Global Business Assignment!

Homework is due by tomorrow, December 25th @ 8:00 pm New york time. It is one paper and answer to journal question (not exceeding 100 words for journal answer)

Based on reading of the Greenfield Venture or Acquisition Section on chapter 13 and 14 attached, on pages 434-438, your Assignment is to address the following in your paper

Checklist:

Discuss the pros of both options (acquisitions versus Greenfield ventures) for Zip-6
Discuss the cons of both options (acquisitions versus Greenfield ventures) for Zip-6
State your choice of options to pursue and your reasons for this choice.

This is the link to initial scenario:

http://extmedia.kaplan.edu/business/AB220_MT220_1203C/Unit_1/index.html

Respond in a minimum of one page in APA format to this Assignment.

Journal question

Perhaps the most significant import into the United States is oil! This Journal Activity asks you to examine the following government energy site:

Go to website of The U.S. Energy Information Administration, then go to the “Sources & Uses” at the top of the website, select “Petroleum”, then scroll down to the “Energy in brief articles” on the left hand bar and choose the article, “How dependent are we on foreign oil?”

After reading this information and the “Learn More” links at the bottom of the web article, journal your thoughts and impressions in 100 words.

Thanks,

Bakiliyam

After you have read this chapter you should be able to:

1 Explain the promises and risks associated with exporting.

2 Identify the steps managers can take to improve their firm’s export performance.
3 Identify information sources and government programs that exist to help exporters.
4 Recognize the basic steps involved in export financing.

5 Describe how countertrade can be used to facilitate exporting. LE
A

R
N

IN
G

O
B

J
E

C
T

IV
E

part 5 Competing in a Global Marketplace

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opening case

V ellus Products was founded in 1991 in Columbus, Ohio, by Sharon Doherty to sell shampoo for pets. Doherty’s original insight was that shampoos for people don’t work well on pets because the skin of most animals is more sensitive than that of humans and becomes
easily irritated. Because of her experience showing dogs, she knew that most existing pet
shampoo left dog hair unmanageable and lacking the glamour needed for a dog show. Working
with her nephew, who had a Ph.D. in chemistry, Doherty developed salon-type formulas specially
suited to dogs (shampoo for horses was added later).
Doherty booked Vellus’s first export sales in 1993 when a Taiwanese businessman, who had
bought the shampoo in the United States, ordered $25,000 worth of product, which he wanted
to sell at dog shows in Taiwan. Before long, Doherty was getting calls from people around the
world, most of whom heard about Vellus’s products in dog shows, and a thriving export busi-
ness was born.
As the volume of inquiries built up, Doherty realized she needed to gain a better under-
standing of foreign markets, export potential, and financing options, so she contacted the
U.S. Department of Commerce’s Commercial Service offices in Columbus. “As business has
grown, I have gone from ordering country profiles to requesting customized exporting
and financing strategies tailored to maximize export potential,” she says. Today Vellus
exports to 28 nations, although the bulk of the firm’s international business operates
through distributors in Sweden, Finland, Britain, France, Germany, Australia, New
Zealand, Canada, and Iceland, where the products are marketed at pet shows and
exhibitions. The company has registered its trademark in 15 European countries,
and international sales account for more than half the firm’s total. “I credit the
Commercial Service for helping me to expand my exports, as it would have
been much more difficult on my own,” Doherty says.

Vellus Products

Exporting, Importing,
and Countertrade

13 c h a p t e r

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444 Part Five Competing in a Global Marketplace

Reflecting on her international success, Doherty has some advice for others
who might want to go down the same road. First, she says, know whom you
are dealing with. Relationships are important to successful exporting. Doherty
says she gives advice and guidance to her distributors, sharing her knowledge
and helping them to be successful. Second, having being duped by a man who
falsely claimed he knew the pet market, she advocates doing background
checks on potential business partners. “Gather as much information as you
can,” she says. “Don’t make any assumptions; the wrong choice can cost your
business valuable time and money.” Third, Doherty believes it is important to
learn the local culture. Vellus products are adapted to best suit different groom-
ing techniques in different countries, something she believes has helped to
make the company more successful. Finally, Doherty says, enjoy the ride! “I
love exporting because it has enabled me to meet so many people from other
cultures. Exporting has made me more broad-minded, and I have developed a
great appreciation for other cultures and the way others live their lives.” •
Sources: U.S. Department of Commerce Web site, “Vellus Products Inc.,” www.export.gov, accessed March 16,
2010; C. K. Cultice, “Best in Show: Vellus Products,” World Trade , January 2007, pp. 70–73; and C. K. Cultice,
“Lathering up World Markets,” Business America , July 1997, p. 33.

Introduction
In the previous chapter, we reviewed exporting from a strategic perspective. We consid-
ered exporting as just one of a range of strategic options for profiting from international
expansion. This chapter is more concerned with the nuts and bolts of exporting (and
importing). Here we look at how to export. As the opening case makes clear, exporting is
not just for large enterprises; many small entrepreneurial firms such as Vellus Products
have benefited significantly from the money-making opportunities of exporting.

The volume of export activity in the world
economy has increased as exporting has become
easier. The gradual decline in trade barriers under
the umbrella of GATT and now the WTO (see
Chapter 6) along with regional economic agree-
ments such as the European Union and the North
American Free Trade Agreement (see Chapter 8)
have significantly increased export opportunities.
At the same time, modern communication and
transportation technologies have alleviated the lo-
gistical problems associated with exporting. Firms
are increasingly using the World Wide Web, toll-
free phone numbers, and international air express
services to reduce the costs of exporting. Conse-
quently, it is no longer unusual to find small com-
panies that are thriving as exporters.

Another Per spect i ve

Autarky: Not in the Vocabulary of Globalization!
The word autarky refers to the belief that a country should be
self-sufficient and avoid trade with other nations. Most econ-
omists regard autarky as an idealistic, but impractical, goal.
Throughout history, countries have tried to achieve autarky,
but soon discovered they could not produce the wide range
of goods their population wants and make those goods avail-
able at competitive prices. In fact, those countries found
themselves worse off economically than nations that engage
in international trade. Word to the wise: Unless your country
can efficiently produce everything it needs, it needs to trade.
(“Economics A-Z,” www.economist.com)

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Chapter Thirteen Exporting, Importing, and Countertrade 445

Nevertheless, exporting remains a challenge for many firms. Smaller enterprises
can find the process intimidating. The firm wishing to export must identify foreign
market opportunities, avoid a host of unanticipated problems that are often associated
with doing business in a foreign market, familiarize itself with the mechanics of export
and import financing, learn where to find financing and export credit insurance, and
learn how it should deal with foreign exchange risk. The process can be made more
problematic by currencies that are not freely convertible. Arranging payment for ex-
ports to countries with weak currencies can be a problem. This brings us to the topic
of countertrade, by which payment for exports is received in goods and services rather
than money. In this chapter, we will discuss all these issues with the exception of for-
eign exchange risk, which was covered in Chapter 10. We open the chapter by consid-
ering the promise and pitfalls of exporting.

The Promise and Pitfalls of Exporting
The great promise of exporting is that large revenue and profit opportunities are to be
found in foreign markets for most firms in most industries. This was true for the com-
pany profiled in the opening case. The international market is normally so much larger
than the firm’s domestic market that exporting is nearly always a way to increase the
company’s revenue and profit base. By expanding the size of the market, exporting can
enable a firm to achieve economies of scale, thereby lowering its unit costs. Firms that
do not export often lose out on significant opportunities for growth and cost reduction. 1
Studies have shown that while many large firms tend to be proactive about seeking
opportunities for profitable exporting, systematically scanning foreign markets to find
ways to leverage their technology, products, and marketing skills in foreign countries,
many medium-sized and small firms are very reactive. 2 Typically, such reactive firms do
not even consider exporting until their domestic market is saturated and the emergence
of excess productive capacity at home forces them to look for growth opportunities in
foreign markets. Also, many small and medium-sized firms tend to wait for the world to
come to them, rather than going out into the world to seek opportunities. Even when
the world does come to them, they may not respond. An example is MMO Music
Group, which makes sing-along tapes for karaoke machines. Foreign sales accounted
for about 15 percent of MMO’s revenues of $8 million, but the firm’s CEO admits that
this figure would probably have been much higher had he paid attention to building
international sales. Unanswered faxes and phone messages from Asia and Europe often
piled up while he was trying to manage the burgeoning domestic side of the business.
By the time MMO did turn its attention to foreign markets, other competitors had
stepped into the breach and MMO found it tough going to build export volume. 3
MMO’s experience is common, and it suggests a need for firms to become more
proactive about seeking export opportunities. One reason more firms are not proac-
tive is that they are unfamiliar with foreign market opportunities; they simply do not
know how big the opportunities actually are or where they might lie. Simple igno-
rance of the potential opportunities is a huge barrier to exporting. 4 Also, many would-
be exporters, particularly smaller firms, are often intimidated by the complexities and
mechanics of exporting to countries where business practices, language, culture, legal
systems, and currency are very different from the home market. 5 This combination of
unfamiliarity and intimidation probably explains why exporters still account for only a
tiny percentage of U.S. firms, less than 5 percent of firms with fewer than 500 employees,
according to the Small Business Administration. 6
To make matters worse, many neophyte exporters run into significant problems when
first trying to do business abroad, and this sours them on future exporting ventures.
Common pitfalls include poor market analysis, a poor understanding of competitive

LEARNING OBJECTIVE 1
Explain the promises and

risks associated with
exporting.

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446 Part Five Competing in a Global Marketplace

conditions in the foreign market, a failure to customize the product offering to the needs
of foreign customers, lack of an effective distribution program, a poorly executed pro-
motional campaign, and problems securing financing. 7 Novice exporters tend to under-
estimate the time and expertise needed to cultivate business in foreign countries. 8 Few
realize the amount of management resources that have to be dedicated to this activity.
Many foreign customers require face-to-face negotiations on their home turf. An ex-
porter may have to spend months learning about a country’s trade regulations, business
practices, and more before a deal can be closed. The accompanying Management Focus,
which documents the experience of FCX Systems in China, suggests that it may take
years before foreigners are comfortable enough to purchase in significant quantities.
Exporters often face voluminous paperwork, complex formalities, and many poten-
tial delays and errors. According to a UN report on trade and development, a typical
international trade transaction may involve 30 parties, 60 original documents, and

Management FOCUS

FCX Systems’ Success Story

Founded with the help of a $20,000 loan from the Small
Business Administration, FCX Systems is an exporting
success story. FCX makes power converters for the aero-
space industry. These devices convert common electric
utility frequencies into the higher frequencies used in air-
craft systems and are primarily used to provide power to
aircraft while they are on the ground. Today the West
Virginia enterprise generates over half of its $20 million in
annual sales from exports to more than 50 countries.
FCX’s prowess in opening foreign markets has earned the
company several awards for export excellence, including
a presidential award for achieving extraordinary growth in
export sales.
FCX initially got into exporting because it found that for-
eigners were often more receptive to the company’s prod-
ucts than potential American customers. According to Don
Gallion, president of FCX, “In the overseas market, they
were looking for a good technical product, preferably made
in the U.S., but they weren’t asking questions about ‘How
long have you been in business? Are you still going to be
here tomorrow?’ They were just anxious to get the product.”
In 1989, soon after FCX’s founding, the company signed
on with an international distribution company to help with
exporting, but Gallion became disillusioned with that com-
pany, and in 1994 FCX started to handle the exporting pro-
cess on its own. At the time, exports represented 12 percent
of sales, but by 1997 they had jumped to more than 50 percent
of the total, where they have stayed since.
In explaining the company’s export success, Gallion cites
a number of factors. One was the extensive assistance that
FCX has received over the years from a number of federal
and state agencies, including the U.S. Department of
Commerce and the Development Office of West Virginia.

These agencies demystified the process of exporting and
provided good contacts for FCX. Finding a good local repre-
sentative to help work through local regulations and cus-
toms is another critical factor, according to Gallion, who
says, “A good rep will keep you out of trouble when it comes
to customs and what you should and shouldn’t do.” Persis-
tence is also very important, says Gallion, particularly when
trying to break into markets where personal relationships
are crucial, such as China.
China has been an interesting story for FCX. Recently the
company has been booking $2 million to $3 million in sales
to China, but it took years to get to this point. China had
been on Gallion’s radar screen since the early 1990s, pri-
marily because of the country’s rapid modernization and
its plans to build or remodel some 179 airports between
1998 and 2008. This constituted a potentially large market
for FCX, particularly compared with the United States
where perhaps only three new airports would be built dur-
ing the same period. Despite the scale of the opportunity,
progress was very slow. The company had to identify
airports and airline projects, government agencies, cus-
tomers, and decision makers, as well as work through
different languages—and make friends. According to
Gallion, “Only after they consider you a friend will they buy
a product. They believe a friend would never cheat you.”
To make friends in China, Gallion estimates he had to make
more than 100 trips to China since the early 1990s, but now
that the network has been established, it is starting to pay
dividends.

Sources: J. Sparshott, “Businesses Must Export to Compete,” The
Washington Times, September 1, 2004, p. C8; “Entrepreneur of the Year
2001: Donald Gallion, FCX Systems,” The State Journal, June 18, 2001,
p. S10; and T. Pierro, “Exporting Powers Growth of FCX Systems,”
The State Journal, April 6, 1998, p. 1.

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Chapter Thirteen Exporting, Importing, and Countertrade 447

360 document copies, all of which have to be checked, transmitted, reentered into
various information systems, processed, and filed. The United Nations has calculated
that the time involved in preparing documentation, along with the costs of common
errors in paperwork, often amounts to 10 percent of the final value of goods exported. 9

Improving Export Performance
Inexperienced exporters have a number of ways to gain information about foreign mar-
ket opportunities and avoid common pitfalls that tend to discourage and frustrate novice
exporters. 10 In this section, we look at information sources for exporters to increase their
knowledge of foreign market opportunities, we consider the pros and cons of using ex-
port management companies (EMCs) to assist in the export process, and we review
various exporting strategies that can increase the probability of successful exporting. We
begin, however, with a look at how several nations try to help domestic firms export.

AN INTERNATIONAL COMPARISON One big impediment to exporting is
the simple lack of knowledge of the opportunities available. Often there are many mar-
kets for a firm’s product, but because they are in countries separated from the firm’s home
base by culture, language, distance, and time, the firm does not know of them. Identifying
export opportunities is made even more complex because more than 200 countries with
widely differing cultures compose the world of potential opportunities. Faced with such
complexity and diversity, firms sometimes hesitate to seek export opportunities.
The way to overcome ignorance is to collect information. In Germany, one of the
world’s most successful exporting nations, trade associations, government agencies, and
commercial banks gather information, helping small firms identify export opportuni-
ties. A similar function is provided by the Japanese Ministry of International Trade and
Industry (MITI), which is always on the lookout for export opportunities. In addition,
many Japanese firms are affiliated in some way with the sogo shosha, Japan’s great trad-
ing houses. The sogo shosha have offices all over the world, and they proactively, con-
tinuously seek export opportunities for their affiliated companies large and small. 11
German and Japanese firms can draw on the large reservoirs of experience, skills, in-
formation, and other resources of their respective export-oriented institutions. Unlike
their German and Japanese competitors, many U.S.
firms are relatively blind when they seek export
opportunities; they are information disadvantaged.
In part, this reflects historical differences. Both
Germany and Japan have long made their living as
trading nations, whereas until recently the United
States has been a relatively self-contained conti-
nental economy in which international trade played
a minor role. This is changing; both imports and
exports now play a greater role in the U.S. econ-
omy than they did 20 years ago. However, the
United States has not yet evolved an institutional
structure for promoting exports similar to that of
either Germany or Japan.

INFORMATION SOURCES Despite
institutional disadvantages, U.S. firms can
increase their awareness of export opportunities.
The most comprehensive source of information
is the U.S. Department of Commerce and its

LEARNING OBJECTIVE 2
Identify the steps managers

can take to improve their
firm’s export performance.

Another Per spect i ve

Product Safety: An Exporting Pitfall
Manufacturers in China have experienced a string of re-
calls from products they exported in recent years. Among
the unsafe items were toys containing lead paint; pet food
contaminated with melamine; packaged dumplings found
to have traces of insecticide; and high levels of toxic cad-
mium in children’s jewelry. The U.S. Consumer Products
Safety Commission and the Department of Housing and
Urban Development advised homeowners in several states
to replace certain types of Chinese-made drywall. Used
widely by contractors after hurricanes swept through the
South, the drywall has been linked to respiratory and elec-
trical problems because of unsafe levels of hydrogen
sulfide. (Javier C. Hernandez, “U.S. Urges Homeowners to
Remove Chinese Drywall,” The New York Times, April 2,
2010, www.nytimes.com)

LEARNING OBJECTIVE 3
Identify information sources

and government programs
that exist to help exporters.

Sogo Shosha
Japan’s great trading
houses.

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448 Part Five Competing in a Global Marketplace

One of the biggest challenges for U.S. businesses trying to go global is finding the right information. The U.S. government
provides assistance and links to other helpful sources on its www.export.gov Web site.

district offices all over the country (as noted in the opening case, Vellus Products
used these services and credits them with the company’s international successes).
Within that department are two organizations dedicated to providing businesses
with intelligence and assistance for attacking foreign markets: the International
Trade Administration and the United States and Foreign Commercial Service.
These agencies provide the potential exporter with a “best prospects” list, which
gives the names and addresses of potential distributors in foreign markets along with
businesses they are in, the products they handle, and their contact person. In addition,
the Department of Commerce has assembled a “comparison shopping service” for
14 countries that are major markets for U.S. exports. For a small fee, a firm can receive
a customized market research survey on a product of its choice. This survey provides
information on marketability, the competition, comparative prices, distribution chan-
nels, and names of potential sales representatives. Each study is conducted on-site by
an officer of the Department of Commerce.
The Department of Commerce also organizes trade events that help potential
exporters make foreign contacts and explore export opportunities. The department

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Chapter Thirteen Exporting, Importing, and Countertrade 449

organizes exhibitions at international trade fairs, which are held regularly in major cit-
ies worldwide. The department also has a matchmaker program, in which department
representatives accompany groups of U.S. businesspeople abroad to meet with quali-
fied agents, distributors, and customers.
Another government organization, the Small Business Administration (SBA), can help
potential exporters (see the accompanying Management Focus for examples of the SBA’s
work). The SBA employs 76 district international trade officers and 10 regional interna-
tional trade officers throughout the United States as well as a 10-person international
trade staff in Washington, D.C. Through its Service Corps of Retired Executives
(SCORE) program, the SBA also oversees some 850 volunteers with international trade
experience to provide one-on-one counseling to active and new-to-export businesses.

Management FOCUS

Exporting with a Little Government Help

Exporting can seem like a daunting prospect, but the reality
is that in the United States, as in many other countries,
many small enterprises have built profitable export busi-
nesses. For example, Landmark Systems of Virginia had
virtually no domestic sales before it entered the European
market. Landmark had developed a software program for
IBM mainframe computers and located an independent
distributor in Europe to represent its product. In the first
year, 80 percent of sales were attributed to exporting. In the
second year, sales jumped from $100,000 to $1.4 million—
with 70 percent attributable to exports. Landmark is not
alone; government data suggest that in the United States
by 2007, nearly 97 percent of the 240,000 firms that exported
were small or medium-sized businesses that employed
fewer than 500 people. Their share of total U.S. exports
grew steadily over the last decade and reached 29 percent
by the mid-2000s.
To help jump-start the exporting process, many small
companies have drawn on the expertise of government
agencies, financial institutions, and export management
companies. Consider the case of Novi, Inc., a California-
based business. Company President Michael Stoff tells
how he utilized the services of the U.S. Small Business
Administration (SBA) Office of International Trade to start
exporting: “When I began my business venture, Novi, Inc.,
I knew that my Tune-Tote (a stereo system for bicycles)
had the potential to be successful in international markets.
Although I had no prior experience in this area, I began
researching and collecting information on international
markets. I was willing to learn, and by targeting key
sources for information and guidance, I was able to pene-
trate international markets in a short period of time. One
vital source I used from the beginning was the SBA.

Through the SBA I was directed to a program that dealt
specifically with business development—the Service
Corps of Retired Executives (SCORE). I was assigned an
adviser who had run his own import/export business for
30 years. The services of SCORE are provided on a continual
basis and are free.
“As I began to pursue exporting, my first step was a thor-
ough marketing evaluation. I targeted trade shows with a
good presence of international buyers. I also went to DOC
(Department of Commerce) for counseling and information
about the rules and regulations of exporting. I advertised
my product in ‘Commercial News USA,’ distributed through
U.S. embassies to buyers worldwide. I utilized DOC’s World
Traders Data Reports to get background information on po-
tential foreign buyers. As a result, I received 60 to 70 inqui-
ries about Tune-Tote from around the world. Once I
completed my research and evaluation of potential buyers,
I decided which ones would be most suitable to market my
product internationally. Then I decided to grant exclusive
distributorship. In order to effectively communicate with my
international customers, I invested in a fax. I chose a U.S.
bank to handle international transactions. The bank also
provided guidance on methods of payment and how best to
receive and transmit money. This is essential know-how for
anyone wanting to be successful in foreign markets.”
In just one year of exporting, export sales at Novi topped
$1 million and increased 40 percent in the second year of
operations. Today, Novi, Inc., is a large distributor of wireless
intercom systems that exports to more than 10 countries.

Sources: Small Business Administration Office of International Trade,
“Guide to Exporting,” www.sba.gov/oit/info/Guide-ToExporting/index.html;
U.S. Department of Commerce, “A Profile of U.S. Exporting Companies,
2000–2001,” February 2003, report available at www.census.gov/foreign-
trade/aip/index.html#profile; and The 2007 National Exporting Strategy
(Washington, DC: U.S. International Trade Commission, 2007).

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450 Part Five Competing in a Global Marketplace

The SBA also coordinates the Export Legal Assistance Network (ELAN), a nationwide
group of international trade attorneys who provide free initial consultations to small busi-
nesses on export-related matters.
In addition to the Department of Commerce and SBA, nearly every state and many
large cities maintain active trade commissions whose purpose is to promote exports.
Most of these provide business counseling, information gathering, technical assistance,
and financing. Unfortunately, many have fallen victim to budget cuts or to turf battles
for political and financial support with other export agencies.
A number of private organizations are also beginning to provide more assistance
to would-be exporters. Commercial banks and major accounting firms are more
willing to assist small firms in starting export operations than they were a decade
ago. In addition, large multinationals that have been successful in the global arena
are typically willing to discuss opportunities overseas with the owners or managers
of small firms. 12

UTILIZING EXPORT MANAGEMENT COMPANIES One way for
first-time exporters to identify the opportunities associated with exporting and to
avoid many of the associated pitfalls is to hire an export management company
(EMC). EMCs are export specialists who act as the export marketing department or
international department for their client firms. EMCs normally accept two types
of export assignments. They start exporting operations for a firm with the under-
standing that the firm will take over operations after they are well established.
In another type, start-up services are performed with the understanding that the
EMC will have continuing responsibility for selling the firm’s products. Many
EMCs specialize in serving firms in particular industries and in particular areas of
the world. Thus, one EMC may specialize in selling agricultural products in the
Asian market, while another may focus on exporting electronics products to East-
ern Europe. MD International, for example, focuses on selling medical equipment
to Latin America.
In theory, the advantage of EMCs is that they are experienced specialists who can
help the neophyte exporter identify opportunities and avoid common pitfalls. A
good EMC will have a network of contacts in potential markets, have multilingual
employees, have a good knowledge of different business mores, and be fully conver-
sant with the ins and outs of the exporting process and with local business regula-
tions. However, the quality of EMCs varies. 13 While some perform their functions
very well, others appear to add little value to the exporting company. Therefore, an
exporter should review carefully a number of EMCs and check references. One
drawback of relying on EMCs is that the company can fail to develop its own
exporting capabilities.

EXPORT STRATEGY In addition to using EMCs, a firm can reduce the risks
associated with exporting if it is careful about its choice of export strategy. 14 A few
guidelines can help firms improve their odds of success. For example, one of the most
successful exporting firms in the world, the Minnesota Mining and Manufacturing
Co. (3M), has built its export success on three main principles—enter on a small scale
to reduce risks, add additional product lines once the exporting operations start to
become successful, and hire locals to promote the firm’s products (3M’s export strat-
egy is profiled in the accompanying Management Focus). Another successful ex-
porter, Red Spot Paint & Varnish, emphasizes the importance of cultivating personal
relationships when trying to build an export business (see the Management Focus at
the end of this section).

LEARNING OBJECTIVE 2
Identify the steps managers
can take to improve their
firm’s export performance.

Export
Management

Company
Export specialists who

act as the export
marketing department for

client firms.

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Chapter Thirteen Exporting, Importing, and Countertrade 451

The probability of exporting successfully can be increased dramatically by taking a
handful of simple strategic steps. First, particularly for the novice exporter, it helps to
hire an EMC or at least an experienced export consultant to help identify opportunities
and navigate the paperwork and regulations so often involved in exporting. Second, it
often makes sense to initially focus on one market or a handful of markets. Learn what
is required to succeed in those markets before moving on to other markets. The firm
that enters many markets at once runs the risk of spreading its limited management
resources too thin. The result of such a shotgun approach to exporting may be a failure
to become established in any one market. Third, as with 3M, it often makes sense to
enter a foreign market on a small scale to reduce the costs of any subsequent failure.
Most importantly, entering on a small scale provides the time and opportunity to learn
about the foreign country before making significant capital commitments to that mar-
ket. Fourth, the exporter needs to recognize the time and managerial commitment in-
volved in building export sales and should hire additional personnel to oversee this
activity. Fifth, in many countries, it is important to devote a lot of attention to building
strong and enduring relationships with local distributors and/or customers (see the
Management Focus on Red Spot Paint for an example). Sixth, as 3M often does, it is
important to hire local personnel to help the firm establish itself in a foreign market.
Local people are likely to have a much greater sense of how to do business in a given

Management FOCUS

Export Strategy at 3M

The Minnesota Mining and Manufacturing Co. (3M), which
makes more than 40,000 products including tape, sandpa-
per, medical products, and the ever-present Post-it Notes,
is one of the world’s great multinational operations. Today
over 60 percent of the firm’s revenues are generated out-
side the United States. Although the bulk of these revenues
came from foreign-based operations, 3M remains a major
exporter with over $2 billion in exports. The company often
uses its exports to establish an initial presence in a foreign
market, only building foreign production facilities once
sales volume rises to a level that justifies local production.
The export strategy is built around simple principles. One
is known as “FIDO,” which stands for First In (to a new
market) Defeats Others. The essence of FIDO is to gain an
advantage over other exporters by getting into a market
first and learning about that country and how to sell there
before others do. A second principle is “make a little, sell a
little,” which is the idea of entering on a small scale with a
very modest investment and pushing one basic product,
such as reflective sheeting for traffic signs in Russia or
scouring pads in Hungary. Once 3M believes it has learned
enough about the market to reduce the risk of failure to
reasonable levels, it adds additional products.
A third principle at 3M is to hire local employees to sell the
firm’s products. The company normally sets up a local sales
subsidiary to handle its export activities in a country. It then

staffs this subsidiary with local hires because it believes
they are likely to have a much better idea of how to sell
in their own country than American expatriates. Because of
the implementation of this principle, less than 200 of 3M’s
40,000-plus foreign employees are U.S. expatriates.
Another common practice at 3M is to formulate global
strategic plans for the export and eventual overseas pro-
duction of its products. Within the context of these plans,
3M gives local managers considerable autonomy to find
the best way to sell the product within their country. Thus,
when 3M first exported its Post-it Notes, it planned to
“sample the daylights” out of the product, but it also told
local managers to find the best way of doing this. Local
managers hired office cleaning crews to pass out samples
in Great Britain and Germany; in Italy, office products dis-
tributors were used to pass out free samples; while in
Malaysia, local managers employed young women to go
from office to office handing out samples of the product. In
typical 3M fashion, when the volume of Post-it Notes was
sufficient to justify it, exports from the United States were
replaced by local production. Thus, after several years 3M
found it worthwhile to set up production facilities in France
to produce Post-it Notes for the European market.

Sources: R. L. Rose, “Success Abroad,” The Wall Street Journal, March 29,
1991, p. A1; T. Eiben, “US Exporters Keep On Rolling,” Fortune, June 14, 1994,
pp. 128–31; 3M Company, A Century on Innovation, 3M, 2002; and 2005 10K
form archived at 3M’s Web site at www.mmm.com.

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452 Part Five Competing in a Global Marketplace

country than a manager from an exporting firm who has previously never set foot in
that country. Seventh, several studies have suggested the firm needs to be proactive
about seeking export opportunities. 15 Armchair exporting does not work! The world
will not normally beat a pathway to your door. Finally, it is important for the exporter
to retain the option of local production. Once exports reach a sufficient volume to
justify cost-efficient local production, the exporting firm should consider establishing
production facilities in the foreign market. Such localization helps foster good relations
with the foreign country and can lead to greater market acceptance. Exporting is often
not an end in itself, but merely a step on the road toward establishment of foreign
production (again, 3M provides an example of this philosophy).

Export and Import Financing
Mechanisms for financing exports and imports have evolved over the centuries in re-
sponse to a problem that can be particularly acute in international trade: the lack of trust
that exists when one must put faith in a stranger. In this section, we examine the financial
devices that have evolved to cope with this problem in the context of international

Management FOCUS

Red Spot Paint & Varnish

Established in 1903 and based in Evansville, Indiana, Red
Spot Paint & Varnish Company is in many ways typical of
the companies that can be found in the small towns of
America’s heartland. The closely held company, whose
CEO, Charles Storms, is the great-grandson of the founder,
has 500 employees and annual sales of close to $90 million.
The company’s main product is paint for plastic compo-
nents used in the automobile industry. Red Spot products
are seen on automobile bumpers, wheel covers, grilles,
headlights, instrument panels, door inserts, radio buttons,
and other components. Unlike many other companies of a
similar size and location, however, Red Spot has a thriving
international business. International sales (which include
exports and local production by licensees) now account for
between 15 percent and 25 percent of revenue in any one
year, and Red Spot does business in about 15 countries.
Red Spot has long had some international sales and once
won an export award. To further its international business,
Red Spot hired a Central Michigan University professor,
Bryan Williams. Williams, who was hired because of his
foreign-language skills (he speaks German, Japanese, and
some Chinese), was the first employee at Red Spot whose
exclusive focus was international marketing and sales. His
first challenge was the lack of staff skilled in the business
of exporting. He found that it was difficult to build an inter-
national business without in-house expertise in the basic
mechanics of exporting. According to Williams, Red Spot
needed people who understood the nuts and bolts of

exporting—letters of credit, payment terms, bills of lading,
and so on. As might be expected for a business based in
the heartland of America, no ready supply of such individu-
als was in the vicinity. It took Williams several years to
solve this problem. Now Red Spot has a full-time staff of
two who have been trained in the principles of exporting
and international operations.
A second problem that Williams encountered was the
clash between the quarter-to-quarter mentality that fre-
quently pervades management practice in the United
States and the long-term perspective that is often neces-
sary to build a successful international business. Williams
has found that building long-term personal relationships
with potential foreign customers is often the key to get-
ting business. When foreign customers visit Evansville,
Williams often invites them home for dinner. His young chil-
dren started calling one visitor from Hong Kong “Uncle.”
Even with such efforts, however, the business may not
come quickly. Meeting with potential foreign customers
yields no direct business 90 percent of the time, although
Williams points out that it often yields benefits in terms of
competitive information and relationship building. He has
found that perseverance pays. For example, Williams and
Storms called on a major German automobile parts manu-
facturer for seven years before finally landing some busi-
ness from the company.

Sources: R. L. Rose and C. Quintanilla, “More Small U.S. Firms Take Up
Exporting with Much Success,” The Wall Street Journal, December 20,
1996, p. A1, A10; and interview with Bryan Williams of Red Spot Paint.

LEARNING OBJECTIVE 4
Recognize the basic steps
involved in export financing.

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Chapter Thirteen Exporting, Importing, and Countertrade 453

trade: the letter of credit, the draft (or bill of exchange), and the bill of lading. Then we
will trace the 14 steps of a typical export–import transaction. 16

LACK OF TRUST Firms engaged in international trade have to trust someone
they may have never seen, who lives in a different country, who speaks a different lan-
guage, who abides by (or does not abide by) a different legal system, and who could be
very difficult to track down if he or she defaults on an obligation. Consider a U.S. firm
exporting to a distributor in France. The U.S. businessman might be concerned that if
he ships the products to France before he receives payment from the French business-
woman, she might take delivery of the products and not pay him. Conversely, the
French importer might worry that if she pays for the products before they are shipped,
the U.S. firm might keep the money and never ship the products or might ship defec-
tive products. Neither party to the exchange completely trusts the other. This lack of
trust is exacerbated by the distance between the two parties—in space, language, and
culture—and by the problems of using an underdeveloped international legal system
to enforce contractual obligations.
Due to the (quite reasonable) lack of trust between the two parties, each has his or
her own preferences as to how the transaction should be configured. To make sure
he is paid, the manager of the U.S. firm would prefer the French distributor to pay
for the products before he ships them (see Figure 13.1). Alternatively, to ensure she
receives the products, the French distributor would prefer not to pay for them until
they arrive (see Figure 13.2). Thus, each party has a different set of preferences.
Unless there is some way of establishing trust between the parties, the transaction
might never occur.

French importer American exporter

2 Importer pays after the goods are received

1 Exporter ships the goods 13.2 figure

Preference of the
French Importer

French importer American exporter

2 Exporter ships the goods after being paid

1 Importer pays for the goods 13.1 figure

Preference of the U.S.
Exporter

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454 Part Five Competing in a Global Marketplace

The problem is solved by using a third party trusted by both—normally a reputable
bank—to act as an intermediary. What happens can be summarized as follows (see
Figure 13.3). First, the French importer obtains the bank’s promise to pay on her be-
half, knowing the U.S. exporter will trust the bank. This promise is known as a letter
of credit. Having seen the letter of credit, the U.S. exporter now ships the products to
France. Title to the products is given to the bank in the form of a document called a
bill of lading. In return, the U.S. exporter tells the bank to pay for the products, which
the bank does. The document for requesting this payment is referred to as a draft. The
bank, having paid for the products, now passes the title on to the French importer,
whom the bank trusts. At that time or later, depending on their agreement, the im-
porter reimburses the bank. In the remainder of this section, we examine how this
system works in more detail.

LETTER OF CREDIT A letter of credit, abbreviated as L/C, stands at the
center of international commercial transactions. Issued by a bank at the request of
an importer, the letter of credit states that the bank will pay a specified sum of
money to a beneficiary, normally the exporter, on presentation of particular, speci-
fied documents.
Consider again the example of the U.S. exporter and the French importer. The
French importer applies to her local bank, say, the Bank of Paris, for the issuance
of a letter of credit. The Bank of Paris then undertakes a credit check of the im-
porter. If the Bank of Paris is satisfied with her creditworthiness, it will issue a letter
of credit. However, the Bank of Paris might require a cash deposit or some other
form of collateral from her. In addition, the Bank of Paris will charge the importer
a fee for this service. Typically this amounts to between 0.5 percent and 2 percent
of the value of the letter of credit, depending on the importer’s creditworthiness
and the size of the transaction. (As a rule, the larger the transaction, the lower the
percentage.)
Assume the Bank of Paris is satisfied with the French importer’s creditworthiness
and agrees to issue a letter of credit. The letter states that the Bank of Paris will pay
the U.S. exporter for the merchandise as long as it is shipped in accordance with spec-
ified instructions and conditions. At this point, the letter of credit becomes a financial
contract between the Bank of Paris and the U.S. exporter. The Bank of Paris then
sends the letter of credit to the U.S. exporter’s bank, say, the Bank of New York. The
Bank of New York tells the exporter that it has received a letter of credit and that he

3 exporter ships “to the bank,”
trusting bank‘s promise to pay

1 Importer obtains bank’s
promise to pay on
importer’s behalf

2 Bank promises exporter to
pay on behalf of importer

5 Bank gives merchandise
to importer

4 Bank pays
exporter

6 Importer
pays bank

BankFrenchimporter
American
exporter

figure 13.3

The Use of a Third Party

Letter of Credit
Issued by a bank,

indicating that the bank
will make payments

under specific
circumstances.

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Chapter Thirteen Exporting, Importing, and Countertrade 455

can ship the merchandise. After the exporter has shipped the merchandise, he draws a
draft against the Bank of Paris in accordance with the terms of the letter of credit, at-
taches the required documents, and presents the draft to his own bank, the Bank of
New York, for payment. The Bank of New York then forwards the letter of credit and
associated documents to the Bank of Paris. If all of the terms and conditions contained
in the letter of credit have been complied with, the Bank of Paris will honor the draft
and will send payment to the Bank of New York. When the Bank of New York receives
the funds, it will pay the U.S. exporter.
As for the Bank of Paris, once it has transferred the funds to the Bank of New York,
it will collect payment from the French importer. Alternatively, the Bank of Paris may
allow the importer some time to resell the merchandise before requiring payment.
This is not unusual, particularly when the importer is a distributor and not the final
consumer of the merchandise, since it helps the importer’s cash flow. The Bank of
Paris will treat such an extension of the payment period as a loan to the importer and
will charge an appropriate rate of interest.
The great advantage of this system is that both the French importer and the U.S.
exporter are likely to trust reputable banks, even if they do not trust each other.
Once the U.S. exporter has seen a letter of credit, he knows that he is guaranteed
payment and will ship the merchandise. Also, an exporter may find that having a
letter of credit will facilitate obtaining preexport financing. For example, having
seen the letter of credit, the Bank of New York might be willing to lend the ex-
porter funds to process and prepare the merchandise for shipping to France. This
loan may not have to be repaid until the exporter has received his payment for the
merchandise. As for the French importer, she does not have to pay for the merchan-
dise until the documents have arrived and unless all conditions stated in the letter
of credit have been satisfied. The drawback for the importer is the fee she must pay
the Bank of Paris for the letter of credit. In addition, since the letter of credit is a
financial liability against her, it may reduce her ability to borrow funds for other
purposes.

DRAFT A draft, sometimes referred to as a bill of exchange, is the instrument
normally used in international commerce to effect payment. A draft is simply an or-
der written by an exporter instructing an importer, or an importer’s agent, to pay a
specified amount of money at a specified time. In the example of the U.S. exporter
and the French importer, the exporter writes a draft that instructs the Bank of Paris,
the French importer’s agent, to pay for the merchandise shipped to France. The per-
son or business initiating the draft is known as the maker (in this case, the U.S. ex-
porter). The party to whom the draft is presented is known as the drawee (in this
case, the Bank of Paris).
International practice is to use drafts to settle trade transactions. This differs
from domestic practice in which a seller usually ships merchandise on an open ac-
count, followed by a commercial invoice that specifies the amount due and the
terms of payment. In domestic transactions, the buyer can often obtain possession
of the merchandise without signing a formal document acknowledging his or her
obligation to pay. In contrast, due to the lack of trust in international transactions,
payment or a formal promise to pay is required before the buyer can obtain the
merchandise.
Drafts fall into two categories, sight drafts and time drafts. A sight draft is payable
on presentation to the drawee. A time draft allows for a delay in payment—normally
30, 60, 90, or 120 days. It is presented to the drawee, who signifies acceptance of it by
writing or stamping a notice of acceptance on its face. Once accepted, the time draft
becomes a promise to pay by the accepting party. When a time draft is drawn on and

Bill of Exchange
An order written by an
exporter instructing an
importer, or an importer’s
agent, to pay a specified
amount of money at a
specified time; also
called a draft.

Draft
An order written by an
exporter instructing an
importer, or an importer’s
agent, to pay a specified
amount of money at a
specified time.

Sight Draft
A draft payable on
presentation to the
drawee.

Time Draft
A promise to pay by the
accepting party at some
future date.

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456 Part Five Competing in a Global Marketplace

accepted by a bank, it is called a banker’s acceptance. When it is drawn on and ac-
cepted by a business firm, it is called a trade acceptance.
Time drafts are negotiable instruments; that is, once the draft is stamped with an
acceptance, the maker can sell the draft to an investor at a discount from its face
value. Imagine the agreement between the U.S. exporter and the French importer
calls for the exporter to present the Bank of Paris (through the Bank of New York)
with a time draft requiring payment 120 days after presentation. The Bank of Paris
stamps the time draft with an acceptance. Imagine further that the draft is for
$100,000.
The exporter can either hold onto the accepted time draft and receive $100,000 in
120 days or he can sell it to an investor, say, the Bank of New York, for a discount from
the face value. If the prevailing discount rate is 7 percent, the exporter could receive
$97,700 by selling it immediately (7 percent per year discount rate for 120 days for
$100,000 equals $2,300, and $100,000 2 $2,300 5 $97,700). The Bank of New York
would then collect the full $100,000 from the Bank of Paris in 120 days. The exporter
might sell the accepted time draft immediately if he needed the funds to finance mer-
chandise in transit and/or to cover cash flow shortfalls.

BILL OF LADING The third key document for financing international trade is
the bill of lading. The bill of lading is issued to the exporter by the common carrier
transporting the merchandise. It serves three purposes: it is a receipt, a contract, and
a document of title. As a receipt, the bill of lading indicates that the carrier has re-
ceived the merchandise described on the face of the document. As a contract, it
specifies that the carrier is obligated to provide transportation service in return for a
certain charge. As a document of title, it can be used to obtain payment or a written
promise of payment before the merchandise is released to the importer. The bill of
lading can also function as collateral against which funds may be advanced to the
exporter by its local bank before or during shipment and before final payment by the
importer.

A TYPICAL INTERNATIONAL TRADE TRANSACTION Now that we
have reviewed the elements of an international trade transaction, let us see how the pro-
cess works in a typical case, sticking with the example of the U.S. exporter and the
French importer. The typical transaction involves 14 steps (see Figure 13.4).

1. The French importer places an order with the U.S. exporter and asks the
American if he would be willing to ship under a letter of credit.

2. The U.S. exporter agrees to ship under a letter of credit and specifies relevant
information such as prices and delivery terms.

3. The French importer applies to the Bank of Paris for a letter of credit to be
issued in favor of the U.S. exporter for the merchandise the importer wishes
to buy.

4. The Bank of Paris issues a letter of credit in the French importer’s favor and
sends it to the U.S. exporter’s bank, the Bank of New York.

5. The Bank of New York advises the exporter of the opening of a letter of credit in
his favor.

6. The U.S. exporter ships the goods to the French importer on a common carrier.
An official of the carrier gives the exporter a bill of lading.

7. The U.S. exporter presents a 90-day time draft drawn on the Bank of Paris in
accordance with its letter of credit and the bill of lading to the Bank of New
York. The exporter endorses the bill of lading so title to the goods is transferred
to the Bank of New York.

Bill of Lading
A document issued to the

exporter by the common
carrier transporting the

merchandise; it serves as
a receipt, a contract, and

a document of title.

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Chapter Thirteen Exporting, Importing, and Countertrade 457

8. The Bank of New York sends the draft and bill of lading to the Bank of Paris.
The Bank of Paris accepts the draft, taking possession of the documents and
promising to pay the now-accepted draft in 90 days.

9. The Bank of Paris returns the accepted draft to the Bank of New York.
10. The Bank of New York tells the U.S. exporter that it has received the accepted

bank draft, which is payable in 90 days.
11. The exporter sells the draft to the Bank of New York at a discount from its face

value and receives the discounted cash value of the draft in return.
12. The Bank of Paris notifies the French importer of the arrival of the documents.

She agrees to pay the Bank of Paris in 90 days. The Bank of Paris releases the
documents so the importer can take possession of the shipment.

13. In 90 days, the Bank of Paris receives the importer’s payment, so it has funds to
pay the maturing draft.

14. In 90 days, the holder of the matured acceptance (in this case, the Bank
of New York) presents it to the Bank of Paris for payment. The Bank of
Paris pays.

Export Assistance
Prospective U.S. exporters can draw on two forms of government-backed assistance to
help finance their export programs. They can get financing aid from the Export–
Import Bank and export credit insurance from the Foreign Credit Insurance Association
(similar programs are available in most countries).

American exporter French importer

2 Exporter agrees to fill order

12 Bank tells
importer
documents
arrive

Bank of New York Bank of Paris

6 Goods shipped to France

1 Importer orders goods

14 Bank of New York
presents matured
draft and gets payment

8 Bank of New York presents
draft and bill of lading to Bank of Paris

9 Bank of Paris returns accepted draft

4 Bank of Paris sends letter of credit to
Bank of New York

13 Importer
pays bank

3 Importer
arranges for
letter of
credit

5 Bank of
New York
informs
exporter of
letter of credit

10 and 11
Exporter sells
draft to bank

7 Exporter
presents draft
to bank

13.4 figure

A Typical International Trade Transaction

LEARNING OBJECTIVE 3
Identify information sources
and government programs
that exist to help exporters.

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458 Part Five Competing in a Global Marketplace

EXPORT–IMPORT BANK The Export–Import Bank, often referred to as
Ex–Im Bank, is an independent agency of the U.S. government. Its mission is to pro-
vide financing aid that will facilitate exports, imports, and the exchange of commodi-
ties between the United States and other countries. In 2010 its financing activities
were expanded from $4 billion to $6 billion following a push by the Obama adminis-
tration to try to create some 2 million new jobs through exports. Ex–Im Bank pursues
its mission with various loan and loan-guarantee programs. The agency guarantees
repayment of medium and long-term loans U.S. commercial banks make to foreign
borrowers for purchasing U.S. exports. The bank guarantee makes the commercial
banks more willing to lend cash to foreign enterprises.
Ex–Im Bank also has a direct lending operation under which it lends dollars to for-
eign borrowers for use in purchasing U.S. exports. In some cases, it grants loans that
commercial banks would not if it sees a potential benefit to the United States in doing
so. The foreign borrowers use the loans to pay U.S. suppliers and repay the loan to the
agency with interest.

EXPORT CREDIT INSURANCE For reasons outlined earlier, exporters
clearly prefer to get letters of credit from importers. However, sometimes an exporter
who insists on a letter of credit will lose an order to one who does not require a letter
of credit. Thus, when the importer is in a strong bargaining position and able to play
competing suppliers against each other, an exporter may have to forgo a letter of
credit. 17 The lack of a letter of credit exposes the exporter to the risk that the foreign
importer will default on payment. The exporter can insure against this possibility by
buying export credit insurance. If the customer defaults, the insurance firm will cover
a major portion of the loss.
In the United States, export credit insurance is provided by the Foreign Credit
Insurance Association (FCIA), an association of private commercial institutions oper-
ating under the guidance of the Export–Import Bank. The FCIA provides coverage
against commercial risks and political risks. Losses due to commercial risk result from

Export–Import
Bank

Agency of the U.S.
government whose

mission is to provide
aid in financing and

facilitate exports and
imports; also referred to

as the Ex–Im Bank.

The Export–Import Bank provides financing aid to companies, such as the example above, that require assistance with
imports, exports, and the exchange of commodities.

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Chapter Thirteen Exporting, Importing, and Countertrade 459

the buyer’s insolvency or payment default. Political losses arise from actions of
governments that are beyond the control of either buyer or seller.

Countertrade
Countertrade is an alternative means of structuring an international sale when con-
ventional means of payment are difficult, costly, or nonexistent. We first encountered
countertrade in Chapter 10 in our discussion of currency convertibility. A government
may restrict the convertibility of its currency to preserve its foreign exchange reserves
so they can be used to service international debt commitments and purchase crucial
imports. 18 This is problematic for exporters. Nonconvertibility implies that the ex-
porter may not be paid in his or her home currency; and few exporters would desire
payment in a currency that is not convertible. Countertrade is a common solu-
tion. 19 Countertrade denotes a whole range of barterlike agreements; its principle is
to trade goods and services for other goods and services when they cannot be traded
for money. Some examples of countertrade are:

• An Italian company that manufactures power-generating equipment, ABB SAE
Sadelmi SpA, was awarded a 720 million baht ($17.7 million) contract by the
Electricity Generating Authority of Thailand. The contract specified that the
company had to accept 218 million baht ($5.4 million) of Thai farm products as
part of the payment.

• Saudi Arabia agreed to buy 10 747 jets from Boeing with payment in crude oil,
discounted at 10 percent below posted world oil prices.

• General Electric won a contract for a $150 million electric generator project in
Romania by agreeing to market $150 million of Romanian products in markets to
which Romania did not have access.

• The Venezuelan government negotiated a contract with Caterpillar under which
Venezuela would trade 350,000 tons of iron ore for Caterpillar earthmoving
equipment.

• Albania offered such items as spring water, tomato juice, and chrome ore in
exchange for a $60 million fertilizer and methanol complex.

• Philip Morris ships cigarettes to Russia, for which it receives chemicals that
can be used to make fertilizer. Philip Morris ships the chemicals to China,
and in return, China ships glassware to North America for retail sale by Philip
Morris. 20

THE INCIDENCE OF COUNTERTRADE In the modern era, counter-
trade arose in the 1960s as a way for the Soviet Union and the Communist states of
Eastern Europe, whose currencies were generally nonconvertible, to purchase im-
ports. During the 1980s, the technique grew in popularity among many developing
nations that lacked the foreign exchange reserves required to purchase necessary
imports. Today, reflecting their own shortages of foreign exchange reserves, some
successor states to the former Soviet Union and the Eastern European Communist
nations periodically engage in countertrade to purchase their imports. Estimates of
the percentage of world trade covered by some sort of countertrade agreement
range from highs of 8 and 10 percent by value to lows of about 2 percent. 21 The
precise figure is unknown but it is probably at the low end of these estimates given
the increasing liquidity of international financial markets and wider currency con-
vertibility. However, a short-term spike in the volume of countertrade can follow
periodic financial crisis. For example, countertrade activity increased notably after

LEARNING OBJECTIVE 5
Describe how countertrade

can be used to facilitate
exporting.

Countertrade
The trade of goods or
services for other goods
or services.

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460 Part Five Competing in a Global Marketplace

the Asian financial crisis of 1997. That crisis left
many Asian nations with little hard currency to fi-
nance international trade. In the tight monetary
regime that followed the crisis in 1997, many
Asian firms found it very difficult to get access to
export credits to finance their own international
trade. Thus they turned to the only option avail-
able to them—countertrade.

Given that countertrade is a means of financing
international trade, albeit a relatively minor one,
prospective exporters may have to engage in this
technique from time to time to gain access to certain
international markets. The governments of develop-
ing nations sometimes insist on a certain amount of
countertrade. 22 For example, all foreign companies
contracted by Thai state agencies for work costing
more than 500 million baht ($12.3 million) are
required to accept at least 30 percent of their pay-
ment in Thai agricultural products. Between 1994

and mid-1998, foreign firms purchased 21 billion baht ($517 million) in Thai goods
under countertrade deals. 23

TYPES OF COUNTERTRADE With its roots in the simple trading of goods
and services for other goods and services, countertrade has evolved into a diverse set of
activities that can be categorized as five distinct types of trading arrangements: barter,
counterpurchase, offset, switch trading, and compensation or buyback. 24 Many coun-
tertrade deals involve not just one arrangement, but elements of two or more.

Barter Barter is the direct exchange of goods and/or services between two parties
without a cash transaction. Although barter is the simplest arrangement, it is not com-
mon. Its problems are twofold. First, if goods are not exchanged simultaneously, one
party ends up financing the other for a period. Second, firms engaged in barter run the
risk of having to accept goods they do not want, cannot use, or have difficulty reselling
at a reasonable price. For these reasons, barter is viewed as the most restrictive coun-
tertrade arrangement. It is primarily used for one-time-only deals in transactions with
trading partners who are not creditworthy or trustworthy.

Counterpurchase Counterpurchase is a reciprocal buying agreement. It occurs
when a firm agrees to purchase a certain amount of materials back from a country to
which a sale is made. Suppose a U.S. firm sells some products to China. China pays the
U.S. firm in dollars, but in exchange, the U.S. firm agrees to spend some of its pro-
ceeds from the sale on textiles produced by China. Thus, although China must draw
on its foreign exchange reserves to pay the U.S. firm, it knows it will receive some of
those dollars back because of the counterpurchase agreement. In one counterpurchase
agreement, Rolls-Royce sold jet parts to Finland. As part of the deal, Rolls-Royce
agreed to use some of the proceeds from the sale to purchase Finnish-manufactured
TV sets that it would then sell in Great Britain.

Offset An offset is similar to a counterpurchase insofar as one party agrees to pur-
chase goods and services with a specified percentage of the proceeds from the original
sale. The difference is that this party can fulfill the obligation with any firm in the

Another Per spect i ve

CARP Stimulates International Trade
Countertrade could soon be booming in Denmark as a
result of a recent $4 billion combat aircraft replacement
program initiated by the Danish government. Under the
terms of the program, Denmark intends to order 30 to
48 combat jets—a purchase that could prove to be a
windfall for many of the country’s defense contractors in
terms of subcontracts and partnership opportunities. For
example, U.S.-based Boeing Company, a leading con-
tender for the contract to build those jets, has already
expressed interest in fuel-cell products manufactured
by Danish defense contractor Falck Schmidt Defence
Systems (FSDS).
(Gerard O’Dwyer, “Looking for a Ride on F-35,” Defense
News.com, December 14, 2009, www.defensenews.com)

Barter
The direct exchange of
goods and/or services

between two parties
without a cash

transaction.

Counterpurchase
A reciprocal buying

agreement.

Offset
A buying agreement

similar to a
counterpurchase, but
the exporting country

can then fulfill the
agreement with any firm

in the country to which
the sale is being made.

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Chapter Thirteen Exporting, Importing, and Countertrade 461

country to which the sale is being made. From an exporter’s perspective, this is more
attractive than a straight counterpurchase agreement because it gives the exporter
greater flexibility to choose the goods that it wishes to purchase.

Switch Trading The term switch trading refers to the use of a specialized third-
party trading house in a countertrade arrangement. When a firm enters a counterpur-
chase or offset agreement with a country, it often ends up with what are called
counterpurchase credits, which can be used to purchase goods from that country.
Switch trading occurs when a third-party trading house buys the firm’s counterpur-
chase credits and sells them to another firm that can better use them. For example, a
U.S. firm concludes a counterpurchase agreement with Poland for which it receives
some number of counterpurchase credits for purchasing Polish goods. The U.S. firm
cannot use and does not want any Polish goods, however, so it sells the credits to a
third-party trading house at a discount. The trading house finds a firm that can use the
credits and sells them at a profit.
In one example of switch trading, Poland and Greece had a counterpurchase
agreement that called for Poland to buy the same U.S.-dollar value of goods from
Greece that it sold to Greece. However, Poland could not find enough Greek goods
that it required, so it ended up with a dollar-denominated counterpurchase balance
in Greece that it was unwilling to use. A switch trader bought the right to 250,000
counterpurchase dollars from Poland for $225,000 and sold them to a European
sultana (grape) merchant for $235,000, who used them to purchase sultanas from
Greece.

Compensation or Buybacks A buyback occurs when a firm builds a plant in
a country—or supplies technology, equipment, training, or other services to the
country—and agrees to take a certain percentage of the plant’s output as partial pay-
ment for the contract. For example, Occidental Petroleum negotiated a deal with
Russia under which Occidental would build several ammonia plants in Russia and as
partial payment receive ammonia over a 20-year period.

THE PROS AND CONS OF COUNTERTRADE Countertrade’s main
attraction is that it can give a firm a way to finance an export deal when other means
are not available. Given the problems that many developing nations have in raising
the foreign exchange necessary to pay for imports, countertrade may be the only
option available when doing business in these countries. Even when countertrade is
not the only option for structuring an export transaction, many countries prefer counter-
trade to cash deals. Thus, if a firm is unwilling to enter a countertrade agreement, it
may lose an export opportunity to a competitor that is willing to make a countertrade
agreement.
In addition, a countertrade agreement may be required by the government of a
country to which a firm is exporting goods or services. Boeing often has to agree to
counterpurchase agreements to capture orders for its commercial jet aircraft. For
example, in exchange for gaining an order from Air India, Boeing may be required
to purchase certain component parts, such as aircraft doors, from an Indian com-
pany. Taking this one step further, Boeing can use its willingness to enter into a
counterpurchase agreement as a way of winning orders in the face of intense com-
petition from its global rival, Airbus. Thus, countertrade can become a strategic
marketing weapon.
However, the drawbacks of countertrade agreements are substantial. Other things
being equal, firms would normally prefer to be paid in hard currency. Countertrade

Switch Trading
The use of a specialized
third-party trading house
in a countertrade
arrangement.

Buyback
When a firm builds a
plant in a country and
agrees to take a certain
percentage of the plant’s
output as partial payment
for the contract.

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462 Part Five Competing in a Global Marketplace

contracts may involve the exchange of unusable or poor-quality goods that the firm
cannot dispose of profitably. For example, a few years ago, one U.S. firm got burned
when 50 percent of the television sets it received in a countertrade agreement with
Hungary were defective and could not be sold. In addition, even if the goods it re-
ceives are of high quality, the firm still needs to dispose of them profitably. To do
this, countertrade requires the firm to invest in an in-house trading department ded-
icated to arranging and managing countertrade deals. This can be expensive and
time-consuming.
Given these drawbacks, countertrade is most attractive to large, diverse multina-
tional enterprises that can use their worldwide network of contacts to dispose of goods
acquired in countertrading. The masters of countertrade are Japan’s giant trading
firms, the sogo shosha, which use their vast networks of affiliated companies to profit-
ably dispose of goods acquired through countertrade agreements. The trading firm of
Mitsui & Company, for example, has about 120 affiliated companies in almost every
sector of the manufacturing and service industries. If one of Mitsui’s affiliates receives
goods in a countertrade agreement that it cannot consume, Mitsui & Company will
normally be able to find another affiliate that can profitably use them. Firms affiliated
with one of Japan’s sogo shosha often have a competitive advantage in countries where
countertrade agreements are preferred.
Western firms that are large, diverse, and have a global reach (e.g., General Elec-
tric, Philip Morris, and 3M) have similar profit advantages from countertrade
agreements. Indeed, 3M has established its own trading company—3M Global
Trading, Inc.—to develop and manage the company’s international countertrade
programs. Unless there is no alternative, small and medium-sized exporters should
probably try to avoid countertrade deals because they lack the worldwide network
of operations that may be required to profitably utilize or dispose of goods acquired
through them. 25

sogo shosha, p. 447
export management company, p. 450
letter of credit, p. 454
bill of exchange, p. 455
draft, p. 455

sight draft, p. 455
time draft, p. 455
bill of lading, p. 456
Export–Import Bank, p. 458
countertrade, p. 459

barter, p. 460
counterpurchase, p. 460
offset, p. 460
switch trading, p. 461
buyback, p. 461

Key Terms

Summary
In this chapter, we examined the steps that firms
must take to establish themselves as exporters. The
chapter made the following points:

1. One big impediment to exporting is ignorance
of foreign market opportunities.

2. Neophyte exporters often become discouraged
or frustrated with the exporting process

because they encounter many problems, delays,
and pitfalls.

3. The way to overcome ignorance is to gather
information. In the United States, a number of
institutions, most important of which is the
Department of Commerce, can help firms
gather information in the matchmaking process.

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Chapter Thirteen Exporting, Importing, and Countertrade 463

Export management companies can also help
identify export opportunities.

4. Many of the pitfalls associated with exporting
can be avoided if a company hires an
experienced export management company, or
export consultant, and if it adopts the
appropriate export strategy.

5. Firms engaged in international trade must do
business with people they cannot trust and
people who may be difficult to track down if
they default on an obligation. Due to the lack
of trust, each party to an international
transaction has a different set of preferences
regarding the configuration of the transaction.

6. The problems arising from lack of trust
between exporters and importers can be solved
by using a third party that is trusted by both,
normally a reputable bank.

7. A letter of credit is issued by a bank at the
request of an importer. It states that the bank
promises to pay a beneficiary, normally the
exporter, on presentation of documents
specified in the letter.

8. A draft is the instrument normally used in
international commerce to effect payment.
It is an order written by an exporter
instructing an importer, or an importer’s
agent, to pay a specified amount of money
at a specified time.

9. Drafts are either sight drafts or time drafts.
Time drafts are negotiable instruments.

10. A bill of lading is issued to the exporter by the
common carrier transporting the merchandise.
It serves as a receipt, a contract, and a
document of title.

11. U.S. exporters can draw on two types of
government-backed assistance to help
finance their exports: loans from the Export–
Import Bank and export credit insurance
from the Foreign Credit Insurance
Association.

12. Countertrade includes a range of barterlike
agreements. It is primarily used when a firm
exports to a country whose currency is not
freely convertible and may lack the foreign
exchange reserves required to purchase
the imports.

13. The main attraction of countertrade is that
it gives a firm a way to finance an export
deal when other means are not available.
A firm that insists on being paid in hard
currency may be at a competitive disadvantage
vis-à-vis one that is willing to engage in
countertrade.

14. The main disadvantage of countertrade is
that the firm may receive unusable or
poor-quality goods that cannot be disposed
of profitably.

Critical Thinking and Discussion Questions
1. A firm based in Washington State wants to

export a shipload of finished lumber to the
Philippines. The would-be importer cannot get
sufficient credit from domestic sources to pay for
the shipment but insists that the finished lumber
can quickly be resold in the Philippines for a
profit. Outline the steps the exporter should take
to effect this export to the Philippines.

2. You are the assistant to the CEO of a small
textile firm that manufactures quality, premium-
priced, stylish clothing. The CEO has decided to
see what the opportunities are for exporting and
has asked you for advice as to the steps the
company should take. What advice would you
give the CEO?

3. An alternative to using a letter of credit
is export credit insurance. What are the
advantages and disadvantages of using export
credit insurance rather than a letter of credit
for exporting (a) a luxury yacht from California
to Canada, and (b) machine tools from New
York to Ukraine?

4. How do you explain the use of countertrade?
Under what scenarios might its use increase
further by 2015? Under what scenarios might its
use decline?

5. How might a company make strategic use of
countertrade schemes as a marketing weapon to
generate export revenues? What are the risks
associated with pursuing such a strategy?

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464 Part Five Competing in a Global Marketplace

Use the globalEDGE Resource Desk (http://global
EDGE.msu.edu/resourcedesk/) to complete the
following exercises:

1. The Internet is rich with resources that provide
guidance for companies wishing to expand their
markets through exporting. GlobalEDGE
provides links under a category called Trade
Tutorials . Identify three sources listed by
globalEDGE and provide a description of

the services available for new exporters through
each of these sources.

2. You work for a banking company that hopes to
provide financial services in India. After searching
a resource that enumerates the import and export
regulations for a variety of countries, outline the
most important foreign trade barriers your firm’s
managers must keep in mind while developing a
strategy for entry into the Indian banking market.

Research Task http://globalEDGE.msu.edu

MD International

Al Merritt founded MD International in 1987. A former sales-
man for a medical equipment company, Merritt saw an op-
portunity to act as an export intermediary for medical
equipment manufacturers in the United States. He chose to
focus on Latin America and the Caribbean, regions in which
he had experience. Trade barriers were starting to fall
throughout the region as Latin governments embraced a
more liberal economic ideology, creating an opening for en-
trepreneurs such as Merritt. Local governments were also
expanding their spending on health care, creating an oppor-
tunity that Merritt was poised to exploit.
Merritt located his company in south Florida to be close
to his market. The company has grown to become the largest
intermediary exporting medical devices to the region. Today
the company sells the products of more than 30 medical
manufacturers to some 600 regional distributors. While many
medical equipment manufacturers don’t sell directly to the
region because of the sizable marketing costs, MD can af-
ford to because it goes into those markets with a broad port-
folio of products.
The company’s success is in part due to its deep-rooted
knowledge and understanding of the Latin American mar-
ket. MD works very closely with teams of doctors, biomedi-
cal engineers, microbiologists, and marketing managers
across Latin America to understand their needs, and what
the company can do for them. The sale of products to cus-
tomers is typically only the beginning of a relationship. MD

International also provides hands-on training to medical
personnel in the use of devices and extensive after-sales
service and support.
Along the way to becoming a successful exporter, MD
International has leaned heavily upon export assistance
programs established by the U.S. government. For example,
in the early 2000s a shipment to Venezuela was held up by the
country’s customs service, demanding proof that the medical
devices were not intended for military use. Within two days,
staff at the U.S. Export Assistance Center in Miami arranged
for the U.S. Embassy in Venezuela to have a letter written and
delivered to customs, assuring that the products had no mili-
tary applications, and the shipment was released. Merritt has
also worked extensively with the Export–Import Bank to gain
financing for its exports (the company needs to finance the
inventory that it exports).
Despite these advantages, it has not all been easy going
for MD International. Latin American economies have often
been highly cyclical, and MD International has ridden those
cycles with them. In 2001, for example, after several years
of solid growth, an economic crisis in both Argentina and
Brazil, coupled with a slowdown in Mexico, resulted in
losses for the year and forced Merritt to layoff one-third of
his staff and cut the pay of others, which included a 50 per-
cent pay cut for himself. Things started to improve in 2002,
and the weak dollar in the mid-2000s also helped to boost
export sales. However, the global financial crisis of 2008

closing case

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Chapter Thirteen Exporting, Importing, and Countertrade 465

ushered in another tough period, although prior experience
suggests that MD International can not only survive such
downturns, but also come out stronger as weaker competi-
tors fall by the wayside.

Sources: J. Bussey, “Where Have All the Exporters Gone?” Miami
Herald, September 30, 2005, p. C1; M. Chandler, “Dade Firm Seeks to
Remake Health Care,” Miami Herald, June 15, 2000; and C. Cultice,
“Exports with a Heart,” U.S. Department of Commerce, export
success stories, at www.export.gov.

Case Discussion Questions
1. How does an intermediary such as MD International

create value for the manufacturers who use it to sell
medical equipment in foreign markets? Why do they

want to use MD International rather than export directly
themselves?

2. Why did MD International focus on Latin America? What
are the benefits of this regional approach? What are the
potential drawbacks?

3. What would it take for MD International to start
exporting to other regions such as Asia or Europe?
Given this, would you advise Al Merritt to continue
his regional focus going forward, or to add other
regions?

4. How important has government assistance been to MD
International? Do you think helping firms such as MD
International represents good use of taxpayer money?

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After you have read this chapter you should be able to:

1 Explain why production and logistics decisions are of central importance to many multinational businesses.
2 Explain how country differences, production technology, and product features all affect the choice of where to locate production

activities.

3 Recognize how the role of foreign subsidiaries in production can be enhanced over time as they accumulate knowledge.
4 Identify the factors that influence a firm’s decision of whether to source supplies from within the company or from foreign suppliers.
5 Describe what is required to efficiently coordinate a globally dispersed production system.

L
E

A
R

N
IN

G
O

B
J
E

C
T

IV
E

part 5 Competing in a Global Marketplace

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opening case

India is well on its way to becoming a small-car manufacturing hub for some of the world’s largest automobile companies. Between 2003 and 2008 automobile exports from India increased fivefold to about 250,000 cars a year. Despite a global economic slowdown, exports are predicted
to increase, reaching half a million vehicles a year by 2012. The leading Indian exporter is the
Korean company Hyundai, which committed early to the Indian market. Hyundai began production
in India in 1998, when consumers were only purchasing 300,000 cars a year, despite the country’s
population of almost 1 billion people. Hyundai invested in a plant in the southern city of Chennai
with the capacity to turn out 100,000 cheap small cars a year. It had to train most of the workers,
often giving them two years of on-the-job training before hiring them full time. Soon Hyundai’s
early investments were paying off, as Indian’s emerging middle class snapped up its cars. Still
the company had excess capacity, so it turned its attention to exports.
By 2004, Hyundai was the country’s largest automobile exporter, shipping 70,000 cars a
year overseas. Things have only improved for Hyundai since then. By 2008 Hyundai was
making 500,000 cars a year in India and exporting over a third of them. Its smallest car,
the i10, is now produced only in India and shipped mainly to Europe. The company plans
to expand its Indian manufacturing capacity to 650,000, and ship up to half of its output
overseas. Hyundai is now considering selling its Indian-made cars in the United
States as well as in Europe.
Hyundai’s success has not gone unnoticed. Suzuki and Nissan have also been
investing aggressively in Indian automobile factories. Suzuki exported about
50,000 cars from India in 2007 and hopes to increase that to 200,000 by 2010.
Nissan also has big plans for India. It has invested some $1.1 billion in a
new factory close to Hyundai’s in Chennai. Completed in 2010, the fac-
tory has the capacity to make some 400,000 cars a year, about half of

Global Production,
Outsourcing, and Logistics

14 c h a p t e r

The Rise of the Indian Automobile Industry

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468 Part Five Competing in a Global Marketplace

which will be exported. Ford, BMW, GM, and Toyota are also building, or
planning to build, cars in India. A notable local competitor is Tata Motors,
which launched a low-cost “people’s car,” priced at $2,500, for the Indian
market in 2009.
For all of these companies, India has several attractions. The rapidly develop-
ing country has a potentially large domestic market. Also, labor costs are low
compared to many other nations. Nissan, for example, notes that wage rates in
India will be one-tenth of those in its Japanese factories. Plus, as Hyundai has
shown, productivity is high and Indian workers can produce quality automo-
biles. Hyundai’s executives claim that its Indian cars are of comparable quality
to those produced in Korea. Nissan’s goal is to use the same highly efficient
flexible manufacturing processes in India as it uses in Japan. Before it starts
production, Nissan plans to send Indian workers to its Japanese factories for
training on manufacturing processes and quality control.
India produces a large number of engineers every year, providing the pro-
fessional skill base for designing cars and managing complex manufacturing
facilities. Nissan intends to draw on this talent to design a low-cost small car
to compete with Tata. According to Nissan executives, the great advantage of
India’s engineers is that they are less likely to have the preconceptions of
automobile engineers in developed nations, are more likely to “think outside
of the box,” and thus may be better equipped to handle the challenges of
designing an ultra-low-cost small car.
Establishing manufacturing facilities in India does have problems, how-
ever. Nissan executives note that basic infrastructure is still lacking, roads
are poor, and often clogged with everything from taxis and motorbikes to
bullocks and carts, making the Japanese practice of just-in-time delivery hard
to implement. It is also proving challenging to find local parts suppliers that
can attain the same high-quality standards as those Nissan follows else-
where in the world. Nissan’s strategy has been to work with promising local
companies, helping them to raise their standards. For example, under the
guidance of engineers from Nissan, the Indian parts supplier Capro, which
makes body panels, has built a new factory near Nissan’s Chennai facility,
using the latest Japanese equipment. Workers there have also been trained
in the Japanese practice of kaizen, or continuous process improvement.
While it is still early, observers see the potential for Chennai to develop
into the Detroit of India, with a cluster of automobile companies and parts
suppliers working in the region producing high-quality, low-cost small cars
that will not only sell well in the rapidly expanding Indian market, but could
also sell well worldwide.

Sources: E. Bellman, “India Cranks Out Small Cars for Export,” The Wall Street Journal, October 6, 2008, p. A1;
N. Lakshman, “India’s Car Market Offers No Relief for Automakers,” BusinessWeek Online, December 23, 2008;
and M. Fackler, “In India, a New Detroit,” The New York Times, June 26, 2008, pp. C1, C4.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 469

Introduction
As trade barriers fall and global markets develop, many firms increasingly confront a
set of interrelated issues. First, where in the world should production activities be lo-
cated? Should they be concentrated in a single country, or should they be dispersed
around the globe, matching the type of activity with country differences in factor
costs, tariff barriers, political risks, and the like to minimize costs and maximize value
added? Second, what should be the long-term strategic role of foreign production
sites? Should the firm abandon a foreign site if factor costs change, moving production
to another more favorable location, or is there value to maintaining an operation at a
given location even if underlying economic conditions change? Third, should the firm
own foreign production activities, or is it better to outsource those activities to inde-
pendent vendors? Fourth, how should a globally dispersed supply chain be managed,
and what is the role of Internet-based information technology in the management of
global logistics? Fifth, should the firm manage global logistics itself, or should it out-
source the management to enterprises that specialize in this activity?
The rise of the Indian automobile industry touches on some of these issues, since
the industry is being driven by investment from foreign companies such as Hyundai
and Nissan. These companies clearly see India, and particularly the region around the
southern city of Chennai, as an emerging global center for the manufacture of low-
cost small cars. In Nissan’s view, for example, not only does India’s own rapidly grow-
ing domestic market make local production attractive, but also the combination of low
labor costs, high quality, good engineering talent, and the beginnings of a network of
local suppliers makes Chennai a good global hub for designing, manufacturing, and
then exporting low-cost small cars to other markets around the globe. From a strategic
perspective, the goal of companies such as Nissan and Hyundai is to turn their
Chennai factories into important components of their global manufacturing system.

Strategy, Production, and Logistics
In Chapter 11, we introduced the concept of the value chain and discussed a number
of value creation activities, including production, marketing, logistics, R&D, human
resources, and information systems. In this chapter, we will focus on two of these
activities— production and logistics —and attempt to clarify how they might be per-
formed internationally to (1) lower the costs of value creation and (2) add value by
better serving customer needs. We will discuss the contributions of information tech-
nology to these activities, which has become particularly important in the era of the
Internet. In later chapters, we will look at other value creation activities in this inter-
national context (marketing, R&D, and human resource management).
In Chapter 11, we defined production as “the activities involved in creating a prod-
uct.” We used the term production to denote both service and manufacturing activities,
since one can produce a service or produce a physical product. Although in this chapter
we focus more on the production of physical goods, one should not forget that the term
can also be applied to services. This has become more evident in recent years with the
trend among U.S. firms to outsource the “production” of certain service activities to
developing nations where labor costs are lower (for example, the trend among many
U.S. companies to outsource customer care services to places such as India, where
English is widely spoken and labor costs are much lower). Logistics is the activity that
controls the transmission of physical materials through the value chain, from procure-
ment through production and into distribution. Production and logistics are closely
linked since a firm’s ability to perform its production activities efficiently depends on a
timely supply of high-quality material inputs, for which logistics is responsible.

LEARNING OBJECTIVE 1
Explain why production and

logistics decisions are of
central importance to many

multinational businesses.

Logistics
The procurement and
physical transmission of
material through the
supply chain, from
suppliers to customers.

Production
Activities involved in
creating a product.

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470 Part Five Competing in a Global Marketplace

The production and logistics functions of an
international firm have a number of important stra-
tegic objectives. 1 One is to lower costs. Dispersing
production activities to various locations around the
globe where each activity can be performed most
efficiently can lower costs. Costs can also be cut by
managing the global supply chain efficiently so as to
better match supply and demand. Efficient supply
chain management reduces the amount of inventory
in the system and increases inventory turnover, which
means the firm has to invest less working capital in
inventory and is less likely to find excess inventory on
hand that cannot be sold and has to be written off.

A second strategic objective shared by produc-
tion and logistics is to increase product quality by
eliminating defective products from both the sup-
ply chain and the manufacturing process. 2 (In this
context, quality means reliability, implying that the

product has no defects and performs well.) The objectives of reducing costs and
increasing quality are not independent of each other. As illustrated in Figure 14.1, the
firm that improves its quality control will also reduce its costs of value creation. Improved
quality control reduces costs by:

• Increasing productivity because time is not wasted producing poor-quality products
that cannot be sold, leading to a direct reduction in unit costs.

• Lowering rework and scrap costs associated with defective products.
• Reducing the warranty costs and time associated with fixing defective products.

The effect is to lower the costs of value creation by reducing both production and
after-sales service costs.
The principal tool that most managers now use to increase the reliability of their
product offering is the Six Sigma quality improvement methodology. The Six Sigma
methodology is a direct descendant of the total quality management (TQM) philoso-
phy that was widely adopted, first by Japanese companies and then American companies

Another Per spect i ve

Careers in Supply Chain Management
With increased outsourcing and overseas production sites
and customers, supply chain management is a growing
field. The Council of Supply Chain Management Profes-
sionals (CSCMP), a professional association with more
than 8,500 members worldwide, says the industry offers a
promising outlook. What’s more, potential employers are
everywhere—manufacturers and distributors; government
agencies; consulting firms; the transport industry; universi-
ties and colleges; service firms such as banks, hospitals,
and hotels; and third-party logistics providers.
For more information about the organization and careers
in this field, visit the CSCMP Web site at www.cscmp.org
and its careers site, www.careersinsupplychain.org.

Improve

performance

reliability

Lowers
rework and
scrap

costs

Lowers
manufacturing

costs

Increases
profits

Increases
productivity

Lowers
warranty

costs

Lowers
service costs

figure 14.1

The Relationship
between Quality

and Costs

Total Quality
Management

(TQM)
Management philosophy

that takes as its central
focus the need to

improve the quality of a
company’s products and

services.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 471

during the 1980s and early 1990s. 3 The TQM philosophy was developed by a number of
American consultants such as W. Edward Deming, Joseph Juran, and A. V. Feigenbaum. 4
Deming identified a number of steps that should be part of any TQM program. He ar-
gued that management should embrace the philosophy that mistakes, defects, and poor-
quality materials are not acceptable and should be eliminated. He suggested that the
quality of supervision should be improved by allowing more time for supervisors to
work with employees and by providing them with the tools they need to do the job.
Deming recommended that management should create an environment in which em-
ployees will not fear reporting problems or recommending improvements. He believed
that work standards should not only be defined as numbers or quotas, but should also
include some notion of quality to promote the production of defect-free output. He ar-
gued that management has the responsibility to train employees in new skills to keep
pace with changes in the workplace. In addition, he believed that achieving better quality
requires the commitment of everyone in the company.
Six Sigma, the modern successor to TQM, is a statistically based philosophy that
aims to reduce defects, boost productivity, eliminate waste, and cut costs throughout a
company. Six Sigma programs have been adopted by several major corporations, such
as Motorola, General Electric, and Allied Signal. Sigma comes from the Greek letter
that statisticians use to represent a standard deviation from a mean, the higher the
number of “sigmas” the smaller the number of errors. At six sigma, a production pro-
cess would be 99.99966 percent accurate, creating just 3.4 defects per million units.
While it is almost impossible for a company to achieve such perfection, Six Sigma
quality is a goal that several strive toward. Increasingly, companies are adopting Six
Sigma programs to try to boost their product quality and productivity. 5
The growth of international standards has also focused greater attention on the
importance of product quality. In Europe, for example, the European Union requires
that the quality of a firm’s manufacturing processes and products be certified under a
quality standard known as ISO 9000 before the firm is allowed access to the EU mar-
ketplace. Although the ISO 9000 certification process has proved to be somewhat bu-
reaucratic and costly for many firms, it does focus management attention on the need
to improve the quality of products and processes. 6

Six Sigma
Statistically based
methodology for
improving product
quality.

ISO 9000
Certification process that
requires certain quality
standards must be met.

Motorola uses the Six Sigma philosophy, which aims to reduce defects, boost productivity, eliminate waste, and cut costs
throughout the company.

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472 Part Five Competing in a Global Marketplace

In addition to the lowering of costs and the improvement of quality, two other objec-
tives have particular importance in international businesses. First, production and logis-
tics functions must be able to accommodate demands for local responsiveness. As we saw
in Chapter 12, demands for local responsiveness arise from national differences in con-
sumer tastes and preferences, infrastructure, distribution channels, and host-government
demands. Demands for local responsiveness create pressures to decentralize production
activities to the major national or regional markets in which the firm does business or to
implement flexible manufacturing processes that enable the firm to customize the prod-
uct coming out of a factory according to the market in which it is to be sold.
Second, production and logistics must be able to respond quickly to shifts in cus-
tomer demand. In recent years, time-based competition has grown more important. 7
When consumer demand is prone to large and unpredictable shifts, the firm that can
adapt most quickly to these shifts will gain an advantage. 8 As we shall see, both pro-
duction and logistics play critical roles here.

Where to Produce
An essential decision facing an international firm is where to locate its production ac-
tivities to best minimize costs and improve product quality. For the firm contemplat-
ing international production, a number of factors must be considered. These factors
can be grouped under three broad headings: country factors, technological factors,
and product factors. 9

COUNTRY FACTORS We reviewed country-specific factors in some detail ear-
lier in the book. Political economy, culture, and relative factor costs differ from coun-
try to country. In Chapter 5, we saw that due to differences in factor costs, some
countries have a comparative advantage for producing certain products. In Chapters 2
and 3, we saw how differences in political economy and national culture influence the
benefits, costs, and risks of doing business in a country. Other things being equal, a
firm should locate its various manufacturing activities where the economic, political,
and cultural conditions, including relative factor costs, are conducive to the perfor-
mance of those activities (for an example, see the accompanying Management Focus,
which looks at the Philips NV investment in China). In Chapter 12, we referred to the
benefits derived from such a strategy as location economies. We argued that one result
of the strategy is the creation of a global web of value creation activities.
Also important in some industries is the presence of global concentrations of activities
at certain locations. In Chapter 7, we discussed the role of location externalities in influ-
encing foreign direct investment decisions. Externalities include the presence of an ap-
propriately skilled labor pool and supporting industries. 10 Such externalities can play an
important role in deciding where to locate manufacturing activities. For example, because
of a cluster of semiconductor manufacturing plants in Taiwan, a pool of labor with experi-
ence in the semiconductor business has developed. In addition, the plants have attracted
a number of supporting industries, such as the manufacturers of semiconductor capital
equipment and silicon, which have established facilities in Taiwan to be near their cus-
tomers. This implies that there are real benefits to locating in Taiwan, as opposed to an-
other location that lacks such externalities. Other things being equal, the externalities
make Taiwan an attractive location for semiconductor manufacturing facilities.
Of course, other things are not equal. Differences in relative factor costs, political
economy, culture, and location externalities are important, but other factors also loom
large. Formal and informal trade barriers obviously influence location decisions (see
Chapter 6), as do transportation costs and rules and regulations regarding foreign direct
investment (see Chapter 7). For example, although relative factor costs may make a

LEARNING OBJECTIVE 2
Explain how country
differences, production
technology, and product
features all affect the
choice of where to locate
production activities.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 473

country look attractive as a location for performing a manufacturing activity, regulations
prohibiting foreign direct investment may eliminate this option. Similarly, a consider-
ation of factor costs might suggest that a firm should source production of a certain
component from a particular country, but trade barriers could make this uneconomical.
Another country factor is expected future movements in its exchange rate (see
Chapters 9 and 10). Adverse changes in exchange rates can quickly alter a country’s
attractiveness as a manufacturing base. Currency appreciation can transform a

Management FOCUS

Philips in China

The Dutch consumer electronics, lighting, semiconductor,
and medical equipment conglomerate Philips NV has been
operating factories in China since 1985 when the country
first opened its markets to foreign investors. Then China
was seen as the land of unlimited demand, and Philips, like
many other Western companies, dreamed of Chinese con-
sumers snapping up its products by the millions. But the
company soon found out that one of the big reasons the
company liked China—the low wage rates—also meant
that few Chinese workers could afford to buy the products
they were producing. Chinese wage rates are currently
one-third of those in Mexico and Hungary, and 5 percent of
those in the United States or Japan. So Philips hit on a new
strategy; keep the factories in China but export most of the
goods to the United States and elsewhere.
By the mid-2000s, Philips had invested over $2.5 billion in
China. The company now operates 25 wholly owned sub-
sidiaries and joint ventures in China. Together they employ
some 30,000 people. Philips exports nearly two-thirds of
the $7 billion in products that the factories produce every
year. Philips accelerated its Chinese investment in antici-
pation of China’s entry into the World Trade Organization.
The company plans to move even more production to China
in the future. In 2003, Philips announced it would phase out
production of electronic razors in the Netherlands, lay off
2,000 Dutch employees, and move production to China by
2005. A week earlier, Philips had stated it would expand
capacity at its semiconductor factories in China, while
phasing out production in higher-cost locations elsewhere.
The attractions of China to Philips include low wage
rates, an educated workforce, a robust Chinese economy,
a stable exchange rate that is pegged to the U.S. dollar, a
rapidly expanding industrial base that includes many other
Western and Chinese companies that Philips uses as sup-
pliers, and easier access to world markets given China’s
entry into the WTO. Philips has stated that ultimately its
goal is to turn China into a global supply base from which
the company’s products will be exported around the
world. By the mid-2000s more than 25 percent of every-
thing Philips made worldwide came from China, and

executives say the figure is rising rapidly. Several prod-
ucts, such as CD and DVD players, are now made only in
China. Philips is also starting to give its Chinese factories
a greater role in product development. In the TV business,
for example, basic development used to occur in Holland
but was moved to Singapore in the early 1990s. Now Phil-
ips is transferring TV development work to a new R&D
center in Suzhou near Shanghai. Similarly, basic product
development work on LCD screens for cell phones was
recently shifted to Shanghai.
Philips is hardly alone in this process. By the mid-2000s
more than half of all exports from China came from foreign
manufacturers or their joint ventures in China. China was the
source of more than 80 percent of the DVD players sold
worldwide, 50 percent of the cameras, 40 percent of all mi-
crowave ovens, 30 percent of the air conditioners, 25 percent
of the washing machines, and 20 percent of all refrigerators.
Some observers worry that Philips and companies pur-
suing a similar strategy might be overdoing it. Too much
dependence on China could be dangerous if political, eco-
nomic, or other problems disrupt production and the com-
pany’s ability to supply global markets. Some observers
believe that it might be better if the manufacturing facili-
ties of companies were more geographically diverse as a
hedge against problems in China. The fears of the critics
were given some substance in early 2003 when an out-
break of the pneumonia-like SARS (severe acute respira-
tory syndrome) virus in China resulted in the temporary
shutdown of several plants operated by foreign compa-
nies and disrupted their global supply chains. Although
Philips was not directly affected, it did restrict travel by its
managers and engineers to its Chinese plants.

Sources: B. Einhorn. “Philips’ Expanding Asia Connections,”
BusinessWeek Online, November 27, 2003; K. Leggett and P. Wonacott,
“The World’s Factory: A Surge in Exports from China Jolts the Global
Industry,” The Wall Street Journal, October 10, 2002, p. A1; “Philips NV:
China Will Be Production Site for Electronic Razors,” The Wall Street
Journal, April 8, 2003, p. B12; “Philips Plans China Expansion,” The Wall
Street Journal, September 25, 2003, p. B13; M. Saunderson, “Eight out of
10 DVD Players Will Be Made in China,” Dealerscope, July 2004, p. 28; and
J. Blau, “Philips Tears Down Eindhoven R&D Fence,” Research Technology
Management 50, no. 6 (2007), pp. 9–11.

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474 Part Five Competing in a Global Marketplace

low-cost location into a high-cost location. Many Japanese corporations had to grap-
ple with this problem during the 1990s and early 2000s. The relatively low value of the
yen on foreign exchange markets between 1950 and 1980 helped strengthen Japan’s
position as a low-cost location for manufacturing. Between 1980 and the mid-1990s,
however, the yen’s steady appreciation against the dollar increased the dollar cost of
products exported from Japan, making Japan less attractive as a manufacturing loca-
tion. In response, many Japanese firms moved their manufacturing offshore to lower-
cost locations in East Asia.

TECHNOLOGICAL FACTORS The type of technology a firm uses to perform
specific manufacturing activities can be pivotal in location decisions. For example, be-
cause of technological constraints, in some cases it is necessary to perform certain man-
ufacturing activities in only one location and serve the world market from there. In
other cases, the technology may make it feasible to perform an activity in multiple loca-
tions. Three characteristics of a manufacturing technology are of interest here: the level
of fixed costs, the minimum efficient scale, and the flexibility of the technology.

Fixed Costs As we noted in Chapter 11, in some cases the fixed costs of setting up
a production plant are so high that a firm must serve the world market from a single
location or from a very few locations. For example, it now costs more than $1 billion
to set up a state-of-the-art plant to manufacture semiconductor chips. Given this,
other things being equal, serving the world market from a single plant sited at a single
(optimal) location can make sense.
Conversely, a relatively low level of fixed costs can make it economical to perform a
particular activity in several locations at once. This allows the firm to better accom-
modate demands for local responsiveness. Manufacturing in multiple locations may
also help the firm avoid becoming too dependent on one location. Being too depen-
dent on one location is particularly risky in a world of floating exchange rates. Many
firms disperse their manufacturing plants to different locations as a “real hedge”
against potentially adverse moves in currencies.

Minimum Efficient Scale The concept of economies of scale tells us that as plant
output expands, unit costs decrease. The reasons include the greater utilization of capital
equipment and the productivity gains that come with specialization of employees within
the plant. 11 However, beyond a certain level of output, few additional scale economies
are available. Thus, the “unit cost curve” declines with output until a certain output level
is reached, at which point further increases in output realize little reduction in unit costs.
The level of output at which most plant-level scale economies are exhausted is referred
to as the minimum efficient scale of output. This is the scale of output a plant must
operate to realize all major plant-level scale economies (see Figure 14.2).
The implications of this concept are as follows: The larger the minimum efficient
scale of a plant relative to total global demand, the greater the argument for centraliz-
ing production in a single location or a limited number of locations. Alternatively, when
the minimum efficient scale of production is low relative to global demand, it may be
economical to manufacture a product at several locations. For example, the minimum
efficient scale for a plant to manufacture personal computers is about 250,000 units a
year, while the total global demand exceeds 35 million units a year. The low level of
minimum efficient scale in relation to total global demand makes it economically fea-
sible for a company such as Dell to manufacture PCs in six locations.
As in the case of low fixed costs, the advantages of a low minimum efficient scale
include allowing the firm to accommodate demands for local responsiveness or to
hedge against currency risk by manufacturing the same product in several locations.

Minimum
Efficient Scale

The level of output at
which most plant-level

scale economies are
exhausted.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 475

Flexible Manufacturing and Mass Customization Central to the concept
of economies of scale is the idea that the best way to achieve high efficiency, and
hence low unit costs, is through the mass production of a standardized output. The
trade-off implicit in this idea is between unit costs and product variety. Producing
greater product variety from a factory implies shorter production runs, which in
turn implies an inability to realize economies of scale. That is, wide product variety
makes it difficult for a company to increase its production efficiency and thus re-
duce its unit costs. According to this logic, the way to increase efficiency and drive
down unit costs is to limit product variety and produce a standardized product in
large volumes.
This view of production efficiency has been challenged by the rise of flexible
manufacturing technologies. The term flexible manufacturing technology —or
lean production, as it is often called—covers a range of manufacturing technolo-
gies designed to (1) reduce setup times for complex equipment, (2) increase the
utilization of individual machines through better scheduling, and (3) improve qual-
ity control at all stages of the manufacturing process. 12 Flexible manufacturing
technologies allow the company to produce a wider variety of end products at a
unit cost that at one time could be achieved only
through the mass production of a standardized
output. Research suggests the adoption of flexible
manufacturing technologies may actually increase
efficiency and lower unit costs relative to what can
be achieved by the mass production of a standard-
ized output, while at the same time enabling the
company to customize its product offering to a much
greater extent than was once thought possible. The
term mass customization has been coined to
describe the ability of companies to use flexible
manufacturing technology to reconcile two goals
that were once thought to be incompatible—low
cost and product customization. 13 Flexible manu-
facturing technologies vary in their sophistication
and complexity.

Volume

Un
it

co
st

Minimum
efficient scale

14.2 figure

A Typical Unit-Cost
Curve

Flexible
Manufacturing
Technology (Lean
Production)
Manufacturing
technology designed to
improve job scheduling,
reduce setup time, and
improve quality control.

Mass
Customization
The production of a
variety of end products at
a unit cost that could
once be achieved only
through mass production
of a standardized output.

Ford Motor Co. uses flexible manufacturing technology at its Louisville,
Kentucky, assembly plant.

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476 Part Five Competing in a Global Marketplace

One of the most famous examples of a flexible manufacturing technology, Toyota’s
production system, has been credited with making Toyota the most efficient auto com-
pany in the world. (Despite Toyota’s recent problems with sudden uncontrolled
acceleration, the company continues to be an efficient producer of high-quality automo-
biles, according to J.D. Power and Associates, which produces an annual quality survey.
Indeed, Toyota’s Lexus models continue to top J.D. Power’s quality rankings.) 14 Toyota’s
flexible manufacturing system was developed by one of the company’s engineers, Ohno
Taiichi. After working at Toyota for five years and visiting Ford’s U.S. plants, Ohno
became convinced that the mass production philosophy for making cars was flawed. He
saw numerous problems with mass production.

First, long production runs created massive inventories that had to be stored in
large warehouses. This was expensive, both because of the cost of warehousing and
because inventories tied up capital in unproductive uses. Second, if the initial ma-
chine settings were wrong, long production runs resulted in the production of a
large number of defects (i.e., waste). Third, the mass production system was unable
to accommodate consumer preferences for product diversity.
In response, Ohno looked for ways to make shorter production runs economical.
He developed a number of techniques designed to reduce setup times for produc-
tion equipment (a major source of fixed costs). By using a system of levers and pul-
leys, he reduced the time required to change dies on stamping equipment from a full
day in 1950 to three minutes by 1971. This made small production runs economical,
which allowed Toyota to respond better to consumer demands for product diversity.
Small production runs also eliminated the need to hold large inventories, thereby
reducing warehousing costs. Plus, small product runs and the lack of inventory
meant that defective parts were produced only in small numbers and entered the
assembly process immediately. This reduced waste and helped trace defects back to
their source to fix the problem. In sum, these innovations enabled Toyota to produce
a more diverse product range at a lower unit cost than was possible with conven-
tional mass production. 15
Flexible machine cells are another common flexible manufacturing technology. A
flexible machine cell is a grouping of various types of machinery, a common materials
handler, and a centralized cell controller (computer). Each cell normally contains four
to six machines capable of performing a variety of operations. The typical cell is dedi-
cated to the production of a family of parts or products. The settings on machines are
computer controlled, which allows each cell to switch quickly between the production
of different parts or products.
Improved capacity utilization and reductions in work in progress (that is, stockpiles
of partly finished products) and in waste are major efficiency benefits of flexible ma-
chine cells. Improved capacity utilization arises from the reduction in setup times and
from the computer-controlled coordination of production flow between machines,
which eliminates bottlenecks. The tight coordination between machines also reduces
work-in-progress inventory. Reductions in waste are due to the ability of computer-
controlled machinery to identify ways to transform inputs into outputs while produc-
ing a minimum of unusable waste material. While freestanding machines might be in
use 50 percent of the time, the same machines when grouped into a cell can be used
more than 80 percent of the time and produce the same end product with half the
waste. This increases efficiency and results in lower costs.
The effects of installing flexible manufacturing technology on a company’s cost struc-
ture can be dramatic. Ford Motor Co. has been introducing flexible manufacturing tech-
nologies into its automotive plants around the world. These new technologies should
allow Ford to produce multiple models from the same line and to switch production

Flexible Machine
Cells

Flexible manufacturing
technology in which a

grouping of various
machine types, a common

materials handler, and a
centralized cell controller

produce a family
of products.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 477

from one model to another much more quickly than in the past, allowing Ford to take
$2 billion out of its cost structure. 16
Besides improving efficiency and lowering costs, flexible manufacturing technolo-
gies also enable companies to customize products to the demands of small consumer
groups—at a cost that at one time could be achieved only by mass-producing a stan-
dardized output. Thus, the technologies help a company achieve mass customization,
which increases its customer responsiveness. Most important for international busi-
ness, flexible manufacturing technologies can help a firm to customize products for
different national markets. The importance of this advantage cannot be overstated.
When flexible manufacturing technologies are available, a firm can manufacture prod-
ucts customized to various national markets at a single factory sited at the optimal
location. And it can do this without absorbing a significant cost penalty. Thus, firms no
longer need to establish manufacturing facilities in each major national market to pro-
vide products that satisfy specific consumer tastes and preferences, part of the ratio-
nale for a localization strategy (see Chapter 11).

Summary A number of technological factors support the economic arguments for
concentrating production facilities in a few choice locations or even in a single location.
Other things being equal, when fixed costs are substantial, the minimum efficient scale
of production is high, and/or flexible manufacturing technologies are available, the
arguments for concentrating production at a few choice locations are strong. This is
true even when substantial differences in consumer tastes and preferences exist between
national markets, because flexible manufacturing technologies allow the firm to cus-
tomize products to national differences at a single facility. Alternatively, when fixed
costs are low, the minimum efficient scale of production is low, and flexible manufactur-
ing technologies are not available, the arguments for concentrating production at one
or a few locations are not as compelling. In such cases, it may make more sense to
manufacture in each major market in which the firm is active if this helps the firm bet-
ter respond to local demands. This holds only if the increased local responsiveness
more than offsets the cost disadvantages of not concentrating manufacturing. With the
advent of flexible manufacturing technologies and mass customization, such a strategy
is becoming less attractive. In sum, technological factors are making it feasible, and
necessary, for firms to concentrate manufacturing facilities at optimal locations. Trade
barriers and transportation costs are major brakes on this trend.

PRODUCT FACTORS Two product features affect location decisions. The first
is the product’s value-to-weight ratio because of its influence on transportation costs.
Many electronic components and pharmaceuticals have high value-to-weight ratios;
they are expensive and they do not weigh very much. Thus, even if they are shipped
halfway around the world, their transportation costs account for a very small percent-
age of total costs. Given this, other things being equal, there is great pressure to pro-
duce these products in the optimal location and to serve the world market from there.
The opposite holds for products with low value-to-weight ratios. Refined sugar, cer-
tain bulk chemicals, paint, and petroleum products all have low value-to-weight ratios;
they are relatively inexpensive products that weigh a lot. Accordingly, when they are
shipped long distances, transportation costs account for a large percentage of total
costs. Thus, other things being equal, there is great pressure to make these products in
multiple locations close to major markets to reduce transportation costs.
The other product feature that can influence location decisions is whether the
product serves universal needs, needs that are the same all over the world. Examples
include many industrial products (e.g., industrial electronics, steel, bulk chemicals) and

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478 Part Five Competing in a Global Marketplace

modern consumer products (e.g., handheld calculators, personal computers, video
game consoles). Because there are few national differences in consumer taste and pref-
erence for such products, the need for local responsiveness is reduced. This increases
the attractiveness of concentrating production at an optimal location.

LOCATING PRODUCTION FACILITIES There are two basic strategies for
locating production facilities: concentrating them in a centralized location and serving
the world market from there, or decentralizing them in various regional or national
locations that are close to major markets. The appropriate strategic choice is deter-
mined by the various country-specific, technological, and product factors we have
discussed in this section and are summarized in Table 14.1.
As can be seen, concentration of production makes most sense when:

• Differences between countries in factor costs, political economy, and culture have
a substantial impact on the costs of manufacturing in various countries.

• Trade barriers are low.
• Externalities arising from the concentration of like enterprises favor certain

locations.
• Important exchange rates are expected to remain relatively stable.
• The production technology has high fixed costs and high minimum efficient scale

relative to global demand, or flexible manufacturing technology exists.
• The product’s value-to-weight ratio is high.
• The product serves universal needs.

Alternatively, decentralization of production is appropriate when:

• Differences between countries in factor costs, political economy, and culture do
not have a substantial impact on the costs of manufacturing in various countries.

• Trade barriers are high.

Concentrated Decentralized
Production Production
Favored Favored

Country factors

Difference in political economy Substantial Few

Difference in culture Substantial Few

Difference in factor costs Substantial Few

Trade barriers Few Substantial

Location externalities Important in industry Not important in industry

Exchange rates Stable Volatile

Technological factors

Fixed costs High Low

Minimum efficient scale High Low

Flexible manufacturing technology Available Not available

Product factors

Value-to-weight ratio High Low

Serves universal needs Yes No

table 14.1

Location Strategy and
Production

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Chapter Fourteen Global Production, Outsourcing, and Logistics 479

• Location externalities are not important.
• Volatility in important exchange rates is expected.
• The production technology has low fixed costs and low minimum efficient scale,

and flexible manufacturing technology is not available.
• The product’s value-to-weight ratio is low.
• The product does not serve universal needs (that is, significant differences in

consumer tastes and preferences exist between nations).

In practice, location decisions are seldom clear cut. For example, it is not unusual for
differences in factor costs, technological factors, and product factors to point toward
concentrated production while a combination of trade barriers and volatile exchange
rates points toward decentralized production. This seems to be the case in the world
automobile industry. Although the availability of flexible manufacturing and cars’ rela-
tively high value-to-weight ratios suggest concentrated manufacturing, the combina-
tion of formal and informal trade barriers and the uncertainties of the world’s current
floating exchange rate regime (see Chapter 10) have inhibited firms’ ability to pursue
this strategy. For these reasons, several automobile companies have established “top-
to-bottom” manufacturing operations in three major regional markets: Asia, North
America, and Western Europe.

The Strategic Role of Foreign Factories
Whatever the rationale behind establishing a foreign production facility, the strategic
role of foreign factories can evolve over time. 17 Initially, many foreign factories are
established where labor costs are low. Their strategic role typically is to produce labor-
intensive products at as low a cost as possible. For example, beginning in the 1970s,
many U.S. firms in the computer and telecommunication equipment businesses estab-
lished factories across Southeast Asia to manufacture electronic components, such as
circuit boards and semiconductors, at the lowest possible cost. They located their fac-
tories in countries such as Malaysia, Thailand, and Singapore precisely because each of
these countries offered an attractive combination of low labor costs, adequate infra-
structure, and favorable tax and trade regime. Initially, the components produced by
these factories were designed elsewhere and the final product was assembled else-
where. Over time, however, the strategic role of some of these factories has expanded;
they have become important centers for the design and final assembly of products for
the global marketplace. For example, Hewlett-Packard’s operation in Singapore was
established as a low-cost location for the production of circuit boards, but the facility
has become the center for the design and final assembly of portable ink-jet printers for
the global marketplace (see the accompanying Management Focus). A similar process
seems to be occurring at some of the factories that Philips has established in China
(see the Management Focus on Philips) and may now be starting to happen in India
with regard to the production of small cars (see the opening case).
Such upward migration in the strategic role of foreign factories arises because many
foreign factories upgrade their own capabilities. 18 This improvement comes from two
sources. First, pressure from the center to improve a factory’s cost structure and/or cus-
tomize a product to the demands of consumers in a particular nation can start a chain of
events that ultimately leads to development of additional capabilities at that factory. For
example, to meet centrally mandated directions to drive down costs, engineers at HP’s
Singapore factory argued that they needed to redesign products so they could be manu-
factured at a lower cost. This led to the establishment of a design center in Singapore. As
this design center proved its worth, HP executives realized the importance of co-locating
design and manufacturing operations. They increasingly transferred more design

LEARNING OBJECTIVE 3
Recognize how the role

of foreign subsidiaries
in production can be
enhanced over time
as they accumulate

knowledge.

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480 Part Five Competing in a Global Marketplace

responsibilities to the Singapore factory. In addition, the Singapore factory ultimately
became the center for the design of products tailored to the needs of the Asian market.
This made good strategic sense because it meant products were being designed by engi-
neers who were close to the Asian market and probably had a good understanding of the
needs of that market, as opposed to engineers located in the United States.
A second source of improvement in the capabilities of a foreign factory can be the
increasing abundance of advanced factors of production in the nation in which the
factory is located. Many nations that were considered economic backwaters a generation

Management FOCUS

Hewlett-Packard in Singapore

In the late 1960s, Hewlett-Packard was looking around
Asia for a low-cost location to produce electronic compo-
nents that were to be manufactured using labor-intensive
processes. The company looked at several Asian locations
and eventually settled on Singapore, opening its first fac-
tory there in 1970. Although Singapore did not have the
lowest labor costs in the region, costs were low relative to
North America. Plus, the Singapore location had several
important benefits that could not be found at many other
locations in Asia. The education level of the local work-
force was high. English was widely spoken. The govern-
ment of Singapore seemed stable and committed to
economic development, and the city-state had one of the
better infrastructures in the region, including good commu-
nication and transportation networks and a rapidly devel-
oping industrial and commercial base. HP also extracted
favorable terms from the Singapore government with re-
gard to taxes, tariffs, and subsidies.
At its start, the plant manufactured only basic compo-
nents. The combination of low labor costs and a favorable
tax regime helped to make this plant profitable early. In
1973, HP transferred the manufacture of one of its basic
handheld calculators from the United States to Singapore.
The objective was to reduce manufacturing costs, which
the Singapore factory was quickly able to do. Increasingly
confident in the capability of the Singapore factory to han-
dle entire products, as opposed to just components, HP’s
management transferred other products to Singapore over
the next few years including keyboards, solid-state dis-
plays, and integrated circuits. However, all these products
were still designed, developed, and initially produced in
the United States.
The plant’s status shifted in the early 1980s when HP em-
barked on a worldwide campaign to boost product quality
and reduce costs. HP transferred the production of its
HP41C handheld calculator to Singapore. The managers at
the Singapore plant were given the goal of substantially
reducing manufacturing costs. They argued that this could

be achieved only if they were allowed to redesign the
product so it could be manufactured at a lower overall
cost. HP’s central management agreed, and 20 engineers
from the Singapore facility were transferred to the United
States for one year to learn how to design application-
specific integrated circuits. They then brought this expertise
back to Singapore and set about redesigning the HP41C.
The results were a huge success. By redesigning the
product, the Singapore engineers reduced manufacturing
costs for the HP41C by 50 percent. Using this newly ac-
quired capability for product design, the Singapore facility
then set about redesigning other products it produced.
HP’s corporate managers were so impressed with the
progress made at the factory that they transferred produc-
tion of the entire calculator line to Singapore in 1983. This
was followed by the partial transfer of ink-jet production to
Singapore in 1984 and keyboard production in 1986. In all
cases, the facility redesigned the products and often re-
duced unit manufacturing costs by more than 30 percent.
The initial development and design of all these products,
however, still occurred in the United States.
In the late 1980s and 1990s, the Singapore plant assumed
added responsibilities, particularly in the ink-jet printer
business. The factory was given the job of redesigning an
HP ink-jet printer for the Japanese market. Although the
initial product redesign was a market failure, the managers
at Singapore pushed to be allowed to try again. They were
given the job of redesigning HP’s DeskJet 505 printer for
the Japanese market. This time the redesigned product
was a success, garnering significant sales in Japan. Em-
boldened by this success, the plant has continued to take
on additional design responsibilities. Today, it is viewed as
a “lead plant” within HP’s global network, with primary
responsibility not just for manufacturing, but also for the
development and design of a family of small ink-jet printers
targeted at the Asian market.

Sources: K. Ferdows, “Making the Most of Foreign Factories,” Harvard
Business Review, March–April 1997, pp. 73–88; and “Hewlett-Packard:
Singapore,” Harvard Business School Case No. 694–035.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 481

ago have been experiencing rapid economic development during the past 20 years.
Their communication and transportation infrastructures and the education level of the
population have improved. While these countries once lacked the advanced infrastruc-
ture required to support sophisticated design, development, and manufacturing opera-
tions, this is often no longer the case. This has made it much easier for factories based
in these nations to take on a greater strategic role.
Because of such developments, many international businesses are moving away from
a system in which their foreign factories were viewed as nothing more than low-cost
manufacturing facilities and toward one where foreign factories are viewed as globally
dispersed centers of excellence. 19 In this new model, foreign factories take the lead role
for the design and manufacture of products to serve important national or regional mar-
kets or even the global market. The development of such dispersed centers of excellence
is consistent with the concept of a transnational strategy, introduced in Chapter 12. A
major aspect of a transnational strategy is a belief in global learning —the idea that
valuable knowledge does not reside just in a firm’s domestic operations; it may also be
found in its foreign subsidiaries. Foreign factories that upgrade their capabilities over
time are creating valuable knowledge that might benefit the whole corporation.
Managers of international businesses need to remember that foreign factories can
improve their capabilities over time, and this can be of immense strategic benefit to the
firm. Rather than viewing foreign factories simply as sweatshops where unskilled labor
churns out low-cost goods, managers need to see them as potential centers of excellence
and to encourage and foster attempts by local managers to upgrade the capabilities of
their factories and, thereby, enhance their strategic standing within the corporation.
Such a process does imply that once a foreign factory has been established and valuable
skills have been accumulated, it may not be wise to switch production to another location
simply because some underlying variable, such as wage rates, has changed. 20 HP has kept
its facility in Singapore, rather than switching production to a location where wage rates
are now much lower, such as Vietnam, because it recognizes that the Singapore factory
has accumulated valuable skills that more than make up for the higher wage rates. Thus,
when reviewing the location of production facilities, the international manager must con-
sider the valuable skills that may have been accumulated at various locations, and the
impact of those skills on factors such as productivity and product design.

Outsourcing Production:
Make-or-Buy Decisions
International businesses frequently face make-or-buy decisions, decisions about
whether they should perform a certain value creation activity themselves or outsource
it to another entity. 21 Historically, most outsourcing decisions have involved the man-
ufacture of physical products. Most manufacturing firms have done their own final
assembly, but have had to decide whether to vertically integrate and manufacture their
own component parts or outsource the production of such parts, purchasing them
from independent suppliers. Such make-or-buy decisions are an important aspect of
the strategy of many firms. In the automobile industry, for example, the typical car
contains more than 10,000 components, so automobile firms constantly face make-or-
buy decisions. Toyota produces less than 30 percent of the value of cars that roll off its
assembly lines. The remaining 70 percent, mainly accounted for by component parts
and complex subassemblies, comes from independent suppliers. In the athletic shoe
industry, the make-or-buy issue has been taken to an extreme with companies such as
Nike and Reebok having no involvement in manufacturing; all production has been
outsourced, primarily to manufacturers based in low-wage countries.

LEARNING OBJECTIVE 4
Identify the factors that

influence a firm’s decision
of whether to source

supplies from within the
company or from foreign

suppliers.

Make-or-Buy
Decisions
Whether a firm should
make or buy component
parts.

Global Learning
The flow of skills and
product offerings from
foreign subsidiary to
home country and from
foreign subsidiary and
foreign subsidiary.

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482 Part Five Competing in a Global Marketplace

In recent years, the outsourcing decision has gone
beyond the manufacture of physical products to em-
brace the production of service activities. For exam-
ple, many U.S.-based companies, from credit card
issuers to computer companies, have outsourced
their customer call centers to India. They are “buy-
ing” the customer call center function, while “mak-
ing” other parts of the product in house. Similarly,
many information technology companies have been
outsourcing some parts of the software development
process, such as testing computer code written in the
United States, to independent providers based in
India. Such companies are “making” (writing) most of
the code in-house, but “buying,” or outsourcing, part
of the production process—testing—to independent
companies. India is often the focus of such out-
sourcing because English is widely spoken there; the
nation has a well-educated workforce, particularly in
engineering fields; and the pay is much lower than in
the United States (a call center worker in India earns
about $200 to $300 a month, about one-tenth of the
comparable U.S. wage). 22

Outsourcing decisions pose plenty of problems
for purely domestic businesses but even more prob-
lems for international businesses. These decisions in
the international arena are complicated by the vola-
tility of countries’ political economies, exchange rate

movements, changes in relative factor costs, and the like. In this section, we examine
the arguments for making products in-house and for buying them, and we consider
the trade-offs involved in such a decision. Then we discuss strategic alliances as an
alternative to producing all or part of a product within the company.

THE ADVANTAGES OF MAKE The arguments that support making all or
part of a product in-house—vertical integration—are fourfold. Vertical integration

may be associated with lower costs, facilitate invest-
ments in highly specialized assets, protect propri-
etary product technology, and ease the scheduling
of adjacent processes.

Lowering Costs It may pay a firm to continue
manufacturing a product or component part in-
house if the firm is more efficient at that produc-
tion activity than any other enterprise.

Facilitating Specialized Investments
Some times firms have to invest in specialized assets
in order to do business with another enterprise. 23 A
specialized asset is an asset whose value is contin-
gent upon a particular relationship persisting. For
example, imagine Ford of Europe has developed a
new, high-performance, high-quality, and uniquely
designed fuel-injection system. The increased fuel

Nike relies on outsourcing to manufacture its products. The company
has received worldwide criticism for turning its back on social
responsibility for the sake of profit.

Another Per spect i ve

Outsourcing: A Strategy for the Future
Although many American workers take a negative view of
outsourcing because it typically means a loss of jobs
stateside, outsourcing can be a useful strategy for manag-
ing quality and controlling costs. In addition, some other
perspectives add to the strategic role that outsourcing de-
cisions play in today’s business environment. For a devel-
oping country, outsourcing provides a way to “get into the
game.” For a global organization, outsourcing creates an
opportunity to build a presence in a future market while
it’s still developing. Establishing an early presence may
lead to first-mover advantages, creating brand loyalty in
consumers and providing valuable market knowledge for
the producer.

Specialized Asset
An asset designed to

perform a specific task,
whose value is

significantly reduced in
its next-best use.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 483

efficiency will help sell Ford cars. Ford must decide whether to make the system
in-house or to contract out the manufacturing to an independent supplier. Manufac-
turing these uniquely designed systems requires investments in equipment that can be
used only for this purpose; it cannot be used to make fuel injection systems for any
other auto firm. Thus, investment in this equipment constitutes an investment in spe-
cialized assets. When, as in this situation, one firm must invest in specialized assets to
supply another, mutual dependency is created. In such circumstances, each party might
fear the other will abuse the relationship by seeking more favorable terms .
To appreciate this, let us first examine this situation from the perspective of an inde-
pendent supplier who has been asked by Ford to make this investment. The supplier
might reason that once it has made the investment, it will become dependent on Ford
for business since Ford is the only possible customer for the output of this equipment.
The supplier perceives this as putting Ford in a strong bargaining position and worries
that once the specialized investment has been made, Ford might use this to squeeze
down prices for the systems. Given this risk, the supplier declines to make the invest-
ment in specialized equipment.
Now take the position of Ford. Ford might reason that if it contracts out production
of these systems to an independent supplier, it might become too dependent on that
supplier for a vital input. Because specialized equipment is required to produce the
fuel injection systems, Ford cannot easily switch its orders to other suppliers who lack
that equipment. (It would face high switching costs.) Ford perceives this as increasing
the bargaining power of the supplier and worries that the supplier might use its bar-
gaining strength to demand higher prices.
Thus, the mutual dependency that outsourcing would create makes Ford nervous
and scares away potential suppliers. The problem here is lack of trust. Neither party
completely trusts the other to play fair. Consequently, Ford might reason that the only
safe way to get the new fuel injection systems is to manufacture them itself. It may be
unable to persuade any independent supplier to manufacture them. Thus, Ford de-
cides to make rather than buy.
In general, we can predict that when substantial investments in specialized assets
are required to manufacture a component, the firm will prefer to make the component
internally rather than contract it out to a supplier. Substantial empirical evidence sup-
ports this prediction. 24

Protecting Proprietary Product Technology Proprietary product technology
is unique to a firm. If it enables the firm to produce a product containing superior
features, proprietary technology can give the firm a competitive advantage. The firm
would not want competitors to get this technology. If the firm outsources the produc-
tion of entire products or components containing proprietary technology, it runs the
risk that those suppliers will expropriate the technology for their own use or that they
will sell it to the firm’s competitors. Thus, to maintain control over its technology, the
firm might prefer to make such products or component parts in-house.

Improving Scheduling Another argument for producing all or part of a product
in-house is that production cost savings result because it makes planning, coordina-
tion, and scheduling of adjacent processes easier. 25 This is particularly important in
firms with just-in-time inventory systems (discussed later in the chapter). In the 1920s,
for example, Ford profited from tight coordination and scheduling made possible by
backward vertical integration into steel foundries, iron ore shipping, and mining. De-
liveries at Ford’s foundries on the Great Lakes were coordinated so well that ore was
turned into engine blocks within 24 hours. This substantially reduced Ford’s produc-
tion costs by eliminating the need to hold excessive ore inventories.

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484 Part Five Competing in a Global Marketplace

For international businesses that source worldwide, scheduling problems can be
exacerbated by the time and distance between the firm and its suppliers. This is true
whether the firms use their own subunits as suppliers or use independent suppliers.
However, ownership of upstream production facilities is not the issue here. By using
information technology, firms can attain tight coordination between different stages in
the production process.

THE ADVANTAGES OF BUY Buying component parts, or an entire product,
from independent suppliers can give the firm greater flexibility, can help drive down the
firm’s cost structure, and may help the firm capture orders from international customers.

Strategic Flexibility The great advantage of buying component parts, or even an
entire product, from independent suppliers is that the firm can maintain its flexibility,
switching orders between suppliers as circumstances dictate. This is particularly
important internationally, where changes in exchange rates and trade barriers can alter
the attractiveness of supply sources. One year Hong Kong might offer the lowest cost
for a particular component, and the next year, Mexico may. Many firms source the
same products from suppliers based in two countries, primarily as a hedge against
adverse movements in factor costs, exchange rates, and the like.
Sourcing products from independent suppliers can also be advantageous when the
optimal location for manufacturing a product is beset by political risks. Under such
circumstances, foreign direct investment to establish a component manufacturing
operation in that country would expose the firm to political risks. The firm can avoid
many of these risks by buying from an independent supplier in that country, thereby
maintaining the flexibility to switch sourcing to another country if a war, revolution,
or other political change alters that country’s attractiveness as a supply source.
However, maintaining strategic flexibility has its downside. If a supplier perceives
the firm will change suppliers in response to changes in exchange rates, trade barriers,
or general political circumstances, that supplier might not be willing to make invest-
ments in specialized plants and equipment that would ultimately benefit the firm.

Lower Costs Although making a product or component part in-house—vertical
integration—is often undertaken to lower costs, it may have the opposite effect. When
this is the case, outsourcing may lower the firm’s cost structure. Making all or part of a
product in-house increases an organization’s scope, and the resulting increase in orga-
nizational complexity can raise a firm’s cost structure. There are three reasons for this.
First, the greater the number of subunits in an organization, the more problems
coordinating and controlling those units. Coordinating and controlling subunits re-
quire top management to process large amounts of information about subunit activi-
ties. The greater the number of subunits, the more information top management must
process and the harder it is to do well. Theoretically, when the firm becomes involved
in too many activities, headquarters management will be unable to effectively control
all of them, and the resulting inefficiencies will more than offset any advantages de-
rived from vertical integration. 26 This can be particularly serious in an international
business, where the problem of controlling subunits is exacerbated by distance and
differences in time, language, and culture.
Second, the firm that vertically integrates into component part manufacture may
find that because its internal suppliers have a captive customer in the firm, they lack an
incentive to reduce costs. The fact that they do not have to compete for orders with
other suppliers may result in high operating costs. The managers of the supply opera-
tion may be tempted to pass on cost increases to other parts of the firm in the form of
higher transfer prices, rather than looking for ways to reduce those costs.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 485

Third, vertically integrated firms have to determine appropriate prices for goods
transferred to subunits within the firm. This is a challenge in any firm, but it is even
more complex in international businesses. Different tax regimes, exchange rate move-
ments, and headquarters’ ignorance about local conditions all increase the complexity
of transfer pricing decisions. This complexity enhances internal suppliers’ ability to
manipulate transfer prices to their advantage, passing cost increases downstream
rather than looking for ways to reduce costs.
The firm that buys its components from independent suppliers can avoid all these
problems and the associated costs. The firm that sources from independent suppliers
has fewer subunits to control. The incentive problems that occur with internal suppli-
ers do not arise when independent suppliers are used. Independent suppliers know
they must continue to be efficient if they are to win business from the firm. Also, be-
cause independent suppliers’ prices are set by market forces, the transfer pricing prob-
lem does not exist. In sum, the bureaucratic inefficiencies and resulting costs that can
arise when firms vertically integrate backward and produce their own components are
avoided by buying component parts from independent suppliers.

Offsets Another reason for outsourcing some manufacturing to independent suppli-
ers based in other countries is that it may help the firm capture more orders from that
country. Offsets are common in the commercial aerospace industry. For example, before
Air India places a large order with Boeing, the Indian government might ask Boeing to
push some subcontracting work toward Indian manufacturers. This is not unusual in
international business. Representatives of the U.S. government have repeatedly urged
Japanese automobile companies to purchase more component parts from U.S. suppliers
to partially offset the large volume of automobile exports from Japan to the United States.

TRADE-OFFS Clearly there are trade-offs in make-or-buy decisions. The bene-
fits of making all or part of a product in-house seem to be greatest when highly spe-
cialized assets are involved, when vertical integration is necessary for protecting
proprietary technology, or when the firm is simply more efficient than external suppli-
ers at performing a particular activity. When these conditions are not present, the risk
of strategic inflexibility and organizational problems suggest it may be better to con-
tract out some or all production to independent suppliers. Because issues of strategic
flexibility and organizational control loom even larger for international businesses
than purely domestic ones, an international business should be particularly wary of
vertical integration into component part manufacture. In addition, some outsourcing
in the form of offsets may help a firm gain larger orders in the future.

STRATEGIC ALLIANCES WITH SUPPLIERS Several international busi-
nesses have tried to reap some benefits of vertical integration without the associated
organizational problems by entering strategic alliances with essential suppliers. For
example, there was an alliance between Kodak and Canon, under which Canon built
photocopiers for sale by Kodak; an alliance between Microsoft and Flextronics, under
which Flextronics built the Xbox for Microsoft; and an alliance between Boeing and
several Japanese companies to build its jet aircraft, including the 787. By these
alliances, Kodak, Microsoft, and Boeing have committed themselves to long-term
relationships with these suppliers, which have encouraged the suppliers to undertake
specialized investments. Strategic alliances build trust between the firm and its
suppliers. Trust is built when a firm makes a credible commitment to continue pur-
chasing from a supplier on reasonable terms. For example, the firm may invest money
in a supplier—perhaps by taking a minority shareholding—to signal its intention to
build a productive, mutually beneficial long-term relationship.

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486 Part Five Competing in a Global Marketplace

This kind of arrangement between the firm and its parts suppliers was pioneered in
Japan by large auto companies such as Toyota. Many Japanese automakers have coop-
erative relationships with their suppliers that go back decades. In these relationships,
the auto companies and their suppliers collaborate on ways to increase value added by,
for example, implementing just-in-time inventory systems or cooperating in the de-
sign of component parts to improve quality and reduce assembly costs. These relation-
ships have been formalized when the auto firms acquired minority shareholdings in
many of their essential suppliers to symbolize their desire for long-term cooperative
relationships with them. At the same time, the relationship between the firm and each
essential supplier remains market mediated and terminable if the supplier fails to per-
form. By pursuing such a strategy, the Japanese automakers capture many of the ben-
efits of vertical integration, particularly those arising from investments in specialized
assets, without suffering the organizational problems that come with formal vertical
integration. The parts suppliers also benefit from these relationships because they
grow with the firm they supply and share in its success. 27
The adoption of just-in-time inventory systems (JIT), computer-aided design
(CAD), and computer-aided manufacturing (CAM) over the past two decades seem to
have increased pressures for firms to establish long-term relationships with their sup-
pliers. JIT, CAD, and CAM systems all rely on close links between firms and their
suppliers supported by substantial specialized investment in equipment and informa-
tion systems hardware. To get a supplier to agree to adopt such systems, a firm must
make a credible commitment to an enduring relationship with the supplier—it must
build trust with the supplier. It can do this within the framework of a strategic alliance.
Alliances are not all good. Like formal vertical integration, a firm that enters long-
term alliances may limit its strategic flexibility by the commitments it makes to its al-
liance partners. As we saw in Chapter 12 when we considered alliances between
competitors, a firm that allies itself with another firm risks giving away key techno-
logical know-how to a potential competitor.

Managing a Global Supply Chain
Logistics encompasses the activities necessary to get materials from suppliers to a man-
ufacturing facility, through the manufacturing process, and out through a distribution
system to the end user. 28 In the international business, the logistics function manages
the global supply chain. The twin objectives of logistics are to manage a firm’s global
supply chain at the lowest possible cost and in a way that best serves customer needs,
thereby lowering the costs of value creation and helping the firm establish a competi-
tive advantage through superior customer service.
The potential for reducing costs through more efficient logistics is enormous. For
the typical manufacturing enterprise, material costs account for between 50 and
70 percent of revenues, depending on the industry. Even a small reduction in these
costs can have a substantial impact on profitability. According to one estimate, for a
firm with revenues of $1 million, a return on investment rate of 5 percent, and mate-
rials costs that are 50 percent of sales revenues, a $15,000 increase in total profits
could be achieved either by increasing sales revenues 30 percent or by reducing mate-
rials costs by 3 percent. 29 In a saturated market, it would be much easier to reduce
materials costs by 3 percent than to increase sales revenues by 30 percent.

THE ROLE OF JUST-IN-TIME INVENTORY Pioneered by Japanese
firms during that country’s remarkable economic transformation during the 1960s
and 1970s, just-in-time inventory systems now play a major role in most manufac-
turing firms. The basic philosophy behind just-in-time ( JIT) inventory systems is

LEARNING OBJECTIVE 5
Describe what is required
to efficiently coordinate a
globally dispersed
production system.

Just-in-Time ( JIT)
Inventory
Logistics system
designed to deliver parts
to a production process
as they are needed, not
before.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 487

to economize on inventory holding costs by
having materials arrive at a manufacturing plant
just in time to enter the production process and
not before. The major cost saving comes from
speeding up inventory turnover. This reduces
inventory holding costs, such as warehousing and
storage costs. It means the company can reduce
the amount of working capital it needs to finance
inventory, freeing capital for other uses and/or
lowering the total capital requirements of the
enterprise. Other things being equal, this will
boost the company’s profitability as measured by
return on capital invested. It also means the com-
pany is less likely to have excess unsold inventory
that it has to write off against earnings or price
low to sell.
In addition to the cost benefits, JIT systems can
also help firms improve product quality. Under a
JIT system, parts enter the manufacturing process
immediately; they are not warehoused. This
allows defective inputs to be spotted right away.
The problem can then be traced to the supply source and fixed before more defective
parts are produced. Under a more traditional system, warehousing parts for weeks
before they are used allows many defective parts to be produced before a problem is
recognized.
The drawback of a JIT system is that it leaves a firm without a buffer stock of in-
ventory. Although buffer stocks are expensive to store, they can help a firm respond
quickly to increases in demand and tide a firm over shortages brought about by dis-
ruption among suppliers. Such a disruption occurred after the September 11, 2001,
attacks on the World Trade Center, when the subsequent shutdown of international
air travel and shipping left many firms that relied upon globally dispersed suppliers and
tightly managed “just-in-time” supply chains without a buffer stock of inventory. A less
pronounced but similar situation occurred again in April 2003 when the outbreak of
pneumonia-like SARS (severe acute respiratory syndrome) virus in China resulted in
the temporary shutdown of several plants operated by foreign companies and dis-
rupted their global supply chains. Similarly, in late 2004, record imports into the
United States left several major West Coast shipping ports clogged with too many
ships from Asia that could not be unloaded fast enough, and disrupted the finely tuned
supply chains of several major U.S. enterprises. 30
There are ways of reducing the risks associated with a global supply chain that op-
erates on just-in-time principles. To reduce the risks associated with depending on one
supplier for an important input, some firms source these inputs from several suppliers
located in different countries. While this does not help in the case of an event with
global ramifications, such as September 11, 2001, it does help manage country-specific
supply disruptions, which are more common.

THE ROLE OF INFORMATION TECHNOLOGY AND THE INTERNET
Web-based information systems play a crucial role in modern materials management.
By tracking component parts as they make their way across the globe toward an as-
sembly plant, information systems enable a firm to optimize its production scheduling
according to when components are expected to arrive. By locating component parts in
the supply chain precisely, good information systems allow the firm to accelerate

Another Per spect i ve

Logistics in the Service Sector: Global Account
Management
Like manufacturers, professional service firms have also
been learning how to better manage their delivery on a
global basis. For example, some global accounting firms
are dealing with other global firms in a new way, using
one supplier for all their accounting-related needs
around the world. The traditional approach involved the
development of market-specific relationships, so the
same multinational client would have 5 to 20 individual
accounting relationships, one in each major market for
each company division. Under a global account manage-
ment approach, one relationship has a global span—and
one contract. Such logistics allow for more effective rela-
tionship management, a better sense of what the client
needs, more product extension opportunities, and better
pricing and economies.

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488 Part Five Competing in a Global Marketplace

production when needed by pulling key components out of the regular supply chain
and having them flown to the manufacturing plant.
Firms now typically use electronic data interchange (EDI) via the Internet to coor-
dinate the flow of materials into manufacturing, through manufacturing, and out to
customers. Sometimes customers also are integrated into the system. These electronic
links are then used to place orders with suppliers, to register parts leaving a supplier, to
track them as they travel toward a manufacturing plant, and to register their arrival.
Suppliers typically use an EDI link to send invoices to the purchasing firm. One con-
sequence of an EDI system is that suppliers, shippers, and the purchasing firm can
communicate with each other with no time delay, which increases the flexibility and
responsiveness of the whole global supply system. A second consequence is that much
of the paperwork between suppliers, shippers, and the purchasing firm is eliminated.
Good EDI systems can help a firm decentralize materials management decisions to
the plant level by giving corporate-level managers the information they need for coor-
dinating and controlling decentralized materials management groups.
Before the emergence of the Internet as a major communication medium, firms and
their suppliers normally had to purchase expensive proprietary software solutions to im-
plement EDI systems. The ubiquity of the Internet and the availability of Web-based
applications have made most of these proprietary solutions obsolete. Less expensive
Web-based systems that are much easier to install and manage now dominate the market
for global supply chain management software. These Web-based systems have trans-
formed the management of globally dispersed supply chains, allowing even small firms to
achieve a much better balance between supply and demand, thereby reducing the inven-
tory in their systems and reaping the associated economic benefits. With many firms now
using these systems, those that do not will find themselves at a competitive disadvantage.

production, p. 469
logistics, p. 469
total quality management
(TQM), p. 470
Six Sigma, p. 471
ISO 9000, p. 471

minimum efficient scale, p. 474
flexible manufacturing technology
(lean production), p. 475
mass customization, p. 475
flexible machine cells, p. 476
global learning, p. 481

make-or-buy decisions, p. 481
specialized asset, p. 482
just-in-time
inventory, p. 486

Key Terms

Summary
This chapter explained how efficient production
and logistics functions can improve an interna-
tional business’s competitive position by lowering
the costs of value creation and by performing
value creation activities in such ways that customer
service is enhanced and value added is maximized.
We looked closely at three issues central to inter-
national production and logistics: where to pro-
duce, what to make and what to buy, and how to
coordinate a globally dispersed manufacturing and

supply system. The chapter made the following
points:

1. The choice of an optimal production location
must consider country factors, technological
factors, and product factors.

2. Country factors include the influence of factor
costs, political economy, and national culture
on production costs, along with the presence of
location externalities.

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Chapter Fourteen Global Production, Outsourcing, and Logistics 489

3. Technological factors include the fixed costs of
setting up production facilities, the minimum
efficient scale of production, and the availability
of flexible manufacturing technologies that
allow for mass customization.

4. Product factors include the value-to-weight
ratio of the product and whether the product
serves universal needs.

5. Location strategies either concentrate or
decentralize manufacturing. The choice should
be made in light of country, technological, and
product factors. All location decisions involve
trade-offs.

6. Foreign factories can improve their capabilities
over time, and this can be of immense strategic
benefit to the firm. Managers need to view
foreign factories as potential centers of
excellence and to encourage and foster
attempts by local managers to upgrade
factory capabilities.

7. An essential issue in many international
businesses is determining which component
parts should be manufactured in-house and
which should be outsourced to independent
suppliers.

8. Making components in-house facilitates
investments in specialized assets and helps the
firm protect its proprietary technology. It may
improve scheduling between adjacent stages in
the value chain, also. In-house production also
makes sense if the firm is an efficient, low-cost
producer of a technology.

9. Buying components from independent
suppliers facilitates strategic flexibility and
helps the firm avoid the organizational
problems associated with extensive vertical
integration. Outsourcing might also be
employed as part of an “offset” policy, which is

designed to win more orders for the firm from
a country by pushing some subcontracting
work to that country.

10. Several firms have tried to attain the benefits of
vertical integration and avoid its associated
organizational problems by entering long-term
strategic alliances with essential suppliers.

11. Although alliances with suppliers can give a
firm the benefits of vertical integration without
dispensing entirely with the benefits of a
market relationship, alliances have drawbacks.
The firm that enters a strategic alliance may
find its strategic flexibility limited by
commitments to alliance partners.

12. Logistics encompasses all the activities that
move materials to a production facility, through
the production process, and out through a
distribution system to the end user. The logistics
function is complicated in an international
business by distance, time, exchange rates,
custom barriers, and other things.

13. Just-in-time systems generate major cost
savings from reducing warehousing and
inventory holding costs and from reducing the
need to write off excess inventory. In addition,
JIT systems help the firm spot defective parts
and remove them from the manufacturing
process quickly, thereby improving product
quality.

14. Information technology, particularly Internet-
based electronic data interchange, plays a major
role in materials management. EDI facilitates
the tracking of inputs, allows the firm to
optimize its production schedule, lets the firm
and its suppliers communicate in real time, and
eliminates the flow of paperwork between a
firm and its suppliers.

Critical Thinking and Discussion Questions
1. An electronics firm is considering how best to

supply the world market for microprocessors used
in consumer and industrial electronic products. A
manufacturing plant costs about $500 million to
construct and requires a highly skilled workforce.
The total value of the world market for this
product over the next 10 years is estimated to be
between $10 billion and $15 billion. The tariffs

prevailing in this industry are currently low.
Should the firm adopt a concentrated or
decentralized manufacturing strategy? What kind
of location(s) should the firm favor for its plant(s)?

2. A chemical firm is considering how best to supply
the world market for sulfuric acid. A
manufacturing plant costs about $20 million to

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490 Part Five Competing in a Global Marketplace

construct and requires a moderately skilled
workforce. The total value of the world market for
this product over the next 10 years is estimated to
be between $20 billion and $30 billion. The tariffs
prevailing in this industry are moderate. Should
the firm favor concentrated manufacturing or
decentralized manufacturing? What kind of
location(s) should the firm seek for its plant(s)?

3. A firm must decide whether to make a
component part in-house or to contract it out to
an independent supplier. Manufacturing the part
requires a nonrecoverable investment in
specialized assets. The most efficient suppliers
are located in countries with currencies that
many foreign exchange analysts expect to
appreciate substantially over the next decade.
What are the pros and cons of (a) manufacturing

the component in-house and (b) outsourcing
manufacturing to an independent supplier?
Which option would you recommend? Why?

4. Reread the Management Focus on Philips in
China then answer the following questions:

a. What are the benefits to Philips of shifting so
much of its global production to China?

b. What are the risks associated with a heavy
concentration of manufacturing assets in
China?

c. What strategies might Philips adopt to
maximize the benefits and mitigate the risks
associated with moving so much product?

5. Explain how an efficient logistics function can
help an international business compete more
effectively in the global marketplace.

Use the globalEDGE Resource Desk (http://global
EDGE.msu.edu/resourcedesk/) to complete the
following exercises:

1. You work for a company whose manufacturing
operations require a highly skilled labor force.
Some executives have recently decided to open a
production plant in Europe to serve that market
because the high cost of transporting the
products from your U.S. plant are making your
company’s products less attractive for consumers.
Using the Chartbook of International Labor
Comparisons, compare the attractiveness of

producing in Spain, Italy, and Portugal based
both on labor market indicators and on
competitiveness indicators for manufacturing.
Prepare an executive summary recommending
where your company should produce.

2. The International Association of Outsourcing
Professionals (IAOP) ranks the world’s best
global outsourcing service providers. What are the
criteria used to rank companies? Identify the
10 best companies. What are the key strengths
for each company? Do you notice any trends in
the information you have gathered?

Research Task http://globalEDGE.msu.edu

Building the Boeing 787

Boeing’s newest commercial jet aircraft, the wide-bodied 787
jet, is a bold bet on the future of both airline travel and plane
making. Designed to fly long-haul point-to-point routes, the
250-seat 787 is made largely out of composite materials, such
as carbon fibers, rather than traditional materials such as
aluminum. Some 80 percent of the 787 by volume is composite
materials, making the plane 20 percent lighter than a tradi-
tional aircraft of the same size, which translates into a big

saving in jet fuel consumption and costs. The 787 is also
packed full of other design innovations, including larger win-
dows, greater headroom, and state-of-the-art electronics on
the flight deck and in the passenger compartment.
To reduce the risks associated with this technological gam-
ble, Boeing outsourced an unprecedented 70 percent of the
content of the 787 to other manufacturers, most of them based
in other nations. In contrast, 50 percent of the Boeing 777 was

closing case

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Chapter Fourteen Global Production, Outsourcing, and Logistics 491

outsourced, 30 percent of the 767, and only 5 percent of the 707.
The idea was that in return for a share of the work, partners
would contribute toward the estimated $8 billion in develop-
ment costs for the 787. In addition, by outsourcing, Boeing be-
lieved it could tap into the expertise of the most efficient
producers, wherever they might be located, thereby driving
down the costs of making the plane. Furthermore, Boeing be-
lieved that outsourcing some work to foreign countries would
help it garner sales in those countries. Boeing’s role in the en-
tire process was to design the plane, market and sell it, and
undertake final assembly in its Everett plant in Washington
State. Boeing also believed that by outsourcing the design of
so many components, it could cut the time to develop this air-
craft to four years from the six that is normal in the industry.
Some 17 partners in 10 countries were selected to pro-
duce major parts of the aircraft. The rear fuselage was to be
made by Vought Aircraft Industries in South Carolina, Alenia
Aeronautical of Italy was to make the middle fuselage sec-
tions and horizontal tailpieces. Three Japanese companies,
Fuji, Kawasaki, and Mitsubishi, were to produce the planes
wing. The nose section was to be made by Toronto-based
Onex Corporation. All of these bulky pieces were to be
shipped to Everett for final assembly aboard a fleet of three
modified Boeing 747 freighters call “Dreamlifters.”
Until late 2007, the strategy seemed to be working remark-
ably well. Boeing had booked orders for more than 770 aircraft,
worth more than $100 billion, making the 787 the most success-
ful aircraft launch in the history of commercial aviation. But
behind the scenes, cracks were appearing in Boeing’s globally
dispersed supply chain. In mid-2007, Boeing admitted the 787
might be a few months late due to problems with the supply of
special fasteners for the fuselage. As it turned out, the prob-
lems were much more serious. By early 2008 Boeing was ad-
mitting to a delay of up to 12 months in the delivery of the first
787, an additional $2 billion in development costs, and was fac-
ing the possibility of having to pay millions in penalty clause
payments for late delivery to its leading customers.
The core issue was that several key partners had not
been able to meets Boeing’s delivery schedules. To make
composite parts, for example, Italy’s Alenia had to build a new
factory, but the site that it chose was a 300-year-old olive
grove, and it faced months of haggling with local authorities
and had to agree to replant the trees elsewhere before it
could break ground. To compound problems, its first fuselage
sections delivered to Boeing did not meet the required quality
standards. Then when parts did arrive at Everett, Boeing

found that many components had not been installed in the fu-
selages (as required), and that assembly instructions were
available only in Italian. Other problems arose because sev-
eral partners themselves outsourced mission critical design
work to other enterprises. Vought, for example, outsourced
the design and building of floor pieces for which it was re-
sponsible to an Israeli company. In turn, the Israeli company
had trouble meeting Boeing’s exacting quality standards.
However, because it was reporting to Vought, not Boeing, ex-
ecutives at Boeing did not learn of this until it had already
become a serious bottleneck. Upon learning of the issue,
Boeing rapidly dispatched engineers to Israel to work with
the company, but by now several months had been lost.
Boeing also subsequently acquired Vought in 2009, bringing
the supplier in-house.
Despite all of these issues, Boeing remains committed to
its outsourcing program.
However, the company has learned that if it is going to
outsource work to foreign suppliers, much closer manage-
ment oversight and coordination is required. The company
has also indicated that as valuable as outsourcing can be, it
probably went too far with the 787. Going forward, Boeing has
signaled that it will not outsource key components that are
seen as a source of Boeing’s competitive advantage (wings,
in particular, are often mentioned as a component that may
not be outsourced for future aircraft models).

Sources: J. L. Lunsford, “Jet Blues,” The Wall Street Journal ,
December 7, 2007, p. A1; J. Gapper, “A Clever Way to Build a
Boeing,” Financial Times , July 9, 2007, p. 11; J. Teresko, “The
Boeing 787: A Matter of Materials,” Industry Week , December 2007,
pp. 34–39; and P. Sanders, “Boeing Takes Control of Plants,” The
Wall Street Journal , December 23, 2009, p. B2.

Case Discussion Questions
1. What are the benefits to Boeing of outsourcing so much

work on the 787 to foreign suppliers? What are the
potential risks? Do the benefits outweigh the risks?

2. In 2007 and 2008 Boeing ran into several publicized
issues with regard to its management of a globally
dispersed supply chain? What are the causes of these
problems? What can a company such as Boeing do to
make sure such problems do not occur in the future?

3. Some critics have claimed that by outsourcing so much
work, Boeing has been exporting American jobs
overseas. Is this criticism fair? How should the company
respond to such criticisms?

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