STRATEGIES FOR MARKET ENTRY: Fast Moving Consumer Goods Companies in Emerging Markets

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1 STRATEGIES FOR MARKET ENTRY: Fast Moving Consumer Goods Companies in Emerging Markets A a r h u s S c h o o l o f B u s i n e s s Mark Sorgenfrey Lasse Munch M.Sc. Strategy, Organisation and Leadership Academic advisor: Mai Skjøtt Linneberg

2 Abstract Multinational enterprises (MNEs) are increasing their presence in the lives of more and more consumers as companies seek to expand and promote their products to a still wider range of markets globally. As markets change and develop, so does the strategy used to enter them, and companies must be able to choose the correct way to enter markets in order to remain competitive. This thesis takes a look at how MNEs in the FMCG industry enters new markets, more specifically emerging markets. In order to gain an understanding of this we look at three specific markets, namely Russia, India and China. We attempt to answer if the way MNEs enter emerging markets is in keeping with what would be expected from the OLI framework (Dunning 2000) as well as the work done by Buckley and Casson (1998). Additionally we try to gain an understanding of why any discrepancies exist and whether they can be explained by the nature of emerging markets as well as the characteristics of the FMCG industry. An ability to adapt and tailor specific strategies to individual markets gains more importance, especially with regard to emerging markets, as the difficulties and obstacles presented when entering these markets often proves both new and unique. In many cases there are difficulties in underdeveloped markets, specifically concerning consumer spending power and brand awareness, as well as logistics and infrastructural inadequacies compared to western markets which serves to make the correct approach to entering emerging markets of high importance. The methods first employed when entering emerging markets are often unsuccessful and needs to be modified as market knowledge is gathered and opportunities present themselves. In the three markets analysed in the thesis to illustrate emerging markets, Carlsberg is used as an example of a company present on all three markets. Examples of entry strategies followed by Carlsberg in the three markets are analysed and the reasons for their success or failure as well as the lessons learned are discussed in relation to the individual markets. In importance, this thesis contributes to the understanding of how MNEs enter emerging markets as well as to which challenges they face. I

3 Contents 1 Introduction Problem statement Objectives and research method Selection of cases for analysis Market entry modes for FMCG firms Reasons for conducting foreign direct investment Internalization level and form of market entry Transaction cost theory The Resource Based View and internalization The Resource Based View and mergers and acquisitions The OLI framework Model of foreign market entry Fast moving consumer goods Choice of the supplier side of the FMCG industry Emerging markets Circumventing infrastructure problems in emerging markets Market analysis of the FMCG industry Threat of new entrants Rivalry among existing competitors Bargaining power of suppliers Bargaining power of buyers Threat of substitute products Carlsberg Breweries A/S Markets India Infrastructure Indian retail and the Indian consumer Five forces analysis of the Indian FMCG industry The Indian beer market Carlsberg India OLI framework Discussion China Special economic zones and growth II

4 Current state of the Chinese economy Rural-urban wage gap Infrastructure Chinese business culture and the importance of guanxi Chinese retail Chinese consumers Five forces analysis of the Chinese FMCG industry OLI framework Discussion for China Russia Market analysis for Russia The Russian beer market Carlsberg on the Russian market OLI framework Discussion and findings Conclusion Appendix Appendix 1 FMCG retail markets and supplier industries III

5 Figures and tables Table 3.1 Table 4.1 Table 11.1 Table 11.2 Table 11.3 GDP per capita and growth rate for emerging countries. Market entry modes Market segments in the Indian market Carlsberg India s facilities Chinese urban and rural per capita income (Chinese yuan) IV

6 1 Introduction This text is the final chapter of our education at the Aarhus School of Business, University of Aarhus. As M.Sc. students within strategy, organization and leadership, we have spent a considerable amount of time for the past two years learning about and working with the concept of strategy. The vast majority of this time has been focused on strategy regarding the choice of which product markets to be in as well as how to develop these markets not concerning which geographical markets would be worth while pursuing and how best to enter these markets. As we find the geographical aspect just as interesting as the product market aspect however, we decided to spend our final semester delving into the topic of market entry strategies. That market entry strategies should be the main topic of our thesis was not our first thought though as we discussed the first ideas for the thesis in the autumn of We settled relatively quickly on the idea of involving the major Danish brewer, Carlsberg, in the thesis however. Carlsberg had at that time only just completed the joint acquisition of Scottish & Newcastle together with Dutch rival Heineken in the biggest foreign acquisition by a Danish firm ever made. This deal reinforced Carlsberg s position among the leading global brewers and increased their activities in high growth foreign markets as well as their dependence on these. This made Carlsberg a highly interesting case for analysis in our perspective. Based on our desire to delve into the topic of market entry strategies as well as our interest in Carlsberg, the idea for the thesis thus became to evaluate the options available to Carlsberg and similar multinational enterprises when entering high growth foreign markets as well as the actual entry strategies pursued by Carlsberg in such markets. The thesis draws information and data from academic articles and books, corporate websites, and news reports as well as governmental and other publicly available statistics. Additionally, we attended Carlsberg s annual general meeting in Copenhagen in March of In importance, this thesis contributes to the understanding of the challenges faced by MNEs in emerging markets. Additionally, it adds to the knowledge on how MNEs enter emerging markets and on the conceivable reasons behind choosing the respective modes of entry in different emerging markets. This is relevant due to the increasing globalization of markets as especially western MNEs look to emerging markets for growth as they face stagnant growth in their core markets in the west. 1

7 2 Problem statement A great deal has been written about strategies for market entry and we will present some of the more important contributions in this thesis in order to offer the reader an overview of relevant theories. When it comes to entry strategies in emerging markets the amount of literature is limited however and is often confined to investigating single economies. This study will therefore contain a comprehensive analysis of a small number of emerging markets in order to offer a better indication of the challenges firms face when entering emerging markets in general. The objective of the thesis will be to make a contribution to the understanding of the challenges and problems associated with entering emerging markets, and why these strategies are implemented and carried out in the way they are. The main focus will be on the differences between what are to be expected based on theoretical approaches and what is actually observed. In order to shed light on this subject, the thesis will analyze three cases covering Carlsberg s strategy on the Russian, Chinese and Indian markets respectively. The main question which this thesis will seek to answer is the following: Can the choice of market entry strategies for FMCG producers in emerging markets be explained through the OLI framework (Dunning 2000)? Secondary question: If differences between actual and expected market entry strategies exist, how are these explained by the special characteristics of emerging markets and/or the FMCG industry? 3 Objectives and research method The primary objective of this thesis is thus to determine whether firms within the FMCG industry follow the theories on market entry in emerging markets. That is, can the market entries of FMCG firms in emerging markets be explained through the theories presented in this thesis; transaction cost theory (Coase 1937, Williamson 1975; 1985), the resource based view (Wernerfelt 1984, Peteraf 1993), the eclectic paradigm (Dunning 2000) as well as the model on foreign market entry developed by Buckley & Casson (1998). Providing this is not the case, the secondary objective of the thesis is to determine whether FMCG firms follow a different pattern in market entries compared to non-fmcg firms due to the characteristics of their particular industry or alternatively; 2

8 can the differences be explained based on the differences between established and emerging markets. In order to answer these questions, we have chosen to analyse a total of three cases of market entry by the Danish multinational FMCG firm, Carlsberg A/S. 3.1 Selection of cases for analysis When the numbers of emergent markets are so large and diverse the question becomes what markets are worth taking a closer look at in order to define the problems and challenges facing FMCG manufacturers and to test their adherence to the theories on market entry. In this thesis we have taken the approach of looking at the three largest emerging economies, namely Russia, China and India, who amongst them represents a significant percentage of the world population as well as the world market. We believe that these countries will provide an interesting view of emerging markets. In our view their size make them more interesting than smaller markets which has less influence on the world, since these three countries could very well be the engines that drive the economy of tomorrow. Additionally, the three markets shows themselves to be interesting in the context that they, despite their large size, shows significant differences in their market structure as well as the challenges entrants and domestic companies face. This means, that these markets will give a fairly representative picture of the numerous challenges faced by the companies operating in emerging markets. In addition to the above mentioned reasons for our case selection, we have further justification for our choices. Looking at the cases in a more scientific view, we consider the Russian, Chinese and Indian markets to be diverse cases with regard to wealth (Gerring 2007 p. 97), which is evident by the differences in GDP per capita in the three countries. As can be seen from table 3.1 below, the Russian GDP per capita was estimated at $15,800 in 2008, the Chinese $6,000 and the Indian $2,800 (CIA 2009). Russia is thus among the wealthiest third on FTSE s list of emerging countries (FTSE 2009) and given the market s size and Carlsberg heavy involvement in the country, it is as a result a logical case to include in our analysis. At the same time, Russia has shown considerable growth in recent years and is part of the upper third of the emerging countries in terms of growth. China is on the other hand part of the lowest third of emerging countries when it comes to GDP per capita. China is however likely to advance on the list in the coming years as it has the highest GDP growth rate of all the emerging countries, and has sustained this 3

9 growth rate for a number for years. For this reason, we consider it fair to use China as our median case, also because Turkey is the only market among the middle third where Carlsberg is active and we do not consider Turkey particularly interesting compared to China. This is primarily due to its more limited size, GDP growth and market potential compared to China. As stated, our final case is the Indian market. India is like Russia and China among the upper third of the emerging countries in terms of growth, but it is however also the one with the second lowest GDP per capita, only slightly superior to Pakistan. These facts combined with a population in excess of 1.1 billion people and a very low consumption of beer makes India an intriguing case for analysis. Table 3.1 GDP per capita and growth rate for emerging countries. Rank Country GDP per capita Country GDP growth rate 1 Taiwan $ China 9,8% 2 Czech Republic $ Peru 9,2% 3 South Korea $ Argentina 7,1% 4 Hungary $ Egypt 6,9% 5 Poland $ India 6,6% 6 Russia $ Indonesia 6,1% 7 Malaysia $ Russia 6,0% 8 Chile $ Morocco 5,9% 9 Mexico $ Pakistan 5,8% 10 Argentina $ Brazil 5,2% 11 Turkey $ Malaysia 5,1% 12 Brazil $ Poland 4,8% 13 South Africa $ Philippines 4,6% 14 Colombia $8.900 Chile 4,0% 15 Thailand $8.500 Czech Republic 3,9% 16 Peru $8.400 Thailand 3,6% 17 China $6.000 Colombia 3,5% 18 Egypt $5.400 South Africa 2,8% 19 Morocco $4.000 South Korea 2,5% 20 Indonesia $3.900 Taiwan 1,9% 21 Philippines $3.300 Turkey 1,5% 22 India $2.800 Mexico 1,4% 23 Pakistan $2.600 Hungary -1,5% Countries in italic type are Advanced Emerging Countries Source: CIA 2009 and 4

10 When using the diverse case selection method, the chosen cases should in combination be somewhat representative of the population due to the selection of high, low and median value cases. It is should therefore also be fair to say that diverse case selection is often more representative than other forms of case selection as it encompasses a greater range of variation (Gerring 2007 p. 101). This requires however, that GDP per capita values are fairly evenly distributed between high and low values. When this is the case, it should be representative of the population to pick one low, one median and one high. If the majority of the population had a low GDP per capita however, that is if there were more low than high cases, it would perhaps be more representative to add an additional low score case (Gerring 2007 p. 101). Since the GDP per capita values seems to be somewhat evenly distributed between the high and low values in the population of emerging countries, it should be fair to select one high, one median, and one low case. 5

11 Increasing control as well as commitment and investment 4 Market entry modes for FMCG firms Root (1994) and Buckley & Casson (1998) have identified 15 and 20 different modes of market entry respectively. These can however be categorized in the five main classes in table 4.1, which are ordered in accordance with increasing control of the entrant (Johnson 2007) and in general also with increasing commitment and investment. Table 4.1 Market entry modes Export Licensing and franchising Strategic alliance Joint venture Wholly owned subsidiary The perhaps simplest form of market entry is to export products from the domestic market to a company or individual in the foreign market who then sells the products on. In addition to being a simple form of market entry it does not require any particular investment either and it is highly flexible. On the other hand, the exporting firm has very limited (if any) control over functions such as marketing and distribution in the target market(s). Licensing and franchising agreements permit an incumbent to produce and sell the foreign firm s product(s) in the markets agreed upon. The agreement thus allows the incumbent to use the foreign firm s proprietary technology and/or knowledge. The incumbent then pays the foreign company compensation for the right to do so, which could for instance be through a fixed annual fee or as payment per unit sold. In licensing and franchising agreements, the vast majority of the necessary investment lies with the incumbent. In a strategic alliance a foreign and an incumbent firm agree to collaborate in the foreign market in order to reach specific goals while remaining independent organizations there are no equity investments. A strategic alliance is often aimed at attaining synergies through combined effort and can additionally involve knowledge and technology transfer as well as shared expense and risk. As opposed to joint ventures, which are described below, strategic alliances require limited upfront investment. In a joint venture, a foreign firm and an incumbent in a target market agree to share activities in the target market. This collaboration can for instance take place through a subsidiary owned equally by both parties. Such an agreement would in most cases involve a substantial investment from the foreign firm although not as much as an acquisition or green field venture. At the same time, a joint venture can benefit from knowledge and technology of both parties. A wholly owned subsidiary can either be obtained in a foreign market by acquiring an entire firm or part of a firm in the target market or it can be started as a green field venture; that is building production and/or distribution facilities from scratch in the target market. Since all costs associated with this sort of entry mode lies upon the entrant, this is naturally the one which requires the largest upfront investment. In case of a green field investment, the entrant cannot rely on an incumbent s knowledge on the foreign market. A major advantage to a wholly owned subsidiary is that the entrant will retain full control of the venture. 6

12 5 Reasons for conducting foreign direct investment In general, doing business in a company s domestic market, or in markets geographically and culturally close to this market, should be much simpler than expanding globally. If a company do wish to sell to distant foreign markets, it should likewise be simpler to export products rather than engage in FDI and setting up subsidiaries with production facilities abroad especially since this incurs costs of communicating the company s technology (Buckley et al 1998). However, businesses seem to increase their international focus year by year, which can be driven by a number of different reasons according to Robock and Simmonds (1989 p. 310). The following six points are focused on reasons for conducting foreign direct investment (FDI). The search for new markets. Expanding internationally through FDI will often be caused by companies seeking to increase turnover and, hopefully, profits by entering new markets. Entering new and distant markets is often not feasible through export due to factors such as logistical costs and import taxes as well as lack of knowledge on local consumer demands. The search for new resources. These resources 1 could be unskilled labour, agricultural products or natural resources such as minerals (Dunning, 2000 p. 164). FDI is in this case not necessarily conducted in order to reach new customers but instead aimed at servicing current customers (Hitt et al 2005 p. 468). Production-efficiency seeking. Where economies of scale are present, it makes sense to increase the customer base internationally and thus increase production volumes, as this will lead to lower average costs for products which will increase the company s competiveness (Ghoshal 1987 p. 434). This is especially the case when it is feasible to concentrate production at a few international locations, preferably where production and logistics costs are lowest, which can then supply nearby markets. Technology seeking. Larger firms often buy smaller firms in order to acquire new technologies, a common occurrence in the medical and biotech industries for instance. In this way the acquiring firm can take advantage of the often more entrepreneurial and innovative culture in smaller firms which often lead to development of superior 1 By a resource is meant anything which could be thought of as a strength or weakness of a given firm. Examples of resources are: brand names, in-house knowledge of technology, employment of skilled personnel, trade contacts, machinery, efficient procedures, capital, etc. (Wernerfelt, 1984 p. 172). 7

13 technologies. According to Ghoshal (1987), doing business in a global market may also in itself aid development of diverse capabilities as companies are subjected to a multitude of stimuli by operating in different environments. This should, ceteris paribus, provide multinationals with greater opportunities for organizational learning. The search for lower risk. Companies may seek to lower their risks by diversifying into additional markets through FDI and thus lowering their dependence on the business cycles of single markets (Hitt et al 2005 p. 468). For this reason, MNEs generally diversify their FDI investments geographically so as not to put all their eggs in one basket (Rugman 1979). Other risks which could be lowered by FDI are policy risks from unfavourable national legislation, competitive risks from lack of knowledge on competitor s actions and resource risks such as dependence on a single source of an important raw material for production (Ghoshal 1987 p. 430). Countering the competition. Companies can also engage in FDI as a reaction to competitor moves, for instance as part of a tit for tat strategy (Frank 2003 pp ). An example could be, that company X enters an important market of a competitor and the competitor could then choose to retaliate by entering one of company X s important markets making both parties worse off. This should then deter X from engaging in such actions again. 6 Internalization level and form of market entry As discussed in the previous section, a company wishing to sell their products abroad can either engage in FDI or choose to license the right to sell the products to a third party when they do not find it advantageous to export. The first question then becomes whether the company should produce and sell the product itself on the foreign market or if it should sell a license. Then, if the company estimates that FDI would be the best solution, then which form of FDI should be used? Some of the theoretical attempts to answer these questions will be covered in the following sections. 6.1 Transaction cost theory One of the theories, which seek to answer why transactions are handled within a firm instead of between independent parties in the market, is transaction cost theory. The theory was introduced by Ronald H. Coase in his 1937 paper The Nature of the Firm (Coase 1937). Though the theory is more than 70 years old, the concept of transaction 8

14 costs is still highly relevant today and is used within the field of industrial organization where Coase s theories have been elaborated on. To put it simply, transaction cost theory states that a company will grow if the internal transaction costs are lower than the external transactions costs. For this to make sense, it is necessary to define what is meant by transactions costs. Coase s 1937 paper mentions three overall types of costs related to external transactions: - Costs associated with information gathering when searching for prices on external offerings, e.g. components or services. - Costs related to negotiating contracts between the firm and external providers in order to specify terms and conditions. - Some taxes and quotas, which have been established by governments for transactions in the market, may not apply to transactions within firms. As mentioned, Coase and others have elaborated on Coase s original paper and have specified additional forms of transaction costs. First and foremost, even the most comprehensive contract cannot cover every possible contingency (Williamson, 1975; 1985). This means that after a contract has been settled on after a highly meticulous, and thus costly, negotiating process there will still be many issues that the parties can disagree on later on. A contract may be excellent when times are good and both parties are in a solid financial state but in times of economic difficulty, one or both parties may attempt to attain a bigger slice of the pie by reinterpreting the contract. Even if it was possible to make the perfect contract the amount of work involved with completing it would most likely entail that it would not be cost effective to do so. The fact that contracts must always be considered incomplete and thus unable to cover every eventuality means, among other things, that both parties to the agreement must monitor whether the other party is acting in accordance with it. Furthermore, if one or both parties fail to comply with the terms and conditions of the agreement, and thus behaves opportunistically, they may need litigation to settle the dispute. Both monitoring a contract and settling disagreements in court can bring about considerable costs. If the parties do not have a relationship built on trust, the uncertainty of future costs may make it impossible to ever get to an agreement at all and it will thus be necessary to internalize what would otherwise be done by the other party or find another, less suitable, supplier if at all possible. The fact that Williamson attributes 9

15 opportunistic behaviour solely to human nature has been criticised by Ghoshal and Moran (1996). However, the fact that humans and organizations have a tendency to behave opportunistically can hardly be disputed, especially in the current economic climate. As an example, the majority of larger Danish firms are currently renegotiating contracts with their suppliers in order to lower prices and achieve better terms (Bjerrum 2009). To summarise, transaction cost theory states that if internal transaction costs are lower than the above mentioned costs associated with transactions in the open market, then the transaction should be handled internally. This is however only valid if other factors do not change this recommendation for instance it the company prefers the often higher level of flexibility of using the market. While transaction cost theory is highly relevant when deciding between using the market and producing internally in a company, its focus is primarily on make or buy decisions within markets. However, when the question is whether a company should export to a foreign market or set up production there, a number of other factors need to be considered and decided on. A later segment in this thesis will cover J. H. Dunning s OLI framework (2000) which includes factors relevant to this decision. Before getting to this, the next segment will turn to the resource based view and its views on internalization. 6.2 The Resource Based View and internalization While transaction cost theory mainly focuses on external circumstances and the quantifiable, the resources based view is concerned with the firm s internal factors and the more intangible subject of resources, also called firm-specific factors. In some of the more classical writings on the resource based view, focus is mostly on the competitive advantage of firms and thus not specifically with theory on market entry (Wernerfelt 1984; Peteraf 1993). However, the resource based view offers some interesting insights with regard to the latter. For this reason, scholars have applied the resource based view on subjects like the timing of market entry in recent years (see for instance Geng et al 2005; Frawley et al 2006). This thesis will use some of the resource based view s insights on the choice between using the market and internalizing transactions; that is, as an alternative view to transaction cost theory which we have covered above. Moreover, transaction cost theory ignores the medium and long term strategic 10

16 considerations with regard to sustaining and expanding the firm s competitive advantage. This is on the other hand central to the resource based view as it explains the possession of competitive advantage from the control of superior resources. Additionally, it highlights the importance of building competitive advantage and suggests possible routes to this by acquiring new superior resources (Wernerfelt 1984). Transaction cost theory is on the other hand focused on short term considerations and profitability. According to Wernerfelt (1984), a firm can use the possession of one or a number of resources as a barrier, shielding its superior profits from entrants as well as from other incumbents as long as these behave rationally. This shield comes from the fact that new acquirers of a resource can be adversely affected, when it comes to costs and/or revenues, by the fact that another company is already in possession of a resource. Given this, the company already in possession of the resource thus has a competitive advantage and a potential for superior profits. Wernerfelt has termed this a resource position barrier as it is somewhat analogous to Porter s (1980) barriers to entry, although Porter s entry barriers in product markets only protects against possible entrants not against other incumbents. Having satisfied and loyal customers could be an example of a resource position barrier against entrants and incumbents, as it is a lot easier to maintain such a position than it is to attract otherwise loyal customers from a competitor. A resource position barrier can of course be based on a number of different resources besides having loyal customers. As mentioned above, the resource however needs to be able to offer a competitive advantage, which means that the following four requirements need to be met (Peteraf 1993): 1) There has to be heterogeneity in the resource bundles and capabilities underlying production among firms. With heterogeneity, superior resources exists which results in the potential of earning rents. 2) There has to be an imperfect market for the resource, as well as for substitutable resources, so that such resources cannot readily be acquired by other firms. That is, there has to be ex post limits to competition. Ex post limits to competition results in rents being preserved as they cannot be competed away in the short term. 11

17 3) Before the resource is acquired by the firm, there has to be limited competition for that resource, that is, there has to be ex ante limits to competition. This prevents the costs of acquiring the resource from offsetting the rents. 4) Finally, there has to be imperfect mobility in the market for the resource meaning that the resource has to be more valuable in the firm where it is currently in use than it would be elsewhere. Imperfect mobility is often caused by the fact that transferring the resource to another firm will incur costs. This ensures that the rents are sustained within the firm. A wide range of things can be considered a resource. Many of these are also able to comply with the above mentioned requirements for a resource to offer a potential competitive advantage. Besides the example of customer loyalty stated above, such examples include managerial skills, technological leads, and access to raw materials as well as production capacity and experience (Wernerfelt 1984 pp ). We will expand on some of these examples in later chapters of this thesis, including a few with relation to our chosen cases. All of this relates to market entry decisions because it is too short-sighted to only look at the short term optimization of transaction cost theory. When entering a new market and having to choose between the different modes of entry, it is important for the long term success and profitability of the firm to consider the impact on the firms future resource position. It may be that the alternative with the lowest cost is to license a firm in the target market to produce and distribute the product. This short-term optimization may however restrict the firm from developing new favourable resource positions thus decreasing the firm s competitive advantage later on. For instance, licensing instead of internalizing the activities in foreign markets could mean that the firm would not benefit from the organizational learning and innovation which can be achieved by being present in foreign markets as the organization is subjected to societal and managerial differences (Ghoshal 1987). This duality between optimizing in the short and the long term is also what Tallman is talking about in Hitt et al (2001 p ) when he discusses capability leverage and capability building strategies and the multinational firm The Resource Based View and mergers and acquisitions While not referring directly to market entries, Wernerfelt (1984 p. 175) offer some interesting thoughts on the subject of mergers and acquisitions, which are highly 12

18 relevant to market entry decisions. One of his points is for instance, that when a firm acquires another firm, it can be likened to buying a bundle of resources. The market for these bundles of resources is highly imperfect as there are few buyers and targets and a low degree of transparency due to the heterogeneity of firms. It can be extremely difficult to assess the value of a possible acquisition, especially since such an assessment must often be done discretely so as not to alert competitors or the organization of interest. At the same time, the value of an acquisition is dependent on the acquiring firm and whether synergies can be achieved or not (Wernerfelt 1984). Additionally, when a MNE plans to expand in current markets or enter new ones, the resource-based acquisition strategies are either to get more of the resources the firm already has or alternatively to get access to resources which complements the ones it already has (Wernerfelt 1984 p. 175). These reasons for acquisitions corresponds well with the resource seeking, technology seeking and production-efficiency seeking reasons to conduct FDI stated by Robock and Simmonds (1989 p. 310). 6.3 The OLI framework The OLI framework, or eclectic paradigm, has been developed by John H. Dunning and dates back to 1958 but it has been revised continuously through the years (Dunning, 2000 p. 168). OLI is an abbreviation for ownership, location and internalization, which are the three sub-paradigms in the framework. The OLI framework combines a number of theories such as transactions cost theory and the resource based view of the firm and in this way serves as an envelope for complementary theories of MNE activity (Dunning 2000 p. 183). The framework describes the three above mentioned factors which are relevant for companies engaged in international expansion. We will give further details about these sub-paradigms below. The ownership sub-paradigm is about the ownership of unique resources, skills or capabilities which can lead to a sustainable competitive advantage (Tallman in Hitt et al 2001). If a company is to expand from its home market into foreign markets successfully, it must of course have some advantage, something to offer, which is not available in the foreign markets already it must have a unique and sustainable competitive advantage (Dunning 2000 p. 164). This corresponds with the resource based view discussed in the previous segment. These advantages can of course take many forms but can in general be grouped into three segments (Dunning 2000 p. 168): 13

19 - Possessing and exploiting monopoly power. - Having scarce, unique and sustainable resources and capabilities, based on the superior technical efficiency of a particular firm relative to its competitors. - Having competent managers who are able to identify valuable resources and capabilities throughout the world and who are likewise able to exploit these resources and capabilities to the long term benefit of the firm in which they are employed. Firstly, companies in a monopoly position on a market are often able to use their position as a barrier to entry to potential competitors. This advantage could for instance consist of economies of scale for the monopolist. I could also be the presence of cost disadvantages for entrants independent of their size such as the possession of proprietary technology by the monopolist (Porter 1980 p. 37). The advantage could likewise be due to product differentiation by the monopolist, for instance when it comes to superior brand power. According to Porter, brewers generally use a combination of scale economics and superior brands to keep potential rivals out of their markets: To create high fences around their businesses, brewers couple brand identification with economies of scale in production, distribution and marketing (Porter 1980 p. 37). Possessing and exploiting monopoly power can thus be considered a competitive advantage since it gives the monopolist a cost advantage relative to its competitors and raises barriers to entry. Secondly, a company is generally able to earn superior profits if it possesses scarce, unique and sustainable resources and capabilities internally in the firm and are able to apply these in the marketplace (Tallman and Fladmoe-Lindquist 2002). This is central to the resource based view and is acknowledged by Dunning in the OLI framework. However, it should be beneficial for the firm to persistently develop new resources and capabilities, not just exploiting existing ones, in order to be competitive in the long term. That is, striking a balance between exploiting existing resources and developing new ones is important in order to achieve optimal growth (Wernerfelt 1984 p. 178). Tallman and Fladmoe-Lindquist (2002 p. 118) expresses this by stating that: the multinational firm will sustain its competitive advantage only if it can continue to develop new capabilities in the face of changing environments and evolving competition. But how does the possession of scarce, unique and sustainable resources 14

20 and capabilities result in superior profits? As mentioned previously in the segment on the resource based view, when a firm is in possession of a resource, this resource can in some cases act as a so-called resource position barrier (Wernerfelt, 1984). This means that new acquirers of the resource can be adversely affected, when it comes to costs and/or revenues, by the fact that another company is already in possession of this resource. Given this, the company already in possession of the resource thus has a competitive advantage and as a consequence superior profits. Finally, besides being in a monopoly position or having scarce, unique and sustainable resources and capabilities, a company wishing to expand internationally can also rely on competent managers to identify and exploit resources and capabilities internationally. According to Hamel and Prahalad (1994 p. 78), To get to the future first, top management must either see opportunities not seen by other top teams or must be able to exploit opportunities, by virtue of preemptive and consistent capability-building, that other companies can't. Research has also shown that top managers really do have significant influence on the performance of firms (Priem et al in Hitt et al 2005 p. 497). Managers are thus in itself a resource that companies can own and benefit from in international expansion and they can of course be considered unique since no two people are alike. However, skilled managers can hardly give a sustainable competitive advantage since they can be employed by another company and even by a competitor. Peteraf (1993 p. 187) exemplifies this by stating that a brilliant, Nobel prize winning scientist may be a unique resource, but unless he has firm-specific ties, his perfect mobility makes him an unlikely source of sustainable advantage. It is however not enough for a company to have a unique and sustainable competitive advantage for FDI to be attractive, it must also be preferable to invest directly in the foreign market instead of simply just exporting or employing the advantage solely in the home market. This is the subject of the next section. The location attractiveness sub-paradigm states that the foreign market must in some way favour local production to export from the company s home market or other markets where the company is present with production facilities. Many factors influence whether local production is preferable to exporting. Examples of these factors could be lower labour costs, more favourable legislation, high transportation costs, governmental trade barriers, superior production processes or consumers preferring products with a 15

21 local image (Hitt et al 2005 p. 472). The following will expand on the above mentioned factors. Low labour costs. In recent years, the transfer of jobs from high wage western countries to low wage regions such as Asia and Eastern Europe have attracted considerable attention as well as some anger and hostility from western workers. This has especially been the case when production is outsourced to low wage countries only for the products to be imported back to the home market. As mentioned above there are however other factors which influences the attractiveness of different locations. For instance, many less developed countries are more lenient than western nations when it comes to legislation on environmental protection as well as worker safety. This leniency can in some businesses lead to significant cost savings through outsourcing although the overall effect on profits is somewhat unsure given the potentially adverse effect on company reputation. Superior production processes. Low labour costs is however not the only reason why companies move production abroad. In some cases other countries or regions have capabilities which offer superior production processes compared to other locations. This could for instance be due to a workforce which is particularly skilled within a certain field such as it has been the case for Germany within engineering. Other examples could be superior skills within wind turbine development and manufacture in Denmark or within manufacture of electronics in South East Asia. Governmental trade barriers. Besides their influence on issues such as worker safety and environmental protection through legislation, governments also play their part in determining the attractiveness of different locations via governmental trade barriers. Among other things, governmental trade barriers include import tariffs, licenses and quotas as well as subsidies to local producers. In some countries it may not even be possible to sell imported goods as they require at least part of the final product to be of local origin, the so-called local content requirements (LCRs). LCRs are often used by governments in less developed countries in order to protect local intermediate product companies from foreign competition (Belderbos et al 2002). Ceteris paribus, when a country impose trade barriers on importers in one way or the other, it becomes more attractive to produce locally instead of exporting to this country thus raising the location attractiveness of the market. 16

22 Preference for local products. Another factor which can make it more attractive to produce in a given market is the fact that products with a local image are often favoured by consumers. Firms, industry organizations and even governments sometimes attempt to increase this form of loyalty by calling upon consumers to buy domestic products through campaigns, often in order to support the local economy. Besides the patriotic reason for preferring local products, when consumers have consumed a certain product for a long time perhaps their entire adult life it is often very difficult to convince them to switch to an alternative product. A good example of this is in fact the beer industry where consumers have often preferred to buy from the local brewery. In China for instance, there is generally a high level of patriotism when it comes to beer drinking (Heracleous 2001 p. 43). Combined with other factors, the preference for local beers have made it highly difficult for the majority of the global players in the beer industry to gain a foothold in China based on non-local brands (Heracleous 2001 p. 37). Another example could be the Danish market for fresh dairy products where there is a strong preference for Danish products among consumers with only limited competition from mostly German products which has been introduced in recent years. Due to the preference for products manufactured locally, it can often be beneficial for MNEs to acquire or join forces with local producers. In this way, the companies can combine their respective competences and in this way improve the competitiveness of both. An example of this could in this case be the strong local brands of the incumbents in conjunction with the superior manufacturing and marketing skills of the MNE. Transportation costs. Last but not least, transportation costs are a major factor when determining whether it is beneficial to produce locally as opposed to exporting to a given market. In a short term perspective, one should choose to export if the combined costs of producing the goods and transporting them to the foreign destination are lower than the costs of producing them locally. Otherwise it would be beneficial to set up production locally in some way. There are a number of different costs related to shipping products across large distances and these are not just related to the price of shipping a container from for instance Asia to Europe. These other costs include all sorts of handling costs, spoilage during 17

23 transport as well as inventory carrying costs 2 which also include carrying costs during the eight weeks of shipping from Asia to Europe. Besides these costs, exporters are also vulnerable to changing demands of consumers due to their long supply lines as demand may change before the products reach their target customers. These changes in demand can make it necessary to lower sales prices in order to sell products or can make it impossible to sell them altogether. Customer service can also suffer from long supply lines especially since companies try to minimize inventories as much as possible due to the above mentioned inventory carrying costs. With long supply lines, average inventory needs to be larger than with short supply lines due to the higher need for safety stock 3, if the inventory service level 4 is to be maintained. In case some part of the long supply line minimizes safety stock excessively, perhaps to avoid perishable products going beyond their sell by date, this is likely to lead to occasional stock outs here as well as further down the supply line. Products will thus periodically become unavailable to retailers and final consumers leading to lower perceived customer service and loss of sales. With other things equal, shorter supply lines can minimize the problem of stock outs considerably. Finally, some products are more or less perishable and have a sell by or freshness date. If the products have been transported from the other side of the planet, they have a relatively limited time left on the shelves near the final consumer when they eventually get there before they have to be discarded. An example of this could be beer as beer often has a sell by date or in some cases a freshness date, which indicates the date of production or the recommended final date of consumption. The amount of time between time of production and freshness/sell by date is mostly between four months for a standard lager and 12 months for stronger brews (The Beverage Testing Institute). This amount of time, the so-called shelf life, is however dependent on correct storage of the products. If the products are not stored correctly the actual shelf life will be lower as product quality will decrease at a faster pace in poor storage conditions. 2 Inventory carrying costs include the cost of money tied up in inventory, storage space, loss and obsolescence, handling, administration, insurance etc. (Waters 2003 p. 257). 3 Safety stock/inventory is a reserve inventory held in addition to the expected needs in order to add a margin of safety. (Waters 2003 p. 267). 4 The inventory service level is the probability that a demand is met directly from inventory thus avoiding backorders. Having safety stocks increases the service level (Waters 2003 p. 268). 18

24 Since shipping a container by container vessel from for instance Italy to China takes at least three weeks (Maersk Line 2009), and in most cases considerably longer, exporting beer across such distances limits the shelf life at retail stores considerably. This will not only decrease the average quality of the products sold to end consumers but will also increase the number of products which are not sold before the sell by date. Lower quality will first of all lead to lower customer satisfaction but also to more products which has to be discarded as they go beyond their sell by dates. All in all, shipping perishable products over long periods of time incurs considerable costs besides the cost of the transport fee itself. Finally, companies can also seek to attain strategic resources they are currently lacking by investing in foreign countries. In this case, investment in foreign countries is conducted in an attempt to enhance their knowledge and global competitiveness, not to use current advantages in new markets to earn higher returns (Chen & Chen 1998 p. 446). The presence of companies in possession of complementary competences in a given country or region can thus attract FDI as foreign companies seek to attain these competences (Dunning 2000 p. 178). The internalization sub-paradigm concerns whether entry into foreign markets is preferable through some sort of inter-firm non-equity agreement such as licensing, by engaging in FDI through investing in green field production facilities, or by purchasing a company in the target market (Dunning 2000 p. 164). As described in the section on transaction cost theory, this decision can be based on a somewhat simple assessment of whether an arm s length market transaction incurs the lowest cost or whether conducting the activity internally is the less costly alternative. That is whether activities in a foreign market should be handled internally or should be performed by a partner in the market. The cost of conducting transactions in the market is in most cases positively correlated with the imperfections of the market (Dunning 2000 p. 179) as this will often allow companies to charge higher prices. Examples of these imperfections could be information asymmetries between the parties to an exchange as well as common property resources, public goods and externalities (Lipsey in Dunning 1999 pp ). The former is in this case the most relevant, as information asymmetries has a highly significant influence on the costs of conducting transactions in the open market as described earlier on in this thesis in the section on transaction cost theory. Information 19