Re-thinking of the Franchising Rationale

Purposeful Franchising: Re-thinking of the Franchising Rationale

Inma, Chutarat

Abstract

Despite the rapid adoption of the franchising concept, there is still a lack of understanding and a consensus on the theoretical determinant and creation of this business strategy. For the past four decades, the agency theory has been popularly used to explain the foundation of franchising. The paper concludes that there is a limitation in using the agency theory to explain the fundamental of franchising. The franchising phenomenon is not a simple array. The complete understanding of franchising practice may require an explanation involving more than one theory.

Key Words: Franchising, franchising theory, agency theory, small business performance

The concept of franchising has become well developed and is a popular business strategy in many nations. A mature level of franchising can be found in the United States, Europe and Australia, while Asia, South America, Central America and Mexico report a rapid growth (Alon and McKee, 1999; Falbe and Welsh, 1998; Hoffman and Preble, 2001; Preble, 1995). Today, franchise businesses are generally involved in most aspects of daily activity. Franchising includes various systems and industries, from fast-food retailing to home care. There are some familiar names, such as: McDonald’s, Kentucky Fried Chicken, 7-Eleven, Body Shop, Tie-Rack, Pizza Hut, and Service Master.

Despite the rapid adoption of the franchising concept, there is still a lack of understanding and a consensus on the theoretical determinant and a creation of this business strategy. For the past four decades, franchising research has placed particular attention on an explanation of the franchising phenomenon. The plausible explanation for the creation of the franchise concept placed emphasis on several fundamental areas; such as reasons why firms franchise (Rubin, 1978; Shane, 1998b), the implication of franchise life cycle (Carney and Gedajlovic, 1991; Combs and Castrogiovanni, 1994; Oxenfelt and Kelly, 1968-69) and franchising as an effective vertical integration strategy (Brickley and Dark, 1987; Falbe and Welsh, 1998; Mathewson and Winter, 1985). Out of these inquiries, two dominant theories emerged: the agency theory and the resource scarcity theory.

Developed from the economic theory, the agency theory and the resource scarcity theory observed the expansion of franchise arrangement in relation to the growth of the company-owned outlets (Felstead, 1993). The resource scarcity theory views franchising as a means of obtaining capital and easing managerial constraints upon the growth of small to medium size firms (Carney and Gedajlovic, 1991; Caves and Murphy, 1976; Oxenfelt and Kelly, 1968-69). On the other hand, the agency theory views franchising as a means of efficiently controlling the problem of monitoring differences between the agent (employee) and the principal (owner) (Brickley and Dark, 1987; Norton, 1988a and 1988b). These theories explicate that firms adopt franchising strategy in order to eliminate the internal constraints that limited the firms’growth.

While the resource scarcity theory has made a valid contribution to the franchising rationale (Caves and Murphy, 1976), the agency theory was more favourable and perceived as making more justifiable contributions to the franchising theory (for example, Brickley and Dark, 1987; Caves and Murphy, 1976; Dant, 1996; Lafontaine, 1992; Mathewson and Winter, 1985; Norton, 1988b). Some researchers imply that due to the prevalence of agency theory, the resource scarcity hypotheses may have been set aside prematurely (Dant, 1996). Owing to this explanation, it is likely that the agency theory was considered as the sole explanation for the creation of franchising. This raises the research question, “Does the agency theory adequately explain the rationale of franchising?” UnderStanding the rationale why firms engage in franchising may be the key to explain the rapid adoption of the franchising strategy. The knowledge obtained from this study may also offer an insight for businesses that wish to adopt franchising as a strategy for firms’ growth.

Literature Review

Franchising is a form of business arrangement which originated from France in the 18th century. The term “franchising” is French, translating as “a granting of right” or “an exemption” (Williamson, 1992). In Australia, franchising started with the First Fleet, circa 1788, when Governor Macquarie granted a franchise to two contractors to import 45,000 gallons of rum in return for building the Sydney Hospital (Mayfield, 1997). The new tide of Australian franchising began in the 1970s with the emergence of franchised real estate chains. By the 1980s, franchising was well established and practised widely (ibid). Today, Australian franchising includes 708 business format franchisors and about 40,900 franchised outlets (Frazer and McCosker, 1999). This makes Australia the most franchised nation per head of population in the world (Adelaide Advertiser, 2002).

Franchising is primarily defined in terms of the legal business agreement between two partners, the franchisor and the franchisee. The franchisor, who has previously established a market-tested business package of products or services, enters into a continuing contractual relationship with a number of franchisees, typically small business owners, who must operate their businesses according to the franchisor’s specified format (Curran and Stanworth, 1983). The franchisor provides a proven method of operation, support, and advice on the setting up of the new franchisees, and also guarantees continuing support to the franchisee. In return, the franchisee pays a lump sum entrant fee and other charges for regular services (that is, royalty on sales, advertising fees, marketing levy) (Fulop and Forward, 1997).

Franchising is regarded as being different from the other forms of business. A franchise organisation is claimed to be a hybrid form which is characterised by complex contractual arrangements (Eisenhardt, 1989). However, many franchise systems operate between the hybrid and the hierarchy (centralised) firm and encompass both franchised units and company-owned outlets (Brickley and Dark, 1987; Bronson and Morgan, 1998; Dandridge and Falbe, 1994; Falbe and Welsh, 1998; Lafontaine, 1992; Mathewson and Winter, 1985; Shane, 1996). In a hybrid operation, the franchisor monitors and controls the franchisee within the limits specified in the franchise agreement. In contrast, the franchisor operates company-owned outlets through his or her authority over a centralised bureaucracy or as a hierarchical organisation. The resource scarcity theory and the agency theory explained the theory of franchising around the hybrid and hierarchy forms of franchise organisation.

Resource Scarcity Theory versus Agency Theory

The resource scarcity theory was a traditional view of franchising. The theory suggested that a firm engaged in franchising in order to obtain capital gain and knowledge of local markets, while reducing managerial constraint of a small or medium size firm and at the same time transferring the risk from the firm to the franchisee (Caves and Murphy, 1976; Oxenfelt and Kelly, 1968-69). According to the theory, the franchisee supplied capital for business growth through a fixed fee1 and a royalty rate2 (Blair and Kaserman, 1982; LaI, 1990), at implicit interest rates below the market price (Caves and Murphy, 1976). At the same time, the franchisor reduced inter-firm controlling and monitoring costs through the use of a franchisee as the franchisee was given a claim to a large part of the profits of the outlet, the franchisor could ensure that the franchisee would put in an adequate amount of time and effort in managing the outlet. Young and small firms in a managerial constraint situation could also use franchising in order to obtain human capital. Most franchisees were recruited from local personnel, who could contribute reliable knowledge about the local market trends and conditions to a franchise organisation (Caves and Murphy, 1976). Therefore, obtaining the financial and human capital through franchising was considered a low risk method for the franchisor.

Although the resource scarcity theory made a constructive contribution to the franchising theory, its validity was questioned. The area that hindered the widespread acceptance of the theory was that franchising is an appropriate means of easing resources constraints only for the young or small firms. The justification for this claim was that once the firm was established in the market, the critical advantage of franchising was reduced. This theory believed that franchise firms tended to buy back franchise units or increased their company-owned outlets as the system matured (Caves and Murphy, 1976; Oxenfelt and Kelly, 1968-69). Firms would also continue to franchise less attractive units in rural areas, as well as in new market territories where they had little local market expertise and were attempting to have rapid expansion of outlets (Carney and Gedajlovic, 1991). It is claimed that the resource scarcity theory inadequately addressed the issues of a large firm which clearly had full access to capital markets but still employed franchising as a strategy for firms’ growth (Lafontaine and Kaufmann, 1994).

Several franchising theorists argued that the agency theory could be a rationale behind the wide spread use of franchising (for example, Mathewson and Winter, 1985; Rubin, 1978; Shane, 1998a). The agency theory postulates that franchising was not a low risk or cheaper way for obtaining a capital as claimed by the resource scarcity theory. The risk concentration was in the hand of the franchisees, because the franchisees were contributing the input fees and the royalty payments (Blair and Kaserman, 1982; Mathewson and Winter, 1985), therefore risk-adverse franchisees should demand a higher return from franchising, resulting in a lower return from the franchisor (Rubin, 1978). As a result, the franchisor would be more risk averse that the franchisee.

In addition, the agency theory has also been used to elucidate agency relationships in franchising. It was proposed that under the conditions of incomplete information and uncertainty of the business environment the managers (agents) tended to shirk their duty to the firm (principal) because their compensation was fixed. As a result, high monitoring costs will be incurred by the firms to insure that the employed managers acted in the firms’ best interest (Rubin, 1978). Thus, firms engaged in franchise business as a response to an agency problem of adverse selection and moral hazard (Birnberg, Turopolec and Young, 1983; Shane, 199Sa). An adverse selection occurred when the principal could not ascertain if the agent accurately represented his ability to do the work for which he was being paid. A moral hazard took place when the principal could not be sure if the agent had put forth maximum effort (Eisenhardt, 1989). Firms employed franchising in an attempt to reduce the agency problems that existed with the company-owned manager by making the franchisee (agent) responsible for the gain or loss of the proceeds of a retail outlet (Brickley and Dark, 1987; Lafontaine, 1992). Thus, the hybrid agency (franchisee) is likely to perform better in terms of lowering monitoring costs and increasing desired outcomes than the hierarchy agency (company-owned manager) out of the franchise firms.

Is the Franchisee an Efficient Agent?

Support for the agency theory as a rationale behind franchising was substantial. Research found that the franchisee motivation as an agent was perceived to be the most important strategy of the franchise firms (Oxenfelt and Kelly, 1968-69) while the capital advantage of franchising, which was proposed by the resource scarcity theory, had a low acknowledgement by the franchisors (Lillis, Narayana and oilman, 1976). The franchisee ‘s high motivation was probably derived from the nature of the franchise relationship. Franchising involves an exchange relationship between franchisor and franchisee which was sometimes described as a partnership or strategic alliance (Stanworth and Kaufmann, 1996). The franchisee is simply managing an outlet featuring the corporate strategy of the franchisor and to a certain extent possesses a degree of autonomy in managing the outlet (Dant and Gundlach, 1998). Unlike the company-owned manager, the franchisee enjoys more dependency in running the day-to-day business (Kaufmann and Eroglu, 1999).

It is likely that the franchisee’s high motivation is related to their satisfaction with the franchise relationship (Andaleeb, 1996). Satisfaction has been defined as a positive affective state resulting from the appraisal of all aspects of a firm’s relationship with another firm (Anderson and Narus, 1984). Franchisee satisfaction can be observed into two areas: economic satisfaction and non-economic satisfaction (Geyskens, Jan-Benedict, and Kumar, 1999). The franchisee is noneconomically satisfied when the franchisee has a positive response to the psychosocial aspect of the franchise relationship. In comparison to the company-owned manager, the franchisee should be more non-economically satisfied as the franchisee has greater independence and autonomy in running the day-to-day business. It can be argued that franchising offers greater agency efficiency in a business operation in which the franchisee is more non-economically satisfied. The franchisee is also more willing to make an effort in managing the outlet compared to the company-owned manager. Thus:

H^sub 1^ : The level of non-economic satisfaction differs between the franchisee and the company-owned manager, with the franchisee possessing a higher level of non-economic satisfaction than the company-owned manager.

Similarly, the franchisee should also be more economically satisfied. Economic satisfaction occurs when the franchisee has a positive response to economic rewards that flow from the relationship with the franchisor (Geyskens, Jan-Benedict, and Kumar, 1999). Generally, franchisor and franchisee share in the investment of and profits from the franchise outlet (Sherman, 1993 ; Spinelli, and Birley, 1996). The personal investment encourages the franchisee to put an effort into beneficial activities and day-to-day outlet operation (Caves and Murphy, 1976; Phan, Butler and Lee, 1996), while the company-owned manager’s compensation is fixed (Caves and Murphy, 1976). As a result, franchising offers greater agency efficiency. Therefore, the franchisee possesses higher motivation to work harder, as they are more economically satisfied, especially when compared to the company-owned manager. Thus:

H^sub 2^ : The level of economic satisfaction differs between the franchisee and the company-owned manager, with the franchisee possessing a higher level of economic satisfaction than the company-owned manager.

Franchising is a form of business arrangement that has been claimed to offer a high business success rate (Castrogiovanni, Justis, and Julian, 1993; Howard, 1996). Thus, the franchise outlet is likely to perform better than the company-owned outlet because the contract between the franchisor (principal) and franchisee (agent) was designed to keep their incentive closely aligned (Brickley and Dark, 1987; Carney and Gedajlovic, 199 l;Mathewson and Winter, 1985;Rubin, 1978). With high agency efficiency, franchise outlets were found to be more competitive and out-perform company-owned stores in sales and profits (Withane, 1991). Therefore:

H^sub 3^: The level of the financial performance differs between the franchisee and the company-owned manager, with the franchisee performing better than the company-owned manager.

The franchisor and the franchisee are bound by the contractual arrangement that is intended to align the goals and incentive of both parties (Brickley and Dark, 1987). An effective contractual design should create high goal congruence between the franchisor and the franchisee. Goal congruence refers to an agreement as to business goals between the franchisor and franchisee (Baucus, Baucus and Human, 1996). In the principal and agency relationship, it is anticipated that franchise goal congruence would exist as the franchisor and the franchisee possess the common intention of successful franchise operation. With agency efficiency, the goal congruence between the franchisor and the franchisee should be higher than the goal congruence between the employer and the employee. Franchise goal congruence resulted from high motivation and a willingness of the franchisee to take part in a franchise arrangement. Therefore:

H^sub 4^ : The level of goal congruence between the hybrid and the hierarchy forms of franchise organisation differs, with the franchisor and the franchisee displaying a higher level of goal congruence when compared to the franchisor and the company-owned manager.

In addition, the agency theory suggested that franchising was favourably employed as a means to reduce high employee monitoring costs (Brickley and Dark, 1987). Research has shown that the franchise firms that operated both company owned and franchised outlets had a higher use of company-owned outlets in metropolitan areas and in locations with low repeat business, where the costs of monitoring the franchisee were greater than monitoring the companyowned employee (Brickley and Dark, 1987; Lafontaine, 1992; Norton, 1988b). Therefore, it is argued that agency efficiency will take place, when there is the difference in a level of control used between the hybrid and the hierarchy forms of franchise arrangement. The franchisor should adopt a higher level of control or use a higher level of centralisation for those outlets managed by the company-owned manager. In contrast, with the agency efficiency, the lower level of control should be found in the franchised outlets. Thus:

H^sub 5^ : The level of monitoring and control by the franchisor differs between the company-owned managers and the franchisees, with the company-owned managers being administered a higher level of control.

The agency theory also postulated that firms engaged in franchising to reduce the gap of incomplete information about the agents and to ensure an appropriate behaviour of the agents in an uncertain business environment (Rubin, 1978). Franchisees were then employed to promote greater agent behaviours and greater agent efficiency of monitoring and control for the franchise firms. At the same time, the franchisees who were usually recruited from the pool of the local candidates were expected to convey the local information or local knowledge, which is perceived to be one of the key success factors for franchise firms, to the franchisors (Jaworski and Maclnnis, 1989). The franchisor possesses knowledge about franchise brand names, products, market activities, and general business arrangements. Conversely, the franchisee possesses better knowledge about local market activity and customer behaviour (Dant and Nasr, 1998). The franchisees are claimed to have better local market knowledge because they are either a local owner or have an accumulation of local experience through employees (LaI, 1990). The combination of both sources makes the franchise business arrangement more competitive than other forms of business.

Better local information or local knowledge is mainly possessed by the agents, who are actively involved in daily activities within the local vicinity, but not the principal. Information asymmetry is defined as information about local knowledge possessed by the agents (the franchisee and the company-owned manager) but not the principal (franchisor) (Jaworski and Maclnnis, 1989). This information can be used to influence competitive advantage of the franchise firms in which the franchisor provides a large scale advantage3 and the franchisee and perhaps the company-owned manager contribute the local knowledge to the niche market advantage. The agency theory postulated that the franchisee was recruited in order to promote greater agent efficiency (Shane, 1998a) and the franchisee’s incentives which act as a behavioural control mechanism would promote franchi see motivation to act for the franchise firm’s best interest (Shane, 1998a). Therefore, it is likely that the level of local information which the franchisee shares with the franchisor should be higher than the company-owned manager counterpart.

H^sub 6^ : The level of information asymmetry differs between the franchisor and the franchisee and between the franchisor and the company-owned manager, with the franchisee conveying greater local information to the franchisor than the company-owned manager does.

Method

The study explored the differences between the franchisees and the company-owned managers within the franchise firms on various variables such as: economic and non-economic satisfaction, financial performance, goal congruence, control and information asymmetry.

Participants

The sample consisted of Australian franchisees and the store managers or company-owned managers from the same franchise system. Several franchise systems, from a large system such as a non-food retailer to a small system such as education provider were investigated. In the sample, the franchisees and the store managers were identified through the randomly selected 93 franchisors from the Franchise Yearbook and Directory (Commonwealth Bank, 2000). In total 113 franchisees and 25 store managers responded to the mail survey. Out of 113 franchisees, 25 of them were randomly selected to obtain an equal number in order to increase statistical consistency (Tabachnick and Fidell, 2001). Overall, 25 franchisees and a matching 25 store managers from the same franchise system as a franchisee were used in the analysis. The moderately low response rates with the use of the probability sampling method were considered acceptable, especially for an exploratory phase (Krosnick, 1999; Lambert and Harrington, 1990).

Measures

All the six measures were a composite response an attitudinal scales as follows:

Satisfaction

Franchisee and store manager non-economic satisfaction was measured by the parties’ positive response to the psychosocial aspect of being a franchisee and working in the franchise related company (Hunt and Nevin, 1974). On the other hand, the economic satisfaction measured the economic rewards obtained by the franchisee and the store manager (Geyskens, Jan-Benedict, and Kumar, 1999). Three items measured the non-economic satisfaction. Examples of the statements are “Overall,! am very satisfied with my job” and “I feel as if my self-worth has been reduced since I have been working in this organisation”.

Two items measured the economic satisfaction. Examples of the statement are “In terms of monetary reward, I am very satisfied working in this organisation” and “The income from working is worth the amount of time and effort I have put in”. The response options were 6-point scales anchored from 1 to 6 in which 1 represented “strongly disagree” and 6 represented “strongly agree”, respectively. Higher scores indicated higher agreement of the respondents with the statement. Both positive and negative wordings were applied to both measures in order to minimise the response bias, with negative statements reverse coded. Reliability for the non-economic satisfaction is acceptable (α= 0.71) and for the economic satisfaction is high (α=0.79).

Financial Performance

Three traditional performance dimensions were used to measure franchise financial performance: return on investment, sales volume and profit before tax (Reimann, 1982). In response to this measure, the respondents were asked to subjectively compare the performance of their companies to the performance of similar competitors of whom they were aware in the same industry and of the same size. The subjective performance was preferred to the objective performance measure for several reasons (Dess and Robinson, 1984; Sapienza, Smith, and Gannon, 1988).

First, subjective evaluation allowed the business partners to estimate their own performance when compared to their competitors who were estimated to be of the same age and at the same stage of development (Chandler and Hanks, 1993). second, if objective performance information could be obtained, it could have weaknesses in terms of error attributed to varying accounting procedures (Sapienza, Smith, and Gannon, 1988). Finally, most of the franchisees are a sole proprietor and all of the company-owned managers are employed by a business corporation, as a result information on performance may be severely restricted or not publicly available. In this context, the subjective performance measure can be used as an effective substitute method of measuring performance where objective performance data is not readily available (for example, Reimann, 1982; Dess and Robinson, 1984; Sapienza, Smith, and Gannon, 1988; Chandler and Hanks, 1993). The subjective performance measures were evaluated in ccomparisons with competing businesses based on seven-point scales ranging from 1, “much worse than the others” to 6, “outstanding performance compared to the others”. Scale reliability on the performance measure was high (a- 0.92).

Goal Congruence

Goal congruence was measured in terms of the perceived level of consensus in the areas of personal values and general management between the franchisor and the franchisee and between the employer (franchisor) and the employee (store manager) (Baucus, Baucus and Human, 1996). Four items were adapted and revised from three previously used instruments (Baucus, Baucus and Human, 1996; Phan, Butler and Lee, 1996; Schul, Pride, and Little, 1983). Participants were asked to record their agreement with a series of statements, such as: “I believe my company and I have similar values”, and “I believe that I share compatible business goals with my company”. The response options were six-point scales anchored from 1 to 6 in which 1 represented “strongly disagree” and 6 represented “strongly agree”, respectively. The reliability of the goal congruence measure was high (α= 0.88).

Control

Control is operationalised as the strategies employed by the franchisors to influence the strategic and operating decisions of the franchisees and the store managers in order to achieve the desired organisational outcomes (Skinner and Guiltinan, 1985). Control mechanisms regulate the management of daily operations and future decisions about organisational routines. Thirteen items were used to measure three dimensions of control of which five items were related to product control, five items to service control, and three items to financial control. Control was considered to be used in a day-to-day business operation. It is related to four core control mechanisms: centralisation, rules, culture and values. To reply to the control measure, the respondents were asked to select one of the most suitable forms of control ranging from 1, “centralisation” to 4, “values”; for example, “what type of control does the franchisor I your employer use to maintain service quality?” and “What type of control does the franchisor/ your employer use to manage financial record-keeping?” The ”’not applicable'” option was also presented in case the respondents viewed the responses as inappropriate. Scale reliability on the control construct was high (α= 0.83).

Information Asymmetry

Information asymmetry was operationalised as information on market trends, market conditions and customer behaviour at the local level of operations which was controlled by the franchisees or company-owned managers and required to be passed to the franchisor. Five items on information asymmetry were constructed based on the previous literature (for example, Dant and Nasr, 1998). Two items relating to franchisee innovation and ideas, such as new operational ideas and new product ideas, and three items exploring local market knowledge, such as local market demand, local competitor activities and local market forecast were constructed (Dant and Nasr, 1998).

Respondents were asked to rate the degree to which the local information and local knowledge were shared by the agents with the principal. The response options were based on a 7-point scale ranging from 1, “never” to 7, “daily”. Internal consistency of the scale items was high (α = 0.93).

Results

Sixty per cent of the respondents to the survey were male and 40 per cent were female. The majority of the franchisees were male (76 per cent), while the proportion of male and female of the company owned-managers were almost equal (44 against 50 per cent). Seventy-two per cent of the company-owned managers were between 21 to 40 years of age. However, the franchisee respondents were much older than the company-owned managers with the majority of the franchisees (96 per cent) being between 31 to 60 years of age. Most of the franchisees (96 per cent) had been with the company for less than 10 years while the relationships between the franchisees and the franchisors ranged from less than five years (36 per cent), between five to 10 years (44 per cent) and between 10 to 20 years (20 per cent). The higher proportion of the franchisee respondents were male, older and more experienced in franchising than the company-owned managers.

Table 1 reports the test statistics, means and standard deviations of noneconomic satisfaction, economic satisfaction, financial performance, goal congruence, control and information asymmetry between the franchisees and the company owned-managers. Correlation analyses and the coefficient alpha of each variable were also reported.

Goal congruence was found to be significantly correlated with various variables: Non-economic satisfaction (r = 0.398,p

The findings supported three of the six hypotheses, however the opposite directions were found on the hypothesised relationships. Hypothesis 1 was supported; the level of non-economic satisfaction differs between the franchisees and the company-employed managers (t = -6.95, p

Hypothesis 4 was supported; the level of goal congruence between the hybrid and the hierarchy forms of franchise organisation differs (t = -2.41, p

Discussion

The results cast doubt on agency theory as a vigorous rationale behind the creation of the franchise arrangement. The agency theory proposes that firms use franchising as a business mechanism to reduce agency problems initiating from the opportunistic behaviour of their own employees. Thus encouraging them take advantage of the highly motivated self-driven agents as franchisees by using effective compensation as a basis to encourage the high franchisee motivation. The agency theory explained that franchise firms could increase their level of efficiency with the likelihood of reducing the level of monitoring and control employing the franchisees as agents. Optimistically, it is anticipated that the franchisees who were self-motivated, would be more satisfied with the franchise relationships and would be likely to display better performance outcomes for the franchise firms when compared to the company employed agents. However, the findings of this study display a conflicting story.

Franchisees were found to be non-economically dissatisfied with the franchise relationship (Knights and Roberts, 1983) while the company-owned managers reported a higher level of non-economic satisfaction with the employeremployee relationship in their organisations. Although some past literature proposing that the franchise arrangement offers the franchisees a certain degree of entrepreneurship in which the franchisees can exercise their initiative, risk taking, authority, independence and adaptation to the franchise outlets (Baucus, Baucus and Human, 1996; Gassenheimer, Baucus, and Baucus, 1996; Phan, Butler, and Lee, 1996). In addition, the franchisees also tend to receive more support, guidance, and ongoing training given by the franchisors than the company owned managers (Forward and Fulop, 1993). However, the level of guidance and support from the franchisors may not offset a demand for greater independence and entrepreneurship in running the franchise outlets for the franchisees. Franchisees and the franchisors are bound by the franchise contracts, which typically guide the franchise relationship rather than values and norms (Leblebici and Shalley, 1996). Franchisees may be non-economically dissatisfied with the relationship when they view their roles as an alliance partner in which they should be given the right to exercise their entrepreneurial initiative to their franchise outlets rather than limit their initiatives within the franchise contract or conform their activities to the organisational norm (Baucus et al, 1996). Nonetheless, it will be easier for the company-owned managers, who are organisational employed personnel, to conform to the organisational norms which is considered to be a common practice in the employee-employer relationship leading to their level of non-economic satisfaction being significantly higher than the franchisees’ level.

The significant difference of the economic satisfaction between the franchisees and the company-employed managers was not supported. Although, the mean on economic satisfaction between the franchisee and the company-employed manager was insignificantly different, the mean of the company-owned managers was slightly higher. It is likely that the expectation of the monetary rewards of the franchisees is slightly higher than the company-owned managers resulting in the lower level of the franchisees ‘ economic satisfaction. The findings concurred with past research in which the employee compensation was found to be slightly greater for the company-owned outlets than franchised outlets (Krueger, 1991). Hence, the results contradicted the agency theory, which predicted that the franchisees should be more economically satisfied as their economic rewards depended on the performance of the franchise outlets, while the economic rewards of the company-owned manager are fixed (Brickley and Dark, 1987; Lafontaine, 1992).

The level of the economic compensation of the franchisees also reflects the financial performance of the franchise units in which case the results showed no significant difference between the franchisees and the company-owned managers. According to the agency theory, the franchise outlet was anticipated to contribute better financial performance to the organisation than the company-owned outlet (Withane, 1991), as the franchisee is usually recruited from local personnel and thus likely to be more familiar with the local market trends and conditions (Caves and Murphy, 1976; Dant and Nasr, 1998). Nevertheless, the average financial performances of the company-owned manager and the franchisee cannot be distinguished. Whilst the agency theory proposed that franchising was used to obtain managerial talent and local knowledge through franchisee selection, evidently these reasons are not justified. The study also found that the franchisees significantly conveyed the local information and local knowledge to the franchisors less frequently than the company-owned managers. Local knowledge that the franchisees possess should be passed to the franchisors so that the organisations may adapt or react to market trends. However, the results concurred with the past literature asserting that the franchisees may not wish to share information (Dant and Nasr, 1998). The franchisee may, for example, perceive that sharing information with the franchisor is a risk. The franchisee might countermand the franchisor power by maintaining control over the local knowledge (Dawes, Lee et al, 1998) or the franchisee might not want to share because of a lack of cooperation or trust between the two parties. Although this study did not identify which party, the franchisees or the company-owned managers, possesses greater local knowledge, a lack of information asymmetry in the franchise relationship would reduce the competitive advantage of the franchise firms as stipulated by the agency theory. Therefore the efficacy of using the sole agency theory to explain franchising is likely to be questioned.

The goal congruence between the franchisor and the franchisee was also significantly lower than the goal congruence of the hierarchy arrangement. The agency theory proposed that the relationship between the franchisor and the franchisee occurs on the basic assumption of pursuing common goals. The franchisor and the franchisee ally in the relationship for the purpose of producing benefits that they believe would be unattainable, if not for the alliance (Rubin, 1978). Therefore, the contractual arrangement between the franchisor and the franchisee should create high goal consensus between both parties, and it should be significantly higher than the hierarchy arrangement. The reverse significant result on the mean difference of the goal consensus between the hybrid and hierarchy form is likely to raise the issue of the limitation in using the agency theory as a rationale for franchising. Perhaps franchise goals are usually set by the franchisor and are imposed on both the franchisor and the franchisee (Baucus, Baucus and Human, 1996), thus, opportunistic behaviour created by the franchisee is bound to occur. For example, as the franchise contract draws upon the power imbalance between the franchisor and the franchisee, the franchisee has a tendency to continue to violate various assumptions stipulated in the franchisee agreement to retaliate against the feeling of disadvantage (Storholm and Scheuing, 1994). Thus, it is likely that franchising could not be explained under the sole assumption of agency efficiency as the fundamental underlying the contractual relationship is operated on the basis of goal divergence between the franchisor and the franchisee.

The lower level of monitoring and control of an agent was also proposed by the agency theory as a dominant factor for firms to employ franchising strategy. It is anticipated that the company-owned outlet should operate under a higher level of control or be more centralised than the franchise outlet, as the franchise outlet requires less monitoring and control resulting from an agency efficiency (Baucus, Baucus and Human, 1996). However, the findings do not confirm this notion. The franchise outlets and the company-owned outlets were found to receive a similar level of control using rules as a strategy for business operation. The results contradicted previous literature in which a lower level of monitoring and control was administered to the franchise outlet (Lafontaine, 1992; Norton, 1988b). The notion that franchising would reduce the administrative cost of monitoring and control as stipulated by the agency theory was unfounded.

The contradictory results of the agency theory suggest the limitation of using the sole economic theory explaining the franchising rationale. The agency theory focuses dominantly on the influence of the principal, in which the agent is perceived as having only concern for self-serving interest and opportunistic behaviours. As a result, the principal is required to search for effective alternatives in order to reduce operating cost. Franchisees are therefore the substitutes for an efficient agent using the aligned incentives to control their opportunistic behaviours. However, the relationship between the franchisors and the franchisees is not only an economic contract, an exchange relationship specified by the written agreement, but also social interaction, which may require an exchange of values and norms, formal and informal that may not be specified in the franchise contract. The successful principal and agent relationship may also be built towards the collaborative perspective, in which collaboration, trust, and corporation, and ethical integration exist between the two parties (Shaw, Gupta, and Delery, 2000).

The findings also offer a practical implication for businesses with administrative constraints which are considering using franchising as a quick fix for their expansion or growth strategy. The findings of this study indicate that franchising may not be an effective strategy to reduce the administrative cost of monitoring and control. The franchisees have a higher expectation, demand more return and may not be highly motivated when compared to the company-owned employees. As a result, businesses may have to pay more for administrative monitoring when engaged in franchising. Although franchising strategy may offer other competitive advantages to businesses (that is, capital resource as suggested by the resource scarcity theory), it should not be viewed as a substitute for agent efficiency as the company employed manager may be able to contribute to the success of the firms with less cost and less expectation.

Limitations

Some limitations should be considered when using the results of this research. First, this study only tested some dominant aspects of the franchising rationale proposed by the agency theory. An in depth inquiry into some aspects of the theory, for example, the degree of local knowledge advantage between the franchisees and the company-owned managers, was ignored. Further research will need to look to advance this aspect. second, the inclusion of other theoretical assumptions on franchising into a single model will offer a fruitful explanation. Third, the study is only preliminary with the small sample size, however it does not limit the statistical power for the test-statistics.

Conclusions

For the past four decades, the agency theory has been popularly used to explain the origin of franchising. This theory is also deemed to be a popular rationale for the spread of the franchise business practice worldwide. However, the results of this study did not confirm the aspects proposed by the agency theory, since the unsupported findings are likely to indicate the limitations of this theory. The largely unsupported results suggested that not only the agency theory but also other explanations could be effectively combined to explicate the franchise phenomenon.

The results of this study indicate that a contemporary view of franchising could be more effective for investigating the franchising phenomenon. Several academic scholars favour the contemporary explanation of franchising in which they combine the two traditional theories as the systematic approach underlying the franchising creation: the resource scarcity theory and the agency theory could be effectively used to explain franchising (Bergen, Dutta, and Walker, 1992; Combs and Ketchen, 1999; Lafontaine and Kaufmann, 1994). In this particular view, franchising occurs when the firms need to enhance the capital and human resources and at the same time create agency efficiency or human capital strength in the participating firms. Franchising is then employed as an entry and growth strategy for firms, resulting in a rapid adoption of this business practice. However, the competitive advantage of agency efficiency on franchising was not confirmed in this study.

While franchising has become a familiar business practice around the globe, the theoretical aspect of franchising is getting stagnant. The popularity of an inquiry into the fundamentals underlying the franchising theory has slowly subsided, while one or two researchers try to initiate interest in this topic by suggesting a new theory or idea (for example, Felstead, 1993; Price, 1997). However, the discussion regarding the fundamental issue of franchising is still ongoing and inconclusive. Perhaps the franchising phenomenon is not a simple array. Since franchising lies in several areas, it could be included in economic, social science, business, and law theories. The application of a sole theory to franchising gives inconclusive results. It is likely that the complete understanding of the franchising phenomenon may require an explanation involving more than one theory.

1 Franchisees paid a lump sum or fixed fee for entering a franchise

2 Franchisee is usually paid a royalty fee which is a fixed percentage based on gross sales of a franchisee unit.

3 Large scale advantage refers to the supports and benefits that the franchisor offers to the franchisees, such as benefit from the franchise brand name and benefit of training and support. Franchise firms also benefit from the economies of scale or costs advantage resulting from a bulk purchase (Anderson and Weitz, 1989; Bronson and Morgan 1998).

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Chutaratlnma

Faculty of Regional Professional Studies

Edith Cowan University

Copyright Singapore Institute of Management 2005

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