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Entry Modes Once a firm decides to enter a foreign market, the question arises as to the best mode of entry. Firms use basically six different modes to enter foreign markets: exporting, turnkey projects, licensing, franchising, establishing joint ventures with a host-country firm, and setting up a wholly owned subsidiary in the host country. Each entry mode has advantages and disadvantages. Managers need to consider these carefully when deciding which to use.8 Exporting Many manufacturing firms begin their global expansion as exporters and only later switch to another mode for serving a foreign market. We take a close look at the mechanics of exporting in the next chapter. Here we focus on the advantages and disadvantages of exporting as an entry mode. Advantages Exporting has two distinct advantages. First, it avoids the often-substantial costs of establishing manufacturing operations in the host country. Second, exporting may help a firm achieve experience curve and location economies (see Chapter 12). By manufacturing the product in a centralized location and exporting it to other national markets, the firm may realize substantial scale economies from its global sales volume. This is how Sony came to dominate the global TV market, how Matsushita came to dominate the VCR market, and how many Japanese auto firms made inroads into the US auto market. Disadvantages Exporting has a number of drawbacks. First, exporting from the firm's home base may not be appropriate if there are lower-cost locations for manufacturing the product abroad (i.e., if the firm can realize location economies by moving production else where). Thus, particularly for firms pursuing global or transnational strategies, it may be preferable to manufacture where the mix of factor conditions is most favorable from a value creation perspective and to export to the rest of the world from that location. This is not so much an argument against exporting as an argument against exporting from the firm's home country. Many US electronics firms have moved some of their manufacturing to the Far East because of the availability of low-cost, highly skilled labor there. They then export from that location to the rest of the world, including the United States. A second drawback to exporting is that high transport costs can make exporting uneconomical, particularly for bulk products. One way of getting around this is to manufacture bulk products regionally. This strategy enables the firm to realize some economies from large-scale production and at the same time to limit its transport costs. For example, many multinational chemical firms manufacture their products regionally, serving several countries from one facility. Another drawback is that tariff barriers can make exporting uneconomical. Similarly, the threat of tariff barriers by the host-country government can make it very risky. An implicit threat by the US Congress to impose tariffs on imported Japanese autos led many Japanese auto firms to set up manufacturing plants in the United States. By 1990, almost 50 percent of all Japanese cars sold in the United States were manufactured locally-up from 0 percent in 1985. A fourth drawback to exporting arises when a firm delegates its marketing in each country where it does business to a local agent. (This is common for firms that are just beginning to export.) Foreign agents often carry the products of competing firms and so have divided loyalties. In such cases, the foreign agent may not do as good a job as the firm would if it managed its marketing itself. There are ways around this problem, however. One way is to set up a wholly owned subsidiary in the country to handle local marketing. By doing this, the firm can exercise tight control over marketing in the country while reaping the cost advantages of manufacturing the product in a single location. Turnkey Projects Firms that specialize in the design, construction, and start-up of turnkey plants are common in some industries. In a turnkey project, the contractor agrees to handle every detail of the project for a foreign client, including the training of operating personnel. At completion of the contract, the foreign client is handed the "key" to a plant that is ready for full operation--hence, the term turnkey. This is a means of exporting process technology to other countries. Turnkey projects are most common in the chemical, pharmaceutical, petroleum refining, and metal refining industries, all of which use complex, expensive production technologies. Advantages The know-how required to assemble and run a technologically complex process, such as refining petroleum or steel, is a valuable asset. Turnkey projects are a way of earning great economic returns from that asset. The strategy is particularly useful where FDI is limited by host-government regulations. For example, the governments of many oil-rich countries have set out to build their own petroleum refining industries, so they restrict FDI in their oil and refining sectors. But because many of these countries lacked petroleum-refining technology, they gained it by entering into turnkey projects with foreign firms that had the technology. Such deals are often attractive to the selling firm because without them, they would have no way to earn a return on their valuable know-how in that country. A turnkey strategy can also be less risky than conventional FDI. In a country with unstable political and economic environments, a longer-term investment might expose the firm to unacceptable political and/or economic risks (e.g., the risk of nationalization or of economic collapse). Disadvantages Three main drawbacks are associated with a turnkey strategy. First, the firm that enters into a turnkey deal will have no long-term interest in the foreign country. This can be a disadvantage if that country subsequently proves to be a major market for the output of the process that has been exported. One way around this is to take a minority equity interest in the operation. Second, the firm that enters into a turnkey project with a foreign enterprise may inadvertently create a competitor. For example, many of the Western firms that sold oil refining technology to firms in Saudi Arabia, Kuwait, and other Gulf states now find themselves competing with these firms in the world oil market. Third, if the firm's process technology is a source of competitive advantage, then selling this technology through a turnkey project is also selling competitive advantage to potential and/or actual competitors. Licensing A licensing agreement is an arrangement whereby a licensor grants the rights to intangible property to another entity (the licensee) for a specified period, and in return, the licensor receives a royalty fee from the licensee.9 Intangible property includes patents, inventions, formulas, processes, designs, copyrights, and trademarks. For example, as described in the accompanying Management Focus, to enter the Japanese market, Xerox, inventor of the photocopier, established a joint venture with Fuji Photo that is known as Fuji-Xerox. Xerox then licensed its xerographic know-how to Fuji-Xerox. In return, Fuji-Xerox paid Xerox a royalty fee equal to 5 percent of the net sales revenue that Fuji-Xerox earned from the sales of photocopiers based on Xerox's patented know-how. In the Fuji-Xerox case, the license was originally granted for 10 years, and it has been renegotiated and extended several times since. The licensing agreement between Xerox and Fuji-Xerox also limited Fuji-Xerox's direct sales to the Asian Pacific region (although Fuji-Xerox does supply Xerox with photocopiers that are sold in North America under the Xerox label).10 Advantages In the typical international licensing deal, the licensee puts up most of the capital necessary to get the overseas operation going. Thus, a primary advantage of licensing is that the firm does not have to bear the development costs and risks associated with opening a foreign market. Licensing is very attractive for firms lacking the capital to develop operations overseas. In addition, licensing can be attractive when a firm is unwilling to commit substantial financial resources to an unfamiliar or politically volatile foreign market. Licensing is also often used when a firm wishes to participate in a foreign market but is prohibited from doing so by barriers to investment. This was one of the original reasons for the formation of the Fuji-Xerox joint venture (see the Management Focus for details). Xerox wanted to participate in the Japanese market but was prohibited from setting up a wholly owned subsidiary by the Japanese government. So Xerox set up the joint venture with Fuji and then licensed its know-how to the joint venture. Finally, licensing is frequently used when a firm possesses some intangible property that might have business applications, but it does not want to develop those applications itself. For example, Bell Laboratories at AT&T originally invented the transistor circuit in the 1950s, but AT&T decided it did not want to produce transistors, so it licensed the technology to a number of other companies, such as Texas Instruments. Similarly, Coca-Cola has licensed its famous trademark to clothing manufacturers, who have incorporated the design into their clothing (e.g., Coca-Cola T-shirts). Disadvantages Licensing has three serious drawbacks. First, it does not give a firm the tight control over manufacturing, marketing, and strategy that is required for realizing experience curve and location economies (as global and transnational firms must do; see Chapter 12). Licensing typically involves each licensee setting up its own production operations. This severely limits the firm's ability to realize experience curve and location economies by producing its product in a centralized location. When these economies are important, licensing may not be the best way to expand overseas. Second, competing in a global market may require a firm to coordinate strategic moves across countries by using profits earned in one country to support competitive attacks in another (see Chapter 12). By its very nature, licensing limits a firm's ability to do this. A licensee is unlikely to allow a multinational firm to use its profits (beyond those due in the form of royalty payments) to support a different licensee operating in another country. A third problem with licensing is one that we first encountered in Chapter 6 when we reviewed the economic theory of FDI. This is the risk associated with licensing technological know-how to foreign companies. Technological know-how constitutes the basis of many multinational firms' competitive advantage. Most firms wish to maintain control over how their know-how is used, and a firm can quickly lose control over its technology by licensing it. Many firms have made the mistake of thinking they could maintain control over their know-how within the framework of a licensing agreement. RCA Corporation, for example, once licensed its color TV technology to Japanese firms including Matsushita and Sony. The Japanese firms quickly assimilated the technology, improved on it, and used it to enter the US market. Now the Japanese firms have a bigger share of the US market than the RCA brand. Similar concerns surfaced over the 1989 decision by Congress to allow Japanese firms to produce the advanced FSX fighter plane under license from McDonnell Douglas. Critics of the decision fear the Japanese will use the FSX technology to support the development of a commercial airline industry that will compete with Boeing in the global marketplace. There are ways of reducing the risks of this occurring. One way is by entering into a cross-licensing agreement with a foreign firm. Under a cross-licensing agreement, a firm might license some valuable intangible property to a foreign partner, but in addition to a royalty payment, the firm might also request that the foreign partner license some of its valuable know-how to the firm. Such agreements are believed to reduce the risks associated with licensing technological know-how, since the licensee realizes that if it violates the licensing contract (by using the knowledge obtained to compete directly with the licensor), the licensor can do the same to it. Cross-licensing agreements enable firms to hold each other hostage, which reduces the probability that they will behave opportunistically toward each other.11 Such cross-licensing agreements are increasingly common in high-technology industries. For example, the US biotechnology firm Amgen has licensed one of its key drugs, Nuprogene, to Kirin, the Japanese pharmaceutical company. The license gives Kirin the right to sell Nuprogene in Japan. In return, Amgen receives a royalty payment, and in addition, through a licensing agreement, it gained the right to sell some of Kirin's products in the United States. Another way of reducing the risk associated with licensing is to follow the Fuji-Xerox model and link an agreement to license know-how with the formation of a joint venture in which the licensor and licensee take an important equity stake. Such an approach aligns the interests of licensor and licensee, since both have a stake in ensuring that the venture is successful. Thus, the risk that Fuji Photo might appropriate Xerox's technological know-how, and then compete directly against Xerox in the global photocopier market, was reduced by the establishment of a joint venture in which both Xerox and Fuji Photo had an important stake. Franchising In many respects, franchising is similar to licensing, although franchising tends to involve longer-term commitments than licensing. Franchising is basically a specialized form of licensing in which the franchiser not only sells intangible property to the franchisee (normally a trademark), but also insists that the franchisee agree to abide by strict rules as to how it does business. The franchiser will also often assist the franchisee to run the business on an ongoing basis. As with licensing, the franchiser typically receives a royalty payment, which amounts to some percentage of the franchisee's revenues. Whereas licensing is pursued primarily by manufacturing firms, franchising is employed primarily by service firms.12 McDonald's is a good example of a firm that has grown by using a franchising strategy. McDonald's has strict rules as to how franchisees should operate a restaurant. These rules extend to control over the menu, cooking methods, staffing policies, and design and location of a restaurant. McDonald's also organizes the supply chain for its franchisees and provides management training and financial assistance.13 Advantages The advantages of franchising as an entry mode are very similar to those of licensing. The firm is relieved of many of the costs and risks of opening a foreign market on its own. Instead, the franchisee typically assumes those costs and risks. This creates a good incentive for the franchisee to build profitable operation as quickly as possible. Thus, using a franchising strategy, a service firm can build up a global presence quickly and at a relatively low cost and risk, as McDonald's has. Disadvantages The disadvantages are less pronounced than in the case of licensing. Since franchising is often used by service companies, there is no reason to consider the need for coordination of manufacturing to achieve experience curve and location economies. But franchising may inhibit the firm's ability to take profits out of one country to support competitive attacks in another. A more significant disadvantage of franchising is quality control. The foundation of franchising arrangements is that the firm's brand name conveys a message to consumers about the quality of the firm's product. Thus, a business traveler checking in at a Hilton International hotel in Hong Kong can reasonably expect the same quality of room, food, and service that she would receive in New York. The Hilton name is supposed to guarantee consistent product quality. This presents a problem in that foreign franchisees may not be as concerned about quality as they are supposed to be, and the result of poor quality can extend beyond lost sales in a particular foreign market to a decline in the firm's worldwide reputation. For example, if the business traveler has a bad experience at the Hilton in Hong Kong, she may never go to another Hilton hotel and may urge her colleagues to do likewise. The geographical distance of the firm from its foreign franchisees, however, can make poor quality difficult to detect. In addition, the sheer numbers of franchisees--in the case of McDonald's, tens of thousands--can make quality control difficult. Due to these factors, quality problems may persist. One way around this disadvantage is to set up a subsidiary in each country in which the firm expands. The subsidiary might be wholly owned by the company or a joint venture with a foreign company. The subsidiary assumes the rights and obligations to establish franchises throughout the particular country or region. McDonald's, for example, establishes a master franchisee in many countries. Typically, this master franchisee is a joint venture between McDonald's and a local firm. The proximity and the smaller number of franchises to oversee reduce the quality control challenge. In addition, because the subsidiary (or master franchisee) is at least partly owned by the firm, the firm can place its own managers in the subsidiary to help ensure that it is doing a good job of monitoring the franchises. This organizational arrangement has proven very satisfactory for McDonald's, Kentucky Fried Chicken, Hilton International, and others. Joint Ventures A joint venture entails establishing a firm that is jointly owned by two or more otherwise independent firms. Fuji-Xerox, for example, was set up as a joint venture between Xerox and Fuji Photo (see the Management Focus). Establishing a joint venture with a foreign firm has long been a popular mode for entering a new market. The most typical joint venture is a 50/50 venture, in which there are two parties, each of which holds a 50 percent ownership stake (as is the case with the Fuji-Xerox joint venture) and contributes a team of managers to share operating control. Some firms, however, have sought joint ventures in which they have a majority share and thus tighter control.14 Advantages Joint ventures have a number of advantages. First, a firm benefits from a local partner's knowledge of the host country's competitive conditions, culture, language, political systems, and business systems. Thus, for many US firms, joint ventures have involved the US company providing technological know-how and products and the local partner providing the marketing expertise and the local knowledge necessary for competing in that country. This was the case with the Fuji-Xerox joint venture. Second, when the development costs and/or risks of opening a foreign market are high, a firm might gain by sharing these costs and/or risks with a local partner. Third, in many countries, political considerations make joint ventures the only feasible entry mode. Again, this was a consideration in the establishment of the Fuji-Xerox venture. Research suggests joint ventures with local partners face a low risk of being subject to nationalization or other forms of government interference.15 This appears to be because local equity partners, who may have some influence on host-government policy, have a vested interest in speaking out against nationalization or government interference. Disadvantages Despite these advantages, there are two major disadvantages with joint ventures. First, as with licensing, a firm that enters into a joint venture risks giving control of its technology to its partner. The joint venture between Boeing and a consortium of Japanese firms to build the 767 airliner raised fears that Boeing was unwittingly giving away its commercial airline technology to the Japanese. However, joint venture agreements can be constructed to minimize this risk. One option is to hold majority ownership in the venture. This allows the dominant partner to exercise greater control over its technology. The drawback with this is that it can be difficult to find a foreign partner who is willing to settle for minority ownership. A second disadvantage is that a joint venture does not give a firm the tight control over subsidiaries that it might need to realize experience curve or location economies. Nor does it give a firm the tight control over a foreign subsidiary that it might need for engaging in coordinated global attacks against its rivals. Consider the entry of Texas Instruments (TI) into the Japanese semiconductor market. When TI established semiconductor facilities in Japan, it did so for the dual purpose of checking Japanese manufacturers' market share and limiting their cash available for invading TI's global market. In other words, TI was engaging in global strategic coordination. To implement this strategy, TI's subsidiary in Japan had to be prepared to take instructions from corporate headquarters regarding competitive strategy. The strategy also required the Japanese subsidiary to run at a loss if necessary. Few if any potential joint venture partners would have been willing to accept such conditions, since it would have necessitated a willingness to accept a negative return on their investment. Thus, to implement this strategy, TI set up a wholly owned subsidiary in Japan. A third disadvantage with joint ventures is that the shared ownership arrangement can lead to conflicts and battles for control between the investing firms if their goals and objectives change or if they take different views as to what the strategy should be. This has apparently not been a problem with the Fuji-Xerox joint venture. According to Tony Kobayashi, the CEO of Fuji-Xerox, a primary reason is that both Xerox and Fuji Photo adopted an arm's-length relationship with Fuji-Xerox, giving the venture's management considerable freedom to determine its own strategy.16 However, much research indicates that conflicts of interest over strategy and goals often arise in joint ventures, that these conflicts tend to be greater when the venture is between firms of different nationalities, and that they often end in the dissolution of the venture.17 Such conflicts tend to be triggered by shifts in the relative bargaining power of venture partners. For example, in the case of ventures between a foreign firm and a local firm, as a foreign partner's knowledge about local market conditions increases, it depends less on the expertise of a local partner. This increases the bargaining power of the foreign partner and ultimately leads to conflicts over control of the venture's strategy and goals.18 Wholly Owned Subsidiaries In a wholly owned subsidiary, the firm owns 100 percent of the stock. Establishing a wholly owned subsidiary in a foreign market can be done two ways. The firm can either set up a new operation in that country or it can acquire an established firm and use that firm to promote its products (as Merrill Lynch did when it acquired various assets of Yamaichi Securities). Advantages There are three clear advantages of wholly owned subsidiaries. First, when a firm's competitive advantage is based on technological competence, a wholly owned subsidiary will often be the preferred entry mode, because it reduces the risk of losing control over that competence. (See Chapter 6 for more details.) Many high-tech firms prefer this entry mode for overseas expansion (e.g., firms in the semiconductor, electronics, and pharmaceutical industries). Second, a wholly owned subsidiary gives a firm the tight control over operations in different countries that is necessary for engaging in global strategic coordination (i.e., using profits from one country to support competitive attacks in another). Third, a wholly owned subsidiary may be required if a firm is trying to realize location and experience curve economies (as firms pursuing global and transnational strategies try to do). As we saw in Chapter 12, when cost pressures are intense, it may pay a firm to configure its value chain in such a way that the value added at each stage is maximized. Thus, a national subsidiary may specialize in manufacturing only part of the product line or certain components of the end product, exchanging parts and products with other subsidiaries in the firm's global system. Establishing such a global production system requires a high degree of control over the operations of each affiliate. The various operations must be prepared to accept centrally determined decisions as to how they will produce, how much they will produce, and how their output will be priced for transfer to the next operation. Since licensees or joint venture partners are unlikely to accept such a subservient role, establishment of wholly owned subsidiaries may be necessary. Disadvantages Establishing a wholly owned subsidiary is generally the most costly method of serving a foreign market. Firms doing this must bear the full costs and risks of setting up overseas operations. The risks associated with learning to do business in a new culture are less if the firm acquires an established host-country enterprise. However, acquisitions raise additional problems, including those associated with trying to marry divergent corporate cultures. These problems may more than offset any benefits derived by acquiring an established operation.19 |
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