Advertising fee in business-format franchising

Most franchisors charge an advertising fee in addition to the better known royalty and franchise fee. We study the role of the advertising fee in improving channel coordination. We begin our analysis with a simple case of one franchisor dealing with two identical franchisees and find that the advertising fee allows the franchisor to commit to a specific level of advertising spending at the time of contract acceptance. We also find that the lump-sum advertising fee is better than the sales-based advertising fee. These results are intriguing because most franchisors use the sales-based advertising fee. We show that when franchisees' markets differ in how advertising affects sales, the franchisor may prefer the sales-based advertising fee. There are two reasons for the higher profitability of the sales-based advertising fee. First, the sales-based advertising fee conditions the franchisor's advertising decision on the franchisees' price and service decisions, and induces them to make better price and service decisions. The second reason is that with heterogeneous franchisees, using the sales-based advertising fee does not increase the total sales-based component in the fee structure. These results also hold when the franchisor pledges to contribute a matching fraction of the advertising fee to the advertising fund.