STRATEGY Pricing Strategies And Fee Structures In Franchising Organizations Robert T. Justis Louisiana State University Peng S. Chan California State University-Fullerton Ben L. Kedia Memphis State University ABSTRACT franchising,asa popular formofsmallbusiness,continuestogrmoataphenomenal ratethroughout theworld. Twoofthemostimportantaspectsofthefranchisorffranchiseerelationshiparethedeterminatfon of pricing and a fee structure. These elements have a profound impact on the profitability and success of a franchise business. This study examined pricing strategies and fee structures across different types of franchising organizations. It was found thai a variety of methods were used to determine pn'cing and fee structures. FRANCHISING AND THE SMALL BUSINESS ECONOMY Franchisingis the fastestgrowingmethodofdoingbusinessin the United Statestoday, and is now rapidly spreading throughout the world (2). Franchised businesses accounted fora third of all U.S. retail sales in19B7. This figure is expected to go up to 50 percent by the end of the century. Destined to be "the wave of the future," more and more small businesses are adopting this business method throughout the world. The reasons why franchising is such a favored method for small businesses are many. First, franchising offers a less risky alternative to entrepreneurs who are desirous of starting their own business. In addition, the franchising method provides entrepreneurs the opportunity to developabusinessata muchmore rapid pacethanmightotherwisebepossiblewithoneperson's limited capital. Last but not least, it provides the entrepreneur with the security of many individual franchise business owners who share a vested interest in the success of the business. PURPOSE OF STUDY Given the increasingly important role of franchising in our small business economy, it is essential that we understand the nature and functioning of franchise institutions. The present study represents one of several attempts undertaken by the authors to investigate important strategic aspects of franchising organizations. This particular paper focuses on pricing strategies (retail prices charged to consumers) and the determination of franchise fees (payments made to 25 franchisors by franchisees) in retail franchising organizations- a group of businesses which has been ignored in small business research. The purpose was to shed light on how pricing and franchise fee decisions are made by corporate headquarters. THE NATURE OF PRICING IN FRANCHISING ORGANIZATIONS Pricing has always been regarded as a critical element of business strategy in retail industries. Its strategic role is assuming even greater importance today in the light of increasing competition, greater consumer awareness, and its important effects on profitability. A carefully developed pricing strategy is often a key to competitive advantage. Even though the importance of pricing has been recognized (4, 11,15),only a limited amount of research exists which guides price determination in retail industries. Research is even more limited when it comes to understanding pricing among franchising organization. (6). In franchising organizations, the pricing decision is usually highly correlated with the fee structure (discussed in the next section). The pricing decision enables the organization to determine the price mix that wifl result in the highest contribution of profits, considering the interplay of price, fees, and volume factors (12). The special nature of pricing decisions in franchised businesses poses several major problems for the development of a pricing strategy for such businesses (7, 14). First, the determination of appropriate pricing structures is very difficult and often highly subjective (9, 10). Invariably, managers make pricing decisions by analyzing competitive prices and associated cost structures. However, it is often difficult to ascertain the relative importance of each factor in the final price determination. Furthermore, a franchisee or consumer may determine a price as "acceptable-high," while another franchisee or consumer may consider the same price as "unacceptable-high" (5, 8). Franchisors may sometimes attempt to prescribe or influence the retail prices established by their franchi sees. Some may even monitor prices charged by the franchisee or provide "fixed" price lists. These price-related restrictions create severe antitrust problems. It has been a long- held tenet of antitrust laws that price fixing and price-related restrictions are per se illegal, that is, they will be condemned without an examination of their actual effect on the business or competition. [See United States v. Northern Pacific Railroad Co. 356 U.S. 1, 5, 1958 (13)]. As a result, most franc hi sors now avoid dictating consumer price structures to franch i sees. Nonetheless, franchisors are allowed to recommend price levels to franchisees (under the Colgate Doctrine); however, they generally do not enforce nor "dictate" price structures to the franchi sees (1). The retail franchisees face, however, the occasional national advertisement at an advertised fixed price with the attached disclaimer: "At participating stores only." The final pricing decision is almost always left to the franchisee. THE NATURE OF FEES IN FRANCHISING ORGANIZATIONS Franchising organizations, unlike other forms of small businesses, are characterized by an ongoing, mutually benefidal relationship between the franchisor and the franchisee. A unique aspect of this relationship is the provision of certain fees that the franchisee is obligated to pay the franchisor, such as the initial franchise fee, royalties, and advertising fees. In return, the franchisor provides the necessary training and ongoing support to the franchisee. 26 To develop, maintain, and sustain this relationship, franchisors provide numerous services to their franchisees in return for certain payment. Although the type of fees charged by the franchisor for these services are generally dictated by the industry, the initial franchise fees, royalty fees, and advertising fees are usually determined solely by the franchisor. A problem which often arises is that a variable predicting the event (a co-variant) may vary in value during the time period under consideration (3). Training fees associated with a franchisee start-up are often more expensive for the first two or three franchise stores than for franchise units started subsequently. The question then arises as to which value of the predictor variable should be used in explaining the determination of the fee. Salary increases in the headquarters corporation may be a "time-varying explanatory variable," while the costs of the operation and training manuals maybe a "constant-time variable," impacting upon the franchise fee structure. Because pricing and fee determination are such important, yet highly related decisions for a franchising organization, we have deemed it worthwhile to investigate them simultaneously in this paper. METHODOLOGY In the Spring of 1989 a questionnaire was mailed to 264 franchisor organizations, all of whom were members of the International Franchise Association. Of these, 81 questionnaires were returned. The 81 responses were representative of the 264 sent as there was fair representation from each of the industry sectors that we had sought to examine. Furthermore, the non- responses were quite random and did not represent any particular industry group or sector. All the returned questionnaires were complete and usable, and they form the data base for this research. Franchisors wereasked to respond to six different typesofpricingand feestructures. These are: (I) retail pricing, (2) promotional/advertising pricing, (3) initial franchise fees, (4) royalty fees, (5) advertising fees, and (6) other fees. The respondents were asked to indicate which methods they use in determining their pricing strategy or in developing fee structures. An open- ended question was used to help determine franchise fees: "If your company uses a formula to determine the amount of this fee, please write and briefly explain this formula." The data were analyzed to determine the frequencies of franchisor responses. Demographic Information Characteristicsoftherespondentsareshownin Tablel. Theaveragesaleofeachfranchisor was in excess of $147 million. Each franchisor, on an average, operated 94 company owned stores and had franchised 259 stores. The types of businesses ranged from automobile (8 percent), fast food restaurants (24 percent), three kinds of retail outlets, and hotel chains. Details of the types of business are provided in Table 2. 27 Table 1. Demographic Information on Respondents Mean Sales level per franchisor $147,059,966 Number of company-owned stores 94 Number of franchised stores 259 Industry Type: Percent Retail 16 Retail services for businesses 19 Retail services for mass markets 19 Automobile 8 Hotel 14 Fast food/restaurants 24 Table 2. Breakdown of Respondents by Business Type Business Types Retail: Hotel: Candy and Confectionery Hotel & Motel Chains Convenience Store Campgrounds Retail Optical Recreation Resorts Specialty Retail Retail Home Furnishing Automobile: Retail Automotive Parts & Accessories Retail Services for Businesses: Automobile Repair Water Treatment Automotive Parts Computer Services Leak Detection Services Fast Food/Restaurants: Employment Pizza Contractors Fast Food Security Full-Service Restaurants Business Consulting Retail Service for Mass Markets: Home Decorating Photo Processing Hair-care Interior Decorator Formal-Wear Rental Pets & Pet Supplies Rent-to-Own 28 ANALYSIS AND RESULTS Suggested Prices on Regular Items From the anecdotal information we collected, approximately 60 percent of the franchise executives surveyed responded that they do suggest prices to their franchisees. Most of the franchisees (about 80 percent) followed the suggested price list supplied by the franchisor. The methods used by franchisors to suggest prices to their franchisees are shown in descending order of importance in Table 3. Table 3. Methods Used by Franchisors to Suggest Retail Prices to their Franchisees Percent During training sessions 68.2 By memos 59.1 ln the operations manual 54.5 By newsletter 50.0 By operations director 45.5 By other methods 36.4 By salesperson 31.8 By national advertising 22.7 As Table 3 shows, price suggestions through training sessions are the most commonly used. This is not surprising since training sessions are important vehicles for disseminating the company's basic policies to the franchisees. Other widely used methods included memos, operation manuals, and newsletters. Suggested Prices on Special Price Campaigns Fifty-four percent of the respondents indicated that they had national campaigns with respect to nationwide specials on pricing. Fifty-seven of the franchisors believed that these campaigns were being followed by more than 90 percent of their franchisees. The methods used by franchisors for monitoring promotional prices are shown in Table 4 in descending order of importance. Table 4. Franchisor Methods of Informing Franchisee About Promotional Pricing Percent By memos 70 By national advertising 55 By newsletter 50 By operations director 40 By salesperson , 35 During training sessions 30 Other methods 20 By operations manual 10 29 Given the short-term nature of special price campaigns, it was not surprising to find that most of the information given to franchisees concerning price specials was done through memos, advertising, newsletters,and personal contact. Based ontheanecdotal informationcollected, we found that 65 percent of the respondents have such campaigns at least once a month, while 80 percent have them at least once every three months. Suggested Prices By Industry Type Industries were divided into two categories: those that typically suggest prices to their franchisees and those that do not. The results are shown in Table 5. Table 5. Typically Suggest Prices Do not Usually Suggest Prices Percent Percent Retail 100.0 Hotel 80.0 Automobile 100.0 Business Services 57.1 Mass Markets 71.4 Fast Food/Restaurants 55.6 (see Table 2 for group classifications) Interestingly, franchisors of hotels, business services, and fast food restaurants do not usually suggest prices to their franchisees. Possible reasons for not suggesting prices may be seasonality affecting prices, building costs, perishability, variability of raw material prices in different markets, and lack of uniformity across different markets (e.g., you may not be able to charge the same price for a hotel room in Baton Rouge as you would in Los Angeles). National Campaign Pricing By Industry Type Industries were again divided into two categories: those that typically have special pro- motional price campaigns and those that do not. The results are shown in Table 6. Table 6. Typically Have Campaign Do Not Usually Have Campaign Percent Percent Fast Food/Rest. 77.8 Business Services 85.7 Mass Markets 71.4 Hotel 60.0 Automobile 66.7 As expected, the fast food industry ranks high in terms of having promotional price campaigns. This maybe due to the fact that mass advertising is a distinctive trait of this industry. In contrast, the business services industry seldom offers promotional price campaigns since it cultivates a more one-on-one, personal relationship with customers. 30 Frequency of Promotional Campaign by Industry Type Industries were divided into two groups: frequent or heavy users of promotional cam- paigns (at least once a month); and infrequent (light) users of promotional campaigns (quarterly, semiannually, annually or more than once a year). The results are shown in Table 7. Table 7. Heavy User Light User Percent Percent Automobile 100.0 Retail 100.0 Fast Food 71.5 28.5 Mass Markets 60.0 40.0 Business Services 100.0 Hotel 100.0 As the results indicate, automobile and retail industries were found to be heavy users of promotional campaign. On the other hand, business services and hotel businesses were found to be very light users of such campaigns. Initial Franchise Fee The methods used to determine the initial franchise fee are varied. As shown in Table 8, costs associated with training, screening and approving franchisees, and on-site assistance seem to be the most important determinants of the initial franchise fee. Table 8. Considerations for Initial Franchising Fee Percent Responding "Important" Advertising 30 Franchisor Administrative Salaries 53 Training 84 Site Selection 56 Accounting and Legal Costs 53 Screening and Approving Franchisees 74 Prior Research & Development 51 On-Site Assistance 72 Store Plans/Layout 56 Manuals 9 Feasibility Study 7 Software 2 Miscellaneous 19 Not Applicable 7 31 Royalty Fees Based on the anecdotal information we collected, 84 percent of the franchisors collected royalties based on a percentage of gross revenues, and 63 percent of those coll ecting royalties did so on a monthly basis. The royalty fee varied between 2-9 percent of gross sales with 4 percent being the most common. However, approximately half the franchisors charged over 4 percent. The results are shown in Table 9. Table 9. Franchisor Royalty Fees Percent Royalty Fees Percent Charged To Franchisees Respondents 0-2 2 3 14 4 33 5 9 6 21. 7 7 8 7 9 or greater 6 Advertising Fees The anecdotal information collected indicated that 65 percent of the franchisors determined advertising fees as a percentage of gross revenues. Advertising fees vary according to the retail outlet and the need for advertising development. The results are shown in Table 10. Interest- ingly, 56 percent of the franchisors charged 2 percent or less, while 46 percent charged 3 percent or more. This may reflect the fact that franchisees with a mobile customer group probably benefit more from franchisor-sponsored promotions while those that depend on patronage from the local geographic market are likely to benefit more from local franchisee advertising aimed at identifying local niches and combating local market competition. Table 10. Advertising Fees Charged by Franchisor Percent Percent of Franchisors 0 28 .5 4 1 8 2 16 3 10 4 9 5 14 6 7 7 2 8 or greater 2 32 Other Fees Finally, the results of our study reported that 21 percent of the franchisors charged fees for leases of equipment. Other than such fees, no other fee was found to be significant. CONCLUSION The development of a sound pricing strategy and fee structure is critical to the success of any franchised business. In this study, a broad-based questionnaire was administered to franchisors throughout the United States. The questionnaire was used to identify the primary factors that franchisors used in suggesting prices to franchisees and in developing franchise fees. Several conclusions can be drawn from the study. First, despite the fact that pricing is heavily regulated and controlled by anti-trust laws, most franchisors nonetheless provide suggested price lists for their franchisees and expect the latter to follow them. The vast majority of franchisors use training sessions, memos, and operations manuals to convey the suggested price list. Many franchisors conduct national campaigns with nationwide speciale including pricing. Franchisors believe that the vast majority of the franchi sees adopt these national price specials. It was also found that franchisors in certain industries such as retail, automotive, and service businesses are more likely to suggest prices than those in other industries; this probably reflects the level of price sensitivity which these particular industries encounter. There are three primary kinds of fees involved in a franchisor-franchisee relationship, namely, the initial franchise fee, royalty fees, and advertising fees. The initial franchise fee is determined by the franchisor based primarily on costs associated with training, screening and approving t'ranchisees, and on-site assistance. Royalty and advertising fees are generally based on gross revenues. 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