Franchising as Entry Option in International Hospitality Industry - Case Study Example

Franchising as Entry Option in International Hospitality Industry 2007 Introduction The global hospitality industry is undergoing a transformation. Over the past, international hotel chains typically grew in the west, that is, in the United States, Canada, Europe and Australia. However, slow growth in these areas over the past decade, fast growth in emerging economies in Asia and Latin America and forecasts of even stronger growth in the latter group of countries have together shifted the trend. In particular, China and India have seen the highest activity in the international hospitality industry. For example, InterContinental Hotels plan to have 125 additional hotels in China by 2008, in preparation for the Beijing Olympics of 2010 (Price Waterhouse Coopers, 2006). Growing business opportunities in these new markets and low labor costs have lured many investors, particularly in the hospitality industry. Yet, it must be recognized that new markets have essentially different characteristics in terms of competition, regulatory framework and cultural parameters, the last being particularly important for a service industry like the hospitality. In order to gain competitive advantage, a hospitality player needs to weigh the returns in terms of profitability and low costs against the risks in terms of bureaucracy, cultural differences, unfamiliar or uncertain legal and political systems and inadequate infrastructure (Price Waterhouse Coopers, 2006). A firm’s entry strategy into a new market depends on its ability to transfer its market and technical knowledge, whether codified or tacit, into competitive advantage on the basis of its organizational structure and culture. There may be a number of ownership types for the hotel industry that in turn affect the organizational culture. The hotel may be independently owned and operated either by itself or through franchise/ brand from a third party; independently owned, franchise/ brand from a hotel chain and operated by a third party; independently owned, branded and operated by a hotel management company or a hotel chain; or independently owned and leased to an operator or a brand owner. In this paper, I will study the alternate ownership and organizational structures that the hospitality industry may adopt while entering a new market. In particular, franchises as a mode of entering a new market will be analyzed vis-à-vis other ownership structures like joint ventures or subsidiaries. This will be followed with examples of franchises into new markets like China and India. Franchises and the internationalisation of the hospitality industry Nearly 70 percent of hotels in the United States are under franchise agreements valid for 20 years (4hoteliers). For the franchisor, the returns are in terms of royalty fee as well as the initial joining fee, annual cost of reservation, frequent guest programs and other marketing costs and the liquidation fee in case the franchisee ends the contract. On the other hand, the franchisee gets access to a strong brand. Typically, the cost of hotel affiliations range from 2.1 percent (Best Western) to 11.3 percent (Marriott). According to a study by Hotelsmag (2006) in the United States, franchise cost as percentage of room revenue ranges from 5.3 percent to 10.4 percent in the economy class, 2.1 percent to 10.5 percent in the mid-market category and 6.8 percent to 11.3 percent in the first-class category. Globalization has meant that there is increasing flow of tourists in and out of all countries. Hence, there is a demand for predictability of service at the hotels and uniformity in hotel properties. With overcapacity in hotel properties in the United States and Europe, internationalization is also the only option for most hotel chains (Arthur Anderson, 2006). International hotel companies achieve economies of scale by expanding brands across national barriers through organizational structures that deliver global services, cross-border employee training to achieve uniformity in services and use the world capital markets to raise funds. In order to achieve operational uniformity, control and ownership patterns are also converging towards the familiar franchise system. Entry options in the emerging market Typically, a business begins its overseas activity through licensing and franchising, followed by relationships through joint ventures or shared ownership deals and finally through direct investments and strategic alliances (Price Waterhouse Coopers, 2006). Historically, the hospitality industry has separated ownership from control while undertaking international expansion. This followed from the homogeneity of the required knowledge – the codified service-level knowledge as well as the tacit knowledge regarding work culture in the organization (Cornell, 2007). However, while entering into the emerging markets, the tacit knowledge of the local partners regarding customer profiles and the cultural parameters of the home countries are significantly higher. Hence, there is the likelihood of the separation of ownership and control being misused. Hence, the ownership structure followed by hospitality chains in the west does not necessarily suit for entry strategies in the emerging markets. There are usually four types of market entry options exercised by the hospitality industry: 1) chain-owned affiliated hotels (COA) operated as franchises, like Holiday Inn Park View, Singapore or as marketing network, like Utell and Leading Hotels of the World, 2) management-company affiliated hotels (MCA) operated by a third-party management company or a franchisee or a marketing network, like Sheraton Four Points, Dubai, 3) management company unaffiliated (MCU) hotels operated under management contract but without a franchise or marketing network, like Hotel Sedona Makassar, Indonesia and 4) chain-owned unaffiliated (COU) hotels operated under a common brand name, like the Shangri-la in Manila. In COA, the new player invests in physical assets under the guidance on local conditions by the franchisee or the marketing partner. In MCA, the new player does not have an equity holding in the entity although the operations of the affiliate hotel form the guidelines of the parent. On the other hand, in MCU, which too is not under the imposition of a franchise or marketing network, is free to develop in-house operations and marketing strategy. In the COU, the new hotel is run independently by the corporate chain. Thus, the level of ownership and management control by the parent chain is highest for the COU, followed by MCA and COU. The parent has the least control over the MCU hotels. The new entrant has to balance the risks associated with the local partner’s vulnerability to opportunism to the rewards of local market knowledge. Researchers have found that undertaking high-risk activities like branding by the parent and outsourcing of low-risk elements like pricing is a prudent strategy for entry into a new hospitality market (Eramilli, Agarwal and Dev, 2002, cited Cornell, 2007) in When the new entrant has limited knowledge of the local market conditions, it is more likely to fall prey to opportunism by the local partner. To protect against such occurrences, the entrant needs to maintain strategic control over ownership. A hospitality company’s comparative advantage depends on its customer service, organizational management and distinctive physical facilities (Cornell, 2007). Typically, the quality of customer service is unrelated to the type of ownership. However, in order to transfer a high level of customer service in the home market to the new market requires a high level of organizational skill set. Hence, a firm that is able to retain a high level of control over the new entity that enables to meet to quality standards in the home country as well as incorporate requirements specific to the new market achieves greater comparative advantage over its international and local competitors. Since the requirements are specific, management company affiliated hotels have the highest control over its service parameters and hence the highest comparative advantage. The organization’s management is also most effective if it has sufficient control over the operations since it has the highest tacit knowledge about the market. Thus, as the company grows in the new market, the new entity tends to move away from chain-affiliation through franchises and marketing networks. Hospitality franchising in the emerging market Franchising as a market entry strategy has been widely used in North America and Western Europe, particularly in the fast food chains, car rentals and other consumer and business services. The main element of franchising is the replication of a business model, like the menu of a fast food retailer. Although this is an easy way of entering into a new market, it provides little choice to alter the business model to the franchisee. However, it has been seen that cultural differences between markets require major alteration of the model in many cases. Marketing budgets at the local levels are then handicapped with only short term promotions for many of the even successful franchises like McDonalds and Marriot (Arnold, 2003). The main benefit of international franchise is in the easy transplant of a successful formula of a particular business in a new host country. The benefits accruing to the franchisee are the easy access to successful brand of the franchisor and the proven operations mechanism. On the other hand, franchisor gets an entry into a new market capitalizing on the strengths of the local franchisee. However, success depends on the smooth transplant of an alien operations system and the ease of interaction between the franchisee and the franchisor. Franchising is described as a “business marriage” in which the franchisor has the blueprint of a successful business while the franchisee is keen to replicate the blueprint in another or a number of other countries. In the process, the franchisor invests in developing the brand and operation manual and training while the franchisee invests in the real business of executing the idea. Typically, international franchising occurs through a Master Franchisee at the national level, the Regional Master Franchisee and the national corporate developer. Most international franchising occurs in retail, food and beverage and hospitality. Typically in the hospitality sector, most franchising occurs through the regional or national corporate developers while there are only a few master franchisees. Organizations then open a number of hotels across the region or country without the requirement of sub-franchisees. Most franchisors look for organizations that have some experience in the indigenous market and have the basic capabilities to carry the business forward (ukfranchisedirectory). According to Hofstede (1980, cited in Toncar, 1999), the number of international franchises in a host country is determined by cultural parameters like the level of individualism, involvement of political power in economic decisions, ratio of female workers to the total, etc. since these affect daily operations, negotiations, human resource management, etc. The culture of the country also affects the management style, communication pattern and market interactions (Toncar, 1999). Hence, it is not only the economic and demographic factors that affect international franchises but also social, cultural and political factors. Hofstede (1980) categorized the four host cultural parameters that affect international franchises: 1) individualism/ collectivism, 2) power distance, 3) uncertainty avoidance, 4) sex role differentiation. Hospitality franchises in China Over the last decade, China has been one of the fastest growing economies in the world, with an annual average growth rate of over 9 percent. As a corollary, international tourist inflow into China has quadrupled since 1990 to 109 million a year. Revenues from international tourists have increased 12 times and are now US$ 25 billion. Domestic tourism has also grown by 10 percent over the past decade and by 2010, the domestic tourism industry will be US$ 100 billion. The spend on tourism in China, growing at 8.3 percent per annum, is obviously higher than 2.6 percent per annum in the United States (Deloitte, 2007). In one sense, the Chinese economy and hence the hospitality industry has already ‘emerged’ (Price Waterhouse Coopers, 2006). However, the business environment in China is distinctively different than from the western world. This means that ownership patterns, level of control required, the service requirements and hence the entry strategy is also different. Franchising has brought about fast growth in Chinese retail and restaurants (like Pizza Hut, MacDonald, KFC and Subway). There are 1,000 KFCs, 560 McDonalds, 110 Pizza Huts and 70 Starbucks (Bennett, 2004). Franchisors target the westernized, youth market and traditional restaurants are not competitors although minor alterations of products may be necessary to suit local tastes. For example, Starbuck in Shanghai has sausage Danish on the menu while McDonalds offers seafood soup, items that it does not offer in the host countries. Similarly, Pizza Hut also decorates its outlets in Chinese designs. In addition to the westernized youngsters, the franchisees of international restaurant chains also target foreign expatriates and business professionals. Hence, the main menus of these restaurants follow the standardized international pattern so that foreigners can relate to them (Alon). Franchising began in China since the 1980s and picked up after the country’s accession into the World Trade Organization in 2001. According to US-China Consulting Group, there are 1,500 franchise companies and 70,000 franchises in China. In 2003, retail sales through franchises increased 44 percent but it still constitutes 2 percent of sales (Bennett, 2004). However, only a handful of hotel players have taken the franchise route in China. According to the Franchise Procedure in China, the franchisor in the hospitality sector needs to operate two directly-owned outlets for more than one year before applying for franchising. The hospitality company needs to invest substantial amounts and management for operating the direct outlets. The process of real estate acquisition and development and that of establishment of the franchise entity would, therefore, take about three years. Hence, the lead time and capital investment for the start of the hospitality franchise is high. In the hospitality industry, master franchisee structures are rare. Typically, direct unit franchises are more common in the hospitality industry. International hospitality chains could also have brand service agreements with the direct unit franchisees. According to the Franchise Procedure, “a franchisor, by entering into a contract, authorizing a franchisee to use operating resources such as trademarks, trade names, and operating model that the franchisor has the right to authorize another party to use; and the franchisee, in accordance with the contract, conducts operating activities under a uniform operating system and pays franchising fees to the franchisor”. Hence, the franchisee has to be legally independent of the franchisor that means that the international hotel chains may have only small equities in the franchisee. On the other hand, the franchisor may set up a new entity in China and simultaneously acquire land property for the hotels (Sommers, 2005). Typically, the culture of the western world is towards individualism that supports franchises while the eastern societies like China is characterized by collectivism. Wide power distances between the principal and the agent in the social hierarchy, too, affects franchises positively since individuals are then comfortable with the power equation in which the franchisor rules the shots. Such cultures are often characterized by autocratic governments like that in China. A culture that has a high level of sex role differentiation is essentially driven by pursuit of masculine ambition, money and success. In such societies, there is the perception that franchises lead to monetary gains and social success. Hence, cultures that have high sex role differentiation are those in which franchises succeed (Toncar, 1999). According to these parameters, China is not positioned culturally to favor franchises although there are some parameters that do encourage the mode of business. The culture of China is towards collectivism and the sex role differentiation is not as aggressively toward the masculine as in the west. Although these parameters have a negative effect on the growth of franchises, the country is also characterized by huge power distances and an autocratic government that would be beneficial if it aimed to support franchises. For the franchisors, the principal concern is whether the franchisee can maintain the service standards and the brand reputation. On the other hand, for the franchisee, the main transaction cost involves converting the independent local hotel under the brand of the international hotel chain. The hospitality sector in China has been opened up to the private sector only recently. Hence, the indigenous hotel industry in not equipped with staff and managerial resources to cater to the international service standards. This is a major challenge to international franchisors that want to build on the capabilities of the local hoteliers. Besides, hotel managers in China have limited customer interaction time so far and hence not yet developed service potentials. The language problem also increases the lack of communication between the staff of the franchisee and the franchisor. Hospitality franchises in India The second-fastest growing economy, India, with over 8 percent rate of growth over the last decade, is also considered an important destination for the international hospitality industry. The growing middle class and the emergence of low-fair airlines have boosted domestic tourist growth while the growing IT industry and increasing foreign investments have been the main drivers of foreign business and leisure tourists. India’s travel and tourism industry is expected to grow by 7.8 percent per annum till 2016 (Deloitte, 2006). Industry has 95,000 hotel rooms and there is an excess demand for 75,000 to 80,000 rooms. According to HVS International, 35,000-40,000 hotel rooms are under various stages of construction. While most activity so far has been in the luxury segment – mostly by international hotel chains - higher returns are offered in the budget hotel segment. The tourism boom led by domestic travelers, boosted by higher disposable income, cheap air flights, as well as the mid-level commercial travelers on account of the IT sector, is heavily dependent on the budget hotel growth. Foreign tourist inflows have been much smaller related to the domestic travelers. So far, luxury hotel growth in India has taken the affiliate with franchise or marketing network route. Lack of quality land with clear titles required for new hotels as well as that of knowledge of local culture have meant that international hotel chains have had no choice but be relatively flexible in exerting control over the franchise agreements (HVS International). Conclusion The hospitality industry in north America and western Europe is in the phase of globalization in order to overcome stagnating returns. Entry into new markets may be through the mechanism of franchising and licensing or through joint ventures. Only after a level of maturity is reached, international hotel players begin to formulate entry strategies into new markets. Franchises are one typical method of entering new markets. However, franchises provide the franchisees only a limited control over the operations of the hotel. Especially, in countries like China and India, which have distinctively cultures, replicating the western business model may not be feasible. Works Cited Alon, Ilan, Opportunities for Restaurant Franchising in China, http://www.franchise-chat.com/resources/restaurant_franchising_in_china.htm Arnold, David, Strategies for Entering and Developing International Markets, Prentice Hall Professional Technical Reference, http://www.phptr.com/articles/article.asp?p=101588&seqNum=2&rl=1 Arthur Anderson, Hospitality Adjusts to Globalization, http://www.hotel-online.com/Trends/Andersen/global.html Bennett, Julie (2004). Chinese Market Offers Franchise Challenge, Wall Street Journal, March 31. Retrieved from http://startup.wsj.com/franchising/franchising/20040331-bennett.html Cornell Hotel and Restaurant Administration Quarterly (2007). Global Brand Expansion: How to Select Market Entry Strategy. January 2. Retrieved from http://www.encyclopedia.com/doc/1Y1-103192751.html Deloitte Touche Tohmatsu, Hospitality 2010, www.scps.nyu.edu/docs/general/marketing/Hospitality2010.pdf Erramilli, M. K., S. Agarwal, and C. S. Dev (2002). Choice between non-equity entry modes: An organizational capability perspective. Journal of International Business Studies 33:223-42. Hofstede, Geert (1980). Culture’s Consequence: International Differences in Work Related Values, Beverly Hills, CA: Sage Publications 4Hoteliers (2006). Things to Consider Before Obtaining a Hotel Franchise by Stephen Rushmore, 15 June http://www.4hoteliers.com/4hots_fshw.php?mwi=1413 Hotelsmag (2001). What do Hotel Franchises Actually Cost? By Stephen Rushmore, June. Retrieved from http://www.hotelsmag.com/archives/2001/06/rushmore-cost-franchise-hotel.asp HVS International (2006). The Great Indian Hospitality Boom: Is it for real? By Siddharth Thaker, 17 February, http://www.hospitalitynet.org/news/4026384.html Sommers, Amy L (2005). Hospitality Franchising in China: Is There Room at the Inn? Franchiseek International, http://www.ssd.com/files/tbl_s29Publications%5CFileUpload5689%5C9605%5CFranchiseek.pdf Toncar, Mark, et al. (1999). Cultural Determinants of International Franchising: An Empirical Examination of Hofstede’s Cultural Dimensions. Retrieved from http://marketing.byu.edu/htmlpages/ccrs/proceedings99/toncar.htm UK Franchise Directory, The International Franchise Market, http://www.theukfranchisedirectory.net/article/The-International-Franchise-Market/25 Read More