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Agency Problems and Administrative Efficiency

Even if you run a single store, you can’t do everything. But if you want to grow the business, you simply must delegate major responsibilities. The problem is that most entrepreneurs think they do things better than almost anyone else. Simply stated, the concept of agency asks, How does the business owner know that delegated tasks are performed exactly as he or she prefers? Once this question can be answered, then the business owner will attain administrative efficiency—a documented process of efficient and effective business operation. Administrative efficiency is the means by which agency problems are managed.

Most businesses grow to the point that the company-owned locations can no longer be managed cost effectively by the corporation. This is the point of zero or negative marginal return. Some additional mechanism for control must be implemented, with additional costs. This can be the trigger for a business to consider franchising.

Monitoring processes implemented through managers or operational and financial system controls are practical ways to monitor quality—but at what cost to the business in dollars, opportunity, or both? One of the biggest cost factors, for instance, occurs when organizations decide to manage and grow their business through the hierarchical use of assistant managers, managers, general managers, district managers, national managers, and so on. When this process of management is used in a corporate-owned chain of outlets, management performance becomes divorced from ownership.[1] The level of performance may become suboptimal because managerial accountability is not directly linked to compensation. Because the outlet managers in a company-owned store do not directly reap the rewards, or suffer the consequences of their actions, the feedback mechanism that could reduce inappropriate management behaviors such as shirking or free riding is, in effect, rusty and relatively less effective.[2] To correct this effect, the entrepreneur and/or the company’s management must incur high system-monitoring costs. This may solve the behavioral problems but restrict both the speed and the extent of growth.

Let’s refer back to the FRPT in Table 3-1 for a moment. Under Agency Concerns, we list outlet performance disclosed or discerned—the economics of the individual unit as a key indicator of an efficient system. In plain language, if the stores are profitable, then the franchisor system has, generally speaking, overcome agency issues. The second criteria, business format, allows you to understand whether profitability is a result of overcoming agency issues through a well-documented system or simply a case of the “rising tide” phenomenon. When a franchise offers something new to an accepting customer base, it may gain success because it was the first and maybe only such offering. Inefficiencies that become more apparent as the market develops and competition increases will deteriorate store-level economics. Boston Chicken is a prime example. In either case you would like to understand whether the system is moving in the right direction toward documentation and monitoring of the mechanisms that generate profits. The best way to discover the truth is to study the revenue growth in existing stores from quarter to quarter and examine how fast new stores reach and exceed breakeven. Asking the franchisor and existing franchisees direct questions is always a good idea!

The next criteria, franchise fee and royalty, is the mechanism that franchising uses to share the productive benefits of the relationship and therefore create the economic motivation for both parties to “act like owners.” The franchise fee and royalties are payments from the franchisee to the franchisor. The profit or loss from operating a store is the incentive for the franchisee. The partners share responsibilities and feel better that their goals are aligned through the profit incentive. Ownership induces behavior that is directly linked to the bottom line—positively or negatively. In order to better understand how franchise fees and royalties are determined, it is helpful to first look at the framework franchisees use in evaluating whether to buy a franchise or open their own business.

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