Information Asymmetry and Dual Distribution in Franchise Networks

• DOI: http://doi.org/10.1111/jbfa.12161
• Published date: 01 November 2015
• Date: 01 November 2015
• Author: Mark Wilson,Greg Shailer

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(9) & (10), 1121–1153, November/December 2015, 0306-686X

doi: 10.1111/jbfa.12161

Information Asymmetry and Dual

Distribution in Franchise Networks

MARK WILSON AND GREG SHAILER∗

Abstract: We examine whether a dual distribution system that uses both franchisor-operated

and franchisee-operated outlets reduces a franchisor’s information disadvantage when contract-

ing with franchisee retailers. Using detailed qualitative and quantitative managerial data, we find

persuasive evidence of the strategic use of performance information obtained from franchisor-

operated outlets to reduce information asymmetry and enhance contracting efficiency for

franchisee-operated outlets. We test whether the proximity of franchisor-operated retail outlets

to franchisee-operated retail outlets reduces underpricing of quasi-franchise contracts. Our

results accord with the proposition that information asymmetry reduces contracting efficiency

and are consistent with our prediction that a manufacturer can reduce intrinsic information

asymmetry by maintaining franchisor-operated outlets that are geographically proximate to

the franchisee-operated outlets, and that this improves the franchisor’s pricing of franchising

contracts. We conclude that dual distribution reduces the franchisor’s information asymmetry

and increases their contract pricing efficiency.

Keywords: performance measurement, inter-organizational control systems, franchising, dual

distribution, contracting costs, information asymmetry, agency theory

1. INTRODUCTION

Franchise networks are used to coordinate a significant proportion of economic

activity in contemporary market economies, with more than 12,000 franchise systems

worldwide.1The US had 1,690 active franchise systems in 2005 (International Franchis-

ing Association Education Foundation, 2007), accounting for 8.1% of private sector

jobs and 4.4% of private sector economic output (PricewaterhouseCoopers, 2008).2

A feature of many franchise networks is the coexistence of franchisor-operated and

∗Both authors are in the Research School of Accounting at the Australian National University. The

authors gratefully acknowledge feedback provided on earlier versions of this paper by Simon Ville, Andre

Sammartino, Stewart Lawrence, Neil Fargher, Steve Kachelmeier and participants at the 2011 AFAANZ

Conference (Darwin) and in the Research Seminar Programs of the School of Accounting and Business

Information Systems at the Australian National University and the School of Accounting at RMIT University.

(Paper received October 2014, revised version accepted September 2015).

Address for correspondence: Mark Wilson, Research School of Accounting, College of Business and

Economics, Australian National University, Canberra, ACT 0200, Australia.

e-mail: mark.wilson@anu.edu.au

1 Source: http://www.gtai.de/GTAI/Navigation/EN/Invest/Industries/Consumer-industries/franchising.

html (last accessed October 2, 2014).

2 The summar y data cited in the IFAEF report (and the PricewaterhouseCoopers report) derive from the

US Census Bureau’s Economic Census of 2007. There will not be another such census until 2017.

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franchisee-operated outlets, usually referred to as a dual distribution system (Anderson

et al., 1997; and Srinivasan, 2006).3Around 23% of US franchise establishments

are franchisor-owned (US Census Bureau, 2010) but the mix of franchisor-operated

outlets varies widely; for example, approximately 19% of McDonalds outlets and 60%

of Hilton hotels are franchisor-operated (International Franchise Association, 2015a,

2015b). Dual distribution systems with franchising-like characteristics occur in most

trade areas (Hempelmann, 2006).

Direct monitoring of franchisees by franchisors is usually impractical or very

costly (Lafontaine and Shaw, 2005), and most franchisee monitoring systems rely

on monitoring sales and random quality audits. The franchise literature gives little

or no attention to the information value of franchisor-operated outlets in managing

downstream contracting. The management accounting and control literature has con-

sidered inter-organizational relationships such as joint ventures (Groot and Merchant,

2000), alliances (Dekker, 2004), and hybrid forms in upstream contracting (Cooper

and Slagmulder, 2004) but, despite the long-lived prevalence of dual distribution as

an organizational form and its implications for information flows within and between

firms, it has received very little attention in the accounting literature. A notable

exception is Campbell et al. (2009), who examine factors affecting the overall level

of franchising within a chain and the likelihood that a particular retail outlet will

be operated by a franchisee. In this paper, we examine whether franchisor-operated

outlets increase the efficiency of the franchise network by reducing information

asymmetry affecting the franchisor’s transactions with franchisees.

Empirical investigations of dual distribution systems are concentrated in marketing

and economics literature and are typically cross-sectional comparisons of franchise

networks differentiated by outlet attributes based on survey responses (Anderson and

Schmittlein, 1984; and Martin, 1988) or aggregate profitability data (Ehrmann and

Spranger, 2007). This literature emphasizes motives for franchising and comparative

firm performance (Srinivasan, 2006), and considers the potential for dual distribution

systems to ameliorate free-rider problems that may harm franchisors’ brand value (e.g.,

Dutta et al., 1995; Bradach, 1997; and Lafontaine and Shaw, 2005), but does not di-

rectly examine contracting behavior or efficiency. Nevertheless, Bradach (1997) argues

that a primary motivation for dual distribution is to acquire performance information

to control and motivate both franchisees and managers of franchisor-operated outlets.

While Bradach (1997) does not provide quantitative evidence to support this conjec-

ture, there is some survey evidence that difficulties in evaluating franchisees’ perfor-

mance may induce a franchisor to also manage their own outlets (Dutta et al., 1995).4

Our study contributes to the literature by examining how franchisor-operated

outlets reduce the franchisor’s costs of contracting with franchisees by reducing

information asymmetry regarding the profitability of retail outlets. An operational

advantage of local knowledge gained through experience is indicated in Kalnins and

Mayer (2004), who find that, for both franchisees and franchisors, initial knowledge

of local conditions acquired from prior local operating experience is more important

than distantly acquired knowledge in explaining future outlet performance. Further,

they and others (e.g. Minkler, 1990; and Hempelmann, 2006) argue that, relative

3 Franchising can be defined as the network of a contract-giving firm (franchisor) with (in principle)

independent contract takers (franchisees) (Hempelmann, 2006).

4 Information asymmetry motives are also considered in upstream dual systems, where firms both make and

buy inputs, in Heide (1994, 2003).

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to franchisors relying on distantly acquired knowledge, franchisees can more easily

observe the idiosyncratic local cost and demand conditions affecting their outlet.

Campbell et al. (2009) find that the likelihood of a particular retail unit being fran-

chised increases with the divergence between the local market conditions affecting the

retail unit and the modal market characteristics of the chain, because the importance

of providing high-powered incentives to decision makers increases with the level of

idiosyncratic information and knowledge present. However, the franchisor must then

monitor a portfolio of franchisees with an inherent local information advantage. We

posit that performance information obtained from strategically located franchisor-

operated retail outlets reduces this information asymmetry, and consequently that the

proximity of a franchisor-operated outlet to a particular franchisee-operated outlet

affects the pricing efficiency of franchise-type contracts. We test our propositions

using rich proprietary data spanning 30 years for a franchising manufacturer, by

examining whether access to information from manufacturer-operated outlets allows

the manufacturer to more accurately price contracts for geographically proximate

franchisee-operated outlets when these contracts are re-negotiated. Under-priced

contracts with franchisee-operated outlets increase the value of those contracts in the

secondary market. Consequently, we use a novel measure of contracting efficiency,

based on the secondary market prices of transferred leases for franchisee-operated

outlets to measure the manufacturer’s pricing efficiency in the primary lease contracts

for these outlets, relative to varying intrinsic information disadvantages.

Our data is from a large Australian brewer, Tooth & Co. Ltd (hereafter Tooth’s)

and its directly operated and franchisee-operated retail outlets. We limit our study

period to 1935–1964, due to the availability of proprietary data and subsequent major

regulatory changes that discouraged manufacturers from exerting direct control over

the retailing of their products. This long series of proprietary data provides two

particular advantages. First, we obtain detailed qualitative and quantitative managerial

data from Tooth’s archives that is likely to be less censored than comparable data

available for contemporary firms.5Second, Tooth’s dual distribution system precedes

the development of modern franchising texts and intermediaries advising on their

administration, so the evolved behavior we observe was developed in context and is

less likely to entail mimicry.

We obtain persuasive evidence of the strategic use of franchisor-operated outlets to

reduce information asymmetry and enhance the pricing efficiency of their primary

contracts with franchisees. We also show that relations between contract pricing

efficiency and dual distribution varied systematically with the extent to which hotels’

retail sales mixes, which were not directly verifiable, affected outlet profitability.

We believe our results have generalizability beyond the study’s jurisdiction and

time period. While technological advances have improved franchisors’ monitoring

capabilities, there is a persistent problem in estimating outlets’ intrinsic profitabil-

ity because of difficulties in obtaining reliable and timely information regarding

franchisee effort and ability. Further, although contemporary franchisee accounting

systems may reveal franchisees’ achieved profits, inferring franchisee effort and ability

requires the franchisor to estimate the opportunity costs for different outlets, which

5 The Tooth & Co. archive is held at the Noel Butlin Archive Centre at the Australian National University.

References to this archive material in this paper commence with “NBAC Tooth & Co. Archive” and then

identify the appropriate catalogue entry.

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