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Profiting from Global Expansion Expanding globally allows firms to increase their profitability in ways not available to purely domestic enterprises.3 Firms that operate internationally are able to:
As we will see, however, a firm's ability to increase its profitability by pursuing these strategies is constrained by the need to customize its product offering, marketing strategy, and business strategy to differing national conditions. Transferring Core Competencies The term core competence refers to skills within the firm that competitors cannot easily match or imitate.4 These skills may exist in any of the firm's value creation activities--production, marketing, R&D, human resources, general management, and so on. Such skills are typically expressed in product offerings that other firms find difficult to match or imitate; thus, the core competencies are the bedrock of a firm's competitive advantage. They enable a firm to reduce the costs of value creation and/or to create value in such a way that premium pricing is possible. For example, Toyota has a core competence in the production of cars. It can produce high-quality, well-designed cars at a lower delivered cost than any other firm in the world. The skills that enable Toyota to do this seem to reside primarily in the firm's production and materials management functions.5 McDonald's has a core competence in managing fast-food operations (it seems to be one of the most skilled firms in the world in this industry); Toys "R" Us has a core competence in managing high-volume, discount toy stores (it is perhaps the most skilled firm in the world in this business); Procter & Gamble has a core competence in developing and marketing name brand consumer products (it is one of the most skilled firms in the world in this business); Wal-Mart has a core competence in information systems and logistics; and so on. For such firms, global expansion is a way to further exploit the value creation potential of their skills and product offerings by applying those skills and products in a larger market. The potential for creating value from such a strategy is greatest when the skills and products of the firm are most unique, when the value placed on them by consumers is great, and when there are very few capable competitors with similar skills and/or products in foreign markets. Firms with unique and valuable skills can often realize enormous returns by applying those skills, and the products they produce, to foreign markets where indigenous competitors lack similar skills and products. For example, as we saw in the opening case, General Motors is trying to create value by leveraging the production skills developed at its Eisenach plant in Germany to new plants being built in Argentina, Poland, China, and Thailand. McDonald's, as detailed later in the chapter, Management Focus, has profited by leveraging its core competence in running fast-food restaurants to foreign markets where indigenous competitors either did not exist or lacked similar skills. In earlier eras, US firms such as Kellogg, Coca-Cola, H. J. Heinz, and Procter & Gamble expanded overseas to exploit their skills in developing and marketing name brand consumer products. These skills and the resulting products, which were developed in the United States market during the 1950s and 60s, yielded enormous returns when applied to European markets, where most indigenous competitors lacked similar marketing skills and products. Their near-monopoly on consumer marketing skills allowed these US firms to dominate many European consumer product markets during the 1960s and 70s. Similarly, in the 1970s and 1980s, many Japanese firms expanded globally to exploit their skills in production, materials management, and new product development--skills that many of their North American and European competitors seemed to lack at the time. Today, retail companies such as Wal-Mart and financial companies such as Citicorp, Merrill Lynch, and American Express are transferring the valuable skills they developed in their core home market to other developed and emerging markets where indigenous competitors lack those skills. Realizing Location Economies We know from earlier chapters that countries differ along
a whole range of dimensions, including the economic, political, legal,
and cultural, and that these differences can either raise or lower the
costs of doing business. We also know from the theory of international
trade that because of differences in factor costs, certain countries have
a comparative advantage in the production of certain products. For example,
Japan excels in the production of automobiles and consumer electronics.
The United States excels in the production of computer software, pharmaceuticals,
biotechnology products, and financial services. Switzerland excels in
the production of precision instruments and pharmaceuticals.6
Firms that pursue such a strategy can realize what we refer to as location economies. We can define location economies as the economies that arise from performing a value creation activity in the optimal location for that activity, wherever in the world that might be (transportation costs and trade barriers permitting). Locating a value creation activity in the optimal location for that activity can have one or two effects. It can lower the costs of value creation and help the firm to achieve a low-cost position, and/or it can enable a firm to differentiate its product offering from that of competitors. Both of these considerations were at work in the case of Clear Vision, which was profiled in the Management Focus. Clear Vision moved its manufacturing operations out of the US, first to Hong Kong and then to mainland China, to take advantage of low labor costs, thereby lowering the costs of value creation. At the same time, Clear Vision shifted some of its design operations from the US to France and Italy. Clear Vision reasoned that skilled Italian and French designers could probably help the firm better differentiate its product. In other words, Clear Vision thinks the optimal location for performing manufacturing operations is China, whereas the optimal locations for performing design operations are France and Italy. The firm has configured its value chain accordingly. By doing so, Clear Vision hopes to simultaneously lower its cost structure and differentiate its product offering. In turn, differentiation should allow Clear Vision to charge a premium price for its product. Creating a Global Web One result of Clear Vision's kind of thinking is the creation of a global web of value creation activities, with different stages of the value chain being dispersed to those locations around the globe where value added is maximized or where the costs of value creation are minimized. Consider the case of General Motors' (GM) Pontiac Le Mans cited in Robert Reich's The Work of Nations.7 Marketed primarily in the United States, the car was designed in Germany; key components were manufactured in Japan, Taiwan, and Singapore; assembly was performed in South Korea; and the advertising strategy was formulated in Great Britain. The car was designed in Germany because GM believed the designers in its German subsidiary had the skills most suited to the job. (They were the most capable of producing a design that added value.) Components were manufactured in Japan, Taiwan, and Singapore because favorable factor conditions there--relatively low-cost, skilled labor--suggested that those locations had a comparative advantage in the production of components (which helped reduce the costs of value creation). The car was assembled in South Korea because GM believed that due to its low labor costs, the costs of assembly could be minimized there (also helping to minimize the costs of value creation). Finally, the advertising strategy was formulated in Great Britain because GM believed a particular advertising agency there was the most able to produce an advertising campaign that would help sell the car. (This decision was consistent with GM's desire to maximize the value added.) In theory, a firm that realizes location economies by dispersing each of its value creation activities to its optimal location should have a competitive advantage vis-à-vis a firm that bases all its value creation activities at a single location. It should be able to better differentiate its product offering and lower its cost structure than its single-location competitor. In a world where competitive pressures are increasing, such a strategy may become an imperative for survival (as it seems to have been for Clear Vision). Some Caveats Introducing transportation costs and trade barriers complicates this picture somewhat. Due to favorable factor endowments, New Zealand may have a comparative advantage for automobile assembly operations, but high transportation costs would make it an uneconomical location for them. Transportation costs and trade barriers explain why many US firms are shifting their production from Asia to Mexico. Mexico has three distinct advantages over many Asian countries. First, low labor costs make it a good location for labor-intensive production processes. In recent years, wage rates have increased significantly in Japan, Taiwan, and Hong Kong, but they have remained low in Mexico. Second, Mexico's proximity to the United States reduces transportation costs. This is particularly important for products with high weight-to-value ratios (e.g., automobiles). And third, the North American Free Trade Agreement (see Chapter 8) has removed many trade barriers between Mexico, the United States, and Canada, increasing Mexico's attractiveness as a production site for the North American market. Although value added and the costs of value creation are important, transportation costs and trade barriers also must be considered in location decisions. Another caveat concerns the importance of assessing political and economic risks when making location decisions. Even if a country looks very attractive as a production location when measured against all the standard criteria, if its government is unstable or totalitarian, a firm might be advised not to base production there. (Political risk is discussed in Chapter 2.) Similarly, if the government appears to be pursuing inappropriate economic policies, production at that location might be ill-advised, even if other factors look favorable. Realizing Experience Curve Economies The experience curve refers to the systematic reductions in production costs that have been observed to occur over the life of a product.8 A number of studies have observed that a product's production costs decline by some characteristic each time accumulated output doubles. The relationship was first observed in the aircraft industry, where each time accumulated output of airframes was doubled, unit costs typically declined to 80 percent of their previous level.9 Thus, production cost for the fourth airframe would be 80 percent of production cost for the second airframe, the eighth airframe's production cost 80 percent of the fourth's, the sixteenth's 80 percent of the eighth's, and so on. Figure 12.2 illustrates this experience curve relationship between production costs and output. Two things explain this: learning effects and economies of scale. Learning Effects Learning effects refer to cost savings that come from learning by doing. Labor, for example, learns by repetition how to carry out a task, such as assembling airframes, most efficiently. Labor productivity increases over time as individuals learn the most efficient ways to perform particular tasks. Equally important, in new production facilities, management typically learns how to manage the new operation more efficiently over time. Hence, production costs eventually decline due to increasing labor productivity and management efficiency. Learning effects tend to be more significant when a technologically complex task is repeated because there is more that can be learned about the task. Thus, learning effects will be more significant in an assembly process involving 1,000 complex steps than in one of only 100 simple steps. No matter how complex the task, however, learning effects typically die out after a time. It has been suggested that they are important only during the start-up period of a new process and that they cease after Figure 12.2 The Experience Curve
two or three years.10 Any decline in the experience curve after such a point is due to economies of scale. Economies of Scale The term economies of scale refers to the reductions in unit cost achieved by producing a large volume of a product. Economies of scale have a number of sources, one of the most important of which seems to be the ability to spread fixed costs over a large volume.11 Fixed costs are the costs required to set up a production facility, develop a new product, and the like, and they can be substantial. For example, establishing a new production line to manufacture semiconductor chips costs about $1 billion. According to one estimate, developing a new drug costs about $250 million and takes about 12 years.12 The only way to recoup such high fixed costs is to sell the product worldwide, which reduces unit costs by spreading them over a larger volume. Also, the more rapidly that cumulative sales volume is built up, the more rapidly fixed costs can be amortized, and the more rapidly unit costs fall. Another source of scale economies arises from the ability of large firms to employ increasingly specialized equipment or personnel. This theory goes back over 200 years to Adam Smith, who argued that the division of labor is limited by the extent of the market. In simple terms, this means that as a firm's output expands, it is better able to make full use of specialized equipment, and has the output required to justify the hiring of specialized personnel. Consider a metal stamping machine that is used in the production of automobile body parts. The machine can be purchased in a customized form, which is optimized for the production of a particular type of body part, or a general purpose form, which will produce any kind of body part. The general form is less efficient and costs more to purchase than the customized form, but it is more flexible. Since these machines cost millions of dollars each, they have to be used continually to recoup a return on their costs. Fully utilized, a machine can turn out about 200,000 units a year. If an automobile company sells only 100,000 cars a year, it will not be worthwhile purchasing the specialized equipment, and it will have to purchase general purpose machines. This will give it a higher cost structure than a firm that sells 200,000 cars per year and for which it is economical to purchase a specialized stamping machine. Thus, because a firm with a large output can more fully utilize specialized equipment (and personnel), it should have a lower unit cost than a firm that must use generalized equipment. Strategic Significance The strategic significance of the experience curve is clear.
Moving down the experience curve allows a firm to reduce its cost of creating
value. The firm that moves down the experience curve
most rapidly will have a cost advantage vis-à-vis its competitors.
Thus, Firm A in Figure 12.2, because it is further down the experience
curve, has a clear cost advantage over Many of the underlying sources of experience-based cost economies are plant based. This is true for most learning effects as well as for the economies of scale derived by spreading the fixed costs of building productive capacity over a large output. Thus, the key to progressing downward on the experience curve as rapidly as possible is to increase the volume produced by a single plant as rapidly as possible. Since global markets are larger than domestic markets, a firm that serves a global market from a single location is likely to build accumulated volume more quickly than a firm that serves only its home market or that serves multiple markets from multiple production locations. Thus, serving a global market from a single location is consistent with moving down the experience curve and establishing a low-cost position. In addition, to get down the experience curve rapidly, a firm must price and market very aggressively so demand will expand rapidly. It will also need to build sufficient production capacity for serving a global market. Also, the cost advantages of serving the world market from a single location will be all the more significant if that location is the optimal one for performing the particular value creation activity. Once a firm has established a low-cost position, it can act as a barrier to new competition. An established firm that is well down the experience curve, such as Firm A in Figure 12.2, can price so that it is making a profit while new entrants, which are further up the curve, such as Firm B in the figure, are suffering losses. One firm that has excelled in the pursuit of such a strategy is Matsushita. Along with Sony and Philips, Matsushita was in the race to develop a commercially viable videocassette recorder in the 1970s. Although Matsushita initially lagged behind Philips and Sony, it got its VHS format accepted as the world standard and reaped enormous experience-curve-based cost economies. This cost advantage constituted a formidable barrier to new competition. Matsushita's strategy was to build global volume as rapidly as possible. To ensure it could accommodate worldwide demand, the firm increased its production capacity 33-fold from 205,000 units in 1977 to 6.8 million units by 1984. By serving the world market from a single location in Japan, Matsushita realized significant learning effects and economies of scale. These allowed Matsushita to drop its prices 50 percent within five years of selling its first VHS-formatted VCR. As a result, Matsushita was the world's major VCR producer by 1983, accounting for approximately 45 percent of world production and enjoying a significant cost advantage over its competitors. The next largest firm, Hitachi, accounted for only 11.1 percent of world production in 1983.13 |
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