Supply Chain Restrictions in Franchising

When you buy a franchise, you essentially buy the right to operate a business that is the same as the other businesses in the franchise network.

What is Franchising?

In order for all of the franchised businesses to essentially be the same, the product or service that is sold by each franchise must be consistent.

To achieve consistency, a franchisor may restrict where you purchase the supplies required to operate your business.

This can sometimes mean that the cost of your supplies (or the cost of goods sold) is higher than it otherwise might be if you were operating an independent business.

Starting Your Own Business vs Buying A Franchise

The Role of Supply Chains in Franchising

Supply chains are the backbone of any franchising system, ensuring that products and services are consistently available to meet customer demand. In a franchising model, the franchisor typically establishes a set of suppliers that franchisees must use, which helps maintain uniformity across all franchise locations.

An example of the effort that can go into developing franchisor supply chains is the supply chain developed by Guzman Y Gomez illustrated below.

Image Supplied

Effective supply chain management allows franchisors to leverage economies of scale and negotiate better terms with suppliers. This not only helps in maintaining brand reputation but also supports the franchisees by reducing operational complexities.

Evaluating Supplier Restrictions and Rebates

Franchise agreements often include restrictions on the suppliers that franchisees can use. Standard franchise agreement clauses refer to "Approved Suppliers" and "Approved Products", stating that a franchisee can only sell Approved Products, and can only purchase goods from Approved Suppliers. 

A franchisor must also set out in the disclosure document whether the franchisee is required to purchase goods or services from specific suppliers, together with details about the specific suppliers and the products that the franchisee is required to purchase from those suppliers.

In addition to ensuring consistency in the product that a franchisee sells, supplier arrangements enable franchisors to benefit from economies of scale. Many suppliers pay a rebate to a franchisor based on the volume of goods purchased.

Some franchisors allow their franchisees to benefit from these rebates or pay the rebates into the franchisor's marketing fund. Traditionally, benefitting from economies of scale was seen as one of the advantages of franchising.

However, today, many franchisors do not pass on the rebates or other financial benefits that they receive from suppliers. While these arrangements can enhance the franchisor's revenue stream, it's important that you understand how these rebates affect your costs, as often you may end up paying more for a product purchased from the franchisor's supplier.

Soft drink is a good example of a product where rebates are often paid to franchisors by the supplier. Franchisees can purchase branded soft drink anywhere without affecting the "consistency" of the product offered by the franchisee. If the franchisee purchases branded soft drink from the Approved Supplier then it may be more expensive than purchasing it elsewhere. However, if the franchisee purchases the branded soft drink elsewhere and not through the Approved Supplier, this is likely to affect the franchisors arrangement with the Approved Supplier. Consequently, the franchisor is likely to require the franchisee to purchase from the Approved Supplier and there may be legal consequences if the franchisee does not purchase from the Approved Supplier. 

The disclosure document provided to a franchisee before the franchisee enters into a franchise agreement will set out the rebates that a franchisor receives from its suppliers. The disclosure document must include details of:

• what the rebate or financial benefit is;
• the name of the business providing the rebate or the financial benefit;
• the rebate received from the supplier in the previous financial year, expressed as a percentage of total group purchases from the supplier (not including purchases by the franchisor or an associate of the franchisor); and
• if the rebate or other financial benefit is shared with franchisees.

Navigating Franchisee and Franchisor Disputes

Disputes between franchisees and franchisors can arise from various issues, including supply chain arrangements. Common points of contention include the quality and pricing of supplied goods, delays in delivery, and the franchisor's financial interests in suppliers.

The Franchising Code of Conduct provides a framework for resolving such disputes, including mediation, conciliation, and arbitration processes. You should be aware of your rights and the legal avenues available to you to effectively navigate and resolve disputes.

Takeaways

Prospective franchisees should conduct thorough due diligence before entering a franchise agreement. This includes reviewing the Disclosure Document, understanding the supply chain arrangements (including rebates), and seeking independent legal, accounting, and business advice.

Key areas to focus on include the franchisor's financial viability, any existing legal disputes, and the specifics of supplier restrictions and rebates. By being well-informed and prepared, prospective franchisees can make more confident decisions and set a solid foundation for their franchise business.

Disclaimer
The information in this article is general in nature and is not intended to address the circumstances of any person or other entity. Although we do our best to provide timely and accurate information, we do not guarantee that the information in this article is accurate or that it will continue to be accurate in the future.