advantages and disadvantages of franchises for the franchisor and franchisee

1.5 Types of Business Organisation – Franchising (Cambridge IGCSE Business Studies 0450)

What is a Franchise? (Definition – AO1)

• Franchisor: owns a recognised brand, a proven operating system and the associated intellectual property.
• Franchisee: is granted, by a legal contract, the right to use that brand, sell the franchisor’s products/services and follow the franchisor’s operating procedures.
• In return the franchisee pays:
  • an initial franchise fee (one‑off payment for the right to join the network);
  • ongoing royalties – usually a percentage of turnover;
  • often a contribution to a national advertising fund.

Franchising is listed in the syllabus alongside sole trader, partnership, private‑limited company and joint venture as a distinct form of business organisation.

Key Syllabus Concepts (Risk, Ownership, Limited Liability & Control) – AO1

• Risk: the franchisee bears day‑to‑day operational risk; the franchisor’s main risk is brand‑reputation risk.
• Ownership: the franchisor retains ownership of the brand and the overall system; the franchisee owns the individual outlet.
• Limited liability: the franchisor and franchisee are separate legal entities. Each is liable only for debts of its own entity unless a personal guarantee is given.
  Example: If a franchisee’s shop goes bankrupt, the franchisor’s brand remains protected, although the franchisor may suffer reputational loss.
• Control: the franchisor sets brand standards, product range and marketing policy; the franchisee runs the outlet within those constraints.

When is Franchising the Most Suitable Form? – AO2 (Recommendation & Justification)

Students should link each criterion to the syllabus wording “recommend and justify a suitable form of business organisation”.

• Strong, recognisable brand already exists.
• Capital for rapid expansion is limited – the franchisor wants growth without large cash outlays.
• The business can be standardised into a replicable operating system.
• Control over quality and brand image is essential, but the owner is willing to share it with independent operators.
• There is market demand for the product/service in multiple locations.

Sample answer cue: “Because the company has a well‑known brand and limited finance for opening new stores, I would recommend franchising. This allows rapid expansion with low capital cost, while the franchisor retains control over brand standards.”

Comparison of Business Organisations – AO3

Advantages for the Franchisor – AO3 (Analysis)

Disadvantages for the Franchisor – AO3

• Control Issues: Maintaining consistent quality across many independent operators can be difficult. Audits, mystery shoppers and detailed manuals are used to mitigate this.
• Initial Set‑up Costs: Developing the franchise system, training programmes, legal documentation and support infrastructure requires a substantial upfront investment.
• Legal & Regulatory Compliance: In the UK franchisors must comply with the Franchise Disclosure Document (FDD) and other legislation; non‑compliance can lead to fines or loss of franchise rights.
• Potential for Conflict: Disagreements over marketing contributions, royalty calculations, or territorial rights can strain relationships and lead to legal disputes.
• Brand‑Reputation Risk: Poor performance by one franchisee can damage the whole brand, reducing sales for all other franchisees.

Advantages for the Franchisee – AO3

Disadvantages for the Franchisee – AO3

1. Initial & Ongoing Costs: Initial fee (often £10 000‑£50 000) plus royalties (4‑8 % of sales) and advertising contributions can cut into profit margins.
2. Limited Autonomy: The franchisee must follow the franchisor’s operating manual, product range and pricing policy, restricting local innovation.
3. Territorial Restrictions: Agreements usually define a protected area; expanding beyond it may require renegotiation or a new franchise.
4. Risk of Brand Damage: A scandal or poor service at another outlet can reduce overall brand perception and sales for all franchisees.
5. Contractual Dependence: The franchisee is bound by a fixed‑term contract; early termination can involve heavy penalties.

Financial Example – Calculating Royalties (AO2)

If a franchisee records the following figures in a year:

• Sales (turnover) = £150 000
• Royalty rate = 6 %
• Advertising contribution = 2 % of sales

Then:

• Royalty = 0.06 × £150 000 = £9 000
• Advertising contribution = 0.02 × £150 000 = £3 000
• Total ongoing payments to franchisor = £12 000

Break‑Even Example for a Franchisee (AO2)

Assume the following annual costs for a new outlet:

• Initial franchise fee (amortised over 5 years) = £20 000 ÷ 5 = £4 000 per year
• Rent & utilities = £30 000
• Staff salaries = £45 000
• Royalty (5 % of sales) = 0.05 × Sales
• Advertising contribution (2 % of sales) = 0.02 × Sales
• Other operating expenses = £10 000

Break‑even occurs when:

£4 000 + £30 000 + £45 000 + £10 000 + 0.07 × Sales = Sales

Simplifying:
£89 000 + 0.07 × Sales = Sales → 0.93 × Sales = £89 000 → Sales ≈ £95 700

Thus the franchisee must generate about £96 000 in annual sales to cover all costs.

Data‑Response Practice (AO3)

Below is a simple bar chart (students should be able to interpret it) showing royalty income for three franchisors in the first year of operation.

Possible analysis: “Fast‑Food Ltd earns the highest royalty income because it operates a larger number of outlets with higher average sales, illustrating how rapid expansion (an advantage) can increase the franchisor’s revenue stream.”

Evaluation – Pros, Cons and Balanced Judgement (AO4)

• Pros for the franchisor
  • Fast, low‑cost expansion.
  • Multiple revenue streams (fees + royalties).
  • Economies of scale in purchasing and marketing.
  • Risk of day‑to‑day operations transferred to franchisee.
• Cons for the franchisor
  • High set‑up and monitoring costs.
  • Difficulty maintaining uniform quality.
  • Potential legal disputes and regulatory compliance costs.
  • Brand reputation vulnerable to a single poor‑performing outlet.
• Pros for the franchisee
  • Access to an established brand and proven system.
  • Training, support and lower failure risk.
  • Economies of scale reduce purchase and advertising costs.
  • Possibility of financing assistance from the franchisor’s network.
• Cons for the franchisee
  • Significant upfront and ongoing fees cut into profit.
  • Limited freedom to adapt the product or marketing locally.
  • Territorial restrictions may limit growth.
  • Dependence on the franchisor – contract termination can be costly.

Balanced judgement: Franchising is most appropriate when a business has a strong brand, can be standardised, and seeks rapid expansion with limited capital. However, high royalty rates and strict control can reduce franchisee profitability, and any lapse in quality control can damage the whole brand. Therefore, the decision to franchise should weigh the need for growth against the ability to maintain consistent standards and the financial impact on both parties.

Legal & Regulatory Considerations – AO4

• Franchisors must produce a Franchise Disclosure Document (or equivalent) that details fees, obligations and financial performance.
• Both parties must comply with competition law, consumer protection legislation and, where applicable, sector‑specific regulations.
• Failure to comply can result in fines, injunctions, or loss of franchise rights – a risk that should be included in any evaluation.

Key Points for the IGCSE Exam (AO1‑AO4)

• AO1 – Knowledge: Define franchising, identify franchisor and franchisee, list the main contractual payments, and state that franchising is a recognised form of business organisation.
• AO2 – Application: Calculate royalties, advertising contributions, and a break‑even sales figure for a franchisee.
• AO3 – Analysis: Compare franchising with other forms of organisation using the table; analyse each advantage and disadvantage for both parties; interpret simple data (e.g., royalty‑income bar chart).
• AO4 – Evaluation: Weigh the pros and cons, consider legal compliance, and give a balanced judgement on when franchising is the most suitable organisational choice.
• Remember to refer to the comparative table when asked to recommend a form of business organisation for a given scenario.