Global Business Today 7e by Charles W.L. Hill Welcome to Global Business Today, Seventh Edition by Charles W.L. Hill.

Entering Foreign Markets Chapter 12 Entering Foreign Markets Chapter 12: Entering Foreign Markets

Introduction Firms can enter foreign markets through exporting Question: How can firms enter foreign markets? Firms can enter foreign markets through exporting licensing or franchising to host country firms a joint venture with a host country firm a wholly owned subsidiary in the host country to serve that market The advantages and disadvantages of each entry mode are determined by transport costs and trade barriers political and economic risks firm strategy Imagine that the company you work for has realized that it can no longer rely on its domestic market for all of its revenues. Your company wants to expand internationally, but it doesn’t really know which markets to consider, or how to get into them. These are all questions that most companies have when they consider global expansion. In this chapter, we’ll look at these questions and how a firm can explore the trade-offs between markets and entry methods. We’ll also look at the timing and scale of international expansion. You already know from previous chapters that there are several methods of expanding into foreign markets including exporting, licensing or franchising to host country firms, establishing a joint venture with a local firm, and setting up a wholly owned subsidiary in the host market. But which method is better? As you’ll see in the Closing Case, GE used to think that going it alone was the only way to enter foreign markets, but recently, the company has formed a number of joint ventures with companies in other countries. GE now feels that this strategy can give the company important knowledge of the local market, and facilitate entry to that market. So, the advantages and disadvantages of the different entry methods are determined by transportation costs and trade barriers, political and economic risks, and the firm’s strategy. So, while it might make sense for one company to export, another company might choose a different entry method.

Basic Entry Decisions Answer: Question: What are the basic entry decisions for firms expanding internationally? Answer: A firm expanding internationally must decide which markets to enter when to enter them and on what scale how to enter them (the choice of entry mode) Let’s look more closely at the three basic decisions firms must make when they expand internationally. The decisions are which market to enter, when to enter those markets, and on what scale.

Which Foreign Markets? Firms need to assess the long run profit potential of each market The most favorable markets are politically stable developed and developing nations with free market systems, low inflation, and low private sector debt The less desirable markets are politically unstable developing nations with mixed or command economies, or developing nations where speculative financial bubbles have led to excess borrowing Successful firms usually offer products that have not been widely available in the market and that satisfy an unmet need There are more than 200 countries in the world, so when a firm is deciding which markets to enter, it needs a system that will allow it to narrow them down. Ultimately, the firm wants to enter the markets with the greatest long term potential. The more favorable markets are usually those that are politically stable with free market systems, and where there is a stable rate of inflation and private sector debt. Politically unstable countries with mixed or command economies, or countries where speculative financial bubbles have led to excess borrowing are usually less desirable. Companies should also consider the competition. They’re more likely to be successful in markets where the product is not widely available and where it satisfies an unmet need. So, countries like China or India would be considered attractive because of their size, but less attractive because of their level of economic development. As you’ll see in the Management Focus in your text, Tesco, the British grocer, has been expanding internationally by focusing on emerging markets that lack strong indigenous competitors.

Timing of Entry After a firm identifies which market to enter, it must determine the timing of entry Entry is early when an international business enters a foreign market before other foreign firms Entry is late when a firm enters after other international businesses have already established themselves in the market When it comes to the timing of entry, we say a firm is early if it enters a market before other foreign firms, and late if it enters the market after foreign firms are already established. A firm that gets to market early can capitalize on first mover advantages like establishing a strong brand name before other firms get there, but also incur first mover disadvantages like the costs and risks involved in learning the rules of the game that other firms can avoid. KFC for example, introduced the American style fast food to China, and incurred the costs of doing so, but McDonald’s, by entering later, was able to avoid these costs.

Timing of Entry Firms entering a market early can gain first mover advantages including the ability to pre-empt rivals and capture demand by establishing a strong brand name the ability to build up sales volume in that country and ride down the experience curve ahead of rivals and gain a cost advantage over later entrants the ability to create switching costs that tie customers into their products or services making it difficult for later entrants to win business So, we say that the advantages associated with entering a market early are called first mover advantages and include the ability to pre-empt rivals and capture market share by establishing a strong brand, the ability to build up sales volume in the foreign market and ride down the experience curve ahead of rivals and in doing so, gain cost advantages over later entrants, and the ability to create switching costs that tie customers to their products or services making it difficult for later entrants to break into the market. Recall from the Opening Case that General Motors has been able to capture some of these benefits by investing early in China.

Timing of Entry First mover disadvantages - the disadvantages associated with entering a foreign market before other international businesses These may result in pioneering costs (costs that an early entrant has to bear that a later entrant can avoid) such as the costs of business failure if the firm, due to its ignorance of the foreign environment, makes some major mistakes the costs of promoting and establishing a product offering, including the cost of educating the customers Similarly, the disadvantages associated with entering a foreign market before other companies are first mover disadvantages and include pioneering costs or the costs that an early entrant has to bear that a later entrant can avoid. Studies have shown that the probability of failure is lower if a company enters a market after several other firms have already successfully entered the market. What makes these pioneering costs so critical? Well, pioneering costs arise when a business system in a foreign market is so different from that in a firm’s home country that the company has to devote lots of resources like time, and capital to learning the rules of the game. The costs include business failure costs if the firm makes major mistakes, and the costs of promoting and establishing a product offering, as well as the costs of educating consumers about the product.

Scale of Entry Firms that enter foreign markets on a significant scale make a major strategic commitment that changes the competitive playing field involves decisions that have a long term impact and are difficult to reverse Small-scale entry can be attractive because it allows the firm to learn about a foreign market, but at the same time it limits the firm’s exposure to that market Finally, firms have to decide what the scale of entry should be. Should the company devote the resources necessary to enter the market in a big way, or should it expand more slowly? To answer these questions, the firm has to look at the strategic commitments involved in entering the market, or the decisions that have long term consequences and are difficult to reverse. You probably already know that entering a market on a significant scale involves a major strategic commitment that can affect the competitive playing field, while small scale entry lets the firm learn about the market before it’s exposed to significant levels of risk. ING, the Dutch financial services company, made the decision to enter the U.S. market on a significant scale in the late 1990s. ING’s decision changed the competitive landscape and forced other companies to respond.

Summary There are no “right” decisions with foreign market entry, just decisions that are associated with different levels of risk and reward Firms in developing countries can learn from the experiences of firms in developed countries Remember, there are no right or wrong decisions when making these decisions, firms just have to decide on the trade-offs involved with the different levels of risks and rewards. For example, Jollibee, a fast food company from the Philippines, managed to become a global player in the industry by differentiating its product and learning from existing companies even though it was a late entrant with limited resources. You can follow Jollibee’s success story in the Management Focus in your text.

Entry Modes Question: What is the best way to enter a foreign market? Answer: Firms can enter foreign market through Exporting Turnkey projects Licensing Franchising Joint ventures Wholly owned subsidiaries Each mode has advantages and disadvantages Once a company has made the decision to expand internationally, it has to decide how to enter the market. Should it export or establish a wholly owned subsidiary for example? As we said earlier, sometimes companies don’t have much choice in the matter, but other times, they have more flexibility. There are six different ways to enter a market - exporting, turnkey projects, licensing, franchising, joint ventures, and wholly owned subsidiaries. Let’s look at the advantages and disadvantages of each one.

Exporting 1. Exporting is often the first method firms use to enter foreign market Exporting is attractive because it is relatively low cost firms may achieve experience curve economies Exporting is not attractive when lower-cost manufacturing locations exist transport costs are high tariff barriers are high foreign agents fail to in the exporter’s best interest Most companies begin their global expansion with exporting, and then later switch to other methods. There are two main advantages of this strategy. First, exporting lets the firm avoid the costs of establishing manufacturing operations in the host country, and second, exporting can help a firm achieve experience curve and location economies. Sony was able to do this in the TV market, and more recently, Samsung used this strategy for memory chips. However, by exporting, companies may be missing out on opportunities for low cost manufacturing elsewhere, they may incur significant transportation costs or tariff barriers, and they take the chance that agents in the foreign market don’t act in their best interests.

Turnkey Projects 2. Turnkey projects involve a contractor that 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 In some cases, turnkey projects make sense. In a turnkey project, the contractor agrees to handle all the details of the foreign project for the firm, even down to training employees. At the end of the project, the client is handed the key to the plant that is ready to operate. This type of arrangement is common in the chemical, pharmaceutical, petroleum refining, and metal refining industries.

Turnkey Projects Turnkey projects are attractive because they allow firms to earn great economic returns from the know-how required to assemble and run a technologically complex process they are less risky in countries where the political and economic environment is such that a longer-term investment might expose the firm to unacceptable political and/or economic risk Turnkey projects are not attractive when the firm's process technology is a source of competitive advantage The advantage of a turnkey operation is that it allows firms to earn a return from the know-how involved in assembling and running technologically complex processes. They make sense in countries where political or economic conditions make it risky to make longer term investments. Keep in mind however, that a company that enters into turnkey deal won’t have a long-term interest in a country, and so forfeits potential profits. In addition, because of the nature of the arrangement, the company might create a competitor, particularly if the firm’s process technology is a source of competitive advantage. Remember, that by selling the process technology through the turnkey project, the firm is essentially selling its competitive advantage! This happened to a number of Western oil refining firms that now find themselves competing with companies from the Gulf States.

Licensing 3. Licensing - an arrangement whereby a licensor grants the rights to intangible property to another entity (the licensee) for a specified time period, and in return, the licensor receives a royalty fee from the licensee intangible property includes patents, inventions, formulas, processes, designs, copyrights, and trademarks Licensing is attractive when the firm does not have to bear the development costs and risks associated with opening a foreign market the firm avoids barriers to investment it allows a firm with intangible property that might have business applications, but which doesn’t want to develop those applications itself, to capitalize on market opportunities Licensing is another way that companies can enter foreign markets. When a firm enters a licensing agreement it gives the licensee the rights to intangible property for a specified period of time in exchange for royalties. What is intangible property? It includes things like patents, inventions, formulas, processes, designs, copyrights, and trademarks. You’re probably wondering why a firm would want to give away its intangible property. Well, the advantage of a licensing agreement is that the firm doesn’t have to incur the costs and risk of opening a foreign market, it avoids barriers to investment, and it allows firms to capitalize on market opportunities that might be associated with its intangible property, that it doesn’t want to develop itself. Xerox used a licensing agreement with Fuji Photo when it wanted to get into the Japanese market in the early 1960s. Xerox couldn’t set up a wholly owned subsidiary in Japan because of government regulations, so the company used a joint venture arrangement instead, and licensed its technology to the joint venture.

Licensing Licensing is unattractive when the firm doesn’t have the tight control over manufacturing, marketing, and strategy necessary to realize experience curve and location economies the firm’s ability to coordinate strategic moves across countries by using profits earned in one country to support competitive attacks in another is compromised There is the potential for loss of proprietary (or intangible) technology or property to reduce this risk, firms can use cross-licensing agreements or link the agreement with the decision to form a joint venture However, firms need to consider the drawbacks of licensing. One disadvantage is that it doesn’t give the firm the tight control over manufacturing, marketing, and strategy that’s required for realizing experience curve and location economies. Instead, each licensee sets up its own production operations. A second disadvantage of licensing is that it limits the firm’s ability to coordinate strategic moves across countries by using profits earned in one country to support competitive attacks in another. Licensees will want to keep their own profits. Third, the company risks losing proprietary information. This happened to RCA when it licensed its color TV technology to Matsushita and Sony. Both Japanese companies took the technology and market share from RCA. A firm can limit this type of risk by using a cross-licensing arrangement where it licenses intangible property to the foreign firm, and in exchange, the foreign firm not only makes a royalty payment, but also licenses its own know-how back.

Franchising 4. Franchising - a form of licensing in which the franchisor sells intangible property and requires the franchisee agree to abide by strict rules as to how it does business Franchising is attractive because can avoid costs and risks of opening up a foreign market Franchising is unattractive because it may inhibit the firm's ability to take profits out of one country to support competitive attacks in another the geographic distance of the firm from its foreign franchisees can make poor quality difficult for the franchisor to detect You may be thinking that licensing sounds a lot like franchising, and you’d be right! Franchising is just a specialized form of licensing where the franchisor not only sells intangible property to the franchisee, but also requires the franchisee to abide by strict rules of how to do business. You might be thinking of McDonald’s right now, and how every McDonald’s has essentially the same feel and processes. As you’d expect given their similarities, the advantages of franchising are similar to those of licensing in that franchising allows firms to avoid many of the costs and risks of opening up a foreign market. Companies like McDonald’s can use franchising to quickly establish a global presence without incurring significant cost or risk. McDonald’s is doing this right now. The company expects to open 800 new locations over the next few years in Russia, China, and India. Keep in mind however, that like licensing, franchising limits a firm’s ability to take profits out of one country to support competitive attacks in another. In addition, the physical distance between the franchisor and the franchisee can make it difficult for the franchisor to detect quality problems with the franchisee. McDonald’s tries to avoid this problem by setting up a master franchise in each country to oversee other franchisees.

Joint Ventures 5. Joint ventures involve the establishment of a firm that is jointly owned by two or more otherwise independent firms Joint ventures are attractive because a firm can benefit from a local partner's knowledge of the host country's competitive conditions, culture, language, political systems, and business systems the costs and risks of opening a foreign market are shared with the partner they can help firms avoid the risk of nationalization or other adverse government interference Joint ventures are another form of market entry. A joint venture is the establishment of a firm that is jointly owned by two or more otherwise independent firms. As you’ll see in the Closing Case, GE used this entry method to get into South Korea and Spain. While most joint ventures are 50-50 arrangements, some companies choose different equity distributions like 60-40. The joint venture between Xerox and Fuji that we talked about early started out as a 50-50 arrangement, but has since shifted to a 25-75 distribution, with Fuji holding the majority share. Why form a joint venture? There are several reasons. First, a joint venture allows a firm to benefit from the local partner’s knowledge of the host country’s competitive conditions, culture, political systems, and business systems. Second, by forming a joint venture, a firm can share the costs and risks of opening the foreign market. Finally, in some cases, joint ventures make the most sense from a political standpoint. Recall from the Opening Case, that General Motors felt that the political contacts it gained by forming a joint venture with a local partner facilitated its entry to China. Even when this strict limitation isn’t in place however, a joint venture can make sense because it lowers the risk of being subject to nationalization or other government interference.

Joint Ventures Joint ventures can be unattractive because the firm risks giving control of its technology to its partner the firm may not have the tight control over subsidiaries that it might need to realize experience curve or location economies shared ownership can lead to conflicts and battles for control if goals and objectives differ or change over time You might have already guessed however, that with these benefits comes the risk of giving away control over technology. Companies have to be careful how they structure agreements to minimize this risk. Other disadvantages include the inability to realize experience curve or location economies because firms don’t have tight control over subsidiaries. Finally, shared ownership can lead to conflicts and battles for control if goals and objectives change over time.

Wholly Owned Subsidiaries 6. Wholly owned subsidiaries involve 100 percent ownership of the stock of the subsidiary Firms establishing a wholly owned subsidiary can set up a new operation in that country acquire an established firm Given these problems, many firms opt for a wholly owned subsidiary where the firm owns 100 percent of the equity. As you might recall from our discussion in Chapter 7, firms can establish a wholly owned subsidiary either by setting up an entirely new operation, or by merging with or acquiring an existing firm.

Wholly Owned Subsidiaries Wholly owned subsidiaries are attractive because they reduce the risk of losing control over core competencies they gives the firm the tight control over operations in different countries that is necessary for engaging in global strategic coordination they may be required if a firm is trying to realize location and experience curve economies Wholly owned subsidiaries are unattractive because firms bear the full costs and risks of setting up overseas operations What are the advantages of setting up a wholly owned subsidiary? There are several. A wholly owned subsidiary reduces the risk of losing control over core competencies, it gives the firms the tight control over operations in different countries that’s necessary for a global strategic coordination approach where profits from one market are used to support competitive attacks in other markets. A wholly owned subsidiary might also be important to firms that are trying to realize location and experience curve economies. This might be particularly important for firms following global or transnational strategies. A big downside of a wholly owned subsidiary though, is that the firm bears the full costs and risks of setting up foreign operations.

Selecting an Entry Mode Table 12.1: Advantages and Disadvantages of Entry Modes So, as you can see each entry method is attractive in some cases, and less attractive in others.

Selecting an Entry Mode Question: How should a firm choose a specific entry mode? Answer: All entry modes have advantages and disadvantages The optimal choice of entry mode involves trade-offs So, which entry method should a firm choose? The answer is that a firm has to consider the trade-offs involved with each choice. As we discussed, there are advantages and disadvantages associated with each method.

Core Competencies and Entry Mode The optimal entry mode depends to some degree on the nature of a firm’s core competencies Core competencies can involve technological know-how management know-how We can make some generalizations about the optimal method of expansion. Firms should consider their core competencies when they think about the trade-offs involved with the different entry methods. For example, does the firm have core competencies based on technological know-how, or on management know-how?

Core Competencies and Entry Mode 1. Technological Know-How When competitive advantage is based on proprietary technological know-how, firms should avoid licensing and joint venture arrangements in order to minimize the risk of losing control over the technology However, if a technological advantage is only transitory, or the firm can establish its technology as the dominant design in the industry, then licensing may be attractive Firms with core competencies based on technological know how should avoid licensing and joint venture arrangements to avoid losing control over the technology. Sometimes however, a firm will engage in licensing even if it does run the risk of losing proprietary know how. Usually, this will be done if the firm believes that its technological advantage is only transitory, or that it can establish its technology as the dominant design. Matsushita was able to do this with its VHS technology, and then earn a steady stream of royalties.

Core Competencies and Entry Mode 2. Management Know-How The competitive advantage of many service firms is based upon management know-how international trademark laws are generally effective for protecting trademarks Since the risk of losing control over management skills to franchisees or joint venture partners is not high, the benefits from getting greater use of brand names is significant Firms, like McDonald’s, that base their competitive advantage on management-know how, don’t run the same risks as firms with technological know-how. McDonald’s brand name is protected by trademarks for example, so it doesn’t have to worry about losing control over management skills. For these types of companies, licensing or franchising may be an attractive option. Joint ventures can also be a good alternative because not only are they often more politically acceptable than wholly owned operations, but local partners can also offer knowledge of the local market.

Pressures for Cost Reductions Firms facing strong pressures for cost reductions are likely to pursue some combination of exporting and wholly owned subsidiaries this will allow the firms to achieve location and scale economies as well as retain some degree of control over worldwide product manufacturing and distribution Another factor that can influence the choice of entry mode is pressure for cost reduction. The greater the pressure to cut costs, the more likely the firm will choose some combination of exporting and wholly owned subsidiaries. By taking this strategy, firms are in a better position to achieve location and scale economies, and maintain control over manufacturing and distribution.

Greenfield or Acquisition? Question: Should a firm establish a wholly owned subsidiary in a country by building a subsidiary from the ground up (greenfield strategy), or by acquiring an established enterprise in the target market (acquisition strategy)? Answer: The number of cross border acquisitions are increasing Over the last decade, 40-80 percent of all FDI inflows have been mergers and acquisitions If a firm decides to go it alone, or operate through a wholly owned subsidiary, the firm has to decide which makes more sense, a greenfield investment or an acquisition? Remember, that in the last decade or so, we’ve seen a significant increase in the number of mergers and acquisitions.

Pros and Cons of Acquisitions are quick to execute enable firms to preempt their competitors can be less risky than green-field ventures However, many acquisitions are not successful Why are so many firms choosing acquisitions? Well, they offer three main benefits. They’re quicker to execute than greenfield investments, they enable firms to preempt their competitors, and they’re less risky than starting from scratch. Kraft Foods for example, acquired Cadbury in 2010 with a goal of using Cadbury’s established distribution network in India. According to Kraft’s CEO, Irene Rosenfeld, Kraft had avoided the Indian market prior to its acquisition because of the costs involved in setting up a distribution network. However, keep in mind that sometimes acquisitions don’t work out as planned.

Pros and Cons of Acquisitions Question: Why do acquisitions fail? Answer: Acquisitions fail when the firm overpays for the assets of the acquired firm there is a clash between the cultures of the acquiring and acquired firm attempts to realize synergies by integrating the operations of the acquired and acquiring entities run into roadblocks and take much longer than forecast there is inadequate pre-acquisition screening Why do acquisitions fail? There are several reasons. Sometimes firms pay too much for their acquisitions. Daimler paid a premium of 40 percent over market value when it bought Chrysler in 1998, for example. Sometimes, the cultures of the two firms don’t mesh well. This problem has created a number of challenges for DaimlerChrysler. Managers at Chrysler were paid more than those at Daimler, which caused resentment, and Chrysler managers believed that Daimler management was too domineering. A third problem that can cause an acquisition to fail occurs when attempts to realize synergies through the integration of the two firms run into roadblocks or take longer than anticipated. DaimlerChrysler experienced this difficulty when the two firms got bogged down in committee meetings and time differences and couldn’t move ahead with an integration plan. Finally, inadequate pre-acquisition screening can also cause problems. Sometimes, prescreening is poor because a company is trying to beat out another firm for the acquisition. Other times, though, there is simply a failure to thoroughly analyze the candidate firm.

Pros and Cons of Acquisitions Question: How can firms reduce the problems associated with acquisitions? Answer: Firms can reduce the problems associated with acquisitions through careful screening of the firm to be acquired by moving rapidly once the firm is acquired to implement an integration plan How can firms minimize the risk of failure? One way to try make an acquisition more successful is to carefully screen the firm that’s to be acquired and be sure that you don’t pay too much, that there won’t be any nasty surprises, and that the two organizational cultures will mesh well. Then, once the acquisition has taken place, firms should move quickly to integrate the units.

Pros and Cons of Greenfield Ventures Question: Why are greenfield ventures attractive? Answer: Greenfield ventures are attractive because they allow the firm to build the kind of subsidiary company that it wants However, greenfield ventures are slower to establish are risky because they have no proven track record can be problematic if a competitor enters via acquisition and quickly builds market share You may be wondering, given that so much FDI is in the form of acquisitions, whether a greenfield investment makes sense. In some cases the answer is yes. The main advantage of a greenfield investment is that it allows the firm to build the kind of subsidiary it wants. In other words, the firm doesn’t inherit someone else’s problems! Keep in mind though, that greenfield investments take longer to set up, and that because they’re not a proven establishment, they can be more risky!

Classroom Performance System The time and effort in learning the rules of a new market, failure due to ignorance, and the liability of being a foreigner are all examples of First mover advantages Strategic commitments Pioneering costs Market entry costs Now, let’s see how well you understand the material in this chapter. I’ll ask you a few questions. See if you can get them right. Ready? Question 1: The time and effort in learning the rules of a new market, failure due to ignorance, and the liability of foreignness are all examples of First mover advantages Strategic commitments Pioneering costs Market entry costs If you picked C, you’re right!

Classroom Performance System Most firms begin their foreign expansion with Exporting Joint ventures Licensing or franchising Wholly owned subsidiaries Question 2: Most firms begin their foreign expansion with Exporting Joint ventures Licensing or franchising Wholly owned subsidiaries If you picked A, you’re correct!

Classroom Performance System A firm that wants the ability to engage in global strategic coordination should choose Franchising Joint ventures Licensing Wholly owned subsidiaries Question 3: A firm that wants the ability to engage in global strategic coordination should choose Franchising Joint ventures Licensing Wholly owned subsidiaries The correct answer is D. Did you get it right?

Classroom Performance System Which of the following is not an advantage of acquisitions as compared to greenfield investments? They are quicker to execute Attempts to realize synergies by integrating the operations of the acquired entities can be challenging and take time They enable firms to preempt their competitors They may be less risky Question 4: Which of the following is not an advantage of acquisitions as compared to greenfield investments? They are quicker to execute Attempts to realize synergies by integrating the operations of the acquired entities can be challenging and take time They enable firms to preempt their competitors They may be less risky Did you pick B? I hope so!