The Effect Of Discounting On Franchise Relations

In a recent interview with Chain Leader magazine, Minnesota attorney J. Michael Dady briefly commented on the current state of the franchise industry.  According to Dady, one of the key problems currently plaguing franchisor-franchisee relations is widespread franchisor-mandated discount pricing programs.  Dady’s view is myopic but understandable, given that he represents franchisees exclusively. 

Taken from the perspective of a franchisee (as Dady does), discounting may appear harmful or even pernicious.  Most franchisors charge royalty fees that are calculated as a percentage of their franchisees’ total revenue, so an increase in overall sales systemwide means more money to the franchisor.  But this view vastly oversimplifies a complex issue and all but ignores the purpose behind discounting programs — positioning the brand to better compete with similar systems. 

By decreasing prices, franchisors hope to increase the overall traffic to individual stores, thereby increasing sales volume.  And it works – when prices drop, customers come.  For example, through an aggressive pricing program ($5 footlongs), Subway has been able to make the brand one of the success stories through the current economic downturn. 

While franchisees may have been affected by the reduction in margins, what would have happened if Subway retained its pre-recession pricing structure?  After all, a higher margin on product sales is useless if no products are being sold.  As a result, simple logic suggests that a lower margin realized on significantly higher sales will benefit store owners.

Of course, the need for good competitive positioning is not a license for the franchisor to ignore the potential effect on franchisees.  “Loss leader” pricing can work to drive traffic, but most franchise companies also understand that it can result in more harm than good if it seriously damages franchise relations. 

For example, Burger King’s $1 double cheeseburger promotion, which Dady mentions in his interview, caused widespread franchisee unrest and resulted in at least one class action lawsuit alleging that Burger King does not have the right to set maximum prices.  Burger King responded to franchisees by reengineering the product – now called a “BK Dollar Double” – with two beef patties and only one slice of cheese (which saves five cents per item).  Maintaining flexibility and reacting appropriately to franchisee response seems to be a wise approach in structuring a discounting program.

There is another downside to discounting that appears to have been ignored by many chains during the recession.  The risk with substantial price reduction is that consumers will resist increases when the economy improves. This is the reason why Darden (which operates brands like Olive Garden and Red Lobster) resisted overall product price reductions and other cutbacks that became common in the industry.  According to Wall Street analysts, that strategy appears to have worked. 

It is not yet clear what effect discount pricing strategies will have in the medium or long run.  But what is apparent is that, for some franchise systems, discounting has helped the brands weather one of the greatest economic storms in recent memory.  That, in turn, has benefitted both franchisees and franchisors.   

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