Virtually all franchise agreements a prospective franchisee would see in Canada will have a section with the heading: “Designated and approved suppliers.” The wording more or less says: “The franchisee shall purchase all equipment, supplies and inventory for the franchised business directly from the franchisor or from the franchisor’s designated or approved suppliers.”

You can’t really talk about this obligation without acknowledging that the franchisor’s designated or approved supplier is often the franchisor itself, or a company it owns or controls. And the franchisor, or its affiliate, normally makes a profit from what it charges franchisees for equipment, product, supplies and inventory.

In cases where the supplier is not the franchisor or its affiliates, the franchisor will often enter into a “supply agreement” or other arrangement with a company or companies, giving the franchisor a volume rebate or other benefit based on the number of items purchased by franchisees and corporate outlets.

With respect to inventory the franchise buys for re-sale, the franchisor may have negotiated a deal with XYZ Widget Co., where the franchisor requires all of its franchisees to buy their widgets directly from XYZ. XYZ would normally sell widgets to the franchisees at a much lower price than on the open widget market but for being part of the franchisor’s “buying group.” The larger the group and the more widgets it buys, the less the group – and therefore each individual – pays per widget.

By purchasing inventory at a lower price than a solo operator, the money saved can be passed on to consumers in the form of lower prices. At least that’s the theory.

There’s something else you should know about buying arrangements that franchisors negotiate with suppliers. Volume rebates are normally paid to the franchisor based on the widgets purchased by it and its franchisees. This sometimes takes the form of cash. Unless the franchise agreement specifically provides that rebates are passed on to franchisees, the franchisor may keep the rebates for its own account, it may decide to share all or a portion of the rebate with its franchisees, or the franchisor can direct the rebate money into its advertising fund, the annual franchise convention, or other purposes that benefit the franchisees.

The ability of franchisees to buy equipment, supplies and inventory at a lower cost than they would pay on their own is arguably the glue that holds the franchise system together. If the franchisor or its supplier cannot provide the same products at competitive prices, franchisees will bend over backward to try to use another supplier, even if the contract forbids it.

Now that you’re all armchair experts on buying groups and volume rebates in franchise systems, here are a few related questions to consider if you’re thinking seriously about buying a franchise:

1. What does the franchisor do with any rebate money it receives from suppliers? Does it keep it all, does it share a portion with franchisees, or does it use the money to subsidize things such as the advertising fund or conventions?
2. A tenant improvement or TI allowance is arguably a form of rebate paid to a franchisor by a landlord to develop the premises it leases and that, in turn, the franchisor subleases to its franchisee. Is the TI allowance passed directly on to the franchisee to offset construction costs, or does the franchisor retain it for its own account?
3. In the restaurant business, equipment costs are high. The franchisor may insist you buy everything from ABC Co. in Italy because they have an arrangement, but what if you can buy the identical equipment from XYZ Co. in Toronto at 15 per cent to 20 per cent less? Remember, whenever you are obligated to purchase equipment from another country, you have to factor in things such as exchange rates, duty and potential delays. Fifteen years ago, when the Canadian dollar was worth somewhere near 68 cents (U.S.), forcing a Canadian franchise to buy restaurant equipment and inventory from the U.S. supplier instead of a comparable Canadian one was a recipe for disaster, as Canadian franchisees were hard pressed to be able to deal with a 32 per cent price differential on exchange rates.
4. In some agreements, there will be a provision that contemplates the possibility of franchisees wanting to use alternate suppliers, in which case the agreement will give the franchisor the right to consent to this, subject to testing and evaluation of the alternate supplier’s products. But you can go further. Perhaps your agreement should be negotiated to permit you, without consent, to buy the identical products from any legitimate supplier in circumstances where the designated supplier is unable to provide on commercially reasonably terms or where there is an interruption in supply.
5. Even if you are able to negotiate a provision where the franchisor or its suppliers will sell to you “on commercially reasonable terms,” remember to factor in freight costs during negotiations. For example, if you’re in Newfoundland and the franchisor agrees not to sell its specially prepared frozen yogurt or pizza dough at a higher price to you than it sells to its Alberta franchisees – because the products are manufactured there – don’t forget to consider that freight and storage costs for shipping a product from Alberta to Newfoundland could be one third the cost of the product itself.
6. If you’re required to purchase food products from a franchisor’s approved supplier in the United States or another country, is this product even importable into Canada or does it need approval from federal health authorities?
7. If you’re required to buy product for re-sale from the franchisor’s designated supplier in the United States, it will likely not have bilingual labels and instructions. The U.S.-based franchisor might not know this. Who is paying for the additional labelling to comply with Canadian law?

These aren’t all the questions to consider when evaluating whether to buy a franchise, but as a franchisee you’ll only make money if you’re able to reduce your expenses.

Negotiating the ability to buy the same product from elsewhere because the franchisor or its supplier is too expensive or too slow is one way to reduce the risk of expenses getting out of hand. If the franchisor can contractually commit to supplying the product and equipment you need to purchase at a lower cost and quicker than anyone else, it sounds like a pretty good franchisor.

By:Tony Wilson http://www.theglobeandmail.com