Foreign Market Entry Modes

Foreign Market Entry Modes


The decision of how to enter a foreign market can have a significant impact on the results. Expansion into foreign markets can be achieved via the following four mechanisms:

• Exporting
• Licensing
• Joint Venture
• Direct Investment

Exporting

Exporting is the marketing and direct sale of domestically-produced goods in another country. Exporting is a traditional and well-established method of reaching foreign markets. Since exporting does not require that the goods be produced in the target country, no investment in foreign production facilities is required. Most of the costs associated with exporting take the form of marketing expenses.
Exporting commonly requires coordination among four players:

• Exporter
• Importer
• Transport provider
• Government

Licensing

Licensing essentially permits a company in the target country to use the property of the licensor. Such property usually is intangible, such as trademarks, patents, and production techniques. The licensee pays a fee in exchange for the rights to use the intangible property and possibly for technical assistance.
Because little investment on the part of the licensor is required, licensing has the potential to provide a very large ROI. However, because the licensee produces and markets the product, potential returns from manufacturing and marketing activities may be lost.

Joint Venture

There are five common objectives in a joint venture: market entry, risk/reward sharing, technology sharing and joint product development, and conforming to government regulations. Other benefits include political connections and distribution channel access that may depend on relationships.
Such alliances often are favorable when:

• the partners' strategic goals converge while their competitive goals diverge;
• the partners' size, market power, and resources are small compared to the industry leaders; and
• partners' are able to learn from one another while limiting access to their own proprietary skills.

The key issues to consider in a joint venture are ownership, control, length of agreement, pricing, technology transfer, local firm capabilities and resources, and government intentions.
Potential problems include:

• conflict over asymmetric new investments
• mistrust over proprietary knowledge
• performance ambiguity - how to split the pie
• lack of parent firm support
• cultural clashes
• if, how, and when to terminate the relationship

Joint ventures have conflicting pressures to cooperate and compete:

• Strategic imperative: the partners want to maximize the advantage gained for the joint venture, but they also want to maximize their own competitive position.
• The joint venture attempts to develop shared resources, but each firm wants to develop and protect its own proprietary resources.
• The joint venture is controlled through negotiations and coordination processes, while each firm would like to have hierarchical control.

Foreign Direct Investment

Foreign direct investment (FDI) is the direct ownership of facilities in the target country. It involves the transfer of resources including capital, technology, and personnel. Direct foreign investment may be made through the acquisition of an existing entity or the establishment of a new enterprise.
Direct ownership provides a high degree of control in the operations and the ability to better know the consumers and competitive environment. However, it requires a high level of resources and a high degree of commitment.

The Case of EuroDisney

Different modes of entry may be more appropriate under different circumstances, and the mode of entry is an important factor in the success of the project. Walt Disney Co. faced the challenge of building a theme park in Europe. Disney's mode of entry in Japan had been licensing. However, the firm chose direct investment in its European theme park, owning 49% with the remaining 51% held publicly.
Besides the mode of entry, another important element in Disney's decision was exactly where in Europe to locate. There are many factors in the site selection decision, and a company carefully must define and evaluate the criteria for choosing a location. The problems with the EuroDisney project illustrate that even if a company has been successful in the past, as Disney had been with its California, Florida, and Tokyo theme parks, future success is not guaranteed, especially when moving into a different country and culture. The appropriate adjustments for national differences always should be made.

Comparision of Market Entry Options

The following table provides a summary of the possible modes of foreign market entry:

Comparison of Foreign Market Entry Modes

Mode	Conditions Favoring this Mode	Advantages	Disadvantages
Exporting	Limited sales potential in target country; little product adaptation required Distribution channels close to plants High target country production costs Liberal import policies High political risk	Minimizes risk and investment. Speed of entry Maximizes scale; uses existing facilities.	Trade barriers & tariffs add to costs. Transport costs Limits access to local information Company viewed as an outsider
Licensing	Import and investment barriers Legal protection possible in target environment. Low sales potential in target country. Large cultural distance Licensee lacks ability to become a competitor.	Minimizes risk and investment. Speed of entry Able to circumvent trade barriers High ROI	Lack of control over use of assets. Licensee may become competitor. Knowledge spillovers License period is limited
Joint Ventures	Import barriers Large cultural distance Assets cannot be fairly priced High sales potential Some political risk Government restrictions on foreign ownership Local company can provide skills, resources, distribution network, brand name, etc.	Overcomes ownership restrictions and cultural distance Combines resources of 2 companies. Potential for learning Viewed as insider Less investment required	Difficult to manage Dilution of control Greater risk than exporting a & licensing Knowledge spillovers Partner may become a competitor.
Direct Investment	Import barriers Small cultural distance Assets cannot be fairly priced High sales potential Low political risk	Greater knowledge of local market Can better apply specialized skills Minimizes knowledge spillover Can be viewed as an insider	Higher risk than other modes Requires more resources and commitment May be difficult to manage the local resources.

Recommended Reading
Foley, James F., The Global Entrepreneur: Taking Your Business International  ---- http://www.quickmba.com ----

Read more »

Porter's Diamond of National Advantage

Porter's Diamond of National Advantage

Classical theories of international trade propose that comparative advantage resides in the factor endowments that a country may be fortunate enough to inherit. Factor endowments include land, natural resources, labor, and the size of the local population.
Michael E. Porter argued that a nation can create new advanced factor endowments such as skilled labor, a strong technology and knowledge base, government support, and culture. Porter used a diamond shaped diagram as the basis of a framework to illustrate the determinants of national advantage. This diamond represents the national playing field that countries establish for their industries.

Porter's Diamond of National Advantage

		Firm Strategy, Structure, and Rivalry
Factor Conditions				Demand Conditions
		Related and Supporting Industries

The individual points on the diamond and the diamond as a whole affect four ingredients that lead to a national comparative advantage. These ingredients are:

1. the availability of resources and skills,
2. information that firms use to decide which opportunities to pursue with those resources and skills,
3. the goals of individuals in companies,
4. the pressure on companies to innovate and invest.

The points of the diamond are described as follows.


I.  Factor Conditions

• A country creates its own important factors such as skilled resources and technological base.
• The stock of factors at a given time is less important than the extent that they are upgraded and deployed.
• Local disadvantages in factors of production force innovation. Adverse conditions such as labor shortages or scarce raw materials force firms to develop new methods, and this innovation often leads to a national comparative advantage.

II.  Demand Conditions

• When the market for a particular product is larger locally than in foreign markets, the local firms devote more attention to that product than do foreign firms, leading to a competitive advantage when the local firms begin exporting the product.
  
• A more demanding local market leads to national advantage.
  
• A strong, trend-setting local market helps local firms anticipate global trends.
  

III.  Related and Supporting Industries

• When local supporting industries are competitive, firms enjoy more cost effective and innovative inputs.
  
• This effect is strengthened when the suppliers themselves are strong global competitors.
  

IV.  Firm Strategy, Structure, and Rivalry

• Local conditions affect firm strategy. For example, German companies tend to be hierarchical. Italian companies tend to be smaller and are run more like extended families. Such strategy and structure helps to determine in which types of industries a nation's firms will excel.
  
• In Porter's Five Forces model, low rivalry made an industry attractive. While at a single point in time a firm prefers less rivalry, over the long run more local rivalry is better since it puts pressure on firms to innovate and improve. In fact, high local rivalry results in less global rivalry.
  
• Local rivalry forces firms to move beyond basic advantages that the home country may enjoy, such as low factor costs.
  

The Diamond as a System

• The effect of one point depends on the others. For example, factor disadvantages will not lead firms to innovate unless there is sufficient rivalry.
• The diamond also is a self-reinforcing system. For example, a high level of rivalry often leads to the formation of unique specialized factors.

Government's Role The role of government in the model is to:

• Encourage companies to raise their performance, for example by enforcing strict product standards.
  
• Stimulate early demand for advanced products.
  
• Focus on specialized factor creation.
  
• Stimulate local rivalry by limiting direct cooperation and enforcing antitrust regulations.
  

Application to the Japanese Fax Machine Industry The Japanese facsimile industry illustrates the diamond of national advantage. Japanese firms achieved dominance is this industry for the following reasons:

• Japanese factor conditions: Japan has a relatively high number of electrical engineers per capita.
• Japanese demand conditions: The Japanese market was very demanding because of the written language.
• Large number of related and supporting industries with good technology, for example, good miniaturized components since there is less space in Japan.
• Domestic rivalry in the Japanese fax machine industry pushed innovation and resulted in rapid cost reductions.
• Government support - NTT (the state-owned telecom company) changed its cumbersome approval requirements for each installation to a more general type approval.

Recommended Reading
Porter, Michael E., The Competitive Advantage of Nations
In this 800+ page work, Michael Porter introduces his diamond of national advantage and its self-reinforcing nature. He then applies the diamond to examples in both manufacturing and service industries, and uses the value chain to explain the growing role of services. The book concludes with implications on company strategy and national agendas.

Read more »

Global Strategic Management

Global Strategic Management

During the last half of the twentieth century, many barriers to international trade fell and a wave of firms began pursuing global strategies to gain a competitive advantage. However, some industries benefit more from globalization than do others, and some nations have a comparative advantage over other nations in certain industries. To create a successful global strategy, managers first must understand the nature of global industries and the dynamics of global competition.

Sources of Competitive Advantage from a Global Strategy

A well-designed global strategy can help a firm to gain a competitive advantage. This advantage can arise from the following sources:

• Efficiency
• Economies of scale from access to more customers and markets
• Exploit another country's resources - labor, raw materials
• Extend the product life cycle - older products can be sold in lesser developed countries
• Operational flexibility - shift production as costs, exchange rates, etc. change over time

• Strategic
• First mover advantage and only provider of a product to a market
• Cross subsidization between countries
• Transfer price

• Risk
• Diversify macroeconomic risks (business cycles not perfectly correlated among countries)
• Diversify operational risks (labor problems, earthquakes, wars)

• Learning
• Broaden learning opportunities due to diversity of operating environments

• Reputation
• Crossover customers between markets - reputation and brand identification

Sumantra Ghoshal of INSEAD proposed a framework comprising three categories of strategic objectives and three sources of advantage that can be used to achieve them. Assembling these into a matrix results in the following framework:

Strategic Objectives	Sources of Competitive Advantage
	National Differences	Scale Economies	Scope Economies
Efficiency in Operations	Exploit factor cost differences	Scale in each activity	Sharing investments and costs
Flexibility	Market or policy-induced changes	Balancing scale with strategic & operational risks	Portfolio diversification
Innovation and Learning	Societal differences in management and organization	Experience - cost reduction and innovation	Shared learning across activities

The Nature of Competitive Advantage in Global Industries

A global industry can be defined as:

• An industry in which firms must compete in all world markets of that product in order to survive.
• An industry in which a firm's competitive advantage depends on economies of scale and economies of scope gained across markets.

Some industries are more suited for globalization than are others. The following drivers determine an industry's globalization potential.

1. Cost Drivers
• Location of strategic resources
• Differences in country costs
• Potential for economies of scale (production, R&D, etc.) Flat experience curves in an industry inhibits globalization. One reason that the facsimile industry had more global potential than the furniture industry is that for fax machines, the production costs drop 30%-40% with each doubling of volume; the curve is much flatter for the furniture industry and many service industries. Industries for which the larger expenses are in R&D, such as the aircraft industry, exhibit more economies of scale than those industries for which the larger expenses are rent and labor, such as the dry cleaning industry. Industries in which costs drop by at least 20% for each doubling of volume tend to be good candidates for globalization.
• Transportation costs (value/bulk or value/weight ratio) => Diamonds and semiconductors are more global than ice.
2. Customer Drivers
• Common customer needs favor globalization. For example, the facsimile industry's customers have more homogeneous needs than those of the furniture industry, whose needs are defined by local tastes, culture, etc.
• Global customers: if a firm's customers are other global businesses, globalization may be required to reach these customers in all their markets. Furthermore, global customers often require globally standardized products.
• Global channels require a globally coordinated marketing program. Strong established local distribution channels inhibits globalization.
• Transferable marketing: whether marketing elements such as brand names and advertising require little local adaptation. World brands with non-dictionary names may be developed in order to benefit from a single global advertising campaign.
3. Competitive Drivers
• Global competitors: The existence of many global competitors indicates that an industry is ripe for globalization. Global competitors will have a cost advantage over local competitors.
• When competitors begin leveraging their global positions through cross-subsidization, an industry is ripe for globalization.
4. Government Drivers
• Trade policies
• Technical standards
• Regulations

The furniture industry is an example of an industry that did not lend itself to globalization before the 1960's. Because furniture has a high bulk compared to its value, and because furniture is easily damaged in shipping, transport costs traditionally were high. Government trade barriers also were unfavorable. The Swedish furniture company IKEA pioneered a move towards globalization in the furniture industry. IKEA's furniture was unassembled and therefore could be shipped more economically. IKEA also lowered costs by involving the customer in the value chain; the customer carried the furniture home and assembled it himself. IKEA also had a frugal culture that gave it cost advantages. IKEA successfully expanded in Europe since customers in different countries were willing to purchase similar designs. However, after successfully expanding to several countries, IKEA ran into difficulties in the U.S. market for several reasons:

• Different tastes in furniture and a requirement for more customized furniture.
• Difficult to transfer IKEA's frugal culture to the U.S.
• The Swedish Krona increased in value, increasing the cost of furniture made in Sweden and sold in the U.S.
• Stock-outs due to the one to two month shipping time from Europe
• More competition in the U.S. than in Europe

Country Comparative Advantages

Competitive advantage is a firm's ability to transform inputs into goods and services at a maximum profit on a sustained basis, better than competitors. Comparative advantage resides in the factor endowments and created endowments of particular regions. Factor endowments include land, natural resources, labor, and the size of the local population.
In the 1920's, Swedish economists Eli Hecksher and Bertil Ohlin developed the factor-proportions theory, according to which a country enjoys a comparative advantage in those goods that make intensive use of factors that the country has in relative abundance.
Michael E. Porter argued that a nation can create its own endowments to gain a comparative advantage. Created endowments include skilled labor, the technology and knowledge base, government support, and culture. Porter's Diamond of National Advantage is a framework that illustrates the determinants of national advantage. This diamond represents the national playing field that countries establish for their industries.

Types of International Strategy: Multi-domestic vs. Global

Multi-domestic Strategy

• Product customized for each market
• Decentralized control - local decision making
• Effective when large differences exist between countries
• Advantages: product differentiation, local responsiveness, minimized political risk, minimized exchange rate risk

Global Strategy

• Product is the same in all countries.
• Centralized control - little decision-making authority on the local level
• Effective when differences between countries are small
• Advantages: cost, coordinated activities, faster product development

A fully multi-local value chain will have every function from R&D to distribution and service performed entirely at the local level in each country. At the other extreme, a fully global value chain will source each activity in a different country.
Philips is a good example of a company that followed a multidomestic strategy. This strategy resulted in:

• Innovation from local R&D
• Entrepreneurial spirit
• Products tailored to individual countries
• High quality due to backward integration

The multi-domestic strategy also presented Philips with many challenges:

• High costs due to tailored products and duplication across countries
• The innovation from the local R&D groups resulted in products that were R&D driven instead of market driven.
• Decentralized control meant that national buy-in was required before introducing a product - time to market was slow.

Matsushita is a good example of a company that followed a global strategy. This strategy resulted in:

• Strong global distribution network
• Company-wide mission statement that was followed closely
• Financial control
• More applied R&D
• Ability to get to market quickly and force standards since individual country buy-in was not necessary.

The global strategy presented Matsushita with the following challenges:

• Problem of strong yen
• Too much dependency on one product - the VCR
• Loss of non-Asian employees because of glass ceilings

A third strategy, which was appropriate to Whirlpool is one of mass customization, discussed below.

Global Cost Structure Analysis

In 1986, Whirlpool Corporation was considering expanding into Europe by acquiring Philips' Major Domestic Appliance Division. From the framework of customers, costs, competitors, and government, there were several pros and cons to this proposed strategy.
Pros

• Internal components of the appliances could be the same, offering economies of scale.
• The cost to customize the outer structure of the appliances was relatively low.
• The appliance industry was mature with low growth. The acquisition would offer an avenue to continue growing.

Cons

• Fragmented distribution network in Europe.
• Different consumer needs and preferences. For example, in Europe refrigerators tend to be smaller than in the U.S., have only one outside door, and have standard sizes so they can be built into the kitchen cabinet. In Japan, refrigerators tend to have several doors in order to keep different compartments at different temperatures and to isolate odors. Also, because houses are smaller in Japan, consumers desire quieter appliances.
• Whirlpool already was the dominant player in a fragmented industry.

Since Philip's had a relatively small market share in the European appliance market, one must analyze the cost structure to determine if the acquisition would offer Whirlpool a competitive advantage. With the acquisition, Whirlpool would be able to cut costs on raw materials, depreciation and maintenance, R&D, and general and administrative costs. These costs represented 53% of Whirlpool's cost structure. Compared to most other industries, this percentage of costs that could benefit from economies of scale is quite large. It would be reasonable to expect a 10% reduction in these costs, an amount that would decrease overall cost by 5.3%, doubling profits. Such potential justifies the risk of increasing the complexity of the organization.
Because of the different preferences of consumers in different markets, a purely global strategy with standard products was not appropriate. Whirlpool would have to adapt its products to local markets, but maintain some global integration in order to realize cost benefits. This strategy is known as "mass customization."
Whirlpool acquired Philips' Major Domestic Appliance Division, 47% in 1989 and the remainder in 1991. Initially, margins doubled as predicted. However, local competitors responded by better tailoring their products and cutting costs; Whirlpool's profits then began to decline. Whirlpool applied the same strategy to Asia, but GE was outperforming Whirlpool there by tailoring its products as part of its multi-domestic strategy.

Globalizing Service Businesses

Service industries tend to have a flat experience curve and lower economies of scale. However, some economy of scale may be gained through knowledge sharing, which enables the cost of developing the knowledge over a larger base. Also, in some industries such as professional services, capacity utilization can better be managed as the scope of operations increases. On the customer side, because a service firm's customers may themselves be operating internationally, global expansion may be a necessity. Knowledge gained in foreign markets can used to better service customers. Finally, being global also enhances a firm's reputation, which is critical in service businesses.
High quality service products often depend on the service firm's culture, and maintaining a consistent culture when expanding globally is a challenge.
A good example of a service firm that experienced global expansion challenges is the management consulting firm Bain & Company, Inc. In consulting, a firm's most important strategic asset is its reputation, so a consistent firm culture is very important. Bain faced the following challenges, which depend on the firm's strategy and which affect the ability to maintain a consistent culture:

• Coordinating across offices and sharing knowledge
• Whether to hire locals or international staff
• How to compensate

Modes of Foreign Market Entry

An important part of a global strategy is the method that the firm will use to enter the foreign market. There are four possible modes of foreign market entry:

• Exporting
• Licensing (includes franchising)
• Joint Venture
• Foreign Direct Investment

These options vary in their degree of speed, control, and risk, as well as the required level of investment and market knowledge. The entry mode selection can have a significant impact on the firm's foreign market success.

Issues in Emerging Economies

In emerging economies, capital markets are relatively inefficient. There is a lack of information, the cost of capital is high, and venture capital is virtually nonexistent. Because of the scarcity of high-quality educational institutions, the labor markets lack well trained people and companies often must fill the void. Because of lacking communications infrastructure, building a brand name is difficult but good brands are highly valued because of lower product quality of the alternatives. Relationships with government officials often are necessary to succeed, and contracts may not be well enforced by the legal system.
When a large government monopoly (e.g. a state-owned oil company) is privatized, there often is political pressure in the country against allowing the firm to be acquired by a foreign entity. Whereas a very large U.S. oil company may prefer acquisitions, because of the anti-foreign sentiment joint ventures often are more appropriate for outside companies interested in newly privatized emerging economy firms.

Knowledge Management in Global Firms

There is much value in transferring knowledge and best practices between parts of a global firm. However, many barriers prevent knowledge from being transferred:

• Barriers attributable to the knowledge source
• lack of motivation
• lack of credibility
• Barriers attributable to the knowledge itself - ambiguity and complexity
• Barriers attributable to the knowledge recipient
• lack of motivation (not invented here syndrome)
• lack of absorptive capacity - need prerequisite knowledge to advance to next level
• Barriers attributable to the recipient's existing process - process rigidity
• Barriers attributable to the recipient's external environment and constraints

Furthermore, even when the transfer is successful, there often is a temporary drop in performance before the improvements are seen. During this period, there is danger of losing faith in the new way of doing things.
To facilitate knowledge transfer a firm can:

• Implement processes to systematically identify valuable knowledge and best practices.
• Create incentives to motivate both the knowledge source and recipient.
• Develop absorptive capacity in the recipient - cumulative knowledge
• Develop strong technical and social networks between parts of the firm that can share knowledge.

Country Management

Country managers must have the following knowledge:

• Knowledge of strategic management
• Firm-specific knowledge
• Country-specific knowledge
• Knowledge of the global environment

Country organizations can assume the role of implementor, contributor, strategic leader, or black hole, depending on the combination of importance of the local market and local resources.

Strategic Importance of Local Market	Level of Local Resources & Capabilities
	Low	High
Low	Implementor	Contributor
High	Black Hole	Strategic Leader

The least favorable of these roles is the black hole, which is a subsidiary in a strategically important market that has few capabilities. A firm can find itself in this situation because of company traditions, ignorance of local conditions, unfavorable entry conditions, misreading the market, excessive reliance on expatriates, and poor external relations. To get out of a black hole a firm can form alliances, focus its investments, implement a local R&D organization, or when all else fails, exit the country.
Country managers assume different roles (The New Country Managers, John A. Quelch, Professor of Business Administration, Harvard Business School).

• International Structure: Country manager is a trader who implements policy.
• Multinational Structure: Country manager plays the role of a functional manager with profit and loss responsibilities.
• Transnational Structure: Country manager acts as a cabinet member (team player) since management control systems are standardized and decision-making power is shifted to the region manager. The country manager develops the lead market in his country and transfers the knowledge gained to other similar markets.
• Global Structure: Country manager acts as an ambassador and administrator. In a global firm there usually are business directors who oversee marketing and sales. The role of the country manager becomes one of a statesman. This person usually is a local with good government contacts.

Recommended Reading
Bartlett, Christopher A., and Sumantra Ghoshal, Managing Across Borders: The Transnational Solution
Ohmae, Kenichi, The Borderless World: Power and Strategy in the Interlinked Economy

Read more »

Core Competencies

Core Competencies

In their 1990 article entitled, The Core Competence of the Corporation, C.K. Prahalad and Gary Hamel coined the term core competencies, or the collective learning and coordination skills behind the firm's product lines. They made the case that core competencies are the source of competitive advantage and enable the firm to introduce an array of new products and services.
According to Prahalad and Hamel, core competencies lead to the development of core products. Core products are not directly sold to end users; rather, they are used to build a larger number of end-user products. For example, motors are a core product that can be used in wide array of end products. The business units of the corporation each tap into the relatively few core products to develop a larger number of end user products based on the core product technology. This flow from core competencies to end products is shown in the following diagram:

Core Competencies to End Products

End Products
1   2   3	4   5   6	7   8   9	10 11 12
Business 1	Business 2	Business 3	Business 4
	Core Product  1
	Core Product  2
Competence 1	Competence 2	Competence 3	Competence 4

The intersection of market opportunities with core competencies forms the basis for launching new businesses. By combining a set of core competencies in different ways and matching them to market opportunities, a corporation can launch a vast array of businesses.
Without core competencies, a large corporation is just a collection of discrete businesses. Core competencies serve as the glue that bonds the business units together into a coherent portfolio.

Developing Core Competencies

According to Prahalad and Hamel, core competencies arise from the integration of multiple technologies and the coordination of diverse production skills. Some examples include Philip's expertise in optical media and Sony's ability to miniaturize electronics.
There are three tests useful for identifying a core competence. A core competence should:

1. provide access to a wide variety of markets, and
2. contribute significantly to the end-product benefits, and
3. be difficult for competitors to imitate.

Core competencies tend to be rooted in the ability to integrate and coordinate various groups in the organization. While a company may be able to hire a team of brilliant scientists in a particular technology, in doing so it does not automatically gain a core competence in that technology. It is the effective coordination among all the groups involved in bringing a product to market that results in a core competence.
It is not necessarily an expensive undertaking to develop core competencies. The missing pieces of a core competency often can be acquired at a low cost through alliances and licensing agreements. In many cases an organizational design that facilitates sharing of competencies can result in much more effective utilization of those competencies for little or no additional cost.
To better understand how to develop core competencies, it is worthwhile to understand what they do not entail. According to Prahalad and Hamel, core competencies are not necessarily about:

• outspending rivals on R&D
• sharing costs among business units
• integrating vertically

While the building of core competencies may be facilitated by some of these actions, by themselves they are insufficient.

The Loss of Core Competencies

Cost-cutting moves sometimes destroy the ability to build core competencies. For example, decentralization makes it more difficult to build core competencies because autonomous groups rely on outsourcing of critical tasks, and this outsourcing prevents the firm from developing core competencies in those tasks since it no longer consolidates the know-how that is spread throughout the company.
Failure to recognize core competencies may lead to decisions that result in their loss. For example, in the 1970's many U.S. manufacturers divested themselves of their television manufacturing businesses, reasoning that the industry was mature and that high quality, low cost models were available from Far East manufacturers. In the process, they lost their core competence in video, and this loss resulted in a handicap in the newer digital television industry.
Similarly, Motorola divested itself of its semiconductor DRAM business at 256Kb level, and then was unable to enter the 1Mb market on its own. By recognizing its core competencies and understanding the time required to build them or regain them, a company can make better divestment decisions.

Core Products

Core competencies manifest themselves in core products that serve as a link between the competencies and end products. Core products enable value creation in the end products. Examples of firms and some of their core products include:

• 3M - substrates, coatings, and adhesives
• Black & Decker - small electric motors
  
• Canon - laser printer subsystems
• Matsushita - VCR subsystems, compressors
• NEC - semiconductors
• Honda - gasoline powered engines

The core products are used to launch a variety of end products. For example, Honda uses its engines in automobiles, motorcycles, lawn mowers, and portable generators.
Because firms may sell their core products to other firms that use them as the basis for end user products, traditional measures of brand market share are insufficient for evaluating the success of core competencies. Prahalad and Hamel suggest that core product share is the appropriate metric. While a company may have a low brand share, it may have high core product share and it is this share that is important from a core competency standpoint.
Once a firm has successful core products, it can expand the number of uses in order to gain a cost advantage via economies of scale and economies of scope.

Implications for Corporate Management

Prahalad and Hamel suggest that a corporation should be organized into a portfolio of core competencies rather than a portfolio of independent business units. Business unit managers tend to focus on getting immediate end-products to market rapidly and usually do not feel responsible for developing company-wide core competencies. Consequently, without the incentive and direction from corporate management to do otherwise, strategic business units are inclined to underinvest in the building of core competencies.
If a business unit does manage to develop its own core competencies over time, due to its autonomy it may not share them with other business units. As a solution to this problem, Prahalad and Hamel suggest that corporate managers should have the ability to allocate not only cash but also core competencies among business units. Business units that lose key employees for the sake of a corporate core competency should be recognized for their contribution.

Recommended Reading
Andrew Campbell and Kathleen Sommers Luchs, Core Competency-Based Strategy

Read more »

GE / McKinsey Matrix

GE / McKinsey Matrix

In consulting engagements with General Electric in the 1970's, McKinsey & Company developed a nine-cell portfolio matrix as a tool for screening GE's large portfolio of strategic business units (SBU). This business screen became known as the GE/McKinsey Matrix and is shown below:

GE / McKinsey Matrix

		Business Unit Strength
		High	Medium	Low
	High
	Medium
	Low

The GE / McKinsey matrix is similar to the BCG growth-share matrix in that it maps strategic business units on a grid of the industry and the SBU's position in the industry. The GE matrix however, attempts to improve upon the BCG matrix in the following two ways:

• The GE matrix generalizes the axes as "Industry Attractiveness" and "Business Unit Strength" whereas the BCG matrix uses the market growth rate as a proxy for industry attractiveness and relative market share as a proxy for the strength of the business unit.
• The GE matrix has nine cells vs. four cells in the BCG matrix.

Industry attractiveness and business unit strength are calculated by first identifying criteria for each, determining the value of each parameter in the criteria, and multiplying that value by a weighting factor. The result is a quantitative measure of industry attractiveness and the business unit's relative performance in that industry.

Industry Attractiveness

The vertical axis of the GE / McKinsey matrix is industry attractiveness, which is determined by factors such as the following:

• Market growth rate
• Market size
• Demand variability
• Industry profitability
• Industry rivalry
• Global opportunities
• Macroenvironmental factors (PEST)

Each factor is assigned a weighting that is appropriate for the industry. The industry attractiveness then is calculated as follows:

Industry attractiveness    =		factor value1   x   factor weighting1
	+	factor value2   x   factor weighting2
	. . .
	+	factor valueN   x   factor weightingN

Business Unit Strength

The horizontal axis of the GE / McKinsey matrix is the strength of the business unit. Some factors that can be used to determine business unit strength include:

• Market share
• Growth in market share
• Brand equity
• Distribution channel access
• Production capacity
• Profit margins relative to competitors

The business unit strength index can be calculated by multiplying the estimated value of each factor by the factor's weighting, as done for industry attractiveness.

Plotting the Information

Each business unit can be portrayed as a circle plotted on the matrix, with the information conveyed as follows:

• Market size is represented by the size of the circle.
• Market share is shown by using the circle as a pie chart.
• The expected future position of the circle is portrayed by means of an arrow.

The following is an example of such a representation:

The shading of the above circle indicates a 38% market share for the strategic business unit. The arrow in the upward left direction indicates that the business unit is projected to gain strength relative to competitors, and that the business unit is in an industry that is projected to become more attractive. The tip of the arrow indicates the future position of the center point of the circle.

Strategic Implications

Resource allocation recommendations can be made to grow, hold, or harvest a strategic business unit based on its position on the matrix as follows:

• Grow strong business units in attractive industries, average business units in attractive industries, and strong business units in average industries.
• Hold average businesses in average industries, strong businesses in weak industries, and weak business in attractive industies.
• Harvest weak business units in unattractive industries, average business units in unattractive industries, and weak business units in average industries.

There are strategy variations within these three groups. For example, within the harvest group the firm would be inclined to quickly divest itself of a weak business in an unattractive industry, whereas it might perform a phased harvest of an average business unit in the same industry.
While the GE business screen represents an improvement over the more simple BCG growth-share matrix, it still presents a somewhat limited view by not considering interactions among the business units and by neglecting to address the core competencies leading to value creation. Rather than serving as the primary tool for resource allocation, portfolio matrices are better suited to displaying a quick synopsis of the strategic business units.

Recommended Reading
David J. Collis, Andrew Campbell, Michael Goold, Harvard Business Review on Corporate Strategy (Harvard Business Review Paperback Series)

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BCG Growth-Share Matrix

BCG Growth-Share Matrix

Companies that are large enough to be organized into strategic business units face the challenge of allocating resources among those units. In the early 1970's the Boston Consulting Group developed a model for managing a portfolio of different business units (or major product lines). The BCG growth-share matrix displays the various business units on a graph of the market growth rate vs. market share relative to competitors:

      BCG Growth-Share Matrix

Resources are allocated to business units according to where they are situated on the grid as follows:

• Cash Cow - a business unit that has a large market share in a mature, slow growing industry. Cash cows require little investment and generate cash that can be used to invest in other business units.
• Star - a business unit that has a large market share in a fast growing industry. Stars may generate cash, but because the market is growing rapidly they require investment to maintain their lead. If successful, a star will become a cash cow when its industry matures.
• Question Mark (or Problem Child) - a business unit that has a small market share in a high growth market. These business units require resources to grow market share, but whether they will succeed and become stars is unknown.
• Dog - a business unit that has a small market share in a mature industry. A dog may not require substantial cash, but it ties up capital that could better be deployed elsewhere. Unless a dog has some other strategic purpose, it should be liquidated if there is little prospect for it to gain market share.

The BCG matrix provides a framework for allocating resources among different business units and allows one to compare many business units at a glance. However, the approach has received some negative criticism for the following reasons:

• The link between market share and profitability is questionable since increasing market share can be very expensive.
• The approach may overemphasize high growth, since it ignores the potential of declining markets.
• The model considers market growth rate to be a given. In practice the firm may be able to grow the market.
  

These issues are addressed by the GE / McKinsey Matrix, which considers market growth rate to be only one of many factors that make an industry attractive, and which considers relative market share to be only one of many factors describing the competitive strength of the business unit.

Recommended Reading
The Boston Consulting Group, Perspectives on Strategy
Perspectives on Strategy contains Bruce Henderson's original writings on the BCG growth-share matrix. Specific articles include:

• The Product Portfolio - introduces the growth-share matrix and its dynamics, including the success sequence and the disaster sequence.
• Cash Traps - explains why the majority of products are cash traps.
• The Star of the Portfolio - and why market share is so important.
• Anatomy of the Cash Cow - including the buying and selling of market share for cash cows.
• The Corporate Portfolio - discussing the advantages of diversified companies.
• Renaissance of the Portfolio - after the portfolio concept's falling out of favor, this article makes the case for its return.

The 75 articles in Perspectives on Strategy also include the pricing paradox, segment-of-one marketing^®, time-based competition, and other articles summarizing the insights of Bruce Henderson and other BCG members.

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Ansoff Matrix

Ansoff Matrix

To portray alternative corporate growth strategies, Igor Ansoff presented a matrix that focused on the firm's present and potential products and markets (customers). By considering ways to grow via existing products and new products, and in existing markets and new markets, there are four possible product-market combinations. Ansoff's matrix is shown below:

Ansoff Matrix

	Existing Products	New Products
Existing Markets	Market Penetration	Product Development
New Markets	Market Development	Diversification

Ansoff's matrix provides four different growth strategies:

• Market Penetration - the firm seeks to achieve growth with existing products in their current market segments, aiming to increase its market share.
• Market Development - the firm seeks growth by targeting its existing products to new market segments.
• Product Development - the firms develops new products targeted to its existing market segments.
• Diversification - the firm grows by diversifying into new businesses by developing new products for new markets.

Selecting a Product-Market Growth Strategy

The market penetration strategy is the least risky since it leverages many of the firm's existing resources and capabilities. In a growing market, simply maintaining market share will result in growth, and there may exist opportunities to increase market share if competitors reach capacity limits. However, market penetration has limits, and once the market approaches saturation another strategy must be pursued if the firm is to continue to grow.
Market development options include the pursuit of additional market segments or geographical regions. The development of new markets for the product may be a good strategy if the firm's core competencies are related more to the specific product than to its experience with a specific market segment. Because the firm is expanding into a new market, a market development strategy typically has more risk than a market penetration strategy.
A product development strategy may be appropriate if the firm's strengths are related to its specific customers rather than to the specific product itself. In this situation, it can leverage its strengths by developing a new product targeted to its existing customers. Similar to the case of new market development, new product development carries more risk than simply attempting to increase market share.
Diversification is the most risky of the four growth strategies since it requires both product and market development and may be outside the core competencies of the firm. In fact, this quadrant of the matrix has been referred to by some as the "suicide cell". However, diversification may be a reasonable choice if the high risk is compensated by the chance of a high rate of return. Other advantages of diversification include the potential to gain a foothold in an attractive industry and the reduction of overall business portfolio risk.

Recommended Reading
Harvard Business Review on Strategies for Growth  (Harvard Business Review Series)

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Horizontal Integration

Horizontal Integration

The acquisition of additional business activities at the same level of the value chain is referred to as horizontal integration. This form of expansion contrasts with vertical integration by which the firm expands into upstream or downstream activities. Horizontal growth can be achieved by internal expansion or by external expansion through mergers and acquisitions of firms offering similar products and services. A firm may diversify by growing horizontally into unrelated businesses.
Some examples of horizontal integration include:

• The Standard Oil Company's acquisition of 40 refineries.
• An automobile manufacturer's acquisition of a sport utility vehicle manufacturer.
• A media company's ownership of radio, television, newspapers, books, and magazines.

Advantages of Horizontal Integration

The following are some benefits sought by firms that horizontally integrate:

• Economies of scale - acheived by selling more of the same product, for example, by geographic expansion.
• Economies of scope - achieved by sharing resources common to different products. Commonly referred to as "synergies."
• Increased market power (over suppliers and downstream channel members)
• Reduction in the cost of international trade by operating factories in foreign markets.

Sometimes benefits can be gained through customer perceptions of linkages between products. For example, in some cases synergy can be achieved by using the same brand name to promote multiple products. However, such extensions can have drawbacks, as pointed out by Al Ries and Jack Trout in their marketing classic, Positioning.

Pitfalls of Horizontal Integration

Horizontal integration by acquisition of a competitor will increase a firm's market share. However, if the industry concentration increases significantly then anti-trust issues may arise.
Aside from legal issues, another concern is whether the anticipated economic gains will materialize. Before expanding the scope of the firm through horizontal integration, management should be sure that the imagined benefits are real. Many blunders have been made by firms that broadened their horizontal scope to achieve synergies that did not exist, for example, computer hardware manufacturers who entered the software business on the premise that there were synergies between hardware and software. However, a connection between two products does not necessarily imply realizable economies of scope.
Finally, even when the potential benefits of horizontal integration exist, they do not materialize spontaneously. There must be an explicit horizontal strategy in place. Such strategies generally do not arise from the bottom-up, but rather, must be formulated by corporate management.

Recommended Reading
Mark N. Clemente and David S. Greenspan, Winning at Mergers and Acquisitions : The Guide to Market Focused Planning and Integration

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Vertical Integration

Vertical Integration

The degree to which a firm owns its upstream suppliers and its downstream buyers is referred to as vertical integration. Because it can have a significant impact on a business unit's position in its industry with respect to cost, differentiation, and other strategic issues, the vertical scope of the firm is an important consideration in corporate strategy.
Expansion of activities downstream is referred to as forward integration, and expansion upstream is referred to as backward integration.
The concept of vertical integration can be visualized using the value chain. Consider a firm whose products are made via an assembly process. Such a firm may consider backward integrating into intermediate manufacturing or forward integrating into distribution, as illustrated below:

Example of Backward and Forward Integration

No Integration Raw Materials Intermediate Manufacturing Assembly Distribution End Customer

Backward Integration Raw Materials Intermediate Manufacturing Assembly Distribution End Customer

Forward Integration Raw Materials Intermediate Manufacturing Assembly Distribution End Customer

Two issues that should be considered when deciding whether to vertically integrate is cost and control. The cost aspect depends on the cost of market transactions between firms versus the cost of administering the same activities internally within a single firm. The second issue is the impact of asset control, which can impact barriers to entry and which can assure cooperation of key value-adding players.
The following benefits and drawbacks consider these issues.

Benefits of Vertical Integration

Vertical integration potentially offers the following advantages:

• Reduce transportation costs if common ownership results in closer geographic proximity.
• Improve supply chain coordination.
• Provide more opportunities to differentiate by means of increased control over inputs.
• Capture upstream or downstream profit margins.
• Increase entry barriers to potential competitors, for example, if the firm can gain sole access to a scarce resource.
• Gain access to downstream distribution channels that otherwise would be inaccessible.
• Facilitate investment in highly specialized assets in which upstream or downstream players may be reluctant to invest.
• Lead to expansion of core competencies.

Drawbacks of Vertical Integration

While some of the benefits of vertical integration can be quite attractive to the firm, the drawbacks may negate any potential gains. Vertical integration potentially has the following disadvantages:

• Capacity balancing issues. For example, the firm may need to build excess upstream capacity to ensure that its downstream operations have sufficient supply under all demand conditions.
• Potentially higher costs due to low efficiencies resulting from lack of supplier competition.
• Decreased flexibility due to previous upstream or downstream investments. (Note however, that flexibility to coordinate vertically-related activities may increase.)
• Decreased ability to increase product variety if significant in-house development is required.
• Developing new core competencies may compromise existing competencies.
• Increased bureaucratic costs.

Factors Favoring Vertical Integration

The following situational factors tend to favor vertical integration:

• Taxes and regulations on market transactions
• Obstacles to the formulation and monitoring of contracts.
• Strategic similarity between the vertically-related activities.
• Sufficiently large production quantities so that the firm can benefit from economies of scale.
• Reluctance of other firms to make investments specific to the transaction.

Factors Against Vertical Integration

The following situational factors tend to make vertical integration less attractive:

• The quantity required from a supplier is much less than the minimum efficient scale for producing the product.
• The product is a widely available commodity and its production cost decreases significantly as cumulative quantity increases.
• The core competencies between the activities are very different.
• The vertically adjacent activities are in very different types of industries. For example, manufacturing is very different from retailing.
• The addition of the new activity places the firm in competition with another player with which it needs to cooperate. The firm then may be viewed as a competitor rather than a partner

Alternatives to Vertical Integration

There are alternatives to vertical integration that may provide some of the same benefits with fewer drawbacks. The following are a few of these alternatives for relationships between vertically-related organizations:

• long-term explicit contracts
• franchise agreements
• joint ventures
• co-location of facilities
• implicit contracts (relying on firms' reputation)

Recommended Reading
Greaver, Maurice F., Strategic Outsourcing : A Structured Approach to Outsourcing Decisions and Initiatives

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