9 Modes of Entering in International Business-II
Kajal Gandhi
Learning Outcome:
After completing this module the students will be clear about:
• Different modes of entry
• Management Contracts
• Local manufacturing in foreign countries
• FDI
• Wholly Owned subsidiaries
• Strategic Alliances
• Acquisitions
• Joint Venture
• Pros and cons of different methods
• Comparative study of different methods
Introduction
As we discussed in the previous module that entering a new market is always a risky business, with a big potential of failure. There are various options of entering in foreign markets and research can help in determining which strategy to use. The major question that company faces in today’s cosmic economy is, what is the most suitable and appropriate way for a company to go global, go beyond its border and enter unpracticed territories on foreign sand. The companies are very skeptical regarding the profitability and safety of the decision. Companies can adopt strategic alliances method or standalone entry modes of doing business depending upon resources, markets, host country environment.
In the previous module, we have studied few methods of entering into the foreign markets. In this module we will continue to discuss other modes of entering into foreign markets.
1. Management Contracts
The international management contract gives the right to the company to control the day-to- day operations in a firm located in a foreign market. Often this contract do not give them the right to take decisions on new capital investment, policy changes, assume long-term debt or alter ownership arrangement. When a manufacturer want to enter a management contract they seldom do so isolated from other arrangements.
A management contract is a low risk method of getting into a foreign market and it yields income from the beginning. It is an arrangement by which a company provides managerial assistance to another company in return for a fee. The firm providing the management know how may not have any equity stake in the enterprise to be managed. The supplier brings together a package of skills that will provide an integrated service to the client without incurring the risk and benefits of ownership. The arrangement becomes more lucrative, if the contracting firm is given an option to purchase some shares in the managed company within a stated period.
Management contracts can also be used in case the operations of a firm are nationalized or expropriated. In certain situations, government pressure and restriction compel a foreign company either to sell its operations in host country or to relinquish control. In such a case and alternative way to generate revenue is to sign a management contract with the government or the new owner in order to manage the business. The new owner may lack technical and managerial expertise and may need the former owner to manage the investment until local employees are trained to manage the facility.
Management contracts provide an opportunity for generating additional revenues for the managing company. It may obtain the business of exporting or selling otherwise products of the managed company. It may also be asked to supply the inputs that the managed company requires.
Some Indian companies – Tata Tea, Harrison Malayalam and AVT – have contracts to manage a number of plantations in Srilanka.
Approach to Overseas Manufacturing
The various approaches to foreign manufacturing vary in the extent of involvement in production and marketing activities. These approaches are as follows:
A. Contract Manufacturing:
This entry mode is a cross between licensing and investment entry. The company contracts a firm in the foreign market to assemble or manufacture the products but they still have the responsibility for marketing and distribution of the products.
This entry mode requires minimum investment of cash, time and executive talent; it also provides fast entry to a new market. On the other hand it also has potential as formidable drawbacks like: training of potential competitor that have access to know-how and high quality products more over the profit from the manufacturing is transferred to the contractor.
Under contract manufacturing a company arranges to have its products manufactured by an independent local company on a contractual basis. The manufacturer’s responsibility is limited to production. Afterwards, the marketing responsibilities for sales, promotion, and distribution are assumed by the international company. In a way, the international company hires the production capacity of the local firm to avoid establishing its own plant or to overcome trade barriers preventing import of its product. Contract manufacturing differs from licensing the local manufacturer produces goods on the basis of orders given by the international firm but the international firm gives no commitment beyond the placement of orders. However, quality control is usually a problem when production is undertaken by another firm.
B. Foreign Assembly:
In foreign assembly, the firm produces domestically all or a set of the components or inputs of a product and ships them to foreign markets for assembly (Assembly means fitting or joining together of fabricated components). In this strategy parts of components are produced in various countries in order to gain each country’s comparative advantage. Capital investment parts may by produced in advanced nations, while labor-intensive assemblies are produced in less developed countries having low labor costs. This strategy is common among manufacturers of consumer electronics. Another reason encouraging the assembly operation is the lower import duty on parts and components than on the finished goods. Moreover, assembly operations can satisfy the “local content” demanded to some extent.
2. Local Manufacturing in Foreign Countries
Sometimes the exporting firm may find it either impossible or undesirable to supply all foreign markets from its domestic base. The goal of a manufacturing strategy may be set up a production base inside a target market country as a means of entering it. Other variations of this method range from complete manufacturing to contract manufacturing and partial manufacturing. Many companies find it beneficial to manufacture locally rather than supplying the particular market with products produced elsewhere.
There are several reasons why a company prefers to invest in manufacturing facilities abroad. The main reason include: easy access to raw materials, lower labor costs; abundance of other factors of production e.g. energy, reduced transportation costs and risks, market size, tariff barriers and political considerations. Due to the presence of these factors the imported goods may become uncompetitive. Honda with 68 per cent of its car sales coming from exports and 43 per cent from US market set up a Plant in Ohio in order to avoid future problems. A gun manufacturing company – Beretta- set up a manufacturing facility for handguns in Maryland, U.S.A. in order to meet the legal requirements that prohibit the import but not the sale of inexpensive, short-barreled pistols.
The positive factors may also encourage a firm to produce abroad. Some markets like the European Union are large enough to ensure an efficient plant size. Also, the local production allows better attention to local needs concerning product design, delivery, and service. Finally, the motivation behind the location of plants in foreign countries may be reduced to cost-reduction rather than to enter new markets.
3. Foreign Direct Investment
The Organization for Economic Co-operation and Development (OECD) define foreign direct investment (FDI) as a category of investment that reflects the objective of establishing a lasting interest by a resident enterprise in one economy (direct investor) in an enterprise (direct investment enterprise) that is resident in an economy other than that of the direct investor. Foreign Direct Investment (FDI) is a strategy approach. This entry modes offers a high degree of control over the international business in the host country. This is high financial commitment mode, but also a transfer of technology, skills, management, manufacturing and marketing, production processes and other recourses. To have unique asset or competitive advantage is often important when a firm want to replicate their good business in on other country. According to there are several factors that influence foreign direct investment. Both mention size of the market as one crucial determinant to which market the company shall choose to precede with.
4. Wholly Owned Subsidiary
Many organizations prefer to establish their presence in foreign markets with 100% ownership through wholly owned subsidiaries. Under this method, organizations obtain greater control over operations and higher profits since there is no ownership split agreement. However, such entry method requires large investments and faces higher risks, especially in the political, legal and economical arenas.
There are two approaches for the wholly owned subsidiaries entry method; one is through acquisition and other is through greenfield investments.
Greenfield investment means using funds to build an entirely new facility. Though such approach entails full control and no risk of cultural conflicts, its costs are extremely high, and returns on investment are obtained in the long-run due to the extent of time required to build the facility, start operations, and attain economies of scale and the experience-curve. In contrast, acquisition allows organizations to get to the foreign market faster. Organizations taking the acquisition approach use its funds to buy existing facilities and operations. This is done by acquiring the equity of the firm that previously owned the facility.
Advantages:
There are several advantages of wholly owned subsidiaries. Firstly, when a firm’s competitive advantage is based on technological competence, a wholly owned subsidiary will often be a preferred mode of entry because it reduces the risk of losing control over that competence. Many technologically sound firms prefer this mode for entering foreign market. Secondly, the wholly owned subsidiary give a firm tight control of operations in different countries. Lastly, a wholly owned subsidiary may be required if a firm is trying to realize location and experience curve economies.
This is considered to be the most costly method of serving a foreign market. Firms choosing this mode of entry has to incur total capital costs and undertake the risks of setting up overseas operations. The risks are a bit lower if host country enterprise is acquired. But acquisitions has different set of problems but the decision to go for acquisition or greenfield ventures is very crucial.
Disadvantages
The limitations of the wholly-owned subsidiary include the inadequacy of capital resources, shortage of management personnel, negative host-government and public relations effect. Further, 100 per cent ownership may deprive the firm of the local business and cultural knowledge and contracts of a national partner.
5. Strategic Alliances
Strategic Alliances have become popular in international business. This strategy seeks to enhance the long term competitive advantage of the firm by forming alliances with its competitors, instead of competing with each other. In an alliance, partners bring a particular skills or resource, usually one that is complementary. By sharing resources both partners are expected to gain an advantage from the other’s experience. In this arrangement a new entity may or may not by formed. Typically, the alliances involve either distribution access technology transfers or production technology, with each partner contributing a different element to the venture.
The automobile industry has witnessed many alliances for overseas operations. The Isuzu Motors Ltd. and Fuzi Heavy Industries Ltd. of Japan have set up a joint plant in the U.S.A. to build cars for Fuji and trucks for Isuzu on the same auto line. In India, Tata Tea has entered into an alliance with Tetley so that the marketing expertise of Tetley is available to market tea abroad.
A strategic alliance implies: (i) that there is a common objective; (ii) that one partner’s weakness is offset by the other’s strength; (iii) that reaching the objectives alone would be too costly, take too much time, or be too risky; and (iv) together their respective strengths make possible what otherwise would be unattainable. In short, a strategic alliance is a synergistic relationship established to achieve a common goal where both parties benefit. Firms ally themselves with actual or potential competitors for various strategic purposes. First, it may facilitate entry into foreign market. For example, Motorola initially found it very difficult to gain access to the Japanese cellular telephone market. In the mid 1980s, the firm complained loudly about formal and informal Japanese trade barriers. The turning point for Motorola came in 1987 when it allied itself with Toshiba to build microprocessors. As part of the deal, Toshiba provided Motorola with marketing help, including some of its best managers. This alliance also helped Motorola in securing government approval to enter the Japanese market.
Strategic alliances also allow firms to share the fixed costs and associated risks of developing new products or processes. Motorola’s alliance with Toshiba also was partially motivated by a desire to share high fixed costs of setting up an operation to manufacture microprocessors. The microprocessor business is so capital intensive – Motorola and Toshiba each contributed close to $I billion to set up their facility – that few firms can afford the costs and risks by themselves. Similarly, an alliance between Boeing and a number of Japanese companies to build the 767 was motivated by Boeing’s desire to share the estimated $2 billion investment required to develop the aircraft.
6. Acquisition
Acquisition is when a company buys an established business in a foreign market. This mode of entry has become very popular. The reason for acquiring a foreign company can be a mix of the following reasons: geographical changes, acquiring of specific asset like management, technology, product diversification, sourcing of raw material or other products of sale outside the host country or financial diversification etc. When you acquire a company the success depends on the selection process on which company to buy, therefore its possible advantages not certain. The specific advantages can be a faster start in the new market due to establish firm, new product line and a short payback period due to immediate income for the investors. The disadvantages on the other hand are transfers of ownership and control and hard to evaluate the prospects, but several of the advantages can turn in to disadvantages if it is not handle right.
7. Joint Ventures
A joint venture means establishing a firm that is jointly owned by two or more otherwise independent firms. This is a popular mode of entry. The term Joint Venture applies to those strategic alliances where there is equity participation from both the foreign entrant and the local collaborator. The equity participation can be of different ratios, ranging from a minority stake, equal stake to a controlling stake or a more predominant majority stake.
The advantages attached to this mode of entry are reduction in the capital risk because the costs are being shared, benefit of the firm from local partner’s knowledge of the host country’s competitive conditions, culture, language, political systems and business. In many countries political conditions dictate this entry to be the only feasible mode of entry.
Many companies avoid joint venture due to complexities involved in coordinating policies, decisions, and execution with a different company. Other drawbacks are distinct difference in culture, managerial styles and communication barrier.
Advantages and Disadvantages of Entry Modes in summary
Figure-1
Factors influencing choice of Entry Strategy
Choice of mode of entering cross-border markets is one of the strategic decision which a multinational enterprise has to make before investing resources. There is no specific rule to facilitate the choice of a correct method nor there is single entry method which could meet the requirements of different situations. Choice of a particular entry method will, therefore depend upon various factors. Usually, any company approaching a new market is looking for profitability and growth. Alternative entry method should be analyzed for expected sale level, costs and assets level that will eventually determine profitability. Other important considerations influencing the choice of a mode of entry include size of the firm, exposure of the firm to international market , product life cycle stage of the firm’s product, level of risk associated with different modes of market entry, and the political and legal environment of the foreign country concerned.
Summary
In this module we studied various modes of entering in foreign countries like management contracts, wholly owned subsidiaries, strategic alliances, joint ventures, acquisitions. Though there are several advantages associated with each mode of entry. These advantages have to weighed against the pioneering costs that early entrants often have to bear, including a greater risk of business failure. There are several factors that are considered regarding which market to enter, when to enter the markets, and on what scale. The most attractive foreign markets tend to be found in politically stable developed and developing nations that have free market systems and where there is not a dramatic upsurge in either inflation rates or private sector debt.