Journal of Consumer Marketing

Emerald Article: A note on applying retail location models in franchise

systems: a view from the trenches
Kenneth C. Schneider, James C. Johnson, Bradley J. Sleeper, William C.
Rodgers

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Franchise systems in the
service industry
290 JOURNAL OF CONSUMER MARKETING, VOL. 15 NO. 3 1998, pp. 290-296 MCB UNIVERSITY PRESS, 0736-3761
A note on applying retail
location models in franchise
systems: a view from the
trenches
Kenneth C. Schneider
Professor of Marketing and Marketing Research,
St Cloud State University, Minnesota, USA
James C. Johnson
Professor of Marketing and Transportation,
St Cloud State University, Minnesota, USA
Bradley J. Sleeper
Assistant Professor of Law
St Cloud State University, Minnesota, USA
William C. Rodgers
Professor of Marketing and Consumer Behavior,
St Cloud State University, Minnesota, USA
Maturation problems in franchise systems
With $800 billion in sales, representing some 40 per cent of all US retail
sales, franchising is rapidly emerging as the dominant form of ownership in
the retail sector of the US economy (International Franchise Association,
1995). Similar trends are underway in other developed countries. In
Australia, for example, franchising accounted for 20 per cent of retail sales
by the end of the 1980s, encompassing some 7,000 franchisees operating in
500 different systems (Terry, 1989).
Overall, franchising remains in a state of relatively strong growth. The
International Franchise Association (1995) suggests that, through the mid-
1990s at least, the number of franchised units was expanding at annual
percentage rates in the low teens and higher. Of course, growth in terms of
either unit expansion or system revenue varies considerably from one system
to another. Many successful newer systems are growing rapidly. For others,
growth has been increasingly difficult to maintain. Such maturity is perhaps
best illustrated by the US fast food industry. Even venerable industry leader
McDonalds has recently encountered more or less stagnant sales in the
domestic market (The Economist, 1996).
Lessons being learned as the domestic fast food industry undergoes
transition from growth to maturity are important ones, especially to franchise
systems in the services industry, where franchise expansion lags fast food by
at least a decade. From a strategic marketing perspective, the fast food
industry has adopted several options to fend off a flattening sales curve.
Again, McDonalds is exemplar. First, the industry has looked abroad, where
competition is less intense, at least so far. McDonalds is currently opening
new units at a rate of nine per day; three in domestic markets and six
overseas (Gibson, 1996a). A burger and fries, McDonalds style, is now
available in some 100 countries (The Economist, 1996).
Second, the industry continues to search out new target markets. The
summer of 1996 saw Ronald McDonald variously attired in business suits
and golf wear while touting the arrival of the deluxe line of sandwiches
aimed at adults (Macleans, 1996; Pollack, 1996). A variant on this strategy
entails placing units within easy reach of captive markets. McDonalds

Strained relationships
Franchisors need to find
new locations
JOURNAL OF CONSUMER MARKETING, VOL. 15 NO. 3 1998
recently opened a unit inside the Toronto Skydome (two other fast food
systems did so inside the student union on the authors campus), and is
testing a new service in which customers place orders by touching a video
screen while waiting at the self-service gas pump; filled orders are then
delivered to the customers car (Mannix, 1996).
Third, and perhaps most troubling to fast food franchisees, the industry
continues to crowd the market with more and more units, often revisiting
markets once deemed fully saturated. This strategy has strained the
relationship between franchisors and franchisees in many systems, especially
in fast food. In one celebrated court case, franchisee Steven Scheck sued
Burger King Corporation for fraud and breach of contract when it opened a
Burger King restaurant approximately two miles from Schecks (Geehern,
1993). Burger King argued for summary dismissal on the grounds that
Schecks contract did not allow for an exclusive territory. Judge William
Hoeveler disagreed, commenting, It is clear that, while Scheck is not
entitled to an exclusive territory, he is entitled to expect that Burger King
will not act to destroy the right of the franchisee to enjoy the fruits of the
contract (Knack and Bader, 1993). In another case, $2.2 million was
awarded a Naugles restaurant franchisee in California when the court found
Naugles has breached its covenant of good faith and fair dealing by
locating another unit within two miles, even though the franchise contract
specified no exclusive territory. The award was recently upheld on appeal
(Gibson, 1996b, p.B1).
Others have sought relief outside the courts. Franchisee complaints filed
with the Federal Trade Commission have grown in excess of 50 per cent
annually during the 1990s, and now number in the neighborhood of 1,000
per year (Whitehead, 1995). Many involve alleged encroachment by the
franchisor. Similarly, within two years of its founding, the National
Franchise Mediation Program had processed 59 disputes. Forty-six per cent
of those involved alleged encroachment, far more than any other single issue
(Franchising World, 1995).
Store location models applied to franchise systems
With the shift from growth to maturity in the life cycle of many franchise
systems, especially among restaurants, significant effort is under way to
assist franchisors in finding suitable new locations. One form of assistance
involves the development of mathematical models capable of determining
best new locations. Such modeling, of course, has a rich history in the
field of retailing (see Ghosh and McLafferty, 1987 for an excellent review).
Typically, location models identify as best that new location which
maximizes some measure of overall financial performance for the
organization, often total revenue. In doing so, the model usually allows
revenue to be cannibalized from existing locations of the organization, as
long as total revenue is maximized. While this poses no problem to the
corporate-owned chain, franchise systems are different. A current franchisee
would be understandably upset if revenue at his/her unit is cannibalized, no
matter that system-wide revenue increases. From the franchisees
perspective, the lost sales have been pirated away, just as surely as if by a
competing system; the modeled franchisees territory has been encroached
upon.
When applying location models in a franchise environment, then, the
modeler must reconcile these naturally conflicting objectives the
291
 franchisors primary objective to maximize performance across the whole
system versus the franchisees primary objective to maximize performance
for only his/her unit(s). Indeed, at least two models allowing for such a
reconciliation were proposed in the early 1990s, at least one of which has
been elsewhere recommended as an aid in making location decisions in the
hospitality industry (Patel and Corgel, 1995). Although the two models, by
Ghosh and Craig (1991) and by Kaufman and Rangan (1990), differ in their
specific mathematical formulations, both stipulate that adding a new unit to
the system gives rise to countervailing forces that impact the financial
performance of existing units. On the negative side, of course, some
customers of existing units find the new unit more conveniently located, and
are thereby attracted to it. On the positive side, the new unit adds to the
overall presence of the system in the market area through additional signage,
increased advertising allotment, and so forth, which in turn enhances
system-wide revenue, and perhaps for at least some existing units. Ghosh
and Craig (1991, p. 470) call this upside effect the brand demand, and
Kaufman and Rangan (1990, p. 159) call it the system attractiveness or
relative preference for the brand.
Protecting current Theoretically, therefore, a new unit can produce a net positive revenue
revenue impact on an existing unit. However, location models must incorporate
safeguards for existing units in case such a net revenue increase does not
occur naturally. The Ghosh and Craig (1991) integer programming model
does so by adding constraints that disallow new unit locations that do not
provide a minimum revenue threshold for the new unit, and/or that fail to
either protect current revenue for existing units as a group; or, protect
current revenue for each existing unit. The first, weaker constraint is not
very satisfying to existing franchisees because then individual units may lose
revenue; and, Ghosh and Craig were hard pressed to identify locations that
meet the stronger one, even in a simplified hypothetical illustration. In that
example, the best location in terms of maximizing system revenues while
protecting current revenue for all existing units resulted in a mediocre new
location that barely met its minimum revenue threshold. In a later attempt to
locate two new units simultaneously, no location pairs could be found that
protected current revenue for all existing units.
The best location The Kaufman and Rangan (1990) model protects existing units differently.
In a hypothetical illustration of their model, only two of 20 locations
naturally protected the current revenue of each existing unit after a new one
was added. For each of the remaining 18 locations, the franchisor is required
to infuse additional advertising spending in the market area (exceeding what
occurs anyway with the added unit) until revenue at each existing unit is
recovered. Such spending, as a percentage of the franchisors royalty
income, varies from modest for some locations to prohibitive for others. The
best location is that which maximizes the franchisors financial
performance net of the additional investment in advertising.

Franchisee reactions to the models safeguards

As part of a larger survey of franchisee concerns, 174 current franchise
owners representing major US fast food franchise systems were queried as to
how palatable the approaches adopted in these two models might be. The
sampling frame for the survey was purchased from a professional list
supplier and consisted of current franchise owners in nine systems: Arbys
A&W, Burger King, Hardees, KFC, Long John Silvers, McDonalds,
Subway and Taco Bell. An initial sample of 50 owners from each system

292 JOURNAL OF CONSUMER MARKETING, VOL. 15 NO. 3 1998


Excellent participation
rate
Concern about franchisor
encroachment
Negative or positive
effects
JOURNAL OF CONSUMER MARKETING, VOL. 15 NO. 3 1998
was randomly selected from the frame. Potential respondents were then
contacted by trained telephone interviewers during normal daytime business
hours over a one-week period. Three to five attempts were made to reach
each owner, using varied times of day and days during the week. Once
contacted, respondents were first screened to ensure that only franchise
owners were surveyed; corporate-owned and managed units were replaced
with substitutes from the frame.
By the end of the week, contact had been made and interviews completed
with 174 of the eligible franchisees. Participation rates varied dramatically
by system, from just 16 per cent for Long John Silvers to over 50 per cent
for Arbys, KFC and Subway. The overall participation rate, 174/450 =
0.387, or 38.7 per cent, was considered excellent, especially given the
entrepreneurial nature, professional status and consequent difficulty in
actually making contact with the targeted sample.
As is true in the fast food industry in general, revenues at the surveyed
restaurants are relatively modest; more than seven in ten reported annual
sales per unit under $1 million. One in three operate multiple units. Finally,
dividing the sample into terciles based on years in the business, one-third has
seven or less years ownership experience in the fast food industry, one-third
between eight and 17 years, and one-third 18 years or more.
Overall, surveyed franchisees expressed considerable concern about
franchisor encroachment. Nearly one in four (24.0 per cent) agreed that their
franchisor has tried to locate another unit much too close, even though no
territorial limits were violated, and nearly one in ten (8.6 per cent) agreed
that their franchisor has tried to violate territorial limits provided in the
franchise contract. While these concerns did not vary significantly by
experience (i.e. years as an owner in the system) nor by unit revenue, owners
of two or more units exhibited significantly less concern than owners of a
single unit. That is, only 10.4 per cent of franchisees with multiple units said
their franchisor has tried to locate another unit too close (versus 32.7 per
cent of franchisees with one unit; p < 0.001), and only 4.0 per cent said their
franchisor has tried to encroach on protected territory (versus 12.2 per cent
of franchisees with one unit; p < 0.05).
Surveyed franchisees did not demonstrate great faith in the ability of
increased advertising, signage and the like to mitigate the negative impact of
cannibalization. Specifically, they were asked:
Which of the following do you think is most likely to result from locating a new
unit nearby an existing one?
a negative effect on sales at the existing unit because some
customers find the new site more convenient; or
a positive effect on sales at the existing unit because the new unit
adds to the signage, advertising and overall presence of the
franchise system in the market.
Respondents indicated the negative effect would predominate by better than
a six-to-one margin (i.e. 86.1 per cent said a negative effect would result,
while just 13.9 per cent said a positive effect would result). There was again
a difference of opinion between franchisees who owned multiple units, 89.7
per cent of whom said the negative effect would predominate, and those who
owned just one unit, 80.3 per cent of whom said the negative effect would
predominate, though this time the difference was only marginally significant
(p < 0.10).
293
 Franchisees were equally dubious of Kaufman and Rangans (1990)
proffered solution of having additional advertising expenditures by the
franchisor beyond the automatic increase resulting from increased system
revenue. While not specifically included in their model, Kaufman and
Rangan suggest two alternative real-world strategies that might be adopted
by franchisors: engaging in conflict resolution (i.e. negotiating a settlement)
and offering existing franchisees the right of first refusal on new locations
located nearby. To investigate their reactions to all three strategies,
franchisees were asked a set of question (see Table I).
Alternative strategies Figure 1 presents the overall results of this query. The third strategy, of
course, is suggestive of the one in Kaufman and Rangans model. As can be
seen in Figure 1, it is by far the least preferred. More than four in ten (42.3
per cent) respondents felt the additional advertising allocation was not at all
fair to the existing franchisee, about twice the number opposing a negotiated
settlement (22.6 per cent) and three times the number opposing offer to
existing franchisees of a right of first refusal. (These findings did not vary
significantly by franchisee characteristics.)

Managerial implications
The implication of these survey results is rather clear. Real-world
franchisees are not particularly enamored of the manner in which their
interests are safeguarded in current generation location models for franchise
systems. While this opposition certainly does not invalidate the models, it
might make them politically untenable as presently cast. Minimally,
franchisees expect to receive the right of first refusal on new units proposed
at locations that might otherwise smack of encroachment.
Direct cash payments Further, franchisees seem more interested in direct cash payments rather
than increased franchisor advertising support as compensation for any
revenue lost by adding a new unit. While beyond the intent of this note, a
franchisor strategy of payment for encroachment appears susceptible to
modeling, especially under Kaufman and Rangans conceptualization. If, in
their model, a projected location would cause a projected 3 per cent annual
decline in revenue for an existing unit, a cash settlement reflecting the net
present value of the profit attending the units lost revenue stream over the
life of the contract (or the expected life of the unit, or some intermediate
duration) would be charged against the franchisors anticipated increase in

Please consider the following situation: Smith owns a franchised unit of ABC Eats. The
franchisor informs Smith of its intention to locate a new unit nearby. The site would not
violate Smiths protected territory, but it would be located close to Smiths territory;
much too close, Smith thinks. How fair to Smith is each of the following: very fair,
somewhat fair, or not at all fair?
Very fair Somewhat fair Not at all fair
Smith is offered first right of refusal
on the new site but nothing else

The franchisor offers to negotiate a

mutually agreeable cash settlement

A permanent 20 per cent increase in

Smiths advertising allocation is offered

Table I. Questionnaire of franchisee safeguards

294 JOURNAL OF CONSUMER MARKETING, VOL. 15 NO. 3 1998

 48.3%

36.0% Smith is offered right of first refusal

on the new site, but nothing else
15.7%

38.7%
The franchisor offers to negotiate
38.7% a mutually agreeable cash
settlement
22.6%

23.8%

A permanent 20% increase in Smiths

33.9% advertising allocation is offered

42.3%

0% 20% 40% 60% 80% 100%

Percent

Key

Very Fair Somewhat Fair Not at all Fair

Figure 1. Reactions to franchisee safeguards

royalty income earned by the new unit. The model could then identify the
location with the maximum net improvement in financial performance for
the franchisor, as before.
Inadequate At any rate, fast food franchisees (at least) seem to doubt that the additional
compensation per centage of sales contributions of the new unit causing modest sales
gains throughout the system, or that the franchisor making greater
advertising allocations directly for the benefit of the affected unit,
adequately compensates for encroachment.

References
Economist (The) (1996), MacWorld, 29 June, pp. 61-2.
Franchising World (1995), Franchisees turn to national franchise mediation program,
September-October, pp. 26-8.
Geehern, C. (1993), Franchising nightmare, Minneapolis Star/Tribune, 11 October, pp. 1D, 7D.
Ghosh, A. and Craig, C.S. (1991), FRANSYS: a franchise distribution system location
model, Journal of Retailing, Winter, pp. 466-95.
Ghosh, A. and McLafferty, S. (1987), Location Strategies for Retail and Service Firms,
Lexington Books, Lexington, MA.

JOURNAL OF CONSUMER MARKETING, VOL. 15 NO. 3 1998 295

 Gibson, R. (1996a), McDonalds decides its Mclean burger fails to cut the mustard with
diners, The Wall Street Journal, 18 January, p. A3:1.
Gibson, R. (1996b), Court decides franchisees get elbow room, The Wall Street Journal,
August, pp. 14, B1.
International Franchise Association (1995), Franchise Fact Sheet, 5 June.
Kaufman, P.J. and Rangan, V.K (1990), A model for managing system conflict during
franchise expansion, Journal of Retailing, Summer, pp. 155-73.
Knack, G.L. and Bader, T.A. (1993), Franchisor liability in the market-development and site-
selection process: location, location ... liability?, Franchise Law Journal, Fall, pp. 39-47.
Macleans (1996), Going after the adults, May 13, p. 47.
Mannix, M. (1996), A big whopper stopper?, US News & World Report, 6 May, p. 60.
Patel, D. and Corgel, J.B. (1995), An analysis of hotel-impact studies, Hotel and Restaurant
Administration Quarterly, August, pp. 27-37.
Pollack, J. (1996), McDonalds to aim its arch at grown-ups, Advertising Age, 8 April, p. 3.
Terry, A. (1989), Franchising fever, Australian Accountant, July, pp. 29-34.
Whitehead, A. (1995), Trouble in franchise nation, Fortune, 6 March, pp. 115-29.

296 JOURNAL OF CONSUMER MARKETING, VOL. 15 NO. 3 1998