10 The Concept and Role of Multinational Companies

Vishal Kumar

1. Learning Objective

After completing this module, you will be able to:

i. Understand the meaning and concept of Multinational Companies

ii. Understand the benefits and criticism of MNCs

iii. Know about the reasons why MNCs perform better than domestic companies?

iv. Understand the scenario of multinational companies in India

2. Introduction

THE CONCEPT AND ROLE OF MULTINATIONAL COMPANIES

Globalization provides new opportunities to underdeveloped nations by allowing them access to new markets around the world. China and India have ridden the wave of globalization throughout the twentieth century and into the twenty-first, for example, and are rapidly becoming economic powerhouses. Even tribal groups in nations, like Brazil and Africa, can ride the wave of globalization, selling locally-made products around the world via the Internet to raise their standard of living.

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The multinational corporation (MNC) is playing a vital role in the globalization of world economy. MNC is a business organization whose activities are located in more than two countries and is the organizational form that defines foreign direct investment. This form consists of a country location where the firm is incorporated and of the establishment of branches or subsidiaries in foreign countries. Multinational companies can, obviously, vary in the extent of their multinational activities in terms of the number of countries in which they operate. The economic definition emphasizes the ability of owners and their managerial agents in one country to control the operations in foreign countries.

3. Meaning and definition of A Multinational Corporation?

A multinational corporation or transnational corporation (MNC/TNC) is a corporation or enterprise that manages production establishments or delivers services in at least two countries. Very large multinationals have budgets that exceed those of many countries. Multinational corporations can have a powerful influence in international relations and local economies. Multinational corporations play an important role in globalization; some argue that a new form of MNC is evolving in response to globalization: the ‘globally integrated enterprise’.

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The World Book Encyclopedia defines a multinational corporation (MNC) as “a business organization that produces a product, sells a product, and provides a service in two or more countries.” It is a company that manages, owns and controls production facilities in several foreign countries. An expert group of United Nations defined Multinational Corporations (MNC’s) as those enterprises which own or control production or service facilities, outside the country in which they are based.

The basic characteristics of an MNC are:

(i) It operates on the basis of internationally owned assets;

(ii) It is concerned with international transfer of distinct, but complementary, factor inputs not merely equity capital, but also knowledge, entrepreneurship and sometimes goods and services of a varied kind;

(iii) Resources are transferred, but not traded in accordance with the traditional norms and practices of international trade.

4. Multinational Corporate Structure

Multinational corporations can be divided into three broad groups according to the configuration of their production facilities:

Horizontally integrated multinational corporations manage production establishments located in different countries to produce the same or similar products. (example: McDonalds)
Vertically integrated multinational corporations manage production establishment in certain country/countries to produce products that serve as input to its production establishments in other country/countries. (example: Addidas)
Diversified multinational corporations manage production establishments located in different countries that are neither horizontally nor vertically nor straight, nor non-straight integrated. (example: Microsoft)

5. Benefits of Multinational Corporations

Create wealth and jobs around the world. Inward investment by multinationals offer much needed foreign currency for developing economies. They also create jobs raises expectations of what is possible.
Their size and scale of operation enables them to benefit from economies of scale enabling lower average costs and prices for consumers. This is particularly important in industries with very high fixed costs, such as car manufacture and airlines.

Large profits can be used for research & development. For example, oil exploration is costly and risky; this could only be undertaken by a large firm with significant profit and resources. It is similar for drug manufacturers.
Ensure minimum standards. The success of multinationals is often because consumers like to buy goods and services where they can rely on minimum standards. i.e. if you visit any country you know that the Starbucks coffee shop will give something you are fairly familiar with. It may not be the best coffee in the district, but it won’t be the worst. People like the security of knowing what to expect.

6. Criticisms of Multinational Corporations

Companies are often interested in profit at the expense of the consumer. Multinational companies often have monopoly power which enables them to make excess profit.
Their market dominance makes it difficult for local small firms to thrive. For example, it is argued that big supermarkets are squeezing the margins of local corner shops leading to less diversity.
In developing economies, big multinationals can use their economies of scale to push local firms out of business.
In the pursuit of profit, multinational companies often contribute to pollution and use of non-renewable resources which is putting the environment under threat.
MNCs have been criticised for using ‘slave labour’ – workers who are paid a pittance by Western standards

7. Why MNCs perform better than domestic companies?

The following are the reasons for the better performance of the MNC’s over domestic companies:

Risk–return trade-off: The maximization of stockholder wealth depends on the tradeoff between risk and profitability. Generally, the higher the risk of a project, the higher the expected return from the project. For example, if you are offered a chance to invest in a project which offers an extremely high rate of return, you should immediately suspect that the project is very risky.

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The risk–return tradeoff does not apply to 100 percent of all cases, but in a free enterprise system, it probably comes close. Thus, the financial manager must attempt to determine the optimal balance between risk and profitability that will maximize the wealth of the MNC’s stockholders. The financial manager should assess the various risk–return tradeoffs available and incorporate this into the wealth maximization goal.

Perfect competition: Perfect competition exists when sellers of goods and services have complete freedom of entry into and exit out of any national market. Under such conditions, goods and services would be mobile and freely transferable. The unrestricted mobility of goods and services creates equality in costs and returns across countries. This cost–return uniformity everywhere in the world would remove the incentive for foreign trade and investment. Factors of production, such as land, capital, and technology, are unequally distributed among nations. Even with such comparative advantages, however, the volume of international business would be limited if all factors of production could be easily transferred among countries.

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The real world has imperfect market conditions where resources available for the production of goods are somewhat immobile. The trend toward a global economy through the World Trade Organization and the European Union will undoubtedly remove market imperfections that restrict international flows of goods and services. However, a variety of barriers still impede free movements of goods, services, and financial assets across national boundaries. These barriers include government controls, excessive transportation and transaction costs, lack of information, and discriminatory taxation. Consequently, companies can still benefit from imperfections in national markets for factors of production, products, and financial assets. In other words, imperfect national markets create a variety of incentives for companies to seek out international business. For example, Japanese automakers such as Toyota established automobile transplants in the United States to avoid US trade restrictions.

Portfolio effect (diversification): The portfolio effect states that as more assets are added to a portfolio, the risk of the total portfolio decreases. There are some qualifying conditions that we will add to this principle later, but diversification is a very valuable quality. This principle explains much of the rationale for large MNCs to diversify their operations not only across industries but also across countries and currencies. Some MNCs, such as Nestle of Switzerland, have operations in countries as varied as the United States, Japan, Hong Kong, France, Russia, Mexico, Brazil, Vietnam, Nigeria, and North Korea. Because it is impossible to predict which countries will outperform other countries in the future, these companies are “hedging their bets.” Domestic investment projects tend to correlate less with foreign investment projects than with other domestic projects. As a result, international diversification is more effective than domestic diversification.
Comparative advantage: You perhaps heard on the news that the Japanese are US competitors in the global economy. In some ways this is true, because American and Japanese companies produce many of the same goods. Ford and Toyota compete for the same customers in the market for automobiles. However, trade between the United States and Japan is not like a sports contest, where one team wins and the other team loses. In fact, the opposite is true.

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Trade between two countries can make each country better off. The classical argument for free trade is based on the principle of comparative advantage. Assume that US workers are better at producing computer software than workers in China and that Chinese workers are better at producing shoes than workers in the United States. Comparative advantage states that trade between the two countries – the United States exporting software and China exporting shoes – can boost living standards in both. This is because the United States has comparative advantage in producing software while China has comparative advantage in producing shoes. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. At the same time, companies earn profits from trade because most trade is carried out by individual companies.

Internationalization advantage: Why do some companies prefer to export while others build overseas manufacturing facilities? When a company expands its operations beyond national borders for the first time, it tends to exploit a foreign market through exports. An export-oriented strategy serves a company well for some time. However, to become part of a global market, a company should have a world presence. Because the world presence cannot be sustained by exports alone, the company should eventually invest. The advantages of internationalization influence companies to invest directly in foreign countries. These advantages depend on three factors: location, ownership, and internationalization. ExxonMobil has ownership advantages, such as technology, marketing expertise, capital, and brand names. Venezuela has location advantages, such as crude oil, abundant labour, and low taxes. Thus, ExxonMobil has built oil refineries in Venezuela. These factories magnify both wages of workers in Venezuela and profits of ExxonMobil from the use of its technology and capital. These magnified portions of location advantages and ownership advantages are called internationalization advantages. These internationalization advantages allow MNCs to enjoy superior earnings performance over domestic companies.
Economies of scale: There are economies of scale in the use of many assets. Economies of scale take place due to a synergistic effect, which is said to exist when the whole is worth more than the mere sum of its parts. When companies produce or sell their primary product in new markets, they may increase their earnings and shareholder wealth due to economies of scale.

Economies of scale explain why so many Asian companies invested in North America in preparation for the North American Free Trade Agreement of 1994. As the European Union removed trade barriers in 1993, it allowed US MNCs to achieve greater economies of scale through their investment in western Europe. Companies can gain from greater economies of scale when their real capital and monetary assets are deployed on a global basis. The expansion of a company’s operations beyond national borders allows it to acquire necessary management skills and spread existing management skills over a larger operation. There are also opportunities to eliminate duplicate facilities and consolidate the functions of production and marketing. In addition, MNCs can raise funds at the lower cost of capital and reduce the pool of money without loss in the level of production. These types of operating and financial economies, along with better management, can cause an MNC to increase its profit margin and reduce its risks as well.

Valuation: The valuation principle states that the value of an asset is equal to the present value of its expected earnings. Because the values of all assets stem from streams of expected earnings, all such assets are valued in essentially the same way. First, the earning is estimated. Second, the required rate of return for each earning is established. Third, each earning is discounted by its required rate of return, and these present values are then summed to find the value of the asset. Alternatively, the value of an entire firm is determined by dividing the firm’s earnings after taxes or net cash flows by its required rate of return. The value of an MNC is usually higher than the value of a domestic company for two reasons. First, studies show that MNCs earn more profits than domestic companies. Second, the earnings of larger companies are capitalized at lower rates. The securities of MNCs have better marketability than those of domestic companies. MNCs are also better known among investors. These factors lead to lower required rates of return and higher price–earnings ratios.

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Some business groups like Adanis started only overseas operations without any linkage with domestic operation right from the beginning. Tata group established a good name at home country and gradually moved to other countries. For companies in IT, such as Wipro or Infosys, the major focus is on overseas operations. All the companies cited as examples above are successful in their own right, but the strategies and operation systems differ from country to country.

Organizations like Reliance Industries have inherent strength in indigenous business such as completing the project prior to stipulated time. This experience enables the company to grab any business opportunity in petrochemicals around the world and build reputation. Gammon India, IRCON (Indian Railway Construction), Larsen & Toubro (L&T) and Sapoorji Pallonji are successful due to their meticulous way of understanding both operations.

8. The Scenario of Multinational Companies in India

The post financial liberation era in India has experienced huge influx of ‘Multinational Companies in India’ and propelled India’s economy to greater heights. Although, majority of these companies are of American origin but it did not take too long for other nations to realize the huge potential that India Inc offers. ‘Multinational Companies in India’ represents a diversified portfolio of companies representing different nations. It is well documented that American companies accounts for around 37% of the turnover of the top 20 firms operating in India. But, the scenario for ‘MNC in India’ has changed a lot in recent years, since more and more firms from European Union like Britain, Italy, France, Germany, Netherlands, Finland, Belgium etc have outsourced their work to India. Finnish mobile handset manufacturing giant Nokia has the second largest base in India. British Petroleum and Vodafone (to start operation soon) represent the British.

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A host of automobile companies like Fiat, Ford Motors, Piaggio etc from Italy have opened shop in India with R&D wing attached. French Heavy Engineering major Alstom and Pharma major Sanofi Aventis is one of the earliest entrant in the scene and is expanding very fast. Oil companies, Infrastructure builders from Middle East are also flocking in India to catch the boom. South Korean electronics giants Samsung and LG Electronics and small and mid-segment car major Hyundai Motors are doing excellent business and using India as a hub for global delivery. Japan is also not far behind with host of electronics and automobiles shops. Companies like Singtel of Singapore and Malaysian giant Salem Group are showing huge interest for investment.

In Spite of the Huge Growth India Inc Have Some Bottlenecks, Like –

Irrational policies (tax structure and trade barriers).
Low invest in infrastructure – physical and information technology.
Slow reforms (political reforms to improve stability, privatization and deregulation, labour reforms).

Reports says, performance of 3 out of every 4 ‘Multinational Companies’ has met or exceeded internal targets and expectations. India is perceived to be at par with China in terms of FDI attractiveness by ‘Multinational Companies in India’. In view of ‘Multinational Companies’ community, it ranks higher than China, Malaysia, Thailand, and Philippines in terms of MNC performance. Multinational Companies Operating in India cite India’s highly educated workforce, management talent, rule of law, transparency, cultural affinity, and regulatory environment as more favourable than others. Moreover, they acknowledged, India’s leadership in IT, business processing, and R&D investments.

Multinational Companies in India’ are bullish on –

India’s market potential.
Labour competitiveness.
Macro-economic stability.
FDI attractiveness.

Summary: In this module we have learnt that the international environment is very important from the point of view of certain categories of business. It is particularly important for industries directly depending on imports or exports and import-competing industries The multinational corporation (MNC) is playing a vital role in the globalization of world economy. MNC is a business organization whose activities are located in more than two countries and is the organizational form that defines foreign direct investment. This form consists of a country location where the firm is incorporated and of the establishment of branches or subsidiaries in foreign countries. Multinational companies can, obviously, vary in the extent of their multinational activities in terms of the number of countries in which they operate. The economic definition emphasizes the ability of owners and their managerial agents in one country to control the operations in foreign countries.

Further Reading:

Sundharam K.P.M. and Datt Ruddar (2010). Indian Economy, S. Chand & Sons, New Delhi.
Sharan Vyptakesh (2003). International Business: Concept, Environment and Strategy. Pearson Education, New Delhi
Cullen. (2010). International Business. Routledge.
Bennett Roger (2011). International Business. Pearson Education, New Delhi
Paul Justin (2010). Business Environment-Text and Cases. Tata McGraw Hill, New Delhi.
Cherunilam Francis (2010). International Business. Prentice Hall of India Private Limited. New Delhi.
Cherunilam Francis (2013). Global Economy and Business Environment. Himalaya Publishing House,
New Delhi.
Levi MauriceD. (2009). International Finance. Routledge.
Conklin David w. (2011). The Global Environment of Business. Sage Publications.
Mithani D M. (2009). Economics of Global Trade and Finance. Himalaya Publishing House New Delhi.
Cherunilam Francis (2011). International Business Environment. Himalaya Publishing House, New Delhi.
Saleem Shaikh (2010). Business Environment. Pearson Education, New Delhi.