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This chapter is from the book

Cost and Risk

Franchising works best in industries in which outlets are neither very expensive nor very risky for people to operate. In fact, research has shown that, in industries in which outlets are larger in terms of employment, sales, or physical space, firms tend to franchise less than firms in industries in which outlets are smaller. For instance, in industries in which the cost of establishing a single outlet is in the tens or hundreds of millions of dollars (industries such as retail appliance sales), franchising is relatively uncommon. Not only is there a small pool of potential franchisees with enough money to purchase franchises in such industries, but the very high investment also leads franchisees to underinvest in the development of the outlet. This problem of underinvestment is discussed in more detail in Chapter 3, "The Disadvantages of Franchising," but let's suffice it to say here that individual franchisees who make large investments are undiversified and, thus, are more risk averse than corporations that have raised money for all of their outlets simultaneously. This lack of diversification leads them to see a given investment as more risky than diversified investors see it and keeps them from making the investments that diversified investors would make.

For similar reasons, franchising works poorly in industries with a high level of risk resulting from factors outside the franchisee's control, such as variation in the general economic environment. For example, franchising doesn't work very well in the mortgage brokerage business because performance at refinancing homes depends a lot on interest rates on mortgages, which franchisees cannot control.

Franchising works poorly in these types of industries because high levels of environmental risk make franchises difficult to sell. A franchisee makes an investment in buying an outlet to earn financial return on that investment. The performance of the franchisee's investment is affected by both the person's own performance and the effect of factors beyond the franchisee's control, such as the condition of the economy. Diversification is the main mechanism that investors have to deal with the effect of factors beyond their control. Because the investments of franchisees are undiversified—they generally buy into only one franchise system at a time—they tend to be unwilling or unable to bear the risk of things beyond their own control. As a result, they tend not to buy franchises in industries in which this type of risk is very high. Diversified corporations are more able to bear this type of risk, so we see company-owned operations in industries with high levels of general economic risk.

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