Paper presented at theEMNet-Conference on

"Economics and Management of Franchising Networks"

Vienna, Austria, June 26 – 28, 2003

Performance of Franchising Networks:

Conceptual Framework

(Second version)

Nina Gorovaia

Frederick Institute of Technology

Nicosia, Cyprus

Tel: 00357-99651709

E-mail:

Abstract:

This paper works out a conceptual framework for studying the performance of franchising networks. Franchising networks, which originally developed in the context of Western economies, are currently operating in transition economies as well. Some franchising networks fail and some succeed. The paper views performance of networks as a complex process of adaptation to the environment. Characteristics of networks, which appear due to the environment, influence the drivers of performance, i.e. the factors that are responsible for the networks’ success or failure. The paper is theoretical and makes use of different sources of evidence: empirical and theoretical studies on franchising and inter-organisational networks. The conceptual framework is finally tested on a small case study of two franchising networks operating in Russia.

JEL-code: Franchising Networks, Performance, Flexibility, Information Exchange, Innovation and Learning

Outline

I.Introduction......

II.Definition of franchising networks......

III.Institutional environment of a transition economy......

IV.Performance of franchising networks......

A. Flexibility......

B. Information exchange......

C. Innovation and learning......

IV.Conceptual Framework......

A. Sociological and Economic Traditions of Network Research......

B. Economic Theories for the Study of Networks......

C. Sociological Theories for the Study of Networks......

D. Conceptual Framework for the study of Performance of Franchising Networks......

V.Empirical case study......

VI.Conclusions......

VII.Bibliography......

I.Introduction

With people waiting in line for three hours to get into the first McDonald’s restaurant opened in Moscow in 1990, the concept of franchising was brought to Russia. After almost a decade this concept does not sound unfamiliar any more. Lots of Western companies like McDonald’s, Alphagraphics, Pizza Hut and MicroAge Computers as well as local Russian companies are using franchising to enter new markets and distribute their products. Forming franchising networks is considered to be a promising business strategy for the development of small and medium enterprises. However, this strategy has not been fully exploited yet (Sanghavi, 1998: 37).

The reason franchising has not been explored yet is that the operating environment of a transition economy is significantly different from that of the Western countries. Specific contexts of transition economies represent certain challenges for operating franchising networks. Some of those challenges are “incompatible business practices, infrastructural deficiencies, underestimated costs of imported ingredients, tariff barriers for input components, the absence or misjudgement of the required demand, lower purchasing power of the target groups etc.” (Sanghavi, 1998: 38). Another aspect is protection of industrial and intellectual property rights which are of critical importance to franchising. Institutional and legal environment of transition economies does not provide enough support to franchising networks from this point of view.

We need to understand the obstacles for development of franchising networks in a transition economy and the mechanisms adopted by franchising networks in order to overcome those obstacles. What do franchising networks do to compensate for the lack of legal protection? In other words, what are the characteristics the networks adopt to succeed in the context of transition economy and how they become successful?

The objective of this paper is to elaborate conceptual framework for the study of performance of franchising networks in different environments. This conceptual framework should be able to explain real cases of success and failure of franchising networks operating in different environments and offer managerial solutions how to make the network fit to operate in a given context. Furthermore, the paper aims to suggest how to test conceptual framework on empirical cases. In general the objective of this paper is to prepare a solid ground for the empirical analysis of the performance of franchising networks. Although the conceptual framework is not limited to the analysis of franchising networks in transition economies, Russia has been chosen as an example.

The paper is organized as follows: first, the institutional environment of Russia is reviewed. Second, the performance of networks is analysed. Factors such as flexibility, information exchange and innovation, and learning which are responsible for the network’s success are outlined. Finally, a conceptual framework, which combines arguments from the economic rationalism and social embeddedness theory, is formulated. A small empirical case study is conducted to test the conceptual framework.

II.Definition of franchising networks

Organisational networks can be defined as

“as form of economic activities that aims to achieve competitive advantages, it is characterised by complex – reciprocal, more co-operative than competitive, relatively stable relationships between juridically independent but economically dependent companies” (Sydow 1992:79, trans. NG).

Under the following requirements organisational networks can be defined more precisely as strategic networks: a network has clearly formulated strategic objectives, it is designed to achieve competitive advantages and is managed by one or several focal companies (Sydow 1992: 81). Franchising networks belong to strategic network type, because they appear as an outcome of intentional strategy, they consist of juridically independent companies and all the companies have common economic objectives. These companies are usually managed by franchisor or master franchisee. Franchising can be broadly defined, including all inter-firm agreements in which a firm [Firm A] authorised another firm [firm B] to conduct business using its [i.e. Firm A’s] trade or service marks as their [Firm B’s] primary means of identification to its clients. Also included are firms with company-owned operations as a prelude to expansion through franchising (Beilock et al, 1998).

III.Institutional environment of a transition economy

Recent studies on franchising in Russia have indicated that the environment in Russia is characterized by high political risks, government instability, monetary instability, underdeveloped infrastructure, crime and corruption (Alon and Banai, 2000). Regulations in respect to franchising are considered to be “the strongest disincentives to the establishment of franchises in Russia possible”(Mendelsohn: 1996).

On the other hand a huge market potential, vast pool of educated, skilled labour, and an unsaturated market are very favourable factors that attract Western companies. Alon and Banai point out that

“…Russian market is simply too large to be ignored, but it is not without problems. Where some see threats, others see opportunities… Political and economic risks are attractive because they deter competition. A preemptive move into the market can lock the competitors out in future” (2000).

Sanghavi argues that “a difficulty of importing foreign franchise systems is in their compatibility with the local environment” (1998: 38). Franchising networks have to make organisational, cultural, legal and other types of adaptations. With all the opportunities and obstacles for development, franchising networks develop their own ways of doing business and either become successful or leave the market. E.g. Pizza Hut, KFC and Dunkin’ Donuts decided to scale back or leave the Russian market (Alon and Banai, 2000). Companies like McDonald’s found their own way to cope with the unfriendly environment by investing in ancillary industries, including food processing facilities, a meat plant, a bakery, a potato plant, a dairy, and quality assurance labs (Alon and Banai, 2000). Also McDonald’s entered into a joint venture agreement with the City of Moscow that smoothed out lots of domestic challenges, such as strict regulatory requirements and adverse social conditions (Alon and Banai, 2000).

Therefore, the context of transition economy pushes franchising networks in finding innovative ways to cope with obstacles, and form specific relationships between franchisors and franchisees in order to compensate for lack of institutional support.

IV.Performance of franchising networks

To perform successfully franchising networks need to adjust to the specific context of a transition economy and their market conditions. Carlsson describes a case of McDonald’s opening its restaurants in the environment of a transition economy: “Working the system is the only way to get things done in Russia…Western companies will never change the system. They can only be successful if they learn how to "work the system" as McDonald's did” (1995).

The literature on networks gives account of the following factors that are responsible for the networks’ success: flexibility in management of the network, building trust with partners, regular information exchange with partners, constructive management of conflict, managing partner expectation (Gulati, 1998: 306). This paper investigates in greater detail the following factors that are responsible for the performance of the network: flexibility, information exchange, learning and innovation.

A. Flexibility

Many organisational studies have indicated flexibility as a major property of networks. Increasing uncertainty of the environment requires organisations to be flexible. Flexibility in this context does not only mean capacity to change network’s output according to contingencies but also capacity to change the organisational arrangement itself. In this sense, networks are hypothesized to entail lower transaction costs with respect to internal organisation – and some forms of network of being more conductive to self-change than others.

Franchising can be a flexible form of network especially as regarding to expansion to large territories. Since the franchisor does not have to manage franchised stores itself but leaves that for the franchisee, it is easier to expand, especially over a large territory. Maylor and Read (1998: 581) analyse total quality management in franchising networks and make a point that “flatter organisational structure” contributes to better performance. When managers experience directly capital and market pressures and when they have a personal stake in the profitability of the firm, it is considered to be an “ideal structure for achieving excellence in quality performance”.

Dunkin’s Donuts decided to close all the four outlets in Moscow because of its inability to find potential franchisees and spread the network. Another example of an effect of flexibility on performance is Baskin Robbins that is doing well in Russia because of its well-spread network of franchisees (Alon and Banai, 2000).

What characteristics of networks contribute to higher flexibility?

Authority structure - decreasing of hierarchical levels, assignment of all control tasks to the lowest organisational levels, less control by the owners, decentralisation, concentration of decision making in a small group of top-executive directors contribute to higher flexibility.

Longevity of co-operation - Long-term contracts and long-term relationships with suppliers can achieve many of the same cost benefits as backward integration without calling into company’s ability to innovate or respond to innovation. Long-term contracts with independent companies ensure continuous production/distribution process, while the focal company enjoys cost benefits, higher flexibility and runs less risks. On the other hand, in the environments characterised by high uncertainty, backward integration provides more security.

Size of the companies - Empirical investigations have shown that large enterprises, organised as alliances of smaller companies can achieve higher flexibility and efficiency than single-plant enterprises. Semlinger (1993:166) explains this phenomenon by the fact that larger firms are often unable to turn higher efficiency into greater profitability. Big companies usually have higher wage and non-wage labour costs, higher administrative costs, more social obligations.

Also the size of franchise fees and start up costs influences the ability of a franchising network to spread. “Most Western franchisors have franchise fees and start-up costs that are beyond the reach of the average Russian investor”. Allied Domecq waived the franchise fees for its initial Baskin-Robbins investors in Russia but will eventually charge some as it develops greater brand name recognition and acceptance by consumers (Alon and Banai, 2000). In this way, Baskin-Robbins has royalties as a main source of revenues. Therefore, the strategy of a franchisor regarding royalties and franchise fees is likely to influence the flexibility of the network.

B. Information exchange

Since most of the important information transmitted between the parties is of tacit rather than codified character, information exchange represents a factor that contributes to better performance. Wolfe (2000:7) makes a point that “easier and cheaper access to information reduces the economic value of more codified forms of knowledge and information”. Therefore, the forms of knowledge that cannot be codified and transmitted electronically (tacit knowledge) increase in value, as well as ability to acquire and access both codified and tacit forms of knowledge. While discussing how information exchange contributes to better economic performance it is important to note that only exchange of unique/novel information as well as exchange of tacit knowledge often in combination with codified knowledge contributes to better performance.

Windsperger (2002:129) refers to the knowledge transfer as “intangible assets between the franchisor and the franchisee, i.e., the brand name of the franchisor and the local know-how of the franchisee”. Since the intangible assets, and returns from them are difficult to stipulate in the contract, difficult to control and difficult to monitor, the ownership of the assets becomes a critical factor for the success of the franchising network. Windsperger (2002: 129) argues that “ownership should be given to the franchisee when he has to make intangible investments that generate a large fraction of residual income”. He goes on explaining that ownership increases the bargaining power concerning the division of residual income and therefore gives incentives to make intangible ex ante investments. The fact that the franchising network of McDonald’s in Russia represents a network of corporate-owned rather than franchises supports the argument, that when high returns from intangible assets are involved, the preferred form of networks structure will be based on ownership.

Granovetter in his well-known article The strength of the weak ties (1982) has proposed that strength of the ties is a decisive factor for information exchange. Weak ties are extremely important because they give access to novel information and connect people to social groups they are not familiar with. In contrast to strong ties weak ties are likely to give new and possibly useful information from the new spheres. Though participants with strong ties are likely to be strongly motivated to assist, since they have common aims, interests, backgrounds etc., they will most likely produce redundant information, whereas weak ties can transfer information from one social milieu to another.

Trust not only enables greater exchange of information, it also promotes ease of interaction and a flexible orientation on the part of each partner. Trust encourages the disclosure of useful information. In many network approaches trust has been found to be “the glue that keeps the partners together” (Osterloh, Weibel: 2001). This can create enabling conditions under which the success of a network is more likely. Finding the right partner is considered to be one of the key success factors in the Russian market. A local partner can help sorting out the operational problems. Alon and Banai point out that a government official or agency is often preferred because of access to key resources and additional protection from mafia (2000). McDonald’s and Vision Express managed to overcome many problems due to the right contacts with Moscow officials, while Blue Kristal and Subway failed because of having wrong partners (Alon and Banai, 2000).

C. Innovation and learning

Both practitioners and academics have identified organisational learning as perhaps the key factor in achieving competitive advantages and superior performance. Lundvall and Borrás (1997a; 1997b) underline that in a context of increased market competition a given set of competencies is no longer the most important for individual firms, but rather the capacity to acquire effectively new ones. A rich literature on organisational learning (Kogut 1993, 2000 etc.) suggests that the firm’s ability to continually learn, adapt and upgrade its capabilities and competencies is key to competitive success.

It is important to note, however, the distinction between two drivers of performance: information exchange and learning/innovation. Exchange of novel relevant information is a complex social process, as compared to easy information transfer, for example, through computer networks. Only access to unique information can enhance the overall performance of the network. Competitive advantage is no longer limited to acquisition of codified knowledge that is available world wide. It is more dependent on the acquisition of unique and tacit knowledge as well as utilisation of knowledge. Learning includes both possessing of knowledge as well as ability to utilise it. Lundvall and Borrás (1997a: 29) point out that learning includes also intuitive elements:

“the capability to interpret and act intelligently when confronted with complex patterns and different kinds of know-how are knowledge elements which are crucial for economic performance and which are essentially tacit in nature”.

Many studies have indicated that the ability of the firms to innovate is critical to their performance. However, not all the individual companies can develop innovative products internally. Therefore, they try to adopt knowledge through other companies and form innovative networks. The modern term of innovation does not include scientific research alone, but all the different steps of the process until a new product or production process has been launched in the market (Lundvall and Borrás, 1997a). The ability of an organisational network to innovate enhances the overall performance, although the contribution of individual members can differ significantly.

Franchising includes transfer of management skills to countries, which are culturally different. Potential franchisees often lack business experience. This is not a big problem, since franchisors often favour relatively inexperienced people to run a store, since they are going to train them anyway. However, the success of the network depends on how well the system knowledge about the business and the brand will be transferred from the franchisor to the franchisee and how well the knowledge of local market conditions and country specific knowledge will be transferred from the franchisee back to the franchisor.

Strength of the ties: Augier and Vendelø (1999) suggest that organisational learning is enhanced when, technically skilled employees are encouraged to collaborate with like-minded individuals elsewhere. This leads us to assume that exchange of tacit knowledge improves the results of learning processes. Turning to the concepts of tacit and explicit knowledge Augier and Vendelø (1999) point out that tacit knowledge is best transferred through strong ties, whereas when weak ties exist between two parties involved then the transfer of tacit or non-codified knowledge is difficult. This happens because strong ties allow face-to-face interaction between the two parties involved in transfer, and thus, the environment used is suited better for transfer of tacit knowledge. Also the existence of strong ties makes knowledge transfer easier because the parties are likely to understand each other well, because they share common backgrounds. In contrast, codified knowledge is equally well transferred through weak and strong ties and in both cases knowledge is most easily searched through weak ties (1999: 255). The efficiency of strong and weak ties for knowledge sharing depends on the tacitness of the knowledge to be shared. Strong ties are best if the knowledge to be shared is tacit and non-codified, whereas the opposite is true for weak ties.