CHAPTER FOURTEEN DIRECT INVESTMENT AND COLLABORATIVE STRATEGIES

OBJECTIVES
To clarify why companies may need to use modes other than exporting to operate effectively in international business To comprehend why and how companies make foreign direct investments To understand the major motives that guide managers when choosing a collaborative arrangement for international business To define the major types of collaborative arrangements To describe what companies should consider when entering into arrangements with other companies To grasp what makes collaborative arrangements succeed or fail To see how companies can manage diverse collaborative arrangements

CHAPTER OVERVIEW
Although most companies operating internationally would prefer exporting to other market entry modes, there are circumstances in which exporting may not be feasible. In these cases, companies may engage in direct investment in other countries, or enter markets through various collaborative strategies such as joint ventures and alliances. Collaborative strategies allow firms to spread both assets and risk across countries by entering into contractual agreements with a variety of potential partners. Chapter Fourteen first discusses reasons for not exporting and then explores the motives that drive firms to engage in noncollaborative and collaborative arrangements, as well as the various types of possible arrangements, including foreign direct investment, licensing, franchising, joint ventures, and equity alliances. It goes on to explore the various problems that may arise in FDI and collaborative ventures and concludes with a discussion of the various methods for managing these evolving arrangements.

CHAPTER OUTLINE
OPENING CASE: Cisco Systems [See Map 14.1] Globalization has pushed Cisco Systems into a broader range of markets in order to follow the expansion patterns of its customers, solicit new business, and study new ideas and products. Ciscos worldwide alliances spur the company to continue learning and to refine its competencies. They enable it to meet customer needs that fall outside its areas of core competencies, while simultaneously permitting Cisco and its partners to enhance

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their competitiveness by focusing on their respective competencies. Alliances have also permitted Cisco to limit its capital outlays in potentially lucrative but risky ventures. Cisco believes alliances improve its processes, reduce its costs and expose it to the best competitive practices. The firms official Strategic Alliances Team manages crucial partnerships with industry-leading technology and integrator firms, and it is the driving force behind the collaborative development effort to accelerate new market opportunities. Cisco has generally standardized the mechanics of partnership agreements. However, it continues to work to improve the odds of collaborative success by better managing the matters of trust, commitment and culture that shape what Cisco calls interwoven dependencies and relationships with its partners. Teaching Tip: Review the PowerPoint slides for Chapter Fourteen and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, review the figures in the text. I. INTRODUCTION When forming objectives and implementing strategies in a variety of country environments, firms must either handle international business operations on their own or collaborate with other companies (Figure 14.2). Although exporting is usually the preferred alternative since it allows firms to produce in their home countries, participating in some markets may require using a variety of other equity and nonequity arrangements (Figure 14.3). These can range from wholly owned operations to partially owned subsidiaries, joint ventures, equity alliances, licensing, franchising, management contracts, and turnkey operations.

II. WHY EXPORTING MAY NOT BE FEASIBLE Companies may find more advantages by producing in foreign countries rather than by exporting to them due to a variety of reasons. A. Cheaper to Produce Abroad Competition requires companies to control their costs and to choose production locations with this factor in mind. B. Transportation Costs Some products and services become impractical to export after the cost of transportation is added to production costs. In general, the farther the target market is from the home country, the higher the transportation costs. Also, the higher transportation costs are relative to production costs, the more difficult it is to be competitive through exporting. Some services are impossible to export and require establishing operations in the target country. C. Lack of Domestic Capacity As long as a company has excess capacity, it can service foreign markets and price on the basis of variable rather than full costs. When demand exceeds capacity, however, new facilities are needed and are often located nearer to the end consumers in other countries. D. Need to Alter Products and Services Special requirements for products in some markets may require additional investments that are often better made in the country the company intends to sell

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to. The more that products must be altered for foreign markets, the more likely production will shift to those foreign markets. E. Trade Restrictions Although import barriers have been on the decline, some significant tariffs continue to exist. In these situations, avoiding barriers through production in the target country must be weighed against other considerations such as the market size of the country and the scale of technology used in production. When barriers fall within a group of countries, companies may be attracted to make direct investments to serve the entire region since the expanded market may justify scale economies. F. Country of Origin Effects Consumers may prefer goods produced in their own country over imports because of nationalistic feelings. For some products, consumers may prefer imported goods from specific countries due to a perception that those products are superior. Other considerations like the availability of service and replacement parts for imported products, or adoption of just-in-time manufacturing systems may influence production locations. III. NONCOLLABORATIVE FOREIGN EQUITY ARRANGEMENTS Two forms of foreign direct investment (FDI) that do not involve collaboration are wholly owned operations and partially owned operations with the remainder widely held. A. Foreign Direct Investment and Control To qualify as a foreign direct investment, the investor must have control. This can be established with a small percentage of the holdings if ownership is widely dispersed. The more ownership a company has, the greater its control over the management decisions of the operation. There are three primary reasons for companies to want a controlling interestinternalization theory, appropriability theory, and freedom to pursue global objectives. 1. Internalization. Control through self-handling of operations is known as internalization. Transactions cost theory holds that companies should organize operations internally when the costs of doing so are lower than contracting with another party to handle it for them. Internalization may result in lower costs because: Different operating units with the same company likely share a common culture which expedites communications The company can use its own managers who understand and are committed to carrying out its objectives Negotiations that might delay the investment or complicate its management can be avoided The company can avoid possible problems with enforcing an agreement 2. Appropriability. Appropriability theory is the idea that companies want to deny rivals and potential rivals access to resources such as capital, patents, trademarks, and management know-how that might be captured through collaborative agreements.

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3. Pursuit of Global Strategies. When a company has a wholly owned foreign operation, it may more easily have that operation participate in a global or transnational strategy. Furthermore, the fact that most countries have laws to protect minority shareholders interest means that sharing of ownership may restrict a company from implementing a global or transnational strategy. B. Methods for Making FDI FDI usually involves international capital movement, but could also involve the transfer of other assets such as managers, cost control systems. Companies can either acquire an interest in an existing company or construct new facilities, known as a greenfield investment. 1. Reasons for Buying. Companies may acquire existing operations in order to avoid adding further capacity to the market, to avoid start-up problems, obtain easier financing, and get an immediate cash flow rather than tying up funds during construction. A company may also save time, reduce costs, and reduce risks by buying an existing company. 2. Reasons for Greenfield. Companies may choose to build if no suitable company is available for acquisition, if the acquisition is likely to lead to carry-over problems, and if the acquisition is harder to finance. In addition, local governments may prevent acquisitions because they want more competitors in the market and fear foreign domination. II. MOTIVES FOR COLLABORATIVE ARRANGEMENTS Each participant in a collaborative arrangement has its own basic objectives for operating internationally as well as its own motives for collaborating with a partner. A. Motives for Collaborative Arrangements: General Companies collaborate with other firms in either their domestic or foreign operations in order to spread and reduce costs, to specialize in particular competencies, to avoid or counter competition, to secure vertical and/or horizontal linkages and to learn from other companies. 1. Spread and Reduce Costs. When the volume of business is small, or one partner has excess capacity, it may be less expensive to collaborate with another firm. Nonetheless, the costs of negotiation and technology transfer must not be overlooked. 2. Specialize in Competencies. The resource-based view of the firm holds that each firm has a unique combination of competencies. Thus, a firm can maximize its performance by concentrating on those activities that best fit its competencies and relying on partners to supply other products, services, or support activities. 3. Avoid or Counter Competition. When markets are not large enough for numerous competitors, or when firms need to confront a market leader, they may band together in ways to avoid competing with one another or combine resources to increase their market presence. 4. Secure Vertical and Horizontal Links. If a firm lacks the competence and/or resources to own and manage all of the activities of the value-added chain, a collaborative arrangement may yield greater vertical

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access and control. At the horizontal level, economies of scope in distribution, a better smoothing of sales and earnings through diversification and an ability to pursue projects too large for any single firm can all be realized through collaboration. 5. Gain Knowledge. Many firms pursue collaborative arrangements in order to learn about their partners technology, operating methods, or home markets and thus broaden their own competencies and competitiveness over time. B. International Motives for Collaborative Arrangements Companies collaborate with other firms in their foreign operations in order to gain location-specific assets, overcome legal constraints, diversify geographically and minimize their exposure in high-risk environments. 1. Gain Location-Specific Assets. Cultural, political, competitive, and economic differences among countries create challenges for companies that operate abroad. To overcome such barriers and gain access to locationspecific assets (e.g., distribution access or a competent workforce), firms may pursue collaborative arrangements. 2. Overcome Governmental Constraints. Countries may prohibit or limit the participation of foreign firms in certain industries, or discriminate against foreign firms via tax rates and profit repatriation. Firms may be able to overcome such barriers via collaboration with a local partner. 3. Diversify Geographically. By operating in a variety of countries, a firm can smooth its sales and earnings; collaborative arrangements may also offer a faster initial means of entering multiple markets or establishing multiple sources of supply. 4. Minimize Exposure in Risky Environments. The higher the risk managers perceive with respect to a foreign operation, the greater their desire to form a collaborative arrangement. III. TYPES OF COLLABORATIVE ARRANGEMENTS While collaborative arrangements allow for a greater spreading of assets across countries, the various types of arrangements necessitate trade-offs among objectives. Finding a desirable partner can be problematic. A firm has a wider choice of operating forms and partners when there is less likelihood of competition and when it has a desired, unique, difficult-to-duplicate resource. A. Some Considerations in Collaborative Arrangements Two critical variables that influence the choice of collaborative arrangement are a firms desire for control over its foreign operations and its prior expansion into foreign ventures. 1. Control. The loss of control over flexibility, revenues and competition is a critical variable in the selection of forms of foreign operation. The more a firm depends on collaborative arrangements, the more likely its control will be lessened over decisions regarding quality, new product directions and production expansion.

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POINT-COUNTERPOINT: Should Countries Limit Foreign Control of Key Industries? POINT: Countries should limit foreign control of key industries in order to protect their economic and security interests, especially in key industries such as transportation, mass media, and energy. History has shown that home governments have used powerful foreign companies to influence policies in the countries where they operate, and that foreign companies have used their home governments as instruments to improve their interests in a country. Whenever a company is controlled from abroad, decisions about that company can be made abroad, possibly to the detriment of the host country. COUNTERPOINT: Decisions made by foreign companies are not likely to be much different than decisions made by local companies. MNEs staff their foreign subsidiaries mainly with nationals of the countries where they operate, and make decisions based on a good deal of local advice. Their decisions have to adhere to local laws and consider the views of suppliers and customers. Protection of certain industries from foreign control could reduce competitiveness in those industries and harm, rather than help, the local people. Those who argue for limits are relying on the outdated dependencia theory, which holds that emerging economies have practically no power in their dealings with MNEs. More recent bargaining school theory states that the terms for a foreign investors operations depend on how much the investor and host country need the others assets. Countries and foreign companies need each other, and both will lose if limitations are placed on foreign control.

2. Prior Expansion of the Company. If a firm already owns and controls operations in a foreign country, the advantages of collaboration may not be as attractive as otherwise. B. Licensing Under a licensing agreement, a firm (the licensor) grants rights to intangible property to another company (the licensee) to use in a specified geographic area for a specified period of time; in exchange, the licensee ordinarily pays a royalty to the licensor. Such rights may be exclusive or nonexclusive. Usually the licensor is obliged to furnish technical information and assistance, while the licensee is obliged to exploit the rights effectively and pay compensation to the licensor. Intangible property may be classified as: patents, inventions, formulas, processes, designs, patterns copyrights for literary, musical, or artistic compositions trademarks, trade names, brand names franchises, licenses, contracts methods, programs, procedures, systems. 1. Major Motives for Licensing. Licensing often has an economic motive, such as the desire for faster start-up, lower costs, or access to additional property rights (e.g., technology). For the licensor, the risks and costs of a given venture are lessened; for the licensee, costs are less than if it

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C.

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had to develop a product or process on its own. Cross-licensing represents the situation in which companies in various countries exchange technology rather than compete with each other with every product in every market. 2. Payment. The amount and type of payment for licensing arrangements may vary. Each contract tends to be negotiated on its own merits; the bargaining range is based on dual expectations. Both agreementspecific and environment-specific factors may affect the value of a license. 3. Sales to Controlled Entities. Many licenses are given to firms owned in part or in whole by the licensor. From a legal standpoint, subsidiaries are separate companies; thus, a license may be required in order to transfer intangible property. Franchising Franchising represents a specialized form of licensing in which the franchisor not only sells an independent franchisee the use of the intangible property essential to the franchisees business, but also operationally assists the business on a continuing basis. In a sense, the two partners act like a vertically integrated firm because they are interdependent and each produces a part of the product that ultimately reaches the customer. 1. Organization of Franchising. A franchisor may penetrate a foreign country by dealing directly with its foreign franchisees, or by setting up a master franchise and giving that organization the right to open outlets on its own or to develop sub-franchises in the country or region. 2. Operational Modifications. Franchise success is derived from three factors: product standardization, effective cost control and high recognition. Nonetheless, franchisors face a classic dilemma: the more they standardize on a global basis, the lower the potential for product acceptance in a given country; the more they permit adaptation to local conditions, the less the franchisor can offer the franchisee, the higher the costs and the less the control by the franchisor. Management Contracts A management contract represents an arrangement in which one firm provides management personnel to perform general or specialized functions to another firm for a fee. A firm usually pursues such contracts when it believes a partner can manage certain operations more efficiently and effectively than it can itself. Turnkey Operations Turnkey operations represent a type of collaborative arrangement in which one firm contracts with another to build complete, ready-to-operate facilities. Usually, suppliers of turnkey facilities are industrial-equipment and construction companies; projects may cost billions of dollars; customers most often are government agencies or large MNEs. Joint Ventures A joint venture represents a direct investment in which two or more partners share ownership. As a firms share of the equity declines, its ability to control a given operation also declines. A consortium represents the joining together of several entities (e.g., companies and governments) to combine resources and/or

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to strengthen the possibility of pursuing a major undertaking. Other forms of joint ventures include: Two companies from the same country joining together in a foreign market, such as NEC and Mitsubishi (Japan) in the United Kingdom A foreign company joining with a local company, such as Great Lakes Chemical (U.S.) and A. H. Al Zamil in Saudi Arabia Companies from two or more countries establishing a joint venture in a third country, such as that of Diamond Shamrock (U.S.) and Sol Petroleo (Argentina) in Bolivia A private company and a local government forming a joint venture (sometimes called a mixed venture), such as that of Philips (Dutch) with the Indonesian government A private company joining a government-owned company in a third country, such as BP Amoco (private British-U.S.) and Eni (governmentowned Italian) in Egypt G. Equity Alliances An equity alliance represents a collaborative arrangement in which at least one of the collaborating firms takes an ownership position (usually a minority) in the other(s). The purpose of an equity alliance is to solidify a collaborating contract, thus making it more difficult to break. IV. PROBLEMS OF COLLABORATIVE ARRANGEMENTS Dissatisfaction with the results of collaboration can cause an arrangement to break down. Problems arise for a number of reasons. A. Collaborations Importance to Partners One partner may give more attention to the collaboration than the otheroften because of a difference in size. An active partner will blame the less active partner for its lack of attention, while the less active partner will blame the other for poor decisions. B. Differing Objectives Although firms may enter into collaborative arrangements with complementary capabilities and objectives, their views regarding such things as reinvestment vs. profit repatriation and desirable performance standards may evolve quite differently over time. C. Control Problems When no single party has control of a collaborative arrangement, the venture may lack direction; if one party dominates, it must still consider the interests of the other. By sharing assets with another firm, a company may lose some control over the extent and/or quality of the assets use. Further, even when control is ceded to one of the partners, both may be held responsible for problems. D. Partners Contributions and Appropriations One partners ability to contribute technology, capital and other assets may diminish (at least on a relative basis) over time. Further, in almost all collaborations the danger exists that one partner will use the others contributed assets, or take more than its fair share from the operation, thus enabling it to

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become a direct competitor. Such weaknesses may cause a drag on a venture and even lead to the dissolution of the agreement. E. Differences in Culture Differences in both national and corporate cultures may cause problems with collaborative arrangements, especially joint ventures. Firms differ by nationality in terms of how they evaluate the success of an operation (e.g., profitability, strategic market position and/or social objectives). Nonetheless, joint ventures from culturally distant countries tend to survive at least as well as those between partners from similar cultures. V. MANAGING FOREIGN ARRANGEMENTS As a collaborative arrangement evolves, partners need to reassess certain decisions in light of their resource bases and external environmental changes. A. Dynamics of Collaborative Arrangements The evolutionary costs of a firms foreign operations may be very high as it switches from one operational mode to another, especially if it must pay termination fees. Thus, a firm must develop the means to evaluate performance by separating the controllable and uncontrollable factors at its various profit centers. B. Finding Compatible Partners A firm may actively seek a partner for its foreign operations, or it can react to a proposal from another company to collaborate with it. Potential partners should be evaluated both for the resources they can offer and their willingness to work together. The proven ability to handle similar types of collaboration is a key professional qualification. C. Negotiating Process Certain technology transfer considerations are unique to collaborative arrangements; often pre-agreements are set up to protect concerned parties. The secrecy of financial terms, especially when government authorities consult their counterparts in other countries, is an especially sensitive area. Market conditions may dictate the need for different terms in different countries. D. Contractual Provisions To minimize potential points of disagreement, contract provisions should address the following factors: Terminating the agreement if the parties do not adhere to the directives Methods of testing for quality Geographical limitations on the assets use Which company will manage which parts of the operation outlined to the agreement What each companys future commitments will be How each company will buy from, sell to, or use intangible assets that come from the collaborative arrangement E. Performance Assessment All parties should establish mutual goals so all involved understand what is expected, and a contract should spell out expectations. In addition to the

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continuing assessment of the ventures performance, a firm should also periodically assess the possible need for a change in the type of collaboration. LOOKING TO THE FUTURE: Why Innovation Breeds Collaboration Because the cost of invention is often so high, it follows that firms of considerable size will carry out most innovation. Although firms can become ever larger through mergers and acquisitions, collaborative arrangements are likely to be increasingly important in the future as governments opt to restrict such activities because of antitrust concerns. At the same time, collaborative arrangements will bring forth both opportunities and problems as firms move simultaneously into new countries and to new types of contractual arrangements with new partners. The more partners in a given alliance, the more strained the decision-making and control processes will likely be.

CLOSING CASE: International Airline Alliances [See Map 14.2] Most of the worlds airlines have formed alliances with other airlines covering things such as combined routes, sales, airline terminal services, and frequent flier programs. In addition, many airlines hold an ownership position in other airlines. Much of this cooperative activity is driven by government regulations that limit foreign participation in domestic markets, making alliances the only practical alternative to increasing breadth of service. Other factors such as cost savings and intense competition have also led to the formation of alliances.

Questions
1. Discuss a question raised by the manager of route strategy at American Airlines: Why should an airline not be able to establish service anywhere in the world simply by demonstrating that it can and will comply with the local labor and business laws of the host country? When considering either the international or simply the domestic environment, a major consideration is whether economic interests in the airline industry are better served through regulation via the market. Proponents of deregulation argue that competition has forced carriers to become efficient or else go out of business, instead of being subsidized by regulated route and fare structures. Proponents also argue that the survival of mega-carriers leads to economies of scale in handling passengers and cargo. Opponents argue that local interests are often ill-served by deregulation since

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airlines are free to discontinue service and to wage predatory price wars that put competitors out of business, at which point the survivors will then raise prices. Opponents also raise fears there may eventually be too few survivors to allow for the competition that was envisioned by the proponents of deregulation; the high barriers to entry in the industry further exacerbate this situation. Another major consideration deals with the political dimensions of the question. Because most governments see airlines as a key national industry, they oppose giving foreign carriers access to domestic routes on grounds of both national security and consumer welfare. 2. The president of Japan Air Lines has claimed that U.S. airlines are dumping air services on routes between the United States and Europe, meaning they are selling below their costs because of the money they are losing. Should governments set prices so that carriers make money on routes? It is very difficult to separate profits and losses on a route-by-route basis. While fares and loads on certain routes may seem to be low, they may in fact be generating marginal revenues that make major routes profitable. A second issue is that of price elasticity. If governments were to set prices above the equilibrium point, traffic and revenues, and hence profitability, would all fall. A third issue is that of ownership. If privately owned carriers abandon routes to government-owned airlines, they could well give advantages to those airlines that could then be used against them on other routes. Finally, the issue of profitability raises the question of subsidies. It is nearly impossible to determine whether dumping is taking place when competitors receive so many direct and indirect subsidies. What will be the consequences if a few large airlines or networks come to dominate global air service? The consequences would be both positive and negative. On the positive side, passengers should be able to travel almost anywhere in the world on a single airline (or network). That in turn should minimize the risk of missed connections and lost baggage. Operating economies should be realized as a result of the higher utilization of airport gates and ground equipmentconsequent savings may or may not be passed along to passengers through lower prices. On the negative side, it is quite possible that minimal competition would lead to poor service and/or high prices. In addition, competition among the destinations associated with particular airlines would likely decline, as would the special services offered by the niche airlines. Some airlines, such as Southwest and Alaska Air, have survived as niche players without going international or developing alliances with international airlines. Can they continue this strategy? When there is sufficient traffic on the city pairs that a route serves, there is little need to have feeder or connecting routes for an airline to be profitable. In fact, without the need for hubs to make connections, some airlines can operate in smaller but closerto-downtown airports, such as Midway in Chicago or La Guardia in New York. They can avoid the costs associated with the transfer of bags to connecting flights and the payment of overnight expenses to passengers who miss connections. In addition, they may be able to overcome any disadvantages from small-scale operations by

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targeting their promotion to regional and niche groups and by running low-cost operations that charge low fares. Conventional wisdom would suggest they can in fact survive in their present operational mode and that attempts to expand and/or modify their operations might make them more, rather than less, vulnerable. WEB CONNECTION Teaching Tip: Visit www.prenhall.com/daniels for additional information and links relating to the topics presented in Chapter Fourteen. Be sure to refer your students to the on-line study guide, as well as the Internet exercises for Chapter Fourteen. _________________________ CHAPTER TERMINOLOGY: internalization, p. 489 appropriability theory, p. 489 resource-based view, p. 492 dependencia theory, p. 496 bargaining school theory, p. 496 _________________________ consortium, p. 502

ADDITIONAL EXERCISES: Collaborative Strategies Exercise 14.1. Ask the students to identify several foreign owned companies with operations in their local area. Are these companies viewed as good corporate citizens and contributors to the local community? Do they employ mostly local people or do they have a large number of expatriates? How do the wages paid by these companies compare to those of other companies in the same industry? Exercise 14.2. Assume that a company near you wanted to expand into foreign markets. What issues should that company explore before deciding whether to export or to engage in foreign direct investment? Exercise 14.1. Ask students to name companies, both domestic and foreign, that operate internationally. Then ask them to discuss the potential types of collaborative arrangements they feel would be appropriate for the various firms. Conclude the discussion by examining the list of firms and asking students if there are particular industries that seem to lend themselves to particular types of collaborative arrangements more readily than others. Be sure the students discuss why this might be so.

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Exercise 14.2. Identify the various home countries of students in your class. Then lead the class in a discussion of the likely types of collaborative arrangements foreign firms might pursue in those countries. Be sure students cite the various economic, political and cultural factors that would influence decisions regarding viable collaborative strategies. Exercise 14.3. While offering desirable advantages, licensing agreements also limit the amount of control a licensor can exercise over a foreign production process. Engage the students in a discussion of the type of firm that would most likely be willing to allow a licensee to use its established brand name, and the type of firm that would not be willing to do so. Explore the reasons for each position as well as the reasons a licensee would be willing to accept a license that did not include rights to the use of the associated brand name.

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