Variable royalty rates for improving franchise channel coordination

A business format franchisor obtains a major part of its revenues from franchise royalties, which are typically a fixed percentage of franchisee gross sales. When a fixed royalty rate is used and the marginal costs of operating the franchise are increasing, the franchisee does not have an incentive to increase sales beyond a certain ‘optimal’ volume. We present a model that recommends the use of a variable franchise royalty rate for extending this optimal sales volume. For a general convex cost function, we show that a new lower rate can be applied to incremental sales beyond the original optimal level. We show that this new rate should be less than half of the original rate when a quadratic cost function is applicable. Adopting a variable royalty rate increases franchisor royalty revenues and franchisee profits.