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introduction_to_the_hospitality_industry_8e_ch05_2.pdf

RESTAURANT INDUSTRY ORGANIZATION:

CHAIN, INDEPENDENT, OR FRANCHISE?

Courtesy of Rainforest Cafe.

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Chapter

T H E P U R P O S E O F T H I S C H A P T E R

T his chapter is concerned with the relationship between the form of ownership of the restaurant and

the likelihood of success. Chains have many advantages, but so do independents. The advantage—or

disadvantage—often depends on the situation; factors such as location, type of operation, and the

operation’s relationship to the community all have a bearing.

Somewhere between private ownership and chain ownership is the franchised operation. Franchisees

have some of the independence of ownership but agree to give up much of it for the right to be a part

of a successful concept. Because franchises play such an important role in food service, it is essential

for you to assess this means of organizing ownership too.

We sometimes hear that the days of the independent restaurant are past. Although this is certainly

not true, the role of the independent restaurant in the industry is changing. Chains have advantages in

some industry segments, but independents have strengths that are hard to match in others. It is useful,

therefore, to discuss the competitive advantages of both independents and chains. Most restaurant

chains include company-owned units as well as franchised units. Franchised units have some aspects

in common with chain operations and others in common with independents. For that reason, the chapter

concludes with a discussion of franchised restaurant systems.

T H I S C H A P T E R S H O U L D H E L P Y O U

1. List the relative advantages and disadvantages of chains and independents in the following key

areas: marketing and brand recognition; site selection; access to capital; purchasing economies;

control and information systems; new product development; and human resources.

2. Identify the independent’s imperative for success; provide an example of this imperative; and

identify the independent’s unique market advantage.

3. Explain the difference between product franchising and business format franchising, identify

which is most commonly used in the hospitality industry, and understand the advantages and

disadvantages of franchising to both the franchisor and the franchisee.

Chapter

5

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134 Chapter 5 Restaurant Industry organization

C H A I N R E S TA U R A N T SY S T E M S

C hains are playing a growing role in food service in North America and elsewhere in the world. In the United States, more than a quarter of all restaurants are chain- affiliated; these chains also represent about half of all restaurant revenues.1 Moreover,

they are prominent among the pool of companies that recruit graduates of hospitality

programs and culinary programs. Both factors make them of interest to us.

Chains have strengths in seven different areas: (1) marketing and brand recognition,

(2) site selection expertise, (3) access to capital, (4) purchasing economies, (5) centrally

administered control and information systems, (6) new product development, and

(7) human resource development. All of these strengths represent economies of scale:

The savings come, in one way or another, from spreading a centralized activity over a

large number of units so that each absorbs only a small portion of the cost but all have

the benefit of specialized expertise or buying power when they need it.

M A R K E T I N G A N D B R A N D R E C O G N I T I O N

More young children in America recognize Santa Claus than any other public figure.

Ronald McDonald comes second. Because McDonald’s and its franchisees spend

well over $2 billion on marketing and advertising, it’s no wonder more children

recognize Ronald than, say, Mickey Mouse, Donald Duck, or the Easter Bunny. Indeed,

McDonald’s has created a generic item—the Big Mac. The company has done for

the hamburger what Coke did for cola, Avon for cosmetics, and Kodak for film. The

reasons for this success are threefold: simplicity of message, enormous spending

on marketing, and the additive effect. Ideally, for a company, the spending results in

brand recognition.

The message of modern advertising is affected by the form in which it is offered:

10-, 30-, or 60-second television commercials, for instance. Even in the print media, the

message must be kept simple, because an advertisement in a newspaper or magazine

has to compete with other ads and news or feature stories for the consumer’s casual

attention. The message of the specialty restaurant resembles its menu. It boils down

to a simple statement or a catchphrase. In fact, marketing people generally try to design a

“tagline” that summarizes the benefits they want an advertising campaign to tell the con-

sumer. Some years ago, Wendy’s used the slogan “Ain’t no reason to go anyplace else.”

Although this slogan set off a letter-writing campaign complaining about the grammar

(apparently organized by high-school English teachers), Wendy’s officials judged it

effective in “breaking through the clutter.” Of the many other advertising messages

that assail the consumer, you will remember classic taglines of the past that are revived

from time to time:

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135

Many chains are synonymous with well-known brand names. (Courtesy of Darden Restaurants.)

“You deserve a break today.”

“Finger lickin’ good.”

“Pizza, Pizza.”

And, more recently:

“It’s that good.”

“When you’re here, you’re family.”

“Eatin’ good in the neighborhood.”

“Have it your way.”

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136

Television advertising, even at the local level, is very expensive. To advertise regularly

on national or even regional television is so expensive that it is limited to the very largest

companies. Chains can pool the advertising dollars of their many units to make television

affordable. Few independents, however, can afford to use television.

Independent restaurants generally spend less than chains on marketing (of all

kinds, including television advertising) as a percentage of sales. Chains have a need to

establish and maintain a brand name in multiple markets and to maintain a presence

in the regional and national media. Furthermore, restaurants that generate a higher level

of sales tend to spend a higher percentage of their revenues on marketing. Table 5.1

reflects spending on marketing, expressed as a percentage of sales, and categorized by

check average. In the table, it is noticeable that the median level of marketing spending

for restaurants with check averages of $15 to $24.99 is greater than other categories.

Also, full-service restaurants spend more than limited service restaurants. This fact can

A standard exterior appearance gives franchise operators and company-owned brands a high recognition value. (Courtesy of Carlson Restaurants Worldwide.)

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Chain Restaurant Systems 137

be explained by economies of scale. Quick-service company-owned and franchised

chain units are fairly close to one another in spending on marketing.2

All this advertising will be effective only if consumers get exactly what they expect.

Therefore, chains also concentrate on ensuring consistency of quality and service in opera-

tions. Customers know what to expect in each of the units, and in an increasingly mobile

society, that is important. For those on the go, such as tourists, shoppers, or businesspeople,

what is more natural than to stop at a familiar sign? If that experience is pleasant, it will

reinforce the desire to return to that sign in the local market or wherever else it might appear.

TABLE 5.1

Marketing Expenditures in Food Service LEVEL OF MARKETING EXPENSEa

RESTAURANT TYPE LOWER

QUARTILE (%) MEDIAN (%) UPPER

QUARTILE (%)

Full service—check average under $15

Under $500,000 in annual sales 1.1 2.5 4.6

Between $500,000 and $999,000 0.7 1.3 2.5

Between $1,000,000 and $1,999,000 0.9 1.9 3.4

$2,000,000 and over 0.8 2.3 6.0

Table service—check average $15 to $24.99

Between $500,000 and $999,000 0.7 1.6 2.9

Between $1,000,000 and $1,999,000 1.0 1.9 3.4

$2,000,000 and over 0.9 1.8 2.9

Table service—check average $25 and over

Between $500,000 and $999,000 1.0 1.8 2.6

Between $1,000,000 and $1,999,000 0.8 2.0 2.7

$2,000,000 and over 1.7 2.4 3.2

Limited service restaurants

Under $500,000 in annual sales 0.8 2.3 3.6

Between $500,000 and $999,000 1.0 2.6 5.6

Between $1,000,000 and $1,999,000 0.5 0.8 2.5

aRatio to total sales.

Source: National Restaurant Association, “Restaurant Industry Operations Report—2008.”

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138 Chapter 5 Restaurant Industry organization

S I T E S E L E C T I O N E X P E R T I S E

The success of most restaurants is also enhanced by a location near the heart of major

traffic patterns. The technique for analyzing location potential requires a special kind

of knowledge, and chains can afford to staff real estate departments with people who

possess this expertise. Numerous examples abound about independent restaurants

not “doing their homework” when choosing a site. Although there is no exact formula

that will guarantee the absolute best site, and success, chains have both experience

and expertise backing them. Site selection, most experts would agree, is only getting

more complex, and successful companies are becoming more sophisticated in their

approach to it. To quote one industry observer: “Restaurant site selection is increas-

ingly complicated business these days. Demographic studies, focus groups, consumer

surveys, consultants, and endless number crunching are all part of the formula. No

restaurateur—single shingle, multiconcept operator, or large chain—can afford to open

an eatery today without spending time and money on some or all of the above.”3

Sophisticated software is now available to assist operators in their decision making.

Papa John’s, Krispy Kreme, and, of course, McDonald’s are all companies that are

recognized for doing an admirable job of site selection.

A C C E S S T O C A P I TA L

Most bankers and other lenders have traditionally treated restaurants as risky businesses,

making access to capital (at least from this source) problematic. Because of this fact, an

independent operator who wants to open a restaurant (or even remodel or expand an

existing operation) may find it difficult to raise the needed capital. However, a banker’s

willingness to lend increases with the size of the company: If one unit should falter, the

banker knows that the company will want to protect its credit record. To do so, it can

divert funds from successful operations to carry one in trouble until the problems can

be worked out. Although franchisees are not likely to be supported financially by the

franchisor, franchise companies regard a failure of one unit as a threat to the reputa-

tion of their whole franchise system and often buy up failing units rather than let them

go under. In any case, failure is much less common among franchised restaurants than

among independent operations. Not surprisingly, banks not only make capital available

to units of larger companies and to franchised units but also offer lower interest rates

on these loans.

Publicly traded companies, whose stocks are bought and sold on markets such

as the New York Stock Exchange, can tap capital from sources including individual

investors buying for their own account as well as mutual funds, insurance companies,

and pension funds that invest people’s savings for them. Hospitality companies with

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Chain Restaurant Systems 139

well-known brand names and well-established operating track records enjoy a wide

following among investors, and their activity is important enough to the industry that

Nation’s Restaurant News, the popular trade magazine, carries a weekly section, “Finance,”

featuring a summary of approximately 100 publicly traded restaurant stocks. In addi-

tion to funds raised through stock sales, companies can sell bonds through public

markets, raising larger sums than are typically available through bank loans. Among

other industr y leaders, Norman Brinker (Brinker International, which includes

such chains as Macaroni Grill) developed a reputation for successfully taking his

restaurant companies public and thus achieving his growth objectives.4

It should be noted that evidence suggests restaurant failure rates tend to be greatly

exaggerated. Without publishing the commonly touted failure rates, we can say that

recent research indicates that the failure rate is relatively similar to other types of

businesses—somewhat lower than 60 percent over a three-year period, according to

one study.5

P U R C H A S I N G E C O N O M I E S

Chains can centralize their purchasing, thereby creating purchasing economies. This

is accomplished either by buying centrally in their own commissary or by negotiating

centrally with suppliers who then deliver the products, made according to rigid speci-

fications, from their own warehouses and processing plants. Chains purchase in great

quantity, and they can use this bargaining leverage to negotiate the best possible prices

and terms. Indeed, the leverage of a large purchaser goes beyond price. McDonald’s,

for instance, has persuaded competing suppliers to work together on the development

of new technology or to share their proprietary technology to benefit McDonald’s. In

addition, chains can afford their own research and development laboratories for testing

products and developing new equipment.

C O N T R O L A N D I N F O R M AT I O N SY S T E M S

Economies of scale are important when it comes to control and information systems

as well. Chains can spend large sums on developing procedures for collecting and

analyzing accounting and marketing information. They can devise costly computer pro-

grams and purchase or lease expensive computer equipment, again spreading the cost

over a large number of operations. Daily reports often go from the unit’s computerized

point-of-sale (POS) system to the central office computer. There they are analyzed, prob-

lems are highlighted, and reports are sent to area supervisors as well as to the unit. This

means follow-up on operating results can be handled quickly. Moreover, centrally man-

aged inspection and quality control staff review units’ efficiency and quality regularly.

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140 Chapter 5 Restaurant Industry organization

N E W P R O D U C T D E V E L O P M E N T

The quest to create newer, better, and more interesting food products continues as

competition in the restaurant industry only intensifies. Chains have the luxury of be-

ing able to staff (and finance) research and development departments that champion

the development of new menu items. With adequate financial support and expertise,

companies are able to test and launch new products, such as McDonald’s new Angus

Third Pounders, Burger King’s Burger Shots 6-pack, or Pizza Hut’s pasta dishes. The de-

velopment of new products for restaurant companies is a combination of culinary ex-

pertise and food science expertise. Many of the chefs who head culinary development

departments for restaurants are enthusiastic members of the Research Chefs Association.

The association currently has over 1,000 members and is devoted to “providing the re-

search chef with a forum for professional and educational development.” Many chain

organizations, including such companies such as Starbucks and Brinker International,

have membership in the association. The ability to add new products to the menu mix

is an important quality; new products can create positive press, increases in sales and

profits, and increased market share.

H U M A N R E S O U R C E P R O G R A M D E V E L O P M E N T

Some restaurant chains have established sophisticated training programs for hourly

employees, using computer-based and, increasingly, Internet-based techniques to dem-

onstrate the proper ways of performing food service tasks and jobs. Special training exer-

cises are also now available to subscribing companies through closed-circuit television.

The standardized procedures emphasized in company training programs, in turn,

lower the cost of training and improve its effectiveness. This saving is especially

advantageous in semiskilled and unskilled jobs, which traditionally experience high

turnover rates and, therefore, consume considerable training time. Companies that are

leading the way in computer-based training include Captain D’s, Sonic, and Damon’s

Grill. At the Cheesecake Factory, recipes are developed at the corporate office, and then

the unit chefs are trained simultaneously using streaming video. Management training

is also important, and large food service organizations usually can afford the cost of

thorough entry-level management training programs. One food service company, for

instance, estimates the costs for training a management trainee fresh out of college to

be about $20,000 over a 12- to 18-month period. This is in addition to the trainee’s salary

while in training, and covers fringe benefits, travel and classroom costs, and the cost

of the manager’s time to provide on-the-job training. In effect, this company spends as

much as or more than a year of college costs on its trainees, a truly valuable education

for the person who receives it.

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141

Houston’s Restaurants, a privately owned company, is well known for its development programs. (Courtesy of Houston’s Restaurants.)

Because of their multiple operations, chains can instill in beginning managers

an incentive to work hard by offering transfers, which involve gradual increases

in responsibility and compensation. In addition, a district and regional management

organization monitors each manager’s progress. Early in a manager’s career, he or

she begins to receive performance bonuses tied to the unit’s operating results. These

bonuses and the success they represent are powerful motivators.

C H A I N S ’ M A R K E T S H A R E

As we mentioned at the beginning of the chapter, chains have dramatically increased

their market share (share of sales), representing over half of all domestic restaurant sales.

This is up from less than 33 percent in the 1970s.6 Of these sales, the ten fastest-growing

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142 Chapter 5 Restaurant Industry organization

chains (see Table 5.2) accounted for $4.9 billion in 2008, which is some 65% of

all chain sales.

Because successful chains usually have deep pockets (i.e., adequate financial

reserves), they are able to ride out recessions. Indeed, some larger chains look on a

recession as a time when they can purchase smaller or less successful chains that

are having trouble weathering the economic storm. Although most experts agree

that the concentration of chains will continue, fierce competition from regional chains

(note the numerous examples used throughout this book), shifting consumer prefer-

ences, and competitive patterns will ensure that few, if any, players will establish

anything resembling market dominance except on a local or temporary basis.

I N D E P E N D E N T R E S TA U R A N T S

Although chains undeniably have advantages in the competitive battle for the con-

sumer’s dollar, independent restaurants also enjoy advantages that will ensure them a

continuing place in the market—a place different from that of the chains, perhaps, but

TABLE 5.2

The Ten Fastest-Growing Chains with Sales over $200 Million

RANK CHAIN 2008 U.S. SALES ($ MILLIONS)

% SALES CHANGE

% UNIT CHANGE

1 Five Guys Burger and Fries $302 59% 49%

2 Jimmy John’s Gourmet Sandwich Shop

497 29 28

3 Potbelly Sandwich Works 225 27 18

4 Noodles & Company 200 25 19

5 Wingstop 255 24 19

6 Peet’s Coffee & Tea 230 23 11

7 Buffalo Wild Wings 1,229 21 14

8 Chipotle 1,275 21 19

9 Pei Wei Asian Diner 278 19 19

10 BJ’s Restaurant & Brewery 377 18 20

Total $4,869 24% 22%

Source: Data from Technomic Inc., Chicago.

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Independent Restaurants 143

significant nevertheless. It is also important to remember that many of the successful

independent restaurants of today represent the chains of tomorrow.

O P E R AT I N G A D V A N TA G E S

We can use the same method to analyze the strengths of the independents that we

used to examine the chain specialty restaurants. The advantages of the chains derive

basically from the large size of their organization. The advantages of the independent

derive from a somewhat different common core but in many ways also claim size as

their advantage. The independent’s flexibility, the motivation of its owner, and the

owner’s presence in the operation affect its success.

In large organizations, a bureaucracy must grow up to guide decision making.

Although this is a necessary—and in some ways healthy—development, it does result

in a slower and more impersonal approach to problem solving in larger organizations.

In contrast, to survive and prosper, the independent must achieve differentiation:

The operation must have unique characteristics in its marketplace that earn consumers’

repeat patronage. Flexibility and a highly focused operation, then, are the independent’s

edge. Differentiation is the independent’s imperative.

Although the following analysis does not deal directly with the issue, we should

note that economies of scale are important in the independent restaurant also. The

small operation, the mom-and-pop restaurant, finds itself increasingly pressed by rising

costs. We cannot specify a minimum volume requirement for success, but National

Restaurant Association figures show that in each size grouping, the restaurants with

higher total sales achieve not only a higher dollar profit but a higher percentage of

sales as profit.

M A R K E T I N G A N D B R A N D R E C O G N I T I O N

Ronald McDonald may be a popular figure, but he is not a real person (even though he

has been named Chief Happiness Officer). The successful restaurant proprietor, however,

is real. In fact, successful restaurateurs often become well known, are involved in com-

munity affairs, and establish strong ties of friendship with many of their customers. You

can probably think of a local restaurant operator who fits this very profile. In a sense,

these operators take on celebrity status. This local “celebrity” can be especially effective in

differentiating the operation in the community, generally being visible, greeting guests by

name as they arrive, moving through the dining room recognizing friends and acquain-

tances, dealing graciously with complaints, and expressing gratitude for praise. “Thanks

and come back again” has an especially pleasant ring when it comes from the boss—the

owner whose status in the town isn’t subject to corporate whim or sudden transfer.

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144 Chapter 5 Restaurant Industry organization

Although chains may have advantages among transients, the operator of a high-

quality restaurant enjoys an almost unique advantage in the local market. Moreover,

word-of-mouth advertising may spread his or her reputation to an even larger area.

The key to recognition for the independent is more than just personality; it is, first and

foremost, quality.

Chains clearly have the advantage when it comes to advertising because of their na-

tional or regional advertising, which can create brand recognition. In contrast to chains,

however, many independents spend relatively little on paid advertising, relying instead on

personal relationships, their reputation, and, as noted, word of mouth. Moreover, indepen-

dents begin with an advantage that chain units must work very hard to achieve: local identity.

S I T E S E L E C T I O N

The chain operation continually faces the problem of selecting the right site as it seeks

new locations for expansion. It may seem that site selection would not be a problem

for an independent operation because that operation is already in place. Successful

independents sometimes expand by moving to a newer and larger location or by add-

ing locations. These may be full-scale operations or, quite commonly in recent years,

scaled-down versions such as the points of distribution (PODs) discussed in Chapter 3.

Another occasion when independents need to make location decisions is when evolving

urban patterns and real estate values change a location’s attractiveness. In some cases, a

neighborhood goes into decline, bringing a threatening environment that is unattractive

to guests. Alternatively, a restaurant may have a lease (rather than outright ownership)

in an area that has become too attractive—at least in terms of rising rents. When the

lease comes up for renewal, the owner may decide to move.

When the topic of relocation or adding a location arises, however, the independent

operator begins with her or his own knowledge of the area and can add to that by

hiring one of the consulting firms that specialize in location analysis. This can be an

expensive service, but such services are generally available and the added expense

probably will be worthwhile.

A C C E S S T O C A P I TA L

In most cases, chains will have the readiest access to capital. Sources of capital, how-

ever, are also available to small businesses. As noted earlier, banks are often hesitant

to lend to restaurants because they are viewed as high-risk enterprises (although their

willingness tends to move in cycles, just like everything else). If an operator has a well-

established banking relationship and a carefully worked out business plan covering a

proposed expansion, however, the local bank may be happy to make the loan.

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145

I N D U S T R Y P R A C T I C E N O T E 5 . 1

Working with the SBA

The key to securing an SBA loan is being prepared and finding the right lender, knowing your needs, and

being able to explain how you arrived at the amount you are requesting.

A successful loan application package provides a financial history of the restaurant. It also includes a nar-

rative background on the operation, the principal participants, and goals for the restaurant. Personal financial

statements and tax returns for the owners are required. Most important are monthly cash flow projections.

However, the SBA counsels that if you can obtain a conventional loan, that’s what you should do. The SBA is

authorized to back loans only where credit is not available on the same terms without a guarantee and only

up to 85 percent. According to the National Restaurant Association, about 5,000 U.S. lenders grant SBA loans.

SBA loans can take a variety of forms including the 7(a) loan. According to the SBA, “7(a) loans are the most

basic and most used type loan of SBA’s business loan programs. Its name comes from section 7(a) of the

Small Business Act, which authorizes the Agency to provide business loans to American small businesses.”1

There are certain things about the loan process you can control; the amount of preparation and how you

approach a bank are two of them. The SBA recommends contacting your bank and asking what elements

it requires in a loan request package. Once you have pulled together all the necessary materials, deliver

the package to your banker a few days in advance of your meeting, so that there will be adequate time

for him or her to review your request. That way, the banker is ready to respond to your request. Four

common criteria used to determine the viability of a loan request are: previous management experience,

net worth, collateral, and cash flow projections.

Whatever you, as a borrower, can bring to the table to calm the fears of the lender and show that you are

well prepared to run your own business helps. That includes training, education, and experience. Knowing

the business is not all it takes to be successful; you also need to have management and financial skills.

One …