VERTICAL INTEGRATION IN FRANCHISE SUPPLY CHAINS

This strategy is generally pursued for two reasons:

In regard to the first of these motivations, the expansion of the franchisor’s supply capability has the result that, in addition to the fees accruing under its franchise agreements, the franchisor now also enjoys the profits realised through the supply and distribution of the goods to its franchisees. For example, Famous Brands is now able to manufacture and distribute a range of products including sauces and spices, meat, bakery goods, ice cream, juice, coffee and cheese to its franchise network as well as to the greater food services industry. Between 2005, when the initiative commenced, and 2016, Famous Brands’ revenue increased by R3.63-billion, with the supply chain division making up 79 percent of this amount.

Another benefit of vertical integration is being able to create a relatively seamless operation. All the businesses in the franchise supply chain operate in synchronisation and this allows the company to become stronger as a self-sufficient unit.

Being vertically integrated also increases the franchisor’s ability to enforce quality control amongst its franchisees. The franchisor can specifically select the ingredients that franchisees use to manufacture their products, according to type and quality. This control is even more important where franchisors have proprietary recipes or formulas which form the basis of the franchisees’ product offerings. These are usually considered to be trade secrets and insourcing the manufacturing makes it easier to protect them against unauthorised use or disclosure.

On the other hand, despite the undoubted commercial and operational benefits that vertical integration may provide it is a potential double-edged sword and raises a number of commercial and legal challenges that the franchisor must consider.

On a commercial level, vertical integration can fundamentally affect the relationship, in particular as regards the priority given by the franchisor to the supply and franchising aspects respectively. In a pure franchise relationship, the primary source of a franchisor’s income emanates from royalties/management fees, usually calculated as a percentage of its franchisees’ sales, and therefore there is an incentive on the franchisor to maximise the revenue of the franchised outlets. This is in contrast with the goal of a supplier, which is to maximise their own profits by marking up its products. The potential for conflict between the supplier and franchise relationship lies in the fact that franchisees may see the mark-up charged by the franchisor as being excessive and inconsistent with the objective of maximising the franchisee’s profits. The franchisor needs to be aware of these competing interests and must attempt to strike a balance between them.

On the legal side, the Consumer Protection Act 68 of 2003 (CPA) comes into play. Section 13 of the CPA provides that a franchisor may only require a franchisee to buy goods and contract for services required for the franchised business if:

Certain provisions of the Competition Act 89 of 1998, may also affect a franchisor’s ability to insist that its franchisees purchase supplies from it, or a company controlled by, or otherwise related to it. These provisions may also constrain the financial structure of such a relationship.

Section 5(1) of the Competition Act prohibits agreements between firms in a vertical relationship (suppliers and customers) that would have the effect of substantially preventing or lessening competition in a market, unless the technological, efficiency or other pro-competitive gain resulting from such an arrangement outweighs the anticompetitive effects.

Exclusive dealing, a term in an agreement that requires the franchisee to buy all of its supplies or all of the ingredients or components for a particular product from the franchisor or a designated supplier, could amount to a contravention of Section 5(1). By limiting the franchisee’s ability to shop around for cheaper or more reliable sources of the goods or services concerned, the franchisor is, prima facie, adversely affecting the competitiveness of its franchisees. The franchisor would have to justify the arrangement on the basis of the ‘technological, efficiency or other pro-competitive benefits’ arising from it. This may prove problematic to the franchisor whose financial model is primarily based on maximising the profit it derives from the supply of products to its franchisees, as opposed to ensuring the viability of their businesses.

Another problem franchisors might encounter if they are predominantly reliant on profits realised through the supply of products, is that of ‘margin squeeze’. It is common for franchisors who are also suppliers to distribute their products through a combination of franchised and franchisor-owned outlets. In those circumstances, it may be tempting (and indeed may make commercial sense) for the franchisor to sell the products to the public through its own outlets at the same, or lower prices, than the prices at which it sells them to its franchisees. This will obviously affect the profitability and competitiveness of the franchisees and, where the franchisor is a dominant supplier of the product concerned (or even the only supplier, where the product is a unique one, especially formulated for the franchisor), may amount to an abuse of dominance in contravention of Section 8(c) of the Competition Act.