Watson et al., 2005). Bergen et al. (1992: 1) posit that "[a]n agency relationship is present whenever one party (the principal) depends on another party (the agent) to undertake some action on the principal's behalf". If we relate this to franchising then the principal is the franchisor and the agent becomes the franchisee, where agency theory implies that enterprises always seek to minimise organisational costs by, according to Norton (1988) aligning the incentives of principles and agents so that the incentive for a franchisee's efficiency is profit. Additionally as the independent operator has a part ownership in the unit then it's unlikely that the individual will not take the growth of the business and profitability seriously. This theory looks to alignment of both the independent operator and the franchisor which ultimately lies at the heart of reducing cost but maximising profitability. According to Combs and Ketchen (1999: 197) "the advantage of franchising is that by transforming outlet managers into owners, franchising induces franchisees to maximize outlet profits and greatly reduces the need for direct monitoring by the franchisor". In contrast Hsu and Jang (2009: 205) assert that "agency theory suggests that firms decide on franchising because they are unable to efficiently monitor their managers as they grow", and "that managers tend to shirk their duties when their compensation is fixed".

The resource scarcity theory, as the name suggests looks to companies to franchise so they can stretch their resources further (Aliouche and Schlentrich, 2009). Carney and Gedajlovic (1991), as cited in Combs and Castrogiovanni (1994: 38) conjecture "that franchisors buy back their most profitable franchises as they mature" because clauses in the franchising agreement regards rent entitles them to the additional revenue stream. This theory can be looked upon as a life-cycle where in the beginning franchises are offered out to independent operators for financing, which as the company matures and accumulates profit the franchisor buys back the franchise (Oxenfeldt and Kelly, 1969). Therefore it can be assumed that if resources are increased the motivation to continue franchising and the population of franchised operations decreases. Combs and Ketchen (1999) undertook a study of 91 publicty-traded restaurant chains which revealed that those companies who struggled for financing were increasingly more likely to use franchising for expansion.

Profitability of franchised restaurants

Aliouche and Schlentrich (2009: 4) argue that "[g]iven the success and popularity of franchising, it may seem evident that franchising helps firms achieve superior financial performance". McDonalds for example has a franchise scheme in the UK which offers them a front-up fee ranging from "£150,000" - "£500,000" dependent on the predicted "cash flow" it will generate. They offer two schemes such as the "Conventional franchise" requesting "25%" of the purchase price, and the "Business Facilities Lease (BFL)" for those without the financing to cover "25%". The stipulation is that the generated cash flow is used to raise the funds needed to purchase the franchise within the first three years (McDonalds, 2007: 25). The success of McDonalds franchises are exhibited in the numbers, where they declare that ROI (return on investment) should yield at "20% per annum" with "profit margins" no lower than "6%" rising to "8%" creating a profit of "£90,000" per franchise per year (McDonalds, 2007: 28). McDonalds (2007: 29) quotes that they "doesn't need your money. What we do always need, however, are committed individuals with a proven track record of success in people development, people management, sales and marketing". Another example is Vapiano a restaurant franchising chain which is worldwide common as well but not well-known compared to McDonalds, Burger King or Pizza Hut. With Vapiano the franchise front-up fee costs simply about £30,000 and is not dependent on the predicted cash flow it will generate (FranchiseKey International, 2009).

This is a strong signal to potential candidates about the untapped profitability and success a McDonalds franchise can generate in the hands of an ambitious franchisee. Evidence from Hsu and Jang (2009) and Economic Census 1992 (1997) suggests that corporate franchises possessed higher survival rates than non-franchised due to the support of the parent company or franchisor which may suggest that the mutually beneficial relationship between the both may lead to greater profitability.

However what we must take into account when discussing profitability and franchise restaurants is the question: At what point is the franchisee entering into the life cycle of the company? Are we taking account of the fact that the enterprise might be new to the industry, or indeed an established player in the market, further what experience does the franchisee have? Maybe they are novices to business therefore profitability may not be as great as an established franchisee with multi-establishments and strong relationships with suppliers, distributors and customers. These factors determine the profitability of a franchised unit.

Profitability of non-franchised restaurants

When we look at non-franchised restaurants there are several key factors which influence the success and ultimately profitability of these stand-alone ventures. One needs to understand the market and barriers they are attempting to enter: What are they and are they high? Is the competition a monopoly, duopoly or are there many other players possibly with franchises also? What are the current laws and regulations? Will they be changing soon, or introducing more which will possibly impact my business? Who are my suppliers, distributors and wholesalers? Are they currently only exclusive to other restaurants or do they undertake business with everyone within the industry? (Caves and Porter, 1977)

Additionally, one have to understand the customers: Have I undertaken sufficient analysis of my market research to create assumptions over their willingness-to-pay, switching costs and motivational factors? Where should I pitch my marketing strategy? Do I fully understand the effectiveness of promotional activity and advertising? What pricing techniques am I going to use? On what basis is my selling point for my products: differentiated from the rest, lower cost, more volume etc.? (Kotler et al., 2006)

Finally, and probably the most critical of all is whether non-franchised restaurants possess sufficient capital to finance the operation? Research by Bates (1995: 27) shows that the CBO "the Census Bureau - the Characteristics of Business Owners" suggests that many under-capitalised creating problems are from the onset which have a significant effect on profitability. What can be concluded from this is that those wanting to 'go it alone' have many important factors to consider within their business plan, therefore if their calculations and theory are logical and well-presented put themselves at a competitive advantage than perhaps a novice franchisee (Stanworth, 1991; Economic Census 1992, 1997).

What effect do company owned restaurants have on the profitability of the franchising system

Botti et al. (2009: 566) argue that "[p]lural form tends to be the most popular organization form in […] service networks compared to purely franchised or purely company-owned systems". Building on Kaufmann and Dant (1996) who remarked that companies actively try to control the ratio of franchising outlets to that of company-owned restaurants in order to retain a balance of ownership, control and profitability suggests that there is a favourable ratio between both which optimises profitability. Hsu and Jang (2009) believe that there is an optimal franchise proportion which, if all other variables are kept constant can mutually benefit both groups. Additionally, Lafontaine and Kaufmann (1994: 99-100) argue that "franchising is initially the most efficient source of capital […] as the system matures […] the proportion of company-owned outlets will increase as the franchiser moves toward a completely company-owned chain. Only the marginal outlets, e.g., those located far from company headquarters, or those facing low demand, will remain in the hands of franchisees".

Successful company owned (non-franchised) restaurants generate positive effects for local similar franchised restaurants through a variety of ways: competition, which ensures that there are customers interested in the products you sell, thus reducing your advertising costs within a captive market. It ensures that the franchisee doesn't become stale and instead looks to new innovations within its service which have the potential to create more sales. Furthermore, company owned restaurants during the recession have partnered with other local business to share suppliers, distributors and wholesalers to reduce cost which has enabled the franchisee the opportunity to increase its profit margins. Additionally, Shane (1996), as quoted in Combs and Ketchen (1999: 204) argues that "by agency considerations, some firms may also be franchising outlets where monitoring could be accomplished most efficiently through company ownership. The result, at least in the short run, may be reduced financial performance. Whereas growth and survival can be enhanced by franchising […]".

One of the main disadvantages of franchised operations is the lack of control on issues such as quality, productivity and culture which the parent company has established over time within its brand. For the franchisee rather, the quest for optimal sales often means that these defining characteristics are ignored for the sake of profitability and growth. If we relate this to the above theory it drives down profitability as customers won't be willing to buy if quality is reduced and if switching costs are low will turn to competitors such as the company-owned restaurants. Sorenson and Sorensen (1991: 717) argue "that company owned units tend to engage in exploitation while franchised units more frequently explore" and further on Brickley et al. (1991: 30) argued "[t]he agency-cost arguments […] suggest that the optimal ownership of individual units can change over time". Hsu and Jang (2009: 209-210) argue that "franchising should improve franchisor profitability and intangible value", "restaurant firms choosing to expand through franchising may have significant advantages over firms that are pursuing growth through company-owned outlets" and that "[h]aving both company-owned outlets and franchise outlets can create synergies, contributing to increases in profitability".

Summarising the findings and arguments, it can be said that the two theories, agency theory and resource scarcity theory, who explained the franchising motivation imply that specific service firms as restaurants, which choose to spread out through franchising may have considerable advantages over non-franchised restaurants. Furthermore, the both theories point out that the franchisor profit from the franchisee's resources, particularly financial and managerial resources, because of the fact that the franchisor can reduce their own amount of risk. However, this study points up that franchised restaurants had higher profitability than non-franchised restaurants. Additionally, it was found out that there exist a positive effect regarding a mix of franchised restaurants and company-owned restaurants.

Recommendations for franchised restaurants in terms of profitability

Undertake a full examination of the market and industry in which you are about to enter. What are the barriers to entry? How high are they? What other franchises are present and how saturated is the current market?

Ensure that you have adequate financing for the franchise, either through own invested capital or through bank loans. When preparing your business plan use a mixture of common sense, sound logic and theory for your calculations which are checked by a professional and if possible an expert in the industry.

Look for franchises where the product is already established in the market thus will require less marketing and promotional tools to create consumer awareness.

Additionally speak to other franchisee's in the area and sound out their costs and profits within a day, week, month related to their structure and ownership. It's possible that you could source raw materials from the same supplier and distributor, buy in bulk with the other unit halving your cost and increasing your profit margin.

Recommendations for company owned restaurants in terms of profitability

Undertake a full examination of the market and industry in which you are about to enter. What are the barriers to entry? How high are they? What is the competition like? How saturated is the current market and how well are other independent restaurants doing at present?

Differentiate yourself from competitors through alternative marketing strategies, an advantage which cannot really be utilised by franchisees. Look to Social Media Marketing through creation of online communities discussing your new menu, dishes and chefs for instance.

As commodity prices rise (for instance corn and wheat) and raw materials become more expensive look to create a menu which utilises seasonal produce at a cheaper price. Additionally greater profit is traditionally yielded from starters and desserts so look to offer specials on these dishes so that customers don't skip these on their visits.