How do franchise rebates work?

Changes to the disclosure provisions of the Franchising Code of Conduct introduced in March 2008 now require franchisors to not only disclose rebates received from suppliers to the franchise network, but to also name those suppliers.

This was one of the recommendations of the Matthews Inquiry into the franchise sector, commissioned during the Howard Government era. At one point it was suggested that this requirement be expanded to not only name the suppliers who pay rebates, but also the amounts paid by each.

The commercial sensitivity of rebate amounts and the potential loss of competitive advantage as rivals reverse-engineer the financial structure of a competitor’s supply chain could have spelled chaos for the franchise sector. Fortunately, the recommendation was watered-down before being adopted.

Still, the disclosure of rebates is a key piece of information potential franchisees should know, yet the true significance of this information is not realised until several months after the franchisee has commenced operating.

The reason for this is straightforward. The information in a disclosure document is often viewed as intangible and theoretical. A rebate on supplies purchased by franchisees might look as innocuous as a percentage of turnover royalty in a disclosure document, however when the business is running and the rebate or royalty is calculated as a dollar amount and paid over to the franchisor, suddenly it becomes a lot more real and tangible.

The very existence, nature, size and extent of rebates can be a source of conflict between franchisees and franchisors.

Firstly there is the question of whether or not rebates should be received at all. This is based around the idea that rebates inflate the cost of goods to franchisees, and therefore decrease franchisee profitability and or competitiveness.

The flipside to this argument is that the collective buying power of the group can generate discounts for franchisees that exceed the rebate amount, which means that the net price to the franchisee could still be lower than if they were not part of a franchise group.

The issue of whether or not rebates are charged at all is often philosophical and will vary from one franchise system to another. Some systems will negotiate group pricing and receive rebates. Other systems will negotiate group pricing and pass all the savings direct to the franchisees. The choice of approach may be determined by other factors, such as the industry in which the franchise operates, the administration cost of managing a rebate program, the type of royalty applied in the franchise system, and the willingness of suppliers to even consider the payment of rebates.

However, if the choice is made to receive rebates from suppliers, the next issue then is how should the income be applied, how much should it be, and across what range of purchases should it be sought?

The application of rebate income

Once a determination has been made about whether or not to seek rebates from suppliers, the next question is what to do with the income received.

Franchisors may choose to retain part or all of the rebate income as a contribution to the running costs of the business above and beyond any royalty income received. (It should be noted that not all franchisors charge royalties, and in some rare instances, rebates may be their only form of income).

Franchisors who already receive royalty income and seek to augment this by also receiving rebate income risk the perception among their franchisees of ‘double-dipping’. In this regard, rebates are considered a reverse or stealth royalty, because the amounts are calculated on what franchisees spend, not on the sales they generate.

While some franchisors will retain 100% of the rebates for their own benefit, others will apply some or all of the rebate income to elements of the system which may provide a benefit to both franchisor and franchisees. For example, rebates might be paid or allocated to the franchise marketing fund, the annual conference fund, research and development programs, or even distributed to social and charitable causes supported by the network.

How much should a rebate be?

There are no hard and fast rules about rebate amounts, but in simple terms, a rebate should be no greater than the value it can deliver.

If a rebate from goods or services where the total cost is still cheaper than the price and terms the franchisees could achieve themselves, the negotiation by the franchisor of the group rate (including the rebate) adds value to the franchise relationship.

However, if the rebate has driven up the cost or terms of supply to franchisees such that they can achieve better terms or prices on exactly the same goods or services themselves, the rebate detracts value from the franchise relationship.

The amount of the rebate, expressed as a percentage, will largely depend on the volume of goods and services purchased by franchisees from the supplier, and the size of the margin on these goods or services. Additionally, the amount of rebate will also depend on how keen the supplier is to deal with the franchise network or to dislodge a competitor from dealing with a franchise network.

The percentage amounts can vary wildly from one supplier to another, and one franchise system to another, but can range from fractions of a percent to as much as 10% (or even more).

Regardless of the amount of the rebate, the worth of any rebate system will be determined by the value it delivers to the franchise network as a whole, and in particular to the franchisees who ultimately pay for it.

On what goods or services should rebates be sought?

The list of goods or services on which rebates might be paid is almost endless.

Goods or services that are consumed in high volumes on a very frequent basis are the most likely candidates for rebate arrangements. For a retail fast food business, this might include component food items (eg. meat items, bread products, drinks, etc) or non-food items such as packaging, cleaning or security services, credit card merchant services, and so on. For a service business, goods or services on which rebates might be received could include insurances, telecommunications, maintenance services, goods, etc.

On high-volume high-frequency purchases, rebates (as a percentage of the sale amount) are likely to be smaller compared to low-volume, low-frequency purchases where the rebate percentage may be much greater.

Suppliers which are medium to large sized companies are more likely to offer rebates in the normal course of business, while smaller organisations may have little, if any experience, in offering rebates and initially struggle with the concept.

Government bodies are unlikely to offer rebates unless these are publicly advertised and available to both franchised and non-franchised entities (eg. solar power rebates for the initial installation of solar panels, and then ongoing rebates for the energy produced).

The bottom line

Negotiating and administering rebates is a minefield for the unwary franchisor. Where rebates fail to add value to a franchisee’s business, the amount and need for rebates will become a source of conflict in a franchise system. Any consideration of the introduction or variation of rebates should be done in the context of the value proposition to the system as a whole.

Jason Gehrke is a director of the Franchise Advisory Centre and has been involved in franchising for 18 years at franchisee, franchisor and advisor level. He provides consulting services to both franchisors and franchisees, and conducts franchise education programs throughout Australia. He has been awarded for his franchise achievements, and publishes Franchise News & Events, Australia’s only fortnightly electronic news bulletin on franchising issues. In his spare time, Jason is a passionate collector of military antiques.

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