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Paper to be presented at the EMNet-Conference on
"Economics and Management of Franchising Networks"
Vienna, Austria, June 26 – 28, 2003
www.univie.ac.at/EMNET
Authors
Dieter Ahlert, Peter Kenning, Heiner Evanschitzky
University of Muenster, Germany
Abstract
F&C networks constitute the fastest- growing form of organizing economic activities especially in the service and retailing sector. Nevertheless, the phenomenon of “fFranchising” as one example of ann F&C network has received relatively little attention in academic research. Moreover, real franchise systems lack a clear vision of how to manage the diverse activities, e.g. the interaction between franchisor and franchisees. Based on these observations, this paper first provides a clear systematization of the object of analysis. A definition rRooted in transaction-cost economics and resource dependence theory a definition is given and criteria toof systematization are developed. Next, the management dilemma of franchise systems is depicted: Franchisor and franchisee do indeed have different levels of output (turnover) at which they maximize their individual utility. It is argued that there are ways out of such a management dilemma. After outlining an ideal fee- structure that avoids a dilemmatic situation, the paper concludes with the management implications of such a modified fee- structure.
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1 Introduction
F&C networks constitute the fastest- growing form of organizing economic activities especially in the service and retailing sector (Ahlert/Evanschitzky, 2003). Nevertheless, the phenomenon of “fFranchising” as one example of ann F&C network has received relatively little attention in academic research, especially in Europe and particularly in Germany. In order to overcome that lack of academic interest, this paper first provides a clear systematization of the object of analysis as a starting point. A definition rRooted in transaction-cost economics and resource dependence theory a definitionis given and three criteria toof systematization are developed. Next, the management dilemma of franchise systems is depicted: Franchisor and franchisee do have different levels of output (turnover) at which they maximize their individual utility. The optima of the franchisor and franchisee are not at an identical level of output and neither optimum is optimal for the franchise system as a whole. It can be argued that there are ways out of such a management dilemma which are based on integrated view on three control areas: the structure-optimizing fee, the process-optimizing transfer and payment system and the innovation-oriented concept of compulsory contribution for the implementation of communal tasks. Based on that reasoning, an “ideal” fee- structure that avoids a dilemmatic situation can be outlining. The paper concludes with the management implications of such a modified fee- structure. Hindering factors are discussed and possible solutions are implied.
2 Systematiszation of Nnetworks
There are many different approaches towards systematization of networks (Etzioni, 1964; Powell, 1987 and 1990; Jarillo, 1988 and 1993; Lorenzoni/Grandi/Boari, 1989; Hakansson/Snehota, 1989 and 1995; Miles/Snow/Coleman, 1992; Alter/Hage, 1993; Sydow, 1999; Ahlert/Evanschitzky, 2002 and 2003 and the articles inthe book “Networks in Marketing”, edited by Dawn Iacobucci, 1996; Special Issue of the International Journal of Research in Marketing, Vol. 13, 1996, edited by Geoff Easton and Håkan Håkanson; Special Issue of the Strategic Management Journal, Vol. 21, 2000, edited by Ranjay Gulati, Nitin Nohria and Akbar Zaheer). All systematiszations are driven by specific research objectives. For the purpose of this paper, three criteria are of particular interest, namely
· the type of transaction in the network,
· the resource dependency of network partners and
· the type of coordination of the network.
The rationale behind engaging in a network-like form is the search for the exchange mechanism that minimizes the sum of “production” costs, transaction cost and costs of cooperation deriving mainly from negotiating the contract and controlling agreed- upon rules. Adding to that (essentially) transaction-cost-based approach towards networks, a more managerial approach leads to the following question: “Which type of configuration best fits the relative, resource-induced power between the service-central (“back-office”) and the service-provider (“front-office”)?”
The rationale behind this resource-based approach towards networks is not to minimize costs but to maximize value through gaining access to other firm’s valuable resources (Das/Teng, 2000, p. 35). Resource- dDependency- tTheory (RDT) proposes three factors that determine the degree of dependency between two units, (Pfeffer/Salancik, 1978; Hickson et al., 1981):
• resource importance,
• availability of alternatives,
• degree of discretion,
whereas maximum dependency occurs when one unit has unfettered discretion over an important resource to which no alternatives exist.
The RDT can be connected theoretically to the rResource-based view (RBV) (e.g. Penrose, 1959; Wernerfeld, 1984, Barney, 1991 and 2002; Mahoney/Pandian, 1992; Peteraf, 1993), since the fundamental concepts are nearly identical in meaning. In order to be a source of competitive advantage, resources must be of value, rare, imperfectly imitable, and imperfectly substitutable. Therefore “resource importance” in RDT is close in meaning to the value-concept of the RBV, just as the concept of “alternatives” is close to the concept of uniqueness. In sum, the relative, resource-induced power of two units is directly proportional to the strategic importance of the resources that a particular unit embodies (Medcof, 2001).
It is obvious that there is reciprocal dependency in company-networks. The actors try to promote the form of organization that best reflects their perception of dependency, meaning the relationship between resources given and resources received (Pfeffer/Salancik, 1978, p. 169). For that purpose, Vroom and Yetton introduced a model arguing that managers should choose a decision model that solves the given problem, e. g. degree of dependency (Vroom and Yetton, 1973). They give three basic decision- making models, “autocracy”, “consultancy” and “inclusive” just as the as well as five criteria for deciding on one of the models. Since services can best be offered through network-like arrangements, where there is a back office and a front-office, both units have numerous unique and valuable resources. In such a constellation, the Vroom-Yetton model calls for a “consultancy” or even “inclusive” approach toward management, depending on the front-office’s tendency to effectively implement effectively the decision made.
That brings us to the third systematiszation criterion: the coordination intensity of the network. Coordination methods are shown within a domain which is based on two main criteria, the level of autonomy on the one hand and the level of commitment on the other. The level of commitment refers to the degree to which parties participating in the network coordinate and fix their behavioural patterns. A high level of commitment means that most areas of activity are constrained. The level of autonomy then specifies how much freedom the actors have at their disposal. These two factors determine the level of intensity of the network.
In short, networks can be defined as follows (Ahlert/Evanschitzky, 2002, p. 8):
Cooperative arrangements of a certain coordinating intensity of more than two legally independent partners which, nonetheless, are not (entirely) independent in terms of economic cooperation. The relationship between the participating enterprises goes beyond pure market aspects (“spot contracts”). That is, they continue for a particular time frame and are not “once off”, but ongoing (at least several times) in the market. Likewise, there is an exchange of resources between the participating network partners which in turn results in (mutual) resource dependency.
In order to narrow the focus of this paper, “F&C networks” (networks of Ffranchising and system Ccooperation) are considered. F&C networks are a specific organiszational model for coordinating activities in order to serve customers. They combine the principle of cooperation and the independent actions of network partners, with systematic control through a focal firm (“system head”, “hub”). F&C networks consisttitute of one focal firm and several legally independent network partners. The focal firm provides the management background (e.g. brand management, innovation of the network concept, cost management, etc.) whereas the network partners are “close to the customer”. That results in high levels of mutual resource dependency since no party can function (or substitute easily) without the other. Therefore, long-term contracts are in place.
That particular type of network can be found in franchise-like arrangements. These arrangements prosper world-wide since they combine “closeness to the customer” (effectiveness) and efficient back-office operations (efficiency). Nonetheless, existing F&C-networks suffer under sub-optimal contracts concerning the fees that have to be paid by network partners.
3 The Mmanagement Ddilemma in F&C Nnetworks
Despite the clear advantages of franchise systems (as F&C networks), such as the combination of being close to the customer with an efficient back-office facility, their increasing use and success is far from automatic or guaranteed. One can identify (at least) three barriers to the massive expansion of these networks (Ahlert/Evanschitzky 2003, p. 409):
1. negative image of franchising,
2. unequal treatment of franchise systems,
3. poor management systems.
In this paper, we focus on management systems, especially on the way the franchise system calculates its licencse fee.
Efficient competitive systems must take advantage of all potential profit-yielding opportunities. Furthermore, in order to justify their existence, they must offer advantages over individual operations. In the area of cost management, integrated branch networks have much to offer in terms of the new information and communication technologies. Each actor can also perform those tasks at which he is most efficient. Hierarchical coordination, on the other hand, leads to high organiszational and bureaucratic costs.
However, in converse, the main disadvantage of integrated systems lies in the difficulty of integrating the freer market-related coordination principle, with the hierarchies that still inevitably prevail in enterprises and even in the network itself. Thus, networks require an optimal balance between hierarchy and autonomy.
F&C networks must attempt to use increasing commitment to the system as a means of avoiding opportunistic behavior which might reduce efficiency. There are also cooperation costs, however, such as those of bureaucracy, or developing common systems concepts. Networks have to overcome goal and resource allocation conflicts, asymmetrical information flows, free riders and other obstaclesso on. The “winning model” is the one which reveals the lowest sum of costs of bureaucracy, transaction costs and cooperation costs (Williamson, 1985). F&C networks are thus confronted with some intrinsic dangers and there can be a tenuous dividing line between the efficiency losses of centralization on the one hand, and the costs of too much laissez faire on the other.
If the network is to function effectively, it needs to maximize its profits as a whole. This means that all actors, including franchisor and franchisees, have to behave as one coherent concern. The appropriate system configuration can at least attempt to achieve an optimum through the constitution, structure and organization of the network. The right “rules of the game”, internal transfer pricing and charging processes can move the system in the right direction and keep it on track.
Currently, most franchise systems use turnover-based franchiseing fees as a means of influencing franchisees. Clearly, that type of fee is suboptimal. Figure 1 demonstrates the inevitable emergence of goal conflicts between franchisor (FR) and franchisee (FE). The FR maximizes profits when turnover potential in the market as a whole is exhausted (Aopt FR). The FE, on the other hand, maximizes profits at a substantially lower level, by maximizing a differential magnitude (Aopt FE). From the network perspective, both extreme points are sub-optimal. Maximum profits are attained when, over the entire life cycle, performance-dependent cost is maximized (each actor performs his most cost-effective activities: Aopt FS). In figure 1, this is somewhere between FRG and FEN.
Fig. 1: The goal conflict in F&C networks
Theoretically, it would be desirable to find an optimum which encompasses all three optima depicted here. andTthis poses the question as to why turnover-based fees are so common. The likely explanation is that they are simple, transparent and low-cost, but that does not make them efficient or optimal. Furthermore, the higher the percentage, the more the optima diverge. Yet, lowering the percentage and raising the entry fee serves only to shift the goal conflict to another level, due, for instance, to recruitment problems.
As a possible way out, the continuing franchise fee could be linked to the FE’s contribution margin (turnover ./. variable costs). However, a high price would have to be paid for a converging of the three optima:
· The percentage would have to be raised sharply to reach the same net profits as with the turnover-based fee – an option which not only for psychological reasons is hardly practicable.
· FEs working more efficiently would be “punished”, for they would need to make a higher contribution to the financing of the system than the businesses working less efficiently. The best enterprises would try to leave the network as soon as possible and sub-optimal structures would be the consequence.
· FEs would be induced to choose an economically “wrong” cost structure by making their fixed costs more variable by force.
This erroneous trend would be even more serious if the franchise fees were linked to the periodical profit of the FEs.
· The attempt at “making oneself poor” (through high manager salaries, for example) would replace the attempt at making fixed costs more variable.
· Due to the very narrow basis for assessment, the percentages would soar to discouraging levels and the enterprises with above-average profitability would be subjected to fluctuation more than ever.
· Above all, there would be the danger of aiming at the (short-term) profit maximum only. There would be no investments into immaterial success potentials.
4 Ways out of the management dilemma
4.1 An overview of control areas
The misdirecting effects of the depicted traditional accounting systems are (presumably) due to an inconsistent separation of the following three control areas:
· the structure-optimizing fee system,
· the process-optimizing transfer and payment system and the
· innovation-oriented concept of compulsory contributions for the implementation of communal tasks.
The structure-optimizing fee system is the object of strategic network management with alterable structures (size of network, division into sales districts, etc.). It should extend only to services which affect the configuration of the network as a whole. The breakdown into a one-time entry fee and a continuing franchise fee has proven successful. For the level of the fees and the relation between both components there are no other determinants than acceptance on the market for potential franchisees.