Franchising of SMEs in China - Essay Example

Small and Medium Sized Enterprises: Franchising of SME’s in China Since the 1990s, rates of growth in the number of SMEs in China have been higher than in other Asian countries. This process can be explained by the fact that the number of self-employed and SMEs has increased because of economic and social changes, population growth rates and urbanization in China. Although SME liquidity information at a Chinese level is not available, it is compiled for certain countries. In China, franchising has played an important role in the development and expansion of businesses for many years. For example, the number of business format franchisors has grown from 909 in 1990 to over 3,080 in 2000 (Garnaut et al 2000). Franchising in China proposes great opportunities for local businesses and international small and medium size enterprises to expend their activities and enter new markets. Following Welsh et al (2006): “franchising is seen as a means of obtaining scarce capital, as the franchisee is generally required to make a substantial investment in the business. Franchisees share risk with the franchiser. Franchising is also identified as a way of addressing the agency problem, specifically, the issue of monitoring managers” (2006, p. 130). In China, key to the success of the organization is the mutually dependent relationship between the two companies—the franchisor and the franchisee. Miller and Grossman (1986) described franchising as an organizational form structured by a long-term contract whereby the franchisor (usually owner) of a product and service grants the non-exclusive rights to a franchisee for the local (in this case Chinese) distribution of the particular product or service. The franchisee has to pay a fee and ongoing royalties and agrees to follow to quality standards. Also, a franchise can be defined as “an incentive distribution system for organizing individual firms pursuing their own rewards” (Abbott 1998, p. 76). Taking this perspective into account, researchers determine the phenomenon as an inter-organizational form. A possible, roughly natural rate of SME density also has limited implications for policies designed to promote 'entrepreneurship'. The logic is as follows: Let's assume that heading a small firm is an important mark of entrepreneurship, since the founder of a firm that quickly disappears may be less entrepreneurial than the leader of an SME that exists and survives, whether or not the leader was the original founder. In this analysis, the number of SMEs then becomes a proxy for the number of 'entrepreneurs': Entrepreneurs are the independent leaders of SMEs (Abbott 1998). Once economists accept that this assumption is one logical proxy of entrepreneurial activity (although by no means the only one), we can then say that a roughly natural rate of SME density implies there is little that can help, or hinder, entrepreneurship at the national level in a broadly liberal trading environment (Ambler & Witzel 2003). Ratios of 'entrepreneurs' (leaders of SMEs) are somewhat constant across European national populations. If one measures entrepreneurial activity by the rates of start-ups, then the analysis would change; but it is not clear that high start-up rates on a national scale really correlate with economic success either. The lowest start-up rates in Europe are in rich Sweden, the highest are in southern Europe, where unemployment is high and GDP per capita is lower. Definitions of entrepreneurship should encompass success measured by economic production and profits, and not just frenetic activities, primarily in the low-tech service sector (Justis & Judd 1999). In China, the majority of franchising companies operate as SMEs. In emerging markets like China, “retail franchising can sometimes supplant traditional and local cultural elements, which over time can lead to homogenization and westernization of preferences, especially among the youth. The older generations and the political establishments often resist such cultural shifts” (Welsh et al 2006, p. 132). In China, franchising is based on a marketing channel of distribution (Drysdale & Song 2000). In China, two different types of franchising are found. Product franchising is the most papillary one. This type is created by the makers of complex durable goods who found existing wholesalers either unable or unwilling to market their products. These manufacturers built their own distribution systems and franchises were created as alternatives to the high cost of company-owned outlets. Product franchising is characterized by franchised dealers who concentrate on a company’s product line and to some extent identify their business with that company (Kueh, 1997). In China, this type of relationships included gas stations, car dealerships and soft-drink bottlers. Business format franchising grew out of the concept of distribution channel development and control. It was formalized in the late 1950s by entrepreneurs who believed that the outlet itself could be a product. Initially the motivation was to enhance efficiency through minimizing cost (franchised outlet versus company-owned outlets) and later as a method of expanding revenue by prescribing detailed operational practices to protect and, ultimately, enhance the trade mark. Thus, franchising was used to create bilateral gains for channel members through vertical integration (Lo & Tian 2005). The second type of franchising is business format franchising. It usually involves the trade mark and distribution rights with information on the production processes and delivery system. This type is not very popular in China as the country cannot ensure the maintenance of the trade mark value. The value is then enhanced through the development and exploitation of economies of scale. Business format franchising usually includes a marketing plan, documented and enforced procedures, process assistance, and business development and innovation. It is an entire way of doing business and is a more complex relationship than product franchising because the method by which the asset is to be shared is stipulated in the license agreement (Krishna & Tan 1998). The best example of this type is franchising in China is McDonald’s. Its franchisee in China must staff and market per the contractually agreed methods whereas the product franchisee, say the Pepsi bottling franchise, centres on the soft drink formula and the packaging of the product (Groombridge & Claude 1999). In China, this complex channel system raises the question of coordination and control over the marketing functions. Each franchisee, as a downstream channel member, impacts the value of the intangible asset as the trademark becomes manifest in the delivery of the product to the consumer. Thus, the performance of each outlet has a pro-rata impact on the total income stream of the franchise system and specifically to the franchisor visà-vis royalty payments. Direct cost and benefits of individual performance are associated with agency concerns which ultimately affect the trade mark value. Clearly, the relationship must necessarily be dynamic because no long-term contract can cover all contingencies. There is an interdependent effect of action taken by the parties either bilaterally or independently. This is due to the continuing interaction between the franchisee and the franchisor involving general business discussion, feedback on marketing, and operations process adjustments (Groombridge & Claude 1999). The issues of goodwill and operating procedures clearly reflect trade mark values concerns. Therefore, it is surprising to see the level of disagreement on these issues. Similarly, on the surface, store cost conversion would cause less concern although the role and intricacy of signage on buildings and equipment in many franchises may explain the group concerned with this expense. Nevertheless, this result does indicate a need for further analysis. Overall, however, there is clear evidence that franchisee’s consider the exit costs to be high (Gregory et al 2000). Alternately stated, they appear to understand the value of the franchise. Developing franchisee-franchisor relations is a dynamic, long-term process. Researchers (Ambler & Witzel 2003) have shown clear theoretical and empirical evidence of the potential for conflict in this relationship. However, our pilot study gives only tentative support for the proposition that the microeconomic structural differences in the franchisee and franchisor firms result in marketing and new store development that leads to hostility. Indeed, the data suggest that franchisee’s consider the marketing services which they receive to be both (Gray, 1999). If the franchisor could induce a high level of recognition of the importance of marketing in the franchisee hierarchy of goals, relational and trade mark gains could ensue. The tentative ‘peace’ in the relationship, as revealed by the conflict construct, may hinge on the day-to-day perception of adequacy in operational and training issues and is supported by franchisee understanding of exit costs (Gillis et al 1996). The tentative nature of the lack of conflict in the relationship is supported by the general lack of ability of the franchisee to quantify the values of the trade mark and by the specific undervaluation when quantified. SME representatives discussing constraints on short-term business developments focus extensively on governmental and non-governmental financial constraints: taxes, the cost of finance, and lack of working capital (Ambler & Witzel 20030. The smallest companies are the ones that are most concerned with these issues. Some of the largest differentials between the smallest and larger companies in opinions about the EU business environment emerge in opinions on taxes, where the largest percentage (almost 40 per cent) of smaller company representatives register concerns about this short-term constraint to their growth potential (Gillis et al 1996). In sum, there is a higher level of support for the proposition that the trade mark value is understood as the primary linkage between the franchisee and the franchisor. However, the maintenance of the trade mark is seen as occurring in the standardization of the systems, not in the marketing functions. Thus, the franchisee would appear to be saying that the franchisor is good at developing an operating system that is proven and which, therefore, reduces franchisee risk. This, in turn, enhances the value of the franchise by allowing the franchisee to apply a lower discount rate to the income stream. Given that an important historical and theoretical reason for franchising is the Chinese economy, there is a great opportunity to enhance the franchisor—franchisee relationship by addressing the specific nature of perceived inadequacy in marketing as viewed by these franchisees. Bibliography 1. Abbott, Frederick M. 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