How to detect and prevent fraud in your franchise system

Author: jkealey@lavablast.com

Date: DEC 1st, 2013

Topic: Industry Experts

We often work with emerging franchisors and one question that comes up repeatedly is "How do we ensure our franchisees pay us our royalties?”. This question can be divided into two different tasks. First: how do we ensure that the franchisees declare the correct amounts? And secondly: how to ensure the royalties are paid on time? This article focuses on the first point.

Secretive franchisees

Each franchisor does their best to select honest franchisees. However, human nature makes it likely that some franchisees will eventually behave dishonestly and franchisors must prepare for this. The majority of franchisors charge royalties based on sales and dishonest franchisees will use different tactics to reduce the declared sales amount. Obviously, these franchisees are exceptions, but franchisors need to be aware of some of the tactics which could be employed.

Tactic 1 : Simply declare a false amount

When no centralized software system is in place within a franchise, franchisees can simply declare false amounts to the franchisor. This tactic can easily be countered by a system that automatically declares sales to the franchisor rather than waiting for statements from the franchisee.

Tactic 2 : Cancelled or refunded transactions

When a software system is in place, clever franchisees quickly realize they will not have to pay royalties on a transaction when it is refunded or cancelled. Therefore, some malicious franchisees simply refund transactions after the customer leaves. Moreover, if the client does not request a receipt, they can leave the transaction pending and simply cancel it after receiving a cash payment. These strategies are more difficult to detect, but a good software system will evaluate cancellation and refund rates and compare these rates between different franchisees. It then becomes easy to find franchisees who behave abnormally.

Tactic 3 : Purchasing from suppliers who aren’t on the approved list

Some franchisees sell items from unauthorized suppliers and do not report these sales to the franchisor. Not only does the franchisee not pay their fair share of royalties, this behavior also affects the consistency of the brand throughout the franchise system. Unexpected periodic visits to the franchisee can easily reveal this tactic.

Tactic 4 : Parallel System

Because a centralized software system assists franchisors in detecting fraud, some franchisees opt to install a parallel point of sale system. By performing a certain percentage of their transactions on this second system, the franchisee reduces their reported sales. An experienced franchisor can detect this situation by using two complementary strategies.

First, the franchisor should obtain copies of orders sent to suppliers. With that data in hand, the franchisor can make a correlation between sales and purchases. Sales on a parallel system therefore become more obvious and anomalies can be automatically discovered by good franchise management software. Additionally, these tools also help identify inventory management issues (inventory stolen by an employee or customers & perishable inventory to be discarded due to poor planning controls).

Second, many franchisors may preemptively prevent the use of a parallel system by providing something special to customers only if the transaction is carried out on the authorized software system. For example, a training franchise could issue diplomas / certificates centrally at the franchisor level. Without making a sale in the system, the customer would not get legitimate proof of their training. As each franchise is unique, one must be creative to find elements which allow the franchisor to keep control of their franchise. The solution is often tied to loyalty programs or integration with the franchisor’s website (online orders, bookings, etc.).

Conclusion

Generally, the franchisor can detect and prevent fraud in their franchise through good franchise management software. Franchisors with more aggregated information at their fingertips are less vulnerable. Although this article focuses on negative aspects which can be avoided with careful monitoring, it is important to remember that these benefits are not the main objective of a good franchise management system but a consequence.

Indeed, honest franchisees also benefit from a management system. For example, these tools help franchisees properly manage their inventory, thus increasing their profitability. It is also important to remember that an involved franchisor remains one of the keys of franchisee growth and that centralized access to information opens the door to this collaboration.