28 Jul 2008  Research & Ideas

Making the Decision to Franchise (or not)

Owners operating outlets across multiple markets have a variety of organizational models to choose from, including franchising. The decision is one of the most important they will make. A new Harvard Business School study looks at how 420 convenience store chains organized to serve diverse customers. Key concepts include:

  • Even firms that have a standardized business face the challenge of serving customers with different preferences and behaviors when that model is stretched across multiple markets.
  • By choosing to franchise, the firm minimizes exposure to risk in a relatively unfamiliar market; as a tradeoff, it also gives up some measure of control.
  • Chains that don't franchise employ fewer corporate and supervisory staff relative to the number of store-level employees.
  • Early evidence from ongoing research indicates that unit sales are lower for firms that expand into multiple markets without franchising or providing some incentive system for local managers.

 

From neighborhood to neighborhood—even from block to block—customers have different tastes in the products they buy and the retail experience they find most enjoyable.

As a business owner operating stores across multiple markets, is it possible to please everyone? Can executives back at headquarters maximize an organization's overall revenues by efficiently (and effectively) monitoring the desires of consumers representing a wide range of ethnicities and income levels, large families and singletons?

Much has been written about product differentiation and its role in retail success. Now the less well-known dynamic of customer differentiation and its effect on the way businesses are structured and run is examined in a recent Harvard Business School working paper, "Organizational Design and Control across Multiple Markets: The Case of Franchising in the Convenience Store Industry." The study was written by HBS professors Dennis Campbell and Srikant Datar, with Tatiana Sandino (HBS DBA '04) of USC's Marshall School of Business.

"Franchising is a very observable, real choice that organizations make."
-Dennis Campbell

"The basic idea is to think about how the complexity of the customer-facing operating environment affects organizational design choices such as control systems, incentives, performance measurement, and ownership structures," explains Campbell. "Even firms that have very standardized business models in terms of products, labor, and merchandising will face the challenge of serving customers with different preferences and behaviors when that model is stretched across multiple markets."

As a starting point in their research, the authors focused on the organizational decision to franchise or not franchise some stores when these outlets served markets with different demographic characteristics.

Motivated managers

That is one of the biggest decisions a business can make, Campbell says. Franchising creates a strong motivation for local managers to maximize performance, since they're rewarded with a residual profit from revenues. The firm minimizes its exposure to risk in a relatively unfamiliar market; as a tradeoff, it also gives up some measure of control.

To explore the link between franchising and the challenge of operating in diverse markets, the authors analyzed data from 420 convenience store chains, finding that chains operating in disparate types of markets were more likely to franchise stores.

They then focused on 43 chains that own some stores and franchise others, and drilled down further to the 34,892 stores operated by those chains to ensure that the decision to franchise was driven by the firm's decision to serve new or unfamiliar markets.

In the third part of their study, they investigated how 53 chains that don't franchise manage operations across multiple markets. They found evidence that chains serving more diverse markets decentralize their operations by employing fewer corporate and supervisory staff relative to the number of store-level employees.

"Franchising is a very observable, real choice that organizations make," says Campbell. It's also an extreme solution to the challenge of operating across multiple markets; future research will focus on other, more subtle choices.

"Firms that don't use franchising still decentralize their operations more; or they may provide more variable pay to employees when operating across diverse market types," Campbell continues. "Reporting structures, performance measurement systems, communication, IT strategies that allow for efficiency in stocking policies—these are all factors we've observed and intend to study further, in addition to measuring their effect on performance."

"When an organization sets up its structure, there's a lot of talk about alignment and fit relative to the addition of new products," adds Datar. "What we're seeing in this research is that also appears to be true when you get a new type of consumer for the same product."

In the pharmaceutical industry, for example, selling medicine to both an independent general practitioner and a hospital will require a different organizational structure than if a company targeted one customer or the other.

Organizational design and performance

The impact of organizational design choices on performance will be considered in other papers; Campbell notes that early evidence indicates that unit sales are lower for firms that expand into multiple markets without franchising or providing some incentive system for local managers.

"This research is really a starting point," says Campbell. "To our knowledge, no one has drawn this link between the complexity that is imposed by customers with divergent demand preferences and these broad organizational design choices."

There are broader implications, too.

"It's possible to think about this in a global context," says Datar. "If my organization is operating in the United States and in China, that demands a very creative response in organizational structure."

About the author

Julia Hanna is associate editor of the HBS Alumni Bulletin.