Burger King's Loss-Leader Case

I wrote an article in September of this year that proposed a possible solution to price promotion issues between franchisors and franchisees. In light of the recent Burger King case I would suggest this article is timely.

Franchisees are sometimes resistant to franchisor promotions that include lower pricing. The reason is fairly straightforward and it’s a situation I’ve faced with franchise programs I’ve managed.

Since a franchisee pays a royalty based upon a percentage of sales, franchisees are protective of their gross margin since the fees are a true fixed cost. For example, if a franchisee pays a total of 9% in royalty and advertising fund fees as a percentage of sales, this is a fixed cost of doing business. If however, lower pricing reduces the franchisee gross margin percent but increases sales a franchisee will pay more fees to the franchisor and could generate less gross margin dollars. A franchisee needs to increase sales to a point whereby the added gross margin dollars make up for the increased fees paid to the franchisor. It’s this risk of paying more royalty fees while receiving less gross margin dollars that causes some franchisees to resist reducing prices to increase sales. In order to overcome objections on the part of franchisees some franchise agreements have provisions requiring franchisees to participate in promotions and advertising campaigns. Absent this provision franchisees are free to opt out of promotional pricing programs. Although there are some franchisors that have a declining royalty schedule based upon sales these arrangements are the exception.

Here is a very simple example of how much additional sales a franchisee must generate in order to compensate for reduced gross margin percent due to a price promotion.

Assume a franchisee pays a total of 9% in royalty and ad fees and that a price promotion increases sales from a base of  $10,000 but reduces the franchisees gross margin percent from 25% to 22.3%. In this example the franchisor earns $180 in added royalties since the sales have increased to $12,000. However, the franchisee needs to reach a sales point where the added royalty payments are offset by more GM dollars. I call this the franchisee BE point, where the added royalty payments are offset by an equal amount of GM dollars.

In this example, a franchisee can recover the reduced gross margin dollars if they reach the sales target of $12,000.  However, some franchisees are unwilling to participate in a price promotion since they believe they risk earning less gross margin dollars while the franchisor receives increased royalties.

Recognizing this relationship between pricing, franchisee fees and gross margin dollars a franchisor can configure a program that can provide an incentive to franchisees to participate in price promotions. As a result participation could be higher and franchisees will appreciate the concept.

An effective program is to allow franchisees that participate to receive a rebate of 50% of their additional royalty payments during the promotional period. In other words, if the franchisee pays $300 in added fees they would receive a rebate of $150. This rebate percent could be higher or lower based upon the anticipated reduction in gross margin dollars that a franchisee would receive and/or depending upon how aggressive the promotional pricing is. The key objective is to return some portion of incremental fees that the franchisees are paying as a result of achieving higher sales. Under this scenario it’s a win-win for both franchisor and franchisee! 

Here are variations on this approach.

• Waive advertising fund payments during the program period
• Reduce the royalty fee by 5-10%
• Provide a rebate to franchisees that reach a minimum sales threshold
• Share the reduction in franchisee gross margin dollars resulting from the promotion
• Have prizes for highest sales increases

Historically, franchisees are often reluctant to participate in marketing programs that reflect reduced pricing. This aversion is based upon the fundamental relationship between franchise fees being a fixed percent of sales and franchisee gross margin being variable. To overcome this factor, franchisors should be willing to implement marketing and sales programs that invite more franchisee participation.

About the Author: Ed Teixeira has over 35 years of franchise industry experience as a franchise executive and franchisee. He has served as a franchise executive in the c-store, manufacturing and home healthcare industries and has licensed franchises in Asia, Europe and South America. Ed operates FranchiseKnowHow  which provides information and advice to prospective and existing franchisees and franchisors. He publishes newsletters for the franchise community.