The Nature of International Business – Part 1
Welcome to the fourth session of the International Socio-Economic Context Course. This class we will start the review of the Chapter the Nature of International Business that aims for the general comprehension of enterprises which have international activities.
This is important because domestic and international firms operate in contexts of different nature so by understanding the differences it becomes clear the special considerations for MNC to achieve a successful internationalization. Also, in this session the different methods to enter a new market will be presented and explained.
So, by the end of this class you will be able to identify the main differences in the management of a domestic and an international corporation at the time that you will posses the information to identify the best way to have presence in a foreign market where collected information plays a key role.
Domestic Versus International Business
According to Ajami R., & Goddard J. G. (2015), a firm needs to identify its potential market, locate adequate and available sources of supplies of raw materials and labor, raise initial amounts of capital, hire personnel, develop a marketing plan, establish channels of distribution, and identify retail outlets. As an overlay upon this comprehensive system, the firm must also establish management controls and feedback systems, as well as accounting, finance, and personnel functions.
Not only must the novice international businesspeople contend with establishing an international component to add to domestic operations, but also they must contend with the fact that international business activities are conducted in environments and arenas that differ from their own in all aspects: in economies, cultures, government, and political systems. The differences range along a continuum.
For example, economies can range from being market-oriented to centrally planned, and political systems from democracies to autocracies. The nations of Zimbabwe and North Korea would be considered centrally planned, autocratic governments. Countries are widely divergent in cultural parameters such as ethnic varieties, religious beliefs, social habits, and customs.
The problems and difficulties these differences generate are exacerbated by problems of distance, which complicate the firm’s ability to communicate clearly, transmit data and documents, and even find compatible business hours, because of the differences in time zones around the world.
Business activities require vast investments of time, energy, and personnel on the do- mestic level. Adding an international component merely intensifies the number of steps necessary and the length and breadth of the firm’s reach of effort and activity. Imagine establishing international components for all business functions as separate and discrete units. The prospective commitment is staggering and is generally avoided by many do- mestic businesses.
It is more likely that domestic firms enter foreign markets in a progressive way, beginning with exporting, which involves the least amount of resources and risk, before moving to a full-scale commitment in the form of establishing wholly owned overseas subsidiaries.
move overseas. It must evaluate its own resources: personnel, assets, experience in overseas markets, and the suitability of its products or organization for transplantation overseas. It is also crucial that a firm decide on the minimum and optimum levels of return it wishes to receive, as well as the amount of risk it is will- ing to bear. A firm must also evaluate the level of control necessary to manage the overseas operation. These factors must be critiqued in light of competition expected in markets abroad and the potential business opportunities that are to be created by the international operation.
All of these factors must be weighted in terms of the overall short-term and long-term strategic goals and objectives of the firm. For example, a firm may have a long-term goal to build a production facility abroad to serve a foreign market within ten years. Consequently, it would be unwise to enter into a licensing agreement that would hold up its use of its rights for a long period of time.
Methods of Going International
Exporting requires the least amount of involvement by a firm in terms of resources required and allocated to serving an overseas market. Basically, the company uses existing domestic capacity for production, distribution, and administration and designates a certain portion of its home production to a market abroad. It makes the goods locally and sends them by air, ship, rail, truck, or even pipeline across its nation’s borders into another country’s market.
Entrance into an export market frequently begins casually, with the placement of an order by a customer overseas. At other times, an enterprise sees a market opportunity and actively decides to take its products or services abroad. A firm can be either a direct or indirect exporter. As a direct exporter, it sees to all phases of the sale and transmission of the merchandise. In indirect exporting, the exporter hires the expertise of someone else to facilitate the exchange. This intermediary is, of course, happy to oblige for a fee. There are several types of intermediaries: manufacturers’ export agents who sell the company’s product overseas; manufacturers’ representatives who sell the products of a number of exporting firms in overseas markets; export commission agents who act as buyers for overseas markets; export commission agents who act as buyers for overseas customers; and export merchants who buy and sell on their own for a variety of markets.
The mechanics of exporting require obtaining appropriate permission from domestic governments (e.g., for food products and some technology and products considered crucial for national security); securing reliable transportation and transit insurance; and fulfilling requirements imposed by the importing nation, such as payment of appropriate duties, declarations, and inspections.
Advantages of Exporting
The prime advantage of exporting is that it involves very little risk and low allocation of resources for the exporter, who is able to use domestic production toward foreign markets and thus increase sales and reduce inventories. The exporter is not involved in the problems inherent in the foreign operating environment; the most that could be lost is the value of the exported products or an opportunity if the venture fails to establish the identity or characteristics of the product.
Exporting also provides an easy way to identify market potential and establish recogni- tion of a name brand. If the enterprise proves unprofitable, the company can merely stop the practice with no diminution of operations in other spheres and no long-term losses of capital investments.
Disadvantages of Exporting
Exporting can be more expensive than other methods of overseas involvement on a per-unit basis because of mistakes and the costs of fees, or commissions, export duties, taxes, and transportation. In addition, exporting could lead to less than optimal market penetration because of improper packaging or promotion. Exported goods could also be lacking features appropriate to specific overseas market. Relying on exporting alone, a firm may have trouble maintaining market share and contacts over long distances. Additional market share could be lost if local competition copies the products or services offered by the exporter. The exporting firm also could face restrictions against its products from the host country.
While some of these problems can be addressed by establishing direct exporting capa- bility through the establishment of a sales company within the foreign market to handle the technical aspects of export trading and keep abreast of market developments, demand, and competition, many firms choose instead to expand their operations in foreign spheres to include other forms of investments.
Through licensing, a firm (licensor) grants a foreign entity (licensee) some type of intangible rights, such as the rights to a process, a patent, a program, a trademark, a copyright, or expertise. In essence, the licensee is buying the assets of another firm in the form of know-how or research and development. The licensor can grant these rights exclusively to one licensee or non exclusively to several licensees.
Advantages of Licensing
Licensing provides advantages to both parties. The licensor receives profits in addition to those generated from operations in domestic markets. These profits may be additional revenues from a single process or method used at home that the manufacturer is unable to utilize abroad. The method or process could have the beneficial effect of extending the life cycle of the firm’s product beyond that which it would experience in local markets. Additional revenues could also represent a return on a product or process that is ancillary to the strategic core of the firm in its domestic market; that is, the firm could have developed a method of production that is marketable as a separate product under a licensing agreement. In addition, by licensing, the firm often realizes increased sales by providing replacement parts abroad. In addition, it protects itself against piracy by having an agent in the licensed user who watches for copyright or patent infringement.
The licensee benefits by acquiring the rights to a process and state-of-the-art technology while avoiding the research and development costs.
Disadvantages of Licensing
The prime disadvantage of licensing to the licensor is that it limits future profit opportunities associated with the property by tying up its rights for an extended period of time. Additionally, by licensing these rights to another, the firm loses control over the quality of its products and processes, the use or misuse of the assets, and even the protection of its corporate reputation.
To protect against such problems, the licensing agreement should clearly delineate the appropriate uses of the process, method, or name, as well as the allowable market and re-export parameters for the licensee. The contract should also stipulate contingencies and recourse, should the licensor fail to comply with its terms.
Franchising is similar to licensing, except that in addition to granting the franchisee permission to use a name, process, method, or trademark, the firm assists the franchisee with the operations of the franchise and/or supplies raw materials. The franchiser generally also has a larger degree of control over the quality of the product than under licensing. Payment is similar to licensing in that the franchiser pays an initial fee and a proportion of its sales or revenues to the franchising firm. The prime examples of US franchising companies are service industries and restaurants, particularly fast-food concerns, soft-drink bottlers, and home and auto maintenance companies (e.g., McDonald’s, Kentucky Fried Chicken, Holiday Inn, Hilton, and Disney in Japan).1 Only companies with models that have been successful in the domestic markets should consider franchising internationally. If the franchisor has not had success in the do- mestic market, it would not be wise to consider an international franchising program.
Advantages and Disadvantages of Franchising
The advantages accruing to the franchiser are increased revenues and expansion of its name brand identification and market reach. The greatest disadvantage, as with licensing, is coping with the problems of assuring quality control and operating standards.
Franchise contracts should be written carefully and provide recourse for the franchising firm, should the franchiser not comply with the terms of the agreement. Other difficul- ties with franchises come with the need to make slight adjustments or adaptations in the standardized product or service. For example, some ingredients in restaurant franchises may need to be adapted to suit the tastes of local clientele, which may differ from those of the original customers.
Management contracts are those in which a firm basically rents its expertise or know-how to a government or company in the form of personnel who go into the foreign environment and run the concern. This method of involvement in foreign markets is often used with a new facility, after expropriation of a concern by a national government, or when an operation is in trouble. Management contracts are frequently used in concert with turnkey operations. Under these agreements, firms provide the service of overseeing all details in the startup of facilities, including design, construction, and operation. These are usually large-scale projects, such as production plants or utility constructions. The problem faced in turnkey operations is often the time length of the contract, which yields long payout schedules and carries greater risk in currency markets. Other problems can arise in the form of an increase in potential competition in the future as overseas capacity is increased by the new facilities. Turnkey operations also face all the problems of operating in remote locations.
Contract manufacturing is another method for firms to enter the foreign arena. Here the MNE contracts with a local firm to provide manufacturing services. This arrangement is akin to vertical integration, except that instead of establishing its own production locations, the MNE subcontracts the production, which it does in two ways. In one case it enters into a full production contract with the local plant producing goods to be sold under the name of the original manufacturer. The other way is to enter into contracts with another firm to provide partial manufacturing services, such as assembly work or parts production.
Contract manufacturing has the advantage of expanding the supply or production expertise of the contracting firm at minimum cost. It is as if it can diversify vertically without a full-scale commitment of resources and personnel. By the same token, however, the firm also forgoes some degree of control over the production supply timetable when it contracts with a local firm to provide specific services. These problems are, however, no more substantial than operating normal raw material supplier contracts.
When a company invests directly within foreign shores, it is making a very real commitment of its capital, personnel, and assets beyond domestic borders. While this commitment of resources increases the profit potential of an MNC dramatically by providing greater control over costs and operations of the foreign firm, it is also accompanied by an increase in the risks involved in operating in a foreign country and environment.
As with other forms of international activity, direct investment runs a continuum from joint ventures where risk is shared (but so are returns) to wholly owned subsidiaries where MNEs have the opportunity to reap the rewards, but also must shoulder the lion’s share of the risk. Multinationals decide to make direct investments for two main reasons. The first is to gain access to enlarged markets. The second reason is to take advantage of cost differentials in overseas markets that arise from closer production resources, available economies of scale, and prospects for developing operating efficiencies. Both reasons lead to the enjoyment of enhanced profitability. Alternatively, a firm enters a foreign market for defensive reasons to counter strategic moves by its competitors or to follow a market leader into new markets.
Strategic alliances (or joint ventures) are business arrangements in which two or more firms or entities join together to establish some sort of operation. Strategic alliances may be formed by two MNEs, an MNE and a government, or an MNE and local businesspersons. If there are more than two participants in the deal, it is also called a consortium operation.
Each party to these ventures contributes capital, equity, or assets. Ownership of the joint venture need not be a 50–50 arrangement and, indeed, it ranges according to the proportionate amounts contributed by each party to the enterprise. Some strategic alli- ances may be for only a short period of time, while others can endure for longer periods. Often the successful alliances are those whereby all parties stand to gain from the new alliance. Some countries stipulate the relative amount of ownership allowable to foreign firms in joint ventures. Vietnam is an example of a country that has historically had foreign ownership limits with regard to joint ventures.
Advantages of Strategic Alliances
Strategic alliances provide many advantages for both local and international participants. By entering a local market with a local partner, the MNE finds an opportunity to increase its growth and access to new markets while avoiding excessive tariffs and taxes associated with the entry of products. At the same time, joining forces with local businesses often neutralizes local existing and potential competition and protects the firm against the risk of expropriation because local nationals have a stake in the success of the operations of the firm. It is also frequently easier to raise capital in local markets when host-country nationals are involved in the operation. In some cases, host governments provide tax benefits as incentives to increase the participation of foreign firms in joint enterprises with local businesspersons.
Disadvantages of Strategic Alliances
The involvement of local ownership can also lead to major disadvantages for overseas partners in strategic alliances. Some of the problems faced by the MNE partners are limits on profit repatriation to the parent office; successful operations becoming an inviting target for nationalization or expropriation by the host government; and problems of control and decision-making. For example, different partners might have different objectives for the joint ventures. An MNE might have a goal of achieving profitability on a shorter timetable than its local partner, who might be more concerned about long-term profit- ability and maintaining local employment levels. It is a necessity, therefore, that firms establish guidelines regarding the objectives, control, and decision-making structures of joint ventures before entering into agreements.
Joint ventures tend to be relatively low-risk operations because the risks are shared by individual partners. Nevertheless, not having full control of the operation remains a predominant problem for the overseas participants in these ventures. A firm can achieve full control over operations, decision-making, and profits only when it establishes its own wholly owned subsidiary on foreign soil.
Wholly owned subsidiaries
By establishing its own foreign arm, a firm retains total control over marketing, pricing, and production decisions and maintains greater security over its technological assets. In return, it is entitled to 100 percent of the profits generated by the enterprise. Although it faces no problems with minority shareholders, the firm bears the entire risk involved in operating the facility. These risks are the same as those customarily encountered in domestic operations, but with an additional layer of special risks associated with international operations, such as expropriation, limits on profits being repatriated, and local operating laws and regulations, including the requirement to employ local labor and management personnel. In these cases, the MNCs do not have the benefit of local shareholders to run interference for them with local governments.
In establishing a subsidiary, a firm must choose either of two routes: acquire an ongo- ing operation or start from scratch and build its own plant. Buying a firm (also known as the brownfield strategy) has the advantage of avoiding startup costs of capital and a time lag. It is a faster process that is often easier to capitalize at local levels and generally cheaper than building. Buying also has the advantages of not adding to a country’s existing capacity levels and of improving goodwill with host-country nationals. Downsides for the brownfield strategy are that any existing labor issues at the acquired site will remain after acquisition and that the purchased facility may no longer be state-of-the-art in use and design.A company may decide to build a new plant (also known as the greenfield strategy) if no suitable facilities exist for acquisition or if it has special requirements for design or equipment. Although building a plant may avoid acquiring the problems of an existing physical plant, the firm may face difficulties in obtaining adequate financing from local capital markets and may generate ill-will among local citizens.
Some theorists believe that consumers around the world are becoming increasingly alike in their goals and requirements for products and product attributes. As a result, the world is becoming a global market in which products would be standardized across all cultures, enabling corporations to manufacture and sell low-cost reliable products around the world. Such firms would be characterized by globalized operations, as distinct from multinational operations. A firm that has globalized operations would be able to take advantage of business opportunities occurring anywhere in the world and would not be constrained to specific sectors. Indeed, some firms have been able to achieve substantial globalization of operations as their products cross national borders without being adapted to individual country preferences. Prime examples include Levi-Strauss & Company, PepsiCo, Coca-Cola, and several other companies ranging from consumer goods to fast food.
Portfolio investments do not require the physical presence of a firm’s personnel or prod- ucts on foreign shores. These investments can be made in the form of marketable securities in foreign markets, such as notes, bonds, commercial paper, certificates of deposit, and non-controlling shares of stock. They can also be investments in foreign bank accounts or foreign loans. Investors make decisions to acquire securities or invest money abroad for several reasons, primarily to diversify their portfolios among markets and locations, to achieve higher rates of return, to avoid political risks by taking their investments out of the country, or to speculate in foreign exchange markets.
Portfolio investments can be made either by individuals or through special investment funds. These investment funds pool local resources for investment in overseas stock and financial markets. Many mutual fund companies, such as Fidelity and Vanguard, have funds with an international focus. These funds invest in companies in a specific region of the world for investors in the United States. This allows both individuals as well as institutional investors to diversify their investments geographically. Over the last few years, some emerging economies have reformed the rules and regu- lations to encourage foreign investment. Most developed countries allow free access to their stock markets to overseas investors. Other developing economies allow less access to their stock markets. Overall, the developing world ranges from being less restrictive than it has been in the past to operating an open market system.
There are several factors that determine the degree to which a particular country will be able to attract portfolio investments. Political stability and economic growth are the most basic factors. The size, liquidity, and stability of stock markets, the level of interest rates and government taxes, and the nature of government regulation are also important determinants. The degree of restrictions on repatriation of income and capital invested are other major variables that affect the attractiveness of a country to overseas portfolio investors. Historically, most international portfolio investment has been concentrated in the industrialized countries; the United States, Japan, France, the United Kingdom, Switzerland, the Netherlands, and Canada receive substantial amounts of portfolio invest- ments in their markets. In recent years, some emerging stock markets, such as China, India, Malaysia, Indonesia, and Taiwan, have been able to attract significant amounts of foreign portfolio investment.
Managing a domestic and a MNC requires different considerations in order to obtain the desired results. Some of the benefits of such analyzed management have been presented in this session.
Also, the different ways to start the participation in international markets were introduced as well as their advantages and disadvantages. This is useful information for the Managers or business professionals who want to prepare the first internationalization of a company or to advance in the evolution of their form of participation in foreign markets.
As it was presented, different elements are crucial in every mode of entry so, this decision must be made keeping in mind those particularities and the different scenarios in which the firm would act internationally,
- Ajami R., & Goddard J. G. (2015). International Business: Theory and Practice. Routledge (31-41)
- Somaya, D. (s. f.). Foreign Market Entry Part 1. Corporate Strategy. Coursera. Video File https://es.coursera.org/lecture/corporate-strategy/foreign-market-entry-part-1-ip17D.
- Somaya, D. (s. f.). Foreign Market Entry Part 2. Corporate Strategy. Coursera. Video File https://es.coursera.org/lecture/corporate-strategy/foreign-market-entry-part-2-GIRxw