A recent Wall Street Journal article described several conflicts between Burger King and its franchisees. In one of these disagreements, three franchisees sued Burger King over the franchisor’s effort to get them to keep their outlets open later at night.
While the courts will have to decide the legal question of whether franchisors have the right to mandate franchisees’ hours, the case points to a bigger problem. Many franchisors and franchisees don’t seem to understand why they often end up in conflict.
The economics behind the conflicts
The basic economics of the franchise arrangement is behind many franchisor-franchisee disputes. Franchisees run outlets according to systems sold to them by franchisors. Under the standard arrangement, franchisees pay franchisors a royalty of a few percent of their gross sales for access to an operating system and a brand name, which is how franchisors make money.
Like most businesses, franchisees earn a profit when their revenues exceed their costs. The difference in how franchisors and franchisees make money is behind much of the conflict between franchisees and franchisors.
Because franchisors earn royalties on franchisees’ sales, anything that increases franchisees’ revenues benefits franchisors. If, as the Wall Street Journal reported, franchisees generate an extra $30 in revenue for each additional hour they are open, the franchisors benefit from longer operating hours. More revenues equate to higher royalties.
Franchisees, on the other hand, don’t necessarily make money when their revenues increase. Consider operating hours again. According to the attorney for the franchisees suing Burger King, staying open late costs the typical franchisee $100 per hour. Assuming these numbers are true, franchisees lose $70 each hour they are open late at night.
If a particular policy makes money for a franchisor, but loses money for his or her franchisees, conflict between the franchisor and franchisee over the policy shouldn’t surprise anyone.
Other types of conflict
Hours of operation aren’t the only thing that can increase franchisor earnings while decreasing franchisee profits. Expansion of the number of outlets in the chain is another example. If a franchisor adds another location near an existing franchisee, the chain’s overall sales often go up because more customers can be served by the two locations than by the original one alone.
The higher overall sales mean more royalties to the franchisor, but not necessarily greater profits for the original franchisee. If the new outlet cannibalizes some of the first franchisee’s sales, the franchisee might end up with lower revenues than before, but with little reduction in costs. In short, adding locations can boost franchisor earnings at the expense of franchisee profits, leading to conflict between the parties.
The franchisees’ surprise is surprising
When conflicts between franchisors and franchisees emerge, franchisees often seem genuinely surprised. Their surprise is disconcerting because many books explain how these conflicts emerge naturally from the franchise structure.
Before people buy a franchise, they should read something about the economics of franchising. Knowledge of the economics of the business might well save them from needing a later education in franchise law.