08 Handout 1 PDF - The Strategy of International Business

BM1917 THE STRATEGY OF INTERNATIONAL BUSINESS Strategy and the Firm When we talk about strategy and the firm, we refer to the firm in the most common way as a method to organize activities. This means that the firm can also be called multinational enterprise, multinat...

BM1917 THE STRATEGY OF INTERNATIONAL BUSINESS Strategy and the Firm When we talk about strategy and the firm, we refer to the firm in the most common way as a method to organize activities. This means that the firm can also be called multinational enterprise, multinational corporation, an international business, international organization, global company, and so on. A unique type of firm, though, is what we call an SME—a small and medium-sized enterprise. SMEs are companies that have fewer than 500 employees (U.S.) or fewer than 250 employees (Europe). Figure 1. Determinants of enterprise value Source: International Business: Competing in the Global Marketplace (12 th ed.), 2017, p. 365 A firm’s strategy can be defined as the actions that managers take to attain the goals of the firm. For most firms, the preeminent goal is to maximize the value of the firm for its owners and its shareholders To maximize the value of a firm, managers must pursue strategies that increase the profitability of the enterprise and its rate of profit growth over time (Figure 1). Profitability can be measured in several ways. Still, for consistency, we define it as the rate of return that the firm makes on its invested capital (ROI), which is calculated by dividing the net profits of the firm by total invested capital. Profit growth is measured by the percentage increase in net profits over time. In general, higher profitability and a higher rate of profit growth will increase the value of an enterprise and thus the returns garnered by its owners, the shareholders. Managers can increase the profitability of the firm by pursuing strategies that lower costs or by pursuing strategies that add value to the firm’s products, which enables the firm to raise prices and maintain an existing customer base. Managers can increase the rate at which the firm’s profits grow over time by pursuing strategies to sell more products in existing markets or by pursuing strategies to enter new markets. Deciding to expand internationally can help managers boost the firm’s profitability and increase the rate of profit growth over time. Value Creation The way to increase the profitability of a firm is to create more value. The amount of value a firm creates is generally measured by the difference between its costs of production and the quality that consumers perceive in its products. In general, the more value customers place on a firm’s products, the higher the price the firm can charge for those products. However, the price a firm charges for a good or service is typically less than the value placed on that good or service by the customer. This is because the customer captures some of that value in the form of what economists call a consumer surplus. The customer can do this because the firm is competing with other firms for the customer’s business, so the firm must charge a lower price than it could as if it were a monopoly supplier. Also, it is normally impossible to segment the market to such a degree that the firm can 08 Handout 1 *Property of STI  [email protected] Page 1 of 15  BM1917 charge each customer a price that reflects a specific customer’s assessment of the value of a product, which economists refer to as a customer’s reservation price. For these reasons, the price that gets charged tends to be slightly less than the value placed on the product by many customers. Figure 2. Value Creation Source: International Business: Competing in the Global Marketplace (12 th ed.), 2017, p.366. Figure 2 illustrates these value concepts. The value of a product to an average consumer is V, the average price that the firm can charge a consumer for that product given competitive pressures and its ability to segment the market is P, and the average unit cost of producing that product is C (C comprises all relevant costs, including the firm’s cost of capital). The firm’s profit per unit sold (p) is equal to P − C, while the consumer surplus per unit is equal to V − P (another way of thinking of the consumer surplus is as “value for the money”; the greater the consumer surplus, the greater the value for the money the consumer gets). The firm makes a profit so long as P is greater than C, and its profit will be greater the lower C is relative to P. The difference between V and P is in part determined by the intensity of competitive pressure in the marketplace; the lower the intensity of competitive pressure, the higher the price charged relative to V. In general, the higher the firm’s profit per unit sold, the greater its profitability, all else being equal. The firm’s value creation is measured by the difference between V and C (V − C). A company creates value by converting inputs that cost C into a product on which consumers place a value of V. A company can create more value (V − C) either by lowering production costs, C, or by making the product more attractive through superior design, styling, functionality, features, reliability, after-sales service, and the like, so that consumers place a greater value on it (V increases) and, consequently, are willing to pay a higher price (P increases). This discussion suggests that a firm has high profits when it creates more value for its customers and does so at a lower cost. We refer to a strategy that focuses primarily on lowering production costs as a low-cost strategy. We refer to a strategy that focuses primarily on increasing the attractiveness of a product as a differentiation strategy. Michael Porter has argued that low cost and differentiation are two (2) basic strategies for creating value and attaining a competitive advantage in an industry. According to Porter, superior profitability goes to those firms that can create superior value, and the way to create superior value is to drive down the cost structure of the business and/or differentiate the product in some way so that consumers value it more and are prepared to pay a premium price. Superior value creation relative to rivals does not necessarily require a firm to have the lowest- cost structure in an industry or to create the most valuable product in the eyes of consumers. However, it does require that the gap between value (V) and the cost of production (C) be greater than the gap attained by competitors. 08 Handout 1 *Property of STI  [email protected] Page 2 of 15  BM1917 Strategic Positioning Porter notes that it is important for a firm to be explicit about its choice of strategic emphasis concerning value creation (differentiation) and low cost, and to configure its internal operations to support that strategic emphasis. Figure 3 illustrates his point. The convex curve in Figure 3 is what economists refer to as an efficiency frontier. The efficiency frontier shows all of the different positions that a firm can adopt about adding value to the product (V) and low cost (C) assuming that its internal operations are configured efficiently to support a particular position (note that the horizontal axis in Figure 3 is reverse scaled—moving along the axis to the right implies lower costs). The efficiency frontier has a convex shape because of diminishing returns. Diminishing returns imply that when a firm already has significant value built into its product offering, increasing value by a relatively small amount requires high additional costs. The converse also holds, when a firm already has a low-cost structure, it has to give up a lot of value in its product offering to get additional cost reductions. Figure 3. Strategic choice in the international hotel industry Source: International Business: Competing in the Global Marketplace (12 th ed.), 2017, p.367. Figure 3 plots three (3) hotel brands with a global presence that cater to international travelers, Four Seasons, Marriott International, and Starwood (the Starwood conglomerate of hotel brands, such as Westin and Sheraton, was bought by Marriott in 2016). Four Seasons positions itself as a luxury chain and emphasizes the value of its product offering, which drives up its costs of operations. The Marriott and Starwood brands are positioned more in the middle of the market. Both emphasize sufficient value to attract international business travelers but are not luxury chains like Four Seasons. In Figure 3, Four Seasons and Marriott are shown to be on the efficiency frontier, indicating that their internal operations are well configured to their strategy and run efficiently. Starwood is inside the frontier, indicating that its operations are not running as efficiently as they might be and that its costs are too high. This implies that Starwood is less profitable than Four Seasons and Marriott and that its managers must take steps to improve the company’s performance. The purchase by Marriott of the Starwood collection of brands in 2016 was potentially a way to leverage the global strategy across multiple hotel brands. Porter emphasizes that it is very important for management to decide where the company wants to be positioned concerning value (V) and cost (C), to configure operations accordingly, and to manage them efficiently to make sure the firm is operating on the efficiency frontier. However, not all positions on the efficiency frontier are viable. In the international hotel industry, for example, there might not be enough demand to support a chain that emphasizes very low cost and strips all the value out of its product offering (see Figure 3). International travelers are relatively affluent and expect a degree of comfort (value) when they travel away from home. A central tenet of the basic strategy paradigm is that to maximize its profitability, a firm must do three things: (1) pick a position on the efficiency frontier that is viable in the sense that there is enough demand to support that 08 Handout 1 *Property of STI  [email protected] Page 3 of 15  BM1917 choice; (2) configure its internal operations, such as manufacturing, marketing, logistics, information systems, human resources, and so on, so that they support that position; and (3) make sure that the firm has the right organizational structure in place to execute its strategy. The strategy, operations, and organization of the firm must all be consistent with each other if it is to attain a competitive advantage and garner superior profitability. The firm as a value chain Figure 4. The value chain. Source: International Business: Competing in the Global Marketplace (12 th ed.), 2017, pp.368. The operations of a firm can be thought of as a value chain composed of a series of distinct value creation activities, including production, marketing and sales, materials management, R&D, human resources, information systems, and the firm infrastructure. We can categorize these value creation activities, or operations, as primary activities and support activities (see Figure 4). If a firm is to implement its strategy efficiently, and position itself on the efficiency frontier shown in Figure 3, it must manage these activities effectively and in a manner that is consistent with its strategy. 1. Primary activities Primary activities have to do with the design, creation, and delivery of the product; its marketing; and its support and after-sale service. Following normal practice, in the value chain illustrated in Figure 4, the primary activities are divided into four functions: research and development, production, marketing and sales, and customer service. Research and development (R&D) is concerned with the design of products and production processes. Although we think of R&D as being associated with the design of physical products and production processes in manufacturing enterprises, many service companies also undertake R&D. For example, banks compete with each other by developing new financial products and new ways of delivering those products to customers. Online banking and smart debit cards are two examples of product development in the banking industry. Earlier examples of innovation in the banking industry included automated teller machines, credit cards, and debit cards. Through superior product design, R&D can increase the functionality of products, which makes them more attractive to consumers (raising V). Alternatively, R&D may result in more efficient production processes, thereby cutting production costs (lowering C). Either way, the R&D function can create value. Production is concerned with the creation of a good or service. For physical products, when we talk about production, we generally mean manufacturing. Thus, we can talk about the production of an automobile. For services such as banking or health care, “production” typically occurs when the service is delivered to the customer (e.g., when a bank originates a loan for a customer, it is engaged in “production” of the loan). For a 08 Handout 1 *Property of STI  [email protected] Page 4 of 15  BM1917 retailer such as Walmart, “production” is concerned with selecting the merchandise, stocking the store, and ringing up the sale at the cash register. For MTV, production is concerned with the creation, programming, and broadcasting of content, such as music videos and thematic shows. The production activity of a firm creates value by performing its activities efficiently so lower costs result (lower C) and by performing them in such a way that a higher-quality product is produced (which results in higher V). The marketing and sales functions of a firm can help create value in several ways.18 Through brand positioning and advertising, the marketing function can increase the value (V) that consumers perceive to be contained in a firm’s product. If these create a favorable impression of the firm’s product in the minds of consumers, they increase the price that can be charged for the firm’s product. For example, Ford produced a high-value version of its Ford Expedition SUV. Sold as the Lincoln Navigator and priced around $10,000 higher, the Navigator has the same body, engine, chassis, and design as the Expedition. Still, through skilled advertising and marketing, supported by some fairly minor features changes (e.g., more accessories and the addition of a Lincoln-style engine grille and nameplate), Ford has fostered the perception that the Navigator is a “luxury SUV.” This marketing strategy has increased the perceived value (V) of the Navigator relative to the Expedition and enables Ford to charge a higher price for the car (P). Marketing and sales can also create value by discovering consumer needs and communicating them back to the R&D function of the company, which can then design products that better match those needs. For example, the allocation of research budgets at Pfizer, the world’s largest pharmaceutical company, is determined by the marketing function’s assessment of the potential market size associated with solving unmet medical needs. Thus, Pfizer is currently directing significant monies to R&D efforts aimed at finding treatments for Alzheimer’s disease, principally because marketing has identified the treatment of Alzheimer’s as a major unmet medical need in nations around the world where the population is aging. The role of the enterprise’s service activity is to provide after-sales service and support. This function can create a perception of superior value (V) in the minds of consumers by solving customer problems and supporting customers after they have purchased the product. Caterpillar, the U.S.-based manufacturer of heavy earthmoving equipment, can get spare parts to any point in the world within 24 hours, thereby minimizing the amount of downtime its customers have to suffer if their Caterpillar equipment malfunctions. This is an extremely valuable capability in an industry where downtime is very expensive. It has helped to increase the value that customers associate with Caterpillar products and thus the price that Caterpillar can charge. 2. Support activities The support activities of the value chain provide inputs that allow the primary activities to occur (see Figure 4). In terms of attaining a competitive advantage, support activities can be as important as, if not more important than, the primary activities of the firm. Consider information systems; these systems refer to the electronic systems for managing inventory, tracking sales, pricing products, selling products, dealing with customer service inquiries, and so on. Information systems, when coupled with the communications features of the Internet, can alter the efficiency and effectiveness with which a firm manages its other value creation activities. Dell, for example, has used its information systems to attain a competitive advantage over rivals. When customers place an order for a Dell product over the firm’s website, that information is immediately transmitted, via the Internet, to suppliers, who then configure their production schedules to produce and ship that product so that it arrives at the right assembly plant at the right time. These systems have reduced the amount of inventory that Dell holds at its factories to under two days, which is a major source of cost savings. The logistics function controls the transmission of physical materials through the value chain, from procurement through production and into distribution. The efficiency with which this is carried out can significantly reduce cost (lower C), thereby creating more value. The combination of logistics systems and information systems is a particularly potent source of cost savings in many enterprises, such as Dell, where information systems tell Dell 08 Handout 1 *Property of STI  [email protected] Page 5 of 15  BM1917 on a real-time basis wherein its global logistics network parts are, when they will arrive at an assembly plant, and thus, how production should be scheduled. The human resource function can help create more value in several ways. It ensures that the company has the right mix of skilled people to perform its value creation activities effectively. The human resource function also ensures that people are adequately trained, motivated, and compensated for performing their value creation tasks. In a multinational enterprise, one of the things human resources can do to boost the competitive position of the firm is to take advantage of its transnational reach to identify, recruit, and develop a cadre of skilled managers, regardless of their nationality, who can be groomed to take on senior management positions. They can find the very best wherever they are in the world. Indeed, the senior management ranks of many multinationals are becoming increasingly diverse, as managers from a variety of national backgrounds have ascended to senior leadership positions. Japan’s Sony, for example, is now headed not by a Japanese national, but by Howard Stringer, a Welshman. The final support activity is the company infrastructure or the context within which all the other value creation activities occur. The infrastructure includes the organization structure, control systems, and culture of the firm. Because top management can exert considerable influence in shaping these aspects of a firm, top management should also be viewed as part of the firm’s infrastructure. Through strong leadership, top management can consciously shape the infrastructure of a firm and, through that, the performance of all its value creation activities. Global Expansion, Profitability, and Profit Growth Expanding globally allows firms to increase their profitability and rate of profit growth in ways not available to purely domestic enterprises. Firms that operate internationally can: 1. Expand the market for their domestic products by selling those products (or services) in international markets. 2. Realize location economies by dispersing value creation activities to those worldwide locations where they can be performed most efficiently and effectively. 3. Realize greater cost economies from experience effects by serving an expanded global market from a geographically central location, thereby reducing the costs of value creation. 4. Earn a greater return by leveraging any valuable skills developed in foreign operations and transferring them to other entities within the firm’s global network of operations. Expanding the market: Leveraging products and competencies A company can increase its growth rate by taking goods or services developed at home and selling them internationally. Almost all multinationals started out doing just this. EXAMPLE: Procter & Gamble developed most of its best-selling products (such as Pampers disposable diapers and Ivory soap) in the United States and subsequently sold them around the world. Likewise, although Microsoft developed its software in the United States, from its earliest days, the company has always focused on selling that software in international markets. Automobile companies such as Volkswagen (Germany) and Toyota (Japan) also grew by developing products at home and then selling them in international markets. The returns from such a strategy are likely to be greater if indigenous competitors in the nations that a company enters lack comparable products. Thus, Toyota increased its profits by entering the large automobile market of North America, offering products that were different from those offered by local rivals (Ford and GM) by their superior quality and reliability. The success of many multinational companies that expand in this manner is based not just upon the goods or services that they sell in foreign nations, but also upon the core competencies that underlie the development, production, and marketing of those goods or services. The term core competence refers to skills within the firm that competitors cannot easily match or imitate. These skills may exist in any of the firm’s value creation activities—production, marketing, R&D, human resources, logistics, general management, and so on. Such skills are typically expressed in product offerings that other firms find it difficult to match or imitate. Core 08 Handout 1 *Property of STI  [email protected] Page 6 of 15  BM1917 competencies are the bedrock of a firm’s competitive advantage. They enable a firm to reduce the costs of value creation and to create perceived value in such a way that premium pricing is possible. EXAMPLE: Toyota has a core competence in the production of cars. It can produce high-quality, well-designed cars at a lower delivered cost than any other firm in the world. The competencies that enable Toyota to do this seem to reside primarily in the firm’s production and logistics functions. Similarly, IKEA has a core competence in the design of stylish and affordable furniture that can be manufactured at a low cost and flat-packed (supplied in pieces packed into a flat box for assembly by the buyer). McDonald’s has a core competence in managing fast-food operations. Also, Procter & Gamble has a core competence in developing and marketing name-brand consumer products. Because core competencies are the source of a firm’s competitive advantage, the successful global expansion by manufacturing companies such as Toyota and P&G was based not just on leveraging products and selling them in foreign markets, but also on the transfer of core competencies to foreign markets where indigenous competitors lacked them. The same can be said of companies engaged in the service sectors of an economy, such as financial institutions, retailers like IKEA, restaurant chains, and hotels. Expanding the market for their services means replicating its business model in foreign nations. Firms like Starbucks and Subway, for example, expanded rapidly outside their home markets in the United States by taking the basic business model that they developed at home and using that as a blueprint for establishing international operations. Location Economies Countries differ along with a range of dimensions—including the economic, political, legal, and cultural—and that these differences can either raise or lower the costs of doing business in a country. The theory of international trade also teaches that due to differences in factor costs, certain countries have a comparative advantage in the production of certain products. Japan might excel in the production of automobiles and consumer electronics, the United States in the production of computer software, pharmaceuticals, biotechnology products, and financial services. For a firm that is trying to survive in a competitive global market, this implies that – trade barriers and transportation costs permitting – the firm will benefit by basing each value creation activity it performs at that location where economic, political, and cultural conditions, and relative factor costs are most conducive to the performance of that activity. Firms that pursue such a strategy can realize what is referred to as location economies, which are the economies that arise from performing a value creation activity in the optimal location for that activity, wherever in the world that might be (transportation costs and trade barriers permitting). Locating a value creation activity in the optimal location for that activity can have one of two (2) effects: It can lower the costs of value creation and help the firm achieve a low-cost position, or it can enable a firm to differentiate its product offering from those of competitors. In terms of Figure 2, it can lower C or increase V (which in general supports higher pricing), both of which boost the profitability of the enterprise. EXAMPLE: For an example of how this works in international business, consider ClearVision Optical, a manufacturer and distributor of eyewear. Started by David Glassman, the firm now generates annual gross revenues of more than $100 million. Not exactly small, but no corporate giant either, ClearVision is a multinational firm with production facilities on three continents and customers around the world. ClearVision began its move toward becoming a multinational when its sales were still less than $20 million. At the time, the U.S. dollar was very strong, and this made U.S.-based manufacturing expensive. Low-priced imports were taking an ever-larger share of the U.S. eyewear market, and ClearVision realized it could not survive unless it also began to import. Initially, the firm bought from independent overseas manufacturers, primarily in Hong Kong. However, the firm became dissatisfied with these suppliers’ product quality and delivery. As ClearVision’s volume of imports increased, Glassman decided the best way to guarantee quality and delivery was to set up ClearVision’s manufacturing operation overseas. Accordingly, ClearVision found a Chinese partner, and together they opened a manufacturing facility in Hong Kong, with ClearVision being the majority shareholder. The choice of the Hong Kong location was influenced by its combination of low labor costs, a skilled workforce, and tax breaks given by the Hong Kong government. The firm’s objective at this point was to lower production costs by locating value creation activities at an appropriate location. After a few years, however, the increasing industrialization of Hong Kong and a growing labor shortage had pushed up wage rates to the extent that it was no longer a low-cost location. In response, Glassman and his Chinese partner moved part of their manufacturing 08 Handout 1 *Property of STI  [email protected] Page 7 of 15  BM1917 to a plant in mainland China to take advantage of the lower wage rates there. Again, the goal was to lower production costs. The parts for eyewear frames manufactured at this plant were shipped to the Hong Kong factory for final assembly and then distributed to markets in North and South America. The Hong Kong factory now employs 80 people and the Chinese plant between 300 and 400. At the same time, ClearVision was looking for opportunities to invest in foreign eyewear firms with reputations for the fashionable design and high quality. Its objective was not to reduce production costs but to launch a line of high-quality differentiated, “designer” eyewear. ClearVision did not have the design capability in-house to support such a line, but Glassman knew that certain foreign manufacturers did. As a result, ClearVision invested in factories in Japan, France, and Italy, holding a minority shareholding in each case. These factories now supply eyewear for ClearVision’s Status Eye division, which markets high-priced designer eyewear. Thus, to deal with a threat from foreign competition, ClearVision adopted a strategy intended to lower its cost structure (lower C): shifting its production from a high-cost location, the United States, to a low-cost location, first Hong Kong and later China. Then ClearVision adopted a strategy intended to increase the perceived value of its product (increase V), so it could charge a premium price (P). Reasoning that premium pricing in eyewear depended on superior design, its strategy involved investing capital in French, Italian, and Japanese factories that had reputations for superior design. In sum, ClearVision’s strategies included some actions intended to reduce its costs of creating value and other actions intended to add perceived value to its product through differentiation. The overall goal was to increase the value created by ClearVision and, thus, the profitability of the enterprise. To the extent that these strategies were successful, the firm should have attained a higher profit margin and greater profitability than if it had remained a U.S.-based manufacturer of eyewear. Experience Effects The experience curve refers to systematic reductions in production costs that have been observed to occur over the life of a product. Several studies have observed that a product’s production costs decline by some quantity about each time cumulative output doubles. The relationship was first observed in the aircraft industry, where each time the cumulative output of airframes was doubled, unit costs typically declined to 80 percent of their previous level. Thus, the production cost for the fourth airframe would be 80 percent of production cost for the second airframe, the eighth airframe’s production costs 80 percent of the fourth’s, the sixteenth’s 80 percent of the eighth’s, and so on. Two things explain this: learning effects and economies of scale. a. Learning effects Learning effects refer to cost savings that come from learning by doing.29 Labor, for example, learns by repetition how to carry out a task, such as assembling airframes, most efficiently. Labor productivity increases over time as individuals learn the most efficient ways to perform particular tasks. Equally important in new production facilities, management typically learns how to manage the new operation more efficiently over time. Hence, production costs decline due to increasing labor productivity and management efficiency, which increases the firm’s profitability. Learning effects tend to be more significant when a technologically complex task is repeated because there is more than can be learned about the task. Thus, learning effects will be more significant in an assembly process involving 1,000 complex steps than in one of only 100 simple steps. No matter how complex the task, however, learning effects typically disappear after a while. It has been suggested that they are important only during the start-up period of a new process and that they cease after two or three years. Any decline in the experience curve after such a point is due to economies of scale. b. Economies of scale Economies of scale refer to the reductions in unit cost achieved by producing a large volume of a product. Attaining economies of scale lowers a firm’s unit costs and increases its profitability. Economies of scale have several sources. One is the ability to spread fixed costs over a large volume. Fixed costs are the costs required to set up a production facility, develop a new product, and the like. They can be substantial. EXAMPLE: The fixed cost of establishing a new production line to manufacture semiconductor chips now exceeds $1 billion. Similarly, according to one estimate, developing a new drug and bringing it to market costs about $800 million and takes about 12 years. The only way to recoup such high fixed costs may be to sell the 08 Handout 1 *Property of STI  [email protected] Page 8 of 15  BM1917 product worldwide, which reduces average unit costs by spreading fixed costs over a larger volume. The more rapidly that cumulative sales volume is built up, the more rapidly fixed costs can be amortized over a large production volume, and the more rapidly unit costs will fall. Second, a firm may not be able to attain an efficient scale of production unless it serves global markets. In the automobile industry, for example, an efficiently scaled factory is designed to produce about 200,000 units a year. Automobile firms would prefer to produce a single model from each factory since this eliminates the costs associated with switching production from one model to another. If domestic demand for a particular model is only 100,000 units a year, the inability to attain a 200,000-unit output will drive up average unit costs. By serving international markets as well, however, the firm may be able to push production volume up to 200,000 units a year, thereby reaping greater scale economies, lowering unit costs, and boosting profitability. Finally, as global sales increase the size of the enterprise, so its bargaining power with suppliers increases, which may allow it to attain economies of scale in purchasing, bargaining down the cost of key inputs and boosting profitability that way. For example, Walmart has used its enormous sales volume as a lever to bargain down the price it pays suppliers for merchandise sold through its stores. Leveraging Subsidiary Skills Implicit in our earlier discussion of core competencies is the idea that valuable skills are developed first at home and then transferred to foreign operations. However, for more mature multinationals that have already established a network of subsidiary operations in foreign markets, the development of valuable skills can just as well occur in foreign subsidiaries. Skills can be created anywhere within a multinational’s global network of operations, wherever people have the opportunity and incentive to try new ways of doing things. The creation of skills that help lower the costs of production, or enhance perceived value and support higher product pricing, is not the monopoly of the corporate center. Leveraging the skills created within subsidiaries and applying them to other operations within the firm’s global network may create value. EXAMPLE: McDonald’s increasingly is finding that its foreign franchisees are a source of valuable new ideas. Faced with slow growth in France, its local franchisees have begun to experiment not only with the menu but also with the layout and theme of restaurants. Gone are the ubiquitous golden arches; gone too are many of the utilitarian chairs and tables and other plastic features of the fast-food giant. Many of McDonald’s restaurants in France now have hardwood floors, exposed brick walls, and even armchairs. Half of the 1,200 or so outlets in France have been upgraded to a level that would make them unrecognizable to an American. The menu, too, has been changed to include premier sandwiches, such as chicken on focaccia bread, priced some 30 percent higher than the average hamburger. In France, at least, the strategy seems to be working. Following the change, increases in same-store sales rose from 1 percent annually to 3.4 percent. Impressed with the impact, McDonald’s executives are considering similar changes at other McDonald’s restaurants in markets where same-store sales growth is sluggish, including the United States. For the managers of the multinational enterprise, this phenomenon creates important new challenges. First, they must have the humility to recognize that valuable skills that lead to competencies can arise anywhere within the firm’s global network, not just at the corporate center. Second, they must establish an incentive system that encourages local employees to acquire new skills. This is not as easy as it sounds. Creating new skills involves a degree of risk. Not all new skills add value. For every valuable idea created by a McDonald’s subsidiary in a foreign country, there may be several failures. The management of the multinational must install incentives that encourage employees to take the necessary risks. The company must reward people for successes and not sanction them unnecessarily for taking risks that did not pan out. Third, managers must have a process for identifying when valuable new skills have been created in a subsidiary. And finally, they need to act as facilitators, helping transfer valuable skills within the firm. Profitability and Profit Growth Summary We have seen how firms that expand globally can increase their profitability and profit growth by entering new markets where indigenous competitors lack similar competencies. Some firms expand by lowering costs and adding value to their product offering through the attainment of location economies, by exploiting experience curve effects, and by transferring valuable skills between their global network of subsidiaries. For completeness, 08 Handout 1 *Property of STI  [email protected] Page 9 of 15  BM1917 it should be noted that strategies that increase profitability may also expand a firm’s business and thus enable it to attain a higher rate of profit growth. For example, by simultaneously realizing location economies and experience effects, a firm may be able to produce a more highly valued product at a lower unit cost, thereby boosting profitability. The increase in the perceived value of the product may also attract more customers, thereby increasing revenues and profits as well. Rather than raising prices to reflect the higher perceived value of the product, the firm’s managers may elect to hold prices low to increase global market share and attain greater scale economies (in other words, they may elect to offer consumers better “value for money”). Such a strategy could increase the firm’s rate of profit growth even further since consumers will be attracted by prices that are low relative to value. The strategy might also increase profitability if the scale economies that result from market share gains are substantial. In sum, managers need to keep in mind the complex relationship between profitability and profit growth when making strategic pricing decisions. Cost Pressures and Pressures for Local Responsiveness Firms that compete in the global marketplace face two (2) types of competitive pressure that affect their ability to realize location economies and experience effects and to leverage products and transfer competencies and skills within the enterprise. They face pressures for cost reductions and pressures to be locally responsive (see Figure 5). These competitive pressures place conflicting demands on a firm. Responding to pressures for cost reductions requires that a firm try to minimize its unit costs. But responding to pressures to be locally responsive requires that a firm differentiates its product offering and marketing strategy from country to country to accommodate the diverse demands arising from national differences in consumer tastes and preferences, business practices, distribution channels, competitive conditions, and government policies. In some cases, companies also need to differentiate between segments within countries, placing even greater pressure on cost than country customization. Because differentiation across countries can involve significant duplication and a lack of product standardization, it may raise costs. Figure 5. Pressures for cost reductions and local responsiveness Source: International Business: Competing in the Global Marketplace (12 th ed.), 2017, p. 378. While some enterprises, such as firm A in Figure 5, face high pressures for cost reductions and low pressures for local responsiveness, and others, such as firm B, face low pressures for cost reductions and high pressures for local responsiveness, many companies are in the position of firm C. They face high pressures for both cost reductions and local responsiveness. Dealing with these conflicting and contradictory pressures is a difficult strategic challenge, primarily because being locally responsive tends to raise costs. Pressures for Cost Reductions In competitive global markets, international businesses often face pressures for cost reductions. Responding to pressures for cost reduction requires a firm to try to lower the costs of value creation. A manufacturer, for example, might mass-produce a standardized product at the optimal location in the world, wherever that might 08 Handout 1 *Property of STI  [email protected] Page 10 of 15  BM1917 be, to realize economies of scale, learning effects, and location economies. Alternatively, a firm might outsource certain functions to low-cost foreign suppliers in an attempt to reduce costs. A service business such as a bank might respond to cost pressures by moving some back-office functions, such as information processing, to developing nations where wage rates are lower. Pressures for cost reduction can be particularly intense in industries producing commodity-type products where meaningful differentiation on nonprice factors is difficult, and the price is the main competitive weapon. This tends to be the case for products that serve universal needs. Universal needs exist when the tastes and preferences of consumers in different nations are similar if not identical. This is the case for conventional commodity products such as bulk chemicals, petroleum, steel, sugar, and the like. It also tends to be the case for many industrial and consumer products, for example, handheld calculators, semiconductor chips, personal computers, and liquid crystal display screens. Pressures for cost reductions are also intense in industries where major competitors are based in low-cost locations, where there is persistent excess capacity and where consumers are powerful and face low switching costs. The liberalization of the world trade and investment environment in recent decades, by facilitating greater international competition, has generally increased cost pressures. Pressures for Local Responsiveness Pressures for local responsiveness arise from national differences in consumer tastes and preferences, infrastructure, accepted business practices, and distribution channels, and host-government demands. Responding to pressures to be locally responsive requires a firm to differentiate its products and marketing strategy from country to country to accommodate these factors, all of which tend to raise the firm’s cost structure. Differences in Customer Tastes and Preferences Strong pressures for local responsiveness emerge when customer tastes and preferences differ significantly between countries, as they often do for deeply embedded historical or cultural reasons. In such cases, a multinational’s products and marketing message have to be customized to appeal to the tastes and preferences of local customers. This typically creates pressure to delegate production and marketing responsibilities and functions to a firm’s overseas subsidiaries. EXAMPLE: Some time ago, the automobile industry moved toward the creation of “world cars.” The idea was that global companies such as General Motors, Ford, and Toyota would be able to sell the same basic vehicle the world over, sourcing it from centralized production locations. If successful, the strategy would have enabled automobile companies to reap significant gains from global scale economies. However, this strategy frequently ran aground on the hard rocks of consumer reality. Consumers in different automobile markets seem to have different tastes and preferences and demand different types of vehicles. North American consumers show strong demand for pickup trucks. This is particularly true in the South and West, where many families have a pickup truck as a second or third car. But in European countries, pickup trucks are seen purely as utility vehicles and are purchased primarily by firms rather than individuals. As a consequence, the product mix and marketing message needs to be tailored to consider the different nature of demand in North America and Europe. Some have argued that customer demands for local customization are on the decline worldwide. According to this argument, modern communications and transport technologies have created the conditions for a convergence of the tastes and preferences of consumers from different nations. The result is the emergence of enormous global markets for standardized consumer products. The worldwide acceptance of Subway sandwiches, McDonald’s hamburgers, Coca-Cola, Gap clothes, Apple iPhones, and Microsoft’s Xbox— all of which are sold globally as standardized products—are often cited as evidence of the increasing homogeneity of the global marketplace. However, this argument may not hold in many consumer goods markets. Significant differences in consumer tastes and preferences still exist across nations and cultures. Managers in international businesses do not yet have the luxury of being able to ignore these differences, and they may not for a long time to come. Differences in Infrastructure and Traditional Practices 08 Handout 1 *Property of STI  [email protected] Page 11 of 15  BM1917 Pressures for local responsiveness arise from differences in infrastructure or traditional practices among countries, creating a need to customize products accordingly. Fulfilling this need may require the delegation of manufacturing and production functions to foreign subsidiaries. EXAMPLE: In North America, consumer electrical systems are based on 110 volts, whereas in some European countries, 240-volt systems are standard. Thus, domestic electric appliances have to be customized for this difference in infrastructure. Although many national differences in infrastructure are rooted in history, some are quite recent. For example, in the wireless telecommunications industry, different technical standards exist in different parts of the world. A technical standard known as the Global System for Mobile Communications (GSM) is common in Europe, and an alternative standard, Code Division Multiple Access (CDMA), is more common in the United States and parts of Asia. Equipment designed for GSM will not work on a CDMA network and vice versa. Thus, companies such as Nokia, Motorola, and Samsung, which manufacture wireless handsets and infrastructure such as switches, need to customize their product offering according to the technical standard prevailing in a given country. Differences in Distribution Channels A firm’s marketing strategies may have to be responsive to differences in distribution channels among countries, which may necessitate the delegation of marketing functions to national subsidiaries. In the pharmaceutical industry, for example, the British and Japanese distribution systems are radically different from the U.S. system. British and Japanese doctors will not accept or respond favorably to a U.S.-style high-pressure sales force. Thus, pharmaceutical companies have to adopt different marketing practices in Britain and Japan compared with the United States—soft-sell versus hard sell. Similarly, Poland, Brazil, and Russia all have similar per capita income on a purchasing power parity basis, but there are big differences in distribution systems across the three countries. In Brazil, supermarkets account for 36 percent of food retailing, in Poland for 18 percent, and in Russia for less than 1 percent. These differences in channels require that companies adapt their distribution and sales strategy. Host-Government Demands Economic and political demands imposed by host-country governments may require local responsiveness. For example, pharmaceutical companies are subject to local clinical testing, registration procedures, and pricing restrictions, all of which make it necessary that the manufacturing and marketing of a drug should meet local requirements. Because governments and government agencies control a significant proportion of the health care budget in most countries, they are in a powerful position to demand a high level of local responsiveness. More generally, threats of protectionism, economic nationalism, and local content rules (which require that a certain percentage of a product should be manufactured locally) dictate that international businesses manufacture locally. For example, consider Bombardier, the Canadian-based manufacturer of railcars, aircraft, jet boats, and snowmobiles. Bombardier has 12 railcar factories across Europe. Critics of the company argue that the resulting duplication of manufacturing facilities leads to high costs and helps explain why Bombardier makes lower profit margins on its railcar operations than on its other business lines. In reply, managers at Bombardier argue that in Europe, informal rules concerning local content favor people who use local workers. To sell railcars in Germany, they claim, you must manufacture in Germany. The same goes for Belgium, Austria, and France. To try to address its cost structure in Europe, Bombardier has centralized its engineering and purchasing functions, but it has no plans to centralize manufacturing. Choosing a Strategy Pressures for local responsiveness (e.g., due to customers’ needs and preferences) imply that it may not be possible for a firm to realize the full benefits from economies of scale, learning effects, and location economies. It may not be possible or even realistic to think that a firm can serve the global marketplace from a single, low- cost location, producing a globally standardized product and marketing it worldwide to attain the cost reductions associated with experience effects. The need to customize the product to local conditions may work against the implementation of such a strategy. EXAMPLE: Automobile firms have found that Japanese, American, and European consumers demand different kinds of cars, and this necessitates producing products that are customized for regional markets. In response, 08 Handout 1 *Property of STI  [email protected] Page 12 of 15  BM1917 firms such as General Motors, Honda, Ford, and Toyota are pursuing a strategy of establishing top-to-bottom design and production facilities in each of these important world regions to serve local demands better. Although such customization brings benefits, it also limits the ability of a firm to realize significant scale economies and location economies. Also, pressures for local responsiveness imply that it may not be possible to leverage skills and products associated with a firm’s core competencies fully from one nation to another. Concessions often have to be made to local conditions; it’s all about getting the sale. The trade-off between obtaining the sale or not by taking a standardized product and customizing it at least to some degree to the local customer needs is rooted in a cost/ benefit analysis and opportunity assessment. Despite being depicted as a “poster child” for the proliferation of standardized global products, even McDonald’s has found that it has to customize its product offerings (i.e., its menu) to account for national differences in tastes and preferences. As we can also see in several cases in this text, companies such as Domino’s, Subway, and other McDonald’s competitors also customize to local tastes and preferences. How do differences in the strength of pressures for cost reductions versus those for local responsiveness affect a firm’s choice of strategy? Firms typically choose among four main strategic postures when competing internationally. These can be characterized as a global standardization strategy, a localization strategy, a transnational strategy, and an international strategy. The appropriateness of each strategy varies given the extent of pressures for cost reductions and local responsiveness. Figure 6 illustrates the conditions under which each of these strategies is most appropriate. Figure 6. Four (4) basic strategies Source: International Business: Competing in the Global Marketplace (12 th ed.), 2017, p. 383. Global Standardization Strategy Firms that pursue a global standardization strategy focus on increasing profitability and profit growth by reaping the cost reductions that come from economies of scale, learning effects, and location economies. Their strategic goal is to pursue a low-cost strategy on a global scale. The production, marketing, R&D, and supply chain activities of firms pursuing a global standardization strategy are concentrated in a few favorable locations. Firms pursuing a global standardization strategy try not to customize their product offering and marketing strategy to local conditions because customization involves shorter production runs and the duplication of functions, which tend to raise costs. Instead, they prefer to market a standardized product worldwide so that they can reap the maximum benefits from economies of scale and learning effects. They also tend to use their cost advantage to support aggressive pricing in world markets. A global standardization strategy makes the most sense when there are strong pressures for cost reductions and demands for local responsiveness are minimal. Increasingly, these conditions prevail in many industrial 08 Handout 1 *Property of STI  [email protected] Page 13 of 15  BM1917 goods industries, whose products often serve universal needs. In the semiconductor industry, for example, global standards have emerged, creating enormous demands for standardized global products. Companies such as Intel, Texas Instruments, and Motorola all pursue a global standardization strategy. However, these conditions are not always found in many consumer goods markets, where demands for local responsiveness remain high. The strategy is inappropriate when demands for local responsiveness can remain high. Localization Strategy A localization strategy focuses on increasing profitability by customizing the firm’s goods or services so that they provide a good match to tastes and preferences in different national markets. Localization is most appropriate when there are substantial differences across nations concerning consumer tastes and preferences and where cost pressures are not too intense. By customizing the product offering to local demands, the firm increases the value of that product in the local market. On the downside, because it involves some duplication of functions and smaller production runs, customization limits the ability of the firm to capture the cost reductions associated with mass-producing a standardized product for global consumption. The strategy may make sense, however, if the added value associated with local customization supports higher pricing, which enables the firm to recoup its higher costs, or if it leads to substantially greater local demand, enabling the firm to reduce costs through the attainment of some scale economies in the local market. At the same time, firms still have to keep an eye on costs. Firms pursuing a localization strategy still need to be efficient and, whenever possible, to capture some scale economies from their global reach. As noted earlier, many automobile companies have found that they have to customize some of their product offerings to local market demands—for example, producing large pickup trucks for U.S. consumers and small, fuel-efficient cars for Europeans and Japanese. At the same time, these multinationals try to get some scale economies from their global volume by using common vehicle platforms and components across many different models and manufacturing those platforms and components at efficiently scaled factories that are optimally located. By designing their products in this way, these companies have been able to localize their product offering, yet simultaneously capture some scale economies, learning effects, and location economies. Transnational Strategy We have argued that a global standardization strategy makes the most sense when cost pressures are intense, and demands for local responsiveness are limited. Conversely, a localization strategy makes the most sense when demands for local responsiveness are high, but cost pressures are moderate or low. What happens, however, when the firm simultaneously faces both strong cost pressures and strong pressures for local responsiveness? How can managers balance the competing and inconsistent demands such divergent pressures place on the firm? According to some researchers, the answer is to pursue what has been called a transnational strategy. Two (2) of these researchers, Christopher Bartlett and Sumantra Ghoshal, argue that competitive conditions are so intense that to survive, firms must do all they can to respond to pressures for cost reductions and local responsiveness. They must try to realize location economies and experience effects, to leverage products internationally, to transfer core competencies and skills within the company, and to pay attention to pressures for local responsiveness simultaneously. Bartlett and Ghoshal note that in the modern multinational enterprise, core competencies and skills do not reside just in the home country, but can develop in any of the firm’s worldwide operations. Thus, they maintain that the flow of skills and product offerings should not be all one way, from home country to a foreign subsidiary. Rather, the flow should also be from foreign subsidiary to home country and from foreign subsidiary to foreign subsidiary. Transnational enterprises, in other words, must also focus on leveraging subsidiary skills. In essence, firms that pursue a transnational strategy are trying to achieve low costs through location economies simultaneously, economies of scale, and learning effects; differentiate their product offering across geographic markets to account for local differences, and foster a multidirectional flow of skills between different subsidiaries in the firm’s global network of operations. As attractive as this may sound in theory, the strategy is not an easy one to pursue since it places conflicting demands on the company. Differentiating the product to respond to local demands in different geographic markets raises costs, which runs counter to the goal of reducing costs. Companies such as 3M and ABB (one of the world’s largest engineering conglomerates) have tried to embrace a transnational strategy and found it difficult to implement. 08 Handout 1 *Property of STI  [email protected] Page 14 of 15  BM1917 How best to implement a transnational strategy is one of the most complex questions large multinationals are grappling with today. Few if any enterprises have perfected this strategic posture. But some clues as to the right approach can be derived from several companies. For example, consider the case of Caterpillar. The need to compete with lowcost competitors such as Komatsu of Japan forced Caterpillar to look for greater cost economies. However, variations in construction practices and government regulations across countries mean that Caterpillar also has to be responsive to local demands. Therefore, Caterpillar confronted significant pressures for cost reductions and local responsiveness. To deal with cost pressures, Caterpillar redesigned its products to use many identical components and invested in a few large-scale component manufacturing facilities, situated at favorable locations, to fill global demand and realize scale economies. At the same time, the company augments the centralized manufacturing of components with assembly plants in each of its major global markets. At these plants, Caterpillar adds local product features, tailoring the finished product to local needs. Thus, Caterpillar can realize many of the benefits of global manufacturing while reacting to pressures for local responsiveness by differentiating its product among national markets.45 Caterpillar doubled output per employee, significantly reducing its overall cost structure in the process. Meanwhile, Komatsu and Hitachi, which are still wedded to a Japan-centric global strategy, have seen their cost advantages evaporate and have been steadily losing market share to Caterpillar. Changing a firm’s strategic posture to build an organization capable of supporting a transnational strategy is a complex and challenging task. Some would say it is too complex because the strategy implementation problems of creating a viable organization structure and control systems to manage this strategy are immense. International Strategy Sometimes it is possible to identify multinational firms that find themselves in the fortunate position of being confronted with low-cost pressures and low pressures for local responsiveness. Many of these enterprises have pursued an international strategy, taking products first produced for their domestic market and selling them internationally with only minimal local customization. The distinguishing feature of many such firms is that they are selling a product that serves universal needs. Still, they do not face significant competitors, and thus unlike firms pursuing a global standardization strategy, they are not confronted with pressures to reduce their cost structure. Xerox found itself in this position after its invention and commercialization of the photocopier. Strong patents protected the technology underlying the photocopier, so for several years, Xerox did not face competitors—it had a monopoly. The product serves universal needs, and it was highly valued in most developed nations. Thus, Xerox was able to sell the same basic product the world over, charging a relatively high price for that product. Since Xerox did not face direct competitors, it did not have to deal with strong pressures to minimize its cost structure. Enterprises pursuing an international strategy have followed a similar developmental pattern as they expanded into foreign markets. They tend to centralize product development functions, such as R&D at home. However, they also tend to establish manufacturing and marketing functions in each major country or geographic region in which they do business. The resulting duplication can raise costs, but this is less of an issue if the firm does not face strong pressures for cost reductions. Although they may undertake some local customization of product offering and marketing strategy, this tends to be rather limited in scope. Ultimately, in most firms that pursue an international strategy, the head office retains fairly tight control over marketing and product strategy. Other firms that have pursued this strategy include Procter & Gamble and Microsoft. Historically, Procter & Gamble developed innovative new products in Cincinnati and then transferred them wholesale to local markets. Similarly, the bulk of Microsoft’s product development work occurs in Redmond, Washington, where the company is headquartered. Although some localization work is undertaken elsewhere, this is limited to producing foreign-language versions of popular Microsoft programs. REFERENCE Hill, C. W., & Hult, G. T. (2018). International business: Competing in the global marketplace (12th ed.). New York: McGraw-Hill Education. 08 Handout 1 *Property of STI  [email protected] Page 15 of 15