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Economics Essays – Franchising System Services

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Published: Tue, 08 Mar 2016

Franchising System Services

Introduction

The practice of franchising is widespread in most Western economies and also has been predicted to become leading form of retailing in most of the developed countries within the worldwide. Franchising became the trendiest system of expanding commercial retail stores rapidly with lower capital risk during the 1990s in the United States (Lafontanie, 1992).

In addition, franchising characterized by locally owned outlets which delivery services according to a standardized model, such as McDonalds, Starbucks or The Body Shop have become omnipresent in all developed and many developing countries. Franchising obtained a huge success in the USA, where over half of all retail sales are generated through franchised outlets.

Nowadays, franchising system is used around the world to sell over 1 trillion dollars worth of goods and services every year. In the UK it is estimated that there are29, 100 franchised businesses employing around 273,000 people. Around an eighth of these franchises operate in the UK hospitality services sector. While franchising has been prevalent in UK and it has emerged as an essential factor of the hospitality services sector. Franchising is proving to represent a major instrument of growth in the modern hospitality services sector. It has a particularly powerful efficiency to extending for hospitality services sector and has been adopted by many hotels, fast food and restaurant organizations. Franchising represents a more fundamental development in business organization that enjoys an increasing global presence in the hospitality services sector.

Aims

This essay aims to explain what is franchising and the operation process in generally. In addition, the essay will centre on discussing the benefits and limitations of franchising on marketing and financial sector. Finally, the challenges and opportunities of franchising in China will be examined in this essay.

What is franchising

Franchising is a business strategy for getting and keeping customers and also it is a marketing system for building an image in the minds of current and future customers about how the company’s products and services can help them. Moreover, franchising is a scheme for distributing products and services that will satisfy customer needs.

Franchising is a legal contract which includes a brand owner (the franchisor) and a local user (franchisee) to sell products or services under the owner’s trademark employing a production process developed by the franchisor. Once a franchise contract is signed, the franchisee pays a franchise fee to franchisor. After signing the contract, the franchisor gives the franchisee a package of needed services to open the unit, in which including training and plan for the production process, giving support for location selection and construction management.

After opening, the franchisor affords periodic inspection of the franchise to assure operating standards are being followed and marketing services such as advertising and development of new product. The franchisees pay a royalty on sales (normally ranging between 1% and 10%) and a royalty for marketing operating cost (from 0% to 6%) that generally called the advertising fee as return for offered service by franchisor. (Lafontaine, 1992) The franchise system is created by units franchised to local operators and units possessed by the franchisor; both types operate the same production process and sell under the same trademark. Lafontaine (1992) found that, in her data on more than 500 franchise systems, the average percentage vertically integrated in a system was 17 %. In addition, in the International Franchise Association (2006) report found the average percentage in their sample was 20%.

Marketing and financial Benefits and limitations of franchising

The generally agreed benefit of franchising that is franchisees instant access to a proven marketing concept. Housden (1984) and Mendelsohn (1990) insisted that franchisees benefit significantly from the franchiser’s experience and expertise and save both time and money at beginning established business. Mendelsohn (1990) also points out that franchisee have access to considerable market information accumulated by the franchiser which would be too expensive to procure. Therefore, many of literature indicated the benefit of franchising is accessing a ready-made business.

However, as franchisee depend on their franchiser’s expertise and experience in developing the business system, so franchisees are vulnerable depend on their franchiser’s predictions of attaining a critical size to achieve economies of scale and market recognition. In addition, in some case the franchiser may put strict controls on products and services sold that has obviously influence on franchisee profitability. Moreover, these controls may prevent franchisees from seizing opportunities to meet local demand for additional products and services. (Housden,1984)

A further significant advantage of franchising that is franchisees were identified as the well-known name of the business. Housden (1984) feature this ready market of brand-loyal customers to the system’s credibility, strength and stability and their cooperative. However, the benefits of public identification and brand well-know may be invalidated if franchisees risk the system’s reputation by poor performance. (Housden,1984)

As previously discussed, a significant benefit for franchisees is an instant access to a ready-made business. This has operational implications a furthermore marketing benefits that are all operational systems and generally documented in an operations manual which have been designed, tested and modified in the light of experience (Housden, 1984). Consequently, the potential marketing benefits and limitations of franchising were investigated in the study-benefits of a ready-made business, well-known name of the business and protection from poor franchisees harming the trademark.

The frequently cited financial benefits from franchising that are increased profitability and reduced financial risk. As Mendelsohn (1990) contended that franchised outlets become feasible and achieve positive cash-flow more speedily than independent businesses, due to their market recognition and the elimination of unnecessary start-up expenses. In addition, Housden (1984) confirms that the reduced working capital, probability of extended credit on supplies and cheaper equipment are contributors for profitability increasing. Nevertheless, there are extensive empirical evidence indicate that franchisees do not always obtain benefit from cheaper supplies accruing from economies of scale. Moreover, the effect of cost of supplies on profitability is aggravated in franchised outlets due to product selling prices are usually imposed by the franchiser. ( Housden, 1984).

Therefore, the potential financial benefits and limitations of franchising were examined in the study-payments made to the franchiser, reduced financial risk cost of supplies, profitability, selling prices imposed by the franchiser.

The challenge and opportunities of Franchising in China hotel industry

In the hotel industry, it is commonly agreed that franchising was initiated in the 1960s as an expansion strategy for Holiday Inn and other brands (Altinay 2003). In recently years, more and more hotel companies have introduced franchising as expansion strategy. According to International Franchise Association (2006), more than 70% of the US hotel room supply was franchised, and also the increasing number of franchised hotels makes the lodging industry the tenth largest franchised industry in the United States.

However, franchising is not very popular outside the United States. For example, in Europe and Asia/Pacific, branded hotel rooms (including both management contracts and franchises) account for only 18% and 15%, respectively, of all hotel rooms (Altinay, 2003). Therefore, franchising is considered a potentially significant growth strategy by most international hotel chains in the near future.

1) Franchising in China hotel industry

In general, hotels in China still prefer foreign management by the brand names especially foreign invested and up-market hotels. However, the most often form of foreign operation is management contract, not franchising. The reason may be due to some companies think it is risky to franchise without strong attendance and experience in China.

Therefore, the “management first, franchise later” strategy (Cruz, 1999) is most popular used for international hotel management companies to enjoy the benefit of operation with lower risk in China. Many researchers indicated that China is be a very vital future market for hotel industry and, although in China franchising still is less popular business form, the enormous potential of the tourism market may attract franchisors.

China has a large market for economic development, vast territory with many industry and trade centers and a large volume of population, all of which build a well environment for franchising. However, the many defects associates with development of market that are incomplete infrastructure (though it has improved significantly in recent years), and poor knowledge or culture of entrepreneurship.

Therefore, for China’s hotel industry more advanced technology is needed which transfer from other mature hotel operations. In Generally speaking, a big country is more expected to produce more franchising businesses than a small one. Franchisors need a solid base to develop operation systems, and more franchisees in a country are more helpful for franchisors to take full advantage of what they could offer.

2) The environment for franchising in China: ownership, connection and commercial culture

As China has a big gap on traditional culture with western countries, it is doubtful that franchising can work very well and take root there due to it is considerated a pure western business format .However, in the hotel sector, some companies’ franchising still have good performance in China. For example, Holiday Inn expands faster and operate a big chain of hotel, with 18 hotels under management and ten projects under negotiation, by franchising in China. Though the current small-scale franchising in China’s hotel industry goes on, a better understanding of the Chinese environment will be helpful for more and more franchisor enter into China’s hotel industry.

a) Ownership and franchising

One of the essential problems in the negotiation or partnership agreement is ownership and control assets and operation (Du and Dai, 1998). In generally speaking, franchising is based on the motivation of franchisees in search of more profit. In China, most hotels belong to state-owned that controlled by different government bodies. The ownership system may cause many problems, primarily may resulted hotels are not profit conscious.

For many hotel owners in China, control of a hotel is generally considered more much more significant than produce profit. Therefore, those hotels in control do not favor franchise or contract management by another party. The ownership system of reform is the fundamental step for China’s hotel chain operation. Only after the owners of hotel have more concern for their improvement of performance, the franchising or management contracting is adopted as a possible form of chain operation in China. (Du and Dai, 1998)

b) Franchisor-franchisee relationship

The successful franchising is based on the willingness of both parties, which are franchisor and franchisee, having a common objective and the creation of a partnership in the course of ongoing operation. The franchising system cannot have good performance when the franchisee doubt whether the franchised brand can bring the expected benefits and the franchisor fears the possible spoiling of his trademark and corporate image by franchising poor operation. (Du and Dai, 1998) Therefore, communication, understanding and trust are very necessary between the two parties in the progress of franchising.

In China, there is a big change in management or franchise contracts that is their years of duration have become much shorter than before in recent years. In 1980s, most contracts signed have a duration of 15 to 20 years, which puts the franchisee in a less flexible situation (Bell, 1993). In generally, shorter contract duration, negotiable franchisee fees and better service of the franchisor are inevitable trends. Therefore, the change in contract duration has positive contribution to attract more and more franchisors entering China hotel market.

c) Chinese commercial culture

As China has a different culture and business tradition with western country, the franchising in China should be cautious of its customs. Saunders and Renaghan (1992) indicated that feature of Chinese commercial culture includes: entrepreneurial style (looking for short payback periods and being acutely conscious of risk and control), nepotism (family members actively involved in running hotels), pragmatism (taking actions less than optimal from a strict business perspective), and confidentiality (secrecy and distrust of outsiders, sparse information exchange). As a result, the franchising system should be introduced to a more specific context with a certain degree of flexibility in China. (Saunders and Renaghan 1992)

In addition, Guanxi (personal connections and favoritism) plays a significant role in China’s business operation. It could be an approach of facilitating and assuring trade, but it could also ruin the business. Therefore, as franchising is a process of networking, wide and tight business Guanxi with hotel owners and investors and operators are very necessary to establish franchisor presence in China.

Therefore, China’s hotel industry will expand considerably to cope with the forecast massive future increases in domestic tourists. This situation presents a great opportunity for franchising of hotels in China. However, a complete understanding of China’s unique business, social, cultural, economic and political context is necessary for franchising successful adapted in hotel industry.

Conclusion

To sum up, franchising has become the trendiest system of expanding commercial retail stores rapidly within the worldwide. It is the cost-minimizing organization form in the presence of low levels of both human capital and business risk. Furthermore, through franchising system, the franchisees can instant access to prove marketing concept and easily obtain considerable marketing information. In addition, as the franchisees enter into a ready and mature market by franchising, which will be contributor to increase profitability and reduce financial risk.

However, the franchising has its limitation such as franchiser may put strict controls on products and services sold that has obviously influence on franchisee profitability. These controls may prevent franchisees from seizing opportunities to meet local demand for additional products and services. In addition, like the given example, though the franchising in China has its challenges, there still have huge opportunities to adapt franchising successful.

While a full understanding of China’s peculiar business, social, cultural, economic and political context is essential for foreign companies to succeed, whilst existing and new indigenous companies require greater technical and operating expertise along with the necessary business acumen to operate hotel chains. Further franchising studies are highly recommended.

References

Altinay, L., Altinay, M., 2003. How will growth be financed by the international hotel companies? International Journal of Contemporary Hospitality Management 15 (5), 274-282.

Bell, C.A. (1993), “Agreement with chain-hotel companies”, The Cornell HRA Quarterly, February, pp. 27-33.

Cruz, T.D. (1999), “Brand loyalty”, Hotels, March, pp. 51-4.

Du, J. and Dai, B. (1998), “Market base and development strategies of national hotel groups”, Seminar on Theories and Practices of Conglomerates in Chinese Hotels, 20-22 November, Beijing

Housden, J.(1984), Franchising and other Business Relationships in Hotel and Catering Service, Heinemann,London

International Franchise Association, 2006. Retrieved January 18, 2007, from /http://www.franchise.org/uploadedFiles/IFA_NEWS/1500_ 8273644.pdfS

Lafontaine, Francine. 1992. Agency theory and franchising: some empirical results. Rand Journal of Economics 23:263-283

Mendelsohn, M.(1990) The Franchiee’s Guide. Franchisors Association of Australasia, Wilberforce,NSW

Saunders, H.A. and Renaghan, L.M. (1992), “Southeast Asia: a new model for hotel development”, The Cornell HRA Quarterly, October, pp.16-23

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R. DANT and P. KAUFMANN (1995) Introduction. In Franchising: Contemporary Issues and Research (P. KAUFMANN and R. DANT, eds). pp 1-4. The Haworth Press, New York.

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R. DANT (1995) Motivations for franchising: rhetoric vs reality. Int. Small Business J. 14, 10-32.

R. DANT, P. KAUFMANN and A. PASWAN (1992) Ownership redirection in franchised channels. J. Public Policy and Marketing 11, 33-44.

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