Evaluating the Advantages and Disadvantages of Franchising through a Case Study of Chipotle Mexican Grill and McDonald’s Corporation

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Introduction

Franchising is one of the most popular market entry strategies adopted by businesses today and is often attributed to the international success of multinational corporations. Yet, because researchers have had difficulties accessing the private data that is necessary to measure the results of franchising, the actual merits of franchising have been called into question. While McDonald’s serves as an example of a restaurant that his expanded its operations and profits globally through franchising, Chipotle Mexican Grill serves as a success story that counters the conventional practice of franchising. As a case study comparing the business strategies of Chipotle Mexican Grill and McDonald’s Corporation will determine, while franchising is an ideal strategy for a global enterprise expansion, direct ownership is an ideal strategy for strengthening domestic sales.

Objectives

The objective of this research is to assess the advantages and disadvantages of franchising as a market entry strategy. The research will answer the questions: 1) what are the benefits of franchising? 2) what are the disadvantages of franchising?, and 3) under what conditions is it desirable for a business to utilize franchising over direct operation?

Scope

This report will assess the merits of franchising in the restaurant industry by evaluating the strategies of two companies: Chipotle Mexican Grill and McDonald’s Corporation. In assessing the competitive strategies of the firms, this research will utilize the annual reports of both companies, information from the company websites, as well as a literature review to determine the advantages and disadvantages associated with franchising.

Methodology

This research consists of a case study that will utilize empirical evidence contained through a qualitative and quantitative analysis of the performance of Chipotle Mexican Grill and McDonald’s Corporation. Further, this research will include a literature review to assess the advantages and disadvantages of franchising.

Analysis

This analysis consists of three sections: 1) an overview of franchising as a market entry strategy, a case study of Chipotle Mexican Grille, and a case study of McDonald’s Corporation. These three components will be unified in order to determine the extent to which franchising is beneficial as a competitive strategy.

Overview of Franchising

The franchising model is popular for businesses that wish to expand their operations while decreasing their upfront investment costs. According to Gillis and Castrogiovanni (2010), franchising is defined as, “a business relationship grounded in a licensing agreement between two independent firms” (p. 75). Further they note:

Business format franchising is defined as a continuing relationship between two parties that provides a full set of services and in which one party, the franchisee, sells goods or services supplied by or approved by the other party, the franchisor (p. 76). When a restaurant establishes a franchise, it typically involves the payment of a fee by an individual who wishes to gain permission to sell the products of and operate under the name of that restaurant franchise.

There are several theories that attempt to explain franchising, but each possesses their weaknesses. According to the resource scarcity theory, franchising is favored because it enables rapid expansion by enabling businesses to gain scarce resources, including managerial skills, local market knowledge, and financial capital (Gillis & Castrogiovanni, 2010, p. 76). However, while this theory implies that firms only franchise in order to gain scarce resources, research has determined that firms still expand their franchises, even after being in operation for 60 years (Gillis & Castrogiovanni, 2010, p. 79). Further, longitudinal studies assert that while companies increase their level of franchising for 7 years, they will continue to add franchises at a stable rate in the subsequent years (Gillis & Castrogiovanni, 2010, p. 79). Thus, the desirability of franchising cannot be entirely explained by the need that small businesses have to access resources for expansion.

Another theory that addresses the merits of franchising is agency theory. This theory posits that there is innate conflict that will emerge as a result of the disparate goals of the principal, or the franchiser, and the agent, or the franchisee or manager (Gillis & Castrogiovanni, 2010, p. 81). For example, principles generally are risk neutral and are open to taking on new risk because they can easily spread their risks across their franchises (Gillis & Castrogiovanni, 2010, p. 81). Yet, because agents only operate one or a small number of franchises, they tend to be risk averse in their outlook (Gillis & Castrogiovanni, 2010, p. 81). Overall, research posits that franchises typically outperform non-franchising firms (Madanoglu, Lee, & Castrogiovanni, 2011, p. 413). As agency theory suggests, the conflicting goals between the franchisers and franchisees can lead to an impasse when the franchisee is uncomfortable with the level of risk that franchisers propose in order to increase profits. This serves as a main disadvantage that the franchising model holds for corporations.

While it is often believed that the cost of establishing a franchise is low, many theories assert that hidden costs can increase the investment a corporation must make in order to establish a franchise. Transactional cost analysis serves as an additional framework for assessing the efficiency of the franchising model. This framework considers the hidden transaction costs that are associated with franchising, including the uncertainty that the franchisers have on the state of the environment, the rationality and cognitive abilities of managers who must make decisions, and the number of buyers who are prone to opportunistic behavior when oversight by the franchiser is lacking (2012, p. 51). Other costs that are associated with franchising include monitoring costs, research costs to evaluate prospective franchise buyers, service costs to transfer knowledge and technology to franchisees, and costs associated with protecting the property rights of franchise owners (2012, p. 52). Thus, while franchising may enable a company to increase the number of stores it opens, the costs associated with establishing new franchises may initially decrease the profitability of the new franchise.

However, while there are many disadvantages to franchising highlighted by the literature, there are several unique advantages to note. First, franchising remains the ideal strategy for expanding a business abroad. As Hoffman and Preble (2004) establish, franchising become a primary strategy during the 1990s and 2000s as domestic markets within the United States became saturated (p. 101). In order to increase profits, U.S. companies expanded their franchises abroad, and U.S. franchising revenues grew to $1 trillion, or approximately 50 percent of all retail sales, by 2004 (2004, p. 101). Further, because franchising is flexible while enabling franchisers to sell proven products, it was most suitable for franchisees in transitional economies, such as the Czech Republic or Slovenia where no previous concepts of entrepreneurship had existed (2004, p. 102). Thus, as United States businesses increased their presence overseas, the prevalence of franchising is expected to grow.

There are many benefits to utilizing franchising as a market entry strategy abroad. As Johansson (2007) notes, to compete in foreign markets, it is important for multinational corporations to adapt to the needs of foreign markets (p. 67). Yet, as Welsh, Alon, and Falbe (2006) note, businesses are able to benefit from the knowledge of their franchisees when they utilize licensing to introduce their business in foreign markets (2006, p. 135). Further, global franchising provides the benefits of requiring fewer financial resources to operate abroad while exposing the business to fewer political, economic, or cultural risks (2006, p. 135). Additionally, foreign franchisees will be more familiar with the local laws, languages, cultures, and business practices that a multinational firm needs in order to succeed (2006, p. 135). In consideration of these advantages, franchising tends to be the top strategy of businesses that seek to increase international sales as a component of their competitive strategy.

Chipotle Mexican Grill

Chipotle Mexican Grill is a restaurant that specializes in providing high-quality Mexican cuisine in a fast food setting. Founded by Steve Ells and opening in 1993, the first Chipotle store distinguished itself from competitors by utilizing “classic cooking methods and a distinctive interior design” (Corporate Profile). In 1998, after establishing 14 locations, the owner sold a portion of the company to McDonald’s Corporation (Adamy, 2007, p. B.1). However, Chipotle distinguishes its brand by referring to its restaurants as “fast casual” and focusing on providing higher quality food at slightly higher prices than fast food competitors, yet they are eating up the competition (2007, p. B.1). Another distinguishing feature of Chipotle Mexican Grill is that it does not utilize franchising, instead directly operating its locations. Currently, there are over 1,410 Chipotle restaurants, with 5 in Canada, 5 in London, and 1 in Paris (2012 Annual Report and Proxy Statement, 2012, p. 3). Because of its ability to maintain direct control over its stores, the Chipotle is able to maintain a close relationship with suppliers to ensure high ingredient quality and involve itself in site selection to select sites that are ideal for growth (2012, p. 6-7; Real Estate Development). Deviating from the traditional fast food model has yielded positive results for the company.

Though Chipotle does not franchise, its performance is significant. For the fiscal year 2011, Chipotle reported a 23.6 percent increase in revenues over the fiscal year 2010 with a new profit of $214 million (Chipotle Mexican Grill, Inc. SWOT Analysis, 2012, p. 3). Further, for the fiscal year 2012, the company reported a 7.1 decrease in sales growth (2012 Annual Report and Proxy Statement, 2012, p. 29). Chipotle’s success in expanding its sales can be attributed to its unique approach to marketing. The company eschews traditional advertising campaigns and attempts to develop loyalty programs and outreach programs that enhance the experience that customers have with the brand (2012, p. 7). As Chipotle’s performance demonstrates, the direct operation of a business can be profitable when it enables corporations to increase brand loyalty by ensuring the quality of their brand in order to enhance sales.

McDonald’s Corporation

In contrast to Chipotle, McDonald’s Corporation primarily utilizes franchising to expand its operations. McDonald’s was founded by Richard and Maurice McDonald in 1937 and sold to Ray Kroc as a franchise in 1954 (Vignali, 2001, p. 97). Currently, there are 34,480 restaurants in 119 countries, of which 27,882 were franchised or licensed (2012 Annual Report, 2012, p. 11). In order to obtain a franchise, franchisees must pay an initial 40 percent down payment for a new restaurant and a 25 percent payment for an existing restaurant (Acquiring a Franchise). Additionally, they must pay a service fee of 4 percent of monthly and pay rent on store facilities (Acquiring a Franchise). The upfront payments made by franchisees reduce the costs of opening a new McDonald’s store for the corporation.

McDonald’s especially utilizes franchising in its operations abroad. Currently, McDonald’s operates in the United States, Europe, Asia/Pacific, Middle East, and Africa. While the United States and Europe constitute individual markets, the latter regions are combined together and termed the APMEA market (2012, p. 11). McDonald’s main strategy in each market is to offer consistent products in a similar store environment (Vignali, 2001, p. 101). However, different products are offered to meet the tastes of consumers in different regions, such as guava juice in tropical markets, beer in Germany stores, and the Samurai Pork Burger in Thailand (Dana, 1999, p. 499). Through the use of franchising, McDonald’s is able to anticipate and accommodate local markets in an effective manner.

However, there is some suggestion that franchising might not be entirely efficient for McDonald’s. For the fiscal year 2012, franchise stores brought in total revenue of 8,964 million (2012 Annual Report, 2012, p. 17). Yet, sales increased by 3.3 percent in 2012 while European sales rose by 2.4 percent and APMEA sales rose by 1.4 percent (2012, p. 12-13). Further, the percentage of visitors decreased in Europe and APMEA for the fiscal year 2012 (2012, p. 12-13). Though sales are consistent overall for the company, sluggish growth in store visitors combined with relatively low growth in sales from their "super-sized" menu suggests future challenges for the franchise.

Conclusion and Recommendations

Though resource theory posits that franchising is favored by small businesses who are strapped for resources, franchising continues to be a dominant strategy among American businesses. During the 1990s, United States businesses adopted franchising in greater numbers in order to expand their operations abroad. While franchising imposes high transactional costs and creates potential conflicts between franchise owners and franchisees, it is still an effective way for businesses to minimize their risk when expanding their operations to foreign markets. Yet, as the cases analyzing Chipotle Mexican Grill and McDonald’s Corporation demonstrate, franchising is not an ideal model for all businesses. In the case of Chipotle, tighter corporate control is a better strategy for improving brand quality and increasing growth. However, this control comes at the cost of growth. In contrast, McDonald’s is located in every region of the world and is able to accommodate a variety of local tastes through its use of franchising. Yet, this comes at the sacrifice of tighter control and sales growth. As transactional cost analysis and agency posit, the hidden costs of franchising might also be responsible for decreasing McDonald’s earning potentials. Thus, while franchising is the recommended market entry strategy for corporations that seek access to foreign markets as their primary strategy, franchising should be limited by corporations that seek to primarily increase sales and enhance their brand image domestically.

References

2012 annual report. (2012). Retrieved from http://www.aboutmcdonalds.com

2012 annual report and proxy statement. (2012). Retrieved from http://ir.chipotle.com/phoenix.zhtml?c=194775&p=irol-reportsAnnual

Acquiring a franchise. (2013). Retrieved from http://www.aboutmcdonalds.com/mcd/franchising/us_franchising/aquiring_a_franchise.html

Adamy, J. (2007, Nov 23). Burrito chain assembles a winning combo; ignoring fast-food formula, chipotle promotes service, costly natural ingredients. Wall Street Journal. Retrieved from http://search.proquest.com/docview/399049064?accountid=14068

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Madanoglu, M., Lee, K., & Castrogiovanni, G. J. (2011). Franchising and firm financial performance among U.S. restaurants. Journal of Retailing, 87(3), 406-417. doi:http://dx.doi.org/10.1016/j.jretai.2011.02.003

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