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The Evolution of Business: Restaurant Franchising in China

Post Series: 2008: Volume 7, Number 2
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The Evolution of Business: Restaurant Franchising in ChinaRestaurant Franchising is an operations strategy that works in various locations around the globe. It is essentially a contractual relationship between a franchisee and a franchisor trading rights and obligations. The franchisee has the right to market the brand and/or process of a franchisor in return for a fee and ongoing royalties. In the case of business-format franchising, the franchisor transfers both the know-how and the brand of the business, and often provides additional support. As firms internationalize, they face differences in operating environments, economics, politics and culture. Successful international franchising usually rests on the ability to transplant strategy that was successful in the home country.

Restaurant franchisors are flocking to invest in China for obvious reasons: 1.3 billion people, 230 million middle-class consumers (in 2005), the world’s highest economic growth rate in the last 20 years, WTO membership, and favorable changes in recent franchise and contract laws. McDonald’s, KFC, Burger King, Gold’s Gym and Papa John’s have already set up shop. And opportunities are not only in the restaurant sector. Across the service industries in China, which typically use franchising, growth abounds (real estate, retailing, hotels, etc.).

There is a dark side, however, to franchising in China. Franchising regulations have changed multiple times, creating an unstable environment for franchising contracts to proliferate. For example, the new regulations require a franchisor to open some stores and operate them before being able to sell franchise rights.

Secondly, the Chinese market is still not culturally used to franchising governance, including the lack of resolve to protect intellectual property rights. Franchising requires a high degree of trust and legal protection. Thus, one way to succeed in the Chinese market is to enter one of the major cities using company-owned outlets. In this way the franchisor can gain familiarity with the cultural, economic and legal environments. Gaining an understanding of the nuances of the local market can help a company assess the potential. This is what most of the large multinational chains, such as McDonald’s, KFC and Yum, have done.

In China today, many of the global franchising companies have a small percentage of their total outlets franchised, while others have used it extensively even though they do not use franchising in their home market. Kodak, for example, wanted to create channels of distribution for its film and, thus, developed a quasi-franchising film-development retail model for Kodak Express in China, relying on the promise of franchisees to buy paper and equipment from Kodak. Royalties, per se, were not charged.

For those interested in investing in the China market, Shanghai is an excellent entry point because the government has helped the city become a magnet for economic growth. Shanghai offers numerous economic incentives, an increasingly westernized population, and a large number of tourists and expatriates. In addition, the per capita income in Shanghai is over $11,000 in purchasing power parity (Kwan, 2002), among the highest in mainland China.

There is also reason for caution here, however. While legal reforms have taken place, laws still seem archaic and sporadically enforced. There remains insufficient protection for copyright, trademark and intellectual property. Add the language barrier, the cultural distance between the West and China, and the fact that many Western brands are unknown in China, and it’s clear that Shanghai is a challenging opportunity to be considered carefully.

In Shanghai, the fundamentals of successful restaurant franchising are similar to those in the west: consumers want flavorful food, delivered quickly and efficiently in a clean, pleasant environment at an affordable price. One recent survey of people in Shanghai conducted by the author revealed that consumers rated taste, service, atmosphere, price and brand name in declining order of importance when selecting a restaurant. Given the cultural, social, political and infrastructure differences in Shanghai, complete standardization is unlikely.

The key is to assess what adaptation will be necessary. The following considerations may be helpful.

Product – The product includes the novelty, service, atmospherics, and overall experience that the restaurant provides. Traditional domestic restaurants are not direct competitors. Franchisors may be more successful by emphasizing the “westernness” of their products, making standardization viable. Of course, minor modifications will be required to adapt to local tastes. For example, Starbucks in Shanghai offers a sausage Danish, and McDonald’s serves seafood soup.

Promotion – Adaptation will depend largely on the product strategy. Standardized products make a standardized message possible, while different products mean different messages. Pizza Hut, for example, localized its business by decorating with large red “Double Happiness” signs, decorative firecrackers, traditional poetic couplets and the traditional Chinese character Fu (fortune); changing the design of the red roof to a Chinese feather calligraphy brush filled with red; and offering a customized “Xinyi” (goodwill) pizza from the Chinese New Year to the Lantern Festival.

Pricing – First-time visitors to Shanghai are amazed at the low prices of locally-made goods. International franchisors need not use local restaurant prices for reference. As long as the product is of high quality, and presents a new concept of consumption, a higher price will signal quality and credibility. Still, average income is substantially lower than in the West. Effective strategy might include portioning some products in sizes that can be purchased at very low price points. Both McDonald’s and KFC ran 1 Yuan (about 12 cents) ice cream specials to entice customers into the store.

Distribution – Three location strategies seem viable.

  • Downtown – The commercial and cultural center boasts the greatest variety of restaurants. But high rents have restricted growth. Only 2,100 of over 29,000 restaurants are located in Xuhui and Jing-an, the busiest sections and the center of the downtown area. Foreign restaurants are concentrated in Huaihai Lu, Maoming, Nan Lu and Henshan Lu – streets of the French Quarter in old Shanghai.
  • Special Economic Zones – Pudong, a financial center and the site of many multinational corporations and government offices, has 2,700 restaurants. Substantial residential construction is also underway. Hongqiao, west of Shanghai, boasts over 1,300 restaurants and is a favorite area of expatriates and foreign investors.
  • Upscale Residential – About 2 million people have moved to suburban residential areas, made possible by numerous infrastructure projects that have increased the commutability of city workers.

Target Markets – Three segments represent attractive targets for international restaurant franchisors.

  • Foreigners and Expatriates – Short and long-term expatriates, visitors and tourists have relatively high income and a willingness to pay a premium for familiar food with consistent quality. Continued foreign investment will result in a growing expatriate population as well as an increase in tourism.
  • Business People and Young Professionals -Includes educated professionals in the 25-50 age group. This group is likely to be the most receptive to new ideas, value the foreign dining experience, and possess sufficient discretionary income.
  • Young Emperors – Preschool through college-age children. There are an estimated 1.25 million one-child families in Shanghai. “Young Emperors” command the attention of the extended family and have a substantial influence on family buying decisions. A foreign restaurant that attracts these children will attract their parents and extended family as well.

Restaurant franchisors that miss the opportunity to enter China now will face intense competition from early entrants. It will be difficult for restaurant franchisors entering now to beat the scale and profitability of the already entrenched McDonald’s and KFC. Nonetheless, the market is vast and great potential exists in many niches.

Despite the potential, doing business in China is difficult. The language and culture are remarkably distinct. Franchisors should consider finding a local partner who can help them navigate the local business environment. A partner in the same industry with channels of distribution, industrial connections, and guanxi (personal connections) can greatly facilitate the success of the franchisor.

References:

Alon, Ilan and Dianne Welsh, eds. (2001), International Franchising in Emerging Markets: China, India and Other Asian Countries, Chicago IL: CCH Inc. Publishing.

Alon, Ilan (2007), “Master International Franchising in China: The Case of the Athlete’s Foot,”International Journal of Entrepreneurship and Small Business, 1 (4), 41-51.

Alon, Ilan and Ke Bian (2005), “Real Estate Franchising: The Case of Coldwell Banker Expansion into China,” Business Horizons, 48 (3), 223-231.

Alon, Ilan, Mark Toncar, and Lu Le (2002), “American Franchising Competitiveness in China,” Journal of Global Competitiveness, 10 (1), 65-83.

Kwan, Chi Hung (2002), “How Far is Coastal China Behind the Industrialized Countries?” available at http://www.rieti.go.jp/en/china/02080901.html.

“An Analysis Based on Purchasing Power Parity,” (retrieved June 8, 2008):http://www.rieti.go.jp/en/china/02080901.html.

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