Diversity

Transnational Management

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Transnational Management TEXT, CASES, AND READINGS IN CROSS-BORDER MANAGEMENT

S I X T H E D I T I O N

Christopher A . Bartlett Harvard Business School

Paul W. Beamish Ivey Business School

The University of Western Ontario

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TRANSNATIONAL MANAGEMENT, SIXTH EDITION

Published by McGraw-Hill, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY 10020. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Previous editions © 2008, 2004, and 2000. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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Library of Congress Cataloging-in-Publication Data

Bartlett, Christopher A., 1943–

Transnational management : text, cases, and readings in cross-border management / Christopher A. Bartlett, Paul W. Beamish. -- 6th ed.

p. cm.

ISBN-13: 978-0-07-813711-2

ISBN-10: 0-07-813711-X

1. International business enterprises--Management. I. Beamish, Paul W.,

1953– II. Title.

HD62.4.B365 2011

658'.049--dc22

2009054449

www.mhhe.com

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About the Authors

Christopher Bartlett is the Thomas D. Casserly, Jr., Professor Emeritus of Business Administration at Harvard Graduate School of Business Administration. He received an economics degree from the University of Queensland, Australia, and both masters and doctorate degrees in business administration from Harvard University. Prior to his academic career, he was a marketing manager with Alcoa in Australia, a management consultant in McKinsey and Company’s London office, and country general manager of Baxter Laboratories’ subsidiary company in France.

He joined the faculty of Harvard Business School in 1979, and over the following 30 years his interests focused on strategic and organizational challenges confronting managers in multinational corporations and on the process of managing transforma- tional change. While at HBS, he served as faculty chair of the International Senior Management Program, area head of the School’s General Management Unit, faculty chairman of the Program for Global Leadership, and as chair of the Humanitarian Leadership Program.

He is the author or co-author of nine books, including Managing Across Borders: The Transnational Solution (coauthored with Sumantra Ghoshal), named by Financial Times as one of the 50 most influential business books of the century. The Individualized Cor- poration, his subsequent major research book with Ghoshal, was the winner of the Igor Ansoff Award for the best new work in strategic management and was named one of the Best Business Books for the Millennium by Strategy�Business magazine. Both books have been translated into over 10 foreign languages. His articles have appeared in jour- nals such as Harvard Business Review, Sloan Management Review, Strategic Manage- ment Journal, Academy of Management Review, and Journal of International Business Studies. He has also researched and written over 100 case studies and teaching notes, and their sales of over 3 1/2 million copies make him the best-selling case author ever. He has been elected by his colleagues as a fellow of the Academy of Management, the Academy of International Business, the Strategic Management Society, and the World Economic Forum.

Paul Beamish is the Donald Triggs Canada Research Chair in International Business at the Ivey Business School, University of Western Ontario. He is the author or coauthor of numerous books, articles, contributed chapters, and teaching cases. His articles have appeared in Academy of Management Review, Academy of Management Journal, Strate- gic Management Journal, Journal of International Business Studies (JIBS), Organiza- tion Science, and elsewhere. He has received best research awards from the Academy of Management and the Academy of International Business (AIB). In 1997 and 2003, he was recognized in the Journal of International Management as one of the top three con- tributors worldwide to the international strategic management literature in the previous decade. He served as Editor-in-Chief of JIBS from 1993–97. He worked for Procter & Gamble and Wilfrid Laurier University before joining Ivey’s faculty in 1987.

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He has supervised 25 doctoral dissertations, many involving international joint ven- tures and alliances. His consulting, management training, and joint venture facilitation activities have been in both the public and private sector.

At Ivey, he has taught in a variety of school programs, including the Executive MBA offered at its campus in Hong Kong. From 1999–2004, he served as Associate Dean of Research. He currently serves as Director of Ivey Publishing, the distributor of Ivey’s collection of over 2,400 current cases; Ivey’s Asian Management Institute (AMI); and the cross-enterprise center, Engaging Emerging Markets.

He is a Fellow of the Academy of International Business, Royal Society of Canada, and Asia Pacific Foundation of Canada.

vi About the Authors

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Preface

This book grew out of the authors’ strongly held belief that the best international busi- ness research did more than capture the challenges, activities, perceptions, and best practices from the field. It also translated those findings into practical and relevant lessons for managers and students of management. Although one of the original authors, our late friend and colleague Sumantra Ghoshal, passed away six years ago, that found- ing philosophy fits very comfortably with his successor co-author on this volume, Paul Beamish, and lives on in this sixth edition.

In preparing this new edition, we have done all we can to ensure that the frameworks, concepts, and practical examples we have included are topical, relevant, and of impor- tance to practitioners working in today’s global business environment. We believe that those are the issues that are described in the case studies, illuminated by the articles, and embedded in the conceptual chapters that provide the framework for this course-long voyage in transnational management.

In the 20 years since the first edition of Transnational Management appeared, much has changed in the field of cross-border business management—new external demands have emerged, new strategic responses have been developed, new organizational capa- bilities have evolved, and new managerial competencies have become necessary. But old international hands will insist that these differences are largely superficial, and beyond such ongoing adjustments at the margin, the basics of managing a worldwide operation remain much as they have always been—understanding one’s host country environment, being sensitive to cross-cultural differences, seeing the world as an integrated strategic reality, and being able to deal with the complexities of managing operations separated by the barriers of distance, language, time, and culture.

In many ways, both views are correct, and we are reminded of this with each revision of this volume, as we deal with conflicting pressures and demands that we must resolve with every new edition. On one hand we receive passionate input from teaching faculty anxious to keep up with the latest developments to keep the material fresh, reflecting the vibrancy of the field. But we also hear from those who recognize the importance of teaching the timeless international management issues that are often best captured in classic favorites. Based on input we received from the users of this text who are repre- sented on our Editorial Advisory Board, we have sought to maintain this balance, re- taining the most powerful existing cases and articles, while adding new material that captures the emerging issues that will keep courses fresh and students challenged. The end result is that, as in all previous editions, around half the cases and readings included in the sixth edition have been retained, and about half are new.

Distinguishing Characteristics of the MNE What makes the study of the multinational enterprise (MNE) unique? The most funda- mental distinction between a domestic company and an MNE derives from the social,

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political, and economic context in which each exists. The former operates in a single na- tional environment where social and cultural norms, government regulations, customer tastes and preferences, and the economic and competitive context of a business tend to be fairly consistent. Although within-country local variations do exist for most of these factors, they are nowhere near as diverse or as conflicting as the differences in demands and pressures the MNE faces in its multiple host countries.

The one feature that categorically distinguishes these intercountry differences from the intracountry ones, however, is sovereignty.1 Unlike the local or regional bodies, the nation-state generally represents the ultimate rule-making authority against whom no appeal is feasible. Consequently, the MNE faces an additional and unique element of risk: the political risk of operating in countries with different legal systems, social atti- tudes, and political philosophies regarding private property, corporate responsibility, and free enterprise.

A second major difference relates to competitive strategy. The purely domestic com- pany can respond to competitive challenges only within the context of its single market; the MNE can, and often must, play a much more complex competitive game. Global- scale or cross-border sourcing may be necessary to achieve a competitive position, implying the need for complex international logistical coordination. Furthermore, on the global chessboard, effective competitive strategy might require that a competitive challenge in one country might call for a response in a different country—perhaps the competitor’s home market. These are options and complexities a purely domestic company does not face.

Third, a purely domestic company can measure its performance in a single compara- ble unit—the local currency. Because currency values fluctuate against each other, how- ever, the MNE is required to measure results with a flexible measuring stick. In addition, it is exposed to the economic risks associated with shifts in both nominal and real exchange rates.

Finally, the purely domestic company must manage an organizational structure and management systems that reflect its product and functional variety; the MNE organiza- tion is intrinsically more complex because it must provide for management control over its product, functional, and geographic diversity. Furthermore, the resolution of this three-way tension must be accomplished in an organization that is divided by barriers of distance and time and impeded by differences in language and culture.

The Management Challenge Historically, the study of international business focused on the environmental forces, structures, and institutions that provided the context within which MNE managers had to operate. In such a macro approach, countries or industries rather than companies were the primary units of analysis. Reflecting the environment of its time, this traditional approach directed most attention to trade flows and the capital transfers that defined the foreign investment patterns.

viii Preface

❚ 1This difference is elaborated in J. N. Behrman and R. E. Gross, International Business and Governments: Issues and Institutions (Columbia: University of South Carolina Press, 1990). See also J. J. Boddewyn, “Political Aspects of MNE Theory,” Journal of International Business Studies 19, no. 3 (1988), pp. 341–63.

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Preface ix

During the 1970s and 1980s, a new perspective on the study of international man- agement began to emerge, with a far greater emphasis on the MNE and management be- havior rather than on global economic forces and international institutions. With the firms as the primary unit of analysis and management decisions as the key variables, these studies both highlighted and provided new insights into the management chal- lenges associated with international operations.

This book builds on the company- and management-level perspective. More specifi- cally, in order to make sense of the practice of managing the MNE, we tend to adopt a management perspective that views the world through the eyes of the executive who is in the thick of it—whether that is the CEO of the corporation, the global account manager, the country subsidiary manager, or the frontline business manager. The most powerful way to do this is to employ cases that require decisions to be made, and most of those in this book provide the reader not only with data on the business context but also with de- tailed information about the key actors, their roles, their responsibilities, and their per- sonal motivations. In many instances, videos and follow-up cases lead to further insight.

It would be easy to build our structure around the traditional functions of the company—R&D, manufacturing, marketing, etc.—and many texts have done so. But we find such an approach limiting because almost all real-world problems cut across these functional boundaries. They require executives to understand all the disparate parts of the organization, and they demand integrative solutions that bring together, rather than divide, the people working in their traditional functional silos. So we have also chosen to focus on the core organizational processes that executives must create and manage—the entrepreneurial process (identifying and acting on new opportunities), the integrative learning process (linking and leveraging those pockets of entrepreneurial initiative), and the leadership process (articulating a vision and inspiring others to follow). This process perspective is sometimes more difficult to grasp than the compart- mentalized functional view, but ultimately it provides a more fulfilling and realistic approach to the management of today’s MNE.

By adopting the perspective of the MNE manager, however, we do not ignore the im- portant and legitimate perspectives, interests, and influences of other key actors in the inter- national operating environment. However, we do view the effects of these other key actors from the perspective of the company and focus on understanding how the various forces they influence shape the strategic, organizational, and operational tasks of MNE managers.

The Structure of the Book The book is divided into three parts (see figure on page xiii). Part 1 consists of three chap- ters that examine the development of strategy in the MNE. In Chapter 1, we focus on the motivations that draw—or drive—companies abroad, the means by which they expand across borders, and the mind-sets of those who built the worldwide operations. Under- standing what we call a company’s “administrative heritage” is important because it shapes both the current configuration of assets and capabilities and the cognitive orientations of managers toward future growth—attitudes that can either enable or constrain such growth.

In Chapter 2, we examine the political, economic, and social forces that shape the business environment in which the MNE operates. In particular, the chapter explores the

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tension created by the political demands to be responsive to national differences, the economic pressures to be globally integrated, and the growing competitive need to de- velop and diffuse worldwide innovation and learning.

In Chapter 3, the focus shifts from the global business environment to MNEs’ com- petitive responses to those external pressures. Building on the themes developed in Chapter 2, we examine the various approaches an MNE can use to generate competitive advantage in its international context. We identify three traditional strategic approaches— global, international, and multinational—each of which focuses on a different source of competitive advantage. We then go on to describe the transnational strategy, which combines the benefits of the other three models.

Part 2 changes the focus from the MNE’s strategic imperatives to the organizational capabilities required to deliver them. Chapter 4 examines the organizational structures and systems that need to be put in place to be effective in a complex and dynamic world. Mirroring the three traditional strategic approaches, we explore three organizational models that all appear to be evolving toward the integrated network form required to manage transnational strategies.

Chapter 5 focuses on one of the most important processes to be developed in a transnational organization. The need to manage effective cross-border knowledge trans- fer and worldwide learning is creating additional organizational demands, and in this chapter, we explore how such processes are built and managed.

Then, in Chapter 6, we lift our organizational analysis up a level to examine the boundary-spanning structures and processes needed to create joint ventures, alliances, and interfirm networks in a global context. In this chapter, we explore how such partner- ships can be built and managed to develop strategic capabilities that may not be available inside any single MNE.

Part 3 focuses on the management challenges of operating a successful MNE. In Chapter 7, the focus is on those who must implement the transnational strategies, operate within the integrated network organizations, and above all, deliver the results. This chapter allows us to look at the world through the eyes of frontline country subsidiary managers, and shows how their actions can have important implications for the competitiveness of the entire corporation.

Finally in Chapter 8, we ask some broad questions about the present and future role of the multinational enterprise in the global economy. The powerful forces unleashed by globalization have had a largely positive impact on economic and social development worldwide. But like all revolutions, the forces of changes have acted unevenly, and there have been casualties. As the divide between the “haves” and “have nots” expands, the challenge facing MNEs is to determine what role they can and should play in mitigating some of the unintended consequences of the globalization revolution. It is a challenge that should confront every current executive and be central to the task of the next gen- eration of leadership in transnational companies.

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Preface xi

Acknowledgments Transnational Management has also benefited from the comments, suggestions, and in- sights provided by colleagues at the hundreds of institutions around the world that have adopted this book. In particular, we would like to acknowledge the role played by the Editorial Advisory Board (listed on page xii) who committed significant effort to pro- viding a detailed critique of the fifth edition that helped us make decisions about what to include in this edition. We have also had extraordinary support from our colleagues in other institutions who have provided valuable feedback and suggestions for improve- ment. In particular, we would like to acknowledge Shih-Fen Chen, Jean-Louis Schaan and Charles Dhanaraj.

Next, we are extraordinarily grateful to the researchers and colleagues who have con- tributed new materials to this edition. In addition to our own case materials, new case studies have been provided by Rod White, Hari Bapuji, Bo Nielsen, Torben Pedersen, Jacob Pyndt, Jean-Louis Schaan, Andreas Schotter, Harry Lane, Jordan Siegel, John Quelch, Stefan Thomke, and Ashok Nimgade. Articles new to this edition and focused on important research have been contributed by Marcus Alexander, Harry Korine, Arindam K. Bhattacharya, David C. Michael, Pankaj Ghemawat, Jeanne Brett, Kristin Behfar, Mary C. Kern, Julian Birkinshaw, Cyril Bouquet, Tina C. Ambos, John Bessant, Rick Delbridge, and Thomas Donaldson.

We must also acknowledge the coordination task undertaken by our respective administrative assistants who worked over many months to coordinate the flow of man- uscript documents back and forth among Boston, Sydney, and London, Ontario. To Jan Simmons and Mary Roberts, we give our heartfelt thanks for helping us through the long and arduous revision process. To Laura Hurst Spell, our sponsoring editor, Erin Melloy, our project manager, and Jane Beck, our editorial coordinator, at McGraw-Hill, as well as Jolynn Kilburg, our developmental editor at S4Carlisle Publishing Services, we thank you for your patience and tolerance through this long process and look forward to a long and productive working relationship.

Despite the best efforts of all the contributors, however, we must accept responsibil- ity for the shortcomings of the book that remain. Our only hope is that they are outweighed by the value you find in these pages and the exciting challenges they repre- sent in the constantly changing field of transnational management.

Christopher A. Bartlett Paul W. Beamish

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Editorial Advisory Board Our sincere thanks to the following faculty who provided detailed feedback and sugges- tions on the materials for this edition.

Name School Andrew H. Hageman, PhD American InterContinental University Axele Giroud University of Manchester Dr. Frank Borrmann Universität Hamburg Linda D. Clarke Florida International University Mohan V. Avvari Nottingham University Business School Dr. Susan Martin University of Hertfordshire Business School

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Preface xiii

Part 1.

The Strategic Imperatives

Chapter 7.

Implementing the Strategy

Chapter 8.

The Future of the Transnational

Chapter 4.

Developing a Transnational Organization

Chapter 5. Creating Worldwide

Innovation and Learning

Chapter 6.

Engaging in Cross-Border Collaboration

Chapter 1.

Expanding Abroad

Chapter 2.

Understanding the International Context

Chapter 3.

Developing Transnational Strategies

Part 2.

The Organizational Challenge

Part 3.

The Managerial Implications

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Table of Contents

Part 1 The Strategic Imperatives 1 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities 1

Cases 1-1 Lincoln Electric 15

1-2 Jollibee Foods Corporation (A): International Expansion 34

1-3 Acer, Inc: Taiwan’s Rampaging Dragon 53

1-4 Research in Motion: Managing Explosive Growth 68

Readings 1-1 The Tortuous Evolution of the

Multinational Corporation 86

1-2 Distance Still Matters: The Hard Reality of Global Expansion 95

1-3 When You Shouldn’t Go Global 105

Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces 113

Cases 2-1 Global Wine War 2009:

New World versus Old 128

2-2 The Globalization of CEMEX 146

2-3 Mattel and the Toy Recalls (A)1 166

Readings 2-1 Culture and Organization 178

2-2 Clusters and the New Economics of Competition 195

Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage 210

Cases 3-1 Marketing the “$100 Laptop” (A) 224

3-2 The Global Branding of Stella Artois 244

3-3 GE’s Imagination Breakthroughs: The Evo Project 259

Readings 3-1 Managing Differences: The

Central Challenge of Global Strategy 278

3-2 How Local Companies Keep Multinationals at Bay 290

3-3 Regional Strategies for Global Leadership 302

Part 2 The Organizational Challenge 314

Chapter 4 Developing a Transnational Organization: Managing Integration, Responsiveness, and Flexibility 314

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Chapter 6 Engaging in Cross-Border Collaboration: Managing across Corporate Boundaries 510

Cases 6-1 Nora-Sakari: A Proposed

JV in Malaysia (Revised) 525

6-2 Mahindra and Mahindra Ltd.—Farm Equipment Sector: Acquisition of Jiangling Tractor Company 538

6-3 Eli Lilly in India: Rethinking the Joint Venture Strategy 552

Readings 6-1 The Design and Management of

International Joint Ventures 567

6-2 Collaborate with Your Competitors–and Win 580

Part 3 The Managerial Implications 588 Chapter 7 Implementing the Strategy: Building Multidimensional Capabilities 588

Cases 7-1 ING Insurance Asia/Pacific 601

7-2 BRL Hardy: Globalizing an Australian Wine Company 612

7-3 Silvio Napoli at Schindler India (A) 629

Readings 7-1 Local Memoirs of a Global Manager 645

7-2 Tap Your Subsidiaries for Global Reach 653

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Cases 4-1 Philips versus Matsushita:

Competing Strategic and Organizational Choices 331

4-2 ECCO A/S–Global Value Chain Management 348

4-3 World Vision International’s AIDS Initiative: Challenging a Global Partnership 366

Readings 4-1 Managing Multicultural Teams 384

4-2 Managing Executive Attention in the Global Company 392

4-3 Matrix Management: Not a Structure, a Frame of Mind 400

Chapter 5 Creating Worldwide Innovation and Learning: Exploiting Cross- Border Knowledge Management 408

Cases 5-1 Siemens AG: Global

Development Strategy (A) 419

5-2 P&G Japan: The SK-II Globalization Project 442

5-3 McKinsey & Company: Managing Knowledge and Learning 461

Readings 5-1 Building Effective R&D

Capabilities Abroad 477

5-2 Connect and Develop: Inside Procter & Gamble’s New Model for Innovation* 487

5-3 Finding, Forming, and Performing: Creating Networks for Discontinuous Innovation 496

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8-3 Killer Coke: The Campaign Against Coca-Cola1 707

8-4 Genzyme’s CSR Dilemma: How to Play its HAND 725

Readings 8-1 Values in Tension: Ethics Away

from Home 743

8-2 Serving the World’s Poor, Profitably 754

Index 765

Table of Contents xvii

Chapter 8 The Future of the Transnational: An Evolving Global Role 662

Cases 8-1 Hitting the Wall: Nike and

International Labor Practices 679

8-2 IKEA’s Global Sourcing Challenge: Indian Rugs and Child Labor (A) 697

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1

C H A P T E R 1

Expanding Abroad: Motivations, Means, and Mentalities

In this chapter, we look at a number of important questions that companies must resolve before taking the leap to operate outside their home environment. What market opportunities, sourcing advantages, or strategic imperatives drive their international expansion? By what means will they expand their overseas presence—through exports, licensing, joint ventures, wholly owned subsidiaries, or some other means? How will the attitudes, assumptions, and beliefs that they bring to their international ventures affect their chances of success? Before exploring these important questions, however, we first need to develop a definition of this entity—the multinational enterprise (MNE)—that we plan to study and develop some sense of its size and importance in the global economy.

This book focuses on the management challenges associated with developing the strate- gies, building the organizations, and managing the operations of companies whose ac- tivities stretch across national boundaries. Clearly, operating in an international rather than a domestic arena presents managers with many new opportunities. Having world- wide operations not only gives a company access to new markets and low-cost re- sources, but also opens up new sources of information and knowledge and broadens the options for strategic moves the company might make in competing with its domestic and international rivals. However, with all these new opportunities come the challenges of managing strategy, organization, and operations that are innately more complex, diverse, and uncertain.

Our starting point is to focus on the dominant vehicle of internationalization, the multinational enterprise (MNE), and briefly review its role and influence in the global economy.1 Only after understanding the origins, interests, and objectives of this key actor will we be in a position to explore the strategies it pursues and the organization it develops to achieve them.

❚ 1Such entities are referred to variously—and often interchangeably—as multinational, international, and global enterprises. (Note that we use the term “enterprise” rather than “corporation” because some of the cross-border entities we will examine are nonprofit organizations whose strategies and operations are every bit as complex as their corporate brethren’s.) At the end of this chapter, we assign each of those terms—multinational, international, and global—specific meanings, but throughout the book, we adopt the widely used MNE abbreviation in a broader, more general sense to refer to all enterprises whose operations extend across national borders.

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The MNE: Definition, Scope, and Influence An economic historian could trace the origins of international business back thousands of years to the seafaring traders of Greece and Egypt,2 through the merchant traders of medieval Venice and the great British and Dutch trading companies of the 17th and 18th centuries. By the 19th century, the newly emerged capitalists in industrialized Europe began investing in the less-developed areas of the world (including the United States), but particularly within the vast empires held by Britain, France, Holland, and Germany.

Definition

In terms of the working definition we use, few if any of these entities through history could be called true MNEs. Most early traders would be excluded by our first qualifica- tion, which requires that an MNE have substantial direct investment in foreign countries, not just the trading relationships of an import–export business. Most of the companies that had established international operations in the 19th century would be excluded by our second criterion, which requires that they be engaged in the active management of these offshore assets rather than simply holding them in a passive investment portfolio.

Thus, though companies that source their raw materials offshore, license their technolo- gies abroad, export their products into foreign markets, or even hold minor equity posi- tions in overseas ventures without any management involvement may regard themselves as “international,” by our definition, they are not true MNEs unless they have substantial, direct investment in foreign countries and actively manage and regard those operations as integral parts of the company, both strategically and organizationally.

Scope

According to our definition, the MNE is a recent phenomenon, with the vast majority de- veloping only in the post–World War II years. However, the motivations for international expansion and the nature of MNEs’offshore activities have evolved significantly over this relatively short period, and we will explore some of these changes later in this chapter.

It is interesting to observe how the United Nations has changed its definition of the MNE as these companies have grown in size and importance.3 In 1973, it defined such an enterprise as one “which controls assets, factories, mines, sales offices, and the like in two or more countries.” By 1984, it had changed the definition to an enterprise (a) comprising entities in two or more countries, regardless of the legal form and fields of activity of those entities; (b) which operates under a system of decision making per- mitting coherent policies and a common strategy through one or more decision-making centers; and (c) in which the entities are so linked, by ownership or otherwise, that one or more of them may be able to exercise a significant influence over the activities of the others, in particular to share knowledge, resources, and responsibilities.

2 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 2See Karl Moore and David Lewis, The Origins of Globalization (New York: Routledge, 2009). ❚ 3The generic term for companies operating across national borders in most U.N. studies is transnational corporation (TNC). Because we use that term very specifically, we continue to define the general form of organizations with international operations as MNEs.

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The MNE: Definition, Scope, and Influence 3

In essence, the changing definition highlights the importance of both strategic and or- ganizational integration, and thereby, the active, coordinated management of operations located in different countries, as the key differentiating characteristic of an MNE. The resources committed to those units can take the form of skilled people or research equip- ment just as easily as plants and machinery or computer hardware. What really differenti- ates the MNE is that it creates an internal organization to carry out key cross-border tasks and transactions internally rather than depending on trade through the external markets, just as the companies in Table 1-1 do. This more recent U.N. definition also expands earlier assumptions of traditional ownership patterns to encompass a more varied set of financial, legal, and contractual relationships with different foreign affiliates. With this understand- ing, our definition of MNEs includes Intel, Unilever, and Samsung, but also Singapore Airlines, McKinsey & Company, and Starbucks.

MNE influence in the Global Economy

Most frequent international business travelers have had an experience like the follow- ing: She arrives on her British Airways flight, rents a Toyota at Hertz, and drives to the downtown Hilton Hotel. In her room, she flips on the Sony television and absent- mindedly gazes out at neon signs flashing “Coca-Cola,” “Canon,” and “BMW.” The latest episode of House is flickering on the screen when room service delivers dinner along with the bottle of Perrier she ordered. All of a sudden, a feeling of disorientation engulfs her. Is she in Sydney, Singapore, Stockholm, or Seattle? Her surroundings and points of reference over the past few hours have provided few clues.

Such experiences, more than any data, provide the best indication of the enormous influence of MNEs in the global economy. As the cases and articles in this book show,

Table 1-1 Comparison of Top MNEs and Selected Countries: 2006

Value-Added Value-Added Company† (millions) Rank Country‡ (millions) Rank

ExxonMobil 111,724 1 United States 13,132,900 1 Royal Dutch/Shell 74,738 2 Japan 4,375,967 2 Toyota Motor 62,313 3 Germany 2,913,311 3 BP 54,829 4 Poland 341,670 24 Wal-Mart 54,094 5 Hungary 113,053 49 Chevron Corp 51,223 6 Morocco 65,637 56 Siemens 49,108 7 Tanzania 14,178 98 General Electric 49,073 8 Nepal 9,043 115 Ford Motor 41,429 9 Haiti 4,961 136 IBM 29,599 10 Burundi 903 166

Notes: “Value-added” refers to gross domestic product (GDP) for countries and to the sum of salaries, pretax profits, and depreciation and amortization for companies. †Calculated from data from World Investment Report 2008, published by the United Nations, assuming the same value- added to sales ratios as in World Investment Report 2000. For Chevron Corp., the value-added is estimated by the authors. ‡Data are from World Development Indicators, published by the World Bank.

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few sectors of the economy and few firms—not even those that are purely domestic in their operations—are free from this pervasive influence. According to U.N. estimates, by 2008, the number of MNEs had risen to approximately 78,000, collectively managing at least 780,000 foreign affiliates. Total revenues were in the range of $20 trillion. The top 500 MNEs account for nearly 70 percent of world trade. Most of the world’s automo- biles, computers, and soft drinks are produced and marketed by MNEs.

Not all MNEs are large, but most large companies in the world are MNEs. Indeed, the largest 100 MNEs, excluding those in banking and finance, accounted for $9.2 trillion of total worldwide assets in 2006, of which $5.2 trillion was located outside their re- spective home countries.

A different perspective on their size and potential impact is provided in Table 1-1, which compares the overall value-added of several of the largest MNEs with the gross domestic products (GDPs) of selected countries. According to the World Investment Re- port, the measure of company value added (the sum of salaries, pretax profits, amorti- zation, and depreciation) provides a more meaningful comparison with country GDP than simply looking at a company’s gross revenues. By using this measure, it is clear that the world’s largest MNEs are equivalent in their economic importance to medium-sized economies such as Chile, Hungary, or Pakistan and considerably more economically im- portant than smaller or less developed economies such as Tanzania, Estonia, or Sri Lanka. They have considerable influence on the global economy, employ a high percentage of business graduates, and pose the most complex strategic and organizational challenges for their managers. For the same reasons, they provide the focus for much of our atten- tion in this book.

The Motivations: Pushes and Pulls to Internationalize What motivates companies to expand their operations internationally? Although occa- sionally the motives may be entirely idiosyncratic, such as the desire of the CEO to spend time in Mexico or link to old family ties in Europe, an extensive body of research suggests more systematic patterns.

Traditional Motivations

Among the earliest motivations that drove companies to invest abroad was the need to secure key supplies. Aluminum producers needed to ensure their supply of bauxite, tire companies went abroad to develop rubber plantations, and oil companies wanted to open new fields in Canada, the Middle East, and Venezuela. By the early part of this cen- tury, Standard Oil, Alcoa, Goodyear, Anaconda Copper, and International Nickel were among the largest of the emerging MNEs.

Another strong trigger for internationalization could be described as market-seeking behavior. This motivation was particularly strong for companies that had some intrinsic advantage, typically related to their technology or brand recognition, that gave them a competitive advantage in offshore markets. Their initial moves were often opportunistic, frequently originating with an unsolicited export order. However, many companies even- tually realized that additional sales enabled them to exploit economies of scale and scope, thereby providing a source of competitive advantage over their domestic rivals. This

4 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

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The Motivations: Pushes and Pulls to Internationalize 5

market seeking was a particularly strong motive for some European multinationals whose small home markets were insufficient to support the volume-intensive manufac- turing processes that were sweeping through industries from food and tobacco to chemicals and automobiles. Companies like Nestlé, Bayer, and Ford expanded internationally pri- marily in search of new markets.

Another traditional and important trigger of internationalization was the desire to access low-cost factors of production. Particularly as tariff barriers declined in the 1960s, the United States and many European countries, for which labor represented a major cost, found that their products were at a competitive disadvantage compared with imports. In response, a number of companies in clothing, electronics, household appli- ances, watch-making, and other such industries established offshore sourcing locations to produce components or even complete product lines. Soon it became clear that labor was not the only productive factor that could be sourced more economically overseas. For example, the availability of lower-cost capital (perhaps through a government invest- ment subsidy) also became a strong force for internationalization.

These three motives (or two, if we ignore their historical differences and combine securing supplies and accessing low-cost factors into a single resource-seeking motive) were the main traditional driving force behind the overseas expansion of MNEs. The ways in which these motives interacted to push companies—particularly those from the United States—to become MNEs are captured in the well-known product cycle theory.4

This theory suggests that the starting point for an internationalization process is typically an innovation that a company creates in its home country. In the first phase of exploiting the development, the company—let’s assume it is in the United States—builds production facilities in its home market not only because this is where its main customer base is located, but also because of the need to maintain close linkages between research and production in this phase of its development cycle. In this early stage, some demand also may be created in other developed countries—in European countries, for example— where consumer needs and market developments are similar to those of the United States. These requirements normally would be met with home production, thereby generating exports for the United States.

During this pre-MNE stage, firms would typically establish an export unit within the home office, to oversee the growing export levels. Committing to this sort of organiza- tional structure would in turn typically lead to stronger performance than would treating exports simply as a part of the domestic business.5

As the product matures and production processes become standardized, the company enters a new stage. By this time, demand in the European countries may have become quite sizable, and export sales, originally a marginal side benefit, have become an impor- tant part of the revenues from the new business. Furthermore, competitors probably begin to see the growing demand for the new product as a potential opportunity to establish themselves in the markets served by exports. To prevent or counteract such competition

❚ 4Raymond Vernon, “International Investment and International Trade in the Product Cycle,” Quarterly Journal of Economics, May 1966, pp. 190–207. ❚ 5Paul W. Beamish, Lambros Karavis, Anthony Goerzen, and Christopher Lane, “The Relationship Between Organizational Structure and Export Performance,” Management International Review 39 (1999), pp. 37–54.

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and to meet the foreign demand more effectively, the innovating company typically sets up production facilities in the importing countries, thereby making the transition from being an exporter to becoming a true MNE.

Finally, in the third stage, the product becomes highly standardized, and many com- petitors enter the business. Competition focuses on price and, therefore, on cost. This trend activates the resource-seeking motive, and the company moves production to low-wage, developing countries to meet the demands of its customers in the developed markets at a lower cost. In this final phase, the developing countries may become net exporters of the product while the developed countries become net importers.

Although the product cycle theory provided a useful way to describe much of the internationalization of the postwar decades,6 by the 1980s, its explanatory power was beginning to wane, as Professor Vernon himself was quick to point out. As the international business environment became increasingly complex and sophisticated, companies developed a much richer rationale for their worldwide operations.

Emerging Motivations

Once MNEs had established international sales and production operations, their percep- tions and strategic motivations gradually changed. Initially, the typical attitude was that the foreign operations were strategic and organizational appendages to the domestic business and should be managed opportunistically. Gradually, however, managers began to think about their strategy in a more integrated, worldwide sense. In this process, the forces that originally triggered their expansion overseas often became secondary to a new set of motivations that underlay their emerging global strategies.

The first such set of forces was the increasing scale economies, ballooning R&D investments, and shortening product life cycles that transformed many industries into global rather than national structures and made a worldwide scope of activities not a matter of choice, but an essential prerequisite for companies to survive in those businesses. These forces are described in detail in the next chapter.

A second factor that often became critical to a company’s international strategy— though it was rarely the original motivating trigger—was its global scanning and learn- ing capability.7 A company drawn offshore to secure supplies of raw materials was more likely to become aware of alternative, low-cost production sources around the globe; a company tempted abroad by market opportunities was often exposed to new technolo- gies or market needs that stimulated innovative product development. The very nature of an MNE’s worldwide presence gave it a huge informational advantage that could result in it locating more efficient sources or more advanced product and process technologies.

6 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 6The record of international expansion of countries in the post–World War II era is quite consistent with the pattern suggested by the product cycle theory. For example, between 1950 and 1980, U.S. firms’ direct foreign investment (DFI) increased from $11.8 billion to $200 billion. In the 1950s, much of this investment focused on neighboring countries in Latin America and Canada. By the early 1960s, attention had shifted to Europe, and the European Economic Community’s share of U.S. firms’ DFI increased from 16 percent in 1957 to 32 percent by 1966. Finally, in the 1970s, attention shifted to developing countries, whose share of U.S. firms’ DFI grew from 18 percent in 1974 to 25 percent in 1980. ❚ 7This motivation is highlighted by Raymond Vernon in “Gone Are the Cash Cows of Yesteryear,” Harvard Business Review, November–December 1980, pp. 150–55.

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The Means of Internationalization: Prerequisites and Processes 7

Thus, a company whose international strategy was triggered by a technological or mar- keting advantage could enhance that advantage through the scanning and learning po- tential inherent in its worldwide network of operations.

A third benefit that soon became evident was that being a multinational rather than a national company brought important advantages of competitive positioning. Certainly, the most controversial of the many global competitive strategic actions taken by MNEs in recent years have been those based on cross-subsidization of markets. For example, a Korean mobile phone producer could challenge a national company in Europe by subsidizing its European losses with funds from its profitable Asian or South American operations.

If the European company did not have strong positions in the Korean company’s key Asian and South American markets, its competitive response could only be to defend its home market positions—typically by seeking government intervention or matching or offsetting the Korean challenger’s competitive price reductions. Recognition of these competitive implications of multicountry operations led some companies to change the cri- teria for their international investment decisions to reflect not only market attractiveness or cost-efficiency choices, but also the leverage such investments provided over competitors.8

Although for the purposes of analysis—and to reflect some sense of historical development—the motives behind the expansion of MNEs have been reduced to a few distinct categories, it should be clear that companies were rarely driven by a single motivating force. More adaptable companies soon learned how to capitalize on the potential advantages available from their international operations—ensuring critical supplies, entering new markets, tapping low-cost factors of production, leveraging their global information access, and capitalizing on the competitive advantage of their multi- ple market positions—and began to use these strengths to play a new strategic game that we will describe in later chapters as global chess.

The Means of Internationalization: Prerequisites and Processes

Having explored why an aspiring MNE wants to expand abroad (i.e., its motivation), we must now understand how it does so by exploring the means of internationalization. Beyond the desire to expand offshore, a company must possess certain competencies— attributes that we describe as prerequisites—if it is to succeed in overseas markets. It must then be able to implement its desire to expand abroad through a series of decisions and commitments that define the internationalization process.

Prerequisites for Internationalization

In each national market, a foreign company suffers from some disadvantages in com- parison with local competitors, at least initially. Being more familiar with the national culture, industry structure, government requirements, and other aspects of doing business in that country, domestic companies have a huge natural advantage. Their existing rela- tionships with relevant customers, suppliers, regulators, and so on, provide additional

❚ 8These competitive aspects of global operations are discussed in detail in Chapter 3.

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advantages that the foreign company must either match or counteract with some unique strategic capability. Most often, this countervailing strategic advantage comes from the MNE’s superior knowledge or skills, which typically take the form of advanced techno- logical expertise or specific marketing competencies. At other times, scale economies in R&D, production, or some other part of the value chain become the main source of the MNE’s advantage over domestic firms. It is important to note, however, that the MNE cannot expect to succeed in the international environment unless it has some distinctive competency to overcome the liability of its foreignness.9

Such knowledge or scale-based strategic advantages are, by themselves, insufficient to justify the internationalization of operations. Often with much less effort, a company could sell or license its technology to foreign producers, franchise its brand name internationally, or sell its products abroad through general trading companies or local distributors, without having to set up its own offshore operations. This approach was explicitly adopted by RCA, which decided to aggressively license its extensive television and other patents to European and Japanese companies rather than set up its own inter- national operations. The CEO argued that the safe return generated by license fees was preferable to the uncertainties and complexities of multinational management. The French multinational Thomson SA now owns the RCA trademark and licenses the name to other companies like Audiovox and TCL.

The other precondition for a company to become an MNE, therefore, is it must have the organizational capability to leverage its strategic assets more effectively through its own subsidiaries than through contractual relations with outside parties. If superior knowledge is the main source of an MNE’s competitive advantage, for example, it must have an organizational system that provides better returns from extending and exploit- ing its knowledge through direct foreign operations than the return it could get by sell- ing or licensing that knowledge.10

To summarize, three conditions must be met for the existence of an MNE. First, some foreign countries must offer certain location-specific advantages to provide the requisite motivation for the company to invest there. Second, the company must have some strate- gic competencies or ownership-specific advantages to counteract the disadvantages of its relative unfamiliarity with foreign markets. Third, it must possess some organiza- tional capabilities to achieve better returns from leveraging its strategic strengths inter- nally rather than through external market mechanisms such as contracts or licenses.11

Understanding these prerequisites is important not only because they explain why MNEs exist but also, as we show in Chapter 3, because they help define the strategic options for competing in worldwide businesses.

8 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 9The need for such strategic advantages for a company to become an MNE is highlighted by the market imperfections theory of MNEs. For a comprehensive review of this theory, see Richard E. Caves, Multinational Enterprise and Economic Analysis, 2nd ed. (Cambridge: Cambridge University Press, 1996). ❚ 10The issue of organizational capability is the focus of what has come to be known as the internalization theory of MNEs. See Alan M. Rugman, “A New Theory of the Multinational Enterprise: Internationalization versus Internalization,” Columbia Journal of World Business, Spring 1982, pp. 54–61. For a more detailed exposition, see Peter J. Buckley and Mark Casson, The Future of Multinational Enterprise (London: MacMillan, 1976). ❚ 11These three conditions are highlighted in John Dunning’s eclectic theory. See John H. Dunning and Sarianna M. Lundan, Multinational Enterprises and the Global Economy, 2nd ed. (Cheltenham, UK: Edward Elgar, 2008).

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Figure 1-1 A Learning Model of Internationalization

The Means of Internationalization: Prerequisites and Processes 9

The Process of Internationalization

The process of developing these strategic and organizational attributes lies at the heart of the internationalization process through which a company builds its position in world markets. This process is rarely well thought out in advance, and it typically builds on a combination of rational analysis, opportunism, and pure luck. Nonetheless, it is still possi- ble to discern some general patterns of behavior that firms typically follow.

The most well-known model for internationalization was developed during the 1970s by two Swedish academics based in Uppsala, who described foreign-market entry as a learn- ing process.12 The company makes an initial commitment of resources to the foreign market, and through this investment, it gains local market knowledge about customers, competitors, and regulatory conditions. On the basis of this market knowledge, the com- pany is able to evaluate its current activities, the extent of its commitment to the market, and thus the opportunities for additional investment. It then makes a subsequent resource com- mitment, perhaps buying out its local distributor or investing in a local manufacturing plant, which allows it to develop additional market knowledge. Gradually, and through several cy- cles of investment, the company develops the necessary levels of local capability and mar- ket knowledge to become an effective competitor in the foreign country (see Figure 1-1).

Whereas many companies internationalize in the incremental approach depicted by the so-called Uppsala model, a great many do not.13 Some companies invest in or ac- quire local partners to shortcut the process of building up local market knowledge. For example, Wal-Mart entered the United Kingdom by buying the supermarket chain ASDA rather than developing its own stores. Others minimize their local presence by subcontract- ing to local partners. Amazon.com has a business in Canada without a single Canadian employee—it manages its website from the United States, and it fulfills orders through the Canadian postal service. Cases such as these highlight the complexity of the decisions MNEs face in entering a foreign market.

One important set of factors is the assimilation of local market knowledge by the sub- sidiary unit, as suggested by the Uppsala model. Other, equally important factors to the

Market Knowledge

Market Commitment

Commitment Decisions

Current Activities

Source: Johanson and Vahlne, 1977.

❚ 12Jan Johanson and Jan-Erik Vahlne, “The Internationalization Process of the Firm—A Model of Knowledge Development and Increasing Foreign Market Commitments,” Journal of International Business Studies 88 (1977), pp. 23–32. ❚ 13Jonathan Calof and Paul W. Beamish, “Adapting to Foreign Markets: Explaining Internationalization,” International Business Review 4 (1995), pp. 115–31.

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Figure 1-2 Approaches to Foreign Market Entry

MNE include its overall level of commitment to the foreign market in question, the re- quired level of control of foreign operations, and the timing of its entry. To help make sense of these different factors, it is useful to think of the different modes of operating overseas in terms of two factors: the level of market commitment made and the level of control needed (see Figure 1-2).

Some companies internationalize by gradually moving up the scale, from exporting through joint venturing to direct foreign investment. Others, like Wal-Mart, prefer to move straight to the high-commitment–high-control mode of operating, in part because they are entering mature markets in which it would be very difficult to build a business from nothing. Still others choose to adopt a low-commitment–low-control mode, such as exporting or subcontracting. For example, Amazon.com is able to make this approach work in Canada because it retains control of its website from the United States and has secured a reliable local partner for order fulfillment. To be clear, none of these ap- proaches is necessarily right or wrong, but they should be consistent with the overall strategic intentions and motivations of the MNE.

It is also important to emphasize that some firms are “born global,” establishing significant international operations at or near their founding. Whether this is due to their internal orientation,14 or the need to move quickly due to the nature of their product or services, such firms do not take such an incremental approach.

Similarly not all MNEs are large firms. By definition, most large MNEs started out small. Yet many small- and medium-sized enterprises (SMEs) retain such a size, while still

10 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 14See Gary A. Knight and Tamar Cavusgil, “Innovation, Organizational Capabilities and the Born-Global Firm,” Journal of International Business Studies, 35 (2004), pp. 124–41 and Daniel J. Isenberg, “The Global Entrepreneur,” Harvard Business Review, December 2008.

Franchising

Licensing

Indirect export

Export (e.g., through agent

or distributor)

Joint venture (e.g., with local

partner)

Wholly owned

subsidiary

Le ve

l o f c

on tr

ol o

ve r

fo re

ig n

ac tiv

iti es

Amount of resources committed to foreign market

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The Evolving Mentality: International to Transnational 11

being MNEs in their own right. Other SMEs, observing a positive impact on performance as a consequence of their FDI activity,15 will grow.

The Evolving Mentality: International to Transnational Even from this brief description of the changing motivations for and means of interna- tionalization, it should be clear that a gradual evolution has occurred in the strategic role that foreign operations play in emerging MNEs. We can categorize this evolutionary pattern into four stages that reflect the way in which management thinking has developed over time as changes have occurred in both the international business environment and the MNE as a unique corporate form.

Although such a classification is necessarily generalized and somewhat arbitrary, it enables us to achieve two objectives. First, it highlights that for most MNEs, the objectives that initially induced management to go overseas evolve into a very different set of motivations over time, thereby progressively changing management attitudes and actions. Second, such a classification provides a specific language system that we use throughout this book to describe the very different strategic approaches adopted by various MNEs.16

International Mentality

In the earliest stages of internationalization, many MNE managers tend to think of the com- pany’s overseas operations as distant outposts whose main role is to support the domestic parent company in different ways, such as contributing incremental sales to the domestic manufacturing operations. We label this approach the international strategic mentality.

The international terminology derives directly from the international product cycle theory, which reflects many of the assumptions implicit in this approach. Products are developed for the domestic market and only subsequently sold abroad; technology and other knowledge are transferred from the parent company to the overseas operators; and offshore manufacturing represents a means to protect the company’s home market. Companies with this mentality regard themselves fundamentally as domestic with some foreign appendages. Managers assigned to overseas operations may be selected because they happen to know a foreign language or have previously lived abroad. Decisions related to the foreign operations tend to be made in an opportunistic or ad hoc manner. Many firms at this stage will prefer to only enter countries where there is low “psychic distance” between it and the home market.

Multinational Mentality

The exposure of the organization to foreign environments and the growing importance of sales and profits from these sources gradually convince managers that international activities can provide opportunities of more than marginal significance. Increasingly,

❚ 15Jane Lu and Paul W. Beamish, “Internationalization and Performance of SMEs,” Strategic Management Journal 22 (2001), pp. 565–86. ❚ 16It should be noted that the terms international, multinational, global, and transnational have been used very differently—and sometimes interchangeably—by various writers. We want to give each term a specific and different meaning and ask that readers put aside their previous usage of the terms—at least for the duration of our exposition.

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they also realize that to leverage those opportunities, they must do more than ship out old equipment, technology, or product lines that had been developed for the home market. The success of local competitors in the foreign markets and the demands of host govern- ments often accelerate the learning of companies that retain an unresponsive, interna- tional mentality for too long.

A multinational strategic mentality develops as managers begin to recognize and em- phasize the differences among national markets and operating environments. Companies with this mentality adopt a more flexible approach to their international operations by modifying their products, strategies, and even management practices country by country. As they develop national companies that are increasingly sensitive and responsive to their local environments, these companies undertake a strategic approach that is literally multi- national: Their strategy is built on the foundation of the multiple, nationally responsive strategies of the company’s worldwide subsidiaries. In companies operating with such a multinational mentality, managers of foreign operations tend to be highly independent entrepreneurs, often nationals of the host country.

Using their local market knowledge and the parent company’s willingness to invest in these growing opportunities, these entrepreneurial country managers often can build sig- nificant local growth and considerable independence from headquarters.

Global Mentality

Although the multinational mentality typically results in very responsive marketing ap- proaches in the different national markets, it also gives rise to an inefficient manufactur- ing infrastructure within the company. Plants are built more to provide local marketing advantages or improve political relations than to maximize production efficiency. Simi- larly, the proliferation of products designed to meet local needs contributes to a general loss of efficiency in design, production, logistics, distribution, and other functional tasks.

In an operating environment of improving transportation and communication facili- ties and falling trade barriers, some companies adopt a very different strategic approach in their international operations. These companies think in terms of creating products for a world market and manufacturing them on a global scale in a few highly efficient plants, often at the corporate center.

We define this approach as a classic global strategy mentality, because it views the world, not just individual national markets, as its unit of analysis. The underlying assumption is that national tastes and preferences are more similar than different or that they can be made similar by providing customers with standardized products at adequate cost and with quality advantages over those national varieties they know. Managers with this global strategic approach subscribe to Professor Levitt’s provocative argument in the mid-1980s that the future belongs to companies that make and sell “the same thing, the same way, everywhere.”17

This strategic approach requires considerably more central coordination and control than the others and is typically associated with an organizational structure in which var- ious product or business managers have worldwide responsibility. In such companies,

12 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 17See Theodore Levitt, “The Globalization of Markets,” Harvard Business Review, May–June 1983, pp. 92–102.

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The Evolving Mentality: International to Transnational 13

research and development and manufacturing activities are typically managed from the headquarters, and most strategic decisions also take place at the center.

Transnational Mentality

In the closing decades of the 20th century, many of these global companies seemed invin- cible, chalking up overwhelming victories over not only local companies, but international and multinational competitors as well. Their success, however, created and strengthened a set of countervailing forces of localization.

To many host governments, for example, these global companies appeared to be a more powerful and thus more threatening version of earlier unresponsive companies with their unsophisticated international strategic mentality. Many host governments increased both the restrictions and the demands they placed on global companies, requiring them to invest in, transfer technology to, and meet local content requirements of the host countries.

Customers also contributed to this strengthening of localizing forces by rejecting homogenized global products and reasserting their national preferences—albeit without relaxing their expectations of high quality levels and low costs that global products had offered. Finally, the increasing volatility in the international economic and political environments, especially rapid changes in currency exchange rates, undermined the efficiency of such a centralized global approach.

As a result of these developments, many worldwide companies recognized that demands to be responsive to local market and political needs and pressures to develop global-scale competitive efficiency were simultaneous, if sometimes conflicting, imperatives.

In these conditions, the either/or attitude reflected in both the multinational and the global strategic mentalities became increasingly inappropriate. The emerging requirement was for companies to become more responsive to local needs while capturing the benefits of global efficiency—an approach to worldwide management that we call the transnational strategic mentality. The president of IBM has noted how the global integration of pro- duction allows the firm to reduce costs and access new skills and knowledge. But he adds a caveat about the challenge of adopting such an approach—“securing a supply of high value skills.”18

In such companies, key activities and resources are neither centralized in the parent company nor so decentralized that each subsidiary can carry out its own tasks on a local- for-local basis. Instead, the resources and activities are dispersed but specialized, to achieve efficiency and flexibility at the same time. Furthermore, these dispersed resources are integrated into an interdependent network of worldwide operations.

In contrast to the global model, the transnational mentality recognizes the importance of flexible and responsive country-level operations—hence, the return of national into the terminology. And compared with the multinational approach, it provides for means to link and coordinate those operations to retain competitive effectiveness and economic efficiency, as is indicated by the prefix trans. The resulting need for intensive, organization-wide coordination and shared decision making implies that this is a much

❚ 18See Samuel J. Palmisano, “Global Integration and the Decline of the Multinational,” World Trade, August 2006, p. 8.

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more sophisticated and subtle approach to MNE management. In subsequent chapters, we will explore its strategic, organizational, and managerial implications.

It should be clear, however, that there is no inevitability in either the direction or the endpoint of this evolving strategic mentality in worldwide companies. Depending on the industry, the company’s strategic position, the host countries’ diverse needs, and a variety of other factors, a company might reasonably operate with any one of these strategic mentalities. More likely, bearing in mind that ours is an arbitrary classification, most com- panies probably exhibit some attributes of each of these different strategic approaches.19

Summary and Concluding Comments This chapter provides the historical context of the nature of the MNE and introduces a number of important concepts on which subsequent chapters will build. In particular, we have described the evolving set of motivations that led companies to expand abroad in the first place; the means of expansion, as shaped by the processes of internationaliza- tion they followed; and the typical mentalities that they developed. Collectively, these motivations, means, and mentalities are the prime drivers of what we call a company’s administrative heritage, the unique and deeply embedded structural, process, and cultural biases that play an important part in shaping every company’s strategic and organizational capabilities.

Chapter 1 Readings

• In Reading 1-1, the now classic “The Tortuous Evolution of the Multinational Cor- poration,” Perlmutter introduces the primary types of headquarters orientation toward subsidiaries: ethnocentric, polycentric, and geocentric, and the forces which move an organization toward—or away—from a geocentric mindset.

• In Reading 1-2, “Distance Still Matters: The Hard Reality of Global Expansion,” Ghemawat introduces the CAGE distance framework. The intent of this cultural, administrative, geographic, and economic distance framework is to help managers understand which attributes create distance, and the impact on various industries.

• Reading 1-3, “When You Shouldn’t Go Global,” serves as a caution to organizations which might unwittingly jump on the globalization bandwagon. Alexander and Korine provide three questions to ask before going global: Are there potential benefits for our company? Do we have the necessary management skills? Will the costs outweigh the benefits?

All three readings are intended to underscore the motivations, means, and mentalities required to expand abroad.

14 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 19Professor Howard Perlmutter was perhaps the first to highlight the different strategic mentalities. See his article, “The Tortuous Evolution of the Multinational Corporation,” Columbia Journal of World Business, January–February 1969, pp. 9–18, reproduced in the readings section of this chapter.

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Most recently, the company had enjoyed increasing success in China as a result of its aggressive expansion through both a joint venture and set of majority-owned plants. As Stropki opened the Cleveland newspaper to check the previous Sunday’s Cleveland Browns score, he wondered how he could apply the lessons of the Chinese experience in particular, to India.

Welding Industry

Welding is a technique for joining pieces of metal by fusion through the application of concentrated heat. Virtually any two metal items can be joined by welding. Welding is also a supporting activity in most industrial activities, from the manufacture of construction equipment to machine tools, from pipelines to petrochemical complexes. The pre- dominant method of welding is arc welding, where a welding power source generates electric current, which is used to create an electric arc, which then melts a filler metal used to create the bond between the two metal parts. The filler metal is in the form of a stick or wire electrode, and the electrode often has a series of chemical coatings and/or shielding gases designed to protect the welded metal from oxygen and nitrogen in the air and thus strengthen the bond. Electrodes are referred to as “consumables,” and

Introduction

John Stropki, CEO of Lincoln Electric, returned home from Mumbai to company headquarters in Cleveland, having sampled the local Maharashtran delicacies while studying opportunities in the Indian market. From his vantage point in 2006, Stropki looked back on his company’s more than 100 years in the welding equipment and consumables indus- try with pride, wondering whether a strong push into India should be the next step in his company’s globalization. An India expansion had been consid- ered for several years, but thus far the company had focused on growing its operations in China and else- where around the globe. If Stropki were to approve a significant allocation of resources toward an India expansion, he wondered what would be the best way to enter. He had a wealth of company lessons and experiences to apply to the India investment decision, as his company had had international operations since the 1940s, had struggled internationally in the late 1980s and early 1990s, and had gone on to regain its global competitive advantage in the late 1990s and early 2000s. During Stropki’s tenure as CEO since 2004, the company had further expanded globally and by 2006 owned manufacturing operations in 19 countries across five continents.

Case 1-1 Lincoln Electric 15

Case 1-1 Lincoln Electric Jordan Siegel

❚ Professor Jordan Siegel prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. ❚ Harvard Business School Case No 9-707-445, Copyright 2006 President and Fellows of Harvard College. All rights reserved. This case was prepared by J. Siegel. HBS Cases are developed solely for class discussion and do not necessarily illustrate either effective or ineffective handling of administrative situation.

Exhibit 1 Global Sales for the Welding Industry in 2005

Welding Equipment Cutting Products

42%

Consumables 58%

Source: Lincoln Electric.

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the power sources and related parts used to create the electric arc are referred to as “equipment.”

As of 2005, the welding industry together with its associated metal-cutting technology was a $13 billion industry globally. As shown in Exhibit 1, 42% of welding industry sales came from equipment, whereas the remaining 58% came from sales of consumables. Welding products played a crucial role in the development of important structures around the world, such as bridges, oil-production facilities, and a range of other building, infrastructure, and commercial construction projects. As a result, the industry’s growth rate in unit volume moved to- gether with the global economic growth rate, which was predicted to be 3.0% in 2006.1 The industry’s growth in sales revenue could be even higher, as was the case in 2005 when growth was driven by high demand for welding products in China, India, and Eastern Europe. Customers included compa- nies involved in general metal fabrication; infra- structure building including oil and gas pipelines

16 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 1“LINK Global Economic Outlook,” Development Policy and Analysis Division, United Nations Department of Economic and Social Affairs, October 2005.

and platforms, buildings and bridges, and power generation; and transportation and defense indus- tries (automotive/trucks, rail, ships and aerospace); equipment manufacturers in construction, farming and mining; and retail do-it-yourself (DIY). Sales were spread out across these various customer seg- ments. As shown in Exhibit 2, sales were also spread geographically across the globe, with Asia responsible for 45% of global sales, followed by North America (23%) and Europe (21%).

Major Welding Competitors in 2006 In 2006 the global arc welding industry was seen as highly competitive. The industry was significantly frag- mented, with more than a thousand companies producing equipment and consumables and the top six accounting for only 45% of the global market. Exhibit 3 presents a visual comparison of the lead- ing welding competitors by their level of revenue. Companies competed on the basis of price, brand preference, product quality, customer service, breadth of product offering, and technical expertise and innovation. In addition, because it was costly to ship welding products due to their weight, it was es- sential in this industry to set up a local or regional production presence to gain significant market share.

Exhibit 2 Geographic Pattern of Sales for the Global Welding Industry in 2005

China 17%

India 3%

North America 23%

Europe 21%

Japan/Korea 16%

Russia, Africa, Middle

East 6%

Southeast Asia 9%

Latin America 5%

Source: Lincoln Electric.

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Case 1-1 Lincoln Electric 17

❚ 2Data on individual companies are from public company releases and casewriter estimates based on publicly released financial statements. Sources for each company: for ESAB, http://www.charterplc.com/ charter/ar2005_links/ar2005.pdf; for ITW, http://library.corporateir.net/ library/71/710/71064/items/175644/AnnualInvestorDayPartI.pdf; for Air Liquide, http://www.airliquide.com/file/stdpagetranslation/ download-center-ra-en/2005-financial-report.pdf; for Kobelco, http://www.kobelco.co.jp/ICSFiles/metafile/2006/01/27/ annual2005comp.pdf; for Thermadyne, http://www.thermadyne.com/ uplFiles/pressRelease/Thermadyne PressReleasewithSchedules- July112006.pdf; for Bohler, http://www.kobelco.co.jp/ICSFiles/ metafile/2006/ 01/27/annual2005comp.pdf; for Daihen, http://www .daihen.co.jp/gaiyou_e/gaimain.htm; for Panasonic, http://ir-site .panasonic.com/annual/2006/; for Fronius, http://www.fronius.com/; for Fronius, http://www. hypertherm.com/; for Sichuan Atlantic, http://www.chinaweld-atlantic.com/weldEn/introduction.htm; and for Hyundai, http://www.hdweld.co.kr/eng/company/introduce.asp.

Exhibit 3 2005 Revenue for Largest Competitors in $13 Billion Welding Market

Sources: Data on individual companies came from public company releases and casewriter estimates based on publicly released financial statements. Sources for each company include: for ESAB, http://www.charterplc.com/charter/ar2005_links/ar2005.pdf; for ITW, http://library.corporateir.net/ library/71/710/71064/items/175644/AnnualInvestorDayPartI.pdf; for AirLiquide, http://www.airliquide.com/file/stdpagetranslation/download- center-ra-en/2005-financial-report.pdf; for Kobelco, http://www.kobelco.co.kp; for Thermadyne, http://www.thermadyne. com/uplFiles/pressRelease/ ThermadynePressReleasewithSchedules-July112006.pdf; for Bohler, http://www.kobelco.co.jp/ICSFiles/metafile/2006/01/27/annual2005comp.pdf; for Daihen, http://www.daihen.co.jp/gaiyou_e/gaimain.htm; for Panasonic, http://ir-site.panasonic.com/annual/2006/; for Fronius, http://www.fronius .com/; for Fronius, http://www. hypertherm.com/; for Sichuan Atlantic, http://www.chinaweld-atlantic.com/weldEn/introduction.htm; and for Hyundai, http://www.hdweld.co.kr/eng/company/introduce.asp.

$1,800

$1,600

$1,300 $1,300

$1,600

$1,400

$1,200

$1,000

in $

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$800

$600 $600 $600

$400

$200

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Est. $470

Est. $580

Est. $395 Est.

$275 Est.

$225 Est. $195 Est.

$145

The following is a brief description of Lincoln’s key global competitors:2

ESAB (Charter plc) – $1.3 billion, 2005 sales of welding and related equipment. ESAB, which represented some 75% of revenues of its parent company Charter, was a European-based company with a global presence. While ESAB was the number-three player in the United States, ESAB en- joyed market leadership in Europe, Brazil, Argentina, and India. In 2000, ESAB had agreed to be pur- chased by Lincoln Electric for $750 million plus the assumption of $300 million in ESAB’s debt. Yet Lincoln Electric decided that same year not to go forward with the acquisition after antitrust and other issues arose in the due diligence process.

Illinois Tool Works (ITW) – $1.3 billion, 2005 revenues from welding products. ITW’s parent

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company had sales of nearly $13 billion, with a di- versified product line from over 700 business units including plastic and metal components, fasteners, industrial fluids, and adhesives. Additionally, ITW manufactured systems for consumer and industrial packaging, identification systems, industrial spray coating, and quality assurance equipment. ITW’s two major welding subsidiaries included Hobart (ac- quired in 1996) and Miller (acquired in 1993). ITW was Lincoln’s strongest U.S. competitor, and ITW maintained a U.S. market position in welding that was second to Lincoln. In U.S. welding equipment, how- ever, ITW’s market share was slightly higher than Lincoln’s. Elsewhere around the world, Lincoln’s welding equipment share was higher than ITW’s. ITW did have a large Asian subsidiary named Tien Tai pro- ducing consumable products in Taiwan and China.

Air Liquide – $600 million, 2005 estimated sales derived from welding products. The main busi- ness of Air Liquide was industrial gases, but they also had a significant welding business in Europe. Their gas distribution business also provided natural leverage in sales of welding products.

Kobelco – $550–600 million, 2005 estimated sales derived from welding consumables. Kobe Steel, the parent company of Kobelco, was a leading Japan- ese steelmaker as well as a supplier of aluminum and copper products. Kobelco itself concentrated on welding consumables and enjoyed a dominant posi- tion in the Asia-Pacific region. Kobelco had also begun establishing a significant position in the China market through its joint venture with Panasonic.

Thermadyne Holding Corp. – $470 million, 2005 sales. Thermadyne was a primarily U.S.-focused manufacturer and also one that had its strongest market position in a specific niche (gas apparatus equipment), with good brand-name recognition for its “Victor” brand. Thermadyne’s competitive posi- tion appeared constrained by its lack of product breadth, the limited liquidity of its shares in the public equity markets, and its excess debt level.

Lincoln Electric: Overview

Starting with a capital investment of only $200 in 1895, John C. Lincoln formed the Lincoln Electric Company to produce and sell electric motors that

18 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 4 Summaries of Lincoln Income Statements

1986 1987 1988 1989 1990 1991 1992 1993 1994

INCOME STATEMENTS Net Sales 370.2 443.2 570.2 692.8 796.7 833.9 853.0 846.0 906.6 Cost of Goods Sold 245.4 279.4 361.0 441.3 510.5 521.8 553.1 532.8 556.3 Gross Profit 124.8 163.8 209.2 251.5 286.2 312.1 299.9 313.2 350.3 SG&A Expense 101.3 121.0 165.2 211.1 241.2 270.7 280.3 273.3 258.5 Operating Profit 23.5 42.8 44.0 40.4 45.0 41.4 19.6 39.9 91.8 Rationalization and – – – – (18.0) 0.1 (42.8) (73.8) (0.4) Non-recurring Items Other Income, Net 0.4 1.2 2.2 3.0 3.1 3.8 4.4 2.9 3.1 EBIT 23.9 44.0 46.2 43.4 30.1 45.3 (18.8) (31.0) 94.5 Interest Expense, Net (5.6) (5.9) (9.7) (5.1) (0.3) 10.9 15.6 16.0 14.3 Pre-Tax Earnings 29.5 49.9 55.9 48.5 30.4 34.4 (34.4) (47.0) 80.2 Income Taxes 13.7 22.3 21.5 21.0 19.3 20.0 11.4 (6.4) 32.2 Accounting Change – – – – – – – 2.5 – Net Income 15.8 27.6 34.4 27.5 11.1 14.4 (45.8) (38.1) 48.0

Source: Lincoln Electric. Note: Distribution expenses were included in SG&A in the years 1994 and prior and the data was not available to facilitate reclasses to cost of sales.

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designer and manufacturer of arc welding and cut- ting products, manufacturing a full line of arc welding equipment, consumable welding prod- ucts, and other welding and cutting products. Be- cause of its technological innovation and product and application support, the company was able to earn a price premium for many of its products. In addition, the company’s human resource and incentive system had led to a history of industry- leading productivity advances. The company’s 20-year record of performance is described in Exhibit 4, and the organizational chart is pre- sented in Exhibit 5.

Human Resources and Incentive System The Lincoln brothers believed that capitalism could actually lead to a classless society if companies would simply provide the right incentives for individuals to fulfill their potential and richly reward those individuals based on their performance. James F. Lincoln was known to begin each company meeting by saying, “Fellow

he had designed. In 1907, John’s brother James joined the company as a senior manager out of Ohio State University and over the years introduced a series of innovative human resource policies and management practices. Starting in 1909, the com- pany diversified into the production of welding equipment, and by 1922 welding equipment and welding consumable products had become the company’s main business.

The company hit $1 billion in sales for the first time in 1995, its centennial year, and that same year the company’s shares began trading on Nas- daq. Between 1995 and 2005, the company rose from being the leading U.S. manufacturer of weld- ing products to the leading global manufacturer in its industry. In 2004, John M. Stropki was named chairman, president, and chief executive officer, becoming only the seventh chairman in the company’s then 109-year history. In 2005 the company’s operating income was $153.5 million and net income was $122 million on sales of $1.6 billion. The company was the world’s largest

Case 1-1 Lincoln Electric 19

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

1,032.4 1,109.1 1,159.1 1,186.7 1,086.2 1,058.6 978.9 994.1 1,040.6 1,333.7 1,601.2 689.4 742.7 777.6 789.7 714.4 703.5 671.6 694.1 759.9 971.3 1,164.3 343.0 366.4 381.5 397.0 371.8 355.1 307.3 300.0 280.7 362.4 436.9 228.7 243.2 243.2 249.6 223.8 216.2 189.1 198.0 210.7 252.1 283.4 114.3 123.2 138.3 147.4 148.0 138.9 118.2 102.0 70.0 110.3 153.5

(6.3) (2.5) (3.5) – (32.0) (13.4) 2.0 (10.5) (1.7) (6.9) (2.3)

2.2 2.1 0.8 1.2 2.3 2.9 0.2 2.3 5.8 7.5 6.6 110.2 122.8 135.6 148.6 118.3 128.4 120.4 93.8 74.1 110.9 157.8 10.6 4.9 0.4 1.6 4.1 6.7 4.4 5.9 4.9 3.1 3.9 99.6 117.9 135.2 147.0 114.2 121.7 116.0 87.9 69.2 107.8 153.9 38.1 43.6 49.8 53.3 40.3 43.6 32.4 21.0 14.7 27.2 31.6 – – – – – – – (37.6) – – –

61.5 74.3 85.4 93.7 73.9 78.1 83.6 29.3 54.5 80.6 122.3

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20 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 5 Organization Chart

Chairman, President & Chief Executive Officer

John Stropki

Executive Secretary

Marylee Baller

Vice President, President Lincoln Electric Asia Pacific

Tom Flohn

Vice President, Group President, Cutting Brazing &

Subsidiaries

Dave Nangle

Sr. Vice President, General Counsel & Secretary

Fred Stueber

Director, Corporate Relations

Roy Morrow

Vice President, President Lincoln Europe & Russia

Dave LeBlanc

Vice President, Strategic Planning & Acquisitions

Rob Gudbranson

Sr. Vice President, Sales & Marketing and Sr. Vice President for Middle East & Africa (MEA)

Richard Seif

Vice President, President Lincoln Electric Latin America

Ralph Fernandez

Sr. Vice President, Global Engineering & U.S. Operations

George Blankenship

Vice President, President & CEO, Lincoln Electric Canada

Joseph Doria

Sr. Vice President, Chief Financial Officer & Treasurer

Vince Petrella

Vice President, Global Operations Development

Vinod Kapoor

Vice President, Human Resources

Gretchan Farrell

Source: Lincoln Electric. Note: All senior executives above report directly to John Stropki, Lincoln Electric’s Chairman, President and Chief Executive Officer.

❚ 3Virginia P. Dawson, Lincoln Electric: A History (Cleveland: Lincoln Electric Company, 1999), p. 3. ❚ 4Dawson, Lincoln Electric: A History.

Workers.”3 Starting in 1907 and under James F. Lincoln’s management, Lincoln was one of the first companies to introduce a number of human re- source innovations, several of which would eventu- ally become standard practice across U.S. manufac- turing industries. These innovations included the use of employee stock ownership, incentive bonuses determined by merit ratings, the creation of an Employee Advisory Board (which had met bimonthly since 1914), an employee suggestion system, piecework pay, annuities for retired em- ployees, and group life insurance.4 Since 1958 for the U.S. operation, the company had a no-layoff

policy, and a large share of company profits were shared with workers through annual bonuses (fully 32% of income before interest, taxes, and bonus, in 2005). During industry downturns all employees, including senior managers, shared the pain through reduced discretionary bonuses. As a result of the company’s emphasis on incentive pay-for-perfor- mance, some 60% of labor costs were variable.

The company encouraged a highly entrepreneurial environment in its manufacturing plants. Lincoln workers managed themselves, with only one foreman in Cleveland for approximately every 68 employees.5

There were tens of thousands of piecework tasks at

❚ 5Data were provided by Lincoln Electric to the casewriter in November 2006.

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as workers needed to believe that they would bene- fit from suggestions they made on a weekly and even daily basis to improve productivity. Trust was something that the company had to build up over many decades, and the no-layoff policy laid a sig- nificant foundation for that culture of trust.

Technology Development Award-winning engi- neers were responsible for Lincoln Electric’s tech- nological leadership in welding, and the company spent approximately 2% of sales on research and development (R&D). With outstanding R&D pro- ductivity, the company led its industry in new market introductions and quality performance. More than 50% of Lincoln Electric’s equipment sales in 2005 were generated by welding machines introduced in the previous five years. The company held many valuable patents, primarily in arc welding. Lincoln Electric took pride in its technological focus and believed that its product focus had led it to become known as “The Welding Experts,” in contrast to its leading competitors who chose to diversify their resources far away from welding. In 1996 the com- pany approved a multimillion-dollar expansion of

Lincoln, and hence individual factory employees were given a great deal of autonomy both in solving problems and reporting their own piecework wages. Lincoln production employees had no paid sick days or holidays, and accepted overtime to meet spikes in demand. Factory workers were paid for what they produced and defective work had to be corrected on an employee’s own time. Furthermore, whereas the piecework encouraged productivity, a large amount of the employee’s annual compensation came from the annual discretionary bonuses. In 1997, for example, the company paid $74 million in bonuses to 3,259 employees (for an average bonus of $23,000; for succeeding years, see Exhibit 6).6 The com- pany determined annual bonuses based on a merit rating, which was based in equal parts on quality, adaptability/flexibility, productivity, dependability/ teamwork, and environmental health and safety. Lincoln’s incentive system required a high degree of trust between employees and senior management,

Case 1-1 Lincoln Electric 21

❚ 6Dawson, Lincoln Electric: A History, p. 149. Also, more recent data were supplied by Lincoln Electric to the casewriter.

Exhibit 6 Gross Bonus Trends at Lincoln Electric in the United States

80,000

70,000

60,000

50,000

40,000

30,000

20,000

10,000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 -

Source: Lincoln Electric.

The Lincoln Electric Company Gross Bonus Trends

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its research and development facilities. In 2001, the $20 million David C. Lincoln Technology Center was completed, ensuring Lincoln Electric’s leadership position in product development. The company had the most aggressive, comprehensive, and successful R&D program in the welding industry. Although many of these activities were located in Cleveland, Lincoln Electric in 2004 began building regional engineering development centers in Shanghai and Poland in addition to its existing training and demon- stration centers in Australia, Canada, Italy, Mexico Netherlands, Singapore, and Spain. During the 1990s, the company invested extensively in automated weld- ing products together with its Japanese supplier FANUC Robotics.

Product Mix Lincoln was one of only a few world- wide broad-line manufacturers of both arc welding equipment and consumable products. The benefits of producing both equipment and consumables were tied to the value of providing welding “solutions” rather than just individual products. Lincoln could solve customers’ process problems and improve pro- cess productivity with its ability to combine both equipment and consumables development needs into one integrated package. Lincoln’s equipment prod- ucts ranged from $300 units available at Home Depot, Lowes, or Wal-Mart, etc., to automated in- dustrial welding systems costing $250,000, although the majority of equipment products were in the $1,000 to $10,000 range. Many of Lincoln’s most advanced equipment products were produced through its sup- ply arrangement with FANUC Robotics. These prod- ucts combined a robotic arm, a welding power source, and a wire feeder to automatically produce welds using various computer software, welding fix- tures and fasteners, and accessories. In 1990, the company expanded its arc welding line by purchas- ing Harris Calorific, a manufacturer of gas-cutting and gas-welding equipment. Starting in the early 1990s the company began growing sales in the North America retail channel. In 1999 the company com- pleted the divestiture of its motor business. In 2002, the company formed Lincoln Electric Welding, Cutting, Tools and Accessories, Inc., dedicated to

growing the retail channel. In 2003 Lincoln comple- mented its successful line of retail products with the acquisition of the Century and Marquette welding and battery-charged brands, which had leading posi- tions in the automotive and retail channels. In 2005, the company broadened its metal-joining base when it acquired J.W. Harris Company, a privately held brazing and soldering alloys business based in Mason, Ohio. J.W. Harris was a global leader in the production of brazing and soldering alloys with about $100 million in annual sales. Harris products could be sold to Lincoln’s existing set of customers, and vice versa. Also, the introduction of Lincoln’s management system and purchasing and logistics ca- pabilities had led to cost savings at the Harris plants. As a result, the acquisition had produced synergies on both the cost and revenue sides by 2006.

Marketing Lincoln’s products were marketed and sold in 86 countries, and one of the company’s sell- ing points was that it could offer advice to its cus- tomers on how to use its welding equipment without charging them directly for the advice. To the extent possible, the company did receive a product price premium in exchange for the advice it gave, and some Lincoln products also received a higher price premium than others based on the size of the pro- ductivity gains they afforded to customers. Lincoln employees applied their skills and knowledge to pro- vide world-class welding training for the company’s distributors and customers. The company believed that it had a competitive advantage because of its highly trained technical sales force and the support of its welding research and development staff, which allowed it to assist the consumers of its products in optimizing their welding applications. As part of the sales process, Lincoln employees visited prospective customers, evaluating their welding requirements, and made specific product recommendations together with a return-on-investment projection. Lincoln also employed its technical expertise to present its Guar- anteed Cost Reduction Program to end users, through which the company guaranteed that the user would save money in its manufacturing process when it uti- lized Lincoln’s products. This allowed the company

22 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

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U.S. employees their annual bonus, the company had to borrow the money.9

There were numerous potential explanations for the difficulties faced after the company’s late 1980s-era expansion. Lincoln wanted the new ac- quisitions to operate in Lincoln USA’s image and to be led by managers from Cleveland. The company’s international managers were expected to introduce piecework, a bonus system, and an advisory board.10 As business historian Virginia Dawson noted in a 1999 history of Lincoln Electric, “The inexperience of Lincoln executives with trade unions and lack of knowledge of labor practices and laws in other countries proved major stumbling blocks in the effort to integrate the new acquisitions into Lincoln’s distinctive management culture.”11

Many of the local managers and local employees did not believe that these practices were appropriate for their local environment, and as a result, many of the practices were either never implemented or im- plemented without success. The company was also unlucky in having bought companies in Europe just before a global economic downturn. Anthony Mas- saro, a 26-year veteran executive at Westinghouse Electric with extensive international experience and a graduate of the Advanced Management Pro- gram at Harvard Business School, was recruited to restructure Lincoln’s international operations. Mas- saro closed unprofitable plants in Japan, Venezuela, Germany, and Brazil. He had found that some of the European plants were engaging in duplicative production and actually competing with each other. Massaro rationalized manufacturing so that some plants made consumables while others made weld- ing machinery.12 The then CEO of the company, Donald Hastings, announced that henceforward the company would learn from its experience and rely more on joint ventures and strategic alliances.13

to introduce its products to new users and to establish and maintain very close relationships with its con- sumers. In addition to these sales activities, the company also marketed itself actively as a leading sponsor of the organized motor racing sport industry. At motor racing events like NASCAR, Indy Car, and NHRA, Lincoln used the opportunity to demonstrate its products to local prospects.

Design and Production As a result of the com- pany’s renewed commitment to R&D starting in 1997, Lincoln was able to design an expanded prod- uct line and diversify its production across multiple welding technologies. In 1997, over 30 new products, including a new computer-based welding machine and the industry’s first digital communications pro- tocol, called ArcLink, were introduced at an inter- national welding show in Essen, Germany. The company, having recovered from the crisis of 1993, also invested heavily in modernization of its Cleveland plant.7

Lincoln’s Global Strategy

While Lincoln had international operations dating back to the 1940s, its first major international ex- pansion occurred between 1986 and 1992, when the company expanded from five manufacturing plants in the U.S., Canada, Australia, and France, to encom- pass 22 plants in 15 countries. In 1987 the company expanded its Australian operation by purchasing as- sets from Air Liquide. Then, the company bought a minority interest in an existing plant and also con- structed a new plant in Venezuela. That was followed by a series of acquisitions in Mexico, Brazil, Scot- land, Norway, the United Kingdom, the Netherlands, Spain, and Germany. The new acquisitions in Europe and Latin America that had cost $325 million suf- fered large operating losses, and in 1992, while the U.S. operation continued to be strongly profitable, the losses internationally were so serious that the company faced a stark choice.8 In order to pay its

Case 1-1 Lincoln Electric 23

❚ 7Ibid. ❚ 8Donald F. Hastings, “Lincoln Electric’s Harsh Lessons from Inter- national Expansion,” Harvard Business Review, May–June 1999, p.164.

❚ 9Dawson, Lincoln Electric: A History, p. 138. ❚ 10Ibid., p. 41. ❚ 11Ibid., p. 138. ❚ 12Ibid., pp. 141–142. ❚ 13Marcus Gleisser, “Lincoln Electric Has Learned Its Lesson and Is Seeking Help in Heading Overseas,” Plain Dealer (Cleveland, Ohio), June 1, 1996.

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Starting in 1996, companywide profitability had returned, and the company renewed its global ex- pansion. In that same year, the company acquired Electronic Welding Systems in Italy and formed a joint venture in Indonesia. Also in 1996, Massaro was promoted to the position of president and chief executive officer. In 1997 the company opened its joint-venture electrode plant in Indonesia. In 1998, the company opened an electrode plant in Shang- hai, along with completing acquisitions of Uhrhan & Schwill, a Germany-based designer and installer of pipe welding systems, and Indalco, a Canada-based manufacturer of aluminum wire and rod. In 1998 the company also acquired a 50% interest in ASKaynak, a leading Turkish producer of welding consumables, and opened a distribution center in Johannesburg, South Africa. In 1999 Lincoln acquired a 35% equity position in Taiwan-based Kuang Tai, a leading supplier of welding consumables in Asia. It also com- pleted construction and start-up of a new wire man- ufacturing facility in Torreón, Mexico. In 2000, Lincoln acquired Italian manufacturer C.I.F.E. Spa, Europe’s premier producer of MIG wire, strength- ening Lincoln’s position as a leader in the European welding consumables business. Also in 2000, pro- duction began in Lincoln’s new manufacturing fa- cility in Brazil. In 2001 the company expanded its operations in South America with the acquisition of Messer Soldaduras de Venezuela, the country’s lead- ing manufacturer of consumable welding products. In 2002, the company acquired Bester S.A., a weld- ing equipment manufacturer based in Poland, driving the company’s growth in Eastern Europe. Exhibit 7 shows the geographic coverage of Lincoln’s plants in 2006, and Exhibit 8 describes how Lincoln senior management viewed their competitive advantage by geographic region. Exhibit 9 describes Lincoln’s subsidiaries according to their operating perfor- mance, total sales, and total assets.

In 2004 Massaro retired, and John Stropki, the newly appointed chairman and CEO, continued the company’s international expansion with particular emphasis on the China market. In 2004, the com- pany acquired controlling interests in two welding businesses in China, giving Lincoln a leading share

in that growing market. Also in 2004, the company started construction of a new welding equipment plant in Shanghai. Adjacent to the plant, Lincoln started building a multistory building that would serve as its regional headquarters, applications, and R&D center, as well as serving as a training, demon- stration, and customer service area. Outside China, the company continued its international expansion in 2004 by upgrading its Bester equipment plant in Poland to serve Eastern Europe, another growing and important market for the company; by construct- ing a new machine manufacturing facility in Mexico; by expanding operations in Brazil, Venezuela, and Australia; and by planning a new welding consum- ables production facility with its joint venture partner in Turkey. In China, also in 2004, Lincoln obtained a controlling interest in the Shanghai Kuang Tai Metal Industry Co. With increased ownership, all China equipment manufacturing was subsequently incorporated into Lincoln’s operations. In addition, Lincoln purchased 70% of Rui Tai Welding and Metal Co., a manufacturer of stick electrodes located in northern China. Exhibit 10 shows the company’s geographic coverage within the country.

Strategic Challenges The company set a series of ambitious financial goals, but meanwhile growth in its primary market of the United States would be far from sufficient to meet these goals. The company was still dependent on North America for approxi- mately 60% of its sales, and yet other markets for welding products and consumables were growing significantly faster. Long-term company financial targets included sales growth at double the rate of growth in worldwide industrial production, operat- ing margins over 15%, earnings growth of 10% annually, and return on equity exceeding 20%. As a result, as of 2005 the company spent approxi- mately two-thirds of free cash flow for international expansion.14

24 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 14Lincoln Electric, personal communication with author on September 5, 2006.

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25

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26 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 8 How Lincoln Senior Management Viewed Their Global Advantage in 2006

North America

• Strong brand identity • Large, technically

trained field sales force

• Leader in innovation and technology

• Broad product line & distribution base

• Very flexible, efficient consumables manufacture

Europe

(including CIS countries)

• Strong brand identity • Product quality,

ruggedness & reliability • Superior machine

warranty policy • Large sales force, good

distribution • Application/solutions

know-how

Asia Pacific

• Valued name in Australia, SE Asia

• Cost-effective consumable manufacture in Indonesia & China

Latin America

• Excellent brand recognition

• Quality image • Broad product range • Lincoln Mexicana

product manufacture

Global

• Strong brand identity • Technical applications

support • Large field selling

force/distribution network

• Global network of cost effective manufacturing facilities

• Broad, market appropriate product range

• Direct sales and distribution network for M. East, Africa export market

Source: Lincoln Electric.

Exhibit 9 Lincoln Electric’s Regional Performance

Total Sales Total Assets Region Year ROA (in USD millions) (in USD millions) U.S.A. and Canada 2005 0.28 1077.5 652.5 Mexico and Latin America 2005 0.16 121.4 83.0 Europe 2005 0.07 426.3 313.3 Asia and Australia 2005 0.05 125.0 98.1

Source: Lincoln Electric. Note: ROA is defined as Operating Income/Total Assets.

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Exhibit 10 Lincoln’s Plants in China

Case 1-1 Lincoln Electric 27

R U S S I A

M O N G O L I A

BEIJING

Taipei

Tianjin

Zhengzhou Nanjing

Wuhan

Taiwan

Hong Kong S.A.R

VIETNAM

Guangzhou Mekong

LOAS THAILAND

BURMA

BHUTAN

LhasaNEPAL

BANGLADESH Macau S.A.R. South

China Sea

Hainan Dao

Brahnaputra

Xi’an Lanzhou

Urumqi

TAJIKISTAN

Chinese line of control

Indian clam

Chengdu Chongqing

Harbin

NORTH KOREA

SOUTH KOREA

Shanghai

Yellow Sea

East China Sea

Lake Balkhash

KYRGYZSTAN

Shenyang

Lake Baikal

Cha ng

Jiang

Huan

g H

e

G ang e s

O b’

LEIM

JIN TAI

SLE

Nanjing

Kuang Tai

Amur

Source: Lincoln Electric.

Lessons from Prior Experience in Asia Lincoln Electric saw Japan, South Korea, and China as advanced versions of what the Indian welding mar- ket was likely to become. Therefore the company wondered which lessons could be gleaned from the company’s mixed record of success in these three countries. In Japan, the market for welding had closely tracked the overall explosive development of the manufacturing sector from the 1960s to the 1980s. The country started out producing low-end consumables for domestic production, but as the market grew domestic producers began focusing domestic production on advanced, automated weld- ing equipment products. Low-end consumables were subsequently imported from first South Korea and then China. The Japanese welding market had

reached a steady state in which the market demanded the latest high-technology welding products with ex- ceptional pre-sales and post-sales support on the one hand, while also requiring high-quality commodity consumables at competitive prices. South Korea was moving toward that same industry steady-state out- come, albeit at a pace that was twice as fast as in Japan. In China, the country had gone from being a producer of only low-end consumables to embrac- ing the most advanced welding technology. This had occurred within a span of just 5–10 years.

Japan Lincoln’s distribution in Japan was very limited. The company did not have any market ac- cess at the commodity end of the market, and the company had limited in-country demonstration or

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after-sales support capability, which was critical in Japan for high-tech sales. There was also no Lincoln distribution channel, brand recognition, or sales force to sell commodity products that might be imported from China or Taiwan. The Lincoln welding consum- ables business in Japan consisted principally of niche products sold to a small group of customers. Lincoln’s welding machine requirements were complicated by the power supply situation in Japan, where there were two voltages and frequencies in use. The one that caused the problem was the common use of 200 volt 3-phase power. While some Lincoln power sources ran adequately on this, the performance was impaired and Japanese customers were reluctant to pay a price premium for a product that was not opti- mized for their application. Yet Lincoln did not un- dertake a program to optimize machines for the Japanese market. The conclusion might be that Lincoln did not enter the Japan market with sufficient resources early enough to establish an effective presence against strong local competitors.

South Korea In South Korea, the company had no production presence but had used the same reli- able local distributor for 27 years. The distributor had good countrywide coverage and was effective in gaining access to most of the business that Lincoln could reasonably expect. Most of the challenge had been that Korean companies were reluctant to invest in high-end welding equipment, but that was chang- ing as Hyundai Heavy Industries and others began to themselves move into high-end shipbuilding and thus demand the latest welding technology. Now that high-end demand was increasing, Lincoln needed to meet the challenge of providing prompt product de- livery and complete technical support without any local production presence. Lincoln was still shipping its high-end machines to Korea from Cleveland and faced long lead times to ship the products. As the company developed its machine production line in China, it planned to ship product from China to Korea and other Asian markets.

China Lincoln had a sales presence in China for several decades, but beginning in 1997 Lincoln was able to establish a viable manufacturing platform.

The company started by creating the Lincoln Elec- tric Shanghai Welding Company in a government- created free trade zone. Establishing the Shanghai operation, however, proved difficult. The company found it difficult to find competent local managers, difficult to deal with the local government authori- ties, difficult to establish distribution channels, and difficult to make the operation profitable (due to a combination of challenges in day-to-day manufac- turing management and the lack of a strong distribu- tion channel for its domestically produced products). As a result of these negative experiences, the company decided to progress further on its Chinese expansion with a Taiwanese partner. As mentioned earlier, this began with acquiring a 35% interest in Kuang Tai, which, although it was a Taiwan-headquartered com- pany, also had one of the largest consumables fac- tories in China (Jin Tai Welding). Lincoln selected Kuang Tai because of its established production plant and distribution network, its ability to locate experi- enced, bilingual operations managers, its reliability, its proven ability to deal effectively with an extensive Chinese bureaucracy, and the company’s concern with the complexities and uncertainties of alterna- tively partnering with a state-owned enterprise. Over time Lincoln increased its minority position in this consumables factory to 46%, and the company also purchased a controlling interest in two other consum- ables plants. Efforts to expand this manufacturing platform continued, which included the opening of the Shanghai machine plant in 2005, but the main effort was subsequently focused on developing stronger distribution and marketing, a local R&D capability, a broad logistics network, and local management and technical staffing.

As a result of these efforts, Lincoln had achieved many of its goals to establish a significant presence in China but now saw its future growth restricted due to the partnership structure. The partner was very competent, but the two sides did not always agree on how to grow the business (volume vs. profits). The decision-making process was time-consuming for an operation that Lincoln did not control. Hence, all subsequent major investment in China was done through majority controlled operations. Yet Lincoln

28 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

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2003 study by Goldman Sachs projected that over the next 50 years India would become the fastest- growing of the world’s major economies. In a 2005 interview with the Pipeline and Gas Journal, Stropki noted that “India is currently rebuilding its infrastructure and therefore will need thousands of miles of new oil and gas pipelines.”16

India’s welding market was also the third-largest in Asia by 2006, with $500 million in annual indus- try sales expected by year end.17 Industry growth was even higher than the country’s growth rate be- cause of India’s recent focus on construction and infrastructure projects. One of the interesting fea- tures of the Indian market was that only approxi- mately 56% of welding consumable sales were taken up by large firms that developed their own de- signs and technology, whereas the other approxi- mately 44% of welding consumables were sold by over 300 small firms that immediately could try to imitate any new design on the market and try to sell it at a sharp discount.18

Significant large competitors who already had a strong presence in the Indian market included Ador Welding Ltd., a company controlled and managed by the local Advani family. As described in Exhibit 11, Ador enjoyed over $50 million in sales in 2005 with a 15% operating margin, and a portion of its shares traded on the local stock exchange. In July 2006, a research analyst at Karvy Stock Broking Limited estimated that Ador’s revenues would grow at a cost-adjusted annual rate of 20% over the next two years and that Ador would continue to enjoy a return on capital employed at over 40%. The com- pany had shifted some production to Silvassa, a government-created tax-free zone, and by concen- trating production at a smaller number of facilities Ador had realized both economies of scale as well as tax savings. In July 2006 the company’s publicly

senior management acknowledged that they could not have gotten to their current market presence without the joint venture experience. Also, in its majority owned operations the company had continued to battle its way through difficulties in finding, retaining, and affording talented local gen- eral managers. The company found that the cost of talented local general managers was equivalent to what the company paid in the U.S. and that there was frequent turnover in the Chinese market. The company also continued to find it challenging to attract and retain the local talent needed to build capabilities in supply chain logistics, IT, quality assurance, product development, and purchasing and sourcing. In 2006 the company had an organiza- tion in China in which the two top managers, and six out of 14 senior managers, were expatriates. Lincoln Electric had set up or acquired 16 operations in 11 countries over the previous nine years, but of all those operations, China had proven to be the most challenging. Yet among these challenges, the com- pany was not overly concerned about the loss of its intellectual property. Lincoln Electric had hereto- fore chosen not to produce its most technologically advanced products in China, although it reserved the option to do so in future years.

Opportunity in India Since the growth of the welding industry closely tracked the development of a country’s entire economy, India had become an attractive market over the previous 15 years. Since 1991 India had enjoyed real average annual growth in GDP of almost 6%, making it one of the faster- growing countries in the world. To put the impor- tance of the Indian market in further perspective, its 2005 market of US$415 million compared to US$601 million for all the countries of Latin America combined and US$312 million for all countries of East Europe, the other two world re- gions with still-developing economies and above- average welding market growth rates (~ 4% CAG).15

India’s growth reached over 7.5% in 2005, and a

Case 1-1 Lincoln Electric 29

❚ 15Data on market size were supplied by Lincoln Electric to the casewriter in March and September 2006.

❚ 16Jeff Share, “CEO sees inevitable move to automatic welding,” Pipeline and Gas Journal, June 1, 2005. ❚ 17Lincoln Electric, personal communication with author on September 24, 2006. ❚ 18Estimates on the size of the organized and unorganized Indian welding sector come from Lincoln Electric and were sent to the author in April 2006.

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Exhibit 11 Ador Welding Limited

Audited Financial Results for ADOR Welding Limited

(Units: Rupees in Crore)

Financial Year ended 31st March

2006 2005 Net Sales/Income from operations 276.14 223.99 Less: Excise Duty 34.54 27.15 Net Sales/Income from operations (Net of Excise Duty) 241.60 196.84

Total Expenditure (Increase)/Decrease in Stock in Trade �2.88 2.30 Consumption of Raw Material & Packing Material 131.18 104.43 Staff Cost 22.98 18.52 Other Expenditure 44.79 43.12 Interest & Finance Charges �0.11 0.38 Depreciation 6.29 6.51 Additional Depreciation 11.09

Profit Before Tax 48.36 28.93 Provision for Taxation 7.55 6.05 Deferred Tax Impact �0.29 �5.05 Fringe Benefit Tax 0.90

Profit After Tax 40.20 27.93 Prior Period Adjustments (Including Excess/Short Provision of Taxes) �0.16 �0.80 Net Profit 40.04 27.13

Basic and diluted EPS excluding exceptional items for the period, 29.45 19.95 for the year to date and for the previous year (not annualized) Basic and diluted EPS excluding exceptional items for the period, 25.20 13.17 for the year to date and for the previous year (not annualized) Aggregate of non-promoter share holding Number of shares 5,995,933 5,829,683 Percentage of shareholding 44.09% 42.87%

Segment Revenue (Net of Excise Duty) Consumables 180.07 153.99 Equipment & Project Engineering 61.53 42.85

Net Sales/Income from Operations 241.60 196.84 Segment Profit before Interest and Tax

Consumables 37.96 28.09 Equipment & Project Engineering 10.94 5.11

Total 48.90 33.20 Less: Interest & Finance Charges �0.11 0.38 Other Unallocable expenses net of Unallocable Income 0.65 3.89

Total Profit Before Tax 48.36 28.93 Capital Employed

Consumables 63.95 33.65 Equipment & Project Engineering 13.62 10.52 Unallocable Corporate Assets net off Unallocable Corporate Liabilities 25.38 42.00

Total Capital Employed 102.95 86.17

Source: Adapted from Ador Welding Limited company website.

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Case 1-1 Lincoln Electric 31

traded shares were valued at 10.9x FY07 estimated net earnings per share, and EBITDA per share was predicted by the same local analyst to grow at a CAGR of 29% and net earnings per share to grow at a CAGR of 23% over the next two years. Ador had annual sales of 241.6 crore (large values of India’s currency, the rupee, are counted in terms of crore, with one crore the same as 10,000,000 rupees). The company had produced 17,217 MT of consumable welding products in FY06, and Ador had previously constructed plant lines that could produce far more than that should the market continue to grow.19Ador had in FY06 paid a dividend of 15 rupees, equal to a 4% yield on the stock.20

As described in Exhibit 12, the other large company was ESAB India, which was controlled by Lincoln’s multinational competitor ESAB and which enjoyed over $50 million in sales in 2005. ESAB entered the market in 1988 with the acquisition of Philips’ Indian welding plant for 6x operating earn- ings at 60 million rupees (otherwise denominated as 6 Indian crore). Through a series of acquisitions, ESAB India built up its market share but had enjoyed little profitability. In fact, the company only attained its admirable 18% operating margin in 2004 after a series of one-time write-offs to clean up the balance sheet, the introduction of current technology, the in- troduction of strict internal controls, staff changes, and the reorganization and expansion of distribution channels. Prior to 2005, ESAB India had invested in India entirely through acquisitions to the amount of 40 Indian crore.21 In August 2005, ESAB India began construction of its first greenfield manufactur- ing plant in India for an announced cost of 20 Indian crore (the same as 200 million Indian rupees, which

amounted at that time to US$4.6 million). ESAB’s announced investment of 20 crore, which included the cost of procuring technology from the parent company, would enable ESAB India to complete a 50,000 square foot facility in eight months.22 The third and remaining large competitor in India was EWAC Alloys Ltd., a 50–50 joint venture between German welding firm Messer and L&T of India. That joint venture enjoyed $30 million in revenues in 2005.

After those three large competitors, the remain- ing incumbent companies were relatively small and included D & H Sécheron, a private Indian com- pany; Indo Matsushita, a subsidiary of Japan’s Matsushita; and Anand Arc, another privately held Indian company. Anand Arc manufactured a full range of welding consumables and claimed that it produced the highest-quality electrodes in India.23

From its plants in Mumbai and Pulghar, its product range included electrodes for welding all types of metals encountered in the Indian welding industry. In addition to Anand Arc, D&H Welding was an- other local company with $3.5 million in sales in 2005.24 GEE Ltd. and MIG Weld were two even smaller local companies controlled by consortia of investment firms.

In regards to India’s labor market institutions, the country was generally friendly to the use of in- centive pay-for-performance, although there were a few notable regulations in place. Most importantly, the company was free to implement both piecework and a discretionary bonus without getting approval from a union, a government, or any other third party, and without incurring any future obligation. The remaining restrictions were for the most part

❚ 19All estimates on Ador Welding’s future growth and performance in this paragraph come from the following local analyst report: Vivek Kumar, “Ador Welding (Rs360),” Karvy Stock Broking Limited, July 19, 2006. The analyst sent a copy of the report by request in September 2006. ❚ 20All estimates on Ador Welding’s future performance in this paragraph come from the following local analyst report: Vivek Kumar, “Ador Welding (Rs360),” Karvy Stock Broking Limited, July 19, 2006. The analyst sent a copy of the report by request in September 2006. ❚ 21“ESAB to Set Up Welding Equipment Plant Near Chennai,” Business Line (The Hindu), July 30, 2005.

❚ 22“Esab’s New Plant to Start Operations by April ’06; ESAB India Has Begun to Build a Plant at Irungatukottai . . .”, Business Standard (India), August 1, 2005. The US dollar amount is calculated by multiplying the 20 crore cost of the plant by 10,000,000 to get the number of rupees, in this case 200,000,000 rupees. That 200,000,000 rupee amount is then divided by the exchange rate on August 1, 2005, 43.515 rupees to one U.S. dollar, to get USD$4.6 million. ❚ 23Company website, accessed from http://www.anandarc.com/flash/ profile.html on August 27, 2006. ❚ 24Securities and Exchange Board of India website, accessed from http://sebiedifar.nic.in/ on September 11, 2006.

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Exhibit 12 ESAB India Limited

Audited Financial Results for ESAB INDIA LIMITED

(Units: Rupees in Millions)

Consolidated and Audited for the year ended 31 December

2005 2004 Gross Sales 2716.0 2138.4 Less Excise Duty 334.4 256.8 Net Sales 2381.6 1881.6 Other Income 53.8 39.6 Profit on sale of land/leasehold rights 45.3 4.2 Total Income 2480.7 1925.4

Increase in Stock-in-trade �55.2 �17.6 Consumption of Raw & Packing Materials 1173.0 957.0 Purchases – Finished Goods 213.7 98.4 Staff Cost 160.6 181.1 Other Expenditure 357.6 314.3 Total Expenditure 1849.7 1533.2 Profit before Interest and Depreciation 631.0 392.2 Interest 5.0 7.5 Depreciation 44.6 53.4 Profit before Tax 581.4 331.3

Taxation �184.7 �127.5

Profit after Taxation 396.7 203.8 Minority Interest 0.5 Profit after Minority Interest 396.7 204.3 Basic and Diluted Earnings Per Share (Rs.) 25.78 13.27 Aggregate of non-promoter shareholding Number of shares 9,649,820 9,649,820 Percentage of holding (to total shareholding) 62.7 62.7

Segment Revenue (Net) Consumables 1829.9 1499.6 Equipment 551.7 382.0

Total 2381.6 1881.6 Segment Profit

Consumables 483.0 381.4 Equipment 93.8 40.6

Total 576.8 422.0 Less:

Interest 5.0 7.5 Other unallocated expenditure net of unallocated income �9.6 83.2

Total Profit Before Tax 581.4 331.3 Capital Employed

Consumables 428.5 411.1 Equipment 122.7 56.3

Source: Adapted from ESAB India company website.

32

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Lincoln could enter India by acquisition, by joint venture, or by building a new plant on its own. If the company were to enter by acquisition, it was unclear what type of valuation to apply to any of the Indian incumbent companies. In other markets, Lincoln would go forward with an acquisition only if it met the following criteria: the acquisition was accretive immediately under the new FASB good- will rule; the investment had a minimum internal rate of return, based upon total investment, of an initial 10%, increasing to a minimum of 18% over the first 3–4 years (with synergy credits); the acqui- sition price was less than 8x EBITDA; the resulting companywide balance sheet would continue to jus- tify the corporate-targeted credit rating; all liabili- ties were recognized appropriately on the balance sheet; and full financial and legal due diligence could be conducted before a Lincoln commitment. In India in 2006, the market was booming and any significant welding acquisition would likely require paying an acquisition premium greater than Lincoln Electric had been used to paying in the past. Other factors also making an acquisition strategy difficult included the fact that one of the targets was already owned by a Lincoln Electric competitor and other local targets had a combination of family control and remaining dispersed ownership structures. Al- ternatively, if the company were to enter by joint venture, the question was: How could Lincoln en- sure its ability to make key business decisions? If the company were to build its own plant, the ques- tion was: Would the cost of starting from scratch be more than sufficiently compensated by the total control the company would enjoy?

not heavily constraining. Piecework could be implemented, but in most cases pay had to meet a minimum wage level.25 The minimum wage varied by state and in a few states there was still no mini- mum wage, though more and more states had been implementing minimum wage levels in recent years. Pieceworkers were entitled to the same num- ber of days of paid annual leave as their salaried counterparts, and annual leave pay was calculated based on average earnings over the preceding month. Discretionary bonuses could be paid, but there was a requirement that they could be paid only in addition to a required statutory bonus.26 The statutory bonus was required for all workers earn- ing up to 3,500 rupees per month, and could range from a minimum of 8.33% to a maximum of 20% of each worker’s annual salary (the exact percent depended on the firm’s performance for the year). The base on which the bonus was calculated was capped at 2,500 rupees per month; that is, any em- ployee earning between 2,501 and 3,500 rupees per month would receive a bonus calculated on a base of 2,500 rupees per month.27 The average industrial worker’s salary was estimated to be just under 4,000 rupees per month in 2005 (approximately $88 at the December 2005 exchange rate).28 How- ever, in August 2006, Indian Prime Minister Man- mohan Singh had promised to raise the legislated base on which a discretionary bonus had to be cal- culated, noting “I agree that current ceilings were set more than a decade ago. We will soon take a favorable decision on it.”29

Case 1-1 Lincoln Electric 33

❚ 25India Minimum Wage Act 1948 and related amending acts through 1961. Sourced on July 29, 2008 at http://indiacode.nic.in/fullact1.asp? tfnm=194811. ❚ 26India Payment of Bonus Act (1965) and related amending acts through 1995. Sourced on July 29, 2008 at http://labour.nic.in/act/acts/ pba.doc. ❚ 27Ibid. ❚ 28Daily wage sourced on August 14, 2008 at URL http://labourbureau .nic.in/ASI_Data_2004_05.htm (item 8b), and multiplied by an estimated 22 workdays per month to arrive at a monthly average. The exchange rate for December 31, 2005 was accessed on August 14, 2008 from http://www.oanda.com/convert/fxhistory.

❚ 29Business Standard, “Bonus Ceiling for Workers Increased,” October 2, 2007.

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Protected by his office air conditioner from Manila’s humid August air, in mid-1997, Manolo P. (“Noli”) Tingzon pondered an analysis of demographic trends in California. As the new head of Jollibee’s Interna- tional Division, he wondered if a Philippine ham- burger chain could appeal to mainstream American consumers or whether the chain’s proposed US operations could succeed by focusing on recent immigrants and Philippine expatriates. On the other side of the Pacific, a possible store opening in the Kowloon district of Hong Kong raised other issues for Tingzon. While Jollibee was established in the region, local managers were urging the company to adjust its menu, change its operations, and refocus its marketing on ethnic Chinese customers. Finally, he wondered whether entering the nearly virgin fast food territory of Papua New Guinea would position Jollibee to dom- inate an emerging market—or simply stretch his recently-slimmed division’s resources too far.

With only a few weeks of experience in his new company, Noli Tingzon knew that he would have to weigh these decisions carefully. Not only would they shape the direction of Jollibee’s future internalization strategy, they would also help him establish his own authority and credibility within the organization.

Company History

Started in 1975 as an ice cream parlor owned and run by the Chinese-Filipino Tan family, Jollibee had diver- sified into sandwiches after company President Tony

Tan Caktiong (better known as TTC) realized that events triggered by the 1977 oil crisis would double the price of ice cream. The Tans’ hamburger, made to a home-style Philippine recipe developed by Tony’s chef father, quickly became a customer favorite. A year later, with five stores in metropolitan Manila, the family incorporated as Jollibee Foods Corporation.

The company’s name came from TTC’s vision of employees working happily and efficiently, like bees in a hive. Reflecting a pervasive courtesy in the com- pany, everyone addressed each other by first names prefaced by the honorific “Sir” or “Ma’am,” whether addressing a superior or subordinate. Friendliness pervaded the organization and become one of the “Five Fs” that summed up Jollibee’s philosophy. The others were flavorful food, a fun atmosphere, flexi- bility in catering to customer needs, and a focus on families (children flocked to the company’s bee mas- cot whenever it appeared in public). Key to Jollibee’s ability to offer all of these to customers at an afford- able price was a well developed operations manage- ment capability. A senior manager explained:

It is not easy to deliver quality food and service con- sistently and efficiently. Behind all that fun and friendly environment that the customer experiences is a well oiled machine that keeps close tabs on our day- to-day operations. It’s one of our key success factors.

Jollibee expanded quickly throughout the Philip- pines, financing all growth internally until 1993. (Exhibit 1 shows growth in sales and outlets.) Tan family members occupied several key positions par- ticularly in the vital operations functions, but brought in professional managers to supplement their expertise. “The heads of marketing and finance have always been outsiders,” TTC noted. (Exhibit 2 shows a 1997 organization chart.) Many franchisees were also members or friends of the Tan family.

34 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Case 1-2 Jollibee Foods Corporation (A): International Expansion

Christopher A. Bartlett and Jamie O’Connell

❚ Professor ChristopherA. Bartlett and ResearchAssociate Jamie O’Connell prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. ❚ Harvard Business School Case No 9-399-007, Copyright 1998 President and Fellows of Harvard College. All rights reserved. This case was prepared by C. Bartlett. HBS Cases are developed solely for class discussion and do not necessarily illustrate either effective or ineffective handling of administrative situation.

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Case 1-2 Jollibee Foods Corporation (A): International Expansion 35

Exhibit 1 Jollibee Philippines Growth, 1975–1997

Total Sales Total Stores Company-Owned Year (millions of pesos) at End of Year Stores Franchises 1975 NA 2 2 0 1980 NA 7 4 3 1985 174 28 10 18 1990 1,229 65 12 54 1991 1,744 99 21 80 1992 2,644 112 25 89 1993 3,386 124 30 96 1994 4,044 148 44 106 1995 5,118 166 55 113 1996 6,588 205 84 124 1997 (projected) 7,778 223 96 134

NA = Not available

In 1993, Jollibee went public and in an initial pub- lic offering raised 216 million pesos (approximately US $8 million). The Tan family, however, retained the majority ownership and clearly controlled Jollibee. Although the acquisition of Greenwich Pizza Corpo- ration in 1994 and the formation of a joint venture with Deli France in 1995 diversified the company’s fast food offerings, in 1996 the chain of Jollibee stores still generated about 85% of the parent company’s revenues. (Exhibits 3 and 4 present Jollibee’s consol- idated financial statements from 1992 through 1996.)

McDonald’s: Going Burger to Burger The com- pany’s first serious challenge arose in 1981, when McDonald’s entered the Philippines. Although Jollibee already had 11 stores, many saw McDonald’s as a juggernaut and urged TTC to concentrate on building a strong second-place position in the mar- ket. A special meeting of senior management con- cluded that although McDonald’s had more money and highly developed operating systems, Jollibee had one major asset: Philippine consumers preferred the taste of Jollibee’s hamburger by a wide margin. The group decided to go head-to-head with McDonald’s. “Maybe we were very young, but we felt we could do anything,” TTC recalled. “We felt no fear.”

McDonald’s moved briskly at first, opening six restaurants within two years and spending large sums

on advertising. Per store sales quickly surpassed Jollibee’s and, by 1983, McDonald’s had grabbed a 27% share of the fast food market, within striking range of Jollibee’s 32%. The impressive perfor- mance of the Big Mac, McDonald’s largest and best-known sandwich, led Jollibee to respond with a large hamburger of its own, called the Champ. Jollibee executives bet that the Champ’s one wide hamburger patty, rather than the Big Mac’s smaller two, would appeal more to Filipinos’ large appetites. Market research indicated that Filipinos still pre- ferred Jollibee burgers’ spicy taste to McDonald’s plain beef patty, so the Champ’s promotions focused on its taste, as well as its size.

But the Champ’s intended knockout punch was eclipsed by larger events. In August 1983, political opposition leader Benigno Aquino was assassinated as he returned from exile. The economic and politi- cal crisis that followed led most foreign investors, including McDonald’s, to slow their investment in the Philippines. Riding a wave of national pride, Jollibee pressed ahead, broadening its core menu with taste-tested offerings of chicken, spaghetti and a unique peach-mango dessert pie, all developed to local consumer tastes. By 1984, McDonald’s for- eign brand appeal was fading.

In 1986, dictator Ferdinand Marcos fled the Philippines in the face of mass demonstrations of

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Managing a Chain The high capital investment required to open new stores led to the growth of franchising which enabled chains to stake out new territory by rapidly acquiring market share and build- ing brand recognition in an area. Such expansion created the critical mass needed to achieve economies of scale in both advertising and purchasing.

Fast food executives generally believed that chain-wide consistency and reliability was a key driver of success. Customers patronized chains be- cause they knew, after eating at one restaurant in a chain, what they could expect at any other restau- rant. This not only required standardization of the menu, raw material quality, and food preparation, but also the assurance of uniform standards of cleanli- ness and service. Particularly among the U.S. chains that dominated the industry, there also was agreement that uniformity of image also differentiated the chain from competitors: beyond selling hamburger or chicken, they believed they were selling an image of American pop culture. Consequently, most major fast food chains pushed their international sub- sidiaries to maintain or impose standardized menus, recipes, advertising themes, and store designs.

Moving Offshore: 1986–1997

Jollibee’s success in the Philippines brought oppor- tunities in other Asian countries. Foreign business- people, some of them friends of the Tan family, heard about the chain’s success against McDonald’s and began approaching TTC for franchise rights in their countries. While most of his family and other executives were caught up in the thriving Philippine business, TTC was curious to see how Jollibee would fare abroad.

Early Forays: Early Lessons

Singapore Jollibee’s first venture abroad began in 1985, when a friend of a Philippine franchisee per- suaded TTC to let him open and manage Jollibee stores in Singapore. The franchise was owned by a partnership consisting of Jollibee, the local manager, and five Philippine-Chinese investors, each with a one-seventh stake. Soon after the first store opened,

“people power” led by Aquino’s widow, Corazon. After she took office as president, optimism returned to the country, encouraging foreign companies to reinvest. As the local McDonald’s franchisee once again moved to expand, however, its management found that Jollibee now had 31 stores and was clearly the dominant presence in the market.

Industry Background

In the 1960s, fast food industry pioneers, such as Ray Kroc of McDonald’s and Colonel Sanders of Kentucky Fried Chicken, had developed a value proposition that became the standard for the industry in the United States and abroad. Major fast food out- lets in the United States, which provided a model for the rest of the world, aimed to serve time-constrained customers by providing good-quality food in a clean dining environment and at a low price.

Managing a Store At the store level, profitability in the fast food business depended on high cus- tomer traffic and tight operations management. Opening an outlet required large investments in equipment and store fittings, and keeping it open imposed high fixed costs for rent, utilities, and labor. This meant attracting large numbers of cus- tomers (“traffic”) and, when possible, increasing the size of the average order (or “ticket”). The need for high volume put a premium on convenience and made store location critical. In choosing a site, at- tention had to be paid not only to the potential of a city or neighborhood but also to the traffic patterns and competition on particular streets or even blocks.

Yet even an excellent location could not make a store viable in the absence of good operations man- agement, the critical ingredient in reducing waste, ensuring quality service and increasing staff pro- ductivity. Store managers were the key to motivating and controlling crew members responsible for taking orders, preparing food, and keeping the restaurant clean. Efficient use of their time—preparing raw materials and ingredients in advance, for example— not only enabled faster service, but could also reduce the number of crew members needed.

Case 1-2 Jollibee Foods Corporation (A): International Expansion 39

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however, relations between Jollibee and the local man- ager began to deteriorate. When corporate inspectors visited to check quality, cleanliness, and efficiency in operations, the franchisee would not let them into his offices to verify the local records. In 1986, Jollibee revoked the franchise agreement and shut down the Singapore store. “When we were closing down the store, we found that all the local company funds were gone, but some suppliers had not been paid,” said TTC. “We had no hard evidence that something was wrong, but we had lost each other’s trust.”

Taiwan Soon after the closure in Singapore, Jollibee formed a 50/50 joint venture with a Tan fam- ily friend in Taiwan. Although sales boomed immedi- ately after opening, low pedestrian traffic by the site eventually led to disappointing revenues. Over time, conflict arose over day-to-day management issues be- tween the Jollibee operations staff assigned to main- tain local oversight and the Taiwanese partner. “Be- cause the business demands excellent operations, we felt we had to back our experienced Jollibee opera- tions guy, but the partner was saying, ‘I’m your part- ner, I’ve put in equity. Who do you trust?’” When the property market in Taiwan took off and store rent in- creased dramatically, Jollibee decided to dissolve the joint venture and pulled out of Taiwan in 1988.

Brunei Meanwhile, another joint venture opened in August 1987 in the small sultanate of Brunei, located on the northern side of the island of Borneo. (Exhibit 5 shows the locations of Jollibee Interna- tional stores as of mid-1997.) The CEO of Shoemart, one of the Philippines’ largest department stores, proposed that Jollibee form a joint-venture with a Shoemart partner in Brunei. By the end of 1993, with four successful stores in Brunei, TTC identified a key difference in the Brunei entry strategy: “In Singapore and Taiwan, the local partners ran the operation, and resented our operating control. In Brunei, the local investor was a silent partner. We sent managers from the Philippines to run the operations and the local partner supported us.”

Indonesia An opportunity to enter southeast Asia’s largest market came through a family friend. In 1989, Jollibee opened its first store, in Jakarta. Initially, the

operation struggled, facing competition from street vendors and cheap local fast food chains. When conflict between the local partners and the manager they had hired paralyzed the operation, in late 1994, Jollibee dissolved the partnership and sold the oper- ation to a new franchisee. Nevertheless, the company viewed the market as promising.

TTC summed up the lessons Jollibee had learned from its first international ventures:

McDonald’s succeeded everywhere because they were very good at selecting the right partners. They can get 100 candidates and choose the best—we don’t have the name to generate that choice yet.

Another key factor in this business is location. If you’re an unknown brand entering a new country or city, you have trouble getting access to prime loca- tions. McDonald’s name gets it the best sites. People were telling us not to go international until we had solved these two issues: location and partner.

Building an Organization In 1993, TTC decided that Jollibee’s international operations required greater structure and more resources. Because most of his management team was more interested in the fast-growing domestic side of the business, in January 1994, he decided to hire an experienced outsider as Vice President for International Operations. He se- lected Tony Kitchner, a native of Australia, who had spent 14 years in Pizza Hut’s Asia-Pacific regional office in Hong Kong. Reporting directly to TTC, Kitchner asked for the resources and autonomy to create an International Division.

Kitchner felt that his new division needed to be separate from Jollibee’s Philippine side, with a dif- ferent identity and capabilities. He agreed with TTC that attracting partners with good connections in their markets should be a priority, but worried that Jollibee’s simple image and basic management approach would hamper these efforts. To project an image of a world-class company, he remodeled his division’s offices on the seventh floor of Jollibee’s Manila headquarters and instituted the company’s first dress code, requiring his managers to wear ties. As one manager explained, “We had to look and act like a multinational, not like a local chain. You can’t have someone in a short-sleeved open-neck shirt asking a wealthy businessman to invest millions.”

40 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

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Exhibit 5 Locations of Jollibee International Division Stores, mid-1997 (locations with Jollibee outlets are underlined)

BURMA

LAOS

THAILAND

VIETNAM

CAMBODIA

Ho Chi Minh City

CHINA TAIWAN

PHILIPPINES

South China Sea

Pacific Ocean

Hong Kong

SINGAPORE

Medan

Jakarta PAPUA NEW GUINEA

Indian Ocean

500 Km

500 Mi.

I N D O N E S I A

M A L A Y S I A BRUNEI

Kota Kinabalu

Bandar Seri Begawan

Seria Kuala Belait

GUAM

LEBANON SYRIA

I S

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EGYPT

Red Sea

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ETHIOPIA

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Persian Gulf

Dubai

OMAN

UNITED ARAB EMIRATES

IRAQ

IRAN

BAHRAIN

Kuwait City

KUWAIT

Dammam

Riyadh

SAUDI ARABIA

Manama

QATAR

Jiddah

Indian Ocean

250 Km

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Within weeks of his arrival, Kitchner began re- cruiting experienced internationalists from inside and outside Jollibee. To his inherited three-person staff, he quickly added seven more professionals, including new managers of marketing, finance, and quality control and product development that he brought in from outside Jollibee. The addition of two secretaries rounded out his staff. He claimed that greater internal recruiting had been constrained by two factors—Philippine management’s resistance to having their staff “poached,” and employees’ lack of interest in joining this upstart division.

Strategic Thrust While endeavoring to improve the performance of existing stores in Indonesia and Brunei, Kitchner decided to increase the pace of international expansion with the objective of making Jollibee one of the world’s top ten fast food brands by 2000. Kitchner’s strategy rested on two main themes formulated during a planning session in the fall of 1994—“targeting expats” and “planting the flag.”

The Division’s new chief saw the hundreds of thousands of expatriate Filipinos working in the Mid- dle East, Hong Kong, Guam, and other Asian territo- ries as a latent market for Jollibee and as a good initial base to support entry. Looking for a new market to test this concept, he focused on the concentrations of Filipino guest-workers in the Middle East. After opening stores in Dubai, Kuwait, and Dammam, however, he found that this market was limited on the lower end by restrictions on poorer workers’ freedom of movement, and on the upper end by wealthier ex- patriates’ preference for hotel dining, where they could consume alcohol. Not all overseas Filipinos were potential customers, it seemed.

The other strategic criterion for choosing markets rested on Kitchner’s belief in first-mover advantages in the fast food industry. Jay Visco, International’s Marketing manager, explained:

We saw that in Brunei, where we were the pioneers in fast food, we were able to set the pace and standards. Now, we have six stores there, while McDonald’s has only one and KFC has three. . . . That was a key learning: even if your foreign counterparts come in later, you already have set the pace and are at top of the heap.

The International Division therefore began to “plant the Jollibee flag” in countries where com- petitors had little or no presence. The expectation was that by expanding the number of stores, the franchise could build brand awareness which in turn would positively impact sales. One problem with this approach proved to be its circularity: only after achieving a certain level of sales could most fran- chisees afford the advertising and promotion needed to build brand awareness. The other challenge was that rapid expansion led to resource constraints— especially in the availability of International Divi- sion staff to support multiple simultaneous startups.

Nonetheless, Kitchner expanded rapidly. Due to Jollibee’s success in the Philippines and the Tan family’s network of contacts, he found he could choose from many franchising inquiries from vari- ous countries. Some were far from Jollibee’s home base—like the subsequently abandoned plan to enter Romania (“our gateway to Europe” according to one manager). In an enormous burst of energy, between November 1994 and December 1996, the company entered 8 new national markets and opened 18 new stores. The flag was being planted. (See Exhibit 6.)

Operational Management

Market entry Once Jollibee had decided to enter a new market, Tony Kitchner negotiated the fran- chise agreement, often with an investment by the parent company, to create a partnership with the franchisee. At that point he handed responsibility for the opening to one of the division’s Franchise Services Managers (FSM). These were the key con- tacts between the company and its franchisees, and Kitchner was rapidly building a substantial support group in Manila to provide them with the resources and expertise they needed to start up and manage an offshore franchise. (See Exhibit 7.)

About a month before the opening, the FSM hired a project manager, typically a native of the new mar- ket who normally would go on to manage the first store. The FSM and project manager made most of the important decisions during the startup process, with the franchisees’ level of involvement varying

42 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

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Case 1-2 Jollibee Foods Corporation (A): International Expansion 43

Exhibit 6 Jollibee International Store Openings

Location Date Opened Bandar Seri Begawan, Brunei August 1987 Bandar Seri Begawan, Brunei (second store) June 1989 Seria, Brunei August 1992 Jakarta, Indonesia August 1992 Jakarta, Indonesia (second store) March 1993 Bandar Seri Begawan, Brunei (third store) November 1993 International Division created

Kuala Belait, Brunei November 1994 Dubai, United Arab Emirates April 1995 Kuwait City, Kuwait December 1995 Dammam, Saudi Arabia December 1995 Guam December 1995 Jiddah, Saudi Arabia January 1996 Bahrain January 1996 Kota Kinabalu, Malaysia February 1996 Dubai (second store) June 1996 Riyadh, Saudi Arabia July 1996 Kuwait City, Kuwait (second store) August 1996 Kuwait City, Kuwait (third store) August 1996 Jiddah, Saudi Arabia (second store) August 1996 Hong Kong September 1996 Bandar Seri Begawan, Brunei (fourth store) October 1996 Ho Chi Minh City, Vietnam October 1996 Medan, Indonesia December 1996 Hong Kong (second store) December 1996 Dammam, Saudi Arabia April 1997 Hong Kong (third store) June 1997 Jakarta, Indonesia (third store) July 1997 Jakarta, Indonesia (fourth store) September 1997

Italics represent new market entry.

from country to country. However, one responsibility in which a franchisee was deeply involved was the key first step of selecting and securing the site of the first store, often with advice from International Division staff, who visited the country several times to direct market research. (Sometimes the franchisee had been chosen partly for access to particularly good sites.) Once the franchisee had negotiated the lease or purchase, the project manager began recruiting local store managers.

The FSM was responsible for engaging local architects to plan the store. The kitchen followed a

standard Jollibee design that ensured proper pro- duction flow, but Kitchner encouraged FSMs to adapt the counter and dining areas to the demands of the space and the preferences of the franchisee. A design manager in the International Division provided support.

During the planning phase, the project manager worked with International Division finance staff to develop a budget for raw materials, labor, and other major items in the operation’s cost structure. He or she also identified local suppliers, and—once International Division quality assurance staff had

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but also to identify ways they could support the local franchisee. When the data suggested prob- lems, the FSM would contact the store manager, highlight the issue, and ask for an appropriate plan of action. For example, if FSM Gina Buan saw a de- cline in sales for two consecutive weeks, she de- manded specific plans within 24 hours of her call. If managers could not come up with solutions them- selves, she would coach them to help them generate answers. “My aim,” she remarked with a smile, “is to turn them into clones of me—or at least teach them my expertise.”

In addition to the required sales reports, many stores voluntarily reported on their costs, because they found their FSM’s analysis so helpful. This open partnership fit with TTC’s view of franchise relations. “We get data from franchisees more to help us provide consulting assistance than for con- trol,” he said. Ernesto Tan, TTC’s brother, explained that although Jollibee’s royalty was a percentage of franchisees’ sales, and local operations were fo- cused more on profits, both interests were similar: “We want sales to grow, so that our royalty grows.

accredited their standards—negotiated prices. (Some raw materials and paper goods were sourced centrally and distributed to franchisees throughout Asia.)

Once architectural and engineering plans were approved, construction began. As it often did in other offshore activities, the International Division staff had to develop skills very different from those of their Jollibee colleagues working in the Philippines. For example, high rents in Hong Kong forced them to learn how to manage highly compacted construc- tion schedules: construction there could take one- third to one-half the time required for similar work in the Philippines.

Under FSM leadership, the International Division staff prepared marketing plans for the opening and first year’s operation. They included positioning and communications strategies and were based on their advance consumer surveys, aggregate market data, and analysis of major competitors. Division staff also trained the local marketing manager and the local store manager and assistant managers who typically spent three months in Philippine stores. (Where appropriate local managers had not been found, the store managers were sometimes drawn from Jol- libee’s Philippine operations.) Just before opening, the project manager hired crew members, and Inter- national Division trainers from Manila instructed them for two weeks on cooking, serving customers, and maintaining the store. (See Exhibit 8 for a typical franchise’s organization.)

Oversight and Continuing Support After a store opened, the FSM remained its key contact with Jollibee, monitoring financial and operational per- formance and working to support and develop the store manager. For approximately two months after opening, FSMs required stores in their jurisdictions to fax them every day their figures for sales by product, customer traffic, and average ticket. As op- erations stabilized and the store manager started to see patterns in sales and operational needs, FSMs allowed stores to report the same data weekly and provide a monthly summary.

FSMs used this information not only to project and track royalty income for corporate purposes,

Case 1-2 Jollibee Foods Corporation (A): International Expansion 45

Exhibit 8 Organization of Typical Jollibee International Franchise

Jollibee International Division

Franchisee

Store Managers

Assistant Managers (about 4 per store)

Crew Members (30 to 50 per store)

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But this will not happen if stores are not profitable, because our franchisees will not push to expand.”

As well as support, however, the International Division was also concerned with control— especially in quality. Unannounced on-site inspec- tions every quarter were Jollibee’s primary tool. Over two days, the FSM evaluated every aspect of opera- tions in detail, including product quality and prepa- ration (taste, temperature, freshness, availability, and appearance), cleanliness, restaurant appearance, service speed, and friendliness. The manual for intensive checks was several inches thick. All inter- national staff had been trained in Jollibee’s quality standards and conducted less detailed “quick checks” whenever they traveled. Based on a 15-page ques- tionnaire, a quick check took roughly two hours to complete and covered all of the areas that intensive ones did, although with less rigor and detail. Each store received an average of two quick checks per quarter.

In addition to FSMs’ own rich industry experiences—Gina Buan, for example, had man- aged stores, districts, and countries for Jollibee and another chain—these field managers engaged the expertise of International Division functional staff. While they tried to shift responsibility gradually to the franchisee, division support staff often bore much of the responsibility long after startup. For example, the marketing staff tried to limit their franchise support role to creating initial marketing plans for new openings and reviewing new store plans. However, often they were drawn into the planning of more routine campaigns for particular stores, work they felt should be handled by the fran- chisee and store managers.

International vs. Domestic Practice As opera- tions grew, Kitchner and his staff discovered that international expansion was not quite as simple as the metaphor of “planting flags” might suggest. It sometimes felt more like struggling up an uncon- quered, hostile mountain. After numerous market entry battles, the international team decided that a number of elements of Jollibee’s Philippine business model needed to be modified overseas. For example,

the company’s experience in Indonesia led Visco to criticize the transplantation of Jollibee’s “mass- based positioning”:

When Jollibee arrived in Indonesia, they assumed that the market would be similar to the Philippines. But the Indonesian masses are not willing to spend as much on fast food as the Philippine working and lower-middle class consumers, and there were lots of cheap alternatives available. We decided that we needed to reposition ourselves to target a more up-market clientele.

Kitchner and Visco also felt that Jollibee needed to present itself as “world class,” not “local” or “re- gional.” In particular, they disliked the Philippine store design—a “trellis” theme with a garden motif—which had been transferred unchanged as Jollibee exported internationally. Working with an outside architect, a five-person panel from the International Division developed three new store decors, with better lighting and higher quality furniture. After Kitchner got TTC’s approval, the Division remodeled the Indonesian stores and used the designs for all subsequent openings.

International also redesigned the Jollibee logo. While retaining the bee mascot, it changed the red background to orange and added the slogan, “great burgers, great chicken.” Visco pointed out that the orange background differentiated the chain’s logo from those of other major brands, such as KFC, Coca-Cola, and Marlboro, which all had red-and- white logos. The slogan was added to link the Jollibee name and logo with its products in people’s minds. Visco also noted that, unlike Wendy’s Old Fashioned Hamburgers, Kentucky Fried Chicken, and Pizza Hut, Jollibee did not incorporate its product in its name and market tests had found that consumers outside the Philippines guessed the logo signified a toy chain or candy store.

Kitchner and his staff made numerous other changes to Jollibee’s Philippine business operating model. For example, rather than preparing new ad- vertising materials for each new promotion as they did in the Philippines, the international marketing group created a library of promotional photographs

46 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

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Although increased menu diversity almost always came at the cost of some operating efficiency (and, by implication, complicated the task of store level operating control), Kitchner was convinced that such concessions to local tastes were necessary. In Guam, for example, to accommodate extra-large local ap- petites, division staff added a fried egg and two strips of bacon to the Champ’s standard large beef patty. And franchisees in the Middle East asked the Division’s R&D staff to come up with a spicier ver- sion of Jollibee’s fried chicken. Although Kentucky Fried Chicken (KFC) was captivating customers with their spicy recipe, R&D staff on the Philippine side objected strenuously. As a compromise, Inter- national developed a spicy sauce that customers could add to the standard Jollibee chicken.

Overall, the International Division’s modification of menus and products caused considerable tension with the Philippine side of Jollibee. While there was no controversy about reformulating hamburgers for Muslim countries to eliminate traces of pork, for ex- ample, adding new products or changing existing ones led to major arguments. As a result, Interna- tional received little cooperation from the larger Philippine research and development staff and cus- tomization remained a source of disagreement and friction.

Strained International-Domestic Relations As the International Division expanded, its relations with the Philippine-based operations seemed to de- teriorate. Tensions over menu modifications reflected more serious issues that had surfaced soon after Kitchner began building his international group. Philippine staff saw International as newcomers who, despite their lack of experience in Jollibee, “dis- carded practices built over 16 years.” On the other side, International Division staff reported that they found the Philippine organization bureaucratic and slow-moving. They felt stymied by requirements to follow certain procedures and go through proper channels to obtain assistance.

The two parts of Jollibee continued to operate largely independently, but strained relations gradu- ally eroded any sense of cooperation and reduced

of each food product that could be assembled, in- house, into collages illustrating new promotions (e.g., a discounted price for buying a burger, fries, and soda). And purchasing changed from styrofoam to paper packaging to appeal to foreign consumers’ greater environmental consciousness.

Customizing for Local Tastes While such changes provoked grumbling from many in the large domestic business who saw the upstart international group as newcomers fiddling with proven concepts, nothing triggered more controversy than the exper- iments with menu items. Arguing that the “flexibil- ity” aspect of Jollibee’s “Five Fs” corporate creed stood for a willingness to accommodate differences in customer tastes, managers in the International Division believed that menus should be adjusted to local preferences.

The practice had started in 1992 when a manager was dispatched from the Philippines to respond to the Indonesian franchisee’s request to create a fast food version of the local favorite nasi lema, a mix- ture of rice and coconut milk. Building on this precedent, Kitchner’s team created an international menu item they called the Jollimeal. This was typi- cally a rice-based meal with a topping that could vary by country—in Hong Kong, for example, the rice was covered with hot and sour chicken, while in Vietnam it was chicken curry. Although it accounted for only 5% of international sales, Kitchner saw Jollimeals as an important way to “localize” the Jollibee image.

But the International Division expanded beyond the Jollimeal concept. On a trip to Dubai, in response to the local franchisee’s request to create a salad for the menu, product development manager Gil Salvosa spent a night chopping vegetables in his hotel room to create a standard recipe. That same trip, he acquired a recipe for chicken masala from the franchisee’s cook, later adapting it to fast food production methods for the Dubai store. The International Division also added idiosyncratic items to menus, such as dried fish, a Malaysian favorite. Since other menu items were sel- dom removed, these additions generally increased the size of menus abroad.

Case 1-2 Jollibee Foods Corporation (A): International Expansion 47

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already limited exchanges to a minimum. Some In- ternational Division staff felt that the Philippine side, which controlled most of Jollibee’s resources, should do more to help their efforts to improve and adapt existing products and practices. Visco re- called that when he wanted assistance designing new packaging, the Philippine marketing manager took the attitude that international could fend for it- self. Similarly, Salvosa wanted more cooperation on product development from Philippine R&D, but was frustrated by the lengthy discussions and approvals that seemed to be required.

However, the domestic side viewed things differ- ently. Executive Vice President Ernesto Tan, who was in charge of Jollibee in the Philippines, recalled:

The strains came from several things. It started when International tried to recruit people directly from the Philippine side, without consulting with their superiors. There also was some jealousy on a personal level be- cause the people recruited were immediately promoted to the next level, with better pay and benefits.

The international people also seemed to develop a superiority complex. They wanted to do everything differently, so that if their stores did well, they could take all the credit. At one point, they proposed run- ning a store in the Philippines as a training facility, but we thought they also wanted to show us that they could do it better than us. We saw them as lavish spenders while we paid very close attention to costs. Our people were saying, “We are earning the money, and they are spending it!” There was essentially no communication to work out these problems. So we spoke to TTC, because Kitchner reported to him.

Matters grew worse throughout 1996. One of the first signs of serious trouble came during a project to redesign the Jollibee logo, which TTC initiated in mid-1995. Triggered by International’s modifica- tion of the old logo, the redesign project committee had representatives from across the company. Having overseen International’s redesign, Kitchner was included. During the committee’s deliberations, some domestic managers felt that the International vice-president’s strong opinions were obstructive, and early in 1996 Kitchner stopped attending the meetings.

During this time, TTC was growing increasingly concerned about the International Division’s con- tinuing struggles. Around November 1996, he de- cided that he could no longer support Kitchner’s strategy of rapid expansion due to the financial problems it was creating. Many of the International stores were losing money, but the cost of support- ing these widespread unprofitable activities was in- creasing. Despite the fact that even unprofitable stores generated franchise fees calculated as a percentage of sales, TTC was uncomfortable:

Kitchner wanted to put up lots of stores, maximizing revenue for Jollibee. Initially, I had supported this ap- proach, thinking we could learn from an experienced outsider, but I came to believe that was not viable in the long term. We preferred to go slower, making sure that each store was profitable so that it would generate money for the franchisee, as well as for us. In general, we believe that whoever we do business with— suppliers and especially franchisees—should make money. This creates a good, long-term relationship.

In February 1997, Kitchner left Jollibee to return to Australia. A restructuring supervised directly by TTC shrank the International Division’s staff from 32 to 14, merging the finance, MIS and human resources functions with their bigger Philippine counterparts. (See Exhibit 9.) Jay Visco became interim head of International while TTC searched for a new Division leader.

A New International Era: 1997

In the wake of Kitchner’s departure, TTC consulted intensively with Jollibee’s suppliers and other contacts in fast food in the Philippines regarding a replacement. The name that kept recurring was Manolo P. (“Noli”) Tingzon, one of the industry’s most experienced managers. Although based in the Philippines his entire career, Tingzon had spent much of this time helping foreign chains crack the Philip- pine market. In 1981 he joined McDonald’s as a management trainee and spent the next 10 years in frustrating combat with Jollibee. After a brief expe- rience with a food packaging company, in 1994 he took on the challenge to launch Texas Chicken,

48 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

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another U.S. fast food chain, in its Philippines entry. When TTC contacted him in late 1996, he was intrigued by the opportunity offered by his old neme- sis and joined the company in July 1997 as general manager, International Division.

A Fresh Look at Strategy Upon his arrival, Tingzon reviewed International’s current and his- torical performance. (See Exhibit 10.) He con- cluded that because of the scale economies of fast food franchising, an “acceptable” return on invest- ment in international operations would require 60 Jollibee restaurants abroad with annual sales of US$800,000 each, the approximate store level sales at McDonald’s smaller Asian outlets. Feeling that Jollibee’s international expansion had sometimes been driven less by business considerations than by a pride in developing overseas operations, Tingzon thought that a fresh examination of existing inter- national strategies might reveal opportunities for improvement. As he consulted colleagues at Jollibee, however, he heard differing opinions.

Many of his own staff felt that the rapid expan- sion of the “plant-the-flag” approach had served Jollibee well and should be continued. For example, Visco argued that establishing a presence in each market before competitors conferred important

first-mover advantages in setting customer expecta- tions, influencing tastes and building brand. He and others felt that Jollibee’s success in the Philippines and Brunei illustrated this point especially well.

Others, particularly on Jollibee’s domestic side, felt the flag-planting strategy was ill-conceived, leading the company into what they saw as rash market choices such as the Middle East, where outlets continued to have difficulty attracting either expatriates or locals. For example, Ernesto Tan advised Tingzon to “focus on expanding share in a few countries while making sure each store does well.” He urged Tingzon to consolidate and build on existing Jollibee markets that had either high profit potential, such as Hong Kong, or relatively mild competition, such as Malaysia and Indonesia.

With respect to the strategy of initially focusing on Filipino expatriates in new markets, Tingzon appreci- ated that this approach had eased Jollibee’s entry into Guam and Hong Kong, but wondered whether it might trap the chain. “Might we risk boxing ourselves into a Filipino niche that prevents us from growing enough to support operations in each country?” he asked. Again opinion was divided between those fa- voring the expatriate-led strategy and those who felt it was time for Jollibee to shake its Philippine identity and target the mainstream market wherever it went.

50 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 10 International Store Sales by Country: 1996 (in U.S. dollars at contemporary exchange rates)

1996

Sales Number of Stores

Bahrain 262,361 1 Brunei 2,439,538 6 Guam 1,771,202 1 Hong Kong 1,142,240 2 Indonesia 854,259 3 Kuwait 864,531 3 Malaysia 391,328 1 Saudi Arabia 976,748 4 United Arab Emirates 487,438 2 Vietnam 112,578 1 Total US$ 9,302,223 24

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overwhelming success. Located near a major transit hub in the Central district, it became a gathering place for Filipino expatriates, primarily domestic workers. However, appealing to the locals had proven more difficult. While volume was high on weekends, when the Filipinos came to Central to socialize, it fell off during the week, when business was primar- ily from local office workers.

Although two more stores in Central had attracted many Filipinos, they both relied extensively on Chi- nese customers and generated sales of only about one-third of the first outlet. One problem was that, despite strenuous efforts, Jollibee had been unable to hire many local Chinese as crew members. Ac- cording to one manager, Chinese customers who did not speak English well were worried that they would be embarrassed if they were not understood by the predominantly Philippine and Nepalese counter staff. Another problem was that in a city dominated by McDonald’s, Jollibee’s brand recognition among locals was weak. Working with Henry Shih, the sub- franchisee who owned the second store, Jollibee staff were trying to help launch a thematic advertising campaign, but due to the Hong Kong operation’s small size, the franchise could not inject sufficient funds.

Shih also blamed rigidity over menu offerings for Jollibee’s difficulties appealing to Chinese customers. In early 1997, his Chinese managers had suggested serving tea the Hong Kong way—using tea dust (powdered tea leaves) rather than tea bags and adding evaporated milk. More than six months later, he had still not received a go-ahead. His proposal to develop a less-fatty recipe for Chicken Joy, one of Jollibee’s core menu items, had met more direct resistance. “The Chinese say that if you eat lots of deep-fried food you become hot inside and will develop health problems,” said Shih who believed that the domestic side had pressured the International Division to re- ject any experimentation with this “core” menu item.

Meanwhile, staffing problems were worsening. The four locally-recruited Chinese managers clashed with the five Filipinos imported from Tommy King’s Philippine franchise, with the Chinese calling the Filipinos’ discipline lax and their style arrogant,

Strategy in Action: Three Decisions Although he eventually wanted to resolve these issues at the level of policy, Tingzon faced three immediate growth opportunities that he knew would shape the emergence of the future strategy.

Papua New Guinea: Raising the Standard In early 1996, at the recommendation of Quality Assur- ance Manager Gil Salvosa, a local New Guinea en- trepreneur in the poultry business approached Tony Kitchner about a Jollibee franchise. He described a country of five million people served by only one poorly managed, 3-store fast-food chain, that had re- cently broken ties with its Australian chicken restau- rant franchise. “Port Moresby does not have a single decent place to eat,” he told Kitchner. He believed Jollibee could raise the quality of service and food enough to take much of the Australian chain’s market share while discouraging further entrants.

Although the original plan had been to open just one store in the foreseeable future—in the capital, Port Moresby—Tingzon was certain that the fran- chisee could only cover the costs of developing the market if he put in at least three or four stores soon after. But he was uncertain whether Papua New Guinea could support the 20 stores that he saw as the target critical mass for new markets. (For com- parison, in the Philippines, approximately 1,200 fast food outlets competed for the business of 75 million people. GNP per capita in both countries was almost at US$2,500.)

When Tingzon explained his concerns, the would-be franchisee’s response was that he would negotiate with a major petroleum retailer and try to open stores in five of their service stations around the country. Furthermore, he emphasized that he was willing to build more stores if necessary and would put up all the capital so that Jollibee would risk no equity in the venture.

Hong Kong: Expanding the Base Also on Tingzon’s plate was a proposal to expand to a fourth store in Hong Kong. The franchise, owned by Jollibee in partnership with local businessmen and managed by Tommy King, TTC’s brother-in-law, opened its first store in September 1996 to instant,

Case 1-2 Jollibee Foods Corporation (A): International Expansion 51

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while the Filipinos saw the Chinese managers as uncommitted. By August 1997, all of the Chinese managers had resigned, leaving Jollibee with only Filipinos in store-level management positions. Shih was afraid this would further undermine Jollibee’s ability to hire local crews, as Chinese preferred to work for Chinese.

Partly due to staff turnover, store managers were focused on dealing with day-to-day operations issues such as uneven product quality and had little time to design even short-term marketing strategies. King’s focus on his Philippine stores slowed decision-making. And while Gina Buan, the FSM, had visited Hong Kong more often than any other markets she supervised (including for an extraordi- nary month-long stay), she had been unable to resolve the management problems. In June, King appointed Shih General Manager to oversee the entire Hong Kong venture.

In this context, Shih and King proposed to open a fourth store. The site in the Kowloon district was one of the busiest in Hong Kong, located at one of just two intersections of the subway and the rail line that was the only public transport from the New Territories, where much of the city’s workforce resided. However, the area saw far fewer Filipinos than Central and the store would have to depend on locals. Acknowledging that the fourth store would test Jollibee’s ability to appeal to Hong Kong peo- ple, Shih argued that the menu would have to be customized more radically. However, Tingzon won- dered whether expansion was even viable at this time, given the Hong Kong venture’s managerial problems. Even if he were to approve the store, he wondered if he should support the menu variations that might complicate quality control. On the other hand, expansion into such a busy site might en- hance Jollibee’s visibility and brand recognition among locals, helping increase business even with- out changing the menu. It was another tough call.

California: Supporting the Settlers Soon after signing his contract, Tingzon had learned of a year- old plan to open one Jollibee store per quarter in California starting in the first quarter of 1998.

Supporting TTC’s long-held belief that Jollibee could win enormous prestige and publicity by gaining a foothold in the birthplace of fast food, Kitchner had drawn up plans with a group of Manila-based busi- nessmen as 40% partners in the venture. Once the company stores were established, they hoped to franchise in California and beyond in 1999.

Much of the confidence for this bold expansion plan came from Jollibee’s success in Guam, a terri- tory of the US. Although they initially targeted the 25% of the population of Filipino extraction, man- agement discovered that their menu appealed to other groups of Americans based there. They also found they could adapt the labor-intensive Philippine oper- ating methods by developing different equipment and cooking processes more in keeping with a high labor cost environment. In the words of one International Division veteran, “In Guam, we learned how to do business in the United States. After succeeding there, we felt we were ready for the mainland.”

The plan called for the first store to be located in Daly City, a community with a large Filipino popula- tion but relatively low concentration of fast-food competitors in the San Francisco area. (With more than a million immigrants from the Philippines living in California, most relatively affluent, this state had one of the highest concentrations of Filipino expatri- ates in the world.) The menu would be transplanted from the Philippines without changes. After initially targeting Filipinos, the plan was to branch out geographically to the San Francisco and San Diego regions, and demographically to appeal to other Asian-American and, eventually, Hispanic-American consumers. The hope was that Jollibee would then expand to all consumers throughout the U.S.

Like the expansion strategies in PNG and Hong Kong, this project had momentum behind it, includ- ing visible support from Filipino-Americans, strong interest of local investors, and, not least, TTC’s great interest in succeeding in McDonald’s back- yard. Yet Tingzon realized that he would be the one held accountable for its final success and wanted to bring an objective outsider’s perspective to this plan before it became accepted wisdom. Could Jollibee hope to succeed in the world’s most competitive

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abroad before the turn of the century was a pipe dream. “It took McDonald’s 20 years for its inter- national operations to count for more than 50% of total sales,” he said. “I’ll be happy if I can do it in 10.” But even this was an ambitious goal. And the decisions he made on the three entry options would have a significant impact on the strategic direction his international division took and on the organiza- tional capabilities it needed to get there.

fast-food market? Could they provide the necessary support and control to operations located 12 hours by plane and eight time zones away? And was the Filipino-to-Asian-to-Hispanic-to-mainstream entry strategy viable or did it risk boxing them into an economically unviable niche?

Looking Forward Noli Tingzon had only been in his job a few weeks, but already it was clear that his predecessor’s plan to open 1000 Jollibee stores

Case 1-3 Acer, Inc: Taiwan’s Rampaging Dragon 53

Case 1-3 Acer, Inc: Taiwan’s Rampaging Dragon Christopher A. Bartlett and Anthony St. George

With a sense of real excitement, Stan Shih, CEO of Acer, Inc., boarded a plane for San Francisco in early February 1995. The founder of the Taiwanese personal computer (PC) company was on his way to see the Aspire, a new home PC being developed by Acer America Corporation (AAC), Acer’s North American subsidiary. Although Shih had heard that a young American team was working on a truly in- novative product, featuring a unique design, voice recognition, ease-of-use, and cutting-edge multime- dia capabilities, he knew little of the project until Ronald Chwang, President of AAC, had invited him to the upcoming product presentation. From Chwang’s description, Shih thought that Aspire could have the potential to become a blockbuster product worldwide. But he was equally excited that

this was the first Acer product conceived, designed, and championed by a sales-and-marketing oriented regional business unit (RBU) rather than one of Acer’s production-and-engineering focused strate- gic business units (SBUs) in Taiwan.

Somewhere in mid-flight, however, Shih’s char- acteristic enthusiasm was tempered by his equally well-known pragmatism. Recently, AAC had been one of the company’s more problematic overseas units, and had been losing money for five years. Was this the group on whom he should pin his hopes for Acer’s next important growth initiative? Could such a radical new product succeed in the highly com- petitive American PC market? And if so, did this unit—one of the company’s sales-and-marketing- oriented RBUs—have the resources and capabilities to lead the development of this important new prod- uct, and, perhaps, even its global rollout?

Birth of the Company

Originally known as Multitech, the company was founded in Taiwan in 1976 by Shih, his wife, and three friends. From the beginning, Shih served as CEO and Chairman, his wife as company accountant. With $25,000 of capital and 11 employees, Multi- tech’s grand mission was “to promote the application of the emerging microprocessor technology.” It

❚ Professor Christopher A. Bartlett and Research Associate Anthony St. George prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Some historical information was drawn from Robert H. Chen, “Made in Taiwan: The Story of Acer Computers,” Linking Publishing Co., Taiwan, 1996, and Stan Shih, “Me-too is Not My Style,” Acer Foundation, Taiwan, 1996. We would like to thank Eugene Hwang and Professor Robert H. Hayes for their help and advice. ❚ Harvard Business School Case No 9-399-010, Copyright 1998 President and Fellows of Harvard College. All rights reserved. This case was prepared by C. Bartlett. HBS Cases are developed solely for class discussion and do not necessarily illustrate either effective or ineffective handling of administrative situation.

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grew by grasping every opportunity available— providing engineering and product design advice to local companies, importing electronic components, offering technological training courses, and pub- lishing trade journals. “We will sell anything except our wives,” joked Shih. Little did the founders real- ize that they were laying the foundations for one of Taiwan’s great entrepreneurial success stories. (See Exhibit 1.)

Laying the Foundations Because Multitech was capital constrained, the new CEO instituted a strong norm of frugality. Acting on what he described as “a poor man’s philosophy,” he leased just enough space for current needs (leading to 28 office reloca- tions over the next 20 years) and, in the early years, encouraged employees to supplement their income by “moonlighting” at second jobs. Yet while Multi- tech paid modest salaries, it offered key employees equity, often giving them substantial ownership positions in subsidiary companies.

Frugality was one of many business principles Shih had learned while growing up in his mother’s tiny store. He told employees that high-tech products, like his mother’s duck eggs, had to be priced with a low margin to ensure turnover. He preached the im- portance of receiving cash payment quickly and avoiding the use of debt. But above all, he told them that customers came first, employees second, and shareholders third, a principle later referred to as “Acer 1-2-3.”

Shih’s early experience biased him against the patriarch-dominated, family-run company model that was common in Taiwan. “It tends to generate opin- ions which are neither balanced nor objective,” he said. He delegated substantial decision-making re- sponsibility to his employees to harness “the natural

entrepreneurial spirit of the Taiwanese.” With his informal manner, bias for delegation, and “hands- off ” style, Shih trusted employees to act in the best interests of the firm. “We don’t believe in control in the normal sense. . . . We rely on people and build our business around them,” he said. It was an approach many saw as the polar opposite of the classic Chinese entrepreneur’s tight personal control. As a result, the young company soon developed a reputation as a very attractive place for bright young engineers.

Shih’s philosophy was reflected in his commitment to employee education and his belief that he could create a company where employees would constantly be challenged to “think and learn.” In the early years, superiors were referred to as “shifu,” a title usually reserved for teachers and masters of the martial arts. The development of strong teaching re- lationships between manager and subordinate was encouraged by making the cultivation and grooming of one’s staff a primary criterion for promotion. The slogan, “Tutors conceal nothing from their pupils” emphasized the open nature of the relationship and reminded managers of their responsibility.

This created a close-knit culture, where cowork- ers treated each other like family, and the norm was to do whatever was necessary for the greater good of the company. But it was a very demanding “fam- ily,” and as the patriarch, Stan Shih worked hard to combat complacency—what he called “the big rice bowl” sense of entitlement—by creating a constant sense of crisis and showering subordinates with ideas and challenges for their examination and follow-up. As long as the managers took responsibility for their actions—acted as responsible older sons or daughters—they had the freedom to make decisions in the intense, chaotic, yet laissez-faire organization. Besides his constant flow of new ideas, Shih’s

54 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 1 Selected Financials: Sales, Net Income, and Headcount, 1976–1994

1976 1977 1978 1979 1980 1981 1982 1983 1984

Sales ($M) 0.003 0.311 0.80 0.77 3.83 7.08 18.1 28.3 51.6 Net income ($M) N/A N/A N/A N/A N/A N/A N/A 1.4 0.4 Employees 11 12 18 46 104 175 306 592 1,130

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resources to occupy the corner. Without the kind of resources that Japanese and American companies had, we started in smaller markets. That gives us the ad- vantage because these smaller markets are becoming bigger and bigger and the combination of many small markets is not small.

Expansion abroad—primarily through Asia, Mid- dle East and Latin America—was greatly helped by a growing number of new products. In 1981, Multitech introduced its first mainstream commercial product, the “Microprofessor” computer. Following the suc- cess of this inexpensive, simple computer (little more than an elaborate scientific calculator), Shih and his colleagues began to recognize the enormous potential of the developing PC market. In 1983, Multitech began to manufacture IBM-compatible PCs— primarily as an original equipment manufacturer (OEM) for major brands but also under its own Multitech brand. In 1984 sales reached $51 million, representing a sevenfold increase on revenues three years earlier.

By 1986, the company felt it was ready to stake a claim in Europe, establishing a marketing office in Dusseldorf and a warehouse in Amsterdam. Multitech also supplemented the commission- based purchasing unit it had previously opened in the United States with a fully-fledged sales office.

Birth of the Dragon Dream By the mid-1980s, Multitech’s sales were doubling each year and con- fidence was high. As the company approached its tenth anniversary, Shih announced a plan for the next ten years that he described as “Dragon Dreams.” With expected 1986 revenues of $150 million, em- ployees and outsiders alike gasped at his projected sales of $5 billion by 1996. Critics soon began quoting the old Chinese aphorism, “To allay your

guidance came mainly in the form of the slogans, stories, and concepts he constantly communicated.

This philosophy of delegation extended to orga- nizational units, which, to the extent possible, Shih forced to operate as independent entities and to compete with outside companies. Extending the model externally, Shih began experimenting with joint ventures as a way of expanding sales. The first such arrangement was struck with a couple of en- trepreneurs in central and southern Taiwan. While capturing the partners’ knowledge of those regional markets, this approach allowed Multitech to expand its sales without the risk of hiring more people or raising more capital.

Early successes through employee ownership, delegated accountability, management frugality, and joint ventures led to what Shih called a “com- moner’s culture.” This reflected his belief that the way to succeed against wealthy multinationals— “the nobility”—was to join forces with other “commoners”—mass-market customers, local dis- tributors, owner-employees, small investors and supplier-partners, for example. The “poor man’s” values supported this culture and guided early ex- pansion. As early as 1978, Shih targeted smaller neighboring markets that were of lesser interest to the global giants. At first, response to Multitech’s promotional letters was poor since few foreign dis- tributors believed that a Taiwanese company could supply quality hi-tech products. Through persis- tence, however, Multitech established partnerships with dealers and distributors in Indonesia, Malaysia, Singapore, and Thailand. Shih described this early expansion strategy:

It is like the strategy in the Japanese game Go—one plays from the corner, because you need fewer

Case 1-3 Acer, Inc: Taiwan’s Rampaging Dragon 55

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

94.8 165.3 331.2 530.9 688.9 949.5 985.2 1,259.8 1,883 3,220 5.1 3.9 15.3 26.5 5.8 (0.7) (26.0) (2.8) 85.6 205

1,632 2,188 3,639 5,072 5,540 5,711 5,216 5,352 7,200 5,825

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hunger, draw a picture of a big cake.” But Shih saw huge potential in overseas expansion. After only a few years of international experience, the company’s overseas sales already accounted for half the total. In several Asian countries Multitech was already a major player: in Singapore, for example, it had a 25% market share by 1986. To build on this Asian base and the new offices in Europe and the United States, Shih created the slogan, “The Rampaging Dragon Goes International.” To implement the ini- tiative, he emphasized the need to identify potential overseas acquisitions, set up offshore companies, and seek foreign partners and distributors.

When the number of Acer employees exceeded 2000 during the tenth year anniversary, Shih held a “Renewal of Company Culture Seminar” at which he invited his board and vice presidents to identify and evaluate the philosophies that had guided Mul- titech in its first ten years. Middle-level managers were then asked to participate in the process, re- viewing, debating, and eventually voting on the key principles that would carry the company forward. The outcome was a statement of four values that captured the essence of their shared beliefs: an as- sumption that human nature is essentially good; a commitment to maintaining a fundamental pragma- tism and accountability in all business affairs; a be- lief in placing the customer first; and a norm of pooling effort and sharing knowledge. (A decade later, these principles could still be found on office walls worldwide.)

Finally, the anniversary year was capped by an- other major achievement: Acer became the second company in the world to develop and launch a 32-bit PC, even beating IBM to market. Not only did the product win Taiwan’s Outstanding Product Design Award—Acer’s fifth such award in seven years—it also attracted the attention of such major overseas high-tech companies as Unisys, ICL and ITT, who began negotiations for OEM supply, and even technology licensing agreements.

Rebirth as Acer: Going Public Unfortunately, Multitech’s growing visibility also led to a major problem. A U.S. company with the registered name

“Multitech” informed its Taiwanese namesake that they were infringing its trademark. After ten years of building a corporate reputation and brand iden- tity, Shih conceded he had to start over. He chose the name “Acer” because its Latin root meant “sharp” or “clever,” because “Ace” implied first or highest value in cards—but mostly because it would be first in alphabetical listings. Despite ad- vice to focus on the profitable OEM business and avoid the huge costs of creating a new global brand, Shih was determined to make Acer a globally rec- ognized name.

Beyond branding, the success of the 32-bit PC convinced Shih that Acer would also have to maintain its rapid design, development and manufacturing capability as a continuing source of competitive ad- vantage. Together with the planned aggressive inter- national expansion, these new strategic imperatives— to build a brand and maintain its technological edge—created investment needs that exceeded Acer’s internal financing capability. When officials from Taiwan’s Securities and Exchange Commis- sion approached Shih about a public offering, he agreed to study the possibility although he knew that many Taiwanese were suspicious of private companies that went public.

A program that allowed any employee with one year of company service to purchase shares had al- ready diluted the Shihs’ original 50% equity to about 35%, but in 1987 they felt it may be time to go further. (Shih had long preached that it was “bet- ter to lose control but make money” and that “real control came through ensuring common interest.”) An internal committee asked to study the issue of going public concluded that the company would not only raise needed funds for expansion but also would provide a market for employee-owned shares. In 1988, Acer negotiated a complex multi-tiered financing involving investments by companies (such as Prudential, Chase Manhattan, China Devel- opment Corporation, and Sumitomo), additional sales to employees and, finally, a public offering. In total, Acer raised NT $2.2 billion (US $88 million). Issued at NT $27.5, the stock opened trading at NT $47 and soon rose to well over NT $100. After the

56 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

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and in mid-1989 the company shipped its one mil- lionth PC. Flush with new capital, the company purchased properties and companies within Taiwan worth $150 million. However, Acer’s drift from its “commoner’s culture” worried Shih, who felt he needed help to restore discipline to the “rampaging dragon.” The ambition to grow had to be reconciled with the reality of Acer’s financial situation.

Enter Leonard Liu Projected 1989 results indi- cated that the overextended company was in a tail- spin. Earnings per share were expected to fall from NT $5 to NT $1.42. The share price, which had been as high as NT $150, fell to under NT $20. (See Exhibit 2.) Concerned by the growing problems, Shih decided to bring in an experienced top-level executive. After more than a year of courting, in late 1989, he signed Leonard Liu, Taiwan-born, U.S.-based, senior IBM executive with a reputation for a no-nonsense professional management style. In an announcement that caught many by surprise, Shih stepped down as president of the Acer Group, handing over that day-to-day management role to Liu. In addition, Liu was named CEO and Chair- man of AAC, the company’s North American subsidiary.

Given Shih’s desire to generate $5 billion in sales by 1996, Liu began to focus on opportunities in the networking market in the United States. Despite the continuing problems at Counterpoint and Service Intelligence, he agreed with those who argued that Acer could exploit this market by build- ing on its position in high-end products, particu- larly in the advanced markets of the United States and Europe. In particular, Liu became interested in the highly regarded multi-user minicomputer spe- cialist, Altos. Founded in 1977, this Silicon Valley networking company had 700 employees, worldwide distribution in 60 countries, and projected sales of $170 million for 1990. Although it had generated losses of $3 million and $5 million in the previous two years, Liu felt that Altos’s $30 million in cash reserves and $20 million in real estate made it an attractive acquisition. In August 1990, Acer paid $94 million to acquire the respected Altos brand, its

IPO, Acer employees held about 65% of the equity including the Shihs’ share, which had fallen to less than 25%.

The Professionalization of Acer

While the public offering had taken care of Acer’s capital shortage, Shih worried about the company’s acute shortage of management caused by its rapid growth. In early 1985, when the number of employ- ees first exceeded 1,000, he began to look outside for new recruits “to take charge and stir things up with new ideas.” Over the next few years, he brought in about a dozen top-level executives and 100 middle managers. To many of the self-styled “ground troops” (the old-timers), these “paratroop- ers” were intruders who didn’t understand Acer’s culture or values but were attracted by the soaring stock. For the first time, Acer experienced signifi- cant turnover.

Paratroopers and Price Pressures Because internally-grown managers lacked international ex- perience, one of the key tasks assigned to the “para- troopers” was to implement the company’s ambitious offshore expansion plans. In late 1987, Acer acquired Counterpoint, the U.S.-based manufacturer of low- end minicomputers—a business with significantly higher margins than PCs. To support this new busi- ness entry, Acer then acquired and expanded the operations of Service Intelligence, a computer service and support organization. Subsequently, a dramatic decline in the market for minicomputers led to Acer’s first new product for this segment, the Concer, being a dismal disappointment. Worse still, the substantial infrastructure installed to support it began generating huge losses.

Meanwhile, the competitive dynamics in the PC market were changing. In the closing years of the 1980s, Packard Bell made department and discount stores into major computer retailers, while Dell es- tablished its direct sales model. Both moves led to dramatic PC price reductions, and Acer’s historic gross margin of about 35% began eroding rapidly, eventually dropping ten percentage points. Yet despite these problems, spirits were high in Acer,

Case 1-3 Acer, Inc: Taiwan’s Rampaging Dragon 57

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Exhibit 2 Acer Share Price History, November 1988–January 1995

technology and its distribution network.1 Almost immediately, however, powerful new PCs began to offer an alternative means of multi-user network- ing, and, as if to remind management of the eclipse of Counterpoint’s minicomputers, within a year of its purchase, Altos was losing $20 million. Through the 1990s, AAC’s losses increased.

In addition to this strategic thrust, Liu also began working on Acer’s established organization and management approaches. For example, under Shih’s leadership, while managers had been given considerable independence to oversee their busi- ness units, they had not been given profit and loss responsibility. Furthermore, because of the family- style relationship that existed among long-time company members, inter-company transfers were often priced to do friends a favor and ensure that a

buyer did not “lose face” on a transaction. Even outsourced products were often bought at prices ne- gotiated to make long-term suppliers look good. With no accountability for the profits of their busi- ness units, managers had little incentive to ensure quality or price, and would let the group absorb the loss. As one Acer observer noted, the company was “frugal and hard-working, but with little organiza- tional structure or procedure-based administration.”

As Shih had hoped, Liu brought to Acer some of IBM’s professional management structures, prac- tices and systems. To increase accountability at Acer, the new president reduced management layers, estab- lished standards for intra-company communications, and introduced productivity and performance eval- uations. Most significantly, he introduced the Re- gional Business Unit/ Strategic Business Unit (RBU/ SBU) organization. Acer’s long-established product divisions became SBUs responsible for the design, development, and production of PC components and system products, including OEM product sales. Simultaneously, the company’s major overseas sub- sidiaries and marketing companies became RBUs responsible for developing distribution channels,

58 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 1Because this was a much larger deal than either Counterpoint (acquired for $1 million plus a stock swap) or Service Intelligence (a $500,000 transaction), Shih suggested the deal be structured as a joint venture to maintain the Altos managers’ stake in the business. However, Liu insisted on an outright acquisition to ensure control, and Shih deferred to his new president’s judgment.

1/ 31

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A ce

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P ric

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T $)

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20

40

60

80

100

120

140

160

Acer Taiwan Market Index

Note: Acer stock price in Taiwan dollars. Source: Datastream.

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Exhibit 3a The Acer Group in 1994

preaching his “duck egg” pricing theory. But de- mand was dropping precipitously and Liu decided stronger measures were required. He implemented tight controls and began layoffs.

Meanwhile, the company’s overall profitability was plummeting. (See Exhibits 4 and 5.) A year earlier, Shih had introduced an austerity campaign that had focused on turning lights off, using both sides of paper, and traveling economy class. By 1990, however, Liu felt sterner measures were called for, particularly to deal with a payroll that had ballooned to 5,700 employees. Under an initia- tive dubbed Metamorphosis, managers were asked to rank employee performance, identifying the top 15% and lowest 30%. In January 1991, 300 of the Taiwan-based “thirty percenters” were terminated— Acer’s first major layoffs.

The cumulative effect of declining profits, lay- offs, more “paratroopers,” and particularly the new iron-fisted management style challenged Acer’s tra- ditional culture. In contrast to Shih’s supportive, family-oriented approach, Liu’s “by-the-numbers”

providing support for dealers, distributor networks, and customers, and working to establish JVs in neighboring markets. All SBUs and RBUs had full profit responsibility. “The pressure definitely in- creased. I was eating fourteen rice boxes a week,” said one RBU head, referring to the practice of or- dering in food to allow meetings to continue through lunch and dinner.

By 1992, in addition to the four core SBUs, five RBUs had been established: Acer Sertek covering China and Taiwan; Acer Europe headquartered in the Netherlands; Acer America (AAC) responsible for North America; and Acer Computer Interna- tional (ACI), headquartered in Singapore and re- sponsible for Asia, Africa, and Latin America. (See Exhibits 3a and 3b.) One of the immediate effects of the new structures and systems was to highlight the considerable losses being generated by AAC, for which Liu was directly responsible. While no longer formally engaged in operations, Shih was urging the free-spending Altos management to adopt the more frugal Acer norms, and even began

Case 1-3 Acer, Inc: Taiwan’s Rampaging Dragon 59

Acer America Corporation

(AAC) Acer Europe

Acer Sertek (Taiwan and China)

Acer Computer International

(ACI) (Asia, Africa,

Latin America)

Acer Group (Headquarters)

Fora Inc. (Trading)

Info. Products Group Servers Desktops Notebooks Motherboards Multimedia Video conferencing SIMM

TI-Acer DRAMs

Acer Peripherals Monitors Keyboards Scanners CD-ROM Mobile phones Acer Laboratories

ASICs

Acer Third Wave Publ. Periodicals & software

Acer Property Devpt.

Names in plain text are RBUs, names in bold are SBUs, and names in italics are classified as “other.”

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management model proved grating. There was also growing resentment of his tendency to spend lav- ishly on top accounting and law firms and hire people who stayed at first-class hotels, all of which seemed out of step with Acer’s “commoner’s culture.” Soon, his credibility as a highly respected world-class executive was eroding and Acer managers began questioning his judgement and implementing his directives half-heartedly.

In January 1992, when Shih realized that Acer’s 1991 results would be disastrous, he offered his res- ignation. The board unanimously rejected the offer, suggesting instead that he resume his old role as CEO. In May 1992, Leonard Liu resigned.

Rebuilding the Base

Shih had long regarded mistakes and their resulting losses as “tuition” for Acer employees’ growth— the price paid for a system based on delegation. He saw the losses generated in the early 1990s as part of his personal learning, considering it an investment rather than a waste. (“To make Acer an organization that can think and learn,” he said, “we must continue

to pay tuition as long as mistakes are unintentional and long-term profits exceed the cost of the educa- tion.”) As he reclaimed the CEO role, Shih saw the need to fundamentally rethink Acer’s management philosophy, the organizational model that reflected it, and even the underlying basic business concept.

“Global Brand, Local Touch” Philosophy At Acer’s 1992 International Distributors Meeting in Cancun, Mexico, Shih articulated a commitment to linking the company more closely to its national markets, describing his vision as “Global Brand, Local Touch.” Under this vision, he wanted Acer to evolve from a Taiwanese company with offshore sales to a truly global organization with deeply- planted local roots.

Building on the company’s long tradition of taking minority positions in expansionary ventures, Shih began to offer established Acer distributors equity partnerships in the RBU they served. Four months after the Cancun meeting, Acer acquired a 19% in- terest in Computec, its Mexican distributor. Because of its role in building Acer into Mexico’s leading PC brand, Shih invited Computec to form a joint venture

62 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 5 Consolidated Balance Sheet, 1988–1994

Acer Group Balance Sheet ($ millions) 1988 1989 1990 1991 1992 1993 1994

Current Assets 277.30 448.80 579.50 600.90 700.20 925.00 1355.00

Fixed Assets

Land, Plant, and Equipment 53.10 126.90 191.10 161.50 179.60 590.00 645.00 (after depreciation)

Deferred charges and other assets 11.50 22.90 60.90 239.50 212.30 69.00 82.00

Total Assets 341.90 598.60 831.50 1001.90 1092.10 1584.00 2082.00

Total Current Liabilities 189.40 248.60 464.60 505.80 504.20 752.00 1067.00 Long-Term Liabilities 11.20 16.60 43.70 168.50 214.30 342.00 312.00

Total Liabilities 200.60 265.20 508.40 674.30 718.50 1094.00 1379.00

Stockholders Equity and 141.30 333.40 323.10 327.60 373.60 490.00 703.00 Minority Interest (including new capital infusions)

Source: Company documents.

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castle,” became his battle cry to confirm the inde- pendence of SBU and RBU heads. Thus, when two SBUs—Acer Peripherals (API) and Information Products (IPG)—both decided to produce CD-ROM drives, Shih did not intervene to provide a top-down decision, opting instead to let the market decide. The result was that both units succeeded, eventually supplying CD-ROMs to almost 70% of PCs made in Taiwan, by far the world’s leading source of OEM and branded PCs.

In another initiative, Shih began urging that at least half of all Acer products and components be sold outside the Group, hoping to ensure internal sources were competitive. Then, introducing the principle, “If it doesn’t hurt, help,” he spread a doc- trine that favored internal suppliers. However, under the “lord of the castle” principle, if an RBU decided to improve its bottom line by sourcing externally, it could do so. But it was equally clear that the affected SBU could then find an alternative distributor for its output in that RBU’s region. In practice, this mutual deterrence—referred to as the “nuclear option”— was recognized as a strategy of last resort that was rarely exercised. Despite Shih’s communication of these new operating principles, the roles and rela- tionships between SBU and RBUs remained in flux over several years as managers worked to under- stand the full implications of the client server model on their day-to-day responsibilities.

The Fast Food Business Concept But the biggest challenges Shih faced on his return were strategic. Even during the two and a half years he had stepped back to allow Liu to lead Acer, competition in the PC business had escalated significantly, with the product cycle shortening to 6 to 9 months and prices dropping. As if to highlight this new reality, in May 1992, the month Liu left, Compaq announced a 30% across-the-board price reduction on its PCs. Industry expectations were for a major shakeout of marginal players. Given Acer’s financial plight, some insiders urged the chairman to focus on OEM sales only, while others suggested a retreat from the diffi- cult U.S. market. But Shih believed that crisis was a normal condition in business and that persistence

company responsible for all Latin America. The re- sult was Acer Computec Latin America (ACLA), a company subsequently floated on the Mexican stock exchange. Similarly, Acer Computers International (ACI), the company responsible for sales in South- east Asia planned an initial public offering in Singapore in mid-1995. And in Taiwan, Shih was even considering taking some of Acer’s core SBUs public.

As these events unfolded, Shih began to articu- late an objective of “21 in 21,” a vision of the Acer Group as a federation of 21 public companies, each with significant local ownership, by the 21st cen- tury. It was what he described as “the fourth way,” a strategy of globalization radically different from the control-based European, American or Japanese models, relying instead on mutual interest and vol- untary cooperation of a network of interdependent companies.

Client Server Organization Model To reinforce the more networked approach of this new manage- ment philosophy, in 1993, Shih unveiled his client- server organization model. Using the metaphor of the network computer, he described the role of the Taiwan headquarters as a “server” that used its re- sources (finance, people, intellectual property) to support “client” business units, which controlled key operating activities. Under this concept of a company as a network, business units could leverage their own ideas or initiatives directly through other RBUs or SBUs without having to go through the corporate center which was there to help and mediate, not dic- tate or control. Shih believed that this model would allow Acer to develop speed and flexibility as competitive weapons.

While the concept was intriguing, it was a long way from Acer’s operating reality. Despite the long- established philosophy of decentralization and the introduction of independent profit-responsible busi- ness units in 1992, even the largest RBUs were still viewed as little more than the sales and distribution arms of the Taiwan-based SBUs. To operationalize the client server concept, Shih began to emphasize several key principles. “Every man is lord of his

Case 1-3 Acer, Inc: Taiwan’s Rampaging Dragon 63

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usually paid off. His immediate priority was to halve Acer’s five months of inventory—two months being inventory “in transit.”

Under Shih’s stimulus, various parts of the orga- nization began to create new back-to-basics initia- tives. For example, the System PC unit developed the “ChipUp” concept. This patented technology allowed a motherboard to accept different types of CPU chips—various versions of Intel’s 386 and 486 chips, for example—drastically reducing inventory of both chips and motherboards. Another unit, Home Office Automation, developed the “2-3-1 System” to reduce the new product introduction process to two months for development, three months for selling and one month for phase-out. And about the same time, a cross-unit initiative to support the launch of Acer’s home PC, Acros, de- veloped a screwless assembly process, allowing an entire computer to be assembled by snapping to- gether components, motherboard, power source, etc.2 Integrating all these initiatives and several oth- ers, a team of engineers developed Uniload, a pro- duction concept that configured components in a standard parts palette for easy unpacking, assem- bly, and testing, facilitating the transfer of final as- sembly to RBU operations abroad. The underlying objective was to increase flexibility and responsive- ness by moving more assembly offshore.

Uniload’s ability to assemble products close to the customer led the CEO to articulate what he termed his “fast-food” business model. Under this approach, small, expensive components with fast-changing technology that represented 50%–80% of total cost (e.g., motherboards, CPUs, hard disc drives) were airshipped “hot and fresh” from SBU sources in Tai- wan to RBUs in key markets, while less-volatile items (e.g., casings, monitors, power supplies) were shipped by sea. Savings in logistics, inventories and import duties on assembled products easily offset higher local labor assembly cost, which typically represented less than 1% of product cost.

As Shih began promoting his fast-food business concept, he met with some internal opposition, particularly from SBUs concerned that giving up systems assembly would mean losing power and control. To convince them that they could increase competitiveness more by focusing on component development, he created a presentation on the value added elements in the PC industry. “Assembly means you are making money from manual labor,” he said. “In components and marketing you add value with your brains.” To illustrate the point, Shih developed a disintegrated value added chart that was soon dubbed “Stan’s Smiling Curve.” (See Exhibit 6.)

The Turnaround Describing his role as “to provide innovative stimulus, to recognize the new strategy which first emerges in vague ideas, then to commu- nicate it, form consensus, and agree on action,” Shih traveled constantly for two years, taking his message to the organization. Through 1993, the im- pact of the changes began to appear. Most dramati- cally, the fast-food business concept (supported by Liu’s systems) caused inventory turnover to double by late 1993, reducing carrying costs, while lower- ing the obsolescence risk. In early 1994, the Group reported a return to profit after three years of losses.

Acer America and the Aspire

After Liu’s resignation in April 1992, Shih named Ronald Chwang to head AAC. With a Ph.D. in Electrical Engineering, Chwang joined Acer in 1986 in technical development. After overseeing the start-up of Acer’s peripherals business, in 1991 he was given the responsibility for integrating the newly acquired Altos into AAC as president of the Acer/Altos Business Unit.

Because AAC had been losing money since 1987, Chwang’s first actions as CEO focused on stemming further losses. As part of that effort, he embraced the dramatic changes being initiated in Taiwan, making AAC’s Palo Alto plant the first test assembly site of the Uniload system. Under the new system, manufacture and delivery time was cut from 80 days to 45 days, reducing inventory levels by almost 45%. To support its Uniload site, AAC

64 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 2To promote the innovative idea, Shih sponsored internal contests to see who could assemble a computer the fastest. Although his personal best time was more than a minute, experts accomplished the task in 30 seconds.

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Exhibit 6 Stan Shih’s PC Industry Conceptualization

Several factors caught Culver’s attention. First, data showed an increasing trend to working at home— from 26 million people in 1993 to a projected 29 mil- lion in 1994. In addition, there was a rapidly growing interest in the Internet. And finally, developments in audio, telecom, video, and computing technologies were leading to industry rumblings of a new kind of multimedia home PC. Indeed, rumor had it that com- petitors like Hewlett Packard were already racing to develop new multimedia systems. Sharing this vision, Culver believed the time was right to create “the first Wintel-based PC that could compete with Apple in design, ease-of-use, and multimedia capabilities.”

In October of 1994, Culver commissioned a series of focus groups to explore the emerging opportunity. In one of the groups, a consumer made a comment that had a profound impact on him. She said she wanted a computer that wouldn’t remind her of work. At that moment, Culver decided that Acer’s new home PC would incorporate radically new design aesthetics to differentiate it from the standard putty-colored, boxy PCs that sat in offices throughout the world.

By November, Culver was convinced of the potential for an innovative multimedia consumer PC,

established a department of approximately 20 engi- neers, primarily to manage component testing, but also to adapt software design to local market needs. By 1994, AAC was breaking even. (See Exhibit 7.)

Birth of Aspire Despite these improvements, AAC and other RBUs still felt that Acer’s Taiwan-based SBUs were too distant to develop product configura- tions that would appeal to diverse consumer and competitive situations around the globe. What might sell well in Southeast Asia could be a year out-of-date in the United States, for example. However, the emerging “global brand, local touch” philosophy and the client server organization model supporting it gave them hope that they could change the situation.

In January 1994, Mike Culver was promoted to become AAC’s Director of Product Management, a role that gave him responsibility for the product de- velopment mandate he felt RBUs could assume under the new client-server model. The 29-year-old engineer and recent MBA graduate had joined Acer America just 21⁄2 years earlier as AAC’s product manager for notebook computers. Recently, how- ever, he had become aware of new opportunities in home computing.

Case 1-3 Acer, Inc: Taiwan’s Rampaging Dragon 65

PC Industry Value-Added Curve

Speed Cost

PC System

V al

ue A

dd ed

Components Segment by Product Line Global Competition

Distribution Segment by Country

Local Competition

Assembly

Software CPU

DRAM

LCD ASIC Monitor HDD/CDD

Motherboard

• Brand • Channel • Logistics

• Technologies • Manufacturing • Volume

Source: Company document.

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and began assembling a project team to develop the concept. While the team believed the Acer Group probably had the engineering capability to develop the product’s new technical features, they were equally sure they would have to go outside to get the kind of innovative design they envisioned. After an exhaustive review, the team selected Frog De- sign, a leading Silicon Valley design firm that had a reputation for “thinking outside of the box.” Up to this point, Culver had been using internal resources and operating within his normal budget. The selec- tion of Frog Design, however, meant that he had to go to Chwang for additional support. “The approval was incredibly informal,” related Culver, “it literally took place in one 20 minute discussion in the hall- way in late November. I told Ronald we would need $200,000 for outside consulting to create the cos- metic prototype.” Chwang agreed on the spot, and the design process began.

In 1994, Acer was in ninth place in the U.S. mar- ket, with 2.4% market share, largely from sales of

the Acros, Acer’s initial PC product, which was an adaptation of its commercial product, the Acer Power. (See Exhibit 8 for 1994 market shares.) Culver and Chwang were convinced they could not only sub- stantially improve Acer’s U.S. share, but also create a product with potential to take a larger share of the global multimedia desktop market estimated at 10.4 million units and growing at more than 20% annually, primarily in Europe and Asia.

Working jointly with designers from Frog Design, the project team talked to consumers, visited com- puter retail stores and held discussions to brainstorm the new product’s form. After almost two months, Frog Design developed six foam models of possible designs. In January 1995, the Acer team chose a striking and sleek profile that bore little resem- blance to the traditional PC. Market research also indicated that customers wanted a choice of colors, so the team decided that the newly named Aspire PC would be offered in charcoal grey and emerald green. (See Exhibit 9.)

66 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 7 AAC Selected Financials (1990–1994)

AAC Results ($millions) 1990 1991 1992 1993 1994

Revenue 161 235 304 434 858 Cost of Sales 133 190 283 399 764 Selling and marketing 27 61 25 23 55 General administration 20 16 17 19 20 Research and development 5 8 6 4 4 Operating profit/(loss) (24) (40) (26) (11) 15 Non-operating profit/(loss) (1) (7) (3) (5) (3) Profit/(loss) before tax (25) (47) (29) (16) 12 Tax 1 (2) 0 0 1 Net income/(loss) (26) (45) (29) (16) 11

Current assets 155 153 123 144 242 Fixed assets (net) 39 43 28 25 25 Other assets (net) 37 37 31 19 11 TOTAL Assets 231 233 182 188 278

Current liabilities 155 169 154 136 218 Long-term debt 17 15 18 58 47 Stockholder equity (including additional capita) 58 50 10 (6) 12 Total Liabilities 231 233 182 188 278

Source: Company documents. Note: Totals may not add due to rounding.

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$17 million for 1995. A global rollout would be even more attractive with an expectation of breakeven within the first few months.

Stan Shih’s Decisions

On his way to San Jose in February 1995, Stan Shih pondered the significance of the Aspire project. Clearly, it represented the client-server system at work: this could become the first product designed and developed by an RBU, in response to a locally sensed market opportunity. Beyond that, he had the feeling it might have the potential to become Acer’s first global blockbuster product.

Despite its promise, however, Shih wanted to lis- ten to the views of the project’s critics. Some pointed out that AAC had just begun to generate profits in the first quarter of 1994, largely on the basis of its solid OEM sales, which accounted for almost 50% of rev- enues. Given its delicate profit position, they argued that AAC should not be staking its future on the ex- tremely expensive and highly competitive branded consumer products business. Established competitors were likely to launch their own multimedia home PCs—perhaps even before Acer. Building a new brand in this crowded, competitive market was

Meanwhile, the team had been working with AAC software engineers and a development group in Taiwan to incorporate the new multimedia capabili- ties into the computer. One significant introduction was voice-recognition software that enabled users to open, close, and save documents by voice commands. However, such enhancements also required new hard- ware design: to accommodate the voice-recognition feature, for example, a microphone had to be built in, and to properly exploit the machine’s enhanced audio capabilities, speakers had to be integrated into the monitor. The multimedia concept also required the integration of CD-ROM capabilities, and a built- in modem and answering machine incorporating fax and telephone capabilities. This type of configuration was a radical innovation for Acer, requiring signifi- cant design and tooling changes.

In early 1995 the price differential between upper-tier PCs (IBM, for example) and lower-end products (represented by Packard Bell) was about 20%. Culver’s team felt the Aspire could be posi- tioned between these two segments offering a high quality innovative product at a less-than-premium price. They felt they could gain a strong foothold by offering a product range priced from $1,199 for the basic product to $2,999 for the highest-end system with monitor. With a September launch, they budgeted US sales of $570 million and profits of

Case 1-3 Acer, Inc: Taiwan’s Rampaging Dragon 67

Exhibit 8 Top Ten PC Manufacturers in the United States and Worldwide in 1994

U.S. Market Worldwide Company Share Market Share

Compaq 12.6% 9.8% Apple 11.5% 8.1% Packard Bell 11.4% 5.1% IBM 9.0% 8.5% Gateway 2000 5.2% 2.3% Dell 4.2% 2.6% AST 3.9% 2.7% Toshiba 3.6% 2.4% Acer 2.4% 2.6% Hewlett-Packard 2.4% 2.5%

Source: Los Angeles Times, January 31, 1996.

Exhibit 9 First-Generation Aspire Prototype Design

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extremely difficult as proven by many failed at- tempts, including the costly failure of Taiwan-based Mitac, launched as a branded PC in the early 1990s.

Even among those who saw potential in the product, there were several who expressed concern about the project’s implementation. With all the company’s engineering and production expertise located in Taiwan, these critics argued that the task of coordinating the development and delivery of such an innovative new product was just too risky to leave to an inexperienced group in an RBU with limited development resources. If the project were to be approved, they suggested it be transferred back to the SBUs in Taiwan for implementation.

Finally, some wondered whether Acer’s client- server organization model and “local touch” man- agement would support Aspire becoming a viable global product. With the growing independence of the RBUs worldwide, they were concerned that each one would want to redesign the product and marketing strategy for its local market, thereby negating any potential scale economies.

As his plane touched down in San Francisco, Shih tried to resolve his feelings of excitement and concern. Should he support the Aspire project, change it, or put it on hold? And what implications would his decisions have for the new corporate model he had been building?

68 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Case 1-4 Research in Motion: Managing Explosive Growth

Rod White and Paul W. Beamish

In early January 2008, David Yach, chief technol- ogy officer for software at Research In Motion (RIM), had just come back from Christmas break.

Returning to his desk in Waterloo, Ontario, relaxed and refreshed, he noted that his executive assistant had placed the preliminary holiday sales figures for BlackBerry on top of his in-box with a note that read “Meeting with Mike tomorrow.” Knowing 2007 had been an extraordinarily good year, with the number of BlackBerry units sold doubling, Dave was curious: Why did Mike Lazaridis, RIM’s visionary founder and co-chief executive officer, want a meeting? A sticky note on page three flagged the issue. Mike wanted to discuss Dave’s research and development (R&D) plans—even though R&D spending was up $124 million from the prior year, it had dropped significantly as a percentage of sales. In an industry driven by engineering innova- tions and evaluated on technological advances, this was an issue.

R&D was the core of the BlackBerry’s success— but success, Dave knew, could be a double-edged sword. Although RIM’s engineers were continually

Daina Mazutis wrote this case under the supervision of Professors Rod White and Paul W. Beamish solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality.

Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. This material is not covered under authorization from any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208, fax (519) 661-3882, email [email protected]

Copyright © 2008, Ivey Management Services

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long battery life, and ease of use, made the product extremely popular with busy executives who valued the safe and secure delivery of corporate mail and seamless extension of other enterprise and internet services.

In particular, organizations that relied on sensi- tive information, such as the U.S. government and large financial institutions, were early and loyal adopters of BlackBerry and RIM’s largest cus- tomers. RIM’s enterprise e-mail servers, which were attached to the customer’s e-mail and IM servers behind company firewalls, encrypted and redirected e-mail and other data before forwarding the information to end consumers through wireless service providers (see Exhibit 3). Having been the first to market with a “push” e-mail architecture and a value proposition built on security, RIM had more than 100,000 enterprise customers and an estimated 42 per cent market share of converged devices, and significantly higher market share of data-only devices, in North America.2

RIM generated revenue through the “complete BlackBerry wireless solution” which included wireless devices, software and services. Rev- enues, however, were heavily skewed to handheld sales (73 per cent), followed by service (18 per cent), software (6 per cent) and other revenues (3 per cent). In handhelds, RIM had recently in- troduced the award-winning BlackBerry Pearl and BlackBerry Curve, which were a significant design departure from previous models and for the first time targeted both consumer and business professionals (see Exhibit 4). RIM had accumu- lated a wide range of product design and innovation awards, including recognition from Computer- world as one of the Top 10 Products of the Past 40 Years.3 Analysts and technophiles eagerly awaited the next-generation BlackBerry series expected for release in 2008.

delivering award-winning products, explosive growth and increased competition were creating pressures on his team to develop new solutions to keep up with changes in the global smartphone marketplace. With 2007 revenue up 98 per cent from the previous year, his team of approximately 1,400 software engineers should also have doubled— but both talent and space were getting increasingly scarce. The current model of “organic” growth was not keeping pace and his engineers were feeling the strain. As the day progressed, Dave considered how he should manage this expansion on top of meeting existing commitments, thinking “How do you change the engine, while you’re speeding along at 200 kilometres per hour?” As his BlackBerry notified him of dozens of other urgent messages, he wondered how to present his growth and implementation plan to Mike the next morning.

RIM: Research in Motion Ltd.

RIM was a world leader in the mobile communica- tions market. Founded in 1984 by 23-year-old University of Waterloo student Mike Lazaridis, RIM designed, manufactured and marketed the very popular line of BlackBerry products that had recently reached 14 million subscribers world- wide and had just over $6 billion in revenue (see Exhibits 1 and 2). In early 2008, RIM was one of Canada’s largest companies with a market capital- ization of $69.4 billion.1

The BlackBerry wireless platform and line of handhelds could integrate e-mail, phone, Instant Messaging (IM), Short Message Service (SMS), internet, music, camera, video, radio, organizer, Global Positioning System (GPS) and a variety of other applications in one wireless solution that was dubbed “always on, always connected.” These features, especially the immediate pushed message delivery, in addition to the BlackBerry’s small size,

Case 1-4 Research in Motion: Managing Explosive Growth 69

❚ 1D. George-Cosh, “Analysts cheer RIM results, hike targets,” Financial Post, April 4, 2008, http://www.nationalpost.com/scripts/story.html? id=420318; accessed April 22, 2008.

❚ 2Of converged device shipments (smartphones and wireless handhelds). Canalys Smart Mobile Device Analysis service, Press Release, February 5, 2008, http://www.canalys.com/pr/2008/ r2008021.htm, accessed April 2, 2008. ❚ 3http://www.rim.com/newsroom/news/awards/index.shtml

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70 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 1 Blackberry Subscriber Account Base (in Millions)

14.0

8.0

4.9

2.5

1.1 0.5

16.0

14.0

12.0

10.0

8.0

6.0

4.0

2.0

0.0 2003 2004 2005 2006 2007 2008

2008

$6,009.4

$3,037.1

$2,065.8

$1,350.4

$594.4 $306.7

20072006200520042003 $0.0

$1,000.0

$2,000.0

$3,000.0

$4,000.0

$5,000.0

$6,000.0

$7,000.0

RIM Annual Revenue (in Millions of U.S. Dollars)

Note: RIM Fiscal year ends in March (Fiscal 2008 is the year ending March 31, 2008) Source: RIM Fiscal 2007 Annual Report and Fiscal 2008 Press Release (April 2, 2008)

Although originally built for busy professionals, BlackBerry had made considerable headway in the consumer market and had become something of a social phenomenon. Celebrity sightings put the BlackBerry in the hands of Madonna and Paris

Hilton among others. The term “crackberry,” used to describe the addictive or obsessive use of the BlackBerry, was added to Webster’s New Millen- nium dictionary. Just six months after launching Facebook for BlackBerry, downloads of the

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Case 1-4 Research in Motion: Managing Explosive Growth 71

Exhibit 2 Consolidated Statement of Operations

Research In Motion Limited Incorporated under the Laws of Ontario (United States dollars, in thousands except per share data)

For the year ended

Mar. 1, Mar. 3, Mar. 4, Feb. 26, Feb. 28, 2008 2007 2006 2005 2004

(Projected)

Revenue $6,009,395 $3,037,103 $2,065,845 $1,350,447 $594,616 Cost of sales 2,928,814 1,379,301 925,598 636,310 323,365 Gross margin 3,080,581 1,657,802 1,140,247 714,137 271,251 Gross margin % 51.30% 54.60% 55.20% 52.88% 45.62% Expenses

Research and development 359,828 236,173 158,887 102,665 62,638 Selling, marketing & admin. 881,482 537,922 314,317 193,838 108,492 Amortization 108,112 76,879 49,951 35,941 27,911 Litigation 201,791 352,628 35,187

1,349,422 850,974 724,946 685,072 234,228

Income from operations 1,731,159 806,828 415,301 29,065 37,023 Investment income 79,361 52,117 66,218 37,107 10,606

Income before income taxes 1,810,520 858,945 481,519 66,172 47,629

Provision for income taxes Current 587,845 123,553 14,515 1,425 Deferred �71,192 103,820 92,348 (140,865)

516,653 227,373 106,863 (139,440) �4,200 Net Income $1,293,867 $631,572 $374,656 $205,612 51,829

Earnings per share Basic $2.31 $1.14 $1.98 $1.10 $0.33 Diluted $2.26 $1.10 $1.91 $1.04 $0.31

Source: Company Annual Reports; Fiscal 2008 form; Press Release, April 2, 2008, Research in Motion reports Fourth Quarter and Year-End Results for Fiscal 2008, http://www.rim.com/news/press/2008/pr-02_04_2008-01.shtml

popular social networking software application had topped one million, indicating that younger con- sumers were gravitating towards the popular handhelds.4 RIM also actively sought partnerships with software developers to bring popular games such as Guitar Hero III to the BlackBerry mobile platform,5 suggesting a more aggressive move to

the consumer, or at least prosumer,6 smartphone space.

Wireless carriers, such as Rogers in Canada and Verizon in the United States, were RIM’s primary direct customers. These carriers bundled BlackBerry handhelds and software with airtime and sold the complete solution to end users. In 2007, RIM had over 270 carrier partnerships in more than

❚ 4AFX International Focus, “RIM: Facebook for BlackBerry downloads top 1M,” April 1, 2008, http://global.factiva.com, accessed April 1, 2008. ❚ 5Business Wire, “Guitar Hero III Mobile will rock your BlackBerry Smartphone,” April 1, 2008, http://global.factiva.com, accessed April 1, 2008.

❚ 6Prosumer refers to “professional consumers,” customers that use their mobile devices for both business and personal communications.

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72 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 3 Blackberry Enterprise Solution Architecture

2

3

4

1

6 5

Email Servers

BlackBerry Mobile Data System

Instant Messaging Servers

Web, Database and Application Servers

BlackBerry Enterprise Server

Firewall

BlackBerry Solution Services BlackBerry Alliance Program

BlackBerry Enabled Devices

BlackBerry Smartphones

Internet

Wireless Networks

1. BlackBerry® Enterprise Server: Robust software that acts as the centralized link between wireless devices, wireless networks and enterprise applications. The server integrates with enterprise messaging and collaboration systems to provide mobile users with access to email, enterprise instant messaging and personal information management tools. All data between applications and BlackBerry® smart- phones flows centrally through the server.

2. BlackBerry® Mobile Data System (BlackBerry MDS): An optimized framework for creating, deploy- ing and managing applications for the BlackBerry Enterprise Solution. It provides essential components that enable applications beyond email to be deployed to mobile users, including developer tools, administrative services and BlackBerry® Device Software. It also uses the same proven BlackBerry push delivery model and advanced security features used for BlackBerry email.

3. BlackBerry Smartphones: Integrated wireless voice and data devices that are optimized to work with the BlackBerry Enterprise Solution. They provide push-based access to email and data from enterprise applications and systems in addition to web, MMS, SMS and organizer applications.

4. BlackBerry® Connect™ Devices: Devices available from leading manufacturers that feature Black- Berry push delivery technology and connect to the BlackBerry Enterprise Server.

5. BlackBerry® Alliance Program: A large community of independent software vendors, system integrators and solution providers that offer applications, services and solutions for the BlackBerry Enterprise Solution. It is designed to help organizations make the most of the BlackBerry Enterprise Solution when mobilizing their enterprises.

6. BlackBerry Solution Services: A group of services that include: BlackBerry® Technical Support Services, BlackBerry® Training, RIM® Professional Services and the Corporate Development Program. These tools and programs are designed to help organizations deploy, manage and extend their wireless solution.

Source: http://na.blackberry.com/eng/ataglance/solutions/architecture.jsp

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Case 1-4 Research in Motion: Managing Explosive Growth 73

Exhibit 4 The Evolution of the Blackberry Product Line (Select Models)

RIM Inter@ctive Pager 850 RIM 957 BlackBerry 6200

BlackBerry 8820 BlackBerry Pearl 8110 BlackBerry Curve 8330

Source: http://www.rim.com/newsroom/media/gallery/index.shtml and Fortune, “BlackBerry: Evolution of an icon,” Jon Fortt, Sept. 21, 2007, accessed April 7, 2008: http://bigtech.blogs.fortune.cnn.com/blackberry-evolution-of-an-icon-photos-610/

110 countries around the world. Through the Black- Berry Connect licensing program other leading device manufacturers such as Motorola, Nokia, Samsung and Sony Ericsson could also equip their handsets with BlackBerry functionality, including

push technology to automatically deliver e-mail and other data. Expanding the global reach of Black- Berry solutions was therefore a fundamental part of RIM’s strategy. In 2007, 57.9 per cent of RIM’s revenues were derived from the United States,

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7.3 per cent from Canada and the remaining 34.8 per cent from other countries. To date, RIM had offices in North America, Europe and Asia Pacific, however, it had only three wholly owned subsidiaries—two in Delaware and one in England.

The Wireless Communications Market and Smartphones

Mobile wireless communication involved the trans- mission of signals using radio frequencies between wireless networks and mobile access devices. Al- though RIM was one of the first to market with two- way messaging, recent technological developments had encouraged numerous handheld and handset ven- dors to go beyond traditional “telephony” and release new “converged”7 devices including smart phones, Personal Digital Assistants (PDA), phone/PDA hy- brids, converged voice and data devices and other

end-to-end integrated wireless solutions. A shift in the telecommunication industry was moving demand beyond just cellphones to smartphones—complete communications tools that marry all the functions of mobile phones with fully integrated e-mail, browser and organizer applications. In 2007, key competitors to RIM’s BlackBerry line-up included the Palm Treo 700 and 750, Sony Ericsson P900 Series, the Nokia E62, Motorola Q and the Apple iPhone.

The number of wireless subscriber connections worldwide had reached three billion by the end of 2007. China led with over 524 million subscribers, followed by the United States at 254 million and India with 237 million (see Exhibit 5). Year over

74 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 7“Converged” refers to the convergence of the digital wireless communication industry (cellular telephony) and information technology industries, signaled by the arrival of 2G networks which merged voice and data transmissions.

Exhibit 5 Mobile Telephone Users Worldwide (in Millions)

0

200

400

600

800

1,000

1,200

1,400

2002 2003 2004 2005 2006 2007

Asia Pacific, 1,285.5

Western Europe, 505.1

Eastern Europe, 345.2 Latin America, 339.8

North America, 271.6

Australasia, 25.0

Middle East & Africa, 299.5

Source: Created from data accessed from the Global Market Information Database, April 4, 2008, http://www.portal.euromonitor.com.proxy1. lib.uwo.ca:2048/portal/server.pt?control=SetCommunity&CommunityID=207&PageID=720&cached=false&space=CommunityPage

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text messaging as reliable, secure and indispensable means of communication. Coupled with the growth of instant messaging as both a business and personal communications tool, the demand for wireless hand- helds and smartphones was robust.

Competing Platforms

Symbian, a proprietary Operating System (OS) de- signed for mobile devices and jointly owned by Nokia, Ericsson, Sony Ericsson, Panasonic, Siemens AG and Samsung, held an estimated 65 per cent worldwide share of the converged devices, shipping 77.3 million smartphones in 2007 (up 50 per cent from 2006).14 This was significantly ahead of Mi- crosoft’s Windows Mobile OS (12 per cent) and RIM’s BlackBerry OS (11 per cent). However, in North America, RIM led with 42 per cent of shipments, ahead of Apple (27 per cent), Microsoft (21 per cent) and Palm (less than nine per cent and shrinking).15

However, RIM could not afford to rest on its lau- rels. In the North American market place, Apple had recently announced that it would be actively pursuing the business segment. Conceding that push-email and calendar integration were key to se- curing enterprise users, Apple licensed ActiveSync Direct Push, a Microsoft technology. Apple hoped to entice corporate users to adopt the iPhone as their converged device of choice.16 Similarly, Microsoft, which had struggled to gain widespread acceptance for its Windows Mobile OS, had recently revamped its marketing efforts and announced an end-to-end solution for enterprise customers as well as desktop-grade web browsing for Windows Mobile enabled phones.17 Even Google had entered

year growth in the United States, however, was only 9.5 per cent, with an already high market penetration rate (87 per cent). In contrast, China’s growth was 18.3 per cent with only 39 per cent penetration. In sheer numbers, India was experiencing the fastest growth rate with a 60 per cent increase and room to grow with 21 per cent market penetration. To put that into context, in late 2007 there were almost 300,000 new wireless network subscribers in India every day.8

Since the launch of Apple’s iPhone in June 2007, competition in the smartphone segment of the mobile telecommunications industry had intensified. The iPhone “set a new standard for usability.”9 In 2007, smartphones represented only 10 per cent of the global mobile phone market in units. However, this segment was projected to reach over 30 per cent mar- ket share within five years.10 In the U.S. the number of smartphone users had doubled in 2007 to about 14.6 million11 while global shipments of smartphones rose by 53 per cent worldwide hitting 118 million in 2007.12 Some analysts saw the opportunity for smart phones as “immense,” predicting that during 2008 and 2009, 500 million smart devices would be sold globally and cumulative global shipments would pass the one billion mark by 2012.13

Worldwide demand for wireless handhelds had been fueled by several global trends, including the commercial availability of high-speed wireless net- works, the emergence of mobile access to corporate intranets, and the broad acceptance of e-mail and

Case 1-4 Research in Motion: Managing Explosive Growth 75

❚ 8GSMA 20 year factsheet, http://www.gsmworld.com/documents/ 20_year_factsheet.pdf, accessed April 5, 2008. ❚ 9P. Svensson, “Microsoft Upgrades Windows Mobile,” Associated Press Newswire, April 1, 2008, http://global.factiva.com, accessed April 1, 2008. ❚ 10Esmerk Finish News, “Global: Survey: Nokia has best innovation strategy,” March 25, 2008, http://global.factiva.com, accessed April 1, 2008. ❚ 11N. Gohring, “Smartphones on the rise? Thank the iPhone, panel says,” Washington Post, March 31, 2008, http://www.washingtonpost .com/wp-dyn/content/article/2008/03/31/AR2008033102392.html, accessed online April 1, 2008. ❚ 12Canalys Smart Mobile Device Analysis service, Press Release, February 5, 2008, http://www.canalys.com/pr/2008/r2008021.htm, accessed April 2, 2008. ❚ 13Chris Ambrosio, Strategy Analytics, January 2008 and Pete Cunningham, Canalys, as quoted on www.symbian.com, accessed April 3, 2008.

❚ 14www.symbian.com, accessed April 3, 2008. ❚ 15Canalys Smart Mobile Device Analysis service, Press Release, February 5, 2008, http://www.canalys.com/pr/2008/r2008021.htm, accessed April 2, 2008. ❚ 16A. Hesseldahl, “How the iPhone is suiting up for work,” Business Week, March 6, 2008, www.businessweek.com, accessed March 21, 2008. ❚ 17“Microsoft unveils smartphone advancements to improve ability to work and play with one phone,” April 1, 2008, Press Release; and “Microsoft announces enterprise-class mobile solution,” April 1, 2008, Press Release, www.microsoft.com/prespass/press/2008/apr08.

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the fray with Android, an open and free mobile plat- form which included an OS, middleware and key applications. Rivalry, it seemed, was intensifying.

In early 2008, an analyst commented about the increasing competition in the converged device (smartphone and wireless handheld) segment:

Apple’s innovation in its mobile phone user interface has prompted a lot of design activity among competi- tors. We saw the beginnings of that in 2007, but we will see a lot more in 2008 as other smart phone ven- dors try to catch up and then get back in front. Expe- rience shows that a vendor with only one smart phone design, no matter how good that design is, will soon struggle. A broad, continually refreshed portfolio is needed to retain and grow share in this dynamic market. This race is a marathon, but you pretty much have to sprint every lap.18

Another analyst observed:

The good news for RIM? There still aren’t many trusted alternatives for business-class mobile e-mail. This company could be one of the world’s biggest handset manufacturers one day. It’s hard for me to be- lieve there won’t be e-mail on every phone in the world. RIM is going to be a major force in this market.19

Given the rapid advances in the mobile communi- cations industry, no technological platform had be- come the industry standard. In light of the dynamic market situation, RIM needed to ensure that its investment in R&D kept up with the pace of change in the industry.

R&D at RIM

R&D and engineering were the heart and soul of RIM. In March 2007, RIM employed just over 2,100 people with different R&D areas of expertise: radio frequency engineering, hardware and software design, audio and display improvement, antenna

design, circuit board design, power management, industrial design, and manufacturing engineering, among others. R&D efforts focused on improving the functionality, security and performance of the BlackBerry solution, as well as developing new de- vices for current and emerging network technolo- gies and market segments. The ratio of software to hardware developers was approximately 2:1 and about 40 per cent of the software engineers were in- volved in core design work while another 40 per cent were engaged in testing and documentation (the remaining 20 per cent were in management, and support functions like documentation and pro- ject management).

R&D had increased significantly both in terms of the total number of employees as well as the ge- ographic scope of its operations. Since 2000, the R&D group had grown more than tenfold, from 200 to 2,100 people and expanded to two more loca- tions in Canada (Ottawa and Mississauga), several in the United States (Dallas, Chicago, Atlanta, Seattle and Palo Alto) and one in England. Water- loo was still the principal location—home to a vibrant and collaborative culture of young and talented engineers.

RIM’s cryptographic and software source code played a key role in the success of the company, de- livering the safe and secure voice and data trans- mission on which the BlackBerry reputation was built. Chris Wormald, vice-president of strategic alliances, who was responsible for acquisitions, licensing and partnerships described the challenge as follows:

At the end of the day, our source code is really among our few enduring technical assets. We have gone through extraordinary measures to protect it. Extra- ordinary is probably still too shallow of a word. We don’t give anyone any access under any circumstances. RIM was founded on a principle of “we can do it better ourselves”—it is a philosophy that is embedded in our DNA. This vertical integration of technology makes geographic expansion and outsourcing of software development very difficult.

Intellectual property rights were thus diligently guarded through a combination of patent, copyright

76 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 18Canalys Smart Mobile Device Analysis service, Press Release, February 5, 2008, http://www.canalys.com/pr/2008/r2008021.htm, accessed April 2, 2008. ❚ 19Ken Dulaney of Gartner, as quoted in A. Hesseldahl, “RIM: Growth rules the day,” February 22, 2008, www.businessweek.com

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to maintain its R&D spending as a consistent percentage of total sales. Investment analysts often looked to this number to gauge the sustainability of revenue growth. R&D expenses were seen as a proxy for new product or service development and therefore used as a key indicator of future revenue potential. Human capital represented the bulk of R&D dollars and the organizational development team in charge of hiring at RIM was working over- time to try and keep up with the growing demand for the qualified engineers needed to deliver on both customer and investor expectations.

and contractual agreements. It was also strategi- cally managed through a geography strategy that divided core platform development from product and technology development, with most of the core work (on the chip sets, software source code, product design) still occurring in Waterloo. How- ever, the exponential growth in sales, competition and industry changes was placing tremendous pressures on the R&D teams at the Canadian headquarters.

Similar to other players in the telecommunica- tions industry (see Exhibit 6), it was RIM’s policy

Case 1-4 Research in Motion: Managing Explosive Growth 77

Exhibit 6 Competitive R&D Spend (Select Competitors)

In Millions (US$)

Nokia Dec. 31/04 Dec. 31/05 Dec. 31/06 Dec. 31/07 Revenue $46,606 $54,022 $64,971 $80,672 R&D $5,784 $6,020 $6,157 $8,229

12.41% 11.14% 9.48% 10.20%

Microsoft June 30/03 June 30/04 June 30/05 June 30/06 June 30/07 Revenue $32,187 $36,835 $39,788 $44,282 $51,122 R&D $6,595 $7,735 $6,097 $6,584 $7,121

20.49% 21.00% 15.32% 14.87% 13.93%

Motorola Dec. 31/03 Dec. 31/04 Dec. 31/05 Dec. 31/06 Dec. 31/07 Revenue $23,155 $29,663 $35,310 $42,847 $36,622 R&D $2,979 $3,316 $3,600 $4,106 $4,429

12.87% 11.18% 10.20% 9.58% 12.09%

Apple Sept. 27/03 Sept. 25/04 Sept. 24/05 Sept. 30/06 Sept. 29/07 Revenue $6,207 $8,279 $13,931 $19,315 $24,006 R&D $471 $491 $535 $712 $782

7.59% 5.93% 3.84% 3.69% 3.26%

RIM Feb. 28/04 Feb. 26/05 Mar. 4/06 Mar. 3/07 Proj. Mar./08 Revenue $595 $1,350 $2,066 $3,037 $6,009 R&D $63 $103 $159 $236 $360

10.59% 7.63% 7.70% 7.77% 5.99%

Palm May 31/03 May 31/04 May 31/05 May 31/06 May 31/07 Revenue $838 $950 $1,270 $1,578 $1,561 R&D $70 $69 $90 $136 $191

8.35% 7.26% 7.09% 8.62% 12.24%

Note: Nokia 2007 includes Nokia Siemens. Source: Company Annual Reports.

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78 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 7 Employee Growth at RIM

6,254

2000 2001 2002 2003 2004 2005 2006 2007 0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

4,700

3,555

2,223 1,8471,950

1,256

512

Source: RIM Annual Reports.

Organizational Development for R&D at RIM

The 2,100 R&D employees made up about 35 per cent of RIM’s 6,254 employees.20 Total headcount had also been growing in double digits over the last five years (see Exhibit 7). However, if investment an- alysts were correct and sales grew by almost 70 per cent again in 2008,21 the large numbers involved could hinder RIM’s ability to rely on its historic growth strategy: sourcing from the local talent pool, through employee referrals and new graduate recruit- ment, and making selective acquisitions of small technology companies. It needed to find upwards of 1,400 new software developers just to maintain the status quo in R&D. And not only did they have to find large numbers of talented individuals, they also had

to figure out where they would be located and how to integrate them into RIM’s culture.

The culture at RIM headquarters was seen as one of its differentiators and was a key factor in RIM’s low employee turnover rate. In fact, the company had recently been recognized as one of “Canada’s 10 Most Admired Corporate Cultures.”22

In describing the way things worked in the soft- ware development group at RIM, Dayna Perry, director of organizational development for R&D, commented:

What we have here is flexibility, adaptability and the ability to work collaboratively and collegially. We haven’t had a lot of process or the kind of bureaucracy that you may see in other larger organizations. . . . It is what has allowed us to be very responsive to mar- ket opportunities. It is sort of the “magic” or the “secret sauce” of how things just work and we get things done.

❚ 20The remaining groups included 836 in sales, marketing and business development; 1,098 in customer care and technical support; 1,158 in manufacturing; and 1,002 in administration, which included information technology, BlackBerry network operations and service development, finance, legal, facilities and corporate administration. ❚ 21http://finance.yahoo.com/q/ae?s=RIMM.

❚ 22Canada’s 10 Most Admired Corporate Cultures for 2006, www.waterstonehc.com, accessed on April 5, 2008.

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in Finland, the United States, India and Germany, among other development sites. In California’s Sil- icon Valley, Apple and Google had scooped up many of the top mobile browser developers in a technology cluster famous for its exaggerated em- ployee benefits and unbeatable climate. Motorola could be the exception to the rule, having an- nounced layoffs of engineers. Although Waterloo, Ontario had recently been named ICF’s “Intelligent Community of the Year,” the city of 115,000 peo- ple26 might not be perceived by some candidates to be as attractive as other high tech centers which were more cosmopolitan, for example: Silicon Val- ley, or previous winners of the ICF, Taipei (2006), Mitaka (2005) or Glasgow (2004).27

Compounding the problem was a shortage of physical space at RIM’s Waterloo campus that was a running joke around headquarters. Even company founder Mike Lazaridis had to laugh about it— responding to a reporter’s question about his most embarrassing moment, Lazaridis replied: “Scrap- ing my Aston Martin in RIM’s driveway. I was leav- ing a space and a car came from nowhere. The scratches have been fixed, but not the too-busy parking lot. It’s a hazard of a growing company.”28

On top of it all, RIM was looking to hire a very particular mix of engineers. Although new gradu- ates were essential, to be ahead of the game a good proportion of the incoming employees was going to have to be senior hires. RIM needed people who could fit with the culture and hit the ground run- ning. Dayna noted: “We just don’t have the luxury of time to grow all our own talent. We do that in parallel and do a lot of internal promotion, but that is an investment you make in the future, it is not going to help you solve your problem today.” And it wasn’t just a question of the number of engineers.

A software developer leading a team working on BlackBerry’s many multi-lingual devices agreed, saying:

RIM, in comparison to some of its competitors, is a nice and dynamic environment . . . RIM is a place en- gineers like to work. Some of our competitors treat their engineers as something unimportant. They don’t participate in decisions. They are interchangeable. There is a very very strong bureaucracy . . . it’s crazy. RIM is very different.

Maintaining its unique culture was a priority for RIM. Remaining centered in Waterloo nurtured this ability. But it was becoming clear that growing mostly in Waterloo was going to become increasingly difficult. Not only did RIM already employ most of the best developers in the area, it already attracted the best and brightest of the nearby University of Waterloo’s engineering and computer science grad- uates. About 300 students came on board every semester through the company’s coveted co-op program and many were asked to remain with RIM after graduation. In fact, the talent at the University of Waterloo was so widely recognized that even Bill Gates made frequent visits to the university to court the best students23 and Google had recently opened facilities there, acknowledging that “Waterloo is an incredible pool of talent”24 and that it was ready to start hiring the best and the brightest “as quickly as possible.”25

Attracting outside talent to Waterloo was diffi- cult given the competitive nature of the global soft- ware development industry. Most of the big players in the smartphone space were also ramping up. For example, Sony Ericsson had posted 230 design and engineering jobs in Sweden, China and the United States. Nokia was looking for 375 R&D employees

Case 1-4 Research in Motion: Managing Explosive Growth 79

❚ 23D. Friend, “Microsoft hunting IT grads,” London Free Press, March 22, 2008. ❚ 24“Google expands Waterloo base,” http://atuw.ca/feature-google- expands-waterloo-base/, accessed April 11, 2008. ❚ 25A. Petroff, “A Recruiter’s Waterloo?” http://www.financialpost.com/ trading_desk/technology/story.html?id=389305, accessed April 11, 2008.

❚ 26The greater Kitchener-Waterloo area had approximately 450,000 inhabitants. ❚ 27Intelligent Community Forum, 2007 Intelligent Community of the Year Awards, Press release May 18, 2007, http://www.intelligentcommunity .org/displaycommon.cfm?an=1&subarticlenbr=221, accessed April 5, 2008. ❚ 28J. Shillingford, “A life run by BlackBerry,” Financial Times, March 19, 2008, http://global.factiva.com, accessed on April 1, 2008.

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In software, breakthrough innovations often came from small teams led by a visionary. Many at RIM believed that “software is as much about art as it is about engineering.” And in the dynamic wireless communications market, exceptional software de- velopers were scarce.

Managing Explosive Growth

The approach to growth used by RIM in the past would not deliver the scale and scope of R&D resources required to maintain its technical superi- ority. RIM had several options.

Do What We Do Now, Only More of It RIM had been very successful in its local recruiting strategy as well as nation-wide campus recruitment drives. It relied heavily on the personal and professional networks of existing employees as an ear-on-the- ground approach to finding new talent. One option was to expand co-op programs to other universities as well as increase the frequency and intensity of its new graduate recruitment efforts. Microsoft’s in- tern program, for example, included subsidized housing and transportation (car rental or bike pur- chase plan), paid travel to Redmond, health club memberships and even subsidized housecleaning!29

Likewise, RIM could follow Microsoft’s lead and form a global scouting group dedicated to find- ing the best talent worldwide and bringing them into RIM. Canada ranked as one of the best coun- tries in the world to live in terms of life expectancy, literacy, education and other standards of living.30

These and other benefits could attract young devel- opers particularly from emerging markets. As well, the stronger dollar made Canada more attractive.

Similar to other players in the industry (e.g., Apple, Motorola, Sony Ericsson, Nokia), RIM posted many of its job openings online and potential employees searched and applied for the positions best suited for their skills and interests. However, with over 800 worldwide job postings, finding the right job was often a daunting task. RIM also had no formal

way to manage qualified candidates that may have simply applied to the wrong team and hence good leads were potentially lost. Some competitors al- lowed candidates to build an open application (sim- ilar to Monster or Workopolis) that could then be viewed by anyone in the organization looking for talent. Revamping the careers website and being more creative in the way in which they structured recruiting was being considered.

Some competitors had also formalized hiring and the onboarding processes of computer scientists by hiring in “waves.” Rather than posting individual job openings, Symbian, for example, solicited re- sumes once a year, which were then reviewed, and successful candidates invited to the London, U.K.- based head office to attend one of nine Assessment Days. If the attendees passed a series of tests and interviews, they were then inducted into the com- pany during a formal “bootcamp” training session that lasted five weeks.31 Symbian had also set up extensive collaborations with 44 universities in 17 countries including China, Russia and India as well as Ethiopia, Kuwait, Lebanon, Thailand and the United States. Dubbed The Symbian Academy, this network allowed partners and licensees to post jobs for Symbian Academy students and for profes- sors to collaborate on the research and development of innovative applications such as pollution moni- tors on GPS-enabled Symbian smartphones.32 Al- though RIM enjoyed an excellent relationship with the University of Waterloo, it did not currently have a recruiting strategy of this scope.

Grow and Expand Existing Geographies RIM had established R&D operations beyond Waterloo, in Ottawa, Mississauga, Dallas and Chicago over the last five years. It was also expanding the number of product and technology development facilities in locations such as Fort Lauderdale by recruiting through general job fairs. This strategy, however, had to be balanced with a number of trade-offs. First, RIM wanted to ensure that its geographic

80 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 29http://www.microsoft.com/college/ip_overview.mspx. ❚ 30United Nations Human Development Index 2007/2008.

❚ 31http://www.symbian.com/about/careers/graduate%20program/index .html, accessed April 3, 2008. ❚ 32www.symbian.com, accessed April 3, 2008.

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Apple also kept their software developers in one location to foster innovation. In some ways, RIM was already more geographically distributed than many larger software organizations.

Although establishing a geographic expansion plan posed difficulties, RIM had nevertheless laid out several criteria for selecting new locations for product and technology development sites. First, the area had to already have a pool of talent that housed a mature skill set; the city or region had to have an existing base of software or hardware companies, thus ensuring that a critical mass of highly skilled employees was available. RIM’s strategic expansion into Ottawa, for example, was influenced by the availability of talented software engineers in the area in the wake of Nortel’s massive layoffs.35 Lastly, the city or region had to have universities with strong technical programs. This allowed RIM to expand on its successful co-op programs and graduate recruit- ment initiatives. Once a satellite development site was set up, however, there was still the issue of how to transfer RIM’s young and dynamic corporate culture to these locations.

Increase Acquisitions RIM had success in bring- ing people on board through acquisition. Several years earlier, RIM had acquired Slangsoft, a high tech start-up in Israel that was developing code which allowed for the ability to display and input Chinese characters—key to tailoring BlackBerry for Asian and other foreign markets. As part of the acquisition, RIM worked with Immigration Canada to relocate 11 of the engineers to Waterloo, 10 of whom were still with RIM more than six years later. Growth by acquisition was a common practice in the high tech and telecommunications sectors. Google had made its initial move to Waterloo in 2006, for example, through the acquisition of a small wireless software company, subsequently dis- continuing the company’s web browser product,

expansion was not haphazard, but rather strategi- cally executed. Second, the cost of talent in various locations had to be considered. Software engineers in Palo Alto, for example, commanded much higher wages than in Waterloo and the competition there was even more intense, with high turnover costs incurred when employees were wooed away by the many other high tech companies in the area.

There was also some internal resistance to ex- panding R&D to locations outside of Waterloo. Although there was a growing realization that RIM could no longer continue to grow locally, one senior executive commented:

There are people here, even leaders and senior people, who have said: “What? Products being built else- where? No! We can’t do that! Then we won’t have any control!” So some of it is a cultural shift and a mind shift for the people that have been here and it is hard for them to let go and to be part of a really big com- pany. And RIM is getting to be a big company now. And for some people, from an organizational culture perspective, it just doesn’t resonate well with them.

This sentiment was not uncommon among software- centric organizations. Despite some geographic ex- pansion, Microsoft, for example, had recently recommitted to its Redmond, Washington campus, spending over $1 billion on new and upgraded fa- cilities there with room to house an additional 12,000 employees.33 Google was also strongly com- mitted to maintaining its Mountain View, California headquarters, with only a few satellite offices. Its unique company culture, built on attracting and keep- ing the best talent in a young and fun environment was part of Google’s incredible success story, and helped it achieve the status of the number one com- pany to work for according to Fortune Magazine.34

Other large software companies such as Oracle and

Case 1-4 Research in Motion: Managing Explosive Growth 81

❚ 33B. Romano, “Microsoft campus expands, transforms, inside out,” The Seattle Times, November 23, 2007, http://seattletimes.nwsource .com/cgi-bin/PrintStory.pl?document_id=2004007121&zsection_id= 2003750725&slug= microsoft11&date=20071111, accessed April 22, 2008. ❚ 34http://money.cnn.com/magazines/fortune/bestcompanies/2007/ snapshots/1.html, accessed April 22, 2008.

❚ 35Estimated at over 15,000 total jobs in the last eight years; B. Hill, “Nortel to keep Ottawa as main R&D centre,” April 4, 2008, The Montreal Gazette, http://www.canada.com/montrealgazette/news/ business/story.html?id=24aa8d53-154a-4d88-aa9d-593ce9794e10, accessed April 11, 2008.

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making it a purchase of talent and intellectual prop- erty.36 Other companies had also made strategic acquisitions of technology. In 2002, Apple, for example, purchased EMagic, a small German com- pany whose software was then used in the develop- ment of the popular Mac program Garage Band.37 In larger and more public acquisitions, Nokia and Motorola had both recently acquired software com- panies in the hopes of gaining faster access to the growing smartphone market. In 2006, Nokia pur- chased Intellisync Corporation, a wireless messaging and mobile-software developer for $430 million, cre- ating Nokia’s “business mobility solutions” group.38

Also in 2006, Motorola purchased Good Technol- ogy for a rumored $500 million and released Good 5.0, allowing for secure access to corporate intranets so enterprise users could download, edit and send documents remotely.39

Given the depressed economic climate in the United States in early 2008, many smaller firms and technology start-ups were struggling financially as were some larger competitors. There were persistent rumors that Palm, for example, was in severe finan- cial trouble.40 Further, growth by acquisition could also allow for the tactical expansion in other strategic markets.

The European mobile telecommunications market, in particular, was highly “nationalistic,” with end users favoring home grown companies over foreign solutions. Establishing a presence there through acquisition could buy RIM goodwill and serve as a portal to this lucrative market. The eco- nomic downturn in the United States and recent competitor plant closures in Europe presented RIM

with the potential for opportunistic acquisitions, either of technology or of software engineering talent.

Go Global In early 2008, most of the R&D was still done in Waterloo, with some core work also being done in Ottawa and product and technology sites throughout the United States and in the United Kingdom. RIM was exploring a broader global ex- pansion. It already had customer service operations in Singapore and sales and marketing representative offices in France, Germany, Italy, Spain, China, Australia, Hong Kong and Japan. Yet it had stopped short of establishing core research and development sites outside of Canada. Nonetheless, despite a strong desire to keep R&D close to home, RIM estimated that of all the new hires in 2008, likely half would have to be outside of Canada. In addition to the United States, it was looking to Europe, the Middle East and Africa (EMEA) and Eastern Europe. The same selection criteria of a mature skill set and strong technological universities applied to choosing R&D sites outside North America.

Some of RIM’s key competitors had a long history of global expansion of their R&D activities. Sym- bian, for example, opened an R&D center in Beijing in August 2007, already having three others in the United Kingdom and India.41 Motorola, had been present in China since 1993 when it established its first R&D center there as part of its Global Soft- ware Group (GSG). It had since set up R&D activ- ities in Beijing, Tianjin, Shanghai, Nanjing, Chengdu and Hangzhou, investing an estimated US$800 million and employing more than 3,000 R&D staff in China. In 2007, Motorola added R&D sites in Vietnam and South Korea42 and announced it would open an additional R&D complex in Wangjing, China, with another 3,000 employees.43

82 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 36M. Evans, “Waterloo gets Googled,” January 6, 2006, http://www .financialpost.com/story.html?id=c4f6f084-d72f-43ea-8a82-affe38df 3830&k=58579, accessed April 11, 2008. ❚ 37A. Hesseldahl, “What to do with Apple’s cash,” Business Week, March 1, 2007, http://www.businessweek.com/technology/content/ mar2007/tc20070301_402290.htm, accessed April 11, 2008. ❚ 38TelecomWeb News Digest, “Nokia completes Intellisync purchase,” February 10, 2006, http://global.factiva.com, accessed April 11, 2008. ❚ 39RCR Wireless News, “Motorola set to leverage Good in competitive e-mail market,” June 25, 2007, http://global.factiva.com, accessed April 11, 2008. ❚ 40S. Weinberg, “Palm acquisition not considered threat to RIM,” Dow Jones Newswire, http://global.factiva.com, accessed April 11, 2008.

❚ 41Business Monitor International, Asia Pacific Telecommunications Insight, April 2008, Issue 24. ❚ 42Business Monitor International, Asia Pacific Telecommunications Insight, January 2008, Issue 21. ❚ 43Press Release, “Twenty years’ commitment ensures a more successful future,” November 8, 2007, http://www.motorola.com/media center/news/detail.jsp?globalObjectId=8923_8852_23&page=archive.

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The Motorola GSG in India had nearly 3,500 engi- neers and was responsible for designing 40 per cent of the software used in Motorola phones world- wide, including the MOTORAZR and MOTOQ. However, Motorola was not noted for having world- class smartphone software. The GSG structure was speculated to have contributed to Motorola’s inabil- ity to deliver a successful follow-up product to the RAZR as well as to have precipitated the company’s recent financial downturn.49

Nonetheless, partnering with major research in- stitutes to source top talent appeared to be a fairly common strategy. Motorola India collaborated with six of the seven Indian Institutes of Technology (IIT), as well as the Indian Institute of Science (IISC) and the Indian Institute of Information Tech- nology (IIIT).50 Other technology firms were also partnering with emerging market governmental and educational institutions to secure a foothold in fu- ture markets. Cisco Systems, for example, a leading manufacturer of network equipment, had recently announced a US$16 billion expansion plan into China, including investments in manufacturing, ven- ture capital and education. Working with China’s Ministry of Education, Cisco had established 200 “Networking Academies” in 70 cities in China and had trained more than 90,000 students.51

These types of collaborations and international research consortiums, however, raised not only logistical but also legal issues. Source code loss, software piracy and product imitations were more common in developing countries where IP protec- tion laws (or enforcement) lagged the United States or Canada, leading to both explicit and tacit knowl- edge “leakage.” For example, despite its strong commitment to China, Nokia was recently forced to file suit against two Beijing firms for manufacturing and selling mobile phones that were a direct copy of

China in particular was beginning to gain world- wide recognition as a center for innovation. The number of patent applications was doubling every two years and the R&D to GDP ratio had also dou- bled in the last decade. In addition to Motorola, Nokia had set up a number of research bases in China.44 In 2005, Nokia had five R&D units there, employing more than 600 people; an estimated 40 per cent of its global Mobile Phones Business Group handsets were designed and developed in the Beijing Product Creation Center.45 The company had also recently announced a long-term joint re- search program with Tsinghua University in Beijing that would see 20 Nokia researchers work- ing alongside 30 professors and associates and up to 50 students.46 Globally, Nokia Research Centers (NRC) described its R&D strategy as:

NRC has a two-fold approach to achieving its man- date of leading Nokia into the future. The work for core technology breakthroughs supporting Nokia’s existing businesses takes place in the Core Technol- ogy Centers, the CTCs. More visionary, exploratory systems research that goes well beyond any current business model is conducted at the many System Research Centers, the SRCs.47

Nokia’s core technology centers were in Finland, with the SRCs in China, Germany, the United Kingdom, United States, Finland and Japan. The company employed 112,262 people, of which 30,415, or 27 per cent, were in R&D.48

The Motorola Global Software Group (GSG) was more decentralized. In addition to China it had R&D centers in Australia, Singapore, Mexico, Ar- gentina, the United Kingdom, Poland, Russia, Italy, Canada and India, among others and employed ap- proximately 27,000 R&D employees worldwide.

Case 1-4 Research in Motion: Managing Explosive Growth 83

❚ 44Business Monitor International, Asia Pacific Telecommunications Insight, November 2007, Issue 19. ❚ 45Press Release, May 21, 2004, “Nokia Expands R&D in China,” http://press.nokia.com/PR/200405/946603_5.html. ❚ 46Press Release, May 28, 2007, “Nokia and Tsinghua University announce new research framework,” http://www.nokia.com/ A4136001?newsid=1129236. ❚ 47http://research.nokia.com/centers/index.html. ❚ 48Nokia annual report 2007.

❚ 49“What’s on Motorola’s agenda?” Business Week, January 9, 2008, http://www.businessweek.com/innovate/content/jan2008/id2008014_304 911_page_2.htm, accessed April 16, 2008. ❚ 50Motorola 2007 10-K and http://www.motorola.com/mot/doc/6/ 6294_MotDoc.pdf ❚ 51Business Monitor International, Asia Pacific Telecommunications Insight, January 2008, Issue 21.

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its proprietary and legally protected industrial de- signs.52 Other large high tech companies such as Cisco and Microsoft had also suffered source code breaches. In late 2006, China Unicom, the state-run telecommunications company, had launched its own wireless e-mail service which it boldly named the Redberry, announcing that their Redberry brand not only continued the already familiar “BlackBerry” image and name, it also fully reflected the symbolic meaning of China Unicom’s new red corporate logo.53 For much of East Asia, reverse engineering and copying foreign products were important sources of learning, helping to transition these markets from imitators of technology to innovators and competi- tive threats.54

Wormald described the difficulties with emerging market dynamics as follows:

I was just talking to a Fortune 500 CEO the other day who is closing up shop in India. This company had a 45 per cent employee turnover rate. They just walk down the street and go work for his competitor and he was tired of his source code just walking out the door.

For RIM, going global was therefore problem- atic on a number of fronts, most notably because the BlackBerry source code had to be protected. In addition, expanding to emerging markets was also complicated by restrictions regarding cryptographic software. Most governments, including those of Canada and the United States, along with Russia and China, regulated the import and export of encryption products due to national security issues. Encryption was seen as a “dual-use technology” which could have both commercial and military value and was thus carefully monitored. The U.S. government would not purchase any product that had not passed

the “Federal Information Processing Standard” (FIPS) certification tests. This would preclude any product that had encrypted data in China because “if you encrypt data in China, you have to provide the Chinese government with the ability to access the keys.”55

India had also recently notified RIM that it planned to eavesdrop on BlackBerry users, claim- ing that terrorists may be hiding behind the en- crypted messages to avoid detection.56

Even if these hurdles could be overcome, going global also brought with it additional challenges of organizational design, communication, and integra- tion between head office and other geographically dispersed locations. Some competitors had chosen to expand globally by product line, while others had outsourced less sensitive functions such as testing and documentation. Eastern European countries such as Poland and Hungary, for example, were emerging as strong contenders for quality assur- ance testing. The lower cost of labor in developing and transitional economies, however, was showing signs of inflationary pressures in some locales and any planned savings might be somewhat offset by the increased monitoring, coordination and integra- tion costs. Furthermore, RIM was not set up to manage a multi-country research consortium and the mindset in Waterloo was still very much such that core engineers needed to be seen to be per- ceived as valuable. On the other hand, the potential could not be ignored. In China, where the penetra- tion rate was only 38 per cent, the Symbian OS sys- tem used in Nokia, Samsung, Sony Ericsson and LG smartphones enjoyed a 68.7 per cent share, and iPhone sales had reached 400,000 “unlocked” units.57 In India, where the penetration rate stood at 21 per cent, Virgin Mobile had recently struck a brand franchise agreement with Tata Teleservices,

84 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

❚ 52Shanghai Daily, “Nokia files suit over alleged copy of model,” June 29, 2006, http://global.factiva.com, accessed April 16, 2008. ❚ 53Hesseldahl, A. “BlackBerry vs. Redberry in China,” September 25, 2006, Business Week http://www.businessweek.com/technology/ content/apr2006/tc20060413_266291.htm?chan=search, accessed April 16, 2008. ❚ 54United Nations World Investment Report 2005, Transnational Corporations and the Internationalization of R&D, New York and Geneva, 2005, p. 165.

❚ 55E. Messmer, “Encryption Restrictions” and “Federal encryption purchasing requirements,” Network World, March 15, 2004, http://www.networkworld.com/careers/2004/0315man.html?page=1; accessed April 22, 2008. ❚ 56N. Lakshman, “India wants to eavesdrop on BlackBerrys,” Business Week, April 1, 2008, http://global.factiva.com, accessed April 7, 2008. ❚ 57Business Monitor International, Asia Pacific Telecommunications Insight, April 2008, Issue 24.

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and then maximize value by reducing its costs. But building a sustainable innovation cycle requires an enormous investment in R&D. You have to understand all the technologies involved.61

Yach knew that his software developers were key to RIM’s continued success; he was committed to de- livering on the expectations for continued and sus- tainable growth in 2008 and beyond. Although he wanted to keep growing organically, sourcing talent locally and bringing his engineers into the cultural fold of RIM in Waterloo, he suspected this era was ending. In light of the unprecedented and exponential growth of the last year, coupled with the increasing competition and untapped global opportunities, he needed a plan.

Leaving the office after a hectic and frenetic first day back, Yach thought to himself—“How can I plan for this growth when it is just one of 10 burning issues on my agenda? We can’t take a time-out to decide how to execute the growth.” Grabbing the sales numbers to prepare for tomor- row’s meeting, Yach knew he had the evening to consider the way ahead. The vacation was definitely over.

announcing plans to gain at least 50 million young subscribers to its mobile services, generating esti- mated revenues of US$350 billion.58 The sheer number of potential new users was overwhelming.

Conclusion

Looking at the holiday sales numbers and the pro- jected growth for 2008, Yach took a minute to think about the path he was on. He knew that first quarter revenue projections alone were estimated at $2.2 billion to $2.3 billion and that RIM was expecting to add another 2.2 million BlackBerry subscribers by the end of May 2008.59 At that rate, analysts projected that 2008 would bring at least another 70 per cent growth in sales.60 Furthermore, Mike Lazaridis had recently said in an interview:

If you really want to build something sustainable and innovative you have to invest in R&D. If you build the right culture and invest in the right facilities and you encourage and motivate and inspire both young and seasoned people and put them all in the right environment—then it really performs for you. It’s what I call sustainable innovation. And it’s very dif- ferent from the idea that you come up with something

Case 1-4 Research in Motion: Managing Explosive Growth 85

❚ 58Business Monitor International, Asia Pacific Telecommunications Insight, April 2008, Issue 24. ❚ 59Press Release, April 2, 2008: http://www.rim.com/news/press/2008/ pr-02_04_2008-01.shtml. ❚ 60http://finance.yahoo.com/q/ae?s=RIMM

❚ 61A. Hesseldahl, “BlackBerry: Innovation Behind the Icon,” Business Week, April 4, 2008, http://www.businessweek.com/innovate/content/ apr2008/id2008044_416784.htm?chan=search, accessed April 6, 2008.

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Howard V. Perlmutter

Four senior executives of the world’s largest firms with extensive holdings outside the home country speak:

Company A: “We are a multinational firm. We distribute our products in about 100 countries. We manufacture in over 17 countries and do research and development in three countries. We look at all new investment projects—both domestic and overseas— using exactly the same criteria.”

Company B: “We are a multinational firm. Only 1% of the personnel in our affiliate companies are non-nationals. Most of these are U.S. executives on temporary assignments. In all major markets, the af- filiate’s managing director is of the local nationality.”

Company C: “We are a multinational firm. Our product division executives have worldwide profit responsibility. As our organizational chart shows, the United States is just one region on a par with Europe, Latin America, Africa, etc., in each product division.”

Company D (non-American): “We are a multi- national firm. We have at least 18 nationalities represented at our headquarters. Most senior executives speak at least two languages. About 30% of our staff at headquarters are foreigners.”

While a claim to multinationality based on their years of experience and the significant proportion of sales generated overseas is justified in each of

these four companies, a more penetrating analysis changes the image.

The executive from Company A tells us that most of the key posts in Company A’s subsidiaries are held by home-country nationals. Whenever replacements for these men are sought, it is the practice, if not the policy, to “look next to you at the head office” and “pick someone (usually a home- country national) you know and trust.”

The executive from Company B does not hide the fact that there are very few non-Americans in the key posts at headquarters. The few who are there are “so Americanized” that their foreign nationality literally has no meaning. His expla- nation for this paucity of non-Americans seems reasonable enough: “You can’t find good foreign- ers who are willing to live in the United States, where our headquarters is located. American executives are more mobile. In addition, Americans have the drive and initiative we like. In fact, the European nationals would prefer to report to an American rather than to some other European.”

The executive from Company C goes on to ex- plain that the worldwide product division concept is rather difficult to implement. The senior executives in charge of these divisions have little overseas ex- perience. They have been promoted from domestic posts and tend to view foreign consumer needs “as really basically the same as ours.” Also, product di- vision executives tend to focus on the domestic market because the domestic market is larger and generates more revenue than the fragmented Euro- pean markets. The rewards are for global perfor- mance, but the strategy is to focus on domestic. His colleagues say “one pays attention to what one understands—and our senior executives simply do not understand what happens overseas and really do not trust foreign executives in key positions here or overseas.”

86 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Reading 1-1 The Tortuous Evolution of the Multinational Corporation

❚ Trained as an engineer and a psychologist, Howard V. Perlmutter spent eight years at M.I.T.’s Center for International Studies and five years at the Institut pour l’Etude des Methodes de Direction de l’Enterprise (IMEDE) in Lausanne, Switzerland. His main interests are in the theory and practice of institution building, particularly the international corporation. He has recently been appointed Director for Research and Development of Worldwide Institutions in association with the Management Science Center at the University of Pennsylvania, as well as a member of the faculty at the Wharton School. ❚ Used with permission of Howard V. Perlmutter.

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want to prove that the greater the degree of multi- nationality of a firm, the greater its total constructive impact will be on host and home nation-states as well as other institutions. Since multinational firms may produce a significant proportion of the world’s GNP, both hypotheses justify a more precise analy- sis of the varieties and degrees of multinationality.1

However, the confirming evidence is limited.

State of Mind

Part of the difficulty in defining the degree of multi- nationality comes from the variety of parameters along which a firm doing business overseas can be described. The examples from the four companies argue that (1) no single criterion of multinationality such as ownership or the number of nationals over- seas is sufficient, and that (2) external and quantifi- able measures such as the percentage of investment overseas or the distribution of equity by nationality are useful but not enough. The more one penetrates into the living reality of an international firm, the more one finds it is necessary to give serious weight to the way executives think about doing business around the world. The orientation toward “foreign people, ideas, resources,” in headquarters and sub- sidiaries, and in host and home environments, be- comes crucial in estimating the multinationality of a firm. To be sure, such external indices as the pro- portion of nationals in different countries holding equity and the number of foreign nationals who have reached top positions, including president, are good indices of multinationality. But one can still behave with a home-country orientation despite foreign shareholders, and one can have a few home-country nationals overseas but still pick those local executives who are home-country oriented or who are provincial and chauvinistic. The attitudes men hold are clearly more relevant than their passports.

Three primary attitudes among international executives toward building a multinational enterprise are identifiable. These attitudes can be inferred from

The executive from the European Company D begins by explaining that since the voting share- holders must by law come from the home country, the home country’s interest must be given careful consideration. In the final analysis he insists: “We are proud of our nationality; we shouldn’t be ashamed of it.” He cites examples of the previous reluctance of headquarters to use home-country ideas overseas, to their detriment, especially in their U.S. subsidiary. “Our country produces good exec- utives, who tend to stay with us a long time. It is harder to keep executives from the United States.”

A Rose by Any Other Name . . .

Why quibble about how multinational a firm is? To these executives, apparently being multinational is prestigious. They know that multinational firms tend to be regarded as more progressive, dynamic, geared to the future than provincial companies which avoid foreign frontiers and their attendant risks and opportunities.

It is natural that these senior executives would want to justify the multinationality of their enterprise, even if they use different yard sticks: ownership crite- ria, organizational structure, nationality of senior executives, percent of investment overseas, etc.

Two hypotheses seem to be forming in the minds of executives from international firms that make the extent of their firm’s multinationality of real interest. The first hypothesis is that the degree of multination- ality of an enterprise is positively related to the firm’s long-term viability. The “multinational” category makes sense for executives if it means a quality of decision making which leads to survival, growth and profitability in our evolving world economy.

The second hypothesis stems from the proposi- tion that the multinational corporation is a new kind of institution—a new type of industrial social archi- tecture particularly suitable for the latter third of the twentieth century. This type of institution could make a valuable contribution to world order and con- ceivably exercise a constructive impact on the nation-state. Some executives want to understand how to create an institution whose presence is considered legitimate and valuable in each nation-state. They

Reading 1-1 The Tortuous Evolution of the Multinational Corporation 87

❚ 1H. V Perlmutter, “Super-Giant Firms in the Future,” Wharton Quarterly, Winter 1968.

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the assumptions upon which key product, functional and geographical decisions were made.

These states of mind or attitudes may be described as ethnocentric (or home-country oriented), polycen- tric (or host-country oriented) and geocentric (or world-oriented).2 While they never appear in pure form, they are clearly distinguishable. There is some degree of ethnocentricity, polycentricity or geocen- tricity in all firms, but management’s analysis does not usually correlate with public pronouncements about the firm’s multinationality.

Home-Country Attitudes

The ethnocentric attitude can be found in compa- nies of any nationality with extensive overseas holdings. The attitude, revealed in executive actions and experienced by foreign subsidiary managers, is: “We, the home nationals of X company, are superior to, more trustworthy and more reliable than any foreigners in headquarters or subsidiaries. We will be willing to build facilities in your country if you acknowledge our inherent superiority and accept our methods and conditions for doing the job.”

Of course, such attitudes are never so crudely ex- pressed but they often determine how a certain type of “multinational” firm is designed. Table 1 illustrates

88 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Table 1 Three Types of Headquarters Orientation toward Subsidiaries in an International Enterprise

Organization Design Ethnocentric Polycentric Geocentric

Complexity of Complex in home Varied and independent Increasingly complex organization country, simple in and interdependent

subsidiaries Authority; decision High in headquarters Relatively low in Aim for a collaborative

making headquarters approach between headquarters and subsidiaries

Evaluation and control Home standards applied Determined locally Find standards which for persons and are universal and performance local

Rewards and High in headquarters, Wide variation; can be International and local punishments; low in subsidiaries high or low rewards executives rewarded incentives for subsidiary for reaching local and

performance worldwide objectives Communication; High volume to Little to and from Both ways and between

information flow subsidiaries; orders, headquarters; little subsidiaries; heads of commands, advice between subsidiaries subsidiaries part of

management team Identification Nationality of owner Nationality of host Truly international

country company but identifying with national interests

Perpetuation Recruit and develop Develop people of local Develop best people (recruiting, staffing, people of home nationality for key everywhere in the development) country for key positions in their own world for key

positions everywhere country positions everywhere in the world in the world

❚ 2H. V. Perlmutter, “Three Conceptions of a World Enterprise,” Revue Economique et Sociale, May 1965.

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Host-Country Orientation

Polycentric firms are those which by experience or by the inclination of a top executive (usually one of the founders), begin with the assumption that host- country cultures are different and that foreigners are difficult to understand. Local people know what is best for them, and the part of the firm which is located in the host country should be as “local in identity” as possible. The senior executives at head- quarters believe that their multinational enterprise can be held together by good financial controls. A polycentric firm, literally, is a loosely connected group with quasi-independent subsidiaries as centers—more akin to a confederation.

European multinational firms tend to follow this pattern, using a top local executive who is strong and trustworthy, of the “right” family and who has an intimate understanding of the workings of the host government. This policy seems to have worked until the advent of the Common Market.

Executives in the headquarters of such a com- pany are apt to say: “Let the Romans do it their way. We really don’t understand what is going on there, but we have to have confidence in them. As long as they earn a profit, we want to remain in the background.” They assume that since people are different in each country, standards for performance, incentives and training methods must be different. Local environ- mental factors are given greater weight (see Table 1).

Many executives mistakenly equate polycentrism with multinationalism. This is evidenced in the le- galistic definition of a multinational enterprise as a cluster of corporations of diverse nationality joined together by ties of common ownership. It is no ac- cident that many senior executives in headquarters take pride in the absence of non-nationals in their subsidiaries, especially people from the head office. The implication is clearly that each subsidiary is a distinct national entity, since it is incorporated in a different sovereign state. Lonely senior executives in the subsidiaries of polycentric companies com- plain that: “The home office never tells us anything.”

Polycentrism is not the ultimate form of multinationalism. It is a landmark on a highway.

how ethnocentric attitudes are expressed in determin- ing the managerial process at home and overseas. For example, the ethnocentric executive is more apt to say: “Let us manufacture the simple products overseas. Those foreign nationals are not yet ready or reliable. We should manufacture the complex products in our country and keep the secrets among our trusted home-country nationals.”

In a firm where ethnocentric attitudes prevailed the performance criteria for men and products are “home-made.” “We have found that a salesman should make 12 calls per day in Hoboken, New Jersey (the headquarters location), and therefore we apply these criteria everywhere in the world. The salesman in Brazzaville is naturally lazy, unmoti- vated. He shows little drive because he makes only two calls per day (despite the Congolese salesman’s explanation that it takes time to reach customers by boat).”

Ethnocentric attitudes are revealed in the commu- nication process where “advice,” “counsel,” and di- rectives flow from headquarters to the subsidiary in a steady stream, bearing this message: “This works at home; therefore, it must work in your country.”

Executives in both headquarters and affiliates express the national identity of the firm by associat- ing the company with the nationality of the head- quarters: this is “a Swedish company,” “a Swiss company,” “an American company,” depending on the location of headquarters. “You have to accept the fact that the only way to reach a senior post in our firm,” an English executive in a U.S. firm said, “is to take out an American passport.”

Crucial to the ethnocentric concept is the current policy that men of the home nationality are recruited and trained for key positions everywhere in the world. Foreigners feel like “second-class” citizens.

There is no international firm today whose exec- utives will say that ethnocentrism is absent in their company. In the firms whose multinational invest- ment began a decade ago, one is more likely to hear, “We are still in a transitional stage from our ethno- centric era. The traces are still around! But we are making progress.”

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Polycentrism is encouraged by local marketing managers who contend that: “Headquarters will never understand us, our people, our consumer needs, our laws, our distribution, etc. . . .”

Headquarters takes pride in the fact that few out- siders know that the firm is foreign-owned. “We want to be a good local company. How many Americans know that Shell and Lever Brothers are foreign-owned?”

But the polycentric personnel policy is also revealed in the fact that no local manager can seri- ously aspire to a senior position at headquarters. “You know the French are so provincial; it is better to keep them in France. Uproot them and you are in trouble,” a senior executive says to justify the paucity of non-Americans at headquarters.

One consequence (and perhaps cause) of poly- centrism is a virulent ethnocentrism among the country managers.

A World-Oriented Concept

The third attitude which is beginning to emerge at an accelerating rate is geocentrism. Senior executives with this orientation do not equate superiority with nationality. Within legal and political limits, they seek the best men, regardless of nationality, to solve the company’s problems anywhere in the world. The senior executives attempt to build an organization in which the subsidiary is not only a good citizen of the host nation, but is a leading exporter from this nation in the international community and con- tributes such benefits as (1) an increasing supply of hard currency, (2) new skills and (3) a knowledge of advanced technology. Geocentrism is summed up in a Unilever board chairman’s statement of ob- jectives: “We want to Unileverize our Indians and Indianize our Unileverans.”

The ultimate goal of geocentrism is a worldwide approach in both headquarters and subsidiaries. The firm’s subsidiaries are thus neither satellites nor independent city states, but parts of a whole whose focus is on worldwide objectives as well as local objectives, each part making its unique contri- bution with its unique competence. Geocentrism is

expressed by function, product and geography. The question asked in headquarters and the subsidiaries is: “Where in the world shall we raise money, build our plant conduct R&D, get and launch new ideas to serve our present and future customers?”

This conception of geocentrism involves a collaborative effort between subsidiaries and head- quarters to establish universal standards and per- missible local variations, to make key allocational decisions on new products, new plants, new labora- tories. The international management team includes the affiliate heads.

Subsidiary managers must ask: “Where in the world can I get the help to serve my customers best in this country?” “Where in the world can I export products developed in this country—products which meet worldwide standards as opposed to purely local standards?”

Geocentrism, furthermore, requires a reward sys- tem for subsidiary managers which motivates them to work for worldwide objectives, not just to defend country objectives. In firms where geocentrism pre- vails, it is not uncommon to hear a subsidiary man- ager say, “While I am paid to defend our interests in this country and to get the best resources for this af- filiate, I must still ask myself the question ‘Where in the world (instead of where in my country) should we build this plant?’” This approach is still rare today.

In contrast to the ethnocentric and polycentric patterns, communication is encouraged among sub- sidiaries in geocentric-oriented firms. “It is your duty to help us solve problems anywhere in the world,” one chief executive continually reminds the heads of his company’s affiliates. (See Table 1.)

The geocentric firm identifies with local company needs. “We aim not to be just a good local company, but the best local company in terms of the quality of management and the worldwide (not local) standards we establish in domestic and export production.” “If we were only as good as local companies, we would deserve to be nationalized.”

The geocentric personnel policy is based on the belief that we should bring in the best man in the world regardless of his nationality. His passport should not be the criterion for promotion.

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decisions. Table 2 summarizes the factors most fre- quently mentioned by over 500 executives from at least 17 countries and 20 firms.

From the external environmental side the grow- ing world markets, the increase in availability of managerial and technological know-how in differ- ent countries, global competition and international customers’advances in telecommunications, regional political and economic communities are positive factors, as is the host country’s desire to increase its balance-of-payments surplus through the location of export-oriented subsidiaries of international firms within its borders.

In different firms, senior executives see in various degrees these positive factors toward geocentrism: top management’s increasing desire to use human and material resources optimally, the observed low- ering of morale after decades of ethnocentric prac- tices, the evidence of waste and duplication under polycentric thinking, the increased awareness and respect for good men of other than the home nation- ality, and, most importantly, top management’s own commitment to building a geocentric firm as evi- denced in policies, practices and procedures.

The obstacles toward geocentrism from the envi- ronment stem largely from the rising political and economic nationalism in the world today, the suspi- cions of political leaders of the aims and increasing power of the multinational firm. On the internal side, the obstacles cited most frequently in U.S.-based multinational firms were management’s inexperience in overseas markets, mutual distrust between home- country people and foreign executives, the resistance to participation by foreigners in the power structure at headquarters, the increasing difficulty of getting good men overseas to move, nationalistic tendencies in staff, and linguistic and other communication difficulties of a cultural nature.

Any given firm is seen as moving toward geocen- trism at a rate determined by its capacities to build on the positive internal factors over which it has control and to change the negative internal factors which are controllable. In some firms the geocentric goal is openly discussed among executives of dif- ferent nationalities and from different subsidiaries

The EPG Profile

Executives can draw their firm’s profile in ethno- centric (E), polycentric (P) and geocentric (G) di- mensions. They are called EPG profiles. The degree of ethnocentrism, polycentrism and geocentrism by product, function and geography can be estab- lished. Typically R&D often turns out to be more geocentric (truth is universal, perhaps) and less eth- nocentric than finance. Financial managers are likely to see their decisions as ethnocentric. The marketing function is more polycentric, particularly in the ad- vanced economies and in the larger affiliate markets.

The tendency toward ethnocentrism in relations with subsidiaries in the developing countries is marked. Polycentric attitudes develop in consumer goods divisions, and ethnocentrism appears to be greater in industrial product divisions. The agreement is almost unanimous in both U.S.- and European- based international firms that their companies are at various stages on a route toward geocentrism but none has reached this state of affairs. Their executives would agree, however, that:

1. A description of their firms as multinational ob- scures more than it illuminates the state of affairs;

2. The EPG mix, once defined, is a more precise way to describe the point they have reached;

3. The present profile is not static but a landmark along a difficult road to genuine geocentrism;

4. There are forces both to change and to maintain the present attitudinal “mix,” some of which are under their control.

Forces Toward and Against

What are the forces that determine the EPG mix of a firm? “You must think of the struggle toward func- tioning as a worldwide firm as just a beginning—a few steps forward and a step backward,” a chief exec- utive puts it. “It is a painful process, and every firm is different.”

Executives of some of the world’s largest multi- national firms have been able to identify a series of external and internal factors that contribute to or hinder the growth of geocentric attitudes and

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92 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Table 2 International Executives’ View of Forces and Obstacles toward Geocentrism in Their Firms

Forces toward Geocentrism Obstacles toward Geocentrism

Environmental Intra-Organizational Environmental Intra-Organizational

1. Technological and managerial know-how increasing in availability in different countries

2. International customers

3. Local customers’ demand for best product at fair price

4. Host country’s desire to increase balance of payments

5. Growing world markets

6. Global competition among international firms for scarce human and material resources

7. Major advances in integration of interna- tional transport and telecommunications

8. Regional suprana- tional economic and political communities

1. Desire to use human versus material resources optimally

2. Observed lowering of morale in affiliates of an ethnocentric company

3. Evidence of waste and duplication in polycentrism

4. Increasing awareness and respect for good people of other than home nationality

5. Risk diversification in having a worldwide production and distribution system

6. Need for recruitment of good people on a worldwide basis

7. Need for worldwide information system

8. Worldwide appeal products

9. Senior manage- ment’s long-term commitment to geocentrism as related to survival and growth

1. Economic national- ism in host and home countries

2. Political nationalism in host and home countries

3. Military secrecy associated with research in home country

4. Distrust of big international firms by host-country political leaders

5. Lack of international monetary system

6. Growing differences between the rich and poor countries

7. Host-country belief that home countries get disproportionate benefits of interna- tional firms’ profits

8. Home-country political leaders’ attempts to control firm’s policy

1. Management inexperience in overseas markets

2. Nation-centered reward and punishment structure

3. Mutual distrust between home- country people and foreign executives

4. Resistance to letting foreigners into the power structure

5. Anticipated costs and risks of geocentrism

6. Nationalistic tendencies in staff

7. Increasing immobility of staff

8. Linguistic problems and different cultural backgrounds

9. Centralization tendencies in headquarters

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more host-government support, and good local managers with high morale.

Geocentrism’s costs are largely related to com- munication and travel expenses, educational costs at all levels, time spent in decision making because consensus seeking among more people is required and an international headquarters bureaucracy. Risks include those due to too wide a distribution of power, personnel problems and those of reentry of international executives. The payoffs are a more powerful total company throughout, a better quality of products and service, worldwide utilization of best resources, improvement of local company manage- ment, a greater sense of commitment to worldwide objectives, and last, but not least, more profit.

Jacques Maisonrouge, the French-born president of IBM World Trade, understands the geocentric concept and its benefits. He wrote recently:

The first step to a geocentric organization is when a corporation, faced with the choice of whether to grow and expand or decline, realizes the need to mobilize its resources on a world scale. It will sooner or later have to face the issue that the home country does not have a monopoly of either men or ideas. . . .

I strongly believe that the future belongs to geocentric companies. . . . What is of fundamental importance is the attitude of the company’s top management. If it is dedicated to “geocentrism,” good international management will be possible. If not, the best men of different nations will soon understand that they do not belong to the “race des seigneurs” and will leave the business.3

Geocentrism is not inevitable in any given firm. Some companies have experienced a “regression” to ethnocentrism after trying a long period of poly- centrism, of letting subsidiaries do it “their way.” The local directors built little empires and did not train successors from their own country. Headquar- ters had to send home-country nationals to take over. A period of home-country thinking took over.

There appears to be evidence of a need for evolutionary movement from ethnocentrism to

as well as headquarters. There is a consequent improvement in the climate of trust and acceptance of each other’s views.

Programs are instituted to assure greater experi- ence in foreign markets, task forces of executives are upgraded, and international careers for execu- tives of all nationalities are being designed.

But the seriousness of the obstacles cannot be underestimated. A world of rising nationalism is hardly a precondition for geocentrism; and over- coming distrust of foreigners even within one’s own firm is not accomplished in a short span of time. The route to pervasive geocentric thinking is long and tortuous.

Costs, Risks, Payoffs

What conclusions will executives from multina- tional firms draw from the balance sheet of advan- tages and disadvantages of maintaining one’s pre- sent state of ethnocentrism, polycentrism or geocentrism? Not too surprisingly, the costs and risks of ethnocentrism are seen to out-balance the payoffs in the long run. The costs of ethnocentrism are ineffective planning because of a lack of good feedback, the departure of the best men in the sub- sidiaries, fewer innovations, and an inability to build a high calibre local organization. The risks are political and social repercussions and a less flexible response to local changes.

The payoffs of ethnocentrism are real enough in the short term, they say. Organization is simpler. There is a higher rate of communication of know- how from headquarters to new markets. There is more control over appointments to senior posts in subsidiaries.

Polycentrism’s costs are waste due to duplica- tion, to decisions to make products for local use but which could be universal, and to inefficient use of home-country experience. The risks include an ex- cessive regard for local traditions and local growth at the expense of global growth. The main advan- tages are an intense exploitation of local markets, better sales since local management is often better informed, more local initiative for new products,

Reading 1-1 The Tortuous Evolution of the Multinational Corporation 93

❚ 3Jacques Maisonrouge, “The Education of International Managers,” Quarterly Journal of AIESEC International, February 1967.

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polycentrism to geocentrism. The polycentric stage is likened to an adolescent protest period during which subsidiary managers gain their confidence as equals by fighting headquarters and proving “their manhood,” after a long period of being under head- quarters’ ethnocentric thumb.

“It is hard to move from a period of headquarters domination to a worldwide management team quickly. A period of letting affiliates make mistakes may be necessary,” said one executive.

Window Dressing

In the rush toward appearing geocentric, many U.S. firms have found it necessary to emphasize progress by appointing one or two non-nationals to senior posts—even on occasion to headquarters. The foreigner is often effectively counteracted by the number of nationals around him, and his influence is really small. Tokenism does have some positive ef- fects, but it does not mean geocentrism has arrived.

Window dressing is also a temptation. Here an attempt is made to demonstrate influence by ap- pointing a number of incompetent “foreigners” to key positions. The results are not impressive for either the individuals or the company.

Too often what is called “the multinational view” is really a screen for ethnocentrism. Foreign affiliate managers must, in order to succeed, take on the traits and behavior of the ruling nationality. In short, in a U.S.-owned firm the foreigner must “Americanize”—not only in attitude but in dress and speech—in order to be accepted.

Tokenism and window dressing are transitional episodes where aspirations toward multinationalism outstrip present attitudes and resources. The fault does not lie only with the enterprise. The human demands of ethnocentrism are great.

A Geocentric Man—?

The geocentric enterprise depends on having an ad- equate supply of men who are geocentrically ori- ented. It would be a mistake to underestimate the human stresses which a geocentric career creates. Moving where the company needs an executive

involves major adjustments for families, wives and children. The sacrifices are often great and, for some families, outweigh the rewards forthcoming—at least in personal terms. Many executives find it dif- ficult to learn new languages and overcome their cultural superiority complexes, national pride and discomfort with foreigners. Furthermore, interna- tional careers can be hazardous when ethnocentrism prevails at headquarters. “It is easy to get lost in the world of the subsidiaries and to be ‘out of sight, out of mind’ when promotions come up at headquar- ters,” as one executive expressed it following a visit to headquarters after five years overseas. To his disappointment, he knew few senior executives. And fewer knew him!

The economic rewards, the challenge of new countries, the personal and professional development that comes from working in a variety of countries and cultures are surely incentives, but companies have not solved by any means the human costs of international mobility to executives and their families.

A firm’s multinationality may be judged by the pervasiveness with which executives think geocentrically—by function, marketing, finance, production, R&D, etc., by product division and by country. The takeoff to geocentrism may begin with executives in one function, say marketing, seeking to find a truly worldwide product line. Only when this worldwide attitude extends throughout the firm, in headquarters and subsidiaries, can execu- tives feel that it is becoming genuinely geocentric.

But no single yardstick, such as the number of foreign nationals in key positions, is sufficient to establish a firm’s multinationality. The multi- national firm’s route to geocentrism is still long because political and economic nationalism is on the rise, and, more importantly, since within the firm ethnocentrism and polycentrism are not easy to overcome. Building trust between persons of differ- ent nationality is a central obstacle. Indeed, if we are to judge men, as Paul Weiss put it, “by the kind of world they are trying to build,” the senior execu- tives engaged in building the geocentric enterprise could well be the most important social architects

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conceivably make war less likely, on the assump- tion that bombing customers, suppliers and em- ployees is in nobody’s interest. The difficulty of the task is thus matched by its worthwhileness. A clearer image of the features of genuine geo- centricity is thus indispensable both as a guideline and as an inviting prospect.

of the last third of the twentieth century. For the in- stitution they are trying to erect promises a greater universal sharing of wealth and a consequent con- trol of the explosive centrifugal tendencies of our evolving world community.

The geocentric enterprise offers an institutio- nal and supranational framework which could

Reading 1-2 Distance Still Matters: The Hard Reality of Global Expansion 95

Reading 1-2 Distance Still Matters: The Hard Reality of Global Expansion

Pankaj Ghemawat

When it was launched in 1991, Star TV looked like a surefire winner. The plan was straightforward: The company would deliver television program- ming to a media-starved Asian audience. It would target the top 5% of Asia’s socioeconomic pyramid, a newly rich elite who could not only afford the services, but who also represented an attractive advertising market. Since English was the second language for most of the target consumers, Star would be able to use readily available and fairly cheap English-language programming rather than having to invest heavily in creating new local programs. And by using satellites to beam programs into peo- ple’s homes, it would sidestep the constraints of ge- ographic distance that had hitherto kept traditional broadcasters out of Asia. Media mogul Rupert Murdoch was so taken with this plan—especially with the appeal of leveraging his Twentieth Century Fox film library across the Asian market—that his company, News Corporation, bought out Star’s founders for $825 million between 1993 and 1995.

The results have not been quite what Murdoch expected. In its fiscal year ending June 30, 1999, Star reportedly lost $141 million, pretax, on rev- enues of $111 million. Losses in fiscal years 1996 through 1999 came to about $500 million all told, not including losses on joint ventures such as Phoenix TV in China. Star is not expected to turn in a positive operating profit until 2002.

Star has been a high-profile disaster, but similar stories are played out all the time as companies pur- sue global expansion. Why? Because, like Star, they routinely overestimate the attractiveness of foreign markets. They become so dazzled by the sheer size of untapped markets that they lose sight of the vast difficulties of pioneering new, often very different territories. The problem is rooted in the very analytic tools that managers rely on in making judgments about international investments, tools that consistently underestimate the costs of doing business internationally. The most prominent of these is country portfolio analysis (CPA), the hoary but still widely used technique for deciding where a company should compete. By focusing on national GDP, levels of consumer wealth, and people’s propensity to consume, CPA places all the empha- sis on potential sales. It ignores the costs and risks of doing business in a new market.

Most of those costs and risks result from barriers created by distance. By distance, I don’t mean only geographic separation, though that is important.

❚ Pankaj Ghemawat is the Jaime and Josefina Chua Tiampo Professor of Business Administration at Harvard Business School in Boston. His article “The Dubious Logic of Global Megamergers,” coauthored by Fariborz Ghadar, was published in the JulyAugust 2000 issue of HBR.

❚ Reprinted by permission of Harvard Business Review. From Distance Still Matters: The Hard Reality of Global Expansion by P. Ghemawat, September 2001. Copyright © 2001 by the Harvard Business School Publishing Corporation; all rights reserved.

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Distancealsohascultural,administrativeorpolitical, and economic dimensions that can make foreign markets considerably more or less attractive. Just how much difference does distance make? A recent study by economists Jeffrey Frankel and Andrew Rose estimates the impact of various factors on a country’s trade flows. Traditional economic factors, such as the country’s wealth and size (GDP), still matter; a 1% increase in either of those measures creates, on average, a .7% to .8% increase in trade. But other factors related to distance, it turns out, matter even more. The amount of trade that takes place between countries 5,000 miles apart is only 20% of the amount that would be predicted to take place if the same countries were 1,000 miles apart. Cultural and administrative distance produces even larger effects. A company is likely to trade ten times as much with a country that is a former colony, for instance, than with a country to which it has no such ties. A common currency increases trade by 340%. Common membership in a regional trading bloc in- creases trade by 330%. And so on. (For a summary of Frankel and Rose’s findings, see the exhibit “Measuring the Impact of Distance.”)

Much has been made of the death of distance in recent years. It’s been argued that information tech- nologies and, in particular, global communications are shrinking the world, turning it into a small and relatively homogeneous place. But when it comes to business, that’s not only an incorrect assumption, it’s a dangerous one. Distance still matters, and compa- nies must explicitly and thoroughly account for it when they make decisions about global expansion. Traditional country portfolio analysis needs to be tempered by a clear-eyed evaluation of the many dimensions of distance and their probable impact on opportunities in foreign markets.

The Four Dimensions of Distance

Distance between two countries can manifest itself along four basic dimensions: cultural, administra- tive, geographic, and economic. The types of dis- tance influence different businesses in different ways. Geographic distance, for instance, affects the costs of transportation and communications, so it is

of particular importance to companies that deal with heavy or bulky products, or whose operations require a high degree of coordination among highly dispersed people or activities. Cultural distance, by contrast, affects consumers’ product preferences. It is a crucial consideration for any consumer goods or media company, but it is much less important for a cement or steel business.

Each of these dimensions of distance encom- passes many different factors, some of which are readily apparent; others are quite subtle. (See the exhibit “The CAGE Distance Framework” for an overview of the factors and the ways in which they affect particular industries.) In this article, I will re- view the four principal dimensions of distance, starting with the two overlooked the most—cultural distance and administrative distance.

Cultural Distance A country’s cultural attributes determine how people interact with one another and with companies and institutions. Differences in re- ligious beliefs, race, social norms, and language are all capable of creating distance between two coun- tries. Indeed, they can have a huge impact on trade: All other things being equal, trade between countries that share a language, for example, will be three times greater than between countries without a common language.

Some cultural attributes, like language, are easily perceived and understood. Others are much more subtle. Social norms, the deeply rooted system of unspoken principles that guide individuals in their everyday choices and interactions, are often nearly invisible, even to the people who abide by them. Take, for instance, the long-standing tolerance of the Chinese for copyright infringement. As William Alford points out in his book To Steal a Book Is an Elegant Offense (Stanford University Press, 1995), many people ascribe this social norm to China’s re- cent communist past. More likely, Alford argues, it flows from a precept of Confucius that encourages replication of the results of past intellectual endeav- ors: “I transmit rather than create; I believe in and love the Ancients.” Indeed, copyright infringement was a problem for Western publishers well before

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appliances to be small, reflecting a social norm common in countries where space is highly valued.

Sometimes products can touch a deeper nerve, triggering associations related to the consumer’s identity as a member of a particular community. In these cases, cultural distance affects entire cate- gories of products. The food industry is particularly sensitive to religious attributes. Hindus, for exam- ple, do not eat beef because it is expressly forbidden by their religion. Products that elicit a strong response of this kind are usually quite easy to identify, though some countries will provide a few surprises. In Japan, rice, which Americans treat as a commodity, carries an enormous amount of cultural baggage.

Ignoring cultural distance was one of Star TV’s biggest mistakes. By supposing that Asian viewers would be happy with English-language program- ming, the company assumed that the TV business

communism. Back in the 1920s, for example, Merriam Webster, about to introduce a bilingual dic- tionary in China, found that the Commercial Press in Shanghai had already begun to distribute its own version of the new dictionary. The U.S. publisher took the press to a Chinese court, which imposed a small fine for using the Merriam Webster seal but did nothing to halt publication. As the film and music industries well know, little has changed. Yet this social norm still confounds many Westerners.

Most often, cultural attributes create distance by influencing the choices that consumers make be- tween substitute products because of their prefer- ences for specific features. Color tastes, for example, are closely linked to cultural prejudices. The word “red” in Russian also means beautiful. Consumer durable industries are particularly sensitive to dif- ferences in consumer taste at this level. The Japan- ese, for example, prefer automobiles and household

Reading 1-2 Distance Still Matters: The Hard Reality of Global Expansion 97

Measuring the Impact of Distance

Economists often rely on the so-called gravity the- ory of trade flows, which says there is a positive re- lationship between economic size and trade and a negative relationship between distance and trade.

Models based on this theory explain up to two- thirds of the observed variations in trade flows be- tween pairs of countries. Using such a model, economists Jeffrey Frankel and Andrew Rose1

have predicted how much certain distance vari- ables will affect trade.

Distance Attribute Change in International Trade (%)

Income level: GDP per capita (1% increase) �0.7 Economic size: GDP (1% increase) �0.8 Physical distance (1% increase) �1.1 Physical size (1% increase)* �0.2 Access to ocean* �50 Common border �80 Common language �200 Common regional trading bloc �330 Colony–colonizer relationship �900 Common colonizer �190 Common polity �300 Common currency �340

1Jeffrey Frankel and Andrew Rose, “An Estimate of the Effects of Currency Unions on Growth,” unpublished working paper, May 2000. *Estimated effects exclude the last four variables in the table.

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was insensitive to culture. Managers either dis- missed or were unaware of evidence from Europe that mass audiences in countries large enough to support the development of local content generally prefer local TV programming. If they had taken cultural distance into account, China and India could have been predicted to require significant in- vestments in localization. TV is hardly cement.

Administrative or Political Distance Historical and political associations shared by countries greatly affect trade between them. Colony-colonizer links between countries, for example, boost trade by 900%, which is perhaps not too surprising given Britain’s continuing ties with its former colonies in the commonwealth, France’s with the franc zone of West Africa, and Spain’s with Latin America. Prefer- ential trading arrangements, common currency, and political union can also increase trade by more than 300% each. The integration of the European Union is probably the leading example of deliberate efforts to diminish administrative and political distance among trading partners. (Needless to say, ties must be friendly to have a positive influence on trade. Al- though India and Pakistan share a colonial history— not to mention a border and linguistic ties—their mutual hostility means that trade between them is virtually nil.)

Countries can also create administrative and po- litical distance through unilateral measures. Indeed, policies of individual governments pose the most common barriers to cross-border competition. In some cases, the difficulties arise in a company’s home country. For companies from the United States, for instance, domestic prohibitions on bribery and the prescription of health, safety, and environmental policies have a dampening effect on their interna- tional businesses.

More commonly, though, it is the target country’s government that raises barriers to foreign competi- tion: tariffs, trade quotas, restrictions on foreign direct investment, and preferences for domestic competitors in the form of subsidies and favoritism in regulation and procurement. Such measures are expressly intended to protect domestic industries,

and they are most likely to be implemented if a do- mestic industry meets one or more of the following criteria:

• It is a large employer. Industries that represent large voting blocs often receive state support in the form of subsidies and import protection. Europe’s farmers are a case in point.

• It is seen as a national champion. Reflecting a kind of patriotism, some industries or compa- nies serve as symbols of a country’s modernity and competitiveness. Thus the showdown be- tween Boeing and Airbus in capturing the large passenger-jet market has caused feelings on both sides of the Atlantic to run high and could even spark a broader trade war. Also, the more that a government has invested in the industry, the more protective it is likely to be, and the harder it will be for an outsider to gain a beachhead.

• It is vital to national security. Governments will intervene to protect industries that are deemed vital to national security—especially in high tech sectors such as telecommunications and aero- space. The FBI, for instance, delayed Deutsche Telekom’s acquisition of Voicestream for reasons of national security.

• It produces staples. Governments will also take measures to prevent foreign companies from dominating markets for goods essential to their citizens’ everyday lives. Food staples, fuel, and electricity are obvious examples.

• It produces an “entitlement” good or service. Some industries, notably the health care sector, produce goods or services that people believe they are entitled to as a basic human right. In these industries, governments are prone to inter- vene to set quality standards and control pricing.

• It exploits natural resources. A country’s physical assets are often seen as part of a national heritage. Foreign companies can easily be considered robbers. Nationalization, therefore, is a constant threat to international oil and mining multi- nationals.

• It involves high sunk-cost commitments. Indus- tries that require large, geography-specific sunk

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Reading 1-2 Distance Still Matters: The Hard Reality of Global Expansion 99

Administrative Geographic Economic Cultural Distance Distance Distance Distance

Different languages Different ethnicities;

lack of connective ethnic or social networks

Different religions Different social norms

Products have high linguistic content (TV)

Products affect cultural or national identity of consumers (foods)

Product features vary in terms of:

• size (cars) • standards (electrical

appliances) • packaging

Products carry country-specific quality associations (wines)

Absence of colonial ties Absence of shared

monetary or politi- cal association

Political hostility Government policies Institutional weakness

Government involvement is high in industries that are:

• producers of staple goods (electricity)

• producers of other “entitlements” (drugs)

• large employers (farming)

• large suppliers to government (mass transportation)

• national champions (aerospace)

• vital to national security (telecommunications)

• exploiters of natural resources (oil, mining)

• subject to high sunk costs (infrastructure)

Physical remoteness Lack of a common

border Lack of sea or river

access Size of country Weak transportation

or communication links

Differences in climates

Products have a low value-to-weight or bulk ratio (cement)

Products are fragile or perishable (glass, fruit)

Communications and connectivity are important (financial services)

Local supervision and operational requirements are high (many services)

Differences in consumer incomes

Differences in costs and quality of:

• natural resources • financial resources • human resources • infrastructure • intermediate inputs • information or

knowledge

Nature of demand varies with income level (cars)

Economies of standardization or scale are important (mobile phones)

Labor and other factor cost differ- ences are salient (garments)

Distribution or business systems are different (insurance)

Companies need to be responsive and agile (home appliances)

Attributes Creating Distance

Industries or Products Affected by Distance

The CAGE Distance Framework

The cultural, administrative, geographic, and eco- nomic (CAGE) distance framework helps man- agers identify and assess the impact of distance on

various industries. The upper portion of the table lists the key attributes underlying the four dimen- sions of distance. The lower portion shows how they affect different products and industries.

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100 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

How Far Away Is China, Really?

As Star TV discovered, China is a particularly tough nut to crack. In a recent survey of nearly 100 multi- nationals, 54% admitted that their total business performance in China had been “worse than planned,” compared with just 25% reporting “better than planned.” Why was the failure rate so high? The survey provides the predictable answer: 62% of respondents reported that they had overestimated market potential for their products or services.

A quick analysis of the country along the dimen- sions of distance might have spared those compa- nies much disappointment. Culturally, China is a long way away from nearly everywhere. First, the many dialects of the Chinese language are notori- ously difficult for foreigners to learn, and the local population’s foreign-language skills are limited. Second, the well-developed Chinese business culture based on personal connections, often sum- marized in the term guanxi, creates barriers to eco- nomic interchange with Westerners who focus on transactions rather than relationships. It can even be argued that Chinese consumers are “home-biased”;

market research indicates much less preference for foreign brands over domestic ones than seems to be true in India, for example. In fact, greater China plays a disproportionate role in China’s economic relations with the rest of the world.

Administrative barriers are probably even more important. A survey of members of the American Chamber of Commerce in China flagged market- access restrictions, high taxes, and customs duties as the biggest barriers to profitability in China. The level of state involvement in the economy contin- ues to be high, with severe economic strains im- posed by loss-making state-owned enterprises and technically insolvent state-owned banks. Corrup- tion, too, is a fairly significant problem. In 2000, Transparency International ranked the country 63rd out of 90, with a rating of one indicating the least perceived corruption. Considerations such as these led Standard & Poor’s to assign China a political-risk ranking of five in 2000, with six being the worst possible score.

So, yes, China is a big market, but that is far from the whole story. Distance matters, too, and along many dimensions.

investments—in the shape, say, of oil refineries or aluminum smelting plants or railway lines— are highly vulnerable to interference from local governments. Irreversibility expands the scope for holdups once the investment has been made.

Finally, a target country’s weak institutional in- frastructure can serve to dampen cross-border eco- nomic activity. Companies typically shy away from doing business in countries known for corruption or social conflict. Indeed, some research suggests that these conditions depress trade and investment far more than any explicit administrative policy or restriction. But when a country’s institutional infrastructure is strong—for instance, if it has a well-functioning legal system—it is much more attractive to outsiders.

Ignoring administrative and political sensitivi- ties was Star TV’s other big mistake. Foreign own- ership of broadcasting businesses—even in an open society like the United States—is always politically loaded because of television’s power to influence people. Yet shortly after acquiring the company, Rupert Murdoch declared on record that satellite television was “an unambiguous threat to totalitar- ian regimes everywhere” because it permitted peo- ple to bypass government-controlled news sources. Not surprisingly, the Chinese government enacted a ban on the reception of foreign satellite TV services soon thereafter. News Corporation has begun to mend fences with the Chinese authorities, but it has yet to score any major breakthroughs in a country that accounts for nearly 60% of Star TV’s potential customers. Murdoch of all people should have

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in mind when assessing the geographic influences on cross-border economic activity.

Economic Distance The wealth or income of consumers is the most important economic at- tribute that creates distance between countries, and it has a marked effect on the levels of trade and the types of partners a country trades with. Rich coun- tries, research suggests, engage in relatively more cross-border economic activity relative to their eco- nomic size than do their poorer cousins. Most of this activity is with other rich countries, as the pos- itive correlation between per capita GDP and trade flows implies. But poor countries also trade more with rich countries than with other poor ones.

Of course, these patterns mask variations in the effects of economic disparities—in the cost and qual- ity of financial, human, and other resources. Com- panies that rely on economies of experience, scale, and standardization should focus more on countries that have similar economic profiles. That’s because they have to replicate their existing business model to exploit their competitive advantage, which is hard to pull off in a country where customer incomes— not to mention the cost and quality of resources— are very different. Wal-Mart in India, for instance, would be a very different business from Wal-Mart in the United States. But Wal-Mart in Canada is virtually a carbon copy.

In other industries, however, competitive advantage comes from economic arbitrage—the exploitation of cost and price differentials between markets. Compa- nies in industries whose major cost components vary widely across countries—like the garment and foot- wear industries, where labor costs are important—are particularly likely to target countries with different economic profiles for investment or trade.

Whether they expand abroad for purposes of replication or arbitrage, all companies find that major disparities in supply chains and distribution chan- nels are a significant barrier to business. A recent study concluded that margins on distribution within the United States—the costs of domestic transporta- tion, wholesaling, and retailing—play a bigger role, on average, in erecting barriers to imports into the

foreseen this outcome, given his experience in the United States, where he was required to become a citizen in order buy the television companies that now form the core of the Fox network.

Geographic Distance In general, the farther you are from a country, the harder it will be to conduct business in that country. But geographic distance is not simply a matter of how far away the country is in miles or kilometers. Other attributes that must be considered include the physical size of the country, average within-country distances to bor- ders, access to waterways and the ocean, and topography. Man-made geographic attributes also must be taken into account—most notably, a country’s transportation and communications infrastructures.

Obviously, geographic attributes influence the costs of transportation. Products with low value-to- weight or bulk ratios, such as steel and cement, incur particularly high costs as geographic distance increases. Likewise, costs for transporting fragile or perishable products become significant across large distances.

Beyond physical products, intangible goods and services are affected by geographic distance as well. One recent study indicates that cross-border equity flows between two countries fall off signifi- cantly as the geographic distance between them rises. This phenomenon clearly cannot be explained by transportation costs—capital, after all, is not a physical good. Instead, the level of information in- frastructure (crudely measured by telephone traffic and the number of branches of multinational banks) accounts for much of the effect of physical distance on cross-border equity flows.

Interestingly, companies that find geography a barrier to trade are often expected to switch to di- rect investment in local plant and equipment as an alternative way to access target markets. But cur- rent research suggests that this approach may be flawed: Geographic distance has a dampening ef- fect, overall, on investment flows as well as on trade flows. In short, it is important to keep both infor- mation networks and transportation infrastructures

Reading 1-2 Distance Still Matters: The Hard Reality of Global Expansion 101

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102 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

ADMINISTRATIVE CULTURAL DISTANCE GEOGRAPHIC ECONOMIC DISTANCE Preferential DISTANCE DISTANCE Linguistic Ties Trading Agreements Physical Remoteness Wealth Differences

Meat and meat preparations

Cereals and cereal preparations

Miscellaneous edible products and preparations

Tobacco and tobacco products

Office machines and automatic data-processing equipment

Photographic apparatuses, optical goods, watches

Road vehicles Cork and wood Metalworking

machinery Electricity current

More Sensitive

Gold, nonmonetary Electricity current Coffee, tea, cocoa,

spices Textile fibers Sugar, sugar

preparations, and honey

Gas, natural and manufactured

Travel goods, handbags

Footwear Sanitary, plumbing,

heating, and lighting fixtures

Furniture and furniture parts

Electricity current Gas, natural and

manufactured Paper, paperboard Live animals Sugar, sugar

preparations, and honey

Pulp and waste paper Photographic

apparatuses, optical goods, watches

Telecommunications and sound- recording apparatuses

Coffee, tea, cocoa, spices

Gold, nonmonetary

Less Sensitive

(Economic distance decreases trade)

Nonferrous metals Manufactured

fertilizers Meat and meat

preparations Iron and steel Pulp and waste paper

(Economic distance increases trade)

Coffee, tea, cocoa, spices

Animal oils and fats Office machines and

automatic data- processing equipment

Power-generating machinery and equipment

Photographic apparatuses, optical goods, watches

Less Sensitive

More Sensitive

Industry Sensitivity to Distance

The various types of distance affect different indus- tries in different ways. To estimate industry sensitiv- ity to distance, Rajiv Mallick, a research associate at Harvard Business School, and I regressed trade be- tween every possible pair of countries in the world in each of 70 industries (according to their SIC designations) on each dimension of distance.

The results confirm the importance of distin- guishing between the various components of dis- tance in assessing foreign market opportunities. Electricity, for instance, is highly sensitive to administrative and geographic factors but not at all to cultural factors. The following table lists some of the industries that are more and less sensitive to distance.

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company that has wrestled with global expansion is Tricon Restaurants International (TRI), the interna- tional operating arm of Tricon, which manages the Pizza Hut, Taco Bell, and KFC fast-food chains, and which was spun off from Pepsico in 1997.

When Tricon became an independent company, TRI’s operations were far-flung, with restaurants in 27 countries. But the profitability of its markets varied greatly: Two-thirds of revenues and an even higher proportion of profits came from just seven markets. Furthermore, TRI’s limited operating cash flow and Tricon’s debt service obligations left TRI with less than one-tenth as much money as archri- val McDonald’s International to invest outside the United States. As a result, in 1998, TRI’s president, Pete Bassi, decided to rationalize its global opera- tions by focusing its equity investments in a limited number of markets.

United States than do international transportation costs and tariffs combined.

More broadly, cross-country complexity and change place a premium on responsiveness and agility, making it hard for cross-border competitors, particularly replicators, to match the performance of locally focused ones because of the added opera- tional complexity. In the home appliance business, for instance, companies like Maytag that concentrate on a limited number of geographies produce far bet- ter returns for investors than companies like Elec- trolux and Whirlpool, whose geographic spread has come at the expense of simplicity and profitability.

A Case Study in Distance

Taking the four dimensions of distance into account can dramatically change a company’s assessment of the relative attractiveness of foreign markets. One

Reading 1-2 Distance Still Matters: The Hard Reality of Global Expansion 103

Exhibit 1a Country Portfolio Analysis (a flawed approach)

Here’s how country portfolio analy- sis (CPA) works. A company’s actual and potential markets are plotted on a simple grid, with a measure of per capita income on one axis and some measure of prod- uct performance, often penetration rates, on the other. The location of the market on the grid reflects the attractiveness of the market in terms of individual consumer wealth and propensity to consume. The size of the bubble represents the total size of the market in terms of GDP or the absolute consumption of the product or service in question. The bubbles provide a rough estimate of how large the relative revenue op- portunities are. This CPA map com- pares a number of non–U.S. markets for fast-food restaurants.

14

P er

C ap

ita F

as t-

F oo

d C

on su

m pt

io n

($ )

Per Capita Income ($)

0

100

0 5,000–5,000 10,000 15,000 20,000 25,000

18

4

8

10

6

15 17

1

13

3 16

5

7

11

19 30,000 35,000 40,000

200

300

400

20 9 12

2

Mexico

1 Japan

Key:

2 Korea 3 Taiwan 4 Puerto Rico 5 Malaysia

6 Australia 7 Thailand 8 New Zealand 9 South Africa 10 Singapore

11 Saudi Arabia 12 Poland 13 Belgium 14 France 15 Germany

16 Spain 17 UK 18 Canada 19 Mexico 20 China

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But which markets? The exhibit “Country Port- folio Analysis: A Flawed Approach” provides a portfolio analysis of international markets for the fast-food restaurant business, based on data used by TRI for its strategy discussions. The analysis sug- gests that the company’s top markets in terms of size of opportunity would be the larger bubbles to the center and right of the chart.

Applying the effects of distance, however, changes the map dramatically. Consider the Mexican market. Using the CPA method, Mexico, with a total fast-food consumption of $700 million, is a relatively small market, ranking 16th of 20. When combined with estimates of individual consumer wealth and per capita consumption, this ranking would imply that TRI should dispose of its investments there. But the exhibit “Country Portfolio Analysis: Adjusted for Distance” tells a different story. When the fast-food consumption numbers for each country are adjusted

for their geographic distance from Dallas, TRI’s home base, Mexico’s consumption decreases less than any other country’s, as you might expect, given Mexico’s proximity to Dallas. Based on just this readjustment, Mexico leaps to sixth place in terms of market opportunity.

Further adjusting the numbers for a common land border and for membership in a trade agree- ment with the United States pushes Mexico’s rank- ing all the way up to second, after Canada. Not all the adjustments are positive: adjusting for a com- mon language—not a characteristic of Mexico— pushes Mexico into a tie for second place with the United Kingdom. Additional adjustments could also be made, but the overall message is plain. Once distance is taken into account, the size of the market opportunity in Mexico looks very different. If TRI had used the CPA approach and neglected distance, the company’s planners might well have

104 Chapter 1 Expanding Abroad: Motivations, Means, and Mentalities

Exhibit 1b Country Portfolio Analysis (adjusted for distance)

Taking distance into account dra- matically changes estimates of mar- ket opportunities. In this chart, each of the fast-food markets has been adjusted for a number of distance attributes, based on the estimates by Frankel and Rose. The relative sizes of the bubbles are now very differ- ent. For example, Mexico, which was less than one-tenth the size of the largest international markets, Japan and Germany, ends up as the second largest opportunity. Clearly, the CPA approach paints an incom- plete picture, unless it is adjusted for distance.

13

14

15

6

18

8

17

10

2 16

19

3

P er

C ap

ita F

as t-

F oo

d C

on su

m pt

io n

($ )

Per Capita Income ($)

0

100

0 5,000–5,000 10,000 15,000 20,000 25,000

1

5 11

30,000 35,000 40,000

200

300

400

Mexico 7

20

4

1 Japan

Key:

2 Korea 3 Taiwan 4 Puerto Rico 5 Malaysia

6 Australia 7 Thailand 8 New Zealand 9 South Africa 10 Singapore

11 Saudi Arabia 12 Poland 13 Belgium 14 France 15 Germany

16 Spain 17 UK 18 Canada 19 Mexico 20 China

9

12

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Consideration of the interaction of company- specific features and distance is beyond the scope of this article. But whether the analysis is at the in- dustry or company level, the message is the same: Managers must always be conscious of distance— in all its dimensions. The CAGE distance frame- work is intended to help managers meet that chal- lenge. While it is necessarily subjective, it represents an important complement to the tools used by most companies seeking to build or ratio- nalize their country market portfolios. Technology may indeed be making the world a smaller place, but it is not eliminating the very real—and often very high—costs of distance.

ended up abandoning a core market. Instead, they concluded, in Bassi’s words, that “Mexico is one of TRI’s top two or three priorities.”

Factoring in the industry effects of distance is only a first step. A full analysis should consider how a company’s own characteristics operate to increase or reduce distance from foreign markets. Companies with a large cadre of cosmopolitan managers, for in- stance, will be less affected by cultural differences than companies whose managers are all from the home country. In TRI’s case, consideration of company-specific features made Mexico even more attractive. The company already owned more than four-fifths of its Mexican outlets and had a 38% share of the local market, well ahead of McDonald’s.

Reading 1-3 When You Shouldn’t Go Global 105

Reading 1-3 When You Shouldn’t Go Global Marcus Alexander and Harry Korine

Even as companies are being told that the future lies in globalization, some are severely punished for their international moves. A simple test can help you decide what makes strategic sense for your organization.

Economic globalization is viewed by some as the best hope for world stability, by others as the great- est threat. But almost everyone accepts that busi- nesses of all types must embrace it. Even smaller enterprises—urged on by the financial markets, by investment bankers and consultants, by the media, and by the moves they see rivals making—feel the strategic imperative to go global in one form or another. Although the current financial crisis is

putting a damper on such activity, the pressure on companies to globalize is likely to persist.

With this sense of inevitability, it’s easy to for- get the serious mistakes some companies have made because of their global strategies. Dutch fi- nancial-services firm ABN Amro, for example, ac- quired banks in numerous countries but wasn’t able to achieve the integration needed to generate value with its international network. AES, a U.S.- based energy firm that operates 124 generation plants in 29 countries on five continents, has in re- cent years struggled to show that it is worth more than the sum of its individual geographic units. Daimler-Benz merged with Chrysler in 1998 in order to create a Welt AG—a world corporation— but never attained the power over markets and suppliers that this global position was supposed to deliver.

And these days, companies can’t always chalk their mistakes up to experience and move on. Indus- try rivals and activist share owners are increasingly forcing firms to undo their international investments—

❚ Marcus Alexander is an adjunct professor of strategic and international management at London Business School, a director of the Ashridge Strategic Management Centre in London, and a coauthor, with Andrew Campbell, of “What’s Wrong with Strategy?” (HBR November–December 1997). ❚ Harry Korine ([email protected]) is a teaching fellow in strategic and international management at London Business School and a senior research fellow at IFGE in Lyon, France. He is a coauthor, with Pierre- Yves Gomez, of The Leap to Globalization (Jossey-Bass, 2002) and Entrepreneurs and Democracy (Cambridge University Press, 2008). Both authors have worked with some of the companies mentioned in this article. ❚ Reprinted by permission of Harvard Business Review. From When You Shouldn't Go Global by Marcus Alexander and Harry Korine .December 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

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grown—with both successes and failures along the way—ever since.

But the accelerated removal of political and reg- ulatory barriers to cross-border trading and invest- ment over the past 15 years, along with the advent of technology that enables companies to conduct business around the world 24 hours a day, has made a global presence a generally accepted requisite in many industries. From the late 1990s onward, with a brief pause during the 2001–2003 bear market, we have witnessed a head-over-heels rush by com- panies to globalize: Foreign direct investments are at record levels, cross-border partnerships and ac- quisitions are burgeoning, worldwide sourcing con- tinues to increase, and the pursuit of customers in emerging economies grows ever more heated.

Although such moves have benefited—or at least not irreparably damaged—many companies, we’re beginning to see fallout. Sometimes firms have failed because their global strategies were deeply misguided, other times because execution was more difficult than anticipated.

We think that many failures could have been prevented—and would be avoided in the future—if companies seriously addressed three seemingly simple questions.

1. Are there potential benefits for our com- pany? Just because a move makes sense for a rival or for companies in other industries doesn’t mean it makes sense for your own company or industry. The race to globalize sometimes leads people to overestimate the size of the prize.

UK-based roof tile maker Redland, for example, expanded aggressively around the world beginning in the 1970s with the aim of leveraging its technical know-how beyond its home market. The problem: It often sought opportunities in countries, such as the United States and Japan, where local building prac- tices provided very little demand for concrete roof tiles. Although the company was fully able to trans- fer the relevant technology, there was no value in doing so in such markets.

2. Do we have the necessary management skills? Even if potential benefits do exist for your company, you may not be in a position to realize

despite, in many cases, early endorsement by ana- lysts and the market—and even to fire the senior management teams that made them. ABN Amro was dismembered last year by the Royal Bank of Scotland, Fortis, and Banco Santander, largely along geographic lines. AES’s share price has tumbled since investors’ initial enthusiasm for its globalization strategy, and some investment advisers are calling for the firm to be split into three or more parts. The architect of the Daimler-Chrysler deal, CEO Jürgen Schrempp, finally yielded to share-owner pressure and resigned, freeing up his successor to sell Chrysler to the private-equity giant Cerberus in 2007.

Indeed, we believe that businesses with ill- considered globalization strategies are poised to become the next targets for breakup or corporate overhaul by activist share owners, just as compa- nies with poorly thought-out business diversifica- tion strategies were targets in the past. Today’s activists include private-equity firms, hedge funds, and traditional pension funds, and they wield influ- ence through a variety of means, from vocal use of the platform offered by a minority stake to all-out takeover and sell-off.

All right, even the best executive teams are going to make mistakes in a business environment as complex as today’s. And no one would deny that the forces driving globalization are powerful and that the business benefits of becoming a global player can be tremendous. What concerns us is that so many companies seem to share unquestioned as- sumptions about the need to go global and are lulled by apparent safety in numbers as they move toward potential disaster. We highlight in this article several industries where this mind-set has been prevalent and a number of companies that have paid a high price for adopting it.

Avoiding Ill-Fated Strategies

Businesses have had international ambitions at least since the founding of the British East India and Hudson’s Bay companies in the seventeenth century. Truly global corporations began appearing early in the last century, and their number has

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them. The theoretical advantages of globalizing— economies of scale, for example—are devilishly difficult to achieve in practice, and companies often lack the management key needed to unlock the cof- fer holding the prize.

By the late 1990s, industrial conglomerate BTR had developed a presence in many countries. However, each business unit was run as a largely autonomous entity, with stringent profit account- ability and little encouragement to work with others. This approach made sense in a fragmented world, but as BTR’s customers globalized, they came to expect coordinated supply and support across bor- ders. Although the opportunity was clear and BTR seemed well positioned to seize it, the company found it impossible to implement an approach so alien to its traditions. Even after a change of CEO and other senior staffers, the company culture blocked attempts at global integration, and the 1999 merger with Siebe was seen by many analysts as an admission that BTR simply could not make the changes needed.

3. Will the costs outweigh the benefits? Even if you are able to realize the benefits of a global move, unanticipated collateral damage to your business may make the endeavor counterproduc- tive. Too often, companies fail to see that the full costs of going global may dwarf even a sizable prize—for example, when an effort to harmonize the practices of national business units drives away customers or distracts national management teams from the needs of their markets.

The increased complexity of managing inter- national operations is also a threat. TCL, a Chinese maker of electronics and home appli- ances, has expanded rapidly into the United States and Europe through a series of acquisitions and joint ventures. As a result of deals in the past few years with Thomson and Alcatel, TCL has found itself with four R&D headquarters, 18 R&D centers, 20 manufacturing bases, and sales organi- zations in 45 countries. The cost of managing this infrastructure has outweighed the benefits of increased scale and resulted in large losses for both joint ventures.

Globalization’s Siren Song

Companies neglect to ask themselves these seem- ingly obvious questions because of their compla- cent assumptions about the virtues of going global—assumptions that are reinforced by seduc- tive messages from, among other places, the stock market. Although the siren song of globalization has lured companies of all kinds into this risky strategic space, recently the call has been particu- larly insidious in certain industry contexts, three of which we describe here. (For a description of how a management imperative such as “Become more global” can rapidly spread, see the sidebar “The Susceptibility to Managerial Fads.”)

Deregulated Industries Many businesses in formerly state-owned industries, such as telecom- munications, postal services, and utilities, have responded to deregulation with aggressive global moves. Faced with limited growth opportunities and often increasing competition in their home markets, companies have accepted that geographic expansion is the best way to exercise their new strategic freedom. These companies, the argument goes, can apply existing competencies—providing voice and data communication, delivering letters and parcels, distributing electricity and water, even dealing with the deregulation process itself— in new markets. They will enjoy significant sav- ings by sharing resources across their international operations while “sticking to their knitting.” The latter point—the importance of focusing on what they know how to do—is a key part of the argument, since unrelated diversification, itself once a widely touted strategy, has been largely discredited.

This apparently sound logic has turned out in many cases to be oversold by investment bankers or to be just plain flimsy. Companies frequently pay far too much to enter foreign markets. Furthermore, many of the deregulated industries are “glocal”— that is, customer expectations, operating environ- ments, and management practices for what seem to be globally standard services can vary greatly

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The Susceptibility to Managerial Fads

The belief that companies must become more global is the latest in a long line of widely held and generally unquestioned assumptions that can undermine the rational behavior of companies or entire industries.

The management trends—you might even call them fads—that grow out of these assumptions can be dangerous because they often lead to sloppy thinking. For example, the label used to describe a trend may get stretched far beyond its original meaning. “Reengineering” has come to mean nearly any corporate reorganization; “related diversification” is used today to justify acquisi- tions within categories, such as “communications media” and “financial services,” that are so broad as to be almost meaningless. More troubling, the stampede by companies to join peers in mind- lessly embracing such trends can cloud managers’ judgment about what is worthwhile and achiev- able in their particular case.

The pathology of management fads has an underlying dynamic that is worth exploring:

Company X, with talented people at the helm, pioneers a new management approach. The firm does well, and others take notice. Maybe one or two experiment with similar innovations. Then stock market analysts and journalists spot the new approach. They view it as part of a broader pattern, and someone comes up with a clever-sounding label. The word “paradigm” may even get tossed around. As the phenomenon gains visibility— often in publications like this one—academics develop “frameworks” to help companies under- stand it. Their codification, intended simply to explain the phenomenon, further validates it. (Consultants also develop frameworks, though usually with the aim of selling the trend as a product.)

Over time, people use the now-familiar label more and more loosely. They group all manner of

activities under the heading. Despite its ambigu- ity, there is a growing sense that activities under the rubric are worthwhile. Investment bankers cite the concept as a reason for companies to make ac- quisitions or other moves, and in the enthusiasm of deal making everyone glosses over the difficul- ties of integration and implementation. Financial markets sometimes reward companies just for announcing that they have adopted the new approach.

Sadly, the original insight, not to mention an appreciation of the context that gave rise to it, soon gets lost as companies scramble to become part of the trend. Before long, they are copying all sorts of elements and manifestations that are at best tangential and often irrelevant to the sought- after benefit. By the time a few books have come out on the topic, managers are embarrassed if they can’t point to examples within their own organizations.

As the herd piles in, smart managers are al- ready scanning the horizon for a new idea that will give them a competitive advantage. But oth- ers continue to give little thought to whether the trend has played out—or was never likely to ben- efit a company in their situation. There is always a lag before misapplications of the concept start to affect companies’ numbers. Even when they do, many corporate managers, with stacks of state- ments and presentations extolling the virtues of the approach, are reluctant to abandon it. The stubborn ones carry on regardless of mounting costs—thereby setting the stage for activist share owners to step in and force a change.

This discouraging scenario doesn’t unfold because the original concept was wrong. (Glob- alizing isn’t necessarily bad; not globalizing isn’t necessarily good.) It plays out because embracing a trend often precludes careful exam- ination of the pros and cons of the specific choices made by a single company in a particu- lar context.

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depending on location. Water distribution, for in- stance, may not in fact be the same industry in the regulatory settings of two different countries. In ad- dition, cross-border economies, if they exist at all, may be hard to achieve. It is difficult, for example, to optimize electricity flows over uncoordinated grids.

Faced with such challenges, a number of compa- nies have struggled with or reversed their global moves. Kelda, a UK water utility, sold its U.S. busi- ness six years after acquiring it because differences in pricing, environmental regulations, and distribu- tion proved so great that the business could be run only on a stand-alone basis.

Partly because of national differences in cus- tomer behavior, Deutsche Telekom has ended up running its U.S. unit, T-Mobile USA, as a com- pletely independent business that could be sold off at any time. Rival telecom operator Vodafone has been forced by dissatisfied share owners to unload its Japanese subsidiary, J-Phone.

Deutsche Post, in assembling an international network of mail, express, and logistics services, overpaid significantly for the U.S. express-delivery services DHL and Airborne. Germany’s former state- owned monopoly has also had great difficulty inte- grating DHL’s entrepreneurial management culture with its own. Some analysts value the sum of Deutsche Post’s separate businesses as 25% greater than the market value of the company—an assessment that is likely to increase pressure to spin off some of those businesses.

Service Industries Companies in traditionally national and fragmented service industries, such as retailing, consumer banking, and insurance, have viewed globalization as a way to realize scale economies and to generate growth beyond home markets themselves facing an incursion of foreign competition. In some cases, globalization seems to make sense because customers and suppliers are also becoming more global.

As in deregulated industries, however, the “global” customer may be more national than an- ticipated. And obtaining scale economies across

borders requires management skills and experi- ence that many companies lack. For example, serving a customer that is truly global in a consis- tent way from multiple national offices is no easy task.

Service businesses seeking to capture the bene- fits of a globalization strategy must, like firms in deregulated industries, pay attention to a mix of global and local factors. Purchasing can benefit from careful coordination across borders, but marketing and sales may suffer from too much standardization. Certain services travel much better than others that seem remarkably similar. In shoe retailing, for instance, offerings targeted at the wealthy or the young are far more global than those aimed at the middle market, which remains doggedly local.

In service businesses, many of the implementa- tion challenges of a global strategy involve the coordination of people or processes. Wal-Mart, for instance, has struggled to get its partner firms and employees abroad to adopt its work routines. ABN Amro’s global empire was dismantled by predators because the international business was a collection of mostly unrelated operations in countries ranging from Brazil to Monaco. The company achieved few economies of scale: In marketing, for example, it didn’t enjoy the efficiencies resulting from a single global brand, because local banks mostly kept their original names. Furthermore, its attempts at sharing information systems, management processes, and other bits of infrastructure were repeatedly delayed and then implemented haphazardly, creating few savings.

The outcomes of some other service companies’ global strategies have not been so dire—but they have still fallen short of expectations. Starbucks has pursued international growth at a breakneck pace, even though margins abroad have been only about half those of the company’s U.S. operations. Axa, the global French insurance group, has enjoyed sat- isfactory financial performance from its many units around the world but has so far been unable to reduce its global cost base or convincingly roll out innova- tions, such as its U.S. variable-annuity program,

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internationally. Thus, although the globalization strategy hasn’t destroyed value, it also hasn’t added as much as originally envisioned.

Manufacturing Industries Over the past decade, companies in manufacturing industries, such as automobiles and communications equipment, have viewed rapid cross-border consolidation as necessary for survival. Global mergers and part- nerships seem to be the only way for companies to obtain the size needed to compete against consoli- dating rivals, to reduce their reliance on home markets, and to gain manufacturing economies of scale.

These benefits, though arguably easier to achieve than those sought by service companies (because local differences seem less problematic), are often outweighed by operational and organizational chal- lenges. The complexities of integrating organizations and operations can cause costly delays or failures. And companies haven’t had the luxury of much time to realize the benefits of integration. Counting on the benefits of size and scale to drop quickly to the bottom line, many manufacturers have become par- ticularly vulnerable to economic slowdowns, which constrain their ability to pay for expansion and consolidation before an increasing debt-to-equity ratio forces their executive teams to cede control to financiers or new management.

The merger of Daimler-Benz and Chrysler is a poster child for this problem: The German and U.S. automakers were different in almost every respect, from company cultures to purchasing practices, and they were never able to attain such benefits as the promised billions of dollars in savings from com- mon supply management.

Taiwanese consumer electronics company BenQ’s acquisition of Siemens’s mobile-device business followed a similar story line, including in- compatibility of cultures and processes, as well as difficulties in integrating R&D activities. In a haunting echo of the scramble by Daimler-Benz and Chrysler to merge, BenQ didn’t visit Siemens workshops and production lines before inking the

deal, relying only on due diligence documents. Al- though BenQ continues to be active in mobile equipment, its German unit was declared bankrupt in 2007.

In both of these cases—and in numerous others— the strategic logic for globalization was tenuous, and the skills needed to implement a globalization strat- egy effectively were in short supply.

A Continuing Danger We aren’t saying that all globalization strategies are flawed. Telefónica, Spain’s former telephone monopoly, has success- fully expanded throughout much of the Spanish- speaking world. The past five years have seen General Electric’s Commercial Finance business move rapidly and effectively into dozens of non- U.S. markets. Renault’s pathbreaking alliance with Nissan has to this point proved beneficial for the French and Japanese automakers.

But focusing on such success stories only rein- forces the conventional wisdom that a globalization strategy is a blanket requirement for doing business—which in turn leads many companies to insufficiently scrutinize their proposed global initiatives. (For a discussion of one of the gravest cases of failed globalization, see the sidebar “Royal Ahold’s Downfall.”)

We expect this trend to continue, as firms in var- ious industries recklessly pursue global strategies. Take the emerging renewable-energy industry— companies developing technologies for biofuel, solar energy, and wind energy. We have talked with executives who, racing to establish a global posi- tion in this booming field, are planning rapid expansion over the next few years in Africa, Asia, and Latin America—and completely underestimat- ing the management challenges involved. Many will, after initial applause from the financial markets, find their hastily conceived strategies challenged after the fact by activists.

We also anticipate that problems will recur in in- dustries that earlier rushed to adopt globalization strategies, with activist share owners ready to pounce on companies as evidence of poor management

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rivals and by the investment committees of pension funds and private equity firms.

Ironically, some predators, having spotted the weaknesses of other companies’ global strategies, may be poised to fall into the same trap. For example, the Royal Bank of Scotland is known for its highly successful 2000 acquisition of

choices surfaces. Activist share owners have already taken significant positions in some companies mentioned in this article. Other target companies, perhaps not quite ripe for direct intervention—and temporarily shielded from attack by the current credit crisis and turbulent equity markets—are nonetheless being discussed in the boardrooms of

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Royal Ahold’s Downfall

Dutch supermarket operator Royal Ahold is best known in recent years for an accounting scandal that led to the resignation of its CEO and its CFO in 2003. The financial irregularities must be seen in light of the company’s ambitious, and ulti- mately unsuccessful, globalization strategy.

Royal Ahold began its international expan- sion in the 1970s and accelerated it in the 1990s, eventually acquiring businesses throughout Eu- rope, Asia, Latin America, and the United States, to become the fourth-largest retailer in the world. But the benefits of owning this network of stores were hard to realize or didn’t exist in the first place.

Global economies of scale are one of the main rationales for international expansion. However, such economies, difficult to attain in many busi- nesses, are particularly elusive in food retailing. Purchasing economies can be achieved only with items furnished by global suppliers to all markets— and these typically represent at most 20% of all supermarket items, because of cultural differ- ences and the frequent need to source fresh food locally. Even apparently “international” products, such as hummus, must be adapted to different countries’ distinct tastes.

Additionally, realizing synergies across a far- flung network requires common information systems and management processes, and Ahold made little effort to integrate its acquired busi- nesses into the existing organization. Different

information systems thus continued to coexist across the company, sometimes even within the same country.

Ironically, the lack of integrated systems and processes needed to secure global benefits helped conceal the company’s financial irregu- larities. And the failure to attain those benefits undoubtedly put pressure on top managers to produce favorable—if false—financial results. When the new executive team finally introduced common management processes in the wake of the scandal, those processes did little to improve such activities as common purchasing across markets. As recently as last year, key suppliers were charging Ahold different prices in different countries.

Ahold’s 2007 sale of most of its U.S. opera- tions to private equity firms highlighted the nearly complete abandonment, under pressure from dis- satisfied minority share owners, of its once ambi- tious globalization strategy. The dissidents were concerned not about the usual over-diversification of business types—after all, Royal Ahold re- mained focused on retailing—but about the over- diversification of geographic locations. (Tests for suitable business diversification are discussed in “Corporate Strategy: The Quest for Parenting Ad- vantage,” by Andrew Campbell, Michael Goold, and Marcus Alexander, in the March–April 1995 issue of HBR.) With the focus on governance at Ahold, the underlying story of failed globalization did not receive adequate attention until activist share owners jumped on it.

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NatWest, a much larger UK rival, and for the sub- sequent overhaul of its target’s culture. But RBS may find it difficult to achieve similar results with the disparate banking assets—spread across more than 50 countries—that it acquired from ABN Amro. And though the recent government bailouts of RBS and Fortis aren’t a direct result of the firms’ international strategies, the acquisition of ABN Amro assets stretched their balance sheets and made the companies more vulnerable to the finan- cial crisis.

We also worry that activist share owners and private equity firms may reproduce flawed globaliza- tion strategies in their own portfolios. The largest of these players are now more diversified, both in type of business and in international footprint, than many of the giant conglomerates of 30 years ago that were subsequently broken up and sold off. Indeed, as you look out on a landscape littered with the remains of dismembered companies weakened by failed global- ization strategies, you have to wonder: Could today’s predators be tomorrow’s prey?

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C H A P T E R 2

Understanding the International Context: Responding to Conflicting Environmental Forces

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In this chapter, we shift our focus from the internal forces that drive companies to expand to the larger, external, international environment in which they must operate. In particular, we focus on three sets of macro forces that drive, constrain, and shape the industries in which entities compete globally. First, we examine the pressures—mostly economic—that drive companies in many industries to integrate and coordinate their activities across national boundaries to capture scale economies or other sources of competitive advantage. Second, we explore the forces—often social and political—that shape other industries and examine how they can drive MNEs to disaggregate their operations and activities to respond to national, regional, and local needs and demands. Third, we examine how, in an information-based, knowledge-intensive economy, players in a growing number of industries must adapt to opportunities or threats wherever they occur in the world by developing innovative responses and initiatives that they diffuse rapidly and globally to capture a knowledge-based competitive advantage.

Recent changes in the international business environment have revolutionized the task facing MNE managers. Important shifts in political, social, economic, and technologi- cal forces have combined to create management challenges for today’s MNEs that differ fundamentally from those facing companies just a couple of decades ago. Yet despite intense study by academics, consultants, and practicing managers, both the nature of the various external forces and their strategic and organizational implications are still widely disputed.

When Professor Theodore Levitt’s classic Harvard Business Review article, “The Globalization of Markets,” was first published, his ideas provoked widespread debate. In Levitt’s view, technological, social, and economic trends were combining to create a uni- fied world marketplace that was driving companies to develop globally standardized products that would enable them to capture global economies. His critics, however, claimed that Levitt presented only one side of the story. They suggested that, like many managers, he had become so focused on the forces for globalization that he was blind to their limitations and equally powerful countervailing forces.

The ensuing debate helped better define the diverse, changeable, and often contra- dictory forces that reshaped so many industries. In this chapter, we summarize a few of the most powerful of these environmental forces and suggest how they have collectively led to a new and complex set of challenges that require managers of MNEs to respond

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to three simultaneous yet often conflicting sets of external demands: cross-market integration, national responsiveness, and worldwide learning.

Forces for Global Integration and Coordination The phenomenon of globalization in certain industries, as described by Levitt, was not a sudden or discontinuous development. It was simply the latest round of change brought about by economic, technological, and competitive factors that, 100 years earlier, had transformed the structures of many industries from regional to national in scope. Economies of scale, economies of scope, and national differences in the availability and cost of productive resources were the three principal economic forces that drove this process of structural transformation of businesses, of which globalization was the latest stage.1 The impact of these forces on MNE strategy had been facilitated by the increas- ingly liberal trading environment of the 1980s, 1990s, and 2000s. We now examine these forces of change in more detail.

Forces of Change: Scale, Scope, Factor Costs, and Free Trade

The Industrial Revolution created pressures for much larger plants that could capture the benefits of the economies of scale offered by the new technologies it spawned. Cheap and abundant energy combined with good transportation networks and new production tech- nologies and began to restructure capital-intensive industries. For the first time, compa- nies combined intermediate processes into single plants and developed large-batch or continuous-process technologies to achieve low-cost volume production.

However, in many industries, such as fine chemicals, automobiles, airframes, electron- ics, and oil refining, production at scale-economy volumes often exceeded the sales lev- els that individual companies could achieve in all but the largest nations, which pushed them to seek markets abroad. Even in industries in which the largest companies could retain a large enough share of their domestic markets to achieve scale economies without exports, those on the next rung were forced to seek markets outside their home countries if they were to remain competitive. In less capital-intensive industries, even companies that were largely unaffected by scale economies were transformed by the opportunities for economies of scope that were opened by more efficient, worldwide communication and transportation networks.

One classic example of how such economies could be exploited internationally was provided by trading companies that handle consumer goods. By exporting the prod- ucts of many companies, they achieved a greater volume and lower per unit cost than any narrow-line manufacturer could in marketing and distributing its own products abroad.

In many industries, there were opportunities for economies of both scale and scope. Consumer electronics companies such as Matsushita, for example, derived scale advan- tages from their standardized TV, VCR, and DVD plants and scope advantages through

❚ 1For a more detailed analysis of these environmental forces, see Alfred D. Chandler Jr., “The Evolution of the Modern Global Corporation,” in Competition in Global Industries, ed. Michael Porter (Boston: Harvard Business School Press, 1986), pp. 405–48. For those interested in an even more detailed exposition, Chandler’s book, Scale and Scope (Cambridge, MA: Harvard University Press, 1990) will prove compelling reading.

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their marketing and sales networks that offered service, repair, and credit for a broad range of consumer electronics.

With changes in technology and markets came the requirement for access to new re- sources at the best possible prices, making differences in factor costs a powerful driver of globalization. Often no home-country sources could supply companies wishing to ex- pand into new industry segments. European petroleum companies, for example, explored the Middle East because they had limited domestic crude oil sources. Others went over- seas in search of bauxite from which to produce aluminum, rubber to produce tires for a growing automobile industry, or tea to be consumed by an expanding middle class.

Less capital-intensive industries such as textiles, apparel, and shoes turned to inter- national markets as a source of cheap labor. The increased costs of transportation and lo- gistics management were more than offset by much lower production costs. However, many companies found that, once educated, the cheap labor rapidly became expensive. Indeed, the typical life cycle of a country as a source of cheap labor for an industry is now only about 5 years. Therefore, companies chased cheap labor from southern Europe to Central America to the Far East and later to Eastern Europe.

Whereas the economics of scale and scope and the differences in factor costs be- tween countries provided the underlying motivation for global coordination, the liber- alization of world trade agreements facilitated much of the broad transition that has occurred in the past half-century. Beginning with the formation of the General Agree- ment on Tariffs and Trade (GATT) in 1945 and moving through various rounds of trade talks, the creation of regional free trade agreements such as the European Union (EU) and North American Free Trade Agreement (NAFTA), and the formation of the World Trade Organization (WTO), the dominant trend has been toward the reduction of barriers to international trade. The result is that the international trading environment of the 21st century is probably less restricted than ever before, which has enabled MNEs to realize most of the potential economic benefits that arise from global coordination.

The Expanding Spiral of Globalization

During the 1970s and 1980s, these forces began to globalize the structure and competi- tive characteristics of a variety of industries. In some, the change was driven by a major technological innovation that forced a fundamental realignment of industry economics. The impact of transistors and integrated circuits on the design and production of radios, televisions, and other consumer electronics represents a classic example of how new technologies drive the minimum efficient scale of production beyond the demand of most single markets. More recently, advances in semiconductor technology led to the boom in the PC industry, and innovations in wireless technology have led to the creation of the mobile phone industry. Advances in both of these technologies, combined with industry convergence, have resulted in the smart phone.

Many other industries lack strong external forces for change but transformed them- selves through internal restructuring efforts, such as rationalizing their product lines, standardizing parts design, and specializing manufacturing operations. This trend led to a further wave of globalization, with companies in industries as diverse as automobiles, office equipment, industrial bearings, construction equipment, and machine tools all

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seeking to gain competitive advantages by capturing scale economies that extended beyond national markets.

Even some companies in classically local rather than global businesses have begun to examine the opportunities for capturing economies beyond their national borders. Rather than responding to the enduring differences in consumer tastes and market structures across European countries, many large, branded packaged goods companies such as Procter & Gamble and Unilever have transformed traditionally national businesses like soap and detergent manufacturing. By standardizing product formulations, rationalizing package sizes, and printing multilingual labels, they have been able to restructure and specialize their nationally dominated plant configurations and achieve substantial scale economies, which gives them significant advantages over purely local competitors.

Even labor-intensive local industries, such as office cleaning and catering, are not immune to the forces of globalization. For example, ISS, the Danish cleaning services company, has built a successful international business by transferring practices and know- how across countries and offering consistent, high-quality service to its international cus- tomers. Sodexo, a French company, has adopted a similar approach in the catering and food services industry and become highly successful on an international basis.

In market terms also, the spread of global forces expanded from businesses in which the global standardization of products was relatively easy (e.g., watches, cameras) to oth- ers in which consumers’preferences and habits only slowly converged (e.g., automobiles, appliances). Again, major external discontinuities often facilitate the change process, as in the case of the 2005 global oil price increases, which triggered a worldwide demand for smaller, more fuel-efficient or alternative-energy cars.

Even in markets in which national tastes or behaviors vary widely, globalizing forces can be activated if one or more competitors in a business choose to initiate and influence changes in consumer preference. Food tastes and eating habits were long thought to be the most culture-bound of all consumer behaviors. Yet, as companies like McDonald’s, Coca-Cola, and Starbucks have shown, in Eastern and Western countries alike, even these culturally linked preferences can be changed.

Global Competitors as Change Agents

As the forces driving companies to coordinate their worldwide operations spread from industries in which such changes were triggered by some external structural discontinu- ity to those in which managers had to create the opportunity themselves, there emerged a new globalization force that spread rapidly across many businesses. It was a competi- tive strategy that some called global chess and that could be played only by companies that managed their worldwide operations as interdependent units that implemented a co- ordinated global strategy. Unlike the traditional multinational strategic approach, which was based on the assumption that each national market was unique and independent of the others, these global competitive games assumed that a company’s competitive posi- tion in all markets was linked by financial and strategic interdependence.

Regardless of consumer tastes or manufacturing scale economies, it was suggested that corporations with worldwide operations had great advantages over national companies, in that they could use funds generated in one market to subsidize their position in another.

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Whereas the classic exponents of this strategy were the Japanese companies that used the profit sanctuary of a protected home market to subsidize their loss-making expansions abroad in the 1980s, many others soon learned to play “global chess.” For example, British Airways rose to become one of the most profitable airlines in the world because its dom- inant position at Heathrow Airport enabled it to make large profits on its long-haul routes (particularly the trans-Atlantic route) and essentially subsidize its lower margin U.K. and European business. In turn, it could fend off new entrants in Europe by push- ing its prices down there while not putting its most profitable routes at risk. And exist- ing competitors such as British Midland suffered because they lacked access to the lucrative Heathrow–U.S. routes.

Although few challenged the existence or growing influence of these diverse global- izing forces that were transforming the nature of competition worldwide, some ques- tioned the unidimensionality of their influence and the universality of their strategic implications. They took issue, for example, with Levitt’s suggestions that “the world’s needs and desires have been irrevocably homogenized,” that “no one is exempt and noth- ing can stop the process,” and that “the commonality of preference leads inescapably to the standardization of products, manufacturing, and the institution of trade and commerce.” Critics argued that, though these might indeed be long-term trends in many industries, there were important short- and medium-term impediments and countertrends that had to be taken into account if companies were to operate successfully in an international economy that jolts along—perhaps eventually toward Levitt’s “global village.”

Forces for Local Differentiation and Responsiveness There are many different stories of multinational companies making major blunders in transferring their successful products or ideas from their home countries to foreign mar- kets. General Motors is reported to have faced difficulties in selling the popular Chevro- let Nova in Mexico, where the product name sounded like “no va,” meaning “does not go” in Spanish.2 Similarly, when managers began investigating why the advertising campaign built around the highly successful “come alive with Pepsi” theme was not having the expected impact in Thailand, they discovered that the Thai copy translation read more like “come out of the grave with Pepsi.” Although these and other such cases have been widely cited, they represent the most extreme and often simple-minded ex- amples of an important strategic task facing managers of all MNEs: how to sense, re- spond to, and even exploit the differences in the environments of the many different countries in which their company operates.

National environments differ on many dimensions. For example, there are clear dif- ferences in the per capita gross national product or the industry-specific technological capabilities of Japan, Australia, Brazil, and Poland. They also differ in terms of political systems, government regulations, social norms, and the cultural values of their people. It is these differences that force managers to be sensitive and responsive to national, social, economic, and political characteristics of the host countries in which they operate.

❚ 2For this and many other such examples of international marketing problems, see David A. Ricks, Blunders in International Business, 4th ed. (Cornwall: Blackwell Publishing, 2006).

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Far from being overshadowed by the forces of globalization, the impact of these localiz- ing forces have been felt with increasing intensity and urgency throughout recent decades. First, in the early 1990s, many Japanese companies that had so successfully ridden the wave of globalization began to feel the strong need to become much more sensitive to host-country economic and political forces. This shift led to a wave of investment abroad, as Japanese companies sought to become closer to their export markets and more responsive to host governments.

Second, as the 1990s progressed, many North American and European companies also realized that they had pushed the logic of globalization too far and that a reconnec- tion with the local environments in which they were doing business was necessary. For example, in March 2000, Coca-Cola’s incoming CEO, Douglas Daft, explained his com- pany’s shift in policy in the Financial Times: “As the 1990s were drawing to a close, the world had changed course, and Coca-Cola had not.” Said Daft, “We were operating as a big, slow, insulated, sometimes even insensitive ‘global’ company; and we were doing it in an era when nimbleness, speed, transparency and local sensitivity had become ab- solutely essential.”

Similarly Nokia realized that its standard mobile phones were not capturing the needs of the rural India customer market. A series of seemingly small product adaptions allowed it to access this rapidly growing base, one estimated at 55 million subscribers by 2004.

Cultural Differences

A large body of academic research provides strong evidence that nationality plays an important and enduring role in shaping the assumptions, beliefs, and values of individ- uals. Perhaps the most celebrated work describing and categorizing these differences in the orientations and values of people in different countries is Geert Hofstede’s study that describes national cultural differences along four key dimensions: power distance, un- certainty avoidance, individualism, and “masculinity.”3 The study demonstrates how distinct cultural differences across countries result in wide variations in social norms and individual behavior (e.g., the Japanese respect for elders, the culturally embedded American response to time pressure) and are reflected in the effectiveness of different organizational forms (e.g., the widespread French difficulty with the dual-reporting relationships of a matrix organization) and management systems (e.g., the Swedes’ egal- itarian culture leads them to prefer flatter organizations and smaller wage differentials).

However, cultural differences are also reflected in nationally differentiated consumption patterns, including the way people dress or the foods they prefer. Take the example of tea as a beverage consumed around the globe. The British drink their tea as a light brew fur- ther diluted with milk, whereas Americans consume it primarily as a summer drink served over ice, and Saudi Arabians drink theirs as a thick, hot, heavily sweetened brew.

❚ 3For a more detailed exposition, see Hofstede’s book Culture’s Consequences, 2nd ed. (Beverly Hills, CA: Sage Publications, 2001). A brief overview of the four different aspects of national culture are presented in the reading “Culture and Organization” at the end of this chapter. For managerial implications of such differences in national culture, see also Nancy J. Adler and A. Gundersen, International Dimensions of Organizational Behavior, 5th ed. (Mason, OH: Thomson South-Western, 2008), and Fons Trompenaars and Charles Hampden-Turner, Riding the Waves of Culture (London: Nicholas Brealey Publishing, 1997).

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To succeed in a world of such diversity, companies often must modify their quest for global efficiency through standardization and find ways to respond to the needs and opportunities created by cultural differences. HSBC has gone so far as to define itself as “The world’s local bank,” for its ability to understand such cultural differences.

Government Demands

Inasmuch as cultural differences among countries have been an important localizing force, the diverse demands and expectations of home and host governments have per- haps been the most severe constraint to the global strategies of many MNEs. Traditionally, the interactions between companies and host governments have had many attributes of classic love–hate relationships.

The “love” of the equation was built on the benefits each could bring to the other. To the host government, the MNE represented an important source of funds, technology, and expertise that could help further national priorities, such as regional development, employment, import substitution, and export promotion. To the MNE, the host government represented the key to local market or resource access, which provided new opportuni- ties for profit, growth, and improvement of its competitive position.

The “hate” side of the relationship—more often emerging as frustration rather than outright antagonism—arose from the differences in the motivations and objectives of the two partners.

To be effective global competitors, MNEs sought three important operating objec- tives: unrestricted access to resources and markets throughout the world; the freedom to integrate manufacturing and other operations across national boundaries; and the unimpeded right to coordinate and control all aspects of the company on a worldwide basis. The host government, in contrast, sought to develop an economy that could sur- vive and prosper in a competitive international environment. At times, this objective led to the designation of another company—perhaps a “national champion”—as its standard bearer in the specific industry, bringing it into direct conflict with the MNE. This conflict is particularly visible in the international airline business, in which flag- carrying companies such as Air France or Malaysia Airlines compete only after receiving substantial government subsidies. But it also has been a thorny issue among their biggest suppliers, with Boeing complaining to the WTO that Airbus is violating free trade agreements through the support it receives from various European governments.

Even when the host government does not have such a national champion and is will- ing to permit and even support an MNE’s operations within its boundaries, it usually does so only at a price. Although both parties might be partners in the search for global competitiveness, the MNE typically tried to achieve that objective within its global sys- tem, whereas the host government strove to capture it within its national boundaries, thereby leading to conflict and mutual resentment.

The potential for conflict between the host government and the MNE arose not only from economic but also from social, political, and cultural issues. MNE operations often cause social disruption in the host country through rural exodus, rising consumerism, rejection of indigenous values, or a breakdown of traditional community structures.

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Similarly, even without the maliciousness of MNEs that, in previous decades, blatantly tried to manipulate host government structures or policies (e.g., ITT’s attempt to overthrow the Allende government in Chile), MNEs can still represent a political threat because of their size, power, and influence, particularly in developing economies.

Because of these differences in objectives and motivations, MNE–host government relationships are often seen as a zero-sum game in which the outcome depends on the balance between the government’s power (arising from its control over local market access and competition among different MNEs for that access) and the MNE’s power (arising from its financial, technological, and managerial resources and the competition among national governments for those resources).

If, in the 1960s, the multinational companies had been able to hold “sovereignty at bay,” as one respected international researcher concluded,4 by the 1980s, the balance had tipped in the other direction. In an effort to stem the flood of imports, many countries began bending or sidestepping trade agreements signed in previous years. By the early 1980s, even the U.S. government, traditionally one of the strongest advocates of free trade, began to negotiate a series of orderly marketing agreements and voluntary restraints on Japanese exports, while threats of sanctions were debated with increasing emotion in legislative chambers around the globe. And countries became more sophisticated in the demands they placed on inward-investing MNEs. Rather than allowing superficial in- vestment in so-called “screwdriver plants” that provided only limited, low-skill employ- ment, governments began to specify the levels of local content, technology transfer, and a variety of other conditions, from reexport commitment to plant location requirements.

In the 1990s, however, the power of national governments was once again on the wane. The success of countries such as Ireland and Singapore in driving their economic development through foreign investment led many other countries—both developed and developing—to launch aggressive inward investment policies of their own.

This increased demand for investment allowed MNEs to play countries off one an- other and, in many cases, to extract a high price from the host country. For example, ac- cording to The Economist, the incentives paid by Alabama to Mercedes for its 1993 auto plant cost the state $167,000 per direct employee.

In the first years of the new millennium, the once-troublesome issue of MNE–country bargaining power evolved into a relatively efficient market system for inward investment, at least in the developed world. However, the developing world was a rather different story, with MNEs continuing to be embroiled in political disputes, such as the 1995 hanging of environmental activist Ken Saro-Wiwa by the Nigerian government because of his opposition to Shell’s exploitation of his people’s land. In addition, MNEs have regularly attracted the brunt of criticism from so-called antiglobalization protestors during WTO meetings. The antiglobalization movement includes a diverse mix of groups with different agendas but that are united in their concern that the increasing liberaliza- tion of trade through the WTO is being pursued for the benefit of MNEs and at the expense of people and companies in less developed parts of the world.

Although this movement does not have a coherent set of policy proposals of its own, it provides a salutary reminder to policymakers and the executives managing MNEs that

❚ 4Raymond Vernon, Sovereignty at Bay (New York: Basic Books, 1971).

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the globalization of business remains a contentious issue. The rewards are not spread evenly, and for many people in many parts of the world, the process of globalization makes things worse before it makes them better. The movement has forced MNEs to re- think their more contentious policies and encouraged them to articulate the benefits they bring to less developed countries. For example, the oil majors Shell and BP now actively promote polices for sustainable development—including research into renewable sources of energy and investments in the local communities in which they operate around the world.

Growing Pressures for Localization

Although there is no doubt that the increasing frequency of world travel and the ease with which communication linkages occur across the globe have done a great deal to reduce the effects of national consumer differences, it would be naïve to believe that worldwide tastes, habits, and preferences have become anywhere near homogenous. One need only look at the breakfast buffet items within any major hotel in Beijing. These hotels need to appeal to large groups of consumers from within China, from North America, from Europe, from Japan, and elsewhere. So separate breakfast stations will variously provide steamed breads and noodles, bacon and eggs, cold cuts and cheese, and miso soup.

Even though many companies have succeeded in appealing to—and accelerating— convergence worldwide, even the trend toward standardized products that are designed to appeal to a lowest common denominator of consumer demand has a flip side. In in- dustry after industry, a large group of consumers has emerged to reject the homogenized product design and performance of standardized global products.

By reasserting traditional preferences for more differentiated products, they have created openings—often very profitable ones—for companies willing to respond to, and even expand, the need for products and services that are more responsive to those needs.

When Office Depot issues a request of its vendors for refrigerators that could be locked for improved security in offices and dormitories, Haier was willing to create such a customized product.5 The fact that such an innovation originated in a firm from China also underscores how localization solutions may appear from previously unlikely locales. Increasingly, it is MNEs from emerging markets that seem best equipped to compete in other emerging markets.

Other consumer and market trends are emerging to counterbalance the forces of global standardization of products. In an increasing number of markets, from telecom- munications to office equipment to consumer electronics, consumers are not so much buying individual products as selecting systems. With advances in wireless and internet technology, for example, the television set is becoming part of a home entertainment and information system, connected to a DVD player, music system, home computer, gaming system, and online databank and information network. This transformation is

❚ 5For further detail, see Peter J. Williamson and Ming Zeng, Dragons at Your Door: How Chinese Cost Innovation is Disrupting Global Competition (Boston: Harvard Business School Press, 2007).

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forcing companies to adapt their standard hardware-oriented products to more flexible and locally differentiated systems that consist of hardware plus software services. In such an environment, the competitive edge lies less with the company that has the most scale-efficient global production capability and more with the one that is sensitive and responsive to local requirements and able to develop the software and services to meet those demands.

In addition to such barriers, other important impediments exist. Although the benefits of scale economies obviously must outweigh the additional costs of supplying markets from a central point, companies often ignore that those costs consist of more than just freight charges. In particular, the administrative costs of coordination and scheduling worldwide demand through global-scale plants usually is quite significant and must be taken into account. For some products, lead times are so short or market service require- ments so high that these scale economies may well be offset by other costs.

More significantly, developments in computer-aided design and manufacturing, robot- ics, and other advanced production technologies have made the concept of flexible man- ufacturing a viable reality. Companies that previously had to produce tens or hundreds of thousands of standardized printed circuit boards (PCBs) in a central, global-scale plant now can achieve the minimum efficient scale in smaller, distributed, national plants closer to their customers. Flexible manufacturing technologies mean there is little differ- ence in unit costs between making 1,000 or 100,000 PCBs. When linked to the consumer’s growing disenchantment with homogenized global products, this technology appears to offer multinational companies an important tool that will enable them to respond to localized consumer preferences and national political constraints without compromis- ing their economic efficiency.

Forces for Worldwide Innovation and Learning The trends we have described have created an extremely difficult competitive environ- ment in many industries, and only those firms that have been able to adapt to the often conflicting forces for global coordination and national differentiation have been able to survive and prosper. But on top of these forces, another set of competitive demands has been growing rapidly around the need for fast, globally coordinated innovation. Indeed, in the emerging competitive game, victory often goes to the company that can most effectively harness its access to worldwide information and expertise to develop and diffuse innovative products and processes on a worldwide basis.

The trends driving this shift in the competitive game in many ways derive from the globalizing and localizing forces we described previously. The increasing cost of R&D, coupled with shortening life cycles of new technologies and the products they spawn, have combined to reinforce the need for companies to seek global volume to amortize their heavy investments as quickly as possible. At the same time, even the most advanced tech- nology has diffused rapidly around the globe, particularly during the past few decades. In part, this trend has been a response to the demands, pressures, and coaxing of host gov- ernments as they bargain for increasing levels of national production and high levels of local content in the leading-edge products being sold in their markets. But the high cost of product and process development has also encouraged companies to transfer new

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technologies voluntarily, with licensing becoming an important source of funding, cross- licensing a means to fill technology gaps for many MNEs, and joint development programs and strategic alliances a strategy for rapidly building global competitive advantage.

When coupled with converging consumer preferences worldwide, this diffusion of technology has had an important effect on both the pace and locus of innovation. No longer can U.S.-based companies assume that their domestic environment provides them with the most sophisticated consumer needs and the most advanced technological capabilities, and thus the most innovative environment in the world. Today, the newest consumer trend or market need might emerge in Australia or Italy, and the latest tech- nologies to respond to these new needs may be located in Japan or Sweden. Innovations are springing up worldwide, and companies are recognizing that they can gain compet- itive advantage by sensing needs in one country, responding with capabilities located in a second, and diffusing the resulting innovation to markets around the globe.

A related trend is the increasing importance of global standards in such industries as computer software, telecommunications, consumer electronics, and even consumer goods. The winners in the battle for a new standard—from software platforms to razor blade cartridges—can build and defend dominant competitive positions that can endure worldwide for decades. First-mover advantages have increased substantially and pro- vided strong incentives for companies to focus attention not only on the internal task of rapidly creating and diffusing innovations within their own worldwide operations, but also on the external task of establishing the new product as an industry standard. This issue is so vital for MNEs today that we will return to examine it in greater detail in Chapter 5.

Responding to the Diverse Forces Simultaneously Trying to distill key environmental demands in large and complex industries is a hazardous venture but, at the risk of oversimplification, we can make the case that until the late 1980s, most worldwide industries presented relatively unidimensional environmental requirements. Though it led to the development of industries with very different characteristics—those we distinguish as global, multinational, and international industries—more recently, this differentiation has been eroding with important consequences for companies’ strategies.

Global, Multinational, and International Industries

In some businesses, the economic forces of globalization were historically strong and dominated other environmental demands. For example, in the consumer electronics industry, the invention of the transistor led to decades of inexorable expansion in the benefits of scale economics: Successive rounds of technological change, such as the introduction of integrated circuits and microprocessors, led to a huge increase in the minimum efficient scale of operations for TV sets. In an environment of falling transportation costs, low tariffs, and increasing homogenization of national markets, these- huge-scale economics dominated the strategic tasks for managers of consumer electron- ics companies in the closing decades of the last century.

Such industries, in which the economic forces of globalization are dominant, we desig- nate as global industries. In these businesses, success typically belongs to companies that

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adopt the classic global strategies of capitalizing on highly centralized, scale-intensive manufacturing and R&D operations and leveraging them through worldwide exports of standardized global products.

In other businesses, the localizing forces of national, cultural, social, and political differences dominate the development of industry characteristics. In laundry detergents, for example, R&D and manufacturing costs were relatively small parts of a company’s total expenses, and all but the smallest markets could justify an investment in a detergent tower and benefit from its scale economies. At the same time, sharp differences in laun- dry practices, perfume preferences, phosphate legislation, distribution channels, and other such attributes of different national markets led to significant benefits from differ- entiating products and strategies on a country-by-country basis.

This differentiation is typical of what we call multinational industries—worldwide businesses in which the dominance of national differences in cultural, social, and polit- ical environments allow multiple national industry structures to flourish. Success in such businesses typically belongs to companies that follow multinational strategies of building strong and resourceful national subsidiaries that are sensitive to local market needs and opportunities and allow them to manage their local businesses by developing or adapting products and strategies to respond to the powerful localizing forces.

Finally, in some other industries, technological forces are central, and the need for companies to develop and diffuse innovations is the dominant source of competitive ad- vantage. For example, the most critical task for manufacturers of telecommunications switching equipment has been the ability to develop and harness new technologies and exploit them worldwide. In these international industries, it is the ability to innovate and appropriate the benefits of those innovations in multiple national markets that differen- tiates the winners from the losers.

In such industries, the key to success lies in a company’s ability to exploit technolog- ical forces by creating new products and to leverage the international life cycles of the product by effectively transferring technologies to overseas units. We describe this as an international strategy—the ability to effectively manage the creation of new products and processes in one’s home market and sequentially diffuse those innovations to foreign affiliates.

Transition to Transnationality

Our portrayal of the traditional demands in some major worldwide industries is clearly oversimplified. Different tasks in the value-added chains of different businesses are sub- ject to different levels of economic, political, cultural, and technological forces. We have described what can be called the center of gravity of these activities—the environmen- tal forces that have the most significant impact on industry’s strategic task demands.

By the closing years of the 20th century however, these external demands were un- dergoing some important changes. In many industries, the earlier dominance of a single set of environmental forces was replaced by much more complex environmental demand, in which each of the different sets of forces was becoming strong simultaneously. For example, new economies of scale and scope and intensifying competition among a few competitors were enhancing the economic forces toward increased global integration

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in many multinational and international industries. In the detergent business, product standardization has become more feasible because the growing penetration and stan- dardization of washing machines has narrowed the differences in washing practices across countries. Particularly in regional markets such as Europe or South America, companies have leveraged this potential for product standardization by developing re- gional brands, uniform multilingual packaging, and common advertising themes, all of which have led to additional economies.

Similarly, localizing forces are growing in strength in global industries such as con- sumer electronics. Although the strengths of the economic forces of scale and scope have continued to increase, host government pressures and renewed customer demand for dif- ferentiated products are forcing companies with global strategies to reverse their earlier strategies, which were based on exporting standard products. To protect their competitive positions, they have begun to emphasize the local design and production of differentiated product ranges in different countries and for different international segments.

Finally, in the emerging competitive battle among a few large firms with comparable capabilities in global-scale efficiency and nationally responsive strategies, the ability to innovate and exploit the resulting developments globally is becoming more and more important for building durable comparative advantage, even in industries in which global economic forces or local political and cultural influences had previously been dominant. In the highly competitive mobile phone business, for example, all surviving major competitors must have captured the minimum scale efficiency to play on the global field, as well as the requisite government relationships and consumer understand- ing to respond to market differences. Today, competition in this industry consists primarily of a company’s ability to develop innovative new products—perhaps in response to a consumer trend in Japan, a government requirement in Germany, or a technological development in the United States—and then diffuse it rapidly around the world.

In the emerging international environment, therefore, there are fewer and fewer examples of pure global, textbook multinational, or classic international industries. Instead, more and more businesses are driven by simultaneous demands for global efficiency, na- tional responsiveness, and worldwide innovation. These are the characteristics of what we call a transnational industry. In such industries, companies find it increasingly difficult to defend a competitive position on the basis of only one dominant capability. They need to develop their ability to respond effectively to all the diverse and conflicting forces at one and the same time to manage efficiency, responsiveness, and innovation without trading off any one for the other.

The emergence of the transnational industry has not only made the needs for efficiency, responsiveness, and innovation simultaneous, it has also made the tasks required to achieve each of these capabilities more demanding and complex. Rather than achieve world-scale economies through centralized and standardized production, companies must instead build global efficiency through a worldwide infrastructure of distributed but specialized assets and capabilities that exploit comparative advantages, scale economies, and scope economies simultaneously. In most industries, a few global competitors now compete head-to-head in almost all major markets.

To succeed in such an environment, companies must understand the logic of global chess: Build and defend profit sanctuaries that are impenetrable to competitors; leverage

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existing strengths to build new advantages through cross-subsidizing weaker products and market positions; make high-risk, preemptive investments that raise the stakes and force out rivals with weaker stomachs and purse strings; and form alliances and coali- tions to isolate and outflank competitors. These and other similar maneuvers must now be combined with world-scale economies to develop and maintain global competitive efficiency.

Similarly, responsiveness through differentiated and tailor-made local-for-local products and strategies in each host environment is neither necessary nor feasible any- more. National customers no longer demand differentiation; they demand sensitivity to their needs, along with the level of cost and quality standards for global products to which they have become accustomed. At the same time, host governments’ desire to build their national competitiveness dominates economic policy in many countries, and MNEs are frequently viewed as key instruments in the implementation of national com- petitive strategies. Changes in regulations, tastes, exchange rates, and related factors have become less predictable and more frequent. In such an environment, more respon- siveness has become inadequate. The flexibility to change product designs, sourcing patterns, and pricing policies continuously to remain responsive to continually changing national environments has become essential for survival.

Finally, exploiting centrally developed products and technologies is no longer enough. MNEs must build the capability to learn from the many environments to which they are exposed and to appropriate the benefits of such learning throughout their global operations. Although some products and processes must still be developed centrally for worldwide use and others must be created locally in each environment to meet purely local demands, MNEs must increasingly use their access to multiple centers of technologies and famil- iarity with diverse customer preferences in different countries to create truly transnational innovations. Similarly, environmental and competitive information acquired in different parts of the world must be collated and interpreted to become a part of the company’s shared knowledge base and provide input to future strategies.

Concluding Comments: The Strategic and Organizational Challenge

The increasing complexity of forces in the global environment and the need to respond simultaneously to their diverse and often conflicting demands have created some major challenges for many multinational companies. The classic global companies, such as many highly successful Japanese and Korean companies whose competitive advantage is rooted in a highly efficient and centralized system, have been forced to respond more effectively to the demands for national responsiveness and worldwide innovation. The traditional multinational companies—many of them European—have the advantage of national responsiveness but face the challenge of exploiting global-scale economic and technological forces more effectively. And U.S. companies, with their more interna- tional approach to leveraging home country innovations abroad, struggle to build more understanding of the cultural and political forces and respond to national differences more effectively while simultaneously enhancing global-scale efficiency through improved scale economies.

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For most MNEs, the challenge of the 2000s is both strategic and organizational. On the one hand, they are forced to develop a more complex array of strategic capabilities that enable them to capture the competitive advantages that accrue to efficiency, respon- siveness, and learning. On the other hand, the traditional organizational approaches of these companies, developed to support their earlier global, multinational, or interna- tional approaches, have become inadequate for the more complex strategic tasks they now must accomplish. In Chapters 3 and 4, we discuss some of the ways in which com- panies can respond to these new strategic and organizational challenges.

Chapter 2 Readings

• In Reading 2-1, “Culture and Organization,” Schneider and Barsoux examine how culture influences organization structure and process. Even with pressure for convergence, they find distinct differences in the way in which organizations from particular cultures have centralized power, and defined jobs, roles, and procedures.

• In Reading 2-2, “Clusters and the New Economics of Competition,” Porter details how clusters—critical masses in one place of unusual success in a particular field— influence competitiveness. By co-locating in near proximity, companies, customers, and suppliers are better able to innovate, thereby creating a competitive advantage within the particular country.

Both of those readings reinforce how MNEs are able to respond to conflicting environmental forces.

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In the Beginning1

Grape growing and wine making have been human preoccupations at least since the times when an- cient Egyptians and Greeks offered wine as tributes to dead pharaohs and tempestuous gods. It was under the Roman Empire that viticulture spread throughout the Mediterranean region, and almost every town had its local vineyards and wine was a peasant’s beverage to accompany everyday meals. By the Christian era, wine became part of liturgical services, and monasteries planted vines and built wineries. By the Middle Ages, the European nobil- ity began planting vineyards as a mark of prestige, competing with one another in the quality of wine served at their tables—the first niche market for premium wine.

Wine Production Tending and harvesting grapes has always been labor intensive, and one worker could typically look after only a three hectare lot. (1 hectare. � 2.47 acres) The introduction of vine- yard horses in the early 19th century led to vines being planted in rows and to more efficient tending and allowed one person to work a plot of 7 hectares.

In 2009, these two views reflected some of the very different sentiments unleashed by the fierce competitive battle raging between traditional wine makers and some new industry players as they fought for a share of the $230 billion global wine market. Many Old World wine producers— France, Italy, and Spain, for example—found themselves constrained by embedded wine- making traditions, restrictive industry regulations, and complex national and European Community legislation. This provided an opportunity for New World wine companies—from Australia, the United States, and Chile, for instance—to chal- lenge the more established Old World producers by introducing innovations at every stage of the value chain.

Case 2-1 Global Wine War 2009: New World versus Old

Christopher A. Bartlett

“We have the people, expertise, technology and commitment to gain global preeminence for Australian wine by 2025. It will come by anticipating the market, influencing consumer demand, and building on our strategy of sustainable growth.”

—Sam Toley, CEO of Australian Wine and Brandy Corporation

“By phasing out the buyback of excess wine and increasing incentives for farmers to uproot their vines, the EC reforms will only bring in the New World’s agro-industry model. We need to protect the age-old European model built on traditional vineyards.”

—Jean-Louis Piton, Copa-Cogeca Farmers Association

❚ Professor Christopher A. Bartlett prepared the original version of this case, “Global Wine Wars: New World Challenges Old (A),” HBS No. 303-056, which is being replaced by this version prepared by the same author. This case was developed from published sources. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

❚ Harvard Business School Case No 9-910-405, Copyright 2009 President and Fellows of Harvard College. All rights reserved. This case was prepared by C. Bartlett. HBS Cases are developed solely for class discussion and do not necessarily illustrate either effective or ineffective handling of administrative situation.

❚ 1Historical discussions are indebted to Harry W. Paul, Science, Vine and Wine in Modern France (Cambridge University Press, 1996), pp. 2–15; to Jancis Robinson, ed., The Oxford Companion to Wine, 2nd Ed. (Oxford University Press, 1999); and to James Wilson, Terroir (Berkeley: University of California Press, 1998), pp. 10–45.

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Yet despite these efficiencies, vineyards became smaller, not larger. Over many centuries, small agri- cultural holdings were continually fragmented as land was parceled out by kings, taken in wars, or broken up through inheritance. During the French Revolution, many large estates were seized, divided, and sold at auction. And after 1815, the Napoleonic inheritance code prescribed how land had to be passed on to all rightful heirs. By the mid-19th century, the average holding in France was 5.5 ha. and was still being subdivided. (In Italy, similar events left the average vineyard at 0.8 ha.)

While the largest estates made their own wine, most small farmers sold their grapes to the local wine maker or vintner. With payment based on weight, there was little incentive to pursue quality by reducing yield. Some small growers formed coop- eratives, hoping to participate in wine making’s downstream profit, but grape growing and wine making remained highly fragmented.

Distribution and Marketing Traditionally, wine was sold in bulk to merchant traders—négociants in France—who often blended and bottled the product before distributing it. But poor roads and complex toll and tax systems made cross-border shipping extremely expensive. In the early 19th century, for example, a shipment of wine from Strasbourg to the Dutch border had to pass through 31 toll stations.2 And since wine did not travel well, much of it spoiled on the long journeys. As a result, only the most sophisticated négociants could handle exports, and only the rich could afford the imported luxury.

Late 18th century innovations such as mass pro- duction of glass bottles, the use of cork stoppers, and the development of pasteurization revolution- ized the industry. With greater wine stability and longevity, distribution to distant markets and bottle aging of good vintages became the norm. Increased vine plantings and expanded production followed, and a global market for wine was born.

Regulation and Classification As the industry developed, it became increasingly important to the cultural and economic life of the producing coun- tries. By the mid-18th century in France, grape growing supported 1.5 million families and an equal number in wine-related businesses. Eventually, it accounted for one-sixth of France’s total trading rev- enue, and was the country’s second-largest export.

The industry’s growing cultural and economic importance attracted political attention, and with it, laws and regulations to control almost every aspect of wine making. For example, Germany’s 1644 wine classification scheme prescribed 65 classes of quality, with rules for everything from ripeness re- quired for harvesting to minimum sugar content. (Even in 1971, a law was passed in Germany re- quiring a government panel to taste each vineyard’s annual vintage and assign it a quality level.3) Simi- lar regulations prescribing wine-making practices also existed in France and Italy.

Rather than resisting such government classifi- cations and controls, producers often supported and even augmented them as a way of differentiating their products and raising entry barriers. For exam- ple, the current French classification system was created by a Bordeaux committee prior to the 1855 Exposition in Paris. To help consumers identify their finest wines, they classified about 500 vine- yards into five levels of quality, from premier cru (first growth) to cinquième cru (fifth growth).

Because it helped consumers sort through the complexity of a highly fragmented market, this marketing tool soon gained wide recognition, lead- ing the government to codify and expand it in the Appellation d’Origin Controllée (AOC) laws of 1935. These laws also defined regional boundaries and set detailed and quite rigid standards for vine- yards and wine makers.4 Eventually, more than 300 AOC designations were authorized, from the well-known (Saint Emilion or Beaujolais) to the obscure (Fitou or St. Péray). (A similar classification

❚ 2Robinson, p. 308.

❚ 3Ibid., p. 312. ❚ 4Dewey Markham, 1855: A History of the Bordeaux Classification (New York: Wiley, 1998), p. 177.

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vineyards in Virginia. And in Australia, vines were brought over along with the first fleet carrying con- victs and settlers in 1788. Nascent wine industries were also developing at this time in Argentina, Chile, and South Africa, usually under the influence of immigrants from the Old World wine countries.

Opening New Markets While climate and soil al- lowed grape growing to flourish in the New World, the consumption of wine in these countries varied widely. It became part of the national cultures in Argentina and Chile, where per capita annual con- sumption reached about 80 liters in Argentina and 50 liters in Chile in the 1960s. While such rates were well behind France and Italy, both of which boasted per capita consumption of 110–120 liters in this era, they were comparable with those of Spain.

Other New World cultures did not embrace the new industry as quickly. In Australia, the hot cli- mate and a dominant British heritage made beer the alcoholic beverage of preference, with wine being consumed mostly by Old World immigrants. The U.S. market was more complex. In keeping with the country’s central role in the rum trade, one segment of the population followed a tradition of drinking hard liquor. But another group reflected the coun- try’s Puritan heritage and espoused temperance or abstinence. (As recently as 1994, a Gallup survey found that 45% of U.S. respondents did not drink at all, and 21% favored a renewal of prohibition.) As a result, in the pre-World War II era, wine was largely made by and sold to European immigrant communities.

In the postwar era, however, demand for wine in- creased rapidly in the United States, Australia, and other New World producers. In the United States, for example, consumption grew from a post-prohibition per capita level of 1 liter per annum to 9 liters by 2006. In Australia the rate of increase was even more rapid, from less than 2 liters in 1960 to 24 liters by 2006. This growth in consumption was coupled with a growing demand for higher quality wines, resulting in a boom in domestic demand that proved a boost for the young New World wine industry.

scheme was later introduced in Italy defining 213 Denominazione di Origne Controllate (or DOC) regions, each with regulations prescribing area, al- lowed grape varieties, yields, required growing prac- tices, acceptable alcohol content, label design, etc.5)

Later, other wine regions of France were given official recognition with the classification of Vins Delimités de Qualite Superieure (VDQS), but these were usually regarded as of lower rank than AOC wines. Below VDQS were Vins de Pays, or country wine—inexpensive but very drinkable wines for French tables, and increasingly, for export. These categories were quite rigid with almost no move- ment across them. This was due to a belief that quality was linked to terroir, the almost mystical combination of soil, aspect, microclimate, rainfall, and cultivation that the French passionately believed gave the wine from each region—and indeed, each vineyard—its unique character.

But terroir could not guarantee consistent quality. As an agricultural product, wine was always subject to the vagaries of weather and disease. In the last quarter of the 19th century, a deadly New World in- sect, phylloxera, devastated the French vine stock. From a production level of 500 million liters in 1876, output dropped to just 2 million liters in 1885. But a solution was found in an unexpected quarter: French vines were grafted onto phylloxera-resistant vine roots native to the United States and imported from the upstart Californian wine industry. It was the first time many in the Old World acknowledged the existence of a New World wine industry. It would not be the last.

Stirrings in the New World

Although insignificant in both size and reputation compared with the well-established industry in tra- ditional wine-producing countries, vineyards and wine makers had been set up in many New World countries since the 18th century. In the United States, for example, Thomas Jefferson, an enthusiastic oenologist, became a leading voice for establishing

❚ 5Robinson, p. 235.

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Case 2-1 Global Wine War 2009: New World versus Old 131

Challenging Production Norms On the back of the postwar economic boom, New World wine producers developed in an industry environment different from their European counterparts. First, suitable land was widely available and less expen- sive, allowing the growth of much more extensive vineyards. As a result, in 2006, the average vine- yard holding in the United States was 213 hectares and in Australia 167 hectares, compared to an Italian average of 1.3 hectares, and 7.4 hectares in France.6

Unconstrained by tradition, New World produc- ers also began to experiment with grape growing and wine making technology. In Australia, con- trolled drip irrigation allowed expansion into marginal land and reduced vintage variability. (In contrast, irrigation was strictly forbidden in France under AOC regulations.) The larger vineyards also allowed the use of specialized equipment such as mechanical harvesters and mechanical pruners which greatly reduced labor costs.

Innovation also extended into viniculture where New World producers pursued techniques such as night harvesting to maximize grape sugars, while innovative trellis systems permitted vines to be planted at twice the traditional density. Other experiments with fertilizers and pruning methods increased yield and improved grape flavor. These innovations, when coupled with typically sunny climates, freed New World farmers from many of the stresses of their counterparts in regions like Bordeaux where the rainy maritime climate made late autumn harvests risky, and held wine producers hostage to wide year-to-year vintage variations.

New World wine companies also broke many wine making traditions. Large estates usually had on-site labs to provide analysis helpful in making growing and harvest decisions. In the 1990s, some experimented with a reverse osmosis technology to concentrate the juice (or must), ensuring a deeper- colored, richer-tasting wine. (Ironically, the tech- nique was developed in France, but most French producers deplored it as “removing the poetry of

wine.” Needless to say, it was a forbidden practice under AOC regulations.) New World wine makers also developed processes that allowed fermentation and aging to occur in huge, computer-controlled, stainless steel tanks rather than in traditional oak barrels. To provide oak flavor, some added oak chips while aging their popular priced wines—another practice strictly forbidden in most traditional- producing countries.

The economic impact of these and other innova- tions became clear in a comparison of the costs of production in the Langedoc region of France with the Riverina district in Australia, both big producers of popular priced wines. The French cost per tonne of €238 was 74% higher than the Australian cost of €137.7 And South American grape costs were even lower, driving down the price of popular premium wine in Europe to €2 a bottle, while the French vins de pays was priced above €3. (Exhibit 1 shows the cost composition of a bottle of French wine.)

Reinventing the Marketing Model Beyond their experiments in growing and wine making, New World

❚ 6Heijbrock, Arend “Changing Competitiveness in the Wine Industry,” Rabobank Research Publication, 2007, p. 5.

Exhibit 1 Consumer Price Breakdown: French Popular Wines

EUR/ EUR/ Cost Structure litre bottle

Juice 0.50 Wine making 0.06 Bulk wine (total) 0.56 � 0.42 Bottling packaging 0.35 Local taxes 0.08 Logistics storage 0.10 Margins/overhead 0.10 Wholesale price 1.05 Excise dutiesa 0.45 Retail and wholesale margins 1.14 If VAT 0.05 Consumer price in EUR 3.14

aExample from the Netherlands. Source: Changing Competitiveness in the Wine Industry, Rabobank Market Study, 2006, p. 16.

❚ 7Heijbrock, p. 16.

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132 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

World’s inferior wine making skills. Yet these exper- iments provided valuable lessons in branding and marketing—skills that were rare in this industry prior to the 1970s.

With wine showing the potential for mass appeal, in 1977 Coca-Cola acquired Taylor California Cel- lars. Other experienced consumer marketers such as Nestlé, Pillsbury, and Seagram followed, and conven- tional wisdom was that their sophisticated marketing techniques would finally crack the last major largely unbranded consumer product. But the challenge proved more difficult than expected, and within a decade the outsiders had sold out. Yet their influence endured in the consumer focused attitudes and the so- phisticated marketing skills they left behind.

The other major change driven by New World companies occurred in distribution. Historically, fragmented producers and tight government regula- tions had created a long, multilevel value chain, with service providers in many of the links lacking either the scale or the expertise to operate efficiently. (See Exhibit 2 for a representation.) In contrast, the

producers also innovated in packaging and market- ing. While the European targeted the huge basic wine market by selling the popular liter bottle of vin de table, the Australians developed the innovative “wine-in-a-box” package. Employing a collapsible plastic bag in a compact cardboard box with a dis- pensing spigot, the box’s shape and weight not only saved shipping costs, it also made storage in the con- sumer’s refrigerator more convenient. More recently, Australian producers began replacing cork stoppers with screw caps, even on premium wines. The logic was based not just on economics, but also on the fact that many wines, particularly the delicate whites, were susceptible to spoiling if corks were deficient.

From their earliest experiences in the marketplace, New World producers learned the value of differen- tiating their products and making them more appeal- ing to palates unaccustomed to wine. Several early products developed for unsophisticated palates were wildly successful—Ripple in the United States and Barossa Pearl in Australia, for example—but were dismissed by connoisseurs as evidence of the New

Exhibit 2 Wine Industry Value Chain

Grape Grower Wine Production Distribution Retailing Consumption

Consumer

Grape grower Cooperative Wholesaler

Auction

Merchant Trader

Foodservice

Supermarket

Specialty ShopPrivate winery

Grape grower Wine maker (Vinter)

Grape grower

Source: Adapted from The World Wine Business, Rabobank Market Study, May 1999.

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Case 2-1 Global Wine War 2009: New World versus Old 133

large New World wine companies typically con- trolled the full value chain, extracting margins at every level and retaining bargaining power with increasingly concentrated retailers. And because their name was on the final product, they controlled quality at every step.

To traditionalists, the New World’s breaks with established grape-growing and wine-making ways were sacrilege. They argued that in the drive for efficiency and consistency, and in the desire to cater to less sophisticated palates, New World producers had lost the character that came with more variable vintages made in traditional ways. And they were shocked that many of these “engineered products” were sold using appellation names—Chablis, Bur- gundy, Champagne, and so on. In response, the European Community (EC) passed regulations mak- ing such practices illegal. New World wine makers gradually adjusted by identifying their wines by the grape variety used, and eventually consumers rec- ognized and developed preferences defined by the varietal name—cabernet sauvignon versus merlot, or chardonnay versus sauvignon blanc, for exam- ple. Indeed, many seemed to find this easier to understand than trying to penetrate the many complex regional designations that each of the tra- ditional wine-producing countries had promoted.

The Judgment of Paris On May 24, 1976, in a publicity-seeking activity linked to America’s Bicentenary, a British wine merchant set up a blind- tasting panel to rate top wines from France and California. Despite the enormous “home field ad- vantage” of an event held in Paris with a judging panel of nine French wine critics, the American en- tries took top honors in both the red and white com- petitions. When French producers complained that the so-called “The Judgment of Paris” was rigged, a new judging was held two years later. Again, Cali- fornian wines triumphed.8

The event was a watershed in the industry. The publicity raised awareness that the New World produced quality wines, to the great shock of those

who dismissed their innovative approaches. It was also a wake-up call to traditional producers, many of whom began taking their new challengers seri- ously for the first time. Finally, it gave confidence to New World producers that they could compete in global markets. In short, it was the bell for the opening round in a fight for export sales.

Maturing Markets, Changing Demand

“The Judgment of Paris” signaled the start of many disruptive changes in the wine industry during the last quarter of the 20th century. More immediately alarming for most traditional producers was a pat- tern of declining demand that saw a 20% drop in worldwide consumption from 1970 to 1990, and a subsequent flattening of demand. When combined with radical changes in consumer tastes, consolida- tion in the distribution channels, and shifts in government support, these trends presented industry participants with an important new set of opportu- nities and threats.

Changing Global Demand Patterns The most dramatic decline in demand occurred in the highest- consumption countries, France and Italy. In the mid-1960s, per capita annual consumption in both countries was around 110 to 120 liters; by 2005 it was about 50 litres. Key causes of the decline were a younger generation’s different drinking prefer- ences, an older generation’s concern about health issues, and stricter drunk-driving penalties. Simul- taneously, steep declines occurred in other major wine drinking cultures—Spain dropped from 60 liters to 35, Argentina from 80 to 30, and Chile from 50 to 15. (See Exhibit 3.)

During the same period, demand was growing in many wine-importing countries, although not fast enough to offset losses in Old World wine countries. From 1966 to 2005, per capita annual consumption in the United Kingdom rose from 3 to 20 liters, in Bel- gium from 10 to 26 liters, and in Canada from 3 to 10 liters. Even more promising was the more recent growth of new markets, particularly in Asia where consumption in China, Japan, Taiwan, South Korea, and Thailand grew at double digit annual rates through

❚ 8Gideon Rachman, “The Globe in a Glass,” The Economist, December 18, 1999, p. 91.

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134 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

consumption of premium wine kept rising. Despite government subsidies, per capita consumption of basic wine in the EU fell from 31 liters in 1985 to 18 liters in 2005, while demand for quality wine in- creased from 10 liters to 15 liters. In that same 20 year period, jug wine sales in the United States declined from 800 million to 600 million liters, while consumption of premium wines increased from 150 million to 600 million liters.

With the shift to quality, a greater fashion element began to influence demand. The decline in impor- tance of working families’ daily consumption of locally produced table wine was offset by upscale urban consumers who chose bottles on the basis of grape variety, vintage, source—and increasingly fashion. The 1980s’ emphasis on lighter foods led to an increase in demand for white wines, making white wine spritzers (wine with soda water) a fashionable drink in the United States market. By the late 1980s, white wine represented over 75% of U.S. sales.

the 1990s. In fact, by 2005, China had emerged as the world’s fifth wine consuming nation—ahead of Spain, Argentina, and the U.K. (Exhibits 4 and 5 lists the world’s major consuming and producing nations.) It was this shift in market demand that escalated the competition for export sales into a global wine war. (See Exhibit 6 for import and export data.)

Shift to Quality, Rise of Fashion Partially offset- ting the overall volume decline was a growing demand for higher-quality wines. While the basic segment (less than $5 a bottle) still accounted for half the world market in volume, the premium ($5 to $7) and the super-premium ($7 to $14) now represented 40% of the total—and more than 50% of the market in younger markets such as the United States and Australia. (Exhibit 7 shows one version of price seg- mentation as defined by a leading industry analyst.)

The trend was worldwide. Even in Old World wine countries where total demand was in decline,

Exhibit 3 Wine Consumption Per Capita, Selected Countries, 1966–2006

1966

120

110

100

90

80

70

60

50

40

30

20

10

0 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

UK France Germany USA Australia Italy

Source: Figures for 1966 to 1999 from The World Wine Business, Rabobank Market Study, May 1999. Figures for 1998 to 2006 from Wine Institute Website www.wineinstitute.org/resources/world statistics/article 49.

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Case 2-1 Global Wine War 2009: New World versus Old 135

Exhibit 4 World Wine Production: By Country

WORLD GRAPE PRODUCTION BY COUNTRY AVERAGE 1996–2000 ACTUAL 2002–2004

ESTIMATED 2005 & 2006 AND PERCENT CHANGE 2006 VS AVERAGE 1996–2000

U.S. TONS (000)(1)

% CHANGE COUNTRY(2) 96-00 2002 2003 2004 2005 2006 2006/96-00

WORLD TOTAL 65,648 67,755 69,081 73,490 72,271 71,089 8.29%

ITALY 9,914 8,150 8,249 9,581 8,700 8,700 (12.25%) FRANCE 8,295 7,544 6,952 8,314 7,600 7,700 (7.17%) SPAIN 6,127 6,481 7,998 8,037 7,500 7,500 22.41% UNITED STATES(3) 6,513 7,339 6,573 6,240 7,814 6,417 (1.47%) CHINA 2,704 4,938 5,705 6,099 6,100 6,100 125.61% TURKEY 3,968 3,858 3,968 3,858 3,900 3,900 (1.72%) IRAN 2,484 2,981 3,086 3,086 3,100 3,100 24.82% ARGENTINA 2,456 2,474 2,537 2,922 2,700 2,700 9.94% AUSTRALIA 1,261 1,933 1,650 2,221 2,300 2,400 90.37% CHILE 1,827 2,064 2,386 2,149 2,200 2,200 20.42% SOUTH AFRICA 1,597 1,654 1,809 1,916 1,790 1,790 12.07% INDIA 1,057 1,334 1,268 1,323 1,300 1,300 23.03% GERMANY 1,515 1,453 1,233 1,235 1,300 1,300 (14.21%) GREECE 1,353 1,213 1,268 1,323 1,300 1,300 (3.92%) EGYPT 1,070 1,217 1,217 1,406 1,280 1,280 19.61% BRAZIL 939 1,235 1,163 1,414 1,200 1,200 27.77% ROMANIA 1,299 1,179 1,162 1,169 1,170 1,170 (9.93%) PORTUGAL 1,000 1,211 1,042 1,134 1,130 1,130 13.03% MOLDOVA 576 707 732 661 700 700 21.63% HUNGARY 757 633 665 698 670 670 (11.45%)

Source: Trade Data and Analysis, The World Wine Institute, 2006.

This all changed following the 1991 publication of a medical report identifying red-wine as a partial explanation of the “French paradox”—low rates of heart disease in a population well-known for its love of rich food. Featured on the U.S. television show 60 Minutes, the report soon led to an increase in demand, with red wine’s market share growing from 27% in 1991 to 43% five years later.

Even within this broad trend of red versus white preference, the demand for different grape varieties also moved with fashion. During the white wine

boom, chardonnay was the grape of choice, but by the late 1990s, Pinot Gris and Sauvignon Blanc were emerging white wine fashion favorites. In red wine, a love affair with Cabernet Sauvignon was followed by a mini-boom for Merlot, which in turn was succeeded by a demand spike for Pinot Noir.

Such swings in fashion posed a problem for growers. Although vines had a productive life of 60 to 70 years, they typically took 3 to 4 years to produce their first harvest, 5 to 7 years to reach full productive capacity, and 35 years to produce top

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136 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Exhibit 5 World Wine Consumption: By Country

WORLD WINE CONSUMPTION CATEGORY A(1) 2002–2006 AND % CHANGE 2006/2002 HECTOLITERS (000)

% Change COUNTRY (2) 2002 2003 2004 2005 2006 2006/2002

CATEGORY A TOTAL 226,179 231,547 234,064 236,991 241,553 6,80%

FRANCE 34,820.00 33,340.00 33,141.00 33,000.00 32,800.00 (5.80%) ITALY 27,709.00 29,343.00 28,300.00 27,600.00 27,300.00 (1.48%) UNITED STATES(3) 23,650.00 24,363.00 25,114.00 26,180.00 26,883.00 13.67% GERMANY 20,272.00 20,150.00 19,593.00 19,437.00 19,850.00 (2.08%) CHINA 11,469.88 11,586.02 13,286.00 15,000.00 16,000.00 39.50% SPAIN 13,960.00 13,798.00 13,898.00 13,735.00 13,735.00 (1.61%) UNITED KINGDOM 9,916.00 10,622.00 10,729.00 12,000.00 11,700.00 17.99% RUSSIA 6,404.00 8,682.00 10,159.00 11,200.00 11,200.00 74.89% ARGENTINA 11,988.00 12,338.00 11,113.00 11,113.00 10,972.00 (8.48%) ROMANIA 4,964.00 5,049.70 5,800.00 2,379.00 5,600.00 12.81% PORTUGAL 4,650.00 5,290.00 4,828.00 4,820.00 4,700.00 1.08% AUSTRALIA 4,007.00 4,196.00 4,361.00 4,523.00 4,600.00 14.80% CANADA 2,883.58 3,440.00 3,607.00 4,000.00 4,200.00 45.65% BRAZIL 3,178.00 3,077.00 3,177.00 3,710.00 3,553.00 11.80% SOUTH AFRICA 3,884.00 3,487.00 3,509.00 3,450.00 3,519.00 (9.40%) NETHERLANDS 3,330.00 3,563.00 3,340.00 3,474.00 3,350.00 0.60% GREECE 2,420.10 2,450.00 3,275.00 3,480.00 3,350.00 38.42% HUNGARY 3,454.00 3,120.00 3,080.00 3,200.00 3,200.00 (7.35%) CHILE 2,297.00 2,552.00 2,547.00 2,740.00 2,850.00 24.07% BELGIUM 2,724.00 2,614.00 2,741.00 2,813.00 2,775.00 1.87%

Source: Trade and Data Analysis, The World Wine Institute, 2006.

quality grapes. But New World wine regions had the capacity and the regulatory freedom to plant new varieties in new vineyards and could respond. For example, in the 1990s, the California acreage planted with chardonnay increased 36%, and mer- lot plantings increased 31%.

As these various demand trends continued, the rankings of the world’s top wine companies under- went radical change. Despite their relative newness and the comparative smallness of their home mar- kets, New World companies took nine slots in a list of the world’s top 15 wine companies, a list previ- ously dominated by Old World companies. (See Exhibit 8 for the listing.)

Increasing Distribution Power Because market- ing had typically been handled by their négociants, most Old World producers were still isolated from such fast-changing consumer tastes and market trends—particularly when they occurred in distant export markets. Equally problematic was their lack of understanding of the rapidly concentrating retail channels. In contrast, because most large New World wine companies controlled their distribution chain from the vineyard to the retailer, they were able to sense changes in consumer preferences and respond to shifts in distribution channels.

Furthermore, the New World companies were able to capture even more economic advantage by

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Case 2-1 Global Wine War 2009: New World versus Old 137

Exhibit 6 Consumption, Production, Export, and Import Figures for Selected Old World and New World Wine Producing and Consuming Countries, 2001

Consumption Production Exports Imports

Liters Per Total hls Total hls Total hls Total hls Value Capita 000s (000s) (000s) (000s) ($Millions) $/Litre

France 52 34,200 45,400 15,180 5,370 789 1.40 Italy 46 28,150 45,900 18,480 1,750 474 2.70 Argentina 31 12,200 15,050 3,260 140 NA 1.30 Spain 27 14,260 34,700 15,280 200 NA 3.20 Germany 26 20,380 10,500 3,450 14,240 2,710 1.90 Australia 28 5,960 14,304 7,980 340 NA 4.70 United Kingdom 22 12,760 — — 12,910 5,090 3.90 United States 9 25,125 20,000 4,240 8,450 4,624 5.40

Source: Rabobank World Wine Map, 2008. Note: In several European countries, production does not equal consumption (plus exports minus imports) due to excess production being subject to government purchase.

Exhibit 7 Quality Segments in the Wine Industry (Rabobank’s Categories)

Icon Ultra Premium Super Premium Premium Basic

Price range More than $50 $20–$50 $10–$20 $5–$10 Less than $5 (approx)

Consumer Connoisseur Wine lover Experimenting Experimenting Price-focused profile consumer consumer consumer

Purchase driver Image, style Quality, image Brand, quality Price, brand Price Retail outlets Winery, Specialty shop, Better Supermarket Supermarket,

boutique, food service supermarket, discounter food service specialty shop

Market trend Little growth Little growth Growing Growing Decreasing Competition Limited, Gradually Increasing, based Fierce, based Based on price

“closed” increasing on brand and on brand, segment quality/price ratio price

Volume 1% 5% 10% 34% 50% market share

Availability Scarce Scarce Sufficient, year Large quantities, Surplus round year round

Source: Adapted by casewriters from The World Wine Business, Market Study, May 1999.

reducing handling stages, holding less inventory, and capturing the intermediaries’ markup. Even the transportation economics that once favored European suppliers’ proximity to the huge United Kingdom market changed. As trucking costs rose,

container-ship rates fell, making the cost of ship- ping wine from Australia to the U.K. about the same as trucking it from the south of France.

Size also gave New World companies bargaining power in the sophisticated negotiations that a

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138 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Exhibit 8 Top 15 World Wine Companies: 2007/08

Constellation

E&J Gallo

The Wine Group

Pernod Ricard

Fosters

Castel Freres

Carcia Carrion

Bacardi

Conchay Toro

LGF

Schlass Wachenhelm

Simeon McGuigan

Caviro

Schenk Group

Distell

0 10 20 30 40 50 60 70 80 90 100

Millions of Cases

Source: Rabobank World Wine Map, September 2008.

concentrated retail sector now demanded. For ex- ample, following the huge wine surpluses flooding the market in the early 2000s, Australian producers used their cost advantage to drive prices lower. But equally important in the battle for volume sales was their ability to respond to retailers’ need for a consis- tent supply of strong brands at a good price/quality ratio.9 In the face of this head-on competitive chal- lenge, the French tried to defend their position through frequent promotions.10 But they were hampered by their lack of consumer knowledge and marketing skills.

The Old World suppliers’ problems became clear from their dealings with Tesco, the world’s largest wine retailer with wine sales of £1.5 billion in 2007. To maximize sales, Tesco emphasized that it wanted to work with creative suppliers. “Don’t just bring the deals, bring me innovation,” said Dan Jago, Tesco’s Wine, Beer, and Spirits division head. “If you want your prices to rise, you have to per- suade customers why they should pay more.”11

While a handful of icon brands prospered at the top of the market based on image and quality, the fragmentation of Old World vineyards forced most to compete at the low end on price. When some chose to take on the New World brands under the

❚ 9Rachman, p. 99. ❚ 10Annemiek Geene, Arend Heijbroek, Anne Lagerwerf, and Rafi Wazir, “The World Wine Business,” Market Study, May 1999, available from Rabobank International.

❚ 11Anonymous, “The World’s Largest Wine Retailer,” Meininger’s Wine Business International, June 2007, pp. 42–45.

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As interest in wine extended beyond educated connoisseurs, new consumers in the fast-growing premium wine segment were faced with hundreds of options and often insufficient knowledge to make an informed—or even a comfortable—choice. Government classification schemes required them to have an understanding of the intricacies of re- gion, vintage, and vineyard reputation, and even if they found a wine they liked, chances were that by their next purchase, that producer was not stocked or the new vintage was less appealing. Unsurpris- ingly, survey data in the early 1990s showed that 65% of shoppers had no idea what they would choose when they entered a wine store.

Yet even in 2009, despite many attempts, no brand had been able to capture as much as 1% of the global wine market, in contrast to soft drinks, beer, and liquor, where global brands were dominant. Although European producers and their importing agents had successfully launched several mass appeal brands in the 1960s and 1970s (e.g., Blue Nun, Mateus, Liebfraumilch), a decade later New World producers had made branding a routine part of wine marketing. For example, by sourcing grapes from multiple vine- yards and regions, Australian wine maker Penfolds built trust in its products by ensuring the vintage- to-vintage consistency that branding demanded. It then leveraged its trusted brand name by creating a hierarchy of Penfolds wines that allowed consumers to move up each step from $9 to $185 wines as their tastes—and their budgets—developed. (See Exhibit 9.)

New World producers who built their marketing expertise in their home markets during the 1960s and 1970s, learned how to respond to consumer preferences for the simpler, more fruit-driven wines that were easy to appreciate. They then took those wines and the marketing and branding skills they had developed at home into the export markets. By 2007, New World companies claimed 14 of the world’s top 20 wine brands. (See Exhibit 10.)

The Government Solution The radical shifts in demand proved extremely challenging to Old World producers. First, there was often no new land

umbrella of the AOC’s reputation, it soon became clear that they lacked the skills or resources to suc- ceed in the last growth middle market. Tesco’s Jago complained that despite its once strong reputation, the Bordeaux “brand” was losing sway with younger consumers. “Heaven knows I’ve tried to help them, but our consumers have such infinite choice that they don’t need to make [Bordeaux] part of it.”12

Ascendancy in of Brand Power For years, the wine industry appeared ripe for branding. The ex- treme fragmentation of the European industry (Bordeaux alone had 20,000 producers) meant that few had the volume to support a branding strategy. Historically, only the handful of Old World producers whose wines achieved icon status—Lafite, Veuve Cliquot, and Chateau d’Yquem, for example—were recognized brands. But these appealed to the elite, who represented only a tiny fraction of the global market.

In providing the consumer confidence that branding offers, government-supported classifica- tions such as France’s AOC had been only partially successful. Their value was weakened not only by their complexity (in 2009 there were 327 designated AOC regions), but also by the erosion of consumers’ confidence in the classification scheme as an assur- ance of quality.13 For example, Burgundy’s most famous vineyard, Chambertin, had its 32 acres di- vided among 23 proprietors. While most produced the high-quality wine that had earned its grand cru status, others rode on that reputation to sell—at $150 a bottle—legitimately labeled Chambertin that wine critic Robert Parker described as “thin, watery, and a complete rip-off.”14

Case 2-1 Global Wine War 2009: New World versus Old 139

❚ 12Ibid. ❚ 13The same problem plagued wines from Italy, where DOC regulations were so often violated that the government eventually introduced a DOCG classification in 1980 (the G stood for guarantita) to restore consumer confidence in notable wine regions. And in Germany, government standards were so diluted that, even in mediocre years, over 75% of wine produced was labeled Qualitatswein (quality wine), while less than 5% earned the more modest Tatelwein (table wine) designation. ❚ 14Robert M. Parker, Jr., Parker Wine Buyer’s Guide, 5th Edition (New York: Fireside Press, 1999), p. 276.

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140 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Exhibit 9 Penfolds Red Wine U.S. Brand Structure, 2009

Varietal Years Before Price Suggested U.S. Retail Label Type Release Segment Price per Bottle ($US)

Rawson’s Retreat Varietal rangea 1 Premium $8.99 Koonunga Hill Varietal rangea 1–2 Premium $10.99 Thomas Hyland Varietal rangea 1–2 Premium $14.99 Bin 138 Shiraz Mourvedre Grenache 2 Super Premium $19.00 Bin 128 Shiraz 3 Super Premium $24.00 Bin 28 Shiraz 3 Super Premium $24.00 Bin 389 Cabernet Shiraz 3 Super Premium $26.00 Bin 407 Cabernet Sauvignon 3 Super Premium $26.00 St. Henri Shiraz 5 Ultra Premium $39.00 Magill Estate Shiraz 4 Ultra Premium $50.00 RWT Shiraz 4 Ultra Premium $69.00 Bin 707 Cabernet Sauvignon 4 Ultra Premium $80.00 Grange Shiraz 6 Icon $185.00

Source: Southcorp Wines, the Americas. aTypical red varietal range included of these brands Merlot, Shiraz Cabernet, and Cabernet Sauvignon. (These brands also offer a range of white wines.)

Exhibit 10 Top 20 Wine Brands 2004–2008

Brand Company Source Country Million Cases 2007

0

Franzia Wine Group US Martini Bacardii Italy Carlo Rossi Gallo US Conchay Toro Conchay Toro Chile Gallo Gallo US Yellowtail Casella Australia Tavernello Caviro Italy Beringer Fosters US Sutter Home Trinchero US Jacobs Creek Pernod Richard Australia Almaden Constellation US Livingstone Cellars Gallo US Woodbridge Constellation US Hardy’s Constellation Australia Chenet Grands Chais de France France Frelxenet Frelxenet Spain Riunite Riunite Italy Peter Vella Gallo US Lindemans Fosters Australia Rotkappchen Rotkappchen Germany

10 15 20 25 Source: Rabobank World Wine Map, September 2008.

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challenge now was to remake their image and move out of the highly competitive low price segment.

The Battle for the US Market

Squeezed by chronic oversupply in producer countries and declining demand in mature markets, the Old and New World were again locked in a competitive battle for export markets which in 2008 accounted for 33% of global demand. Nowhere was the battle more intense than in the United States, which one industry analyst called “perhaps the most attractive market in the world.” 15

The US Market It was easy to see why the U.S. was so attractive. In Germany, the world’s largest wine importer, 65% of the market was accounted for by basic wine that sold for less than €2 a bottle. As the second largest importer, the U.K. offered a more attractive market (the €3–5 segment ac- counted for 57% of sales), but it was showing signs of saturation. But as third-place importer, the United States market had grown faster than any other major wine market—from $11 billion in 1993 to $30 billion in 2007. Better yet, the rate of in- crease in value was four times the volume growth. This reflected the fact that wine that sold for more than €5 ($7) accounted for 48% of the market, and this segment was growing at 15% p.a.—three times the rate of lower price segments.

Still, the U.S. wine market had long been one of the most difficult for imports to crack due to its dis- tance from most producing countries, its state-by- state regulatory strictures, and particularly its complex three-tier distribution system that forced all sales to pass through state-licensed wholesalers. Not only did these wholesalers add cost, they also exercised great power. (The largest of them, South- ern Wine and Spirits, had twice the sales of Conso- lation Brands, the world’s largest wine company.) But all this changed when a 2005 Supreme Court ruling allowed interstate wine shipments, triggering a series of state and federal regulation challenges

available to plant, particularly in controlled AOC regions. Equally restrictive were the regulations prescribing permitted grape varieties and winemak- ing techniques that greatly limited their flexibility. So, for example, when fashion switched away from sweeter white wines, the German wine industry which was constrained by tight regulations on sugar content, watched its exports drop from over 3 million hectoliters in 1992 to under 2 million just five years later.

But the biggest problem was that declining demand at home and a loss of share in export mar- kets had caused a structural wine surplus—popularly called the European wine lake. The EU’s initial re- sponse was to pay farmers to uproot their vineyards, leading to 500,000 hectares (13% of production) being uprooted between 1988 and 1996. A parallel “crisis distillation program” provided for the EU to purchase surplus wine for distillation into industrial alcohol. An average of 26 million hectoliters (15% of total production) was distilled annually in the decade since 1999. In a 2006 reform proposal, the EU aimed to uproot a further 200,000 hectares—equal to the size of the U.S. wine industry—and gradually phase out crisis distillation.

Critics contended that despite their intent to move towards more market-driven policies, the EU regulators were still dealing with challenges from the supply-side perspective of the grape growers. Little was being done to address marketing support, wine style, the freedom and willingness to innovate, or the business models Old World wine companies were pursuing so successfully.

But New World wine companies were also facing challenges. Problems of global oversupply were made worse by emerging signs of saturation in several major export markets. For example, after 2003, Australia’s wine export value to its major U.K. market was growing at less than half the rate of volume sales. And by 2005, its U.K. export volume increase slowed to only 1.6% while its average price in that market declined by 4.4%. There was also some evidence that New World wines were developing image problems born of their willingness to lower prices aggressively in an era of excess supply. The

Case 2-1 Global Wine War 2009: New World versus Old 141

❚ 15Stephen Rannekiev, “The Future of the California Wine Industry,” F&A Research Advisory, Rabobank Industry Note, August 2007, p.1.

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that began to open up the U.S. distribution system. Finally, the largest entry barrier for imports began to erode.

One of the key drivers of U.S. market growth was due to Generation Y (born after 1977) embrac- ing wine much more than Generation X, and almost as much as the Baby Boomers. These new con- sumers were not only price-sensitive, but also very Internet savvy, and consequently were well edu- cated about their purchases. As they came of drink- ing age, research showed that they chose imported wines more than earlier generations, a cause for concern for in the U.S. industry.

Not surprisingly, in the first decade of the mil- lennium, the U.S. became a major battleground in the fight for exports. Despite the fact that it had a successful domestic industry, wine imports into the U.S. increased by 185% between 1995 and 2006, by which time they claimed a record 31% market share. Soon, the champions of the Old World and New World were battling head-to-head—the Americans defending their home market against the three coun- tries that accounted for 77% of imports by value: Italy, France, and Australia. It had become a microcosm of the global wine wars.

The American Defense Some industry critics suggested that because American producers had long focused on their large, high priced domestic market, they had fallen behind the prevailing global price/quality ratio, not only at the low end, but even at the higher price points. One wake-up call was an analysis comparing the prices of all 2004 vintage Cabernet Sauvignon wines that achieved a Robert Parker Wine Enthusiast rating of 90. The average price for the Californian wines was $55, while the price for similarly rated wines from Australia was $20.16

Having become a high cost producer, the U.S. industry recognized that it needed to respond to the new competitive challenges. One of the greatest problems was that its land costs were extremely high. In 2008, an average acre of land in Napa cost

$150,000, more than 10 times the price of an average Australian vineyard, and 20 times the cost in Chile. Furthermore, there was virtually no land available for expansion in Napa or other premium wine areas. And labor costs were being squeezed as control over illegal immigration increased. The cost of pruning an acre in Napa in 2008 was $350, similar to the cost in France, but much higher than in highly mecha- nized Australia ($120 an acre), or in low labor cost Chile ($75 an acre).

Because of their high cost, vineyards in North Coast locations such as Napa and Sonoma targeted the super-premium and ultra-premium segments at $12 a bottle and above. Meanwhile, the Central Valley which produced 70% of California’s wine volume was focused on the basic segment typified by Gallo’s Carlo Rossi brand. And as market oversup- ply grew in 2002 and beyond, surplus wine purchased on the spot market created the Charles Shaw brand, nicknamed “Two Buck Chuck” for its $1.99 price. Soon it was selling 5 million cases a year.

This bifurcated focus led to the middle segment of the market ($5–$8 a bottle) being underserved. Into that gap stepped Yellow-Tail, an Australian im- port with a trendy label, and the full-bodied fruity wine the U.S. market preferred. Soon it was selling 10 million cases a year worldwide. With little abil- ity to respond quickly from domestic sources, U.S. wineries began looking to an unexpected source— imported wine from low-cost producing countries, a development we will describe below.

Europe’s Renewed Advance As EU agricultural policy changes shifted the focus from reducing oversupply to subsidizing marketing and promo- tion, European wines began growing their market share in the U.S. Finally, after years of beating a re- treat to New World competitors, the major EU wine exporting countries could boast that they captured 99% of the 2006 dollar volume increase in imported wine sales into the U.S.

With the Australians charging into the popular premium segment, French wines extended their penetration into the super premium segment. While ranked number three in imports by volume, France

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❚ 16Ibid, p.5.

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But celebrations were dampened by the recogni- tion that in the mid-2000s, exports to the U.K., its largest market, were stagnating and average price was eroding. Fortunately, the U.S. market was growing rapidly, and by 2007 represented 31% of Australia’s wine export market value, compared to 33% for the U.K. But with an average price per liter of $4.46 for Australian imports into the U.S., it rep- resented a much more attractive market than the U.K. where the average had slipped to $3.35.

But Australian wine was also facing price and image problems in the U.S. market. Challenged by overproduction since 2000, its bumper crops of 2004, 2005, and 2006 had led Australian producers to aggressively reduce prices in all export markets. While this led to a boom in export sales, it also es- tablished an image of Australian wines as “cheap and cheerful.” The image was typified by Yellow Tail, the phenomenally successful brand that sold 8.1 mil- lion cases into the U.S. in 2007, accounting for 36% of all Australian imports to the country.

Being trapped by this image was particularly problematic as costs started to rise. Serious droughts in Australia led to major cost increases for water at the same time as global energy prices were soaring. Together, these factors caused an increase in pro- duction cost of almost $200 at tonne, and forced Australian producers to recognize that regardless of their greater efficiency, Argentina and Chile were lower cost producers. For example, while Australia could land its bulk table wine in the U.S. at $0.80 a liter, Argentina’s price was $0.36 a liter.

Like other countries, the Argentineans and Chileans had learned from Australia’s success, and had copied its successful strategy to develop their own accessible wines marketed under consistent brands. For example, Concha y Toro was the world’s fourth largest wine brand, ahead of Gallo and Yellow Tail, for example. And even where emerging New World producers had not developed the necessary marketing skills, a growing number of global wine companies could offset that shortcoming. For example, in 2007, the top selling new wine in the U.S. was the popular premium South African brand Sebeka—sourced, bottled, branded, and marketed

beat all other countries in terms of import value. Its price per bottle, at 77% above the average of all imports, reflected its strong position in the luxury segment including champagne. In contrast, the growth in Italian imports was occurring mostly in the popular priced range that was their historic strength. Promoting well-known brands such as Riunite, Cavit and Bolla, they increased their 2006 volume by 2 billion cases, thereby retaining their position as the number one importer by volume.

But ironically, the success of the European im- ports was also helped by U.S. domestic producers. As they became more global in scope, many U.S. wine companies began divesting vineyards and expanding their marketing role. Foreign wine sup- pliers benefited from this shift in two ways. First, when domestic companies took advantage of a law that permitted up to 25% foreign wine in products that could still be labeled as American, the imports became the source of the less expensive bulk wine required for blending. Foreign suppliers also bene- fited when domestic companies broadened their line by importing and marketing country specific wines. Gallo became particularly adept at this strategy, and successfully launched brands such as Bella Sera and Ecco Domani with wines sourced in Italy, and Red Bicyclette, its brand of imported French wine. In essence, the American companies filled the gap in marketing capability and distribution expertise that had previously been a barrier to entry for many European imports.

Australia’s New Challenge For more than a decade, Australia’s wine producers had become accustomed to success. In 1996, the industry’s “Strategy 2025” plan had detailed a “total commit- ment to innovation and style” as its means of becoming “the world’s most influential and prof- itable supplier of branded wines by 2025.” Ten years later, grape production had more than doubled and exports of had grown by 530% to 782 million liters in 2006, making Australia the world’s number four wine exporter. In fact, most of Strategy 2025’s goals had been achieved by 2006, almost 20 years ahead of schedule.

Case 2-1 Global Wine War 2009: New World versus Old 143

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by Gallo. In short, Australia’s competitive position in the U.S. was being seriously challenged.

Behind the Battle Lines: Strategy in France and Australia

Buoyed by a decade of success, yet also concerned by the recent weakening of the average price recorded by Australian export wines, the Australian Wine and Brandy Corporation, the government’s wine export body, linked up with the industry- led Winemakers Federation of Australia to develop a new strategy supporting the continued growth of the industry. Under the title “Directions to 2025,” the document detailed how the industry would implement the second stage of the land- mark “Strategy 2025” which had emphasized volume growth to 2002, value growth to 2015, and achieving global preeminence for Australian wine by 2025.

On a broad platform of Wine Australia, “Direc- tions to 2025” planned to support four sub-brands, each targeting a separate consumer group. “Brand Champions” would cover accessible premium brand wines and promote ease of enjoyment; “Generation Next” would emphasize innovation which was im- portant to younger consumers who associated wine with social occasions not grape attributes; “Regional Heroes” would develop an association between Australian regions and wine varieties or styles; and “Landmark Australia” would support Australia’s high profile aspirational wines and provide an umbrella of world-class reputation. (Exhibit 11 shows a map off brand attributes.)

But a 2008 crush of 32% more than the previous year led many to believe that the recent drought- related production declines were over. Within the industry, there were concerns that as supply increased, producers would abandon the long-term strategy and return to their earlier discounting practices, particularly for popular brands that could generate the volume to remove excess supply. Australian wine making icon Wolf Blass despaired at what he called “a wrongheaded approach.” He felt that Australian wine could not compete long-term in a low-cost battle, and argued that the export business should focus on full-bodied, quality wines that would raise

its image. That would be a real challenge in an in- dustry that was forecasting a 7% oversupply of fruit by 2013.

Meanwhile, in France, the industry and the gov- ernment were responding differently to the global surplus. In 2005, the grower-led Comite d’Action Viticole (CAV) launched its campaign of violence against imports, blocking highways and overturning the trucks of foreign wine. In a subsequent meeting with the prime minister, a delegation of winemakers extracted his commitment to support a national strat- egy “to help French wine recover lost markets.” The plan, funded to €90 million, offered direct support to wineries in financial difficulty, and promised funds to relaunch French wines into the world mar- ket. Furthermore, a new national wine committee would work on simplifying the complex classifica- tion systems, perhaps moving towards larger, sim- pler regional appellations such as Bordeaux or Burgundy. Finally, the prime minister directed his agriculture minister to go to Brussels and argue for more funds to distill surplus wine into industrial alcohol.

But the EU was moving in a different direction. In 2007, it announced plans to use its annual €1.3 billion wine budget more effectively. It would be ending the €500 million annual buyback of unsold wine, redirecting those funds to new incentives en- couraging farmers to uproot vines on 200,000 hectares of vineyards, and providing €120 million a year for a marketing campaign. The plans were extremely unpopular with farmers, and when the EU plan passed in spite of their objections, the protests escalated. In France, the CAV claimed re- sponsibility for explosions at supermarkets selling imported wines, particularly in the high productiv- ity Languedoc-Roussillon wine region in the south of France. Then, five balaclava-clad men appeared on French television threatening more violence unless wine prices increased.

Most in the industry felt such actions were un- helpful, and undermined their marketing efforts. They urged winemakers to get behind the new promotion campaign for “South of France” wines that was supported with €20 million from govern- ment and industry coffers. In an unusual display

144 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

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Case 2-1 Global Wine War 2009: New World versus Old 145

Exhibit 11 Wine Australia’s Market Segment

History, heritage & c ultu

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Wine Australia

BRAND CHAMPIONS

Retail

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Source: Wine Australia Marketing Strategy, Australian Wine and Brandy Corp.

of unity, producers from various AOC, VDQS, and Vin de Pays regions had agreed to launch products under this common banner. While some felt it was the only chance they had to compete against strongly branded New World wines, others

worried that the “South of France” brand was too generic, and hid the richness of the area’s diverse sources of wine. But in the battle for export markets, everyone agreed that something had to be done.

Wine Australia—features and benefits

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In 1990, Cementos Mexicanos was a Mexican ce- ment company that faced trade sanctions in its major export market, the United States. By the end of 1999, CEMEX operated cement plants in 15 countries, owned production or distribution facilities in a total of 30, and traded cement in more than 60. Non- Mexican operations accounted for nearly 60% of assets, slightly over 50% of revenues and 40% of EBITDA (earnings before interest, taxes, deprecia- tion, and amortization) that year. CEMEX’s sales revenues had increased from less than $1 billion in 1989 to nearly $5 billion in 1999, and it had become the third largest cement company in the world in terms of capacity, as well as the largest international trader. Growth had been achieved without compro- mising profitability: in the late 1990s, its ratio of EBITDA to sales ranged between 30% and 40%— ten to fifteen percentage points higher than its lead- ing global competitors. In addition, the company was celebrated as one of the few multinationals from Latin America, and as a model user of information technology in an otherwise low-tech setting.

CEMEX executives sometimes characterized the company’s international operations as a “ring of grey gold,” comprising commitments to high-growth mar- kets, mostly developing and mostly falling in a band that circled the globe north of the Equator. By the end of the 1990s, the addition of countries such as Indone- sia and Egypt to the ring had prompted discussions about the scope and speed of CEMEX’s international expansion. So had the hostile bid, in early 2000, by Lafarge, the second-largest cement competitor world- wide in cement for Blue Circle, the sixth largest. Hec- tor Medina, CEMEX’s Executive Vice President of Planning and Finance, likened the takeover struggle to “ripples in an agitated environment” that could have significant implications for the other cement majors.

This case begins with a brief overview of the cement industry and international competition within it. It then describes the globalization of CEMEX and how it was managed.

The Cement Industry

Cement had been used since antiquity as a binding agent that hardened when mixed with water. It was first made in its modern form in England during the early part of the 19th century. The production process, which remained broadly unchanged, involved burn- ing a blend of limestone (or other calcareous rocks) and smaller quantities of materials containing aluminum, silicon, and iron in a kiln at high tem- peratures to yield marble-sized pellets of “clinker.” Clinker was then ground with gypsum and other minerals to yield cement, a fine gray powder. The mixture of cement, aggregates, and water that hard- ened into a rocklike mass after hydration was

146 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Case 2-2 The Globalization of CEMEX Pankaj Ghemawat

Geographic diversification enables us to operate in multiple regions with different business cycles. For the long term, we are trying to ensure that no one market accounts for more than one-third of our business. Yet we do not diversify simply to balance cyclic downturns and upswings. We do not see volatility as an occasional, random element added to the cost of doing business in an interconnected global marketplace. We plan for volatility. We prepare for it. We have learned how to profit from it.

—Lorenzo Zambrano, CEO of CEMEX1

❚ Professor Pankaj Ghemawat and Research Associate Jamie L. Matthews prepared this case drawing, in part, on a course paper by Pau Cortes, Heriberto Diarte and Enrique A. Garcia. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

❚ Harvard Business School Case No 9-701-017, Copyright 2000 President and Fellows of Harvard College. All rights reserved. This case was prepared by P. Ghemawat. HBS Cases are developed solely for class discussion and do not necessarily illustrate either effective or ineffective handling of administrative situation.

❚ 1CEMEX 1998 annual report, p. 4.

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High transportation costs in relation to production costs meant that there was only a limited distance within which a plant could deliver cement at compet- itive prices. Road transportation was the most expen- sive, and limited the effective distribution radius to 150–300 miles.3 Waterborne transportation was the most economical and, as a result of innovations since the mid-1950s, had led to a substantial expansion of MES.4 New systems of loading and unloading barges were introduced and specialized ships for carrying cement were developed. As a result, cement produc- ers began to establish much larger plants that shipped cement to distribution terminals in distant markets as well as serving local ones. Still, a host of other costs had to be layered on top of the costs of ocean freight for long-distance trade to take place (see Exhibit 2). In the late 1990s, international seaborne traffic in cement and clinker averaged about 50 million tons per year. It was believed that about 10 million tons of this traffic was carried by small vessels on short coastal or estuarial voyages, and about 40 million tons by oceangoing vessels.5

Demand Cross-country comparisons indicated that the long-run demand for cement was directly

known as concrete. Concrete could be mixed “on site” where it was to be used, or it could be obtained in “ready-mix” form from a central drum at the plant or a ready-mix truck.

Supply Since limestone, clay and the other raw materials required were abundant in many regions of the world, cement could usually be produced locally. Cement companies often owned raw material quar- ries and located their production facilities close by to minimize materials handling. The production tech- nology was continuous process, consisted of a num- ber of stages (see Exhibit 1) and was marked by high capital- and energy-intensity. It was also considered relatively mature: no major innovations had been recorded in the last 20 years. The minimum efficient scale (MES) for a cement plant approximated 1 mil- lion tons of capacity per year. New capacity cost about $120–$180 per ton, depending on local factors such as the cost of land, environmental legislation, and the need for ancillary equipment and infrastruc- ture, including investment in quarries and kilns. A cement plant’s assets were largely dedicated to the production of cement and might last for decades. Operating costs typically ranged from $20–$50 per ton, with labor accounting for well under $10 per ton.2 Transportation costs, in contrast, could account for as much as one-third of total delivered costs.

Case 2-2 The Globalization of CEMEX 147

Exhibit 1 How CEMEX Makes Cement

Mining of raw materials

Calcination Cement milling

Product packaging Shipping

Raw meal homegenization

Crushing of raw materials Prehomogenization Dry powder mill

Raw material storage

Source: CEMEX Company book, pp. 18–19.

❚ 3ING Barings, European Cement Review, February 2000, p. 24. ❚ 4Hervé Dumez and Alain Jeunemaître, Understanding and Regulating the Market at a Time of Globalization: The Case of the Cement Industry, p. 113. ❚ 5Drewry Shipping Consultants, Cement Shipping: Opportunities in a Complex and Volatile Market, January 1998.

❚ 2Merrill Lynch, Ownership Changes in Asian Cement, December 3, 1999, p. 117.

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related to GDP, with per capita consumption in- creasing up to the $20,000-plus per capita income mark and then declining very gradually. Numerous other local attributes affected cement demand as well. Rainfall had a negative effect since it made cement-based construction more difficult and in- creased the likelihood of using substitutes such as wood or steel instead. Population density had a pos- itive effect, as higher density led to taller buildings and more complex infrastructure. Demand also tended to be higher in areas with a warm climate and lower under extremes of heat or cold. Demand generally decreased with a long coastline, since more sea transport meant fewer roads, and in- creased with the share of governmental expendi- tures in GDP. CEMEX forecast total world demand to grow at slightly under 4% per annum through 2010. Demand growth was expected to be highest in the developing Asian economies, Central Amer- ica, the Caribbean, and Sub-Saharan Africa, where it would approach or exceed 5%, and lowest in Western Europe and North America, where it would be closer to 1%.

In the short run, cement demand varied directly with GDP and, even more reliably, with construction expenditure/investment. As a result, construction plans could be used to develop short-run forecasts for cement demand. However, the cyclicality of the con- struction sector made medium-run forecasts some- what dicey. Bulk sales were very sensitive to GDP growth, interest rates, and other macroeconomic factors that affected the formal construction mar- ket. Retail sales to individual consumers for home construction and the like, which were important in developing countries, were discovered to be less cyclical and also offered opportunities for some branding, as described below.

Competition Cyclicality on the demand side com- bined with capital-intensity, durability, and special- ization on the supply side to meant that overcapacity in the cement industry could be ruinous in its effects. Cement firms tried to cushion their interactions under conditions of overcapacity by relying on “basing point” pricing systems, other leadership strategies, and even direct restraints on competition.

148 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Exhibit 2 Cost Structure of Asian Exports to the United States

Cash cost per ton

FOB

Freight

Duties

Handling/ Storage

Land Transport

Taxes/ Credit

Margin

Total Costs

Minimum Price

Port

Source: Holderbank, as quoted in “The Global Cement, Aggregates and Plasterboard Analyser,” Warburg Dillon Read, September 1999, p. 229.

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the 1980s and another in Switzerland during the early 1990s. Governmental support was instrumental in erecting trade barriers to curb foreign competitors as well. The antidumping duties imposed in the late 1980s by the United States on cement imports from Mexico are an example that will be discussed in some detail later on.

International Competitors

By 1999, six major international competitors had emerged in cement: Holderbank, Lafarge, CEMEX, Heidelberger, Italcementi, and Blue Circle. Given their geographic diversification, these competitors tended to be outperformed in any given year by competitors focused on local markets that happened to be “booming” (see Exhibit 3), but they had achieved significantly greater stability in their

The basing point system had been common in the United States until the end of World War II, and in Europe until much more recently. Under this sys- tem, the leading firm set a base price, and the other firms calculated their prices by taking the base price and increasing it by the cost of transportation from the leading firm’s plant to the delivery point. This offered a transparent price structure in the ab- sence of hidden discounts, and let the biggest play- ers sell throughout the entire market, while smaller producers ended up selling in relatively small areas around their plants.

Other devices that cement firms relied on to mit- igate competition included attempts to collude and to secure protection from imports. There had even been explicit cartels in the industry. Well-documented examples included one in southern Germany during

Case 2-2 The Globalization of CEMEX 149

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Source: “The Global Cement, Aggregates and Plasterboard Analyser,” Warburg Dillon Read, September 1999, p. 26.

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returns. In aggregate, the six majors controlled 500 million tons of capacity, representing slightly over one-quarter of the world total, or over one-third of the total excluding China. The six-firm concentra- tion ratio had been only 12% in 1988, with Votoran- tim of Brazil edging out CEMEX for the sixth spot.6

In 1999, each of the six major international com- petitors still had clearly identifiable national origins and controlled a significant share of its home mar- ket. But each had also come to operate production facilities in anywhere between a dozen and several

dozen countries around the world. Exhibit 4 sup- plies financial data on the six majors, and Exhibit 5 summarizes their capacity shares in a number of major markets.

Although some of the majors, such as Holder- bank, had operated in several countries for decades, internationalization, particularly in an interregional sense, did not begin until the 1970s. This was when European players began to penetrate the United States. During the 1960s and 1970s, the U.S. cement industry had fallen into a crisis as profitability dropped with the collapse in prices, and domestic firms responded by lowering investment in cement and diversifying into other lines of business. This

150 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Exhibit 4 Selected Data on Global Competitors (December 1999)

Holder- Heidel- Ital- Blue Company bank Lafarge CEMEX berger cementi Circle

Accounting Data Sales (US$ m) 7,618 10,552 4,828 6,404 3,414 3,604 Cement volume (m tons) 74.6 64.3 39.1 46.0 37.8 NA EBIT (US$ m) 1,066 1,766 1,436 645 511 466 EBITDA (US$ m) 1,785 2,446 1,791 1,195 838 684 CAPEX (US$ m) 784 1,144 262 540 310 295 Free Cash Flow (US$ m) 144 511 862 487 200 (294) Net debt (US$ m) 4,767 5,422 4,794 2,957 1,731 538 Net debt/EBITDA .7 2.2 2.7 2.5 2.1 0.8 Total debt to capitalization 54.1% 46.5% 44.1% 51.3% 43.0% 31.0% Interest coverage 4.6 6.6 3.6 4.8 6.8 5.7

Stock Market Dataa (to Dec. ’99) Market value (US$ m) 11,122 12,132 7,203 4,209 2,488 4,707 Profitability of stock US$b (12 mth) 16% 22% 114% 3% 9% 12% TEVc (US$ m) 17,015 19,157 12,500 7,373 5,050 5,593 TEV adjusted/ton (US$)d 160 130 172 86 90 93

Capacity Data Footprinte (m tons) 140 107 85 71 55 45 Degree of control of footprint 72% 79% 77% 75% 98% 97% Controlled capacity (m tons) 101 85 65 53 54 44 Number of Countries 53 38 15 33 14 14

aEnd-of-period exchange rate used for calculations. bFor Holderbank, class B stock; for CEMEX, New CPO. cTEV defined as total enterprise value (debt plus equity). dExcluding non-cement assets for Lafarge (35%), Heidelberger (10%) and Blue Circle (25%). eFootprint defined as total capacity in which a given company has a significant stake. Sources: Annual Reports; Datastream; JP Morgan; CEMEX

❚ 6Podolny, Joel, John Roberts, Joon Han, and Andrea Hodge, 1999, “CEMEX, S.A. de C.V.: Global Competition in a Local Business,” Stanford, CA: Stanford University. ECCH #IB17.

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Case 2-2 The Globalization of CEMEX 151

resulted in shortages in some regional markets and provided an opening for European cement firms that had remained strong and were looking to ex- pand. By 2000, European groups controlled 65% of the U.S. market.

Cross-border investment in the United States had been concentrated in certain periods—most recently, 1985–1988 and 1991–1993—instead of trickling in more continuously. Such waves were characteristic of cross-border investment in other regions as well, given the cement majors’ emphasis on buying existing capacity rather than adding new capacity to enter new markets (see Exhibit 6). Obviously, acquisitions were most attractive to them when the market values of target companies were less than their underlying

Exhibit 5 Capacity Shares of the Big 6 in Selected Markets

Country Holderbank Lafarge CEMEX Heidelberger Italcementi Blue Circle

Japan 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Korea 0.0% 12.0% 0.0% 0.0% 0.0% 0.0% Taiwan 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Indonesia 0.0% 2.6% 43.7% 0.0% 0.0% 0.0% Malaysia 0.0% 6.6% 0.0% 3.9% 0.0% 46.4% Philippines 37.5% 20.5% 22.0% 0.0% 0.0% 16.7% Thailand 25.3% 0.0% 0.0% 0.0% 13.2% 0.0% India 1.4% 0.3% 0.0% 0.0% 0.0% 0.0% South Africa 36.3% 25.8% 0.0% 0.0% 0.0% 0.0% Egypt 5.4% 5.0% 16.9% 0.0% 0.0% 3.3% Greece 0.0% 0.0% 0.0% 0.0% 5.5% 58.9% Poland 0.0% 21.2% 0.0% 22.4% 0.0% 0.0% Turkey 0.0% 8.3% 0.0% 17.3% 9.2% 0.0% France 12.6% 33.9% 0.0% 26.8% 26.4% 0.0% Germany 6.6% 7.0% 0.0% 25.3% 0.0% 0.0% Italy 6.2% 5.0% 0.0% 0.0% 36.9% 0.0% Portugal 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Spain 9.9% 19.3% 26.5% 0.0% 6.6% 0.0% UK 0.0% 0.0% 0.0% 23.8% 0.0% 50.3% Canada 19.1% 32.9% 0.0% 20.4% 11.2% 13.8% US 13.5% 8.3% 1.8% 11.2% 4.6% 6.2% Argentina 37.6% 11.2% 0.0% 0.0% 0.0% 0.0% Brazil 10.0% 13.4% 0.0% 0.0% 0.0% 0.0% Mexico 19.2% 4.3% 64.6% 0.0% 0.0% 0.0% Venezuela 24.5% 23.6% 40.6% 0.0% 0.0% 0.0%

Source: CEMEX

Exhibit 6 Waves of Acquisitions

Period Region Period Region

1985–1988 U.S./ 1995–1997 Latin Canada America

1987–1990 Latin 1996–1998 E. Europe America

1989–1991 Mediter- 1998 onwards SE. Asia ranean

1991–1993 U.S. 1999 onwards W. Europe 1990–1994 E. Europe

Source: Adapted by casewriters from ING Barings, European Cement Review, February 2000.

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152 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

values—a condition more likely to be fulfilled at the bottom of the local economic cycle rather than the top. The underlying values of acquired franchises could be assessed by estimating their average prof- itability, capacity utilization, weighted average cost of capital and, probably most problematically, ex- pected long-run growth rates. See Exhibit 7 for an attempt by an investment bank to perform such cal- culations at the country level. In practice, of course, such country-level analyses had to be supplemented with target-specific considerations such as the target’s

cost position and market share, and the kind of base it afforded for further cost-reduction and expansion.

Starting in 1997 and particularly after the sum- mer of 1998, the largest and most concentrated wave of cross-border investment ever began in South East Asia. The international players had their eye on the market for many years, but had been unable to justify the entry premium—some compa- nies in the region had been valued at up to $300 per ton of capacity on an enterprise value basis! The Asian crisis that began in 1997 changed the

Exhibit 7 Market Statistics and Valuations for Selected Countriesa

Ex-plant Cash Cost EBITDA Equity Risk Price per per Ton per Ton Risk Free Premium Market WACC

Country Ton (US$) (US$) (US$) Rate (%) (%) Gearing (%) (%)

Japan 48 38 10 1.8 5.0 50.0 4.8 Korea 50 33 17 8.5 8.0 20.0 15.1 Taiwan 58 37 21 5.7 8.0 25.0 12.0 Indonesia 41 23 18 12.0 8.0 50.0 16.5 Malaysia 41 28 13 8.0 8.0 25.0 14.3 Philippines 49 34 15 14.0 8.0 50.0 18.5 Thailand 48 26 22 10.0 8.0 40.0 15.2 India 52 38 14 9.5 8.0 40.0 19.0 S. Africa 55 37 18 15.0 6.0 15.0 20.3 Egypt 53 33 20 10.0 8.0 0.0 18.0 Greece 58 30 28 6.4 6.0 20.0 11.4 Poland 38 28 10 9.5 6.0 20.0 14.5 Turkey 40 26 14 10.3 8.0 0.0 18.3 France 78 49 29 4.7 4.0 30.0 7.8 Germany 72 51 21 4.6 4.0 25.0 7.9 Italy 55 38 17 4.8 4.0 25.0 8.1 Portugal 66 40 26 4.8 5.0 10.0 9.4 Spain 64 40 24 4.8 5.0 10.0 9.4 UK 74 51 23 5.4 4.0 10.0 9.1 Argentina 62 40 22 12.0 8.0 40.0 17.2 Brazil 59 39 20 13.0 8.0 40.0 18.2 Mexico 96 40 56 12.0 8.0 50.0 16.5 Venezuela 95 35 60 15.0 8.0 20.0 21.6 Canada 67 42 25 5.5 4.0 0.0 9.5 US 69 48 21 5.7 4.0 0.0 9.7

Source: Adapted by casewriters from ING Barings, European Cement Review, February 2000, p. 29. aFranchise value represents the theoretical value of one ton of capacity (assuming all sales are made domestically). The first step in its derivation is to obtain the capital value of cash flow generated in perpetuity by one ton of production. This is calculated by taking EBITDA per ton ($) and dividing by the weighted average cost of capital. The second step is to find the ratio of domestic demand to domestic supply. Dividing the value of one ton of

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Case 2-2 The Globalization of CEMEX 153

Domestic Domestic Value/Ton Value/Ton of Value/Ton of Demand Capacity of Capacity (no Trend Growth Capacity

Demand (US$) (m tons) (m tons) growth) (US$) (%) (trended) (US$)

208 72.8 97.0 156 0.1 160 113 47.6 62.1 86 5.0 129 176 20.5 24.5 147 3.0 196 109 18.1 45.3 44 7.5 80 90 8.2 17.5 42 7.8 93 81 12.5 20.4 50 8.0 88

145 25.6 58.0 64 8.0 135 74 80.8 85.0 70 7.5 116 89 8.8 12.0 65 0.9 68

111 24.7 23.0 119 5.9 178 246 8.5 15.0 139 1.5 161 69 13.8 16.3 58 5.0 89 77 36.4 61.0 46 6.5 71

372 19.1 28.1 253 �1.5 211 268 37.0 51.0 194 1.0 221 211 35.0 52.5 141 �0.3 136 277 10.0 9.6 289 0.0 289 255 31.0 39.3 201 2.7 283 253 12.8 14.4 225 �0.2 219 128 8.2 9.5 110 3.0 134 110 40.1 45.8 96 5.0 133 339 25.7 44.0 198 2.5 233 278 4.5 8.6 145 -0.5 142 263 8.6 15.2 148 0.5 157 216 107.1 97.3 238 1.0 266

production by the ratio calculated in the second step gives the value of one ton of capacity. (The idea is that if domestic demand exceeds available supply then the value of owning capacity is greater than the value suggested by current EBITDA alone). The final step is to adjust franchise value for growth in domestic demand, trend growth, which is defined as the average of rolling averages for the previous 5, 10 and 20 years and is therefore less vulnerable to short-run fluctuations in growth rates.

situation dramatically and gave the majors the op- portunity they were waiting for. The six majors’ Asian cement deals through fall 1999 are summa- rized in Exhibit 8. They quickly increased their share of capacity in Asia, excluding China, from less than 20% to about 60%.

Of the leading international competitors in cement, two, Holderbank and Lafarge, were larger than CEMEX. Holderbank had cement operations on five continents and in more than 50 countries, making it the most global as well as the largest

international competitor. Its globalization strategy could be traced back to the early 1920s when the company (formed in 1912) first moved out of Switzerland and into neighboring France, Belgium, and the Netherlands. The company’s 1999 sales were $7,618 million and its EBIT was $1,066 million. Cement accounted for 68% of 1999 sales and concrete and aggregates for 24%.

Lafarge was ranked second in the global cement market and also had strong positions in other building such as plaster, aggregates, concrete, and gypsum.

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Exhibit 8 Cement Majors’ Asian Deals after the Asian Crisis

Price Capacity Value/Ton Country Date Stake % (US$ m) (m tons) (US$) Source

Holderbank Union Cement Philippines Jul-98 40% 210 5.8 146 A Alsons Cement Philippines Jan-99 25% 22 2.5 130 B Tengara Cement Malaysia Jun-98 70% 28 1.1 42 A Siam City Cement Thailand Aug-98 25% 153 12.3 95 A Huaxin Cement China Jan-99 23% 20 1.4 61 A Total 433 23.1 107

Lafarge Republic Cement Philippines Feb-98 14% 25 1.6 119 A Continental Cement

and South East Philippines Oct-98 100% 460 4.6 132 C Asia Cement 64%

Haifa Cement Korea Jul-99 33% 100 7.4 68 A Andalas Indonesia n/a 16% 10 1.2 D Tisco India 1999 100% 127 0.3 107 A Totala 712 13.9 109

CEMEX Rizal and Philippines Dec-97, 70% 219 2.8 166 C

Solid Cement Nov-98 Apo Cement Philippines Jan-99 100% 400 3.0 164 A Semen Gresik Indonesia mid-98 14% 115 20.1 55 A Semen Gresik Indonesia Nov-98 8% 49 20.1 56 A Semen Gresik Indonesia 1999 4% 28 20.1 58 A Total 811 25.9 109

Italcementi Jalaprathan Cement Thailand Oct-98 55% 26 1.6 58 A Asia Cement Thailand Jul-99 53% 180 4.8 131 A Total 206 6.4 112

Blue Circle Iligan Cement Corp Philippines Jul-99 95% 53 0.5 109 C Kedah Cement Malaysia Oct-98 65% 185 3.5 164 A APMC Malaysia Dec-98 50% 309 4.7 157 A Inflow from Malaysia Dec-98 65% �118 D

Minorities in Malaysian rights

Republic Cement Philippines 1998 54% 90 1.6 138 C Fortune Cement Philippines Jul-98 20% 35 1.9 114 A Fortune Cement Philippines Jan-99 31% 86 1.9 147 A Zeus Holdings Philippines Jul-98 73% 31 0.4 204 A Totalb 671 12.6 153

Sources: Adapted by casewriters from: A) CEMEX; B) SDC database, Cembureau, World Cement Directory 1996, p. 322; C) Warburg Dillon Read, Global Equity Research, The Global Cement, Aggregates and Plasterboard Analyser, September 1999, p. 230; D) Merrill Lynch, Asian Cement, December 1999, p. 5. aExcludes Andalas. Also, value/ton includes a weighting of 94% for Continental/SEACem to reflect breakdown of capacity between the companies. bIncludes inflow from minorities in Malaysian rights in total price.

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Case 2-2 The Globalization of CEMEX 155

Its 1999 sales were $10,552 million and EBIT was $1,766 million. Cement accounted for 35% of 1999 sales and concrete and aggregates for another 30%. Lafarge was not as focused on emerging markets as some of the other global players. In February 2000, it mounted a hostile bid, valued at nearly $5.5 billion, for Britain’s Blue Circle, the sixth-largest cement competitor. Motives for the deal included achieving a certain size in order to remain visible and attrac- tive to investors, expanding cashflow and, relatedly, geographic presence and, probably, dislodging Holderbank from the top spot in the global cement industry. However, by May, Lafarge had managed to attract only 44% of Blue Circle’s shares with its aggressively priced offer.

CEMEX

By the year 2000, CEMEX had become the third largest cement company in the world with approxi- mately 65 million tons of capacity (see Exhibit 9 for historical financial data). CEMEX traced its origins back to 1906 when the Cementos Hidalgo cement plant was opened, with a capacity of less than 5,000 tons per year, in northern Mexico, near Monterrey. In 1931, it was merged with Cementos Portland Monterrey, founded by Lorenzo Zambrano, to form Cementos Mexicanos, later renamed CEMEX. Over the next half-century, the company expanded its capacity to about 15 million tons, and was well on its way to becoming Mexico’s market leader by the early 1980s.

In 1985, Lorenzo Zambrano, scion of the Zambrano family that still controlled CEMEX and a grandson as well as namesake of the company’s founder, took over as CEO. In his first few years at the helm, CEMEX continued to grow by construct- ing additional cement capacity. It also began to diver- sify horizontally into areas such as petrochemicals, mining, and tourism in order to reduce the risks related to its dependence on a highly cyclical core business. However, it wasn’t long before Zambrano decided to refocus the company on cement and cement-related businesses. Based partly on the work of the Boston Consulting Group, he had concluded

that geographic diversification within the cement business was preferable to horizontal diversifica- tion outside it. All the non-core assets were eventu- ally divested and CEMEX switched to a strategy of growth through acquisitions.

This strategy focused, in the first instance, on Mexico. As Mexico began to open up in the late 1980s, large firms such as Holderbank and Lafarge viewed it as a possible market to expand their oper- ations. Faced with this threat, CEMEX decided to unify its Mexican operations. In 1987, CEMEX acquired Cementos Anahuac, giving the company access to Mexico’s central market and bolstering its export capabilities with the addition of two plants and four million tons of capacity. Two years later, the acquisition of Cementos Tolteca, Mexico’s second- largest cement producer with seven new plants and 6.6 million tons of capacity, made CEMEX Mexico’s largest producer. These mergers, which cost CEMEX nearly $1 billion, secured its position in Mexico and gave it the size and financial resources to begin the process of geographic expansion.

When the 1994/1995 peso crisis struck, CEMEX had just finished a plan for revamping its Mexican operations. In December 1994, after a year of polit- ical instability that included the assassination of a presidential candidate, Mexico’s foreign reserves dropped to about $5 billion, down from nearly $30 billion in March. Incoming President Zedillo warned his citizens to prepare for tough times. CEMEX quickly reworked its planned Mexican revamp and compressed it from 18 months to 3 months. Despite the recession that followed, it managed to maintain margins at reasonable levels. One reason was that many Mexicans did not have credit, so the self-construction part of the market was affected to only a limited extent, even though demand from the formal sector went down by 50%.7 Another was that the company had already begun to expand into foreign markets. At the start of the year 2000, CEMEX was the leader in the

❚ 7Interview with Hector Medina, Executive Vice President—Planning and Finance.

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deal with threats from particular competitors and let CEMEX study local markets and their structure at minimal cost before deciding whether to make more of a commitment to them by acquiring capac- ity locally.

After the imposition of trade sanctions by the United States, foreign direct investment had become a much more important component of CEMEX’s internationalization strategy than pure trade. CEMEX’s foreign investments focused on acquir- ing existing capacity rather than building “green- field” plants. Its major international moves are summarized in Exhibit 10 and described in more detail in the rest of this section.

The United States CEMEX had begun to export to the U.S. market in the early 1970s. In the late 1980s, it established distribution facilities in the southern United States in order to expand this effort. However, the U.S. economy and the con- struction industry in particular were experiencing a downturn. As a result, eight U.S. producers banded together to file an antidumping petition claiming that they were being harmed by low-cost Mexican

Mexican market, with an installed capacity of 28 million tons, or about 60% of the country’s total. Apasco, which Holderbank had acquired and in- vested heavily in expanding in the early 1990s, was the second largest player, with another 9 million tons of capacity. Analysts did not expect further increases in CEMEX’s share of the Mexican market.

International Expansion After having secured its leadership in Mexico, CEMEX began to look for opportunities beyond Mexico’s borders. Internation- alization began with exports, principally to the United States. By 2000, CEMEX was the largest international cement trader in the world, with projected trading volumes of 13 million tons of cement and clinker that year, 60% of which was expected to be third-party product.8 International trade offered opportunities to arbitrage price differ- entials across national boundaries and to divert low-priced imports away from one’s own markets. It also expanded the range of options available to

Case 2-2 The Globalization of CEMEX 157

❚ 8Interview with Jose L. Saenz de Miera, President of Europe-Asia Region.

Exhibit 10 Timeline of CEMEX’s International Expansion

Year Event

1985 GATT signed; CEMEX began to concentrate on cement and divests other business lines 1987 Acquired Cementos Anáhuac in Mexico 1989 Acquired Cementos Tolteca; became Mexico’s largest producer and one of ten largest worldwide 1992 Acquired Valenciana and Sanson in Spain; became world’s fifth largest cement producer 1993–1994 Acquired 0.7 mt of capacity in Jamaica, 0.4 mt in Barbados, and 0.7 mt in Trinidad & Tobago 1994 Acquired Vencemos in Venezuela, Cemento Bayano in Panama, and the Balcones plant in Texas 1995 Acquired Cementos Nacionales in the Dominican Republic 1996 Acquired a majority stake in Colombia’s Cementos Diamante and Industrias e Inversiones

Samper; became world’s third largest cement company 1997 Acquired 30% stake in Rizal Cement Company in the Philippines 1998–1999 Acquired a 20% interest in PT Semen Gresik in Indonesia; acquired an additional 40% of Rizal,

and 99.9% of APO Cement Corp, also in the Philippines 1999 Acquired Assiut in Egypt, a 12% stake in Bio Bio in Chile, and Cemento del Pacifico in

Costa Rica 2000 Announced availability of $1.175 billion for global acquisitions during the course of the year

(36% more than 1999 spending)

Source: CEMEX

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imports and demanding protection. After finding that cement prices were higher in Mexico than in the southern United States and inferring that Mexi- can producers were dumping cement in the U.S. market at artificially low prices, the U.S. Interna- tional Trade Commission (ITC) imposed a 58% countervailing duty on CEMEX’s exports from Mexico to the United States. The duty was reduced to 31% after CEMEX started limiting exports to U.S. states where prices were relatively high.9 The company tried to fight these actions before the rele- vant U.S. bodies, but this proved very difficult. Medina recalled that at one point, CEMEX was simultaneously being investigated by the ITC for artificially lowering prices and by the U.S. Federal Trade Commission for purchasing a distribution terminal with the intent of artificially raising them! A ruling by the General Agreement on Tariffs and Trade (GATT) in 1992 sided with Mexico in this dispute, but the United States refused to give way. As of early 2000, the countervailing duty was still in place, although there were also reports that the United States was finally moving closer to repealing it.

After the countervailing duty was imposed, CEMEX had acquired a 1 million ton cement plant in Texas to reinforce its ready-mix and distribution facilities in the southern United States. Zambrano sometimes referred to this constellation of facilities as a firewall protecting the Mexican market from incursions from the United States. In addition, CEMEX’s coastal terminals in the United States continued to import cement into the United States, from third parties as well as from the company’s other plants. Thus, CEMEX credited imports of Chinese cement to the west coast of the United States for doubling the profits of its activities in the United States during 1999, to the point where they accounted for 12% of CEMEX’s total sales and 7% of its EBITDA.

Spain In 1991, CEMEX built distribution termi- nals in Spain to trade cement that was produced in Mexico, and also to study the European market. In July 1992, it spent about $1.8 billion to acquire what ended up being 68% of the stock and 94% of the voting rights in two large Spanish cement com- panies, Valenciana and Sanson, with a total of nearly 12 million tons of capacity. These acquisitions yielded a market-leading 28% share in one of Europe’s largest cement markets, which then happened to be in the throes of a major boom. The acquisitions also lowered dependence on the Mexican market, gave CEMEX significant capacity in a major market for Holderbank and Lafarge, and raised its international profile. But shareholders generally took a dim view of the deals: CEMEX’s American Depositary Receipts, issued just a year earlier (another first for a Latin American com- pany), tumbled by about one-third around the dates at which the acquisitions were announced. And immediately afterwards, the Spanish economy plunged into its deepest recession in 30 years, with the Spanish peseta having to be devalued three times during late 1992 and 1993. These develop- ments added to the urgency of orchestrating major turnarounds at the two Spanish companies.

It was in this context that CEMEX began to de- velop and codify its post-merger integration process. Every aspect of the Spanish acquisitions was re- viewed, from procurement policies to the location of the mines to the use of automation. Processes were streamlined, as was the workforce (by 25%) and investments in information technology were stepped up. Simultaneously, CEMEX moved quickly to har- monize and integrate the systems for its Spanish operations with its Mexican ones. The post-merger integration process reportedly took a little more than a year, or less than one-half the amount of time originally budgeted, and was followed by major im- provements in operating margins, from 7% at the time of the acquisitions to about 20% by 1994 and an average of 25% for the second half of the 1990s. The Spanish operations turned out to be critical in helping CEMEX weather the Mexican peso crisis of 1994/1995.

158 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

❚ 9David P. Baron, “Integrated Strategy: Market and Nonmarket Components,” California Management Review, vol. 37, no. 2 (Winter 1995), pp. 51–52.

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In mid-1996, CEMEX acquired a 54% interest— subsequently increased—in Cementos Diamante, Colombia’s second-largest cement producer, for $400 million, and a 94% interest in Inversiones Samper, the third-largest producer, for $300 million. The acquisitions gave CEMEX 3.5 million tons of capacity, or a bit less than one-third of the Colombian total, behind industry leader Sindicato Antioqueño—a loose confederation of small ce- ment producers—with a share of about 50%. Weak demand topped off by a price war caused CEMEX’s operating margins in Colombia to decline from more than 20% at the beginning of 1998 to 3% by late in the year. Margins began to recover, however, during 1999.12 That year, Colombia accounted for 3–4% of CEMEX’s revenues and EBITDA.

Next, CEMEX entered Chile, paying $34 million for an 12% stake in Cementos Bio-Bio, Chile’s third- largest competitor. The largest producer in Chile was Cement Polpaico, a subsidiary of Holderbank, and the second-largest was one of Blue Circle’s sub- sidiaries. Compared to them, Bio-Bio was relatively focused on the northern and southern parts of Chile rather than on its populous middle. Elsewhere in Latin America, CEMEX acquired controlling stakes in the largest producers in Panama, the Dominican Republic, and Costa Rica.13

Other Regions Between late 1997 and early 1999, CEMEX invested in Filipino cement produc- ers Rizal (a 70% interest in 2.3 million tons of ca- pacity for $218 million) and APO (a 100% interest in 2.0 million tons of capacity for $400 million). Both Rizal and APO were close to ports and there- fore had export as well as domestic potential. The Philippines itself had been a Spanish colony in the 19th century, and was one of the first East Asian economies to experience macroeconomic pressures in the second half of the 1990s. Less than 20% of Filipino cement capacity had been controlled by foreign firms in early 1997, when there had been

In 1998, CEMEX sold its cement plant in Sevilla for $260 million. The Sevilla plant, which had ac- counted for about 10% of CEMEX’s capacity in Spain, was relatively old, and had high production costs. CEMEX remained the largest competitor in the Spanish market after the sale. It used the proceeds to invest in capacity in South East Asia, particularly Indonesia. According to its annual report for 1998, “We effectively exchanged one million metric tons of production capacity in Spain for the equivalent of approximately 4 million metric tons in Southeast Asia, a higher long-term growth market.” In 1999, Spain accounted for 16% of CEMEX’s revenues and 15% of EBITDA.

Latin America CEMEX’s next major interna- tional move was entry into Venezuela, which initiated a broader series of engagements in Latin America, mostly around the Caribbean Basin. Venezuela had been wracked by macroeconomic instability since the late 1980s, depressing demand for cement and forcing large losses on the industry. In April 1994, CEMEX paid $360 million for a 61% stake in in- dustry leader Vencemos, which operated about 4 million tons of capacity, or about 40% of the Venezuelan total. Virtually all remaining Venezue- lan capacity ended up in the hands of Holderbank and Lafarge. As in Spain, CEMEX moved quickly to integrate and improve the efficiency of its Venezuelan operations. Vencemos’ operating mar- gin improved from 9% in the third quarter of 1994 to 41% a year later,10 and stood at 34% in 1998.11

Although the Venezuelan economy had continued to disappoint, Vencemos was able to keep capacity utilization high even when domestic demand was low because it was located near a major port facility. This permitted it to export surplus production to places such as the Caribbean islands and the southern United States. In 1998, Venezuela accounted for 12% of CEMEX’s revenues and 13% of EBITDA. Earnings were down in 1999, however.

Case 2-2 The Globalization of CEMEX 159

❚ 10“Global Invasion,” International Cement Review, Jan. 2000, p. 35. ❚ 11Company fact book.

❚ 12International Cement Review, January 2000, pp. 35–36. ❚ 13Ibid., p. 36.

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nearly 20 producers and a supply shortage as the re- sult of a decade in which demand had grown at about 10% per year.14 But the Filipino market just as large capacity additions by domestic competitors were coming on line. This gave international com- petitors their opening. CEMEX ended up control- ling about 22% of Filipino cement capacity, well behind Holderbank but slightly ahead of Lafarge and Blue Circle. In 1999, the Philippines accounted for 2.5% of CEMEX’s revenues and approximately one-half that percentage of its EBITDA.

Indonesia was the other Southeast Asian market in which CEMEX had established a presence: in September 1998, it paid $115 million for a 14% stake in Semen Gresik, Indonesia’s largest cement com- pany with 17 million tons of capacity, and considered by many to be its most efficient. Originally, 35% of the company was supposed to have been sold (out of a total of 65% held by the Indonesian govern- ment), but public protests reduced the number of shares offered. By 2000, CEMEX had increased its stake to 25% by spending another $77 million, but continued to have the Indonesian state as a major partner. The political and economic environment in Indonesia remained fluid, and further negotiations to buy out more of the government’s stake were complicated by weakened institutions and the turnover of officials as well as by continued public opposition. In addition, excess capacity of almost 20 million tons—the largest such amount in the region—needed to be restructured. Still, the Indonesian market had significant long-run poten- tial, not least because its population numbered 220 million (three times that of the Philippines). As the dollar value of the Indonesian rupiah collapsed, the dollar price of cement in the local market had decreased from about $65 per ton in early 1997 to less than $20 per ton in 1998, before starting to re- cover in 1999. As part of its investment in Semen Gresik, CEMEX had also entered into export commitments, which it intended to fulfill in part by setting up a grinding mill in Bangladesh to receive and process shipments of clinker from Indonesia.

In November 1999, CEMEX acquired a 77% stake in Assiut Cement Company, the largest cement producer in Egypt with about 4 million tons in capac- ity, for a total of about $370 million. In May 2000, CEMEX announced plans to invest in expanding Assiut’s capacity to 5 million tons, and to add 1.5 million tons of capacity in a new Egyptian fa- cility. These plans catered to the Egyptian govern- ment’s interest in increasing domestic production of cement to help meet demand that had been growing at an average annual rate of 11% since 1995. But the Egyptian market remained fragmented—Assiut accounted for only 17% of it—and the Egyptian regulatory context cumbersome.

The Future In May 2000, CEMEX announced that it had accumulated $1.175 billion to spend on global acquisitions. China was an obvious target because of the size of its market, variously pegged at about half a billion tons by official estimates and closer to half that according to independent ana- lysts.15 However, approximately 75% of Chinese production took place in small, technologically ob- solete kilns owned by local authorities and not run on a commercial basis. Even after discounting op- portunities in China, the bulk of the capacity that might be consolidated by the six major international competitors was located in emerging markets, par- ticularly in Asia and Africa/the Middle East (see Exhibit 11). CEMEX was thought likely to enter India, where it thought the restructuring process was farther advanced, before China. Indian demand amounted to about 100 million tons, or more than three times Mexico’s, and was served by 28 com- petitors, the eight largest of which combined to ac- count for two-thirds of total demand. Holderbank and Lafarge already had a degree of presence there. In Latin America, CEMEX had its eye on Brazil, although it was unwilling to pay prices for acquisi- tions that, at $250 or more per ton, exceeded its capacity valuations. In May 2000, the company announced that it was negotiating with the Portuguese government over a 10% stake in Cimentos de

160 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

❚ 14International Cement Review, January 2000, p. 37. ❚ 15ING Barings, European Cement Review, February 2000, p. 40.

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the market or at least control 25% of it. These con- siderations tended to favor opportunities in emerg- ing countries. Quantitative factors were assigned a 65% weight in country analysis, and qualitative factors, such as political risk, a weight of 35%. The analysis was complicated by the fact that CEMEX looked at countries in a regional context rather than as independent markets and was particularly inter- ested in the Caribbean Basin, South East Asia, and the Mediterranean. According to CFO Rodrigo Treviño, “We now have a very balanced and well- diversified portfolio and we can afford to be more selective.”16

If detailed market analysis was the top-down component of the process for identifying opportu- nities, the process of identifying target companies constituted its bottom-up component. CEMEX’s conceptual framework for looking at targets is sum- marized in Exhibit 12. CEMEX pursued control- ling stakes—often as close to 100% as possible—in

Portugal (Cimpor), that country’s largest cement maker. Such a deal might permit consolidation of operations around the Mediterranean as well as giv- ing CEMEX access to Brazil and some African markets. Holderbank and Lafarge were reportedly also interested.

The Expansion Process As CEMEX moved to more distant markets, the various stages in the ex- pansion process—opportunity identification, due diligence, and post-merger integration—became more formalized and greater attempts were made to standardize them, reflecting past experiences.

Opportunity Identification While the logic of expanding to the U.S., Spain, and, in particular, Latin America, had been relatively obvious, CEMEX had had to develop better tools for screen- ing opportunities as it ventured farther afield. CEMEX looked at several factors in deciding whether to invest in other countries. A country had to have a large population and high population growth as well as a relatively low level of current consumption. In addition, CEMEX wanted to lead

Case 2-2 The Globalization of CEMEX 161

Exhibit 11 Capacity Consolidation Potential (millions of tons)

China

Rest of the world

1964

489

1377

Total Capacity Top 6 Capacity Developed Markets

Emerging Markets

241

647

Europe

27%

40%

23%

10%

Asia*

*Excluding China

Latin America & Caribbean

Africa/ Middle East588

Source: CEMEX

❚ 16Tim Duffy, “CEMEX’s CFO: Still Eying International Markets for Diversification,” Dow Jones International News, March 7, 2000.

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the companies that it bought into, in order to maxi- mize flexibility. When identifying a possible acqui- sition target, CEMEX also examined the potential for restructuring both the target company and the market as a whole. Restructuring the target com- pany meant increasing its efficiency and optimizing capacity utilization. Restructuring the market might involve reductions in the number of players or volume of imports, moves toward rational pric- ing, fragmentation of distribution channels, product differentiation and other attempts to get closer to the customer. Speed in both respects was very im- portant to improving target valuations.

Due Diligence After a target was identified, a process of due diligence was performed whereby it was assessed in depth by a team of people. In 1999, about 20 processes of due diligence were under- taken, resulting in three acquisitions. The due dili- gence process typically lasted one to two weeks and involved about ten people per team, half of whom usually had prior experience with the process. Once a team was formed, it was briefed on the target company and given a standardized methodology to

follow in assessing it. Negotiations with the gov- ernment usually continued through the due dili- gence process, and meetings with local competitors and industry associations were often held as well to allay any concerns about the acquisition. The final output from the due diligence process was a stan- dardized report, to be presented to the Executive Vice President of Planning and Finance, Hector Medina, that was critical in pricing deals. Only rarely, however, would CEMEX bid prices that exceeded top-down estimates of the value of capacity in particular markets (as illustrated in Exhibit 7).

Especially in Southeast Asia, CEMEX had re- cently found itself looking at the same targets as other international cement companies. CEMEX believed that its due diligence process was more specific and systematic. To cite just one example, the human re- sources component of its process looked at the age, education, and average years of service of the target’s employees, and at labor union affiliations, govern- ment involvement, and relationship to the community in order to estimate the optimal number of employees and recommend strategies for moving towards those targets. Other issues related to human resources,

162 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Exhibit 12 Framework for Acquisition Analyses

1. Attractiveness profile 2. Transaction feasibility

• Ownership structure

• Financial resources

• Regulatory/legal

• PMI feasibility

– Cultural fit

– Organization

– Management resourcesStrategic fit to CEMEX • Business portfolio • Operations overlap • Risk-return profile

Potential targets

Low interestP

ot en

tia l u

ps id

e

High

High

Low

Low

Source: CEMEX

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was over. CEMEX also viewed the PMI process as a vehicle for continuous improvement in existing operations. Thus, every two or three years, a PMI process was performed on CEMEX’s Mexican operations, which were looked at as if they had just been acquired.

Management As CEMEX expanded internation- ally, other broad aspects of its management changed as well. Geographic diversification had reduced earn- ings volatility: thus, over 1994–1997, the standard deviation of quarterly cash flow margins averaged 7.1% for CEMEX as a whole, compared to 9.5% for Mexico, 12% for Spain, 22% for the U.S., and 30% for Venezuela. Financing, nevertheless loomed large as an issue because of the asset-intensity of the international acquisition strategy, which included not only paying for equity but also the assumption of significant debt and incurral of large investments in modernization—up to 50% of purchase prices in some cases. While high costs of capital had always been a major issue for Mexican companies, the sit- uation was exacerbated by the peso crisis, which simultaneously raised domestic interest rates and restricted the extent to which Mexican cashflows could be used to finance foreign direct investment (because of the 70% devaluation of the peso against the U.S. dollar). CEMEX responded by folding the ownership of its non-Mexican assets into its Span- ish operations and financing new acquisitions through the latter. This was several hundred basis points cheaper for CEMEX, partly because Spain had an investment-grade sovereign rating, and partly because all interest expenses were tax-deductible in Spain (compared to just real interest expenses in Mexico). Consolidating its bank debt through the Spanish operations in 1996 was estimated to have saved CEMEX about $100 million per year in interest costs, and to have better matched dollar-linked assets and its principally dollar- denominated debt.17

such as training programs and organizational re- structuring, were also covered. Such thoroughness was thought to reduce the possibility of unpleasant surprises down the road, and to speed up the post- merger integration process if an acquisition was, in fact, undertaken. The process methodology was re- vised every six months to reflect recent experiences.

Post-Merger Integration (PMI) Process Once the decision to proceed with an acquisition was made, CEMEX formed a PMI team. The purpose was to improve the efficiency of the newly obtained operation and adapt it to CEMEX’s standards and culture. PMI teams had become more diverse and multinational over time. The PMI process took any- where from six months to a year, during which team members kept their original positions and salaries, returning home one week in every six. At the beginning of the process, the team was briefed on the country and methodology, and attended cultural awareness and teambuilding workshops. The process itself had a monthly cadence: the regional director visited every month, the country president of the new operation reported to headquarters in Monterrey every month in the same format as the other CEMEX country presidents, and CEO Zambrano, the regional directors and all the country presidents met every month in Monterrey or, occasionally, New York or Madrid.

The PMI process involved integration at three levels: the improvement of the situation at the plant acquired, the sharing or replication of basic manage- ment principles, and the harmonization of cultural beliefs. CEMEX tried to send in a PMI team as soon after an acquisition as possible and, while there were differences in terms of how quickly and to what ex- tent the team tried to take charge, regarded itself as moving much more quickly in this respect than its leading international competitors. Integration almost always involved substantial manpower reductions, most of which were concentrated within the first six months. But the PMI team also tried to discover whom to retain or promote to managerial positions. It was possible for as many as half the members of a PMI team to stay on as expatriates after the process

Case 2-2 The Globalization of CEMEX 163

❚ 17CEMEX 1997 Annual Report, and International Cement Review, December 1999, p. 40.

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CEMEX’s net debt amounted to $4.8 billion at the end of 1999, leaving it relatively close to the 55% limit on debt-to-total-capital that was specified in bank covenants. The company had managed, how- ever, to satisfy the cap on leverage and the floor on in- terest coverage that it had set for itself more than one year ahead of schedule, and further strengthening of capital structure had been promised. CEMEX had also tried to broaden its sources of capital. In 1998, it sold its plant in Sevilla, as described above. In early 1999, it partnered with AIG, the insurance company, and the private equity arm of the Government of Sin- gapore Investment Corporation, among others, to set up a fund of up to $1.2 billion to invest in some of the cement assets it was acquiring in Asia. In September 1999, CEMEX listed and started to trade on the New York Stock Exchange. And while no new shares were offered in conjunction with that listing, the company issued $500 million of warrants later on in the year.

CEMEX also continued to distinguish itself by the intent of its emphasis on emerging markets, even though some of its competitors had moved in the same direction. The company calculated that the weighted average growth rate in cement demand in the countries in which it was present was close to 4%, compared to 3% for Holderbank and Lafarge and 2% for the three other international majors. CEMEX also thought that its emerging market business should command higher price-earnings ratios in cement than business in advanced markets—the reverse of the situation that prevailed. According to CEO Lorenzo Zambrano, “They assign us the ratios of developing-country companies, even though we have very little volatility and our risk is limited due to our geographical diversification.”18

Despite the increasing number of countries in which CEMEX participated, Mexico continued to play a critical role in its strategy as a lab for devel- oping, testing, and refining new ideas about how to compete in emerging markets. Thus, in addition to reinforcing CEMEX’s skills at handling macroeco- nomic fluctuations, the peso crisis had led to the discovery of a distinct customer segment involving

informal construction that demanded bagged ce- ment through retail channels, exhibited less cycli- cality than the formal construction sector, and was apparently ubiquitous in emerging markets. Such demand lent itself to branding and promotion, which CEMEX first worked out in Mexico, before rolling out marketing campaigns to other countries. Another example was provided by the idea of using global positioning satellites to link dispatchers, truckers, and customers in a system that could track deliveries and guarantee them to within 20 minutes, rather than the usual three-hours-plus. This idea originated with visits to Federal Express in Mem- phis and an emergency call center in Houston and required the assistance of consultants from the U.S. in using complexity theory to model cement deliv- ery logistics. The innovation was, once again, first implemented in Mexico, aided by imaginative ad- vertising comparing the speeds of cement and pizza delivery. Customer willingness-to-pay went up while fuel, maintenance, and payroll costs came down.

CEMEX’s organizational arrangements also dif- fered in important ways from its competitors’. One key difference was that country-level managers at CEMEX reported directly to regional directors whereas competitors often had an extra layer of area managers between regional and country managers. CEMEX plants were organized into 7–9 departments, each with its own vice president. Every month, the vice presidents reported to the country president and the regional manager during the latter’s visit. The reports covered all aspects of the plants and used a standardized format. In addi- tion, the country presidents, regional directors, CEO Zambrano, and his executive committee all met every month as well. Other global competitors might hold such meetings as infrequently as once a quarter and tended to be more decentralized in their decision- making. CEMEX had recently reorganized from a structure with a Mexican division and an interna- tional one to a structure with three regional divi- sions: North America, South America and the Caribbean, and Europe and Asia. Also, while it re- sisted setting up full-fledged regional offices, it had made some recent attempts to coordinate more for- mally across different countries within a region. For

164 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

❚ 18James F. Smith, “Making Cement a Household Word,” Los Angeles Times, January 16, 2000, p. C1.

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site delivery guarantee, already described, was a very visible example that led to the company’s being canonized as a master of “digital business design.”19

The company was also connected via the Internet to distributors and suppliers. More recently, it had an- nounced plans to launch a Latin American e-business development accelerator and, in alliance with B2B specialist Ariba and three large Latin American companies (Alfa of Mexico, and Bradespar and Vo- torantim of Brazil), a neutral business-to-business integrated supplier exchange, Latinexus, that was supposed to become the leading e-procurement marketplace in Latin America. Within CEMEX, IT made an enormous amount of information became available to Zambrano and his top management. Sales figures were reported daily, broken out by prod- uct and geography. On the production side, various operating metrics were available kiln by kiln. Even emissions data were included. And information flowed sideways as well as upwards: country man- agers could view data from other countries, and kiln managers were able to look at other kilns.

CEMEX provided its employees with a number of IT training programs and had also been aggressive in using new technology to overhaul its training function. A private satellite TV channel was acquired for this purpose, and CEMEX developed a virtual MBA program in collaboration with Monterrey Tech that combined satellite TV, the Internet, and the uni- versity’s network of campuses to deliver courses to executive (part-time) MBA students. Recruitment was greatly aided by the company’s public profile and included not only the graduates of Mexico’s top educational institutions, but also Mexican graduates of top foreign business schools and alumni of other leading firms. Thus, while the Boston Consulting Group had long been CEMEX’s principal strategy consultant, more than one of the professionals in the company’s strategic planning function was a McKin- sey alumnus. Overall, many regarded CEMEX as having shifted over time from an engineering-driven approach to one more dependent on economics.

example, it had consolidated the administrative and financial functions for six countries in the South American and Caribbean region in Venezuela.

At the apex of this structure sat CEMEX’s CEO, Lorenzo Zambrano. Zambrano had begun working at CEMEX during the summers in the early 1960s while he was a teenager attending nearby ITESM (Monterrey Tech), and had returned to the company after earning his MBA from Stanford University in 1968. Lorenzo Zambrano favored a very hands-on approach to running CEMEX, often checking kiln statistics and sales data on a daily basis. He was a bachelor who devoted the vast majority of his time to the company, and encouraged his subordinates to do the same. He also got personally involved in sending and receiving e-mail and using Lotus Notes, which was still unusual among local CEOs.

Zambrano’s personal commitment to information technology mirrored CEMEX’s early and consistent use of IT. When Zambrano took over as CEO in the mid-1980s, heavy investments in IT in Mexico seemed to be overruled by the country’s weak telecom infrastructure. Zambrano was convinced, however, that the importance of using IT to increase productiv- ity would become more apparent as the Mexican economy opened up, and that the optimal private response to the disabilities of Mexico’s public infra- structure was to invest more rather than less in this area. In 1987, CEMEX created a satellite system to link the Mexican plants it had begun to acquire. In 1988, the company transferred internal voice and data communications to its own private network. The Spanish acquisitions were also connected immedi- ately to each other as well as to the Mexican opera- tions. In 1992, the company founded Cemtec, which was supposed to complement the company’s IT de- partment by performing the functions of software de- velopment and hardware installation, and which was eventually spun off. In 1987, CEMEX spent about 0.25% of its sales on IT; by 1999, this figure had in- creased to about 1%. CEMEX’s competitors were considered slower at capitalizing on the possibilities afforded by IT, although they were moving in the same direction.

CEMEX’s use of IT had transformed the way the company worked in numerous ways. The 20-minute

Case 2-2 The Globalization of CEMEX 165

❚ 19Adrian J. Slywotzky and David J. Morrison, with Ted Moser, Kevin A. Mundt, and James A. Quella, Profit Patterns: 30 Ways to Anticipate and Profit from Strategic Forces Reshaping Your Business, New York: Times Business/Random House, April 1999.

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recalls began to severely erode the confidence of U.S. consumers in Chinese-made goods. On July 30, 2007, the senior executive team of Mattel under the leadership of Bob Eckert, CEO received reports that the surface paint on the Sarge Cars made in China contained lead in excess of U.S. federal reg- ulations.2 It was certainly not good news for Mattel, which was about to recall 967,000 Chinese-made children’s character toys such as Dora, Elmo, and Big Bird, because of excess lead in the paint. Not surprisingly, the decision ahead was not only about whether to recall the Sarge Cars and other toys that might be unsafe, but also how to deal with the recall situation.

Toy Industry—Overview

The global toy market was estimated to be a $71 billion business in 2007—an increase of about six per cent over the previous year.3 About 36 per cent

Jay Leno aptly reflected the mood of U.S. con- sumers during the summer of 2007. Many Chinese- made goods such as pet food, toothpaste, seafood, and tires had been recalled in recent weeks. These

Outlook While CEMEX faced a number of is- sues in 2000, perhaps the most important one concerned how far its competitive advantage could travel. CEMEX’s entry into Indonesia and Egypt, in particular, stirred some concerns about the difficulties of working across language barri- ers and the challenges of adapting to different cultures—such as incorporating prayer-breaks into continuous process operations in Muslim countries. Others, however, were more optimistic,

pointing out that CEMEX already used English as its semiofficial language, arguing that cement it- self was a language of sorts, and noting that the company had its own strong culture that could serve as a binder. And everybody recognized that while Lafarge’s hostile bid for Blue Circle ap- peared to have failed, consolidation at a new level—of international competitors rather than by them—might be the next big dynamic in the cement industry.

166 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Case 2-3 Mattel and the Toy Recalls (A)1

Hari Bapuji and Paul Beamish

It’s sad to say that the most safe product coming out of China these days is fireworks.

—Jay Leno, U.S. Talk Show Host

❚ Proffessors Hari Bapuji and Paul Beamish wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality.

Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. This material is not covered under authorization from any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208, fax (519) 661-3882, email [email protected]

❚ Copyright © 2008, Ivey Management Services

❚ 1This case has been written on the basis of published sources. Consequently, the interpretations and perspectives presented are not necessarily those of Mattel and other organizations represented in this case or any of their employees.

❚ 2Mattel, Inc.’s communication (dated September 5, 2007) to the Subcommittee on Commerce, Trade and Consumer Protection. ❚ 3Source: International Council of Toy Industries and NPD.

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leaders were Mattel and Hasbro, whose combined sales in 2006 were about US$8.7 billion. The sales of many other major players were under a billion dollars. Exhibit 1 contains key financial data of some major U.S. toy makers.

Big retailers like Wal-Mart and Target had be- come major players in the U.S. toy market. They not only sold the products of other toy companies such as Mattel, Hasbro, and Lego, but also sourced toys directly from China. These toys were often sold under their own brand names. For example, Wal-Mart sold toys under its Kid-Connection brand while Target sold toys under its PlayWonder brand.6 It was esti- mated that Wal-Mart accounted for about 25 per cent of the toy sales in the United States.7 As a result of the entry of big-box retailers in the toy industry, specialty toy retailers such as Toys’R’Us had steadily lost market share.8 The top five retailers sold

of the global market was concentrated in North America (about $24 billion), but annual sales in this region were growing at a slower pace—about one per cent. European markets accounted for about 30 per cent of the global toy sales and were growing at about five per cent each year. In contrast, the markets in Asia grew at 12 per cent in 2006, and were expected to grow by 25 per cent in 2007.4 A large part of this growth was expected to occur in China and India, whose burgeoning middle-classes were thriving on the double-digit economic growth in their countries.

The toy industry in the United States had a large number of players. About 880 companies operated in the dolls, toys, and games manufacturing industry in 2002. This figure was about 10 per cent less than the 1,019 companies that operated in 1997. Approx- imately 70 per cent of the toy companies employed less than 20 persons.5 The industry was dominated by a few key players such as Mattel, Hasbro, RC2, JAAKS Pacific, Marvel, and Lego. The industry

Case 2-3 Mattel and the Toy Recalls (A) 167

❚ 4Ibid. ❚ 5Source: U.S. Census Bureau.

❚ 6Doug Desjardins. Target to leapfrog over Toys ‘R’ Us into no. 2 spot. Retailing Today. 2006. 45(7):36. ❚ 7Allan Drury. Concerns about China-made toys hurt holiday sales. The Journal News, January, 2008. ❚ 8Kelly Nolan. Toys ‘R’ Us not playing games with success. Retailing Today. Sep 10, 2007. Vol. 46, Iss. 13; p. 24.

Exhibit 1 Key Financial Data of Toy Majors (All figures in thousands of U.S. dollars, except number of employees)

Mattel Hasbro RC2 JAAKS Pacific

2006 2005 2006 2005 2006 2005 2006 2005

Sales 5650156 5179016 3151481 3087627 518829 504445 765386 661536 Net Profits 592927 417019 230055 212075 34094 53130 72375 63493 Total Assets 4955884 4372313 3096905 3301143 614640 629736 881894 753955 Debt/Liabilities 940390 807395 494917 528389 22438 82647 98000 98000 Stockholder Equity 2432974 2101733 1537890 1723476 451926 398951 609288 524651 R & D Expenses 173514 182015 171358 150586 N.A. N.A. N.A. N.A. Marketing/Advertising 650975 629115 368996 366371 N.A. N.A. N.A. N.A.

and Promotion Number of employees 32000 N.A. 5800 N.A. 821 842 N.A. N.A.

(worldwide) Property, Plant & Equipment 536749 547104 181726 164045 38991 47039 16883 12695 Capital Expenditure 314784 82191 83604 120671 8319 6643 121914 9467

Source: Company Annual Reports

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about 60 per cent of all the toys sold in the United States.9

Toy markets in the United States were catego- rized into multiple segments such as Action Fig- ures & Accessories, Arts & Crafts, Building Sets, Dolls, Games/Puzzles, Infant/Preschool Toys, Youth Electronics, Outdoor & Sports Toys, and Plush Vehicles. Of these, the infant/preschool toy segment was the largest, followed by outdoor and sport toys, and dolls. These segments had largely remained stagnant over the years. As a result of kids getting old younger (KGOY), the only seg- ment with noticeable growth was youth electron- ics. By contrast, video games which were outside the traditional toy industry had been experiencing remarkable growth. For segment-wise sales of toys in the United States, see Exhibit 2.

While the major markets for toys existed in the United States and Europe, production was concen- trated in Asia, primarily China. About 60 per cent of the toys sold in the world were made in China. More than 10,500 toy makers operated in China.10

168 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

❚ 9Lazich, Robert S. Market Share Reporter. Farmington Hills, MI: Gale Group, 2004. ❚ 10David Barboza. “China Bars Two Companies From Exporting Toys.” New York Times. Aug. 10, 2007.

Exhibit 2 U.S. Toy Sales by Product Category (All figures in billion USD)

Product Category 2006 2005

Action Figures & Accessories 1.3 1.4 Arts & Crafts 2.6 2.5 Building Sets 0.67 0.68 Dolls 2.7 2.7 Games/Puzzles 2.4 2.5 Infant/Preschool 3.2 3.2 Youth Electronics 1.1 0.91 Outdoor & Sports Toys 2.9 2.9 Plush 1.3 1.4 Vehicles 2.1 2.0 All Other Toys 2.0 2.1 Total (Traditional Toy Industry) 22.3 22.2 Total Video Games 12.5 10.5

Source: Toy Industry Association/NPD Group.

❚ 11Toy industry outlook 2006 http://www.ita.doc.gov/td/ocg/ outlook06_toys.pdf ❚ 12Ibid.

These companies typically had contacts with large Western toy companies. The toy companies in China formed a complex web of supply chains, with contractors themselves sub-contracting pro- duction of components, and often, entire products to various companies.

Toy Production in China

Over the years, U.S. toy companies shifted their production overseas and focused their domestic op- erations on product design, marketing, research and development, and other high-value activities. As a result, employment in the domestic toy industry de- clined from 42,300 workers in 1993, to 17,400 workers in 2005, while toy imports increased.11 Ap- proximately 10 per cent of the demand for toys in the U.S. market was met by domestic production, while the rest was met through imports, primarily from China (see Exhibit 3).12

Chinese toy imports accounted for a full 86 per cent of toy imports to the United States in 2006, up dramatically from 41 per cent in 1992. The rise of China came at the expense of other toy exporting countries, whose combined share of toy imports to the United States plummeted from 59 per cent to 14 per cent during the same period. For instance, Japan remained a strong exporter of toys to the United States until a substantial drop around 2001. Despite its proximity to the United States, Mexico had not been able to sustain the up-tick it experienced in 2002. Further, Taiwan and Hong Kong toy exports had both been in decline for over a decade.

China’s rising share of U.S. toy imports, and more generally China’s position in the global toy industry, can be attributed to the lower cost business environ- ment in China. China had attracted tremendous foreign direct investment and outsourcing of manu- facturing operations. While analysts have often pointed to the phenomenal economic growth in China, they have also noted the resultant pressure

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Toy Safety

The safety of consumer goods in the United States is managed by four federal agencies: (i) the Food and Drug Administration (FDA) has jurisdiction over foods, drugs and cosmetics, (ii) the Depart- ment of Transportation oversees the safety of cars, trucks, motorcycles, and their accessories such as tires and car seats, (iii) the Department of Treasury has jurisdiction over alcohol, tobacco and firearms, and (iv) the U.S. Consumer Product Safety Com- mission (CPSC) has jurisdiction over about 15,000 types of consumer products, from microwave ovens to cribs to lawn mowers.15

The safety of toys and other children’s products falls within the jurisdiction of CPSC, which was created in 1972 by Congress in the Consumer Prod- uct Safety Act to “protect the public against unrea- sonable risks of injuries and deaths associated with consumer products.” In 2007, the CPSC had an operating budget of $66 million and a staff of 393 full-time equivalent employees. Its strategic goals

on the physical, technical, and human resource in- frastructures.13 These pressures, some analysts argue, have resulted in the Chinese manufacturers compromising on the product safety.

According to American regulators, tainted pet food imported from China was responsible for deaths of, or injuries to, about 4,000 cats and dogs. As a result, regulators initiated the biggest pet food recall in U.S. history. This was followed by world- wide recalls of Chinese toothpaste laced with anti- freeze called diethylene glycol, which was found to be responsible for nearly 200 deaths in Haiti and Panama. Shortly thereafter, Chinese-made tires were linked to two deaths in an accident in the United States and recalled. The tires lacked a safety feature that prevented tire treads from splitting and falling apart.14 The spate of recalls of Chinese- made goods began to erode consumer confidence in products made in China.

Case 2-3 Mattel and the Toy Recalls (A) 169

Exhibit 3 U.S. Toy Imports–Total Vs. China (1989–2006)

19 89

30

25

20

15

10

5

0

19 90

19 91

Total U.S. Imports

19 92

Year

U .S

. $ B

ill io

n s

19 93

19 94

19 95

19 96

19 97

19 98

19 99

20 00

20 01

20 02

20 03

20 04

20 05

20 06

U.S. Imports from China

Source: Bapuji H, Beamish P, Laplume A. 2007. Toy import and recall levels: Is there a connection? Asia Pacific Foundation of Canada: Vancouver, Canada.

❚ 13Paul Beamish. “The High Cost of Cheap Chinese Labor.” Harvard Business Review. June: 23, 2006. ❚ 14David Barboza. “China Steps up its Safety Efforts.” New York Times, July 7, 2007. ❚ 15Source: CPSC.

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for the year were to reduce deaths and injuries by fire hazards, carbon monoxide poisoning hazard, and hazards from children’s products.16 According to CPSC, 22 toy-related deaths and an estimated 220,500 toy-related injuries occurred in 2006.17

Based on its analysis, CPSC identified the Top Five Hidden Home Hazards. These hazards were listed on the CPSC website to make consumers aware of the hazards and avoid injuries due to those. In 2007, CPSC listed the following as the top hazards: mag- nets, recalled products, tip-overs, windows and covering, pool and spa drains.

The CPSC collects information about product safety issues from sources such as hospitals, doc- tors, newspaper reports, industry reports, consumer complaints, investigations conducted by its staff, and reports from companies. When a company becomes aware of hazards associated with the products it sold, it is required by law to immediately inform the CPSC. Based on the information it received, CPSC worked in coordination with the companies involved to recall the hazardous products from the market. Exhibit 4 presents the number of toy recalls made by CPSC since 1988. Not surprisingly, the majority of recalls in recent years involved toys made in China. See Exhibit 5 for a list of the toys recalled in the United States since the beginning of 2007. All the toys recalled, with one exception, were made in China. Seven of the recalls were a result of excess lead in the surface paint of the toys.

Lead in children’s products poses a serious hazard because exposure to lead can affect almost every organ and system in the human body. Children ex- posed to high levels of lead can suffer from damage such as IQ deficits, attention deficit hyperactivity disorder, motor skills, and reaction time. Considering the damages that lead can cause to humans, particu- larly children, the U.S. government limited the per- missible amount of lead in products. Under the Consumer Safety Product Act 1972, lead in products accessible to children should not be greater than

600 parts per million (ppm). The standards for per- missible lead in other products vary depending on the usage and amount of lead in the product that is accessible.

Although lead use is banned or restricted in many developed countries, the same is not true for devel- oping countries. In developed countries, the only source of lead exposure to children is from paint. In contrast, lead exposure in developing countries oc- curs due to lead gasoline, ceramics, mining, batteries, and even medication and cosmetics. Manufacturers use paint with a high percentage of lead because it is highly resistant to corrosion, extremely malleable, and has poor electrical conductivity. In addition, paint with higher lead is heavy and bright, making the products such as jewelry more appealing to consumers.

170 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Exhibit 4 Toy Recalls by CPSC (1988–2006)

Recalls of Toys

Total Number Made in China

Year of Toy Recalls Number Percentage

1988 32 2 6 1989 54 5 9 1990 34 6 18 1991 36 14 39 1992 25 10 40 1993 19 5 26 1994 31 19 61 1995 25 11 44 1996 22 9 41 1997 26 9 35 1998 30 12 40 1999 23 4 17 2000 37 20 54 2001 43 21 49 2002 34 16 47 2003 35 20 57 2004 30 22 73 2005 35 29 83 2006 41 33 80

Source: Bapuji H., Laplume A. 2008. Toy Recalls and China: One Year Later. Asia Pacific Foundation of Canada: Vancouver, Canada.

❚ 16CPSC. Performance and accountability report. 2007. http://www .cpsc.gov/cpscpub/pubs/reports/2007par.pdf ❚ 17CPSC. Toy related deaths and injuries. 2006. http://www.cpsc.gov/ library/toymemo06.pdf

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Case 2-3 Mattel and the Toy Recalls (A) 171

Exhibit 5 Toy Recalls in the United States (January 2007–July 24, 2007)

1. Risk of Explosion and Hearing Damage Prompts Recall of Remote Control Airplanes (July 24) 2. New Easy-Bake Oven Recall Following Partial Finger Amputation; Consumers Urged to Return Toy Ovens (July 19) 3. AAFES Expands Recall of “Soldier Bear” Toy Sets Due to Lead Poisoning Hazard (July 18)—Made in Hong Kong 4. Serious Intestinal Injury Prompts Kipp Brothers Recall of Mag Stix Magnetic Building Sets (July 5) 5. Infantino Recalls Children’s Toy Castles Due to Choking Hazard (July 3) 6. Target Recalls Toy Barbeque Grills Due to Laceration Hazard (June 28) 7. RC2 Corp. Recalls Various Thomas & Friends™ Wooden Railway Toys Due to Lead Poisoning Hazard (June 13) 8. Gemmy Industries Corp. Recalls Flashing Eyeball Toys Due to Chemical Hazard (June 7) 9. Toy Drums Recalled by The Boyds Collection Ltd. Due to Lead Poisoning Hazard (May 30)

10. AAFES Recalls “Soldier Bear” Toy Sets Due to Lead Poisoning Hazard (May 23)—Made in Hong Kong 11. Tri-Star International Recalls Children’s Toys Due to Choking Hazard (May 23) 12. Bookspan Recalls Discovery Bunny Books Due to Choking Hazard (May 17) 13. Bookspan Recalls Clip-on Baby Books Due to Choking Hazard (May 17) 14. Small World Toys Recalls Children’s Take-Apart Townhouse Toys; Detached Magnets Pose Aspiration and

Intestinal Hazards (May 3) 15. Battat Inc. Recalls Parents® Magazine Toy Cell Phones for Choking Hazard (May 3) 16. Graco Children’s Products Recalls to Replace Soft Blocks Towers on Activity Centers Due to Choking

Hazard (May 2) 17. Target Recalls Anima Bamboo Collection Games Due to Lead Poisoning Hazard (May 2) 18. Magnetix Magnetic Building Set Recall Expanded (April 19) 19. Small World Toys Recalls Children’s Wooden Sound Puzzles with Knobs for Choking Hazard (April 11) 20. Target Recalls Activity Cart Toys Due to Choking Hazard (April 4) 21. OKK Trading Recalls Baby Dolls Due to Choking Hazard (April 4) 22. Regent Products Corp. Recalls Stuffed Ball Toys Due to Lead Hazard (March 28) 23. Estes-Cox Radio Control Airplanes with Lithium Polymer Batteries Recalled for Fire Hazard (March 27) 24. Toys “R” Us Recalls “Elite Operations” Toy Sets Due to Lead and Laceration Hazards (March 13) 25. Sportcraft Recalls Inflatable Bounce Houses Due to Impact Injury Hazard (February 27) 26. Jazwares Inc. Recalls Link-N-Lite™ Magnetic Puzzles, Ingested Magnets Pose Aspiration and Intestinal

Hazards (February 15) 27. Fisher-Price Recalls “Laugh and Learn” Bunny Toys Due to Choking Hazard (February 15) 28. Battery Packs for Toy Vehicles Recalled by JAKKS Pacific Due to Fire Hazard (February 13) 29. Easy-Bake Ovens Recalled for Repair Due to Entrapment and Burn Hazards (February 6) 30. Geometix International LLC Recalls MagneBlocks™ Toys, Ingested Magnets Pose Aspiration and Intestinal

Hazards (January 18) 31. Target Recalls Baby Rattles and Ornaments for Choking Hazard (January 18)

Source: CPSC

While excess lead in toys and other children’s products is an issue of concern, CPSC has identi- fied another major hazard associated with small magnets in toys. Due to the availability of powerful rare-earth magnets at cheap prices, the manufactur- ers began to use them in many toys such as building blocks and jewelry. On some of these products, the

magnets came loose. If a child swallowed more than one magnet, they could attach to each other and cause intestinal perforations and blockage, which can be fatal. In April 2006, CPSC and Rose Art Industries recalled 3.8 million Magnetix magnetic building sets following the death of a 20-month-old boy after he swallowed magnets that

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twisted his small intestine and created a blockage. In addition, several other children required surgery and intensive care to remove the magnets they swallowed.18

Following the recall of Magnetix building sets, Rose Art Industries redesigned its building sets to cover the magnets and reinforced these with resins so that the magnets could not be detached from the building set. Further, they changed the age suitability of their product to six years or older and provided new warnings about the dangers associated with in- gesting magnets.19 The recall of Magnetix was fol- lowed by another five recalls of toys that contained small magnets that detached. One of those recalls in- volved 2.4 million Polly Pocket play sets (an addi- tional 2 million sets were sold worldwide), which was prompted by 170 reports of magnets coming loose and three children who swallowed the magnets requiring surgical care.20 The Polly Pocket play sets, recalled on November 21, 2006, were made by Mat- tel and sold between May 2003 and September 2006.

Mattel—The No.1 Toy Maker in the World

With a vision to provide “the world’s premier toy brands—today and tomorrow,” Mattel “designs, manufactures, and markets a broad variety of toy products worldwide through sales to its customers and directly to consumers.”21 Mattel’s position as a leader in the global toy industry was so formidable that Mattel’s international business division with gross sales of $2.7 billion in 2006 would be the industry’s third largest company, if it was a separate company, and Mattel’s U.S. business with $3.4 billion would still be No.1.22

Mattel was an industry leader not only by its sales, but also through its pioneering efforts to be a

172 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

good corporate citizen. In 1996, Mattel initiated its Global Manufacturing Principles, which aimed to ensure responsible management practices used in Mattel’s factories as well as by its vendors. Mattel’s factories were audited by the International Center for Corporate Accountability, an independent body, and its results were made publicly available by Mattel. Mattel engaged in philanthropic activities through Mattel Children’s Foundation in 37 countries. It was named one of the top 100 Best Corporate Citizens by CRO Magazine in 2006. More saliently, Mattel’s corporate governance received the highest global rating of 10 by Governance Metrics International (GMI), which placed the company among the top one per cent of more than 3,400 global companies.

The journey of Mattel, however, began modestly in 1944, when Harold Matson and Elliot Handler began to make toys out of a converted garage in California. They named the company Mattel, using letters from their last and first names. Matson sold his share to Elliot Handler and his wife, Ruth Handler, who incorporated the company in 1948. Mattel’s first products were picture frames and doll house furniture.23 Their first big product was a mass-produced, and thus, inexpensive music box, which established Mattel firmly in the toy business. The introduction of Barbie in 1959, and Ken two years later, propelled company growth. The prod- ucts introduced later such as Hot Wheels went fur- ther to establish Mattel’s position as an industry leader. Mattel went public in 1960.

Mattel’s products were organized in three differ- ent business groups: (i) Mattel Girls & Boys Brands that includes brands like Barbie dolls and accessories, Polly Pocket, Hot Wheels, Matchbox, Batman, CARS, and Superman. (ii) Fisher-Price Brands consisting of brands such as Fisher-Price, Little People, Sesame Street, Dora the Explorer, Go-Diego-Go!, Winnie the Pooh, and Power Wheels. (iii) American Girl Brands, with brands such as Just Like You and Bitty Baby. In the United States alone, the sales of these three groups in 2006

❚ 18http://www.cpsc.gov/cpscpub/prerel/prhtml06/06127.html ❚ 19U.S. PIRG Education Fund. Trouble in Toyland. 21st Annual Toy Safety Survey. ❚ 20http://www.cpsc.gov/cpscpub/prerel/prhtml07/07039.html ❚ 21Mattel Annual Report, 2006, p.3. ❚ 22Letter to Shareholders by Bob Eckert, Mattel CEO, Mattel Annual Report, 2006.

❚ 23J. Amerman. The story of Mattel, Inc.: Fifty years of innovation. 1995.

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sponsorship quickly established a continuous con- nection for Mattel with the kids and gave it an opportunity to influence the buying habits of its consumers. Not surprisingly, this move changed the nature of marketing in the toy industry. Also, for Mattel, it paved the way for further partnerships with entertainment companies to produce character toys.

Mattel entered into licensing agreements to make toys based on the characters owned by companies such as Disney, Warner Brothers, Viacom (Nick- elodeon), Origin Products, and Sesame Workshop. These agreements gave the company access to char- acters such as Winnie the Pooh, Disney Princesses, CARS, Dora the Explorer, Go-Diego-Go!, Sponge Bob SquarePants, Polly Pocket, Batman, Superman, and Elmo. In 2005, Mattel partnered with Scholas- tic Entertainment to produce educational learning systems.

Not only did Mattel license characters, but also li- censed some of its core brands to other non-toy com- panies to design and develop an array of products sporting the core brand names. These deals included Barbie eyewear for little girls (with REM Eyewear), Hot Wheels apparel and accessories (with Innovo Group), Barbie video games (with Activision), and CD Players, learning laptops, and MP3 players. Re- cently, Mattel was trying to reduce its reliance on its big customers such as Wal-Mart, Target, and Toys’R’Us through internet and catalogue sales.24

Traditionally, toy companies relied on point-of- sale (POS) data to forecast demand for toys. With its Hot Wheels brand, Mattel realized that variety was the key driver of the sales and introduced a rolling mix strategy. This strategy involved changing the physical 72-car assortment mix by seven to eight per cent every two weeks. This changed the nature of its practices and instead of relying on POS data, Mattel only needed to design the varieties and supply an assortment pack to the retailer.25

Mattel designed and developed toys in the corporate headquarters. In 2006, Mattel spent

were: Mattel Girls & Boys Brands—$1.57 billion, Fisher-Price Brands—$1.47 billion, and American Girl Brands—$0.44 billion.

About 45 percent of Mattel’s sales were accounted for by three major buyers: Wal-Mart, Toys’R’Us, and Target. In addition to its principal competitors, such as Hasbro and RC2, Mattel also competed with a large number of smaller companies that made toys, video games, and consumer electronics, and pub- lished children’s books.

In the 1990s, Mattel made a number of significant acquisitions, including Fisher-Price (1993, leader in preschool segment), Kransco (1994, made battery- powered ride-on vehicles), Tyco (1997, made Tickle Me Elmo and Matchbox cars), Pleasant Company (1998, mail-order firm that made American Girl- brand books, dolls, and clothing), and Bluebird Toys (1998, made toys such as Polly Pocket and The Tiny Disney Collection). Mattel’s acquisition of The Learning Company, a leading educational software maker, in 1999 at a cost of $3.6 billion proved to be troublesome. The company lost money and was later sold. Mattel also made a hostile bid to acquire Has- bro, the second largest toy company. This bid, made in 1996, failed to materialize.

The toy industry is different from other industries on two major counts. First, toy sales are seasonal. Most sales occurred during the third and last quarter of the year, which coincide with the traditional holi- day period. Second, there is a lot of uncertainty around new product success. It was difficult, almost impossi- ble, to predict whether a particular toy would be liked by children. Not surprisingly, many companies in the toy industry made millions with one successful toy and also went bankrupt with one big failure.

Over a long period, Mattel had managed the peculiarities of the toy industries well with a num- ber of innovative and often revolutionary ideas. Traditionally, the retailers promoted toys during the holiday season and toy manufacturers had little, if any, role to play. In 1955, Mattel tied-up with ABC Television and sponsored a 15-minute segment of Walt Disney’s Mickey Mouse Club for one full year. At that time, Mattel’s revenues were only $5 million, but it paid $500,000 for the sponsorship. The

Case 2-3 Mattel and the Toy Recalls (A) 173

❚ 24Hoover Company Report on Mattel. ❚ 25Eric Johnson and Tom Clock. Mattel, Inc: Vendor Operations in Asia. Tuck School of Business at Dartmouth. 2002.

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US$174 million on in-house product design and development. In contrast, the company spent US$261 million on royalties and US$651 million on advertising. Mattel manufactured products in its own factories as well as through third-party manu- facturers. Also, it marketed the products purchased from unrelated companies that designed, devel- oped, and manufactured those products.

Offshoring the Toy Production Mattel’s princi- pal manufacturing facilities were located in China, Indonesia, Thailand, Malaysia, and Mexico. It closed its last toy factory in the U.S., originally part of its Fisher-Price divisions, in 2002.26 Mattel pro- duced its core brands such as Barbie and Hot Wheels in company-owned facilities, but used third-party manufacturers to produce its non-core brands. It used third-party manufacturers in a number of countries, including the United States, Mexico, Brazil, India, New Zealand, and Australia. This manufacturing mix minimized Mattel’s risk and gave it focus and flexi- bility. The core brands were a staple business, while the non-core brands tended to be those products that were expected to have a short market life. The non- core brands were typically associated with popular movie characters and had a life of one year.27

The development of new toys was done at Mat- tel’s corporate headquarters. Outsourcing for the manufacturing of non-core brand toys followed a strict multi-step process. The design teams created a bid package containing the new product’s blue- print and engineering specifications. It often con- tained a physical model. After the selection of a vendor, the company established the vendor’s pro- duction infrastructure. At this point, Mattel assumed responsibility for the cost of tooling. The vendor then produced 50 units as “First Shots” to verify if any tool modifications were required. This was followed by one or more “Engineering Pilot,” depending on the toy’s complexity, and the “Final Engineering Pilot.” After this, a “Production Pilot”

of 1,000 units was run using the entire assembly line to run the product. Finally, the “Production Start” phase began only when the new toy met design compliance.28

Mattel and its vendors manufactured about 800 million products each year. Approximately half of the toys Mattel sold were made in its own plants, a higher proportion than other large toy makers. Also, Mattel made a larger percentage of its toys outside China than other large toy companies. Mattel’s man- ufacturing and offshoring strategy was developed over a period of five decades. The company made its first Barbie doll in Asia in 1959. Since then, Mattel managed the risks of offshored operations by employing a mix of company-owned and vendor- owned manufacturing facilities all over Asia.

In China alone, Mattel had contracts with approx- imately 37 principal vendors who made toys for the company.29 The principal vendors further used smaller companies for the full or partial production of toys. As a result, the supply chains in China were long and complex. According to some estimates, about 3,000 Chinese companies made Mattel prod- ucts.30 However, Mattel had direct contact only with the principal vendors.

A Recall Underway

In June 2007, a French direct importer of Mattel’s products, Auchan, performed pre-shipment tests with the help of Intertek, an independent labora- tory. These tests revealed that Mattel’s toys, made by a vendor Lee Der Industrial Company, contained lead above permissible limits. Intertek sent the test results, on June 8, 2007, to Mattel employees in China. Consequently, Mattel employees contacted Lee Der instructing it to correct the problem and provide another sample for testing. Another test by Intertek on June 29, for Auchan, on the same toy produced by Lee Der had passed the test.

174 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

❚ 26Louis Story, “After stumbling, Mattel cracks down in China.” New York Times. August 29, 2007. ❚ 27Company annual reports and chat excerpts of Mattel India CEO on CNN-IBN.

❚ 28Op. cit. Johnson and Clock. 2002. ❚ 29Testimony of Robert Eckert, CEO, Mattel, to the Sub-committee on Commerce, Trade, and Consumer Protection of the Committee on Energy and Commerce. September 19, 2007. ❚ 30David Barboza, “Scandal and Suicide in China: A Dark Side of Toys.” New York Times. August 23, 2007.

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was a good friend of Cheng Shu-hung. In April 2007, Dongxing ran out of yellow pigment and sourced about 330 pounds of it for $1,250 from Dongguan Zhongxin Toner Powder Factory. Then, Dongxing supplied the paint to Lee Der, which used it in Mattel’s toys. Initial reports suggested that Dongguan Zhongxin Toner Powder Factory was fake and that its owners were not traceable.33

An essential component of Mattel’s contracts with its vendors is that the products made by ven- dors comply with applicable safety standards. Mat- tel had systems which required the vendors to either purchase paint from a list of eight certified vendors in China or test for compliance each batch of the paint purchased from a non-certified vendor. Mattel also conducted audits of certified paint suppliers and vendors to ensure that Mattel’s requirements were being followed. The frequency of audits depended on Mattel’s prior experience with the suppliers and vendors.

Following its investigations, Mattel filed an ini- tial report with the CPSC on July 20 and followed it up with another on July 26, indicating that it would like to issue a recall of all the products man- ufactured by Lee Der between April 19, 2007 (the date when Lee Der took delivery of the lead- tainted paint from its supplier), and July 6, 2007, the date when Mattel stopped accepting products from Lee Der.34 Work on this recall was underway and Mattel and the CPSC were scheduled to an- nounce the recall on August 2, 2007. See Exhibit 6 for the press release announcing the recall, ex- pected to be issued by the CPSC. Mattel had already informed big retailers such as Wal-Mart and Toys’R’Us of the impending recall. The retail- ers pulled the toys off their shelves and flagged the cash registers so that customers could not buy the toys from the stores.35

On June 27, 2007, Mattel’s call center in the United States received a report from a consumer, who informed them that a home test kit found excessive lead in Mattel’s toys. These were also manufactured by Lee Der. Following this, Mattel tested five sam- ples of Lee Der toys and found on July 6 that three of them contained excess lead. As the testing was underway, Auchan informed Mattel on July 3 about lead violations in another toy made by Lee Der. As soon as the test results were out, Mattel employees in China notified Lee Der and stopped accepting products made by Lee Der. Further tests on the toy samples collected from Lee Der were conducted on July 9 in Mattel’s own laboratories, which revealed that nine of the 23 samples of Lee Der toys con- tained excess lead in surface paint.

Mattel’s employees in China notified the senior management team at corporate headquarters on July 12 about the issues with Lee Der products. Following this, Mattel management ordered an im- mediate suspension of all shipments of products made by Lee Der. Further investigations by Mattel revealed that the nonconforming lead levels were because of a yellow pigment in paint used on portions of toys manufactured by Lee Der.31

Lee Der Industrial Company was located in Fos- han City of Guangdong Province, where thousands of small toy factories existed. The company was founded by two Chinese entrepreneurs, Cheng Shu- hung and Xie Yuguang. Mattel first used Lee Der for making a small batch of educational toys in 1993. By July 2007, Lee Der employed approx- imately 2,500 people and made toys almost exclusively for Mattel. With annual sales of about $25 million, Lee Der was about to open a new $5 million plant.32

Lee Der had purchased its paint from Dongxing New Energy Co. since 2003. The owner of Dongxing

Case 2-3 Mattel and the Toy Recalls (A) 175

❚ 31Mattel’s response to the information request from the Sub-committee on Commerce, Trade, and Consumer Protection of the Committee on Energy and Commerce. September 5, 2007. ❚ 32http://www.ckgsb.edu.cn:8080/article/600/3051.aspx

❚ 33Ibid. ❚ 34Testimony of Robert Eckert, CEO, Mattel, to the Sub-committee on Commerce, Trade, and Consumer Protection of the Committee on Energy and Commerce. September 19, 2007. ❚ 35http://www.reuters.com/article/domesticNews/idUSN023040192 0070802

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Another Instance of Lead and Further Reports of Loose Magnets

While Mattel was preparing to announce its recall, on July 30, 2007, it found that paint on Sarge cars contained excess lead. The Sarge cars were made for Mattel by Early Light Industrial Company, Ltd. of Hong Kong, which made them in its manufactur- ing facility located in Pinghu, China.36 Early Light had supplied toys to Mattel for 20 years.37 Only further investigation would be able to clarify where

exactly in the supply chain the problem originated and why. Initial reports indicated that approximately 250,000 Sarge cars made between May 2007 and August 2007 may have been affected with lead paint.

After the November 2006 recall of eight different Polly Pocket play sets made in China for the prob- lem of magnets coming loose, Mattel reinforced the magnets by locking them in the toys rather than glu- ing them. Nonetheless, in recent months Mattel had received a few hundred reports of magnets coming loose from a number of play sets sold before November 2006. The play sets affected with magnet problems were: (i) fifty additional models of Polly Pocket play sets (about five million of these play

176 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Exhibit 6 Recall Notice of Mattel’s Character Toys for Lead Paint Violations

U.S. Consumer Product Safety Commission

Office of Information and Public Affairs Washington, DC 20207 FOR IMMEDIATE RELEASE Firm’s Recall Hotline: (800) 916-4498 August 2, 2007 CPSC Recall Hotline: (800) 638-2772 Release #07-257 CPSC Media Contact: (301) 504-7908

Fisher-Price Recalls Licensed Character Toys Due To Lead Poisoning Hazard

WASHINGTON, D.C. - The U.S. Consumer Product Safety Commission, in cooperation with the firms named below, today announced a voluntary recall of the following consumer product. Consumers should stop using recalled products immediately unless otherwise instructed.

Name of Product: Sesame Street, Dora the Explorer, and other children’s toys Units: About 967,000 Importer: Fisher-Price Inc., of East Aurora, N.Y. Hazard: Surface paints on the toys could contain excessive levels of lead. Lead is toxic if ingested by young

children and can cause adverse health effects. Incidents/Injuries: None reported. Description: The recalled involves various figures and toys that were manufactured between April 19, 2007 and

July 6, 2007 and were sold alone or as part of sets. The model names and product numbers for the recalled toys, which are all marked with “Fisher-Price,” are listed below. The toys may have a date code between 109-7LF and 187-7LF marked on the product or packaging.

Sold at: Retail stores nationwide from May 2007 through August 2007 for between $5 and $40. Manufactured in: China Remedy: Consumers should immediately take the recalled toys away from children and contact Fisher-Price.

Consumers will need to return the product and will receive a voucher for a replacement toy of the consumer’s choice (up to the value of the returned product).

Consumer Contact: For additional information contact Fisher-Price at (800) 916-4498 anytime or visit the firm’s Web site at www.service.mattel.com

Product List: A list of about 50 different toys. The case authors excluded this list in the interest of space.

Source: CPSC

❚ 36Ibid. ❚ 37Op. cit. Louis Story. 2007.

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Case 2-3 Mattel and the Toy Recalls (A) 177

Exhibit 7 Product Recalls in Mattel-Fisher Price History (Up to July 2007)

Mattel Recalls 1. Serious Injuries Prompt Recall of Mattel’s Polly Pocket Magnetic Play Sets (November 21, 2006) 2. Children’s Jewelry Sold at American Girl Stores Recalled for Lead Poisoning Hazard (March 30, 2006) 3. Mattel, Inc. Recall of Batman Batmobile Toy Vehicle (April 14, 2004) 4. Fisher-Price Intelli-Table Toy Recall (March 29, 2001) 5. Barbie Sunglasses Recalled by IMT Accessories (February 21, 2001) 6. Cabbage Patch Kids Snacktime Dolls Refund (January 6, 1997) 7. Disney Play ’N Pop Activity Toy Recalled by Arcotoys (February 23, 1995) 8. Mattel Voluntarily Recalls Disney Poppin’ Sounds Pull Train (November 18, 1991) 9. Battlestar Galactica Space Toys Replaced by Mattel (January 11, 1979)

Fisher-Price Recalls 10. Fisher-Price Rainforest Infant Swings Recalled Due to Entrapment Hazard (May 30, 2007) 11. Fisher-Price Recalls “Laugh and Learn” Bunny Toys Due to Choking Hazard (February 15, 2007) 12. Fisher-Price Recalls Infant Musical Toy Chair Posing Strangulation Hazard (January 18, 2006) 13. Fisher-Price Recall of Scooters and Mini Bikes (June 14, 2005) 14. Fisher-Price Recall of Push Toys (May 10, 2005) 15. Fisher-Price Recall of Pogo Sticks (May 10, 2005) 16. Scooters and Mini Bikes Recalled by Fisher-Price (November 13, 2003) 17. Crib Mobile Toys Recalled by Fisher-Price (June 19, 2003) 18. Little People® Animal Sounds Farms Recalled by Fisher-Price (April 23, 2003) 19. Fisher-Price Recall for In-Home Repair of Infant Swings (April 10, 2002) 20. Fisher-Price Portable Bassinet Recall (July 31, 2001) 21. Basketball Sets Recalled by Fisher-Price (May 10, 2001) 22. Fisher-Price Intelli-Table Toy Recall (March 29, 2001) 23. McDonald’s “Scooter Bug” Happy Meal Toy Recall (March 5, 2001) 24. Children’s Riding Vehicles Recalled by Fisher-Price (August 31, 2000) 25. Swings and Toys Recalled by Fisher-Price (August 23, 2000) 26. Baby Jumper Seats & Construction Toys Recalled by Fisher-Price (July 21, 2000)

the company. Third, recalls are often viewed as an admission of guilt and open the company to con- sumer litigations. Finally, recalls damage the repu- tation of the company and result in increased costs, lost sales, and stock price erosion.

Mattel and Fisher Price were not new to recalls. In their long history, they had recalled products in the past (see Exhibit 7). Nevertheless, the current situa- tion seemed entirely new, complex, and challenging. It was not clear if and which products needed to be recalled. As importantly, how could the company minimize the negative consequences which are ger- mane to any product recall? Finally, how could the company ensure such recalls did not recur?

sets were sold between March 2003 and November 2006), (ii) Batman and One Piece action figures (about 350,000 toys sold between June 2006 and June 2007), (iii) Barbie and Tanner play sets (about 683,000 toys sold between May 2006–July, 2007), and (iv) Doggie Day Care play sets (about one million sold between July 2004 and July 2007).

Recalls are a nightmare to companies for several reasons. First, the recalls pose major logistics chal- lenges as the company needs to establish a set-up to handle the recalls. Second, the company has to deal with regulators who tend to push the company to ensure that not only a recall is issued, but the prod- ucts in consumers’ hands are actually returned to

(continued)

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178 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

(continued) 27. Swings & Domes Recalled by Fisher-Price (April 7, 2000) 28. Toy Basketball Nets Recalled by Little Tikes, Today’s Kids & Fisher-Price (December 22, 1998) 29. Power Wheels Ride-On Battery-Powered Vehicles Recall to Repair (October 22, 1998) 30. Infant Toys Recalled by Fisher-Price (March 2, 1998) 31. Toy Police Cars Recalled by Fisher-Price (May 19, 1997; Revised October 29, 2002) 32. Baseball Training Toy Recall/Repair by Fisher-Price (July 7, 1995; Revised October 29, 2002) 33. Fisher-Price Recalls Kiddicraft Racing Rover Car (August 17, 1993; Revised October 29, 2002) 34. Fisher-Price Recalls Snuggle Light Doll (August 12, 1993; Revised October 29, 2002)

Fun Bus Safety Modification Program by Fisher-Price (March 15, 1990; Revised October 29, 2002) 35. “Pop-Up Playhouse” Modification by Fisher-Price (July 27, 1988; Revised October 29, 2002) 36. Strollers Repair by Fisher-Price (November 24, 1987; Revised October 29, 2002) 37. Crib Toy Safety Alert issued by Fisher-Price (October 10, 1984; Revised October 29, 2002) 38. “Splash & Stack Bluebird” Toys Recalled by Fisher-Price (July 26, 1984; Revised December 2, 2005)

Source: CPSC

Reading 2-1 Culture and Organization Susan Schneider and Jean-Louis Barsoux

Intuitively, people have always assumed that bureaucratic structures and patterns of action differ in the different countries of the Western world and even more markedly between East and West. Practitioners know it and never fail to take it into account. But contemporary social scientists . . . have not been concerned with such comparisons.

—Michel Crozier1

Just how does culture influence organization struc- ture and process? To what extent do organizational structures and processes have an inherent logic which overrides cultural considerations? Given the nature of today’s business demands, do we find con- vergence in the ways of organizing? To what extent will popular techniques such as team management and empowerment be adopted across cultures? With what speed and with what possible (re) inter- pretation? What cultural dimensions need to be recognized which may facilitate or hinder organiza- tional change efforts?

In this chapter, we present the evidence for na- tional differences and consider the cultural reasons for these differences. Examining the degree to which organizations have centralized power, spe- cialized jobs and roles, and formalized rules and procedures, we find distinct patterns of organizing which prevail despite pressures for convergence. This raises concerns regarding the transferability of organizational forms across borders and questions the logic of universal “best practices.”

Different Schools, Different Cultures

While many managers are ready to accept that na- tional culture may influence the way people relate to each other, or the “soft stuff,” they are less con- vinced that it can really affect the nuts and bolts of organization: structure, systems, and processes.

❚ Schneider, Susan C., Barsoux, Jean-Louis, Managing Across Cultures, 2nd Edition, © 2002. Adapted by permission of Pearson Education, Inc., Upper Saddle River, NJ.

❚ 1Crozier, M. (1964) The Bureaucratic Phenomenon, Chicago: University of Chicago Press, p. 210.

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French emphasis on social systems, roles and rela- tionships (unity of command), and the American emphasis on the task system or machine model of organization, most recently popularized in the form of reengineering.

Indeed, many of the techniques of modern management—performance management, participa- tive management, team approach, and job enrichment all have their roots firmly embedded in a particular historical and societal context. Furthermore, these approaches reflect different cultural assumptions regarding, for example, human nature and the im- portance of task and relationships. While the scien- tific management approach focused on how best to accomplish the task, the human relations approach focused on how best to establish relationships with employees. The human resources approach assumed that workers were self-motivated, while earlier schools assumed that workers needed to be moti- vated by more or less benevolent management.

These models of management have diffused across countries at different rates and in different ways. For example, mass-production techniques promoted by scientific management were quickly adopted in Germany, while practices associated with the human relations school transferred more readily to Spain.6 For this reason the historical and societal context needs to be considered to under- stand the adoption and diffusion of different forms of organization across countries. While some theo- rists focus on the institutional arrangements,7 such as the nature of markets, the educational system, or the relationships between business and government, to explain these differences, we focus here, more specifically, on the cultural reasons.

The culture-free argument is that structure is deter- mined by organizational features such as size and technology. For example, the famous Aston studies,2

conducted in the late 1960s in the United Kingdom and widely replicated, point to size as the most im- portant factor influencing structure: larger firms tend to have greater division of labor (specialized) and more formal policies and procedures (formalized) although not necessarily more centralized. Further- more, the nature of technology, such as mass pro- duction, is considered to favor a more centralized and formal (mechanistic) rather than decentralized and informal (organic) approach.3

Other management scholars argue that the soci- etal context, for example culture, creates differences in structure in different countries.4 In effect, the “structuralists” argue that structure creates culture, while the “culturalists” argue that culture creates structure. The debate continues, with each side arm- ing up with more sophisticated weapons: measure- ments and methodologies.

Taking an historical perspective, theories about how best to organize—Max Weber’s (German) bu- reaucracy, Henri Fayol’s (French) administrative model, and Frederick Taylor’s (American) scientific management—all reflect societal concerns of the times as well as the cultural backgrounds of the in- dividuals.5 Today, their legacies can be seen in the German emphasis on structure and competence, the

Reading 2-1 Culture and Organization 179

❚ 2Pugh, D. S., Hickson, D. J., Hinings, C. R., and Turner, C. (1969) “The context of organization structure,” Administrative Science Quarterly, 14, 91–114; Miller, G. A. (1987) “Meta-analysis and the culture-free hypothesis,” Organization Studies, 8(4), 309–25; Hickson, D. J. and McMillan, I. (eds) (1981) Organization and Nation:TheAston Programme IV, Farnborough: Gower. ❚ 3Burns, T. and Stalker, G. M. (1961) The Management of Innovation, London: Tavistock. ❚ 4Child, J. (1981) “Culture, contingency and capitalism in the crossnational study of organizations” in L. L. Cummings and B. M. Staw (eds) Research in Organizational Behavior, Vol 3, 303–56, Greenwich, CT: JAI Press; Scott, W. R. (1987) “The adolescence of institutional theory,” Administrative Science Quarterly, 32, 493–511; Lincoln, J. R., Hanada, M. and McBride, K. (1986) “Organizational structures in Japanese and US manufacturing,” Administrative Science Quarterly, 31, 338–64. ❚ 5Weber, M. (1947) The Theory of Social and Economic Organization, NewYork: Free Press; Fayol, H. (1949) General Industrial Management, London: Pitman; Taylor, F. (1947, first published 1912) Scientific Management, NewYork: Harper & Row.

❚ 6Kogut, B. (1991) “Country capabilities and the permeability of borders,” Strategic Management Journal, 12, 33–47; Kogut, B. and Parkinson, D. (1993) “The diffusion of American organizing principles to Europe” in B. Kogut (ed.) Country Competitiveness: Technology and the Organizing of Work, Ch. 10, New York: Oxford University Press, 179–202; Guillen, M. (1994) “The age of eclecticism: Current organizational trends and the evolution of managerial models,” Sloan Management Review, Fall, 75–86. ❚ 7Westney, D. E. (1987) Imitation and Innovation, Cambridge, MA: Harvard University Press.

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This does not mean that institutional factors are irrelevant. In effect, it is quite difficult to separate out the influence of institutions from culture as they have both evolved together over time and are thus intricately linked. For example, the strong role of the state and the cultural emphasis on power and hi- erarchy often go hand in hand, as in the case of France. Or in the words of the French roi soleil Louis XIV, L’étât, c’est moi (“The state is me”). Our argument (the culturalist perspective) is that different forms of organization emerge which re- flect underlying cultural dimensions.

Hofstede’s Findings One of the most important studies which attempted to establish the impact of culture differences on management was conducted by Geert Hofstede, first in the late 1960s, and continuing through the next three decades.8 The original study, now considered a classic, was based on an employee opinion survey involving 116,000 IBM employees in 40 different countries. From the results of this survey,

which asked people for their preferences in terms of management style and work environment, Hof- stede identified four “value” dimensions on which countries differed: power distance, uncertainty avoid- ance, individualism/collectivism, and masculinity/ femininity.

Power distance indicates the extent to which a society accepts the unequal distribution of power in institutions and organizations. Uncertainty avoid- ance refers to a society’s discomfort with uncertainty, preferring predictability and stability. Individualism/ collectivism reflects the extent to which people prefer to take care of themselves and their immedi- ate families, remaining emotionally independent from groups, organizations, and other collectivities. And the masculinity/femininity dimension reveals the bias towards either “masculine” values of as- sertiveness, competitiveness, and materialism, or towards “feminine” values of nurturing, and the quality of life and relationships. Country rankings on each dimension are provided in Table 1.

180 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

❚ 8Hofstede, G. (1980) Cultures Consequences, Beverly Hills, CA: Sage; Hofstede, G. (1991) Cultures and Organizations: Software of the Mind, London: McGraw-Hill.

Table 1 Hofstede’s Rankings

Power Distance Individualism Masculinity Uncertainty Avoidance

Country Index Rank Index Rank Index Rank Index Rank

Argentina 49 35–6 46 22–3 56 20–1 86 10–15 Australia 36 41 90 2 61 16 51 37 Austria 11 53 55 18 79 2 70 24–5 Belgium 65 20 75 8 54 22 94 5–6 Brazil 69 14 38 26–7 49 27 76 21–2 Canada 39 39 80 4–5 52 24 48 41–2 Chile 63 24–5 23 38 28 46 86 10–15 Colombia 67 17 13 49 64 11–12 80 20 Costa Rica 35 42–4 15 46 21 48–9 86 10–15 Denmark 18 51 74 9 16 50 23 51 Equador 78 8–9 8 52 63 13–14 67 28 Finland 33 46 63 17 26 47 59 31–2

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Reading 2-1 Culture and Organization 181

Power Distance Individualism Masculinity Uncertainty Avoidance

Country Index Rank Index Rank Index Rank Index Rank

France 68 15–16 71 10–11 43 35–6 86 10–15 Germany (F.R.) 35 42–4 67 15 66 9–10 65 29 Great Britain 35 42–4 89 3 66 9–10 35 47–8 Greece 60 27–8 35 30 57 18–19 112 1 Guatemala 95 2–3 6 53 37 43 101 3 Hong Kong 68 15–16 25 37 57 18–19 29 49–50 Indonesia 78 8–9 14 47–8 46 30–1 48 41–2 India 77 10–11 48 21 56 20–1 40 45 Iran 58 19–20 41 24 43 35–6 59 31–2 Ireland 28 49 70 12 68 7–8 35 47–8 Israel 13 52 54 19 47 29 81 19 Italy 50 34 76 7 70 4–5 75 23 Jamaica 45 37 39 25 68 7–8 13 52 Japan 54 33 46 22–3 95 1 92 7 Korea (S) 60 27–8 187 43 39 41 85 16–17 Malaysia 104 1 26 36 50 25–6 36 46 Mexico 81 5–6 30 32 69 6 82 18 Netherlands 38 40 80 4–5 14 51 53 35 Norway 31 47–8 69 13 8 52 50 38 New Zealand 22 50 79 6 58 17 49 39–40 Pakistan 55 32 14 47–8 50 25–6 70 24–5 Panama 95 2–3 11 51 44 34 86 10–15 Peru 64 21–3 16 45 42 37–8 87 9 Philippines 94 4 32 31 64 11–12 44 44 Portugal 63 24–5 27 33–5 31 45 104 2 South Africa 49 36–7 65 16 63 13–14 49 39–40 Salvador 66 18–19 19 42 40 40 94 5–6 Singapore 74 13 20 39–41 48 28 8 53 Spain 57 31 51 20 42 37–8 86 10–15 Sweden 31 47–8 71 10–11 5 52 29 49–50 Switzerland 34 45 68 14 70 4–5 58 33 Taiwan 58 29–30 17 44 45 32–3 69 26 Thailand 64 21–3 20 39–41 34 44 64 30 Turkey 66 18–19 37 28 45 31–3 85 16–17 Uruguay 61 26 36 29 38 42 100 4 United States 40 38 91 1 62 15 46 43 Venezuela 81 5–6 12 50 73 3 76 21–2 Yugoslavia 76 12 27 33–5 21 48–9 88 8

Regions: East Africa 64 21–3 27 33–5 41 39 52 36 West Africa 77 10–11 20 39–41 46 30–1 54 34 Arab countries 80 7 38 26–7 53 23 68 27

Rank numbers: 1—Highest, 53—Lowest. Source: Geert Hofstede, Cultures and Organizations (New York: McGraw-Hill, 1991).

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Although some concern has been voiced that the country differences found by Hofstede were not representative due to the single company sample and that the data he originally collected is over thirty years old, further research supports these dimensions and the preferences for different profiles of organi- zation. Efforts to replicate the factors found in 1994 version of Hofstede’s survey proved difficult, however significant differences were found among countries and in most cases similar rankings.9

Given the differences in value orientations, Hof- stede questioned whether American theories could be applied abroad and discussed the consequences of cultural differences in terms of motivation, lead- ership, and organization.10 He argued, for example, that organizations in countries with high power dis- tance would tend to have more levels of hierarchy (vertical differentiation), a higher proportion of su- pervisory personnel (narrow span of control), and more centralized decision-making. Status and power would serve as motivators, and leaders would be revered or obeyed as authorities.

In countries with high uncertainty avoidance, or- ganizations would tend to have more formalization evident in greater amount of written rules and pro- cedures. Also there would be greater specialization evident in the importance attached to technical com- petence in the role of staff and in defining jobs and functions. Managers would avoid taking risks and would be motivated by stability and security. The role of leadership would be more one of planning, organizing, coordinating, and controlling.

In countries with a high collectivist orientation, there would be a preference for group as opposed to individual decision-making. Consensus and cooper- ation would be more valued than individual initia- tive and effort. Motivation derives from a sense of belonging, and rewards are based on being part of

the group (loyalty and tenure). The role of leader- ship in such cultures is to facilitate team effort and integration, to foster a supportive atmosphere, and to create the necessary context or group culture.

In countries ranked high on masculinity, the management style is likely to be more concerned with task accomplishment than nurturing social re- lationships. Motivation will be based on the acqui- sition of money and things rather than quality of life. In such cultures, the role of leadership is to en- sure bottom-line profits in order to satisfy share- holders, and to set demanding targets. In more fem- inine cultures, the role of the leader would be to safeguard employee well-being, and to demonstrate concern for social responsibility.

Having ranked countries on each dimension, Hofstede then positioned them along two dimen- sions at a time, creating a series of cultural maps. He found country clusters—Anglo, Nordic, Latin, and Asian similar to those found in prior research.11

One such cultural map, as shown in Figure 1 (see also Table 2), is particularly relevant to struc- ture in that it simultaneously considers power dis- tance (acceptance of hierarchy) and uncertainty avoidance (the desire for formalized rules and pro- cedures). Countries which ranked high both on power distance and uncertainty avoidance would be expected to be more “mechanistic”12 or what is commonly known as bureaucratic. In this corner we find the Latin countries.

In the opposite quadrant, countries which rank low both on power distance and uncertainty avoid- ance are expected to be more “organic”13—less hierarchic, more decentralized, having less formal- ized rules and procedures. Here we find the Nordic countries clustered and to a lesser extent, the Anglo countries.

In societies where power distance is low but uncertainty avoidance is high, we expect to find

182 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

❚ 9Spector, P.E., Cooper, C.L., and Sparks, K. (2001) “An international study of the psychometric properties of the Hofstede values survey module 1994: A comparison of individual and country/province level results,” Applied Psychology: An International Review, 30 (2), 269–81. ❚ 10Hofstede, G. (1980) “Motivation, leadership, and organization: Do American theories apply abroad?” Organizational Dynamics, Summer, 42–63.

❚ 11Ronen, S. and Shenekar, O. (1985) “Clustering countries on attitudinal dimensions: A review and synthesis,” Academy of Management Review, 10(3), 435–54. ❚ 12Burns and Stalker, Op. cit. ❚ 13Ibid.

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Emerging Cultural Profiles: Converging Evidence These differences in structural preferences also emerged in a study conducted by Stevens14 at INSEAD. When presented with an organizational problem, a conflict between two department heads within a company, MBA students from Britain, France, and Germany proposed markedly different solutions. The majority of French students referred the problem to the next level up, the president. The Germans argued that the major problem was a lack of structure; the expertise, roles, and responsibili- ties of the two conflicting department heads had

organizations where hierarchy is downplayed, decisions are decentralized, but where rules and reg- ulations are more formal, and task roles and respon- sibilities are more clearly defined. Thus there is no need for a boss, as the organization runs by routines. This is characteristic of the Germanic cluster.

In societies where power distance is high but un- certainty avoidance is low, organizations resemble families or tribes. Here, “the boss is the boss”, and the organization may be described as paternalistic. Subordinates do not have clearly defined task roles and responsibilities (formalization), but instead so- cial roles. Here we find the Asian countries where business enterprise is often characterized by cen- tralized power and personalized relationships.

Reading 2-1 Culture and Organization 183

Figure 1 Hofstede’s Maps

0

8

16

24

32

40

48

56

64

72

80

88

96

10 20 30 40 50 60 70 80 90 100 110

104

112

Power distance index

U nc

er ta

in ty

a vo

id an

ce in

de x

Small power distance Weak uncertainty avoidance (village market)

Small power distance Strong uncertainty avoidance (well-oiled machine)

Large power distance Weak uncertainty

avoidance (family)

Large power distance Strong uncertainty avoidance

(pyramid of people)

JAM

DEN

SWE

IRE

GBR

NZL

AUT

ISR

GER

JPN

COS

ITA

ARG

GRE

POR URU

SALBEL PER

FRA

TUR COL

TAIPAK

IRA THA

EAF

IND

HOK

SIN

IDO

PHI

MAL

WAF

EQA

ARA

CHL

YUG

GUA

PAN MEX

VENBRA

SPA KOR

FIN SWI

NOR AUL

CAN U.S.A.

NET SAF

Source: G. Hofstede (1991) Cultures and Organizations, McGraw-Hill, Maidenhead.

❚ 14Stevens, O.J., cited in Hofstede, G. (1991) Cultures and Organizations, London: McGraw-Hill, 140–2.

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never been clearly defined. Their suggested solution involved establishing procedures for better coordina- tion. The British saw it as an interpersonal commu- nication problem between the two department heads which could be solved by sending them for inter- personal skills training, preferably together.

On the basis of these findings, Stevens described the “implicit model” of the organization held by each culture. For the French, the organization represents a “pyramid of people” (formalized and centralized). For the Germans, the organization is like a

“well-oiled machine” (formalized but not central- ized), in which management intervention is limited to exceptional cases because the rules resolve prob- lems. And for the British, it was more like a “village market” (neither formalized nor centralized) in which neither the hierarchy nor the rules, but rather the demands of the situation determine structure.

Going beyond questionnaires by observing the actual behavior of managers and company practices, further research reveals such cultural profiles as shown in Figure 2. Indeed, in studies comparing firms

184 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Table 2 Abbreviations for the Countries and Regions Studied

Abbreviation Country or Region Abbreviation Country or Region

ARA Arabic-speaking countries ITA Italy (Egypt, Iraq, Kuwait, Lebanon, JAM Jamaica Libya, Saudi Arabia, JPN Japan United Arab Emirates) KOR South Korea

ARG Argentina MAL Malaysia AUL Australia MEX Mexico AUT Austria NET Netherlands BEL Belgium NOR Norway BRA Brazil NZL New Zealand CAN Canada PAK Pakistan CHL Chile PAN Panama COL Colombia PER Peru COS Costa Rica PHI Philippines DEN Denmark POR Portugal EAF East Africa (Ethiopia, Kenya, SAF South Africa

Tanzania, Zambia) SAL Salvador EQA Equador SIN Singapore FIN Finland SPA Spain FRA France SWE Sweden GBR Great Britain SWI Switzerland GER Germany F.R. TAI Taiwan GRE Greece THA Thailand GUA Guatemala TUR Turkey HOK Hong Kong URU Uruguay IDO Indonesia USA United States IND India VEN Venezuela IRA Iran WAF West Africa (Ghana, IRE Ireland (Republic of) Nigeria, Sierra Leone) ISR Israel YUG Yugoslavia

Source: G. Hofstede (1991) Cultures and Organizations, McGraw-Hill, Maidenhead.

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need not be industry or company specific. The staff function plays an important role in providing analytic expertise. These capabilities are developed in the elite grandes écoles of engineering and administration.

The research findings confirmed the image of German firms as “well-oiled machines” as they were more likely to be decentralized, specialized, and formalized. In fact, German managers were more likely to cite structure as a key success factor, having a logic of its own, apart from people. German firms were more likely to be organized by function (sometimes to the extent that they are

in France, Germany, and the United Kingdom,15

French firms were found to be more centralized and formalized with less delegation when compared with either German or British firms. The role of the PDG (French CEO) was to provide coordination at the top and to make key decisions, which demands a high level of analytical and conceptual ability that

Reading 2-1 Culture and Organization 185

Figure 2 Emerging Cultural Profiles

Uncertainty avoidance

Low

Low

Hierarchy

High

Power distance

High

F o

rm a

liz a

tio n

Village market (Anglo/Nordic)

Decentralized Generalist People as free agents Entrepreneurial Flexibility More delegation Coordination through informal, personal communication Output control

Well-oiled machine (Germanic)

Decentralized decision making Narrow span of control Specialist, technical competence Discretion limited by expertise Strong role of staff “experts” Top management team Industry and company knowledge Organized by function Compartmentalized (chimneys) Coordination through routines and rules Structural solutions Throughput control Efficiency

Family or tribe (Asian)

Centralized Paternalistic Loyalty Generalist Strong social versus task roles Personal relationships Social control

Traditional bureaucracy “pyramid of people”

(Latin)

Centralized decision making Coordination at the top Less delegation “Cloisonne” highly specialized Strong role of staff Analytic ability Pyramid of people Informal relationships “Système D” Elitist (power and authority) Input control

15Brossard, A. and Maurice, M. (1976) “Is there a universal model of organization structure?” International Studies of Management and Organizations, 6, 11–45; Horovitz, J. (1980) Top Management Control in Europe, London: Macmillan; Stewart, R., Barsoux, J. L., Kieser, A., Ganter, D. and Walgenbach, P. (1994) Managing in Britain and Germany, London: Macmillan.

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referred to as “chimney” organizations) with coor- dination achieved through routines and procedures.

Although German organizations tended to be flatter and to have a broader span of control when compared with the French, middle managers had less discretion than their British counterparts as they were limited to their specific technical competence. The premium placed on competence was expressed in the concern to find competent people to perform specialized tasks, the strong role of staff to provide technical expertise, and expectations that top man- agement not only has specific technical competence, but also in-depth company knowledge. Furthermore, top management typically consists of a managing board, Vorstand, which integrates the specialized knowledge of the various top managers (rather than in the head of a lone individual as in the case of France, Britain, or the United States).

In contrast to the well-oiled machine model with its greater concern for efficiency, the “village market” model reflects a greater concern for flexibility. In- deed, structure in British firms was found to be far more flexible, more decentralized and less formal- ized, when compared with the French and German firms. Organized by divisions, there is greater de- centralization and delegation in the company and the role of central staff is far less important. Here, the burden of coordinating functions was placed on individual managers requiring a constant need for persuasion and negotiation to achieve cooperation.16

British managers, compared with Germans, were more ready to adapt the structure to the people work- ing in it. Changes in personnel were often used as opportunities to reshuffle the jobs and responsibili- ties in order to accommodate available talent, and to create opportunities for personal development (free agents). Top management’s role was to identify market opportunities and convince others to pursue them, underlining the importance of taking a more strategic view and of being able to communicate it persuasively.17

Studies in Asia have also found companies to fit the “family model,” being more hierarchic and less formalized, with the exception of Japan. When compared with the Japanese, Hong Kong Chinese firms were less likely to have written manuals and Hong Kong Chinese bosses were also found to be more autocratic and paternalistic.18 Another study of thirty-nine multinational commercial banks from fourteen different countries operating in Hong Kong found the Hong Kong banks to have the greatest number of hierarchical levels (eleven); the banks from Singapore, the Philippines, and India were also among those most centralized.19

A recent study of Chinese entrepreneurs found the Confucian tradition of patriarchal authority to be remarkably persistent. Being part of the family is seen as a way of achieving security. Social roles are clearly spelled out in line with Confucian pre- cepts, which designate the responsibilities for the roles of father, son, brothers, and so on. Control is exerted through authority, which is not questioned. In 70 percent of the entrepreneurial firms studied, even large ones, the structure of Chinese organiza- tions was found to resemble a hub with spokes around a powerful founder, or a management struc- ture with only two layers.20

Recent studies of Russian managers using Hof- stede’s framework found them to be autocratic and political (reflecting high power distance), while expected to take care of their subordinates (low masculinity). Managers tend to seek security and to be risk averse (high uncertainty avoidance). While performance appraisal is still seen to be highly

186 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

❚ 16Stewart et al., Op. cit. ❚ 17Ibid.

❚ 18Redding, S.G. and Pugh, D.S. (1986) “The formal and the informal: Japanese and Chinese organization structures” in S. Clegg, D. Dunphy, and S.G. Redding (eds) The Enterprise and Management in East Asia, Hong Kong: Center of Asian Studies, University of Hong Kong, 153–68; Vertinsky, I., Tse, D.K.,Wehrung, D.A. and Lee, K. (1990) “Organization design and management norms: A comparative study of managers’ perceptions in the People’s Republic of China, Hong Kong and Canada,” Journal of Management, 16(4), 853–67. ❚ 19Wong, G.Y.Y. and Birnbaum-More, P.H. (1994) “Culture, context and structure: A test on Hong Kong banks,” Organization Studies, 15(l), 99–23. ❚ 20Kao, J. (1993) “The world wide web of Chinese business,” Harvard Business Review, March–April, 24–35.

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with statements regarding beliefs about organiza- tion and management. A sample of the questions is shown in Table 3.

The results of this survey are very much in line with the discussion above in that they show similar cultural differences regarding power and uncertainty in views of organizations as systems of hierarchy, authority, politics, and role formalization. What would these different views of organization actually look like, were we to observe managers at work and even to question them? What arguments would man- agers from different countries put forth to support their responses?

Having a view of organizations as hierarchical systems would make it difficult, for example, to tol- erate having to report to two bosses, as required in a matrix organization, and it would make it difficult to accept bypassing or going over or around the boss. The boss would also be expected to have precise answers to most of the questions that subordinates have about their work. Asian and Latin managers argue that this is necessary in order for bosses to be respected, or to have power and authority. And if the most efficient way to get things done is to bypass the hierarchical line they would consider that there was something wrong with the hierarchy.

Scandinavian and Anglo managers, on the other hand, argue that it is perfectly normal to go directly to anyone in the organization in order to accomplish the task. It would seem intolerable, for example, to have to go through one’s own boss, who would con- tact his or her counterpart in a neighboring depart- ment before making contact with someone in that other department.

Furthermore, they argue that it is impossible to have precise answers, since the world is far too com- plex and ambiguous, and even if you could provide precise answers, this would not develop the capability of your subordinates to solve problems. Thus a Swedish boss with a French subordinate can antici- pate some problems: the French subordinate is likely to think that the boss, not knowing the answers, is incompetent, while the Swedish boss may think that the French subordinate does not know what to do and is therefore incompetent.

political, motivation is however becoming more calculative based on growing individualism.21

What begins to emerge from these various research studies is a converging and coherent picture of differ- ent management structures when comparing countries within Europe, as well as when comparing countries in Europe, the United States, and Asia. The primary cultural determinants appear to be those related to re- lationships between people in terms of power and sta- tus and relationship with nature, for example how uncertainty is managed and how control is exercised.

These underlying cultural assumptions are ex- pressed in beliefs (and their subsequent importance, or value) regarding the need for hierarchy, for formal rules and procedures, specialized jobs and functions. These beliefs and values, in turn, are observable in behavior and artifacts, such as deference to the boss, the presence of executive parking and dining facili- ties (“perks”), and the existence of written policies and procedures, specific job descriptions, or manu- als outlining standard operating procedures.

The research findings in the above-mentioned studies were based on observations as well as ques- tionnaires and interviews of managers and companies in different countries. The same, of course, can be done comparing companies in different industries or within the same industry, and managers in different functions providing corresponding models of indus- try, corporate and/or functional cultures. From these findings, management scholars interpret underlying meaning.

The Meaning of Organizations: Task versus Social System

André Laurent argues that the country differences in structure described above reflect different conceptions (or understandings) of what is an organization.22

These different conceptions were discovered in surveys which asked managers to agree or disagree

Reading 2-1 Culture and Organization 187

❚ 21Elenkov, D.S. (1998) “Can American management concepts work in Russia?” Academy of Management Review, 40(4), 133–56. ❚ 22Laurent, A. (1983) “The cultural diversity of western conception of management,” International Studies of Management and Organization, 13(1–2), 75–96.

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Those who view the organization as a political system consider managers to play an important political role in society, and to negotiate within the organization. Thus obtaining power is seen as more important than achieving specific objectives. Here again, Latin European managers are more likely to adhere to this view than their Nordic and Anglo counterparts.

In France, for example, executives have often played important roles in the French administration before assuming top positions in companies.

Furthermore, Latin managers are acutely aware that it is necessary to have power in order to get things done in the organization. Nordic and Anglo man- agers, however, tend to downplay the importance of power and therefore reject the need for political maneuvering.

When organizations are viewed as systems of role formalization, managers prefer detailed job descriptions, and well-defined roles and functions. These serve to clarify complex situations and tasks. Otherwise it is difficult to know who is responsible

188 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Table 3 Management Questionnaire

A � Strongly agree B � Tend to agree C � Neither agree, nor disagree D � Tend to disagree E � Strongly disagree

1. When the respective roles of the members of a department become complex, A B C D E detailed job descriptions are a useful way of clarifying.

2. In order to have efficient work relationships, it is often necessary to bypass A B C D E the hierarchical line.

8. An organizational structure in which certain subordinates have two direct A B C D E bosses should be avoided at all costs.

13. The more complex a department’s activities, the more important it is for A B C D E each individual’s functions to be well-defined.

14. The main reason for having a hierarchical structure is so that everyone knows A B C D E who has authority over whom.

19. Most organizations would be better off if conflict could be eliminated forever. A B C D E

24. It is important for a manager to have at hand precise answers to most of the A B C D E questions that his/her subordinates may raise about their work.

33. Most managers have a clear notion of what we call an organizational structure. A B C D E

38. Most managers would achieve better results if their roles were less precisely A B C D E defined.

40. Through their professional activity, managers play an important role in society. A B C D E

43. The manager of tomorrow will be, primarily, a negotiator. A B C D E

49. Most managers seem to be more motivated by obtaining power than by A B C D E achieving objectives.

52. Today there seems to be an authority crisis in organizations. A B C D E

Source: André Laurent. Reproduced by permission.

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in keeping with Taylor’s scientific management) focuses on what is to be achieved and whether objec- tives are met (achievement orientation). Structure is defined by activities—what has to be done—and the hierarchy exists only to assign responsibility. It follows that authority is defined by function and is limited, specific to the job not the person.

Here, coordination and control are impersonal, decentralized, and reside in the structure and systems. Rules and regulations are applied universally. If the rules and regulations are dysfunctional, then they are changed rather than circumvented or broken. Man- agement consultants are called in to figure out the best way to devise strategy, design structure, classify jobs and set salary scales, and develop concrete pro- grams such as “total quality” or “performance management.”

These findings can be further corroborated by asking managers to describe the approach to man- agement in their countries, or “how we see us,” . . . For example, many of the research results discussed above place Scandinavian managers at one end of a continuum, with Latin and Asian managers at the other. Jan Selmer,25 a Swedish management profes- sor, proposed the following profile of “Viking Man- agement.” Compare this with the self-descriptions of Brazilian26 and Indonesian managers in Table 4.

According to self-reports, clear differences and similarities emerge in terms of the nature of rela- tionships (hierarchy) and the relationship with na- ture (uncertainty and control). For example, in keeping with the findings discussed above, Viking Management is characterized as decentralized (less hierarchy) when compared with the Brazilian and Indonesian views, which emphasize status and power or respect for elders.

On the other hand, in each case there is a strong emphasis on the importance of relationships: family and friends, avoiding conflict, being tolerant, seeking consensus, and “keeping everyone happy.” For the

for what and to hold people accountable. In addition they argue that lack of clear job descriptions or role definitions creates overlap and inefficiency. Nordic and Anglo managers, on the other hand, argue that the world is too complex to be able to clearly define roles and functions. Furthermore they say that de- tailed descriptions interfere with maintaining flexi- bility and achieving coordination.

From his research, Laurent concluded that under- lying these arguments managers had different con- ceptions of organization: one which focused on the task, called instrumental, and one which focused on relationships, called social. For Latin European managers, organizations are considered as social sys- tems, or systems of relationships, where personal networks and social positioning are important. The organization achieves its goals through relation- ships and how they are managed (as prescribed by Fayol). Roles and relationships are defined formally (by the hierarchy) and informally, based on author- ity, power, and status which are seen as attributes of the person, not the task or function. Personal loyalty and deference to the boss are expected.

However, getting things done means working around the system—using informal, personal net- works to circumvent the hierarchy as well as the rules and regulations—what the French call, Système D. According to sociologist Michel Crozier, it is this informal system that gives the French “bureaucratic model” its flexibility.23 Organizations are thus con- sidered to be necessarily political in nature. When asked to diagnose organizational problems, French social scientists and consultants typically start by an- alyzing the power relationships and power games (les enjeux).24

In contrast, for Anglo-Saxon, and northern European managers, the organization is a system of tasks where it is important to know what has to be done, rather than who has power and authority to do so (as in the socio/political view). This instrumental or functionalist view of organizations (very much

Reading 2-1 Culture and Organization 189

❚ 23Crozier, M. (1964) The Bureaucratic Phenomenon, Chicago: University of Chicago Press. ❚ 24Crozier, M. and Friedberg, E. (1977) L’Acteur et le système: Les contraintes de l’action collective, Paris: Seuil.

❚ 25Selmer, J. (1988) Presentation, International Conference on Personnel and Human Resource Management Conference, Singapore. ❚ 26Amado, G. and Brasil, H.V. (1991) “Organizational behaviors and cultural context: The Brazilian ‘Jeitiñho,’” International Studies of Management and Organization, 21(3), 38–61.

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Swedes, this corresponds to their “mother-daughter” relationships between headquarters and subsidiaries, and their keen concern for social well-being and qual- ity of relationships, reflected in their number one ranking on Hofstede’s femininity dimension.

In all three self-descriptions there is less empha- sis placed on formalization. In Swedish companies, organization structures and decision processes are often experienced as vague and ambiguous. Uncer- tainty is managed though “values and not rules,” and communication is informal. For the Indonesians, higher order principles (The Five Principles) provide guidance not organizational ones. Furthermore, as the perceived control over nature is low, they are more likely to “go with the flow.” Brazilian man- agers, faced with great uncertainty in the day-to-day business environment over which they feel they have little control, say that they have developed a finely tuned sense of intuition, having learned to trust their “gut” feel. For the Brazilians, the notion of Jeitiñho is similar to that of the French Système D, going around the system in order to get things done. This assures flexibility and adaptability such that any- thing is possible (although perhaps too much so as Brazilian managers themselves acknowledge).

Now imagine a Brazil–Sweden–Indonesia joint venture. This raises the possibility that three firms would have to resolve their differences on several fronts while using their similarities to create a shared sense of purpose. In particular, there would probably be a clash between the cultural assumptions underly- ing Swedish management—little concern with power and status and high perceived control over the environment—with those of Brazilian and Indone- sian management—more emphasis on power and authority and less perceived control.

This would probably cause the biggest headaches for the Swedes when it came to efforts to delegate decision-making and to encourage individual respon- sibility and accountability. For the Indonesian and Brazilian managers, the frustration would come from confusion as to “who is the boss?” and “why isn’t he/she making decisions?,” and “how can I be held responsible when I have no control over what hap- pens?” In decision-making, the Brazilians would find the Indonesians and Swedes interminably slow, seeking consensus or democratic compromise, while they in turn would see the Brazilians as impetuous, and too individualistic. On the other hand, the similarity in importance placed on relationships, on

190 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Table 4 As We See Us . . .

Viking Management

Decentralized decision making Organization structure is often ambiguous Perceived by others to be indecisive Goal formulation, long-range objectives, and per-

formance evaluation criteria are vague and implicit Informal channels of communication Coordinate by values not rules (normative versus

coercive) Case-by-case approach versus standard procedures Consensus-oriented Avoid conflict Informal relationships between foreign subsidiaries

and headquarters (mother–daughter relationships)

Brazilian Management

Hierarchy and authority; status and power are important

Centralized decision making Personal relationships are more important than the task Rules and regulations are for enemies Flexible and adaptable (too much?) Jeitiñho Anything is possible Short-term oriented—immediatism Avoid conflict—seen as win/lose Rely on magic—low control over environment Decisions based on intuition and feeling

Indonesian Management

Respect for hierarchy and elders Family-oriented Group- versus individual-oriented Friendly and helpful, hospitable Tolerant Decisions based on compromise—“keep everyone

happy” Importance of religion—Islam Five principles Bhinneka Tunggal lka (unity through diversity)

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structure and process. We have proposed different profiles or models of organizing which evolve from different underlying cultural assumptions. This raises questions about what is considered to be “universal wisdom” and the transferability of “best practice.” For the most part, arguments for transferability are in line with convergence notions which claim univer- sality; “Management is management and best practice can be transferred anywhere.” This was the rationale behind the 1980s rush to copy Japanese management practice and more recent rash of American-style restructuring and re-engineering.

Those that question transferability point to dif- ferences in the cultural or national (institutional) con- text. The culturalists question the effectiveness with which Japanese quality circles, say, can be transferred to individualist countries, such as the United States and France. The institutionalists stress the nature of ownership, and the role of government, and of labor unions in promoting such practices.

The transfer of best practice nevertheless assumes, to some extent, universality. For example, matrix structures were heralded in the 1970s as a means of combining the benefits of product, geographic, and functional structures. In theory, decentralized decision-making, overlapping roles and responsi- bilities, and multiple information channels were all supposed to enable the organization to capture and analyze external complexity, to overcome internal parochialism, and to enhance response time and flexibility.27

While matrix management may have promised more than it could deliver, Laurent found deep re- sistance to matrix structures among both French and German managers, but for different reasons.28 For the French, matrix structures violated the principle of “unity of command” and clear hierarchical re- porting relationships. The idea of having two bosses was undesirable, as it created divided loyalties and caused unwelcome conflict. On the other hand, German managers resisted matrix structures, as

informal communication, and on avoiding conflict can help to work through these difficulties together, on a personal basis.

Although there are variations within countries, due to industry and corporate culture, as well as in- dividual styles of key managers, the above research findings and self-descriptions point to different cultural profiles of organization. The underlying assumptions can be interpreted to reveal the nature of relationships, as seen in the importance of hierar- chy, and control over nature, as seen in the need for formal or social rules and procedures. The underly- ing cultural meaning of the organization can then be interpreted as systems of tasks versus systems of re- lationships. These cultural profiles provide a starting point to explore different structural preferences and to begin to anticipate potential problems when transferring practices from one country to another or in forming joint ventures and strategic alliances.

On a less serious note, these differences have been caricatured in the organizational charts shown in Fig- ure 3. Using these caricatures can provoke discussion of structural differences across countries in a humor- ous mode while allowing us to discover the grain of truth within and to imagine how our own organiza- tion chart might seem to others. Constructing cultural profiles enables us to appreciate the impact of culture on management as multidimensional. It would there- fore be a mistake to base a prediction regarding struc- ture or process on a single cultural dimension.

In addition, managers need to recognize that the relationships between cultural dimensions and structure are not simple cause–effect links, but in- stead, are multi-determined. Similar approaches may exist for different cultural reasons, and differ- ent approaches may exist for the same reason. Thus formalized rules and procedures or participative management approaches may have a different rai- son d’être on different sides of the national border.

Transferability of Best Practice? Alternative Approaches

By pulling together the various experiences of man- agers and more systematic research studies, we have demonstrated how culture affects organization

Reading 2-1 Culture and Organization 191

❚ 27Davis, S. and Lawrence, P. R. (1977) Matrix, Reading, MA: Addison- Wesley. ❚ 28Laurent, A. (1981) “Matrix organization and Latin cultures,” International Studies of Management and Organization, 10(4), 101–14.

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192 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Figure 3 The Organization Chart

BritishLatin American

American Irish Women’s Lib

Chinese Arabian Italian

United Nations Vatican Norwegian

Albanian (former) Yugoslav(former) Soviet Union French

Source: International Management. Copyright © Reed Business Publishing.

they frustrated the need for clear-cut structure, in- formation channels, roles and responsibilities. Again, the principles underlying matrix management ran counter to the German need to reduce uncertainty.

Thus cultural differences often undermine the best intentions and the assumed rationality of best prac- tices. Different logics of organization exist in differ- ent countries, which can be equally effective, if not

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the “Five Asian Dragons”: China, Hong Kong, Taiwan, Japan, and South Korea.30

Consider this testimony regarding the entre- preneurial, family model characteristic of the overseas Chinese business community which has been quite successful whether transplanted to Malaysia or Canada.

. . . The Confucian tradition of hard work, thrift and respect for one’s social network may provide con- tinuity with the right twist for today’s fast-changing markets. And the central strategic question for all cur- rent multinationals—be they Chinese, Japanese or Western—is how to gather and integrate power through many small units. The evolution of a world- wide web of relatively small Chinese businesses, bound by undeniable strong cultural links, offers a working model for the future.31

Whatever the model of the future, be it team management or network organizations, we need to consider how culture may facilitate or hinder their diffusion. Will the more collective culture of Russia facilitate the team approach, while the greater rela- tionship orientation of Chinese culture facilitates creating networks? Could it be that the greater emphasis on the task and the individual, which prevails in the performance management approach, will actually hinder American firms in their attempts to become more team- and network-oriented?

Given recent trends in the United States and Europe towards participative management and em- powerment, the role of the leadership is changing. Rather than the more authoritarian notion of being the “boss,” the role model is that of the “coach.” Rather than directing and controlling, the new role calls for facilitating and developing. Notions of em- powerment and the leader as coach, however, may not readily transfer.

Take, for example, two items from the Manage- ment Questionnaire designed by Laurent regarding the role of the boss (hierarchy) and of power as shown in Figure 4. Comparing the responses of managers

more so, given different societal contexts. In fact, there seems to be little doubt that some contexts are more favorable to the success of certain management practices, and it need not always be the country where that practice originated. Japanese quality-control methods originally came from the American gurus, Demming and Juran. Quality circles were the Japanese value-added.

Effectively transferring management structures and processes relies on the ability to recognize their inherent assumptions and to compare them with the cultural assumptions of the potential host country recipient. Countries also differ in their readiness to adopt or adapt foreign models, or to manifest a NIH (not invented here) syndrome. Throughout their history, the Japanese have borrowed models from China and then Europe. Other countries, such as Germany, may be more resistant to importing alien management practices. In developing countries, the eagerness to adopt foreign models is tempered by the desire to develop their own models which are more culturally appropriate.

For example, managers in Eastern Europe may re- ject “team” approaches looking for strong leadership and a sense of clear direction in an effort to break with the more collective approach of the past.29

Despite the prevailing wisdom that organizations need to be less hierarchical and more flexible, some man- agers argue that faced with competitive threats and conditions of economic decline or instability, greater centralization and stronger controls are needed.

Indeed, companies in Hong Kong, Japan, and Singapore, where the hierarchy remains firmly in place, have performed well in industries, such as banking, which are facing turbulent environments. Here, other value orientations, not readily apparent in Western business, may be at work. For example, when trying to replicate Hofstede’s original study in China, another dimension was discovered— “Confucian dynamism,” thrift, persistence and a long-term perspective. This added dimension was considered to account for the competitiveness of

Reading 2-1 Culture and Organization 193

❚ 30Hofstede, G. and Bond, M. H. (1988) “The Confucius connection: From cultural roots to economic growth,” Organizational Dynamics, 16, 4–21; see also Hofstede, G. (1991) Cultures and Organizations: Software of the Mind, London: McGraw-Hill. ❚ 31Kao, Op. cit., p. 36.

❚ 29Cyr, D. J. and Schneider, S. C. (1996) “Implications for learning: human resources management in east-west joint ventures,” Organization Studies, 17(2), 207–226.

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194 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Figure 4 Convergence?

0

20

40

60

80

100 %

a gr

ee

0

10

30

20

50

40

60

70

80

% a

gr ee

NR 20

S 58 60

U.S. 136 60

NL 107 42

DK 128 64

U.K. 374 190

GR 128 72

CH 63 63

BL 82 45

FR 314 219

CR 26

IT 66 32

J 26 50

SP 124

1990 1980

#24 Precise answers

N DK 128 64

J 26

S 68 60

NL 107 42

CH 63 63

U.K. 374 190

U.S. 138 60

GR 128 72

FR 314 219

SP 124

BL 82

CR 25

IT 66 32

#49 Power versus objectives

It is important for a manager to have at hand precise answers to most of the questions his/her subordinates may raise about their work.

Most managers seem to be more motivated by obtaining power than by achieving objectives.

1990 1980

Source: Reproduced by permission of A. Laurent.

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greater need for negotiation and persuasion. Managers will increasingly have to elicit the cooperation of people over whom they have no formal authority. In fact this may demand a more political view of organi- zations to which Latin firms may be more attuned.

These are the challenges facing many companies as they remodel their corporate structures. They must not lose sight of the impact of national culture in their search for a model of organization that can respond best to the demands of the rapidly changing business context, and the pressures for internation- alization. They must also recognize that the “best models” are not necessarily “home grown,” but that other ways of organizing may be equally, if not more, effective. And as local managers in these regions gain experience and knowledge, they become less willing to adopt models imposed by head offices from other countries. Thus searching for ‘best practices’ wher- ever they may be located becomes an increasing strategic imperative.

attending training seminars from 1990 to 1994 with the results reported in 1980, we find some signs of convergence. According to self-reports, managers are becoming less authoritarian and more concerned with achieving objectives than obtaining power. Nev- ertheless, while country differences may have eroded, the different country rankings remain in place.

Even in countries which supposedly do not put much stock in hierarchy, such as The Netherlands and the United Kingdom, this new leadership be- havior may be difficult to achieve. Therefore, what will that mean for countries in Asia where the hier- archy is still revered? What would the Asian version of empowerment look like? Perhaps there are dif- ferent means of achieving this end. In the case of Japanese firms, the hierarchy is clearly, albeit im- plicitly, present. Nevertheless, there are apparently high levels of participation.

And as hierarchies collapse and as cooperation between units becomes more of a necessity, there is a

Reading 2-2 Clusters and the New Economics of Competition 195

Reading 2-2 Clusters and the New Economics of Competition

Michael E. Porter

Paradoxically, the enduring competitive advantages in a global economy lie increasingly in local things-knowledge, relationships, and motivation that distant rivals cannot match.

Now that companies can source capital, goods, in- formation, and technology from around the world, often with the click of a mouse, much of the conven- tional wisdom about how companies and nations compete needs to be overhauled. In theory, more open global markets and faster transportation and

communication should diminish the role of location in competition. After all, anything that can be effi- ciently sourced from a distance through global markets and corporate networks is available to any company and therefore is essentially nullified as a source of competitive advantage.

But if location matters less, why, then, is it true that the odds of finding a world-class mutual-fund company in Boston are much higher than in most any other place? Why could the same be said of textile-related companies in North Carolina and South Carolina, of high-performance auto compa- nies in southern Germany, or of fashion shoe com- panies in northern Italy?

❚ Michael E. Porter is the C. Roland Christensen Professor of Business Administration at the Harvard Business School in Boston, Massachusetts. Further discussion of clusters can be found in two new essays—“Clusters and Competition” and “Competing Across Locations”—in his new collection titled On Competition (Harvard Business School Press, 1998). ❚ Reprinted by permission of Harvard Business Review. From Clusters and the New Economics of Competition by Michael E. Porter, November/December 1998. Copyright © 1998 by the Harvard Business School Publishing Corporation; all rights reserved.

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Today’s economic map of the world is dominated by what I call clusters: critical masses—in one place—of unusual competitive success in particular fields. Clusters are a striking feature of virtually every national, regional, state, and even metropoli- tan economy, especially in more economically advanced nations. Silicon Valley and Hollywood may be the world’s best-known clusters. Clusters are not unique, however; they are highly typical—and therein lies a paradox: the enduring competitive ad- vantages in a global economy lie increasingly in local things—knowledge, relationships, motivation—that distant rivals cannot match.

Although location remains fundamental to com- petition, its role today differs vastly from a genera- tion ago. In an era when competition was driven heavily by input costs, locations with some important endowment—a natural harbor, for example, or a supply of cheap labor—often enjoyed a comparative advantage that was both competitively decisive and persistent over time.

Competition in today’s economy is far more dynamic. Companies can mitigate many input-cost disadvantages through global sourcing, rendering the old notion of comparative advantage less rele- vant. Instead, competitive advantage rests on mak- ing more productive use of inputs, which requires continual innovation.

Untangling the paradox of location in a global economy reveals a number of key insights about how companies continually create competitive ad- vantage. What happens inside companies is impor- tant, but clusters reveal that the immediate business environment outside companies plays a vital role as well. This role of locations has been long overlooked, despite striking evidence that innovation and competitive success in so many fields are geograph- ically concentrated—whether it’s entertainment in Hollywood, finance on Wall Street, or consumer elec- tronics in Japan.

Clusters affect competitiveness within countries as well as across national borders. Therefore, they lead to new agendas for all business executives—not just those who compete globally. More broadly, clus- ters represent a new way of thinking about location,

challenging much of the conventional wisdom about how companies should be configured, how institu- tions such as universities can contribute to competi- tive success, and how governments can promote economic development and prosperity.

What Is a Cluster?

Clusters are geographic concentrations of intercon- nected companies and institutions in a particular field. Clusters encompass an array of linked indus- tries and other entities important to competition. They include, for example, suppliers of specialized inputs such as components, machinery, and services, and providers of specialized infrastructure. Clusters also often extend downstream to channels and cus- tomers and laterally to manufacturers of comple- mentary products and to companies in industries related by skills, technologies, or common inputs. Finally, many clusters include governmental and other institutions—such as universities, standards- setting agencies, think tanks, vocational training providers, and trade associations—that provide spe- cialized training, education, information, research, and technical support.

The California wine cluster is a good example. It includes 680 commercial wineries as well as several thousand independent wine grape growers. (See the exhibit “Anatomy of the California Wine Cluster.”) An extensive complement of industries supporting both wine making and grape growing exists, includ- ing suppliers of grape stock, irrigation and harvest- ing equipment, barrels, and labels; specialized public relations and advertising firms; and numer- ous wine publications aimed at consumer and trade audiences. A host of local institutions is involved with wine, such as the world-renowned viticul- ture and enology program at the University of California at Davis, the Wine Institute, and special committees of the California senate and assembly. The cluster also enjoys weaker linkages to other California clusters in agriculture, food and restau- rants, and wine-country tourism.

Consider also the Italian leather fashion cluster, which contains well-known shoe companies such as Ferragamo and Gucci as well as a host of specialized

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A cluster’s boundaries are defined by the linkages and complementarities across industries and insti- tutions that are most important to competition. Although clusters often fit within political bound- aries, they may cross state or even national borders. In the United States, for example, a pharmaceuticals cluster straddles New Jersey and Pennsylvania near Philadelphia. Similarly, a chemicals cluster in Germany crosses over into German-speaking Switzerland.

Clusters rarely conform to standard industrial classification systems, which fail to capture many important actors and relationships in competition. Thus significant clusters may be obscured or even go unrecognized. In Massachusetts, for example, more than 400 companies, representing at least 39,000 high-paying jobs, are involved in medical

suppliers of footwear components, machinery, molds, design services, and tanned leather. (See the exhibit “Mapping the Italian Leather Fashion Cluster.”) It also consists of several chains of related industries, including those producing different types of leather goods (linked by common inputs and tech- nologies) and different types of footwear (linked by overlapping channels and technologies). These in- dustries employ common marketing media and compete with similar images in similar customer segments. A related Italian cluster in textile fashion, including clothing, scarves, and accessories, pro- duces complementary products that often employ common channels. The extraordinary strength of the Italian leather fashion cluster can be attributed, at least in part, to the multiple linkages and synergies that participating Italian businesses enjoy.

Reading 2-2 Clusters and the New Economics of Competition 197

Figure 1 Anatomy of the California Wine Cluster

Grape stock

Fertilizer, pesticides, herbicides

Grape harvesting equipment

Irrigation technology

Wine-making equipment

Barrels

Bottles

Caps and corks

Labels

Public relations and advertising

Specialized publications

California agricultural cluster

Tourism cluster

Food and restaurant cluster

State government agencies

Educational, research, and trade organizations

Wineries and processing

facilities

Growers and vineyards

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devices in some way. The cluster long remained all but invisible, however, buried within larger and overlapping industry categories such as elec- tronic equipment and plastic products. Executives in the medical devices cluster have only recently come together to work on issues that will benefit them all.

Clusters promote both competition and coopera- tion. Rivals compete intensely to win and retain customers. Without vigorous competition, a cluster will fail. Yet there is also cooperation, much of it vertical, involving companies in related industries and local institutions. Competition can coexist with cooperation because they occur on different dimen- sions and among different players.

Clusters represent a kind of new spatial organi- zational form in between arm’s-length markets on the one hand and hierarchies, or vertical integration, on the other. A cluster, then, is an alternative way of organizing the value chain. Compared with market

transactions among dispersed and random buyers and sellers, the proximity of companies and institu- tions in one location—and the repeated exchanges among them—fosters better coordination and trust. Thus clusters mitigate the problems inherent in arm’s-length relationships without imposing the inflexibilities of vertical integration or the manage- ment challenges of creating and maintaining formal linkages such as networks, alliances, and partner- ships. A cluster of independent and informally linked companies and institutions represents a ro- bust organizational form that offers advantages in efficiency, effectiveness, and flexibility.

Why Clusters Are Critical to Competition

Modern competition depends on productivity, not on access to inputs or the scale of individual enterprises. Productivity rests on how companies compete, not

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Figure 2 Mapping the Italian Leather Fashion Cluster

Textile fashion cluster

Athletic footwear

Synthetic footwear

Leather footwear

Hiking boots

Ski boots

Aprés-ski boots

Footwear machinery

Processed leather

Lasts

Design service

Injection-molding machinery

Molds

Models

Tanneries

Leather-working machinery

Plastic-working equipment

Footwear CAD systems

Tanning equipment

Specialized machine tools

Woodworking equipment

Leather belts

Leather clothing

Leather handbags

Leather gloves

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Clusters and Productivity Being part of a clus- ter allows companies to operate more productively in sourcing inputs; accessing information, technol- ogy, and needed institutions; coordinating with re- lated companies; and measuring and motivating improvement.

Better Access to Employees and Suppliers Com- panies in vibrant clusters can tap into an existing pool of specialized and experienced employees, thereby lowering their search and transaction costs in recruiting. Because a cluster signals opportunity and reduces the risk of relocation for employees, it can also be easier to attract talented people from other lo- cations, a decisive advantage in some industries.

A well-developed cluster also provides an efficient means of obtaining other important inputs. Such a cluster offers a deep and specialized supplier base. Sourcing locally instead of from distant suppliers lowers transaction costs. It minimizes the need for inventory, eliminates importing costs and delays, and—because local reputation is important—lowers the risk that suppliers will overprice or renege on commitments. Proximity improves communications and makes it easier for suppliers to provide ancillary or support services such as installation and debug- ging. Other things being equal, then, local outsourc- ing is a better solution than distant outsourcing, especially for advanced and specialized inputs involving embedded technology, information, and service content.

Formal alliances with distant suppliers can mitigate some of the disadvantages of distant out- sourcing. But all formal alliances involve their own complex bargaining and governance problems and can inhibit a company’s flexibility. The close, infor- mal relationships possible among companies in a cluster are often a superior arrangement.

In many cases, clusters are also a better alternative to vertical integration. Compared with in-house units, outside specialists are often more cost effective and responsive, not only in component production but also in services such as training. Although extensive vertical integration may have once been the norm, a fast-changing environment can render vertical inte- gration inefficient, ineffective, and inflexible.

on the particular fields they compete in. Companies can be highly productive in any industry—shoes, agriculture, or semiconductors—if they employ so- phisticated methods, use advanced technology, and offer unique products and services. All industries can employ advanced technology; all industries can be knowledge intensive.

The sophistication with which companies com- pete in a particular location, however, is strongly influenced by the quality of the local business en- vironment.1 Companies cannot employ advanced logistical techniques, for example, without a high- quality transportation infrastructure. Nor can com- panies effectively compete on sophisticated service without well-educated employees. Businesses can- not operate efficiently under onerous regulatory red tape or under a court system that fails to resolve disputes quickly and fairly. Some aspects of the busi- ness environment, such as the legal system, for ex- ample, or corporate tax rates, affect all industries. In advanced economies, however, the more decisive as- pects of the business environment are often cluster specific; these constitute some of the most important microeconomic foundations for competition.

Clusters affect competition in three broad ways: first, by increasing the productivity of companies based in the area; second, by driving the direction and pace of innovation, which underpins future produc- tivity growth; and third, by stimulating the formation of new businesses, which expands and strengthens the cluster itself. A cluster allows each member to benefit as if it had greater scale or as if it had joined with others formally—without requiring it to sacri- fice its flexibility.

Reading 2-2 Clusters and the New Economics of Competition 199

❚ 1I first made this argument in The Competitive Advantage of Nations (New York: Free Press, 1990). I modeled the effect of the local business environment on competition in terms of four interrelated influences, graphically depicted in a diamond: factor conditions (the cost and quality of inputs); demand conditions (the sophistication of local customers); the context for firm strategy and rivalry (the nature and intensity of local competition); and related and supporting industries (the local extent and sophistication of suppliers and related industries). Diamond theory stresses how these elements combine to produce a dynamic, stimulating, and intensely competitive business environment.

A cluster is the manifestation of the diamond at work. Proximity—the colocation of companies, customers, and suppliers—amplifies all of the pressures to innovate and upgrade.

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Even when some inputs are best sourced from a distance, clusters offer advantages. Suppliers trying to penetrate a large, concentrated market will price more aggressively, knowing that as they do so they can realize efficiencies in marketing and in service.

Working against a cluster’s advantages in assem- bling resources is the possibility that competition will render them more expensive and scarce. But companies do have the alternative of outsourcing many inputs from other locations, which tends to limit potential cost penalties. More important, clus- ters increase not only the demand for specialized inputs but also their supply.

Access to Specialized Information Extensive market, technical, and competitive information accumulates within a cluster, and members have preferred access to it. In addition, personal relation- ships and community ties foster trust and facilitate the flow of information. These conditions make information more transferable.

Complementarities A host of linkages among cluster members results in a whole greater than the sum of its parts. In a typical tourism cluster, for ex- ample, the quality of a visitor’s experience depends not only on the appeal of the primary attraction but also on the quality and efficiency of complementary businesses such as hotels, restaurants, shopping out- lets, and transportation facilities. Because members of the cluster are mutually dependent, good perfor- mance by one can boost the success of the others.

Complementarities come in many forms. The most obvious is when products complement one another in meeting customers’ needs, as the tourism example illustrates. Another form is the coordination of activities across companies to optimize their col- lective productivity. In wood products, for instance, the efficiency of sawmills depends on a reliable supply of high-quality timber and the ability to put all the timber to use—in furniture (highest quality), pallets and boxes (lower quality), or wood chips (lowest quality). In the early 1990s, Portuguese sawmills suffered from poor timber quality because local landowners did not invest in timber manage- ment. Hence most timber was processed for use in

pallets and boxes, a lower-value use that limited the price paid to landowners. Substantial improvement in productivity was possible, but only if several parts of the cluster changed simultaneously. Log- ging operations, for example, had to modify cutting and sorting procedures, while sawmills had to develop the capacity to process wood in more sophis- ticated ways. Coordination to develop standard wood classifications and measures was an important en- abling step. Geographically dispersed companies are less likely to recognize and capture such linkages.

Other complementarities arise in marketing. A cluster frequently enhances the reputation of a location in a particular field, making it more likely that buyers will turn to a vendor based there. Italy’s strong reputation for fashion and design, for exam- ple, benefits companies involved in leather goods, footwear, apparel, and accessories. Beyond reputa- tion, cluster members often profit from a variety of joint marketing mechanisms, such as company re- ferrals, trade fairs, trade magazines, and marketing delegations.

Finally, complementarities can make buying from a cluster more attractive for customers. Visit- ing buyers can see many vendors in a single trip. They also may perceive their buying risk to be lower because one location provides alternative suppliers. That allows them to multisource or to switch ven- dors if the need arises. Hong Kong thrives as a source of fashion apparel in part for this reason.

Access to Institutions and Public Goods Investments made by government or other public institutions—such as public spending for specialized infrastructure or educational programs—can enhance a company’s productivity. The ability to recruit employees trained at local programs, for example, lowers the cost of internal training. Other quasi- public goods, such as the cluster’s information and technology pools and its reputation, arise as natural by-products of competition.

It is not just governments that create public goods that enhance productivity in the private sector. Investments by companies—in training programs, infrastructure, quality centers, testing laboratories,

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Figure 3 Mapping Selected U.S. Clusters

Here are just some of the clusters in the United States. A few—Hollywood’s entertainment cluster and High Point, North Carolina’s household-furniture cluster—are well known. Others are less familiar, such as golf equipment in Carlsbad, California, and optics in Phoenix, Arizona. A relatively small number of clusters usually account for a major share of the economy within a geographic area as well as for an overwhelming share of its economic activity that is “exported” to other locations. Exporting clusters—those that export products or make investments to compete outside the local area—are the primary source of an area’s economic growth and prosperity over the long run. The demand for local industries is inherently limited by the size of the local market, but exporting clusters can grow far beyond that limit.

Seattle Aircraft equipment and design Boat and ship building Metal fabrication

Silicon Valley Microelectronics Biotechnology Venture capital

Los Angeles area Defense and aerospace Entertainment

Carlsbad Golf equipment

Boston Mutual funds Biotechnology Software and networking Venture capital

Oregon Electrical measuring equipment Woodworking equipment Logging and lumber supplies

Wisconsin/ lowa/Illinois Agricultural equipment

Detroit Auto equipment and parts

Western Massachusetts Polymers

Providence Jewelry Marine equipment

Rochester Imaging equipment

Minneapolis Cardiovascular equipment and services

BoiseBoise SawmillsSawmills FarmFarm machinerymachinery

Boise Sawmills Farm machinery

Las VegasLas Vegas AmusementsAmusements and casinosand casinos Small airlinesSmall airlines

Las Vegas Amusements and casinos Small airlines

PhoenixPhoenix HelicoptersHelicopters SemiconductorsSemiconductors Electronic testingElectronic testing labs Opticslabs Optics

Phoenix Helicopters Semiconductors Electronic testing labs Optics

WitchitaWitchita Light aircraftLight aircraft Farm equipmentFarm equipment

Witchita Light aircraft Farm equipment

Dallas Real estate development

Nashville/Nashville/ LouisvilleLouisville HospitalHospital managementmanagement

Nashville/ Louisville Hospital management

Warsaw, Indiana Orthopedic devices

Warsaw, Indiana Orthopedic devices

Cleveland/Cleveland/ LouisvilleLouisville Paints and coatingsPaints and coatings

Cleveland/ Louisville Paints and coatings

Dalton,Dalton, GeorgiaGeorgia CarpetsCarpets

Dalton, Georgia Carpets

Pittsburgh Advanced materials Energy

Southern Florida Health technology Computers

North Carolina Household furniture Synthetic fibers Hosiery

Pennsylvania/ New Jersey Pharmaceuticals

New York City Financial services Advertising Publishing Multimedia

Hartford Insurance

Baton Rouge/ New Orleans Specialty foods

Southeastern Texas/ Louisiana Chemicals

Colorado Computer-integrated systems and programming Engineering services Mining and oil and gas exploration

OmahaOmaha TelemarketingTelemarketing Hotel reservationsHotel reservations Credit cardCredit card processingprocessing

Omaha Telemarketing Hotel reservations Credit card processing

Western Michigan Office and institutional furniture

Michigan Clocks

and so on—also contribute to increased productivity. Such private investments are often made collectively because cluster participants recognize the potential for collective benefits.

Better Motivation and Measurement Local rivalry is highly motivating. Peer pressure amplifies competitive pressure within a cluster, even among noncompeting or indirectly competing companies.

Pride and the desire to look good in the local commu- nity spur executives to attempt to outdo one another.

Clusters also often make it easier to measure and compare performances because local rivals share gen- eral circumstances—for example, labor costs and local market access—and they perform similar activi- ties. Companies within clusters typically have inti- mate knowledge of their suppliers’costs. Managers are

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able to compare costs and employees’ performance with other local companies. Additionally, financial in- stitutions can accumulate knowledge about the cluster that can be used to monitor performance.

Clusters and Innovation In addition to enhanc- ing productivity, clusters play a vital role in a com- pany’s ongoing ability to innovate. Some of the same characteristics that enhance current productivity have an even more dramatic effect on innovation and productivity growth.

Because sophisticated buyers are often part of a cluster, companies inside clusters usually have a better window on the market than isolated competi- tors do. Computer companies based in Silicon Valley and Austin, Texas, for example, plug into customer needs and trends with a speed difficult to match by companies located elsewhere. The ongoing relation- ships with other entities within the cluster also help companies to learn early about evolving technol- ogy, component and machinery availability, service and marketing concepts, and so on. Such learning is facilitated by the ease of making site visits and frequent face-to-face contact.

Clusters do more than make opportunities for in- novation more visible. They also provide the capac- ity and the flexibility to act rapidly. A company within a cluster often can source what it needs to implement innovations more quickly. Local suppli- ers and partners can and do get closely involved in the innovation process, thus ensuring a better match with customers’ requirements.

Companies within a cluster can experiment at lower cost and can delay large commitments until they are more assured that a given innovation will pan out. In contrast, a company relying on distant suppli- ers faces greater challenges in every activity it coor- dinates with other organizations—in contracting, for example, or securing delivery or obtaining associated technical and service support. Innovation can be even harder in vertically integrated companies, especially in those that face difficult trade-offs if the innovation erodes the value of in-house assets or if current products or processes must be maintained while new ones are developed.

Reinforcing the other advantages for innovation is the sheer pressure—competitive pressure, peer pressure, constant comparison—that occurs in a cluster. Executives vie with one another to set their companies apart. For all these reasons, clusters can remain centers of innovation for decades.

Clusters and New Business Formation It is not surprising, then, that many new companies grow up within an existing cluster rather than at isolated locations. New suppliers, for example, proliferate within a cluster because a concentrated customer base lowers their risks and makes it easier for them to spot market opportunities. Moreover, because developed clusters comprise related industries that normally draw on common or very similar inputs, suppliers enjoy expanded opportunities.

Clusters are conducive to new business formation for a variety of reasons. Individuals working within a cluster can more easily perceive gaps in products or services around which they can build businesses. Beyond that, barriers to entry are lower than else- where. Needed assets, skills, inputs, and staff are often readily available at the cluster location, wait- ing to be assembled into a new enterprise. Local financial institutions and investors, already familiar with the cluster, may require a lower risk premium on capital. In addition, the cluster often presents a significant local market, and an entrepreneur may benefit from established relationships. All of these factors reduce the perceived risks of entry—and of exit, should the enterprise fail.

The formation of new businesses within a cluster is part of a positive feedback loop. An expanded cluster amplifies all the benefits I have described—it increases the collective pool of com- petitive resources, which benefits all the cluster’s members. The net result is that companies in the cluster advance relative to rivals at other locations.

Birth, Evolution, and Decline

A cluster’s roots can often be traced to historical circumstances. In Massachusetts, for example, sev- eral clusters had their beginnings in research done at MIT or Harvard. The Dutch transportation cluster

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less unique attributes such as its central-time-zone location and easily understandable local accent, provided the underpinnings of the area’s telemar- keting cluster.

Once a cluster begins to form, a self-reinforcing cycle promotes its growth, especially when local insti- tutions are supportive and local competition is vigor- ous. As the cluster expands, so does its influence with government and with public and private institutions.

A growing cluster signals opportunity, and its success stories help attract the best talent. Entrepre- neurs take notice, and individuals with ideas or relevant skills migrate in from other locations. Specialized suppliers emerge; information accumu- lates; local institutions develop specialized training, research, and infrastructure; and the cluster’s strength and visibility grow. Eventually, the cluster broadens to encompass related industries. Numer- ous case studies suggest that clusters require a decade or more to develop depth and real competi- tive advantage.2

Cluster development is often particularly vibrant at the intersection of clusters, where insights, skills, and technologies from various fields merge, spark- ing innovation and new businesses. An example from Germany illustrates this point. The country has distinct clusters in both home appliances and household furniture, each based on different tech- nologies and inputs. At the intersection of the two, though, is a cluster of built-in kitchens and appli- ances, an area in which Germany commands a higher share of world exports than in either appli- ances or furniture.

Clusters continually evolve as new companies and industries emerge or decline and as local institutions develop and change. They can maintain vibrancy as competitive locations for centuries; most successful clusters prosper for decades at least. However, they can and do lose their competitive edge due to both

owes much to Holland’s central location within Europe, an extensive network of waterways, the effi- ciency of the port of Rotterdam, and the skills accu- mulated by the Dutch through Holland’s long maritime history.

Clusters may also arise from unusual, sophisti- cated, or stringent local demand. Israel’s cluster in irrigation equipment and other advanced agricultural technologies reflects that nation’s strong desire for self-sufficiency in food together with a scarcity of water and hot, arid growing conditions. The environ- mental cluster in Finland emerged as a result of pol- lution problems created by local process industries such as metals, forestry, chemicals, and energy.

Prior existence of supplier industries, related industries, or even entire related clusters provides yet another seed for new clusters. The golf equip- ment cluster near San Diego, for example, has its roots in southern California’s aerospace cluster. That cluster created a pool of suppliers for castings and advanced materials as well as engineers with the requisite experience in those technologies.

New clusters may also arise from one or two in- novative companies that stimulate the growth of many others. Medtronic played this role in helping to create the Minneapolis medical-device cluster. Simi- larly, MCI and America Online have been hubs for growing new businesses in the telecommunications cluster in the Washington, D.C., metropolitan area.

Sometimes a chance event creates some advantageous factor that, in turn, fosters cluster development—although chance rarely provides the sole explanation for a cluster’s success in a location. The telemarketing cluster in Omaha, Nebraska, for example, owes much to the decision by the United States Air Force to locate the Strategic Air Command (SAC) there. Charged with a key role in the country’s nuclear deterrence strategy, SAC was the site of the first installation of fiber-optic telecommunications cables in the United States. The local Bell operat- ing company (now U.S. West) developed unusual capabilities through its dealings with such a demanding customer. The extraordinary telecom- munications capability and infrastructure that consequently developed in Omaha, coupled with

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❚ 2.Selected case studies are described in “Clusters and Competition” in my book On Competition (Boston: Harvard Business School Press, 1998), which also includes citations of the published output of a number of cluster initiatives. Readers can also find a full treatment of the intellectual roots of cluster thinking, along with an extensive bibliography.

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external and internal forces. Technological disconti- nuities are perhaps the most significant of the external threats because they can neutralize many advantages simultaneously. A cluster’s assets—market informa- tion, employees’ skills, scientific and technical exper- tise, and supplier bases—may all become irrelevant. New England’s loss of market share in golf equip- ment is a good example. The New England cluster was based on steel shafts, steel irons, and wooden- headed woods. When companies in California began making golf clubs with advanced materials, East Coast producers had difficulty competing. A number of them were acquired or went out of business.

A shift in buyers’needs, creating a divergence be- tween local needs and needs elsewhere, constitutes another external threat. U.S. companies in a variety of clusters, for example, suffered when energy effi- ciency grew in importance in most parts of the world while the United States maintained low energy prices. Lacking both pressure to improve and insight into customer needs, U.S. companies were slow to innovate, and they lost ground to European and Japanese competitors.

Clusters are at least as vulnerable to internal rigidities as they are to external threats. Overcon- solidation, mutual understandings, cartels, and other restraints to competition undermine local rivalry. Regulatory inflexibility or the introduction of restric- tive union rules slows productivity improvement. The quality of institutions such as schools and universi- ties can stagnate.

Groupthink among cluster participants—Detroit’s attachment to gas-guzzling autos in the 1970s is one example—can be another powerful form of rigidity. If companies in a cluster are too inward looking, the whole cluster suffers from a collective inertia, mak- ing it harder for individual companies to embrace new ideas, much less perceive the need for radical innovation.

Such rigidities tend to arise when government suspends or intervenes in competition or when com- panies persist in old behaviors and relationships that no longer contribute to competitive advantage. Increases in the cost of doing business begin to out- run the ability to upgrade. Rigidities of this nature

currently work against a variety of clusters in Switzerland and Germany.

As long as rivalry remains sufficiently vigor- ous, companies can partially compensate for some decline in the cluster’s competitiveness by outsourcing to distant suppliers or moving part or all of production elsewhere to offset local wages that rise ahead of productivity. German compa- nies in the 1990s, for example, have been doing just that. Technology can be licensed or sourced from other locations, and product development can be moved. Over time, however, a location will decline if it fails to build capabilities in major new technologies or needed supporting firms and institutions.

Implications for Companies

In the new economics of competition, what matters most is not inputs and scale, but productivity—and that is true in all industries. The term high tech, nor- mally used to refer to fields such as information tech- nology and biotechnology, has distorted thinking about competition, creating the misconception that only a handful of businesses compete in sophisti- cated ways.

In fact, there is no such thing as a low-tech in- dustry. There are only low-tech companies—that is, companies that fail to use world-class technology and practices to enhance productivity and innova- tion. A vibrant cluster can help any company in any industry compete in the most sophisticated ways, using the most advanced, relevant skills and technologies.

Thus executives must extend their thinking be- yond what goes on inside their own organizations and within their own industries. Strategy must also address what goes on outside. Extensive vertical integration may once have been appropriate, but companies today must forge close linkages with buyers, suppliers, and other institutions.

Specifically, understanding clusters adds the following four issues to the strategic agenda.

1. Choosing locations. Globalization and the ease of transportation and communication have led many companies to move some or all of their operations

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While it is essential that clusters form, where they form also matters. In developing economies, a large proportion of economic activity tends to con- centrate around capital cities such as Bangkok and Bogotá. That is usually because outlying areas lack infrastructure, institutions, and suppliers. It may also reflect an intrusive role by the central govern- ment in controlling competition, leading companies to locate near the seat of power and the agencies whose approval they require to do business.

This pattern of economic geography inflicts high costs on productivity. Congestion, bottle- necks, and inflexibility lead to high administrative costs and major inefficiencies, not to mention a diminished quality of life. Companies cannot eas- ily move out from the center, however, because neither infrastructure nor rudimentary clusters exist in the smaller cities and towns. (The building of a tourism cluster in developing economies can be a positive force in improving the outlying in- frastructure and in dispersing economic activity.)

Even in advanced economies, however, eco- nomic activity may be geographically concentrated. Japan offers a particularly striking case, with nearly 50% of total manufacturing shipments located around Tokyo and Osaka. This is due less to inade- quacies in infrastructure in outlying areas than to a powerful and intrusive central government, with its centralizing bias in policies and institutions. The Japanese case vividly illustrates the major ineffi- ciencies and productivity costs resulting from such a pattern of economic geography, even for advanced nations. It is a major policy issue facing Japan.

An economic geography characterized by spe- cialization and dispersion—that is, a number of metropolitan areas, each specializing in an array of clusters—appears to be a far more productive in- dustrial organization than one based on one or two huge, diversified cities. In nations such as Germany, Italy, Switzerland, and the United States, this kind of internal specialization and trade—and internal competition among locations—fuels productivity growth and hones the ability of companies to compete effectively in the global arena.

Clusters, Geography, and Economic Development

Poor countries lack well-developed clusters; they compete in the world market with cheap labor and natural resources. To move beyond this stage, the development of well-functioning clusters is essen- tial. Clusters become an especially controlling fac- tor for countries moving from a middle-income to an advanced economy. Even in high-wage eco- nomies, however, the need for cluster upgrading is constant. The wealthier the economy, the more it will require innovation to support rising wages and to replace jobs eliminated by improvements in effi- ciency and the migration of standard production to low-cost areas.

Promoting cluster formation in developing economies means starting at the most basic level. Policymakers must first address the foundations: improving education and skill levels, building ca- pacity in technology, opening access to capital markets, and improving institutions. Over time, additional investment in more cluster-specific as- sets is necessary.

Government policies in developing economies often unwittingly work against cluster formation. Restrictions on industrial location and subsidies to invest in distressed areas, for example, can disperse companies artificially. Protecting local companies from competition leads to excessive vertical inte- gration and blunted pressure for innovation, retard- ing cluster development.

In the early stages of economic development, countries should expand internal trade among cities and states and trade with neighboring countries as important stepping stones to building the skills to compete globally. Such trade greatly enhances clus- ter development. Instead, attention is typically riv- eted on the large, advanced markets, an orientation that has often been reinforced by protectionist poli- cies restricting trade with nearby markets. However, the kinds of goods developing countries can trade with advanced economies are limited to commodi- ties and to activities sensitive to labor costs.

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to locations with low wages, taxes, and utility costs. What we know about clusters suggests, first, that some of those cost advantages may well turn out to be illusory. Locations with those advantages often lack efficient infrastructure, sophisticated suppliers, and other cluster benefits that can more than offset any savings from lower input costs. Savings in wages, utilities, and taxes may be highly visible and easy to measure up front, but productivity penalties remain hidden and unanticipated.

More important to ongoing competitiveness is the role of location in innovation. Yes, companies

have to spread activities globally to source inputs and gain access to markets. Failure to do so will lead to a competitive disadvantage. And for stable, labor- intensive activities such as assembly and software translation, low factor costs are often decisive in driving locational choices.

For a company’s “home base” for each product line, however, clusters are critical. Home base activities—strategy development, core product and process R&D, a critical mass of the most sophisti- cated production or service provision—create and renew the company’s product, processes, and services.

206 Chapter 2 Understanding the International Context: Responding to Conflicting Environmental Forces

Figure 4 Mapping Portugal’s Clusters

In a middle-income economy like Portugal, exporting clusters tend to be more natural-resource labor intensive.

Cotton textiles Leather

Furniture

Sheep and goats

Port wine

Automotive components

Clothing

Red wine

Wool textiles

Clothing

Clothing

Ornamental stone

Red wine

Tourism

Horticulture

Cork agglomerates

Tourism

Cork-transformed products

Automotive

Tourism

Leather

Fruit

Pine wood furniture

Plastic molds

Pulp and paper

Ceramic tiles

Cork stoppers

Clothing

Casual shoes

Wine

Dress shoes

Dairy

Viana do Castelo

Braga

Vila RealVila RealVila Real

Bragança

Porto

AveiroAveiroAveiro Viseu Guarda

Coimbra

Leiria

Santarem Portalegre

Évora

Beja

Faro

Castelo Branco

Lisbon

Setúbal

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2. Engaging locally. The social glue that binds clusters together also facilitates access to important resources and information. Tapping into the com- petitively valuable assets within a cluster requires personal relationships, face-to-face contact, a sense of common interest, and “insider” status. The mere colocation of companies, suppliers, and institutions creates the potential for economic value; it does not necessarily ensure its realization.

To maximize the benefits of cluster involvement, companies must participate actively and establish a significant local presence. They must have a sub- stantial local investment even if the parent company is headquartered elsewhere. And they must foster ongoing relationships with government bodies and local institutions such as utilities, schools, and re- search groups.

Companies have much to gain by engaging be- yond their narrow confines as single entities. Yet managers tend to be wary, at least initially. They fear that a growing cluster will attract competition, drive up costs, or cause them to lose valued employ- ees to rivals or spin-offs. As their understanding of the cluster concept grows, however, managers real- ize that many participants in the cluster do not com- pete directly and that the offsetting benefits, such as a greater supply of better trained people, for exam- ple, can outweigh any increase in competition.

3. Upgrading the cluster. Because the health of the local business environment is important to the health of the company, upgrading the cluster should be part of management’s agenda. Companies up- grade their clusters in a variety of ways.

Consider Genzyme. Massachusetts is home to a vibrant biotechnology cluster, which draws on the region’s strong universities, medical centers, and venture capital firms. Once Genzyme reached the stage in its development when it needed a manufacturing facility, CEO Henri Termeer ini- tially considered the pharmaceuticals cluster in the New Jersey and Philadelphia area because it had what Massachusetts lacked: established ex- pertise in drug manufacturing. Upon further re- flection, however, Termeer decided to influence the process of creating a manufacturing capability

Therefore locational decisions must be based on both total systems costs and innovation potential, not on input costs alone. Cluster thinking suggests that every product line needs a home base, and the most vibrant cluster will offer the best location. Within the United States, for example, Hewlett-Packard has chosen cluster locations for the home bases of its major prod- uct lines: California, where almost all of the world’s leading personal computer and workstation busi- nesses are located, is home to personal computers and workstations; Massachusetts, which has an extraordi- nary concentration of world-renowned research hospitals and leading medical instrument companies, is home to medical instruments.

As global competition nullifies traditional com- parative advantages and exposes companies to the best rivals from around the world, a growing number of multinationals are shifting their home bases to more vibrant clusters—often using acquisitions as a means of establishing themselves as insiders in a new location. Nestlé, for example, after acquiring Rowntree Mackintosh, relocated its confectionary business to York, England, where Rowntree was originally based, because a vibrant food cluster thrives there. England, with its sweet-toothed consumers, so- phisticated retailers, advanced advertising agencies, and highly competitive media companies, constitutes a more dynamic environment for competing in mass-market candy than Switzerland did. Similarly, Nestlé has moved its headquarters for bottled water to France, the most competitive location in that industry. Northern Telecom has relocated its home base for central office switching from Canada to the United States—drawn by the vibrancy of the U.S. telecom- munications-equipment cluster.

Cluster thinking also suggests that it is better to move groups of linked activities to the same place than to spread them across numerous locations. Colocating R&D, component fabrication, assembly, marketing, customer support, and even related busi- nesses can facilitate internal efficiencies in sourcing and in sharing technology and information. Group- ing activities into campuses also allows companies to extend deeper roots into local clusters, improving their ability to capture potential benefits.

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in Genzyme’s home base, reasoning that if his plans were successful, the company could become more competitive.

Thus Genzyme deliberately chose to work with contractors committed to the Boston area, bypass- ing the many specialized engineering firms located near Philadelphia. In addition, it undertook a num- ber of initiatives, with the help of city and state government, to improve the labor force, such as offering scholarships and internships to local youth. More broadly, Genzyme has worked to build critical mass for its cluster. Termeer believes that Genzyme’s success is linked to the cluster’s—and that all members will benefit from a strong base of supporting functions and institutions.

4. Working collectively. The way clusters oper- ate suggests a new agenda of collective action in the private sector. Investing in public goods is normally seen as a function of government, yet cluster think- ing clearly demonstrates how companies benefit from local assets and institutions.

In the past, collective action in the private sector has focused on seeking government subsidies and special favors that often distort competition. But ex- ecutives’ long-term interests would be better served by working to promote a higher plane of competi- tion. They can begin by rethinking the role of trade associations, which often do little more than lobby government, compile some statistics, and host so- cial functions. The associations are missing an important opportunity.

Trade associations can provide a forum for the ex- change of ideas and a focal point for collective action in overcoming obstacles to productivity and growth. Associations can take the lead in such activities as establishing university-based testing facilities and training or research programs; collecting cluster- related information; offering forums on common managerial problems; investigating solutions to envi- ronmental issues; organizing trade fairs and delega- tions; and managing purchasing consortia.

For clusters consisting of many small and mid- size companies—such as tourism, apparel, and agriculture—the need is particularly great for col- lective bodies to assume scale-sensitive functions.

In the Netherlands, for instance, grower coopera- tives built the specialized auction and handling facilities that constitute one of the Dutch flower cluster’s greatest competitive advantages. The Dutch Flower Council and the Association of Dutch Flower Growers Research Groups, in which most growers participate, have taken on other functions as well, such as applied research and marketing.

Most existing trade associations are too narrow; they represent industries, not clusters. In addition, because their role is defined as lobbying the federal government, their scope is national rather than local. National associations, however, are rarely sufficient to address the local issues that are most important to cluster productivity.

By revealing how business and government to- gether create the conditions that promote growth, clusters offer a constructive way to change the na- ture of the dialogue between the public and private sectors. With a better understanding of what fosters true competitiveness, executives can start asking government for the right things. The example of MassMEDIC, an association formed in 1996 by the Massachusetts medical-devices cluster, illustrates this point. It recently worked successfully with the U.S. Food and Drug Administration to streamline the approval process for medical devices. Such a step clearly benefits cluster members and enhances competition at the same time.

What’s Wrong with Industrial Policy

Productivity, not exports or natural resources, deter- mines the prosperity of any state or nation. Recog- nizing this, governments should strive to create an environment that supports rising productivity. Sound macroeconomic policy is necessary but not suffi- cient. The microeconomic foundations for competi- tion will ultimately determine productivity and competitiveness.

Governments—both national and local—have new roles to play. They must ensure the supply of high-quality inputs such as educated citizens and physical infrastructure. They must set the rules of competition—by protecting intellectual property and enforcing antitrust laws, for example—so that

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sources of uniqueness. Finding areas of specializa- tion normally proves more effective than head-on competition with well-established rival locations.

New Public-Private Responsibilities

Economic geography in an era of global competition, then, poses a paradox. In a global economy—which boasts rapid transportation, high-speed communica- tion, and accessible markets—one would expect location to diminish in importance. But the opposite is true. The enduring competitive advantages in a global economy are often heavily local, arising from concentrations of highly specialized skills and knowl- edge, institutions, rivals, related businesses, and sophisticated customers. Geographic, cultural, and institutional proximity leads to special access, closer relationships, better information, powerful incentives, and other advantages in productivity and innovation that are difficult to tap from a distance. The more the world economy becomes complex, knowledge based, and dynamic, the more this is true.

Leaders of businesses, government, and institu- tions all have a stake—and a role to play—in the new economics of competition. Clusters reveal the mutual dependence and collective responsibility of all these entities for creating the conditions for productive competition. This task will require fresh thinking on the part of leaders and the willingness to abandon the traditional categories that drive our thinking about who does what in the economy. The lines between public and private investment blur. Companies, no less than governments and universi- ties, have a stake in education. Universities have a stake in the competitiveness of local businesses. By revealing the process by which wealth is actually created in an economy, clusters open new public- private avenues for constructive action.

productivity and innovation will govern success in the economy. Finally, governments should promote cluster formation and upgrading and the buildup of public or quasi-public goods that have a significant impact on many linked businesses.

This sort of role for government is a far cry from industrial policy. In industrial policy, governments target “desirable” industries and intervene—through subsidies or restrictions on investments by foreign companies, for example—to favor local companies. In contrast, the aim of cluster policy is to reinforce the development of all clusters. This means that a traditional cluster such as agriculture should not be abandoned; it should be upgraded. Governments should not choose among clusters, because each one offers opportunities to improve productivity and sup- port rising wages. Every cluster not only contributes directly to national productivity but also affects the productivity of other clusters. Not all clusters will succeed, of course, but market forces—not govern- ment decisions—should determine the outcomes.

Government, working with the private sector, should reinforce and build on existing and emerg- ing clusters rather than attempt to create entirely new ones. Successful new industries and clusters often grow out of established ones. Businesses involving advanced technology succeed not in a vacuum but where there is already a base of related activities in the field. In fact, most clusters form in- dependently of government action—and sometimes in spite of it. They form where a foundation of lo- cational advantages exists. To justify cluster devel- opment efforts, some seeds of a cluster should have already passed a market test.

Cluster development initiatives should embrace the pursuit of competitive advantage and specializa- tion rather than simply imitate successful clusters in other locations. This requires building on local

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C H A P T E R 3

Developing Transnational Strategies: Building Layers of Competitive Advantage

210

The strategies of MNEs at the start of the 21st century were shaped by the turbulent in- ternational environment that redefined global competition in the closing decades of the 20th century. It was during that turmoil that a number of different perspectives and pre- scriptions emerged about how companies could create strategic advantage in their worldwide businesses.

Consider, for example, three of the most influential articles on global strategy pub- lished during the 1980s—the decade in which many new trends first emerged.1 Each is reasonable and intuitively appealing. What soon becomes clear, however, is that their prescriptions are very different and often contradictory, a reality that highlights not only the complexity of the strategic challenge that faced managers in large, worldwide com- panies but also the confusion of advice being offered to them.

• In one of the most provocative articles of that era, Theodore Levitt argued that effec- tive global strategy was not a bag of many tricks but the successful practice of just

❚ 1See Theodeore Levitt, “The Globalization of Markets” Harvard Business Review 61, no. 3 (1983), pp. 92–102; T. Hout, M. E. Porter, and E. Rudden, “How Global Companies Win Out,” Harvard Business Review 60, no. 5 (1982), pp. 98–109; G. Hamel and C. K. Prahalad, “Do You Really Have a Global Strategy?” Harvard Business Review 63, no. 4 (1985), pp. 139–49.

In this chapter, we discuss how the numerous conflicting demands and pressures de- scribed in the first two chapters shape the strategic choices that MNEs must make. In this complex situation, an MNE determines strategy by balancing the motivations for its own international expansion with the economic imperatives of its industry structure and competitive dynamics, the social and cultural forces of the markets it has entered world- wide, and the political demands of its home- and host-country governments. To frame this complex analysis, in this chapter, we examine how MNEs balance strategic means and ends to build the three required dimensional capabilities: global-scale efficiency and competitiveness, multinational flexibility and responsiveness, and worldwide innovation and learning. After defining each of the dominant historic strategic approaches—what we term classic multinational, international, and global strategies—we explore the emerging transnational strategic model that most MNEs must adopt today. Finally, we describe not only how companies can develop this approach themselves but also how they can defend against transnational competitors.

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Worldwide Competitive Advantage: Goals and Means 211

one: product standardization. According to him, the core of a global strategy lay in developing a standardized product to be produced and sold the same way throughout the world.

• In contrast, an article by Michael Porter and his colleagues suggested that effective global strategy required the approach not of a hedgehog, who knows only one trick, but that of a fox, who knows many. These “tricks” include exploiting economies of scale through global volume, taking preemptive positions through quick and large investments, and managing interdependently to achieve synergies across different activities.

• Gary Hamel and C. K. Prahalad’s prescription for a global strategy contradicted Levitt’s even more sharply. Instead of a single standardized product, they recom- mended a broad product portfolio, with many product varieties, so that investments in technologies and distribution channels could be shared. Cross-subsidization across products and markets and the development of a strong worldwide distribution system were at the center of these authors’ view of how to succeed in the game of global chess.

As we described in the preceding chapter, what was becoming increasingly clear dur- ing the next two decades was that to achieve sustainable competitive advantage, MNEs needed to develop layers of competitive advantage—global-scale efficiency, multina- tional flexibility, and the ability to develop innovations and leverage knowledge on a worldwide basis. Though each of the different prescriptions focuses on one or another of these different strategic objectives, the challenge for most companies today is to achieve all of them simultaneously.

Worldwide Competitive Advantage: Goals and Means To develop worldwide advantage, a company must achieve three strategic objectives: It must build global-scale efficiency in its existing activities, it must develop multina- tional flexibility to manage diverse country-specific risks and opportunities, and it must create the ability to learn from its international exposure and opportunities and exploit that learning on a worldwide basis. Competitive advantage is developed by taking strate- gic actions that optimize a company’s achievement of these different and, at times, con- flicting goals.

In developing each of these capabilities, the MNE can utilize three very different tools and approaches, which we described briefly in Chapter 1 as the main forces motivating companies to internationalize. It can leverage the scale economies that are potentially available in its different worldwide activities, it can exploit the differences in sourcing and market opportunities among the many countries in which it operates, and it can capitalize on the diversity of its activities and operations to create synergies or develop economies of scope.

The MNE’s strategic challenge, therefore, is to exploit all three sources of global competitive advantage—scale economies, national differences, and scope economies— to optimize global efficiencies, multinational flexibility, and worldwide learning. Thus, the key to worldwide competitive advantage lies in managing the interactions between the different goals and the different means.

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212 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

Figure 3-1 The Integration–Responsiveness Framework

The Goals: Efficiency, Flexibility, and Learning Let us now consider each of these strategic goals in a little more detail.

Global Efficiency

Viewing an MNE as an input–output system, we can think of its overall efficiency as the ratio of the value of its outputs to the value of its inputs. In this simplified view of the firm, its efficiency could be enhanced by increasing the value of outputs (i.e., securing higher revenues), lowering the value of its inputs (i.e., lowering costs), or doing both. This is a simple point but one that is often overlooked:

• Efficiency improvement is not just cost reduction but also revenue enhancement.

To help understand the concept of global efficiency, we use the global integration— national responsiveness framework first developed by C. K. Prahalad (see Figure 3-1).2

The vertical axis represents the potential benefits from the global integration of activities— benefits that largely translate into lower costs through scale and scope economies. The horizontal axis represents the benefits of national responsiveness—those that result from the country-by-country differentiation of product, strategies, and activities. These benefits essentially translate into better revenues from more effective differentiation in response to national differences in tastes, industry structures, distribution systems, and government regulations.

As Figure 3-1 illustrates, the framework can be used to understand differences in the benefits of integration and responsiveness at the aggregate level of industries, as well as to identify and describe differences in the strategic approaches of companies competing in the same industry. Also as the figure indicates, industry characteristics alone do not determine company strategies. In automobiles, for example, Fiat historically pursued a classical multinational strategy, helping establish national auto industries through its joint venture partnerships and host government support in Spain, Yugoslavia, Poland,

❚ 2For a detailed exposition of this framework, see C. K. Prahalad and Yves Doz, The Multinational Mission (New York: The Free Press, 1987).

Automobiles

Telecom, switching

Consumer electronics

Cement Packaged foods

Efficiency benefits from global integration

Toyota

Ford

Fiat

Differentiation benefits from national responsiveness

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The Goals: Efficiency, Flexibility, and Learning 213

and many other countries with state-sponsored auto industries. Toyota, by contrast, succeeded originally by developing products and manufacturing them in centralized, globally scaled facilities in Japan. This sort of strategic choice to focus on the objective of global efficiency (rather than local responsiveness) creates vulnerabilities and chal- lenges as well as clear benefits.

Multinational Flexibility

A worldwide company faces an operating environment characterized by diversity and volatility. Some opportunities and risks generated by this environment are endemic to all firms; others, however, are unique to companies operating across national borders. A key element of worldwide competitiveness, therefore, is multinational flexibility—the ability of a company to manage the risks and exploit the opportunities that arise from the diversity and volatility of the global environment.3

Although there are many sources of diversity and volatility, it is worth highlighting four that we regard as particularly important. First, there are macroeconomic risks that are completely outside the control of the MNE, such as changes in prices, wages, or exchange rates caused by wars, natural calamities, or recessions. Second, there are political risks that arise from policy actions of national governments, such as managed changes in exchange rates or interest rate adjustments. Third, there are competitive risks arising from the uncertainties of competitors’ responses to the MNE’s own strategies. Fourth, there are resource risks, such as the availability of raw materials, capital, or managerial talent. In all four categories, the common characteristic of the various types of risks is they vary across countries and change over time. This variance makes flexi- bility the key strategic management requirement, because diversity and volatility create attendant opportunities that must be considered jointly.

In general, multinational flexibility requires management to scan its broad environ- ment to detect changes and discontinuities and then respond to the new situation in the context of the worldwide business. MNEs following this approach exploit their exposure to diverse and dynamic environments to develop strategies—and structures— in more general and more flexible terms so as to be robust to different international environmental scenarios. For example, having a network of affiliated subsidiaries which emphasize global exports rather than individual local markets provides a flexibility to shift production when a particular national market faces an economic crisis.

Worldwide Learning

Most existing theories of the MNE view it as an instrument to extract additional rev- enues from internalized capabilities. The assumption is that the firm goes abroad to make more profits by exploiting its technology, brand name, or management capabilities in different countries around the world. And most traditional theory assumes that the key competencies reside at the MNE’s center.

❚ 3This issue of multinational flexibility is discussed more fully in Bruce Kogut, “Designing Global Strategies: Profiting from Operating Flexibility,” Sloan Management Review, Fall 1985, pp. 27–38.

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214 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

Although the search for additional profits or the desire to protect existing revenues may explain why MNEs come to exist, it does not provide a complete explanation of why some of them continue to grow and flourish. As we suggested in Chapter 1, an alternative view may well be that a key asset of the multinational is the diversity of environments in which it operates. This diversity exposes the MNE to multiple stimuli, allows it to develop diverse capabilities, and provides it with broader learning opportuni- ties than are available to a purely domestic firm. Furthermore, its initial stock of knowl- edge provides the MNE with strength that allows it to create organizational diversity in the first place. In Chapter 5, we engage in a detailed discussion of the approaches that MNEs use to deliver on the objective of worldwide learning.

The Means: National Differences, Scale, and Scope Economies There are three fundamental tools for building worldwide competitive advantage: exploit- ing differences in sourcing and market potential across countries, exploiting economies of scope, and exploiting economies of scale. In this section, we explore each of them in more depth.

National Differences

In the absence of efficient markets, the fact that different nations have different factor endowments (e.g., an abundance of labor, land, materials) leads to intercountry differ- ences in factor costs. Because different activities of the firm, such as R&D, production, or marketing, use various factors to different degrees, a firm can gain cost advantages by configuring its value chain so that each activity is located in the country that has the least cost for its most intensively used factor. For example, R&D facilities may be placed in the United Kingdom because of the available supply of high-quality, yet modestly paid, scientists; manufacturing of labor-intensive components may be undertaken in Taiwan to capitalize on the lower cost, efficient labor force; and software development could concentrate in India, where skilled software engineers are paid a fraction of Western salaries. General Electric’s “Global Product Concept” was set up to concentrate manu- facturing wherever it could be implemented in the most cost-effective way (while still retaining quality).

National differences may also exist in output markets. As we have discussed, customer tastes and preferences may differ in different countries, as may distribution systems, government regulations applicable to the pertinent product markets, or the effectiveness of different promotion strategies. A firm can obtain higher prices for its output by tailoring its offerings to fit the unique requirements in each national market.

Scale Economies

Microeconomic theory provides a strong basis for evaluating the effect of scale on cost reduction, and the use of scale as a competitive tool is common in industries ranging from roller bearings to semiconductors. Whereas scale, by itself, is a static concept, there may be dynamic benefits of scale through what has been variously described as the experience or learning effect. The higher volume that helps a firm exploit scale benefits

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The Means: National Differences, Scale, and Scope Economies 215

also allows it to accumulate learning, which leads to progressive cost reduction as the firm moves down its learning curve. So though emerging Korean electronics firms were able to match the scale of experienced Japanese competitors, they were initially unable to compensate for the innumerable process-related efficiencies the Japanese had learned after decades of operating their global-scale plants.

Scope Economies

The concept of scope economies is based on the notion that certain economies arise from the fact that the cost of the joint production (or development or distribution) of two or more products can be less than the cost of producing them separately.4 Such cost reductions may take place for many reasons—for example, resources such as informa- tion or technologies, once acquired for use in producing one item, are available without cost for production of other items.

The strategic importance of scope economies arises from a diversified firm’s ability to share investments and costs across the same or different value chains—a source of economies that competitors without such internal and external diversity cannot match. Such sharing can take place across segments, products, or markets and may involve the joint use of different kinds of assets (see Table 3-1).

Implicit with each of these tools is the ability to develop an organizational infra- structure which supports it. As we discuss in later chapters, the organizational ability to leverage a global network and value chain will differentiate the winners and losers.

Mapping Ends and Means: Building Blocks for Worldwide Advantage

Table 3-2 shows a mapping of the different goals and means for achieving worldwide competitiveness. Each goals–means intersection suggests some of the factors that may enhance a company’s strategic position. Although the factors are only illustrative, it may be useful to study them carefully and compare them against the proposals of the

Table 3-1 Scope Economies in Product and Market Diversification

Sources of Scope Economies

Product Diversification Market Diversification

Shared physical assets Factory automation with flexibility Global brand name (Nokia) to produce multiple products (Ford)

Shared external relations Using common distribution channels Servicing multinational customers for multiple products (Samsung) worldwide (Citibank)

Shared learning Shared R&D in computer and Pooling knowledge developed in communications business (NEC) different markets (Procter &

Gamble)

✺ 4For a detailed exposition of scope economies, see W. J. Baumol, J. C. Panzer, and R. D. Willig, Contestable Markets and the Theory of Industry Structure (New York: Harcourt Brace Jovanovich, 1982).

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216 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

different articles mentioned at the beginning of the chapter. It will become apparent that each author focuses on a specific subset of factors—essentially, some different goals– means combinations—and the differences among their prescriptions can be understood in terms of the differences in the particular aspect of worldwide competitive advantage on which they focus.

International, Multinational, Global, and Transnational Strategies

In Chapter 2, we described how environmental forces in different industries shaped alternative approaches to managing worldwide operations that we described as interna- tional, multinational, global, and transnational. We now elaborate on the distinctions among these different approaches, as well as their respective strengths and vulnerabilities in terms of the different goals–means combinations we have just described.

International Strategy

Companies adopting this broad approach focus on creating and exploiting innovations on a worldwide basis, using all the different means to achieve this end. MNEs head- quartered in large and technologically advanced countries often adopted this strategic approach but limited it primarily to exploiting home-country innovations to develop their competitive positions abroad. The international product cycle theory we described in Chapter 1 encompasses both the strategic motivation and competitive posture of these

Table 3-2 Worldwide Advantage: Goals and Means

Sources of Competitive Advantage

Strategic Objectives National Differences Scale Economies Scope Economies

Achieving efficiency in Benefiting from Expanding and Sharing of investments current operations differences in factor exploiting potential and costs across

costs—wages and scale economies in markets and cost of capital each activity businesses

Managing risks Managing different Balancing scale with Portfolio diversification through kinds of risks arising strategic and of risks and creation of multinational from market- or policy- operational options and side bets flexibility induced changes in flexibility

comparative advantages of different countries

Innovation, learning, Learning from societal Benefiting from Shared learning across and adaptation differences in experience—cost organizational

organizational and reduction and components in managerial processes innovation different products, and systems markets, or businesses

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International, Multinational, Global, and Transnational Strategies 217

companies: At least initially, their internationalization process relied heavily on transferring new products, processes, or strategies developed in the home country to less advanced overseas markets.

This approach was common among U.S.-based MNEs such as Kraft, Pfizer, Procter & Gamble, and General Electric. Although these companies built considerable strengths out of their ability to create and leverage innovations, many suffered from deficiencies of both efficiency and flexibility because they did not develop either the centralized and high-scale operations of companies adopting global strategies or the very high degree of local responsiveness that multinational companies could muster through their autonomous, self-sufficient, and entrepreneurial local operations.

Multinational Strategy

The multinational strategic approach focuses primarily on one means (national differences) to achieve most of its strategic objectives. Companies adopting this approach tend to focus on the revenue side, usually by differentiating their products and services in response to national differences in customer preferences, industry characteristics, and government regulations. This approach leads most multinational companies to depend on local-for-local innovations, a process requiring the subsidiary to not only identify local needs but also use its own local resources to respond to those needs. Carrying out most activities within each country on a local-for-local basis also allows those adopting a multinational strategy to match costs and revenues on a currency-by-currency basis.

Historically, many European companies such as Unilever, ICI, Philips, and Nestlé followed this strategic model. In these companies, assets and resources historically were widely dispersed, allowing overseas subsidiaries to carry out a wide range of activities from development and production to sales and services. Their self-sufficiency was typically accompanied by considerable local autonomy. But, though such independent national units were unusually flexible and responsive to their local environments, they inevitably suffered problems of inefficiencies and an inability to exploit the knowledge and competencies of other national units.

Global Strategy

Companies adopting the classic global strategic approach, as we have defined it, depend primarily on developing global efficiency. They use all the different means to achieve the best cost and quality positions for their products.

This means has been the classic approach of many Japanese companies such as Toyota, Canon, Komatsu, and Matsushita. As these and other similar companies have found, however, such efficiency comes with some compromises of both flexibility and learning. For example, concentrating manufacturing to capture global scale may also result in a high level of intercountry product shipments that can raise risks of policy intervention, particularly by host governments in major importer countries. Similarly, companies that centralize R&D for efficiency reasons often find they are constrained in their ability to capture new developments in countries outside their home markets or to leverage innovations created by foreign subsidiaries in the rest of their worldwide operations. Fi- nally, the concentration (most often through centralization) of activities like R&D and

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218 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

manufacturing to achieve a global scale exposes such companies to high sourcing risks, particularly in exchange rate exposure.

The descriptions we have presented to this point regarding multinational versus global strategies have been described in their pure forms. In practice of course many firms do adopt a regional strategy, focusing much of their international expansion on the home region, plus perhaps one or two other regions.

Transnational Strategy

Beneath each of these three traditional strategic approaches lie some implicit assump- tions about how best to build worldwide competitive advantage. The global company as- sumes that the best-cost position is the key source of competitiveness; the multinational company sees differentiation as the primary way to enhance performance; and the inter- national company expects to use innovations to reduce costs, enhance revenues, or both. Companies adopting the transnational strategy recognize that each of these traditional approaches is partial, that each has its own merits but none represents the whole truth.

To achieve worldwide competitive advantage, costs and revenues have to be managed simultaneously, both efficiency and innovation are important, and innovations can arise in many different parts of the organization. Therefore, instead of focusing on any subpart of the set of issues shown in Table 3-2, the transnational company focuses on exploiting each and every goals–means combination to develop layers of competitive advantage by exploiting efficiency, flexibility, and learning simultaneously.

To achieve this ambitious strategic approach, however, the transnational company must develop a very different configuration of assets and capabilities than is typical of traditional multinational, international, and global company structures. The global com- pany tends to concentrate all its resources—either in its home country or in low-cost overseas locations—to exploit the scale economies available in each activity. The multi- national company typically disperses its resources among its different national opera- tions to be able to respond to local needs. And the international company tends to centralize those resources that are key to developing innovations but decentralize others to allow its innovations to be adapted worldwide.

The transnational, however, must develop a more sophisticated and differentiated configuration of assets and capabilities. It first decides which key resources and capa- bilities are best centralized within the home-country operation, not only to realize scale economies but also to protect certain core competencies and provide the necessary su- pervision of corporate management. Basic research, for example, is often viewed as such a capability, with core technologies kept at home for reasons of strategic security as well as competence concentration. For different reasons, the global account team or international management development responsibility may be located centrally to facil- itate top-management control over these key corporate resources.

Certain other resources may be concentrated but not necessarily at home—a config- uration that might be termed “excentralization” rather then decentralization. World- scale production plants for labor-intensive products may be built in a low-wage country such as Mexico or Malaysia. The advanced state of a particular technology may demand concentration of relevant R&D resources and activities in Japan, Germany, or the United

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Worldwide Competitive Advantage: The Strategic Tasks 219

States. Such flexible specialization—or excentralization—complements the benefits of scale economies with the flexibility of accessing low input costs or scarce resources and the responsiveness of accommodating national political interests. This approach can also apply to specific functional activities. For example, Sony relocated its treasury op- erations to London to improve its access to financial markets.

Some other resources may best be decentralized on a regional or local basis, because either potential economies of scale are small or there is a need to create flexibility by avoiding exclusive dependence on a single facility. Local or regional facilities may not only afford protection against exchange rate shifts, strikes, natural disasters, and other disruptions but also reduce logistical and coordination costs. An important side benefit provided by such facilities is the impact they can have in building the motivation and ca- pability of national subsidiaries, an impact that can easily make small efficiency sacri- fices worthwhile.

Table 3-3 summarizes the differences in the asset configurations that support the dif- ferent strategic approaches of the various MNE models. We explore these strategy– organizational linkages in more detail in Chapter 4.

Worldwide Competitive Advantage: The Strategic Tasks In the final part of this chapter, we look at how a company can respond to the strategic challenges we have described. The task will clearly be very different depending on the company’s international posture and history. Companies that are among the major world- wide players in their businesses must focus on defending their dominance while also building new sources of advantage. For companies that are smaller but aspire to worldwide competitiveness, the task is one of building the resources and capabilities needed to chal- lenge the entrenched leaders. For companies that are focused on their national markets and lack either the resources or the motivation for international expansion, the challenge is to protect their domestic positions from others that have the advantage of being MNEs.

Table 3-3 Strategic Orientation and Configuration of Assets and Capabilities in International, Multinational, Global, and Transnational Companies

International Multinational Global Transnational

Strategic Exploiting parent- Building flexibility to Building cost Developing global orientation company knowledge respond to national advantages efficiency,

and capabilities differences through through flexibility, and through worldwide strong, resourceful, centralized, worldwide diffusion and and entrepreneurial global-scale learning adaptation national operations operations capability

simultaneously Configuration of Sources of core Decentralized and Centralized and Dispersed,

assets and competencies nationally self- globally interdependent, capabilities centralized, others sufficient scaled and specialized

decentralized

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220 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

Defending Worldwide Dominance

Over the past decade or so, the shifting external forces we have described have resulted in severe difficulties—even for those MNEs that had enjoyed strong historical positions in their businesses worldwide.

Typically, most of these companies pursued traditional multinational, international, or global strategies, and their past successes were built on the fit between their specific strategic capability and the dominant environmental force in their industries. In multi- national industries such as branded packaged products in which forces for national re- sponsiveness were dominant, companies such as Unilever developed strong worldwide positions by adopting multinational strategies. In contrast, in global industries like con- sumer electronics or semiconductor chips, companies such as Matsushita or Hitachi built leadership positions by adopting global strategies.

In the emerging competitive environment, however, these companies could no longer rely on their historic ability to exploit global efficiency, multinational flexibility, or worldwide learning. As an increasing number of industries developed what we have termed transnational characteristics, companies faced the need to master all three strate- gic capabilities simultaneously.

The challenge for the leading companies was to protect and enhance the particular strength they had while simultaneously building the other capabilities.

For many MNEs, the initial response to this new strategic challenge was to try to re- structure the configuration of their assets and activities to develop the capabilities they lacked. For example, global companies with highly centralized resources sought to de- velop flexibility by dispersing resources among their national subsidiaries; multina- tional companies, in contrast, tried to emulate their global competitors by centralizing R&D, manufacturing, and other scale-intensive activities. In essence, these companies tried to find a new “fit” configuration through drastic restructuring of their existing configuration.

Such a zero-based search for the ideal configuration not only led to external prob- lems, such as conflict with host governments over issues like plant closures, but also re- sulted in a great deal of trauma inside the company’s own organization. The greatest problem with such an approach, however, was that it tended to erode the particular com- petency the company already had without effectively adding the new strengths it sought.

The complex balancing act of protecting existing advantages while building new ones required companies to follow two fairly simple principles. First, they had to con- centrate at least as much on defending and reinforcing their existing assets and capabil- ities as on developing new ones. Their approach tended to be one of building on—and eventually modifying—their existing infrastructure instead of radical restructuring. To the extent possible, they relied on modernizing existing facilities rather than dismantling the old and creating new ones.

Second, most successful adaptors looked for ways to compensate for their deficiency or approximate a competitor’s source of advantage, rather than trying to imitate its asset structure or task configuration. In searching for efficiency, multinational companies with a decentralized and dispersed resource structure found it easier to develop efficiency by adopting new flexible manufacturing technologies in some of their existing plants and

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Worldwide Competitive Advantage: The Strategic Tasks 221

upgrading others to become global sources rather than to close those plants and shift pro- duction to lower-cost countries to match the structure of competitive global companies.

Similarly, successful global companies found it more effective to develop responsive- ness and flexibility by creating internal linkages between their national sales subsidiaries and their centralized development or manufacturing units rather than trying to mimic multinational companies by dispersing their resources to each country operation and, in the process, undermining their core strength of efficiency.

Challenging the Global Leader

Over the past two decades, a number of companies have managed to evolve from relatively small national players to major worldwide competitors, challenging the dominance of traditional leaders in their businesses. Dell in the computer industry, Magna in auto parts, Electrolux in the domestic appliances business, and CEMEX in the cement industry are some examples of companies that have evolved from relative obscurity to global visi- bility within relatively short periods of time.

The actual processes adopted to manage such dramatic transformations vary widely from company to company. Electrolux, for example, grew almost exclusively through acquisitions, whereas Dell built capabilities largely through internal development, and Magna and CEMEX used a mix of greenfield investments and acquisitions. Similarly, whereas Dell built its growth on the basis of cost advantages and logistics capabilities, it expanded internationally because of its direct-sales business model and its ability to react quickly to changes in customer demand. Despite wide differences in their specific approaches, however, most of these new champions appear to have followed a similar step-by-step approach to building their competitive positions.

Each developed an initial toehold in the market by focusing on a narrow niche—often one specific product within one specific market—and developing a strong competitive position within that niche. That competitive position was built on multiple sources of competitive advantage rather than on a single strategic capability.

Next, they expanded their toehold to a foothold by limited and carefully selected expansion along both product and geographic dimensions and by extending the step-by- step improvement of both cost and quality to this expanded portfolio. Such expansion was typically focused on products and markets that were not of central importance to the established leaders in the business. By staying outside the range of the leaders’ peripheral vision, the challenger could remain relatively invisible, thereby building up its strength and infrastructure without incurring direct retaliation from competitors with far greater resources. For example, emerging companies often focused initially on relatively low- margin products such as small-screen televisions or subcompact cars.

While developing their own product portfolio, technological capabilities, geographic scope, and marketing expertise, challengers were often able to build up manufacturing volume and its resulting cost efficiencies by becoming original equipment manufacturer suppliers to their larger competitors. Although this supply allowed the larger competitor to benefit from the challenger’s cost advantages, it also developed the supplying company’s understanding of customer needs and marketing strategies in the advanced markets served by the leading companies.

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222 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

Once these building blocks for worldwide advantage were in place, the challenger typically moved rapidly to convert its low-profile foothold into a strong permanent po- sition in the worldwide business. Dramatic scaling up of production facilities—increasing VCR capacity 30-fold in eight years as Matsushita did, or expanding computer produc- tion 20-fold in seven years as Acer did a decade later—typically preceded a wave of new product introductions and expansion into the key markets through multiple channels and their own brand names.

Protecting Domestic Niches

For reasons of resources or other constraints, some national companies may not be able to aspire to such worldwide expansion, though they are not insulated from the impact of global competition. Their major challenge is to protect their domestic niches from worldwide players with superior resources and multiple sources of competitive advantage.5 This concern is particularly an issue in developing markets such as India and China, where local companies face much larger, more aggressive, and deeper-pocketed competitors.

There are three broad alternative courses of action that can be pursued by such national competitors. The first approach is to defend against the competitor’s global advantage. Just as MNE managers can act to facilitate the globalization of industry structure, so their counterparts in national companies can use their influence in the op- posite direction. An astute manager of a national company might be able to foil the attempts of a global competitor by taking action to influence industry structure or mar- ket conditions to the national company’s advantage. These actions might involve influ- encing consumer preference to demand a more locally adapted or service-intensive product; it could imply tying up key distribution channels; or it might mean preempting local sources of critical supplies. Many companies trying to enter the Japanese market claim to have faced this type of defensive strategy by local firms.

A second strategic option would be to offset the competitor’s global advantage. The simplest way to do this is to lobby for government assistance in the form of tariff protec- tions. However, in an era of declining tariffs, this is increasingly unsuccessful. A more ambitious approach is to gain government sponsorship to develop equivalent global capa- bilities through funding of R&D, subsidizing exports, and financing capital investments. As a “national champion,” the company would theoretically be able to compete globally. However, in reality, it is very unusual for such a company to prosper. Airbus Industrie, which now shares the global market for large commercial airplanes with Boeing, is one of the few exceptions—rising from the ashes of other attempts by European governments to sponsor a viable computer company in the 1970s and then to promote a European electronics industry a decade later.

The third alternative is to approximate the competitors’ global advantages by linking up in some form of alliance or coalition with a viable global company. Numerous such linkages have been formed with the purpose of sharing the risks and costs of operating in a high-risk global environment. By pooling or exchanging market access, technology,

❚ 5For a detailed discussion of such strategies, see N. Dawar and T. Frost, “Competing with Giants: Survival Strategies for Local Companies Competing in Emerging Markets,” Harvard Business Review 77, no. 2 (1999), pp. 119–30.

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Concluding Comments 223

and production capability, smaller competitors can gain some measure of defense against global giants. For example, Siemens, ICL, and other small computer companies entered into agreements and joint projects with Fujitsu to enable them to maintain viability against the dominant transnational competitor, IBM. Similarly, the Indian telecom company Bharti has established a variety of inbound alliances with foreign firms such as Nortel Networks and Transcend Technologies to create a winning strategy for the Indian market.

Concluding Comments Although these three strategic responses obviously do not cover every possible scenario, they highlight two important points from this chapter. First, the MNE faces a complex set of options in terms of the strategic levers it can pull to achieve competitive advantage, and the framework in Table 3-2 helps make sense of those options by separating out means and ends. Second, the competitive intensity in most industries is such that a company cannot just afford to plough its own furrow. Rather, it is necessary to gain competitive parity on all relevant dimensions (efficiency, flexibility, learning) while also achieving differentiation on one. To be sure, the ability to achieve multiple competitive objectives at the same time is far from straightforward, and as a result, we see many MNEs exper- imenting with new ways of organizing their worldwide activities. And this organization will be the core issue we will address in the next chapter.

Chapter 3 Readings

• In Reading 3-1, “Managing Differences: The Central Challenge of Global Strategy,” Ghemewat introduces a framework to help managers think through their options. The three broad strategies available are: aggregation—achieving economies of scale by standardizing regional or global operations; adaptation—boosting market share by customizing processes and offerings to meet local markets’ unique needs; and arbitrage—exploiting difference, by such activities as offshoring certain processes to countries with cheaper labor. Each strategy is considered against seven questions.

• In Reading 3-2, “How Local Companies Keep Multinationals at Bay,” Bhattacharya and Michael explain the challenges for MNEs of competing with formidable local firms in emerging markets. They outline a six-part strategy used by these firms to fend off foreign MNEs (create customized products or services; develop business models to overcome key obstacles; deploy the latest technologies; take advantage of low-cost labor, and train staff in-house; scale up quickly; invest in talent to sustain rapid growth).

• In Reading 3-3, “Regional Strategies for Global Leadership,” Ghemawat argues how regionally focused strategies, when used with local and global initiatives, can increase performance. He outlines five types of regional strategy (home base, portfolio, hub, plat- form, and mandate) and how they can be switched/combined as their businesses evolve.

As all three readings in this chapter demonstrate, there are a multitude of ways for MNEs to build competitive advantage. The appropriateness of each will evolve over time, yet the constant in a dynamic competitive environment is the need for the MNE to build, layer by layer, its capabilities.

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224 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

impossible.6 Intel Chairman Craig Barrett dismissed it as a “$100 gadget.”7

Yet in 2005 Negroponte unveiled a working proto- type of a $100 Laptop at the UN World Summit on the Information Society (see Exhibit 1 for photos). The machine, which used freely available, open source Linux software as its operating system (OS), was the instant hit of the show.8 Although aimed at primary school children (aged 6 to 12), other age groups could use it too. “People get it quickly, they sleep on it, and very often they wake up the next morning saying, ‘Oh my god, this is a really big change,’ ” said Negroponte. “The appeal was obvi- ously the price, and people realize that you can do one laptop per child. When it sinks in, they realize that you would not propose ‘one pencil per classroom.’ ”9

In the two and a half years since the UN summit, technology companies including AMD (Advanced

In 2002, Professor Nicholas Negroponte, successful venture capitalist, author, and cofounder and chair- man emeritus of the Massachusetts Institute of Technology (MIT) Media Lab,1 announced his in- tention to build a personal computer so cheap as to make it possible to provide Internet- and multimedia- capable machines to millions of children in devel- oping countries.2 The concept—later referred to as the “$100 Laptop”3—was launched at the Media Lab in 2003 before being spun into a separate nonprofit association, One Laptop Per Child (OLPC), founded by Negroponte in January 2005.4 The news made global headlines that conveyed a mixture of admi- ration and derision. OLPC’s critics said Negroponte’s $100 laptop could not be built.5 Technology execu- tives argued that such an extreme drop in price was

Case 3-1 Marketing the “$100 Laptop” (A) John A. Quelch and Carin-Isabel Knoop

❚ Professor John A. Quelch and Carin-Isabel Knoop, Executive Director, Global Research Group, prepared this case. This case was developed from published sources. The authors are grateful for the assistance of Global Research Group Research Associate Reed Martin. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

❚ Harvard Business School Case No 9-508-024, Copyright 2007 President and Fellows of Harvard College. All rights reserved. This case was prepared by J. Quelch. HBS Cases are developed solely for class discussion and do not necessarily illustrate either effective or ineffective handling of administrative situation.

❚ 1The MIT Media Lab was a $30 million research center dedicated to advancing multimedia design and implementation. ❚ 2Stephen Leahy, “Laptops For Kids With No Power,” WIRED, June 6, 2005, www.wired.com, accessed January 10, 2007. ❚ 3Douglas McGray, “The Laptop Crusade,” WIRED, August 2006, www.wired.com, accessed January 10, 2007. ❚ 4James Surowiecki, “Philanthropy’s New Prototype,” Technology Review, November 13, 2006, www.technologyreview.com/Biztech/17722/, accessed January 10, 2007. ❚ 5McGray.

❚ 6Kathrin Hille, “The race for the $100 laptop,” Financial Times, April 9, 2007. ❚ 7Jonathan Fildes, “$100 laptop production begins,” BBC News, http:// news.bbc.co.uk/2/hi/technology/6908946.stm, accessed July 30, 2007. ❚ 8Kevin Poulsen, “Negroponte: Laptop for Every Kid,” WIRED, November 17, 2005, www.wired.com, accessed January 10, 2007. ❚ 9Poulsen.

Exhibit 1 Early $100 Laptop Prototype

Source: OLPC, http://www.laptop.org/download.en_US.html, accessed June 23, 2007.

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Case 3-1 Marketing the “$100 Laptop” (A) 225

Micro Devices), Google, Red Hat, and News Corp., had given at least $29 million to fund the project10

(including $16.5 million in 2006)11 and had pledged additional monies and technical expertise for the future.12 OLPC had worked hard to sell its concept to the world’s education ministries. Negroponte had set a self-imposed minimum of five million laptop orders before production could commence.13 In 2006, OLPC had received purchase orders (but no deposits) for six million laptops (at $175 a piece) from education ministries in China, Brazil, and other countries. Making the sale had not been easy, even though OLPC machines cost less than half the nor- mal price of an entry-level computer, and weighed half as much with double the operating battery time as comparable laptops.14 Quick production had also been assured: Quanta, a large Taiwanese laptop maker, was ready to produce a million laptops per month by the end of 2007, an impressive number given that global laptop production was only 5 million units per month.15 Finally, OLPC intended to offer local schools around the world a $100 server filled with 200 gigabytes of educational material that students could access remotely.16 Participating governments could purchase solar, foot-pump, or pull-string chargers for the laptop.

Nevertheless, as of mid-2007, commitments had yet to be finalized.17 “It’s a big check to write,” Ne- groponte conceded. “Nations are being asked to invest in the laptop one million at a time. That’s $175 mil- lion for the machines alone, at current pricing, plus money for distribution and Internet provision—the actual price tag could be closer to $200 million to $250 million.”18 Only when the project scaled up,

however, would the price drop, possibly to $100 per unit in 2009 and $50 per unit in the next decade.

In the meantime, the computer industry was changing. New entrants and incumbents such as Intel had launched very low-cost machines for individual sale. Intel, an early and vocal critic of OLPC, had launched its $285 Classmate PC in May 2006. In 2007 Dell launched a desktop computer in China at a retail price of $336, which was 60% lower than its previously cheapest offering.19 Further, major com- puter makers had begun to target the “next billion,” a swath of poorer consumers whose access to PCs had so far been precluded by high prices and poor access to electricity. The OLPC had proven that PCs could be made significantly cheaper with an open source OS, a cheaper liquid crystal display, and by omitting the hard drive. Given the evolving competitive landscape, however, observers won- dered if the time had come for the OLPC to rethink its strategy and mission.

Computers in the Classroom20

The Idea In 1999, Negroponte had seen the power of laptops firsthand at a rural village school that he and his wife established in Cambodia. There, chil- dren used rugged Panasonic “Toughbook” laptops equipped with Wi-Fi Internet capability via a satel- lite link.21 “A village that had no books suddenly had access to Google,” recalled Negroponte. “It changed their lives in several ways, improving self-esteem and empowerment and fulfilling the passion for learning.”22 The laptops made school more popular and drew appreciation from parents as well, since, in a village with no electricity, the laptop became the brightest light source in the house. “Talk about a metaphor and a reality simultaneously,” Negroponte reflected, “It just illuminated that household.”23

❚ 10“Low-Cost Laptop Could Transform Learning,” January 3, 2007, AFX Asia, via Factiva, accessed January 8, 2007. ❚ 11Steve Stecklow, “A little laptop with big ambitions,” The Wall Street Journal, November 24, 2007, via Factiva, July 10, 2008. ❚ 12Leahy. ❚ 13McGray. ❚ 14“A computer in every pot,” Economist, July 27, 2007. ❚ 15Ethan Zuckerman, “An Update on OLPC from Dr. Negroponte,” Worldchanging, June 1, 2007, http://www. worldchanging.com/archives/ 006798.html, accessed June 28, 2007. ❚ 16McGray. ❚ 17Leahy. ❚ 18Zuckerman.

❚ 19Hille. ❚ 20This section draws on Douglas MacMillan, “A Laptop at Every Desk,” BusinessWeek, September 20, 2006, via Factiva, accessed January 20, 2007. ❚ 21Leahy. ❚ 22Leahy. ❚ 23Lesley Stahl, “What if Every Child Had a Laptop,” 60 Minutes on the Web, May 20, 2007, http://www.cbsnews.com/stories/2007/ 05/20/60minutes/main2830058.shtml, accessed August 10, 2007.

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226 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

necessities.25 Negroponte’s lead designer, Yves Behar, believed these critics imagined the entire de- veloping world as a string of famine-stricken vil- lages in Africa.26 “This was the typical ignorance of the West,” Behar said. “There are different condi- tions in different places, and there are a lot of places where kids are not starving, where kids want to learn more than anything else.”27 Supporters of the $100 Laptop initiative seconded this observation, warning against the erroneous assumption that tech- nology was something that only wealthy nations could afford, or that poorer nations were better off concentrating on more basic challenges, such as im- proving health and providing clean water.28 The United Nations 2006 Millennium Development Goals report estimated that 1.9 billion children were under the age of 18 (compared with 206 mil- lion in the developed world) and that 22% of them lived in households that subsisted on $1 per day or less. One in three of these children lacked access to

That visit prompted the idea of designing a basic laptop model that would link people in developing countries to the world.

At the time, most computers were used in the de- veloped world. By 2003 there were about 496 mil- lion PCs in use in the largest 67 countries in the world, with 178 million in the U.S. followed by Japan (45 million), Germany (27 million), and the U.K. (22 million). By the end of 2006, the total number of PCs in use had risen to more than 755 million. While experts estimated that PC usage worldwide would ex- ceed 1 billion in 2008 and double by 2015, the bulk of the growth was expected to come from countries such as Brazil, Russia, India, and China (BRIC), account- ing for the more than 800 million new PCs by 2015, and other emerging economies as incomes rose and telecom infrastructures improved.24 (See Exhibits 2 and 3 for worldwide forecasts.)

Critics charged that Negroponte’s concept would require high-speed fiber-optic T1 lines to run through the center of villages struggling with basic

❚ 24Simon Yates, “Worldwide PC Adoption Forecast, 2007 to 2015,” Forrester Research, Inc., June 11, 2007.

Exhibit 2 The “PC Adoption Pyramid” and Worldwide PC Adoption, 2003–2015

1990–2007 1

2

3

4

5

6

2008–2015

2015–? World

popluation (in billions)

Poor, uneducated, rural, nontechnology users

Weathy, educated, urban technology users Market drivers for the first billon: • Sufficient income, falling tech prices, mobility • Access to multl-channel distrtbution, Internet • Better technology, more apps, new usage models

Market drivers for the second billion: • Increased capabilities, rapidly falling tech prices • Channel development, Internet growth, support • Userful and relevant applications

Market drivers for the next two billion: • Radical change in hardware and software design • Internet usage and education investments • Educational to create tech aware workforce

Market drivers for the last two billion: • No cost or heavlly subsidized • Access to the Internet • Simple, tailored, application-specific experience

Source: Simon Yates, “Worldwide PC Adoption Forecast, 2007 to 2015,” Forrester Research, Inc., June 11, 2007.

❚ 25McGray. ❚ 26McGray. ❚ 27McGray. ❚ 28Surowiecki.

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Case 3-1 Marketing the “$100 Laptop” (A) 227

adequate shelter, one in five had no access to safe drinking water, and one in seven had no access to health services. Although Negroponte saw note- book computers as an educational tool that might eventually alleviate world poverty, critics main- tained that achieving such a goal would require far more than inexpensive computers.29

The U.S. Experience The idea that technology could serve as a catalyst for education was not new. “One-to-one” school programs that provided each student with a computer had initially garnered sup- port in 1991 in Australia, where several schools purchased enough PCs to match enrollment.30 In the U.S. in September 2002, the state of Maine’s Department of Education launched The Maine Learning Technology Initiative, a program designed to give every seventh- and eighth-grade public school

child and teacher an Apple iBook laptop. The pro- gram was built on the principle that educational transformation occurred through the use of tech- nology by students and teachers on a one-to-one basis.31 Michigan, New Hampshire, Pennsylvania, and New Mexico instituted laptop programs similar to Maine’s, and several other school boards across the U.S. were considering their own laptop initiatives.32

In 2006, about 13 million computers served 49.5 million students attending public schools in the U.S.33 Some companies sought to take technological integration in the classroom even further. In 2006 Dell experimented with a program it called “Intelli- gent Classrooms,” which delivered to schools a $40,000 package of technologies including wireless Internet and electronic whiteboards built around a

Exhibit 3 Forecasts for PC Adoption in Select Regions (2003–2015)

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Russia Brazil India China

7.2 12.2 15.1 18.8 22.3 3.5 40.2 50.5 60.5 69.3 76.4 81.7 85.4 10.8 13.4 15.1 19.1 22.5 30.1 39.3 49.7 60.8 72.0 82.6 92.1 100.4 6.2 8.0 10.1 12.9 13.5 19.1 26.8 37.4 51.9 71.3 96.9 129.5 169.9 24.4 34.0 42.8 53.9 65.8 94.6 133.7 184.5 247.2 319.8 398.1 476.3 548.9

1,000

800

600

400

200

0

904.6 million total104.7 million total

Number of PCs in use by country (in millions)

Actual Forecast

(numbers have been rounded)

Together, China, India, Brazil, and Russia will add 800 million new PCs by 2015.

Russia

Brazil

India

China

Source: The Economist Pocket World in Figures (2004, 2005, 2006, and 2007 editions) and Profile Books (2003, 2004, 2005, and 2006). Published in Simon Yates, “Worldwide PC Adoption Forecast, 2007 to 2015,” Forrester Research, Inc., June 11, 2007.

❚ 29Leahy. ❚ 30MacMillan.

❚ 31Maine Learning Technology Initiative, “About MLTI,” Maine Learning Technology Initiative website, http://www.maine .gov/mlti/about/index.htm, accessed June 18, 2007. ❚ 32Leahy. ❚ 33MacMillan.

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228 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

Exhibit 3 APACa PC Adoption, 2003–2015 (continued)

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 New Zealand Singapore Hong Kong Australia Taiwan Malaysia South Korea Thailand Philippines Vietnam Japan Bangladesh Pakistan Indonesia

New Zealand

Singapore

Hong Kong

Australia

Taiwan

Malaysia

South Korea

Thailand

Philippines

Vietnam

Japan

Bangladesh

Pakistan

Indonesia

1.5 1.2 1.5 1.9 2.1 2.3 2.4 2.6 2.7 2.7 2.8 2.8 2.9 2.1 2.3 2.5 2.7 4.6 4.7 4.8 4.9 4.9 5.0 5.0 4.9 4.9 2.7 3.1 3.7 4.4 5.3 5.7 6.0 6.2 6.4 6.5 6.6 6.7 6.8 10.0 10.9 12.2 13.7 14.2 14.7 15.0 15.3 15.6 15.8 16.0 16.2 16.4 5.0 7.6 9.6 12.1 13.5 14.9 16.0 16.8 17.4 17.8 18.1 18.4 18.6 2.9 3.6 4.1 4.6 5.6 7.1 8.6 10.1 11.5 12.6 13.6 14.4 15.1 16.7 20.9 23.4 26.1 29.9 31.3 32.3 33.2 33.8 34.3 34.7 35.0 35.3 1.7 2.5 3.1 3.9 5.7 8.2 11.3 15.0 18.9 22.8 26.3 29.3 31.7 1.7 2.3 2.9 3.7 5.5 7.5 10.2 13.5 17.7 22.5 27.9 33.6 39.4 0.8 0.9 1.0 1.1 1.2 1.7 2.3 3.2 4.5 6.1 8.2 10.9 14.2 44.4 56.0 62.3 69.3 75.9 82.1 86.8 90.1 92.4 94.0 95.1 95.9 96.5 0.3 1.0 1.3 1.8 3.1 4.1 5.6 7.4 9.8 12.8 16.6 21.1 26.5 0.6 0.7 0.7 0.9 1.0 1.4 1.9 2.6 3.6 4.8 6.5 8.7 11.6 2.4 2.5 2.8 3.1 3.3 4.5 6.0 8.0 10.6 13.8 18.0 23.2 29.4

349.2 million total

14 APAC countries will add 200 million new PCs by 2015, led by Japan with 96.5 million

Actual 350

300

250

200

150

100

50

0

Forecast

149.3 million total

Number of PCs in use by country (in millions)

Source: The Economist Pocket World in Figures (2004, 2005, 2006, and 2007 editions) and Profile Books (2003, 2004, 2005, and 2006). Published in Simon Yates, “Worldwide PC Adoption Forecast, 2007 to 2015,” Forrester Research, Inc., June 11, 2007. aAsian Pacific.

specific subject, such as math, science, or English.34

However, studies showed that laptops boosted stu- dent test scores only when teachers were trained to use the machines in their teaching plans.35 “We’ve been working now with computers and education for 30 years,” Negroponte explained, “with comput- ers in developing countries for 20 years, and trying to make low-cost machines for 10 years. This was not a sudden turn down the road. What put us over the edge was that it [became] possible to do it.”36

Making It Possible

Design Challenges From the onset, the $100 Laptop’s parameters of low-cost, lightweight, and modern seemed contradictory, since lightweight, ultra-thin laptops were typically more expensive and harder to manufacture than heavier and bulkier mod- els. For example, the Toshiba Protégé 2000, three- quarters of an inch thick and 3.25 pounds, was priced at $2,199 in an era when most standard laptops cost $600 to $1,200. The more powerful and compact Sony Vaio PC UX Premium Series VGN-UX390N weighed 1.2 pounds but cost $2,500.

Negroponte and his team set up a website to provide extensive details on the laptop’s

❚ 34MacMillan. ❚ 35“Laptops: Easy Fix For Global Education?” The Christian Science Monitor, January 5, 2007, via Factiva, accessed February 5, 2007. ❚ 36Poulsen.

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Case 3-1 Marketing the “$100 Laptop” (A) 229

Exhibit 3 Eastern European PC Adoption, 2003–2015 (continued)

Estonia 0.3 0.4 0.5 0.6 0.6 0.7 0.7 0.7 0.7 0.7 0.7 0.7

Slovenia 0.4 0.5 0.6 0.7 0.8 0.9 0.9 1.0 1.0 1.0 1.1 1.1

Latvia 0.3 0.3 0.4 0.5 0.5 0.7 0.9 1.0 1.1 1.2 1.3 1.3

Lithuania 0.3 0.3 0.4 0.5 0.6 0.8 1.0 1.3 1.5 1.7 1.8 1.9

Slovakia 0.1 1.0 1.3 1.6 1.9 2.1 2.4 2.5 2.7 2.8 2.8 2.9

Bulgaria 0.4 0.4 0.4 0.5 0.7 0.9 1.2 1.7 2.2 2.8 3.4 4.0

Hungary 1.0 1.0 1.3 1.4 1.6 2.1 2.6 32 3.7 4.2 4.5 4.8

Czech Republic 1.3 1.4 1.8 2.2 5.4 7.0 8.5 9.8 10.9 11.8 12.4 12.8

Greece 0.9 0.6 0.8 1.0 1.2 1.6 22 2.8 3.5 4.1 4.8 5.4

Poland 3.3 4.7 5.9 7.4 8.4 10.5 12.6 14.6 16.4 18.0 19.3 20.2

Turkey 2.8 3.1 3.3 3.6 4.4 6.3 8.9 12.2 16.3 21.0 26.0 31.0

Estonia

Slovenia

Latvia

Lithuania

Slovakia

Bulgaria

Hungary

Czech Republic

Greece

Poland

Turkey

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Strong economic growth with EU membership bodes well for Eastern European PC adoption.

Actual 100

80

60

40

20

0

Forecast

20 million total 93.5 million total

Number of PCs in use by country (in millions)

0.7

1.1

1.4

2.0

2.9

4.6

5.0

13.2

6.0

21.0

35.6

Source: The Economist Pocket World in Figures (2004, 2005, 2006, and 2007 editions) and Profile Books (2003, 2004, 2005, and 2006). Published in Simon Yates, “Worldwide PC Adoption Forecast, 2007 to 2015,” Forrester Research, Inc., June 11, 2007.

specifications and goals and to report on the latest developments. The website became a home for breakthrough ideas as well as searing skepticism. MIT media lab staffers, suppliers, and volunteers managed the site. “There would be no way to launch and ramp in any way other than open and viral,” Negroponte explained. “A command and control model, the way one runs an army, is not well suited for new ideas.”37 The challenge was significant.

Major design contributions came from Hawaii but also from Argentina, Brazil, China, Italy, Israel, and Taiwan. The key user interface was designed in Milan. Key parts of the operating system were developed in Brazil. “It is breaking all the rules of designing something,” remarked OLPC’s chief tech- nology officer, Mary Lou Jepsen, a former director of technology development at Intel’s Display Division. “And it’s working better and faster than anything I’ve ever worked on.”38

❚ 37Jonathan Fahey, “The Soul of the New Laptop,” Forbes, May 7, 2007. ❚ 38Fahey.

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230 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

Exhibit 3 Middle East and African PC Adoption, 2003–2015 (continued)

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 0

30

60

90

120

150 United Arab Emirates Israel

Zimbabwe

Cameroon

Cote d’Ivoire

Saudi Arabia

Morocco

Algeria

Kenya

South Africa

Egypt

Iran

Nigeria

Number of PCs in use by country (in millions)

146.9 million total29.5 million total

Actual Forecast

? Did you know? Big investments in African education will drive growth rates to add 40 million new PCs by 2015.

United Arab

Emirates 0.2 0.2 0.3 0.3 0.7 0.9 1.2 1.5 1.8 2.1 2.4 2.6 2.8

Israel 1.5 2.2 2.8 3.5 4.1 4.4 4.7 4.9 5.1 5.2 5.4 5.5 5.6

Zimbabwe 0.2 0.7 0.9 1.1 1.6 1.9 2.4 2.8 3.3 3.7 4.1 4.5 4.9

Cameroon 0.0 0.1 0.1 0.2 0.2 0.3 0.4 0.5 0.7 1.0 1.3 1.6 2.1

Cote d'Ivoire 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.8 1.1 1.4 1.9 2.4 3.0

Saudi Arabia 3.4 4.7 6.1 7.8 9.3 11.2 12.9 14.5 15.8 16.9 17.8 18.7 19.4

Morocco 0.4 0.5 0.6 0.7 0.9 1.2 1.6 2.0 2.6 3.3 4.2 5.3 6.5

Algeria 0.2 0.2 0.3 0.3 0.4 0.5 0.7 1.0 1.4 2.0 2.7 3.7 4.9

Kenya 0.2 0.3 0.4 0.5 0.6 0.8 1.1 1.4 1.9 2.5 3.2 4.1 5.1

South Africa 2.9 3.2 3.4 3.7 3.5 4.6 6.1 7.7 9.6 11.6 13.6 15.5 17.3

Egypt 1.1 1.5 1.9 2.4 2.9 4.1 5.6 7.5 9.9 12.8 16.1 19.7 23.5

Iran 5.0 5.8 6.5 7.8 10.4 13.7 17.5 21.7 25.9 30.0 33.7 37.0 39.7

Nigeria 0.1 0.5 0.7 0.9 1.1 1.5 2.1 2.8 3.8 5.2 6.9 9.2 12.1

Source: The Economist Pocket World in Figures (2004, 2005, 2006, and 2007 editions) and Profile Books (2003, 2004, 2005, and 2006). Published in Simon Yates, “Worldwide PC Adoption Forecast, 2007 to 2015,” Forrester Research, Inc., June 11, 2007.

Given the fact that most of the children using $100 Laptops would not have ready access to elec- tricity, power generation presented a major design hurdle. The MIT team explored both solar and windup mechanisms and had hoped to rely on a so- called “parasitic power,” or the ability to power the laptop simply by typing on the keys.39 Ultimately they settled on the hand-crank. Although Behar’s

team planned to put the crank directly onto the machine, engineers soon realized that cranking the handle shook the machine and put stress on the hardware.40

The early OLPC computers were made of green and white plastic with seven-inch screens that swiveled like tablet PCs. Power was provided by rotating the computer’s electricity-generating crank,

❚ 39Leahy. ❚ 40McGray.

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resulting in 40 minutes of power for each minute of turning. Built-in Wi-Fi connectivity allowed the $100 Laptops to create their own mini-network, let- ting users collaborate with each other on screen or communicate via voice through each laptop’s micro- phone and speaker system.41 Indeed, a couple of wireless antennas rising up from the screen’s sides gave the laptop two to three times the normal Wi-Fi range, making each laptop a router as well as its own communication device. Children could create a mini- network of machines up to 10 miles apart without satellites or cellular towers.42 Each laptop became part of a “wireless mesh” which relayed the broad- band signal from laptop to laptop and enabled out- of-range machines to connect to the Internet.43

The original working prototype of the $100 Lap- top was faulted for trying to look like something for business but colored for kids. “Too many parts were flapping around, too many open places,” Behar re- called. “It wasn’t realistic. It should have been com- pact and sealed, like a suitcase. And it should really look and feel different.”44 “It’s sort of a cheap plas- tic look right now which is only because of the pro- totype nature,” Negroponte told journalists at the time. “Future models will be more rugged and have a tougher outer shell.”45 In the end, the computer fit in a tiny white plastic briefcase that could resist a rainstorm. Its keyboard had a waterproof rubber coating and the case was sealed to keep dust out. Folded down, the laptop’s Wi-Fi antennas locked the case and sealed off its ports. To make it even more rugged, the design team avoided any rotating parts.

Because the effort to create the $100 Laptop was followed closely in the consumer electronics press, every design misstep was reported, leading to an un- commonly public R&D period in which the OLPC’s diverse and demanding client base could participate.46

Negroponte relayed feedback from governments around the world, trading e-mails about the design with Behar.47

“The Brazilians wanted a bigger display, and we did that,” Negroponte recalled. “The Thais wanted a taller touch tablet, big enough so kids could write on it in tall Thai script—and we did that.”48

A key to building the PC cheaply was its innova- tive, low-power LCD screen, a Jepsen invention that also included a built-in camera.49 She also found a way to cut each screen’s manufacturing cost to $40 while reducing its power consumption by more than 80%, two advances that allowed OLPC to win over many initial skeptics.50 To save power, the laptop’s liquid-crystal display (the component that consumed the most power) could be flipped from backlit color to self-reflecting monochrome to save electricity but also make the screen more visible in direct sunlight. The choice of the computer’s processor, the AMD Geode, was also driven by the need to economize on power consumption. It ran at 433 megahertz, com- pared with the 2–3 gigahertz of conventional laptops. Furthermore, using less power meant generating less heat, obviating the need for a power-consuming cool- ing fan. Finally, the laptop had a 1 gigabyte flash drive and USB 2.0 ports to which additional storage could be attached, and it had built-in speakers.51

Breaking the Wintel Paradigm Through OLPC, Negroponte hoped to cast off the “Wintel” paradigm of Intel-based processors running Microsoft’s Win- dows software, and in so doing, to reinvent the PC with a simpler and more intuitive user interface for children.52 The OLPC machines were potentially the first computers that many children would ever expe- rience. This was liberating to Negroponte’s design team, since their end users would not be prejudiced about what PCs should be like, enabling them to

❚ 41Poulsen. ❚ 42McGray. ❚ 43“A computer in every pot,” The Economist, July 27, 2007. ❚ 44McGray. ❚ 45“Negroponte OLPC and Intel,” Exclusivo Domino Digital TV, November 29, 2006, http://www.youtube.com/watch?v= HK90TnOQE0E, accessed January 21, 2007. ❚ 46McGray.

❚ 47McGray. ❚ 48McGray. ❚ 49”$150 Laptop To Offer Unusual Interface,” AFX Asia, January 1, 2007, via Factiva, accessed January 8, 2007. ❚ 50Markoff. ❚ 51“Low-Cost Laptop Could Transform Learning,” January 3, 2007, AFX Asia, via Factiva, accessed January 8, 2007. ❚ 52“$150 Laptop To Offer Unusual Interface,” AFX Asia, January 1, 2007, via Factiva, accessed January 8, 2007.

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232 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

As a result of Negroponte’s vision, the $100 Laptops would come equipped with a completely new OS, organized around a “journal,” instead of a legacy paradigm that focused on storage folders. The OS, dubbed “XO” (which evoked the acronym for Operating System (OS) but was also a symbol for kisses (X) and hugs (O) in the U.S.) would auto- matically generate a log of every file or document created by each user on the laptop.59 Students could then review their journals to see their work and re- trieve files created or altered during each session.60

In contrast, the folders system used by Windows forced users to remember where they stored their information rather than what they did with it.61 Ini- tially, students turning on XO-based computers would be greeted by a basic home screen with a stick-figure icon at the center, surrounded by a white ring.62 (Its creators bristled at the suggestion that the XO operating system made the $100 Laptop a toy.) The $100 Laptop would run a range of programs, including a Web browser, a word processor, and an RSS reader that delivered Internet blog updates.63

Red Hat, the world’s largest Linux distributor, had provided an extremely compact version of its Fedora operating system, called Sugar, that used only 130 megabytes of the XO’s flash memory (Windows XP required 1.65 gigabytes). Sugar or- ganized everything on a user’s computer around what had been used recently. Alternatively, it could group applications and files in terms of who was connected on the wireless mesh, providing an array of collaborative tools.64

Production One of Behar’s first decisions was to position all of the computer’s components behind the display, instead of putting them beneath the keyboard as in most traditional laptops such as Lenovo’s ThinkPad. This configuration allowed the device to be folded into a flat “e-book” mode; it also cut

employ a stripped-down, simplified interface, color- ful and accessible.53 “Seventy-five percent of your laptop is used just to support the OS and the obesity of the software in it,” said Negroponte. “It’s like a fat person using their energy to move their weight. I am not picking on Microsoft any more than Adobe or any piece of software. It’s outrageous. People keep adding features and features and features and [in the end], these features cost us.”54

While some critics believed that an alternative in- terface would underscore the digital divide between developed and developing nations, and that a facility with Microsoft Office was a requirement of many standardized jobs, Negroponte specifically sought to shield children from the limitations of Microsoft’s suite of software.55 “One of the saddest but most common conditions in elementary school computer labs, when they exist in the developing world, is where children are being trained to use Word, Excel and PowerPoint,” Negroponte said. “I consider that criminal, because children should be making things, communicating, exploring, sharing, not running of- fice automation tools!”56 “We do not focus on com- puter literacy,” the OLPC website explained, “as that is a by-product of the fluency children will gain through use of the laptop for learning.”57 Negroponte explained further: “Giving the kids a programming environment of any sort, whether it’s a tool like Squeak or Scratch or Logo to write programs in a childish way—and I mean that in the most generous sense of the word, that is, playing with and building things—is one of the best ways to learn. Particularly to learn about thinking and algorithms and problem solving and so forth.”58

❚ 53“Low-Cost Laptop Could Transform Learning,” January 3, 2007, AFX Asia, via Factiva, accessed January 8, 2007. ❚ 54“$100 Laptop . . . Billion-Dollar Idea,” video, eSNTV, accessible from Dennis Pierce, “Educators Salute $100 laptop’s architect,” eSchool News Online, July 7, 2006, http://www.eschoolnews.com/news/ showStory.cfm?ArticleID=6425, accessed February 15, 2007. Also available at http://www.youtube.com/watch?v=UvpP3Farb2g. ❚ 55“Low-Cost Laptop Could Transform Learning,” January 3, 2007, AFX Asia, via Factiva, accessed January 8, 2007. ❚ 56Ibid. ❚ 57For more details, see http://wiki.laptop.org/go/ One_Laptop_per_Child, accessed June 14, 2007. ❚ 58Poulsen.

❚ 59“$150 Laptop To Offer Unusual Interface,” AFX Asia, January 1, 2007, via Factiva, accessed January 8, 2007. ❚ 60Ibid. ❚ 61Ibid. ❚ 62Ibid. ❚ 63Ibid. ❚ 64“A computer in every pot,” Economist, July 27, 2007.

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Case 3-1 Marketing the “$100 Laptop” (A) 233

production costs and simplified the wiring, but made the machine somewhat top-heavy.65

While more established technology firms had well-established supply chains and manufacturing operations around the world, OLPC was starting from scratch. To build the machines, OLPC turned to OEMs. “The process of building the computers, how- ever, was complex. It doesn’t just go from zero to one million units overnight,” Negroponte underlined.66

The final design brought together more than 800 parts from multiple suppliers.67 “The manufacturers were the toughest audience,” recalled Jepsen.68

Ultimately, the machines would be made by Quanta Computer Inc., the Taiwanese manufacturer that in 2006 made roughly a third of the world’s lap- tops.69 In 2005, Quanta manufactured 18.4 million laptops for brands such as Dell, Hewlett-Packard, Lenovo Group and Acer.70 The $100 Laptop project was a risky venture for Quanta since it would not make its normal unit margin, given that each ma- chine would have to be designed to withstand heavy use and to interface in the language of the country of destination.71 Quanta expected to test the prototypes by dropping them from various heights, exposing them to extreme heat and humidity, soiling them, and pounding on keyboards.72 For example, while typical laptops were only tested to 35°C (95°F) or 40°C (104°F), unacceptable for children using lap- tops in hot climates (as well as direct sunlight and without air conditioning), the OLPC computer was tested to sustain 52°C (125°F) during the day.73 Fur- thermore, OLPC continually innovated. In March 2007, OLPC began testing Lithium Iron Phosphate battery (LiPeFo4) technology. The battery was praised

for being less toxic and more cost-effective.74 OLPC’s partners made plans to build a factory specifically to produce the LiPeFo4 batteries.

Selling the Concept

In OLPC’s early stages, the “$100 Laptop” label was a misnomer; Negroponte had predicted an initial cost closer to $150 per machine, although he expected the price to fall as more units were produced.75 By No- vember 2006, Negroponte said the $100 Laptop’s manufacturing cost was below $150 and that it would fall below $100 by the end of 2008.76 Negro- ponte believed that even the poorest country could afford “about $200 per year per child.” OLPC had estimated that a connected, unlimited Internet-access $100 laptop would cost about $30 to own and run per year. “That has got to be the very best investment you can make,” he believed. “Period.”77

Furthermore, “each school year you should have something new that lowers the price,” Negroponte noted.78 Based on a $10 per unit margin for OLPC, only 20 full-time OLPC employees,79 and Negro- ponte’s own target of 100 million laptop sales, the $100 Laptop initiative was often referred to as Negroponte’s “billion-dollar idea.”80 “Getting to $100 is not magic,” Negroponte explained in 2006, continuing:

50% of the cost of your laptop is sales, marketing, dis- tribution, and profit, and that’s not unique to laptops. That’s true for cellphones . . . PDAs, almost all con- sumer electronics. And in fact, in the case of laptops, depending on which one you have, it could be as high as 60%. We have none of those . . . When it pops out

❚ 65McGray. ❚ 66Poulsen. ❚ 67Fildes. ❚ 68Poulsen. ❚ 69Surowiecki. ❚ 70Jason Dean, “The Laptop Trail,” The Wall Street Journal, June 9, 2005, via Factiva, accessed September 8, 2008. ❚ 71Dean. ❚ 72“One Laptop Per Child Hits Milestone,” Wireless News, November 26, 2006, via Factiva, accessed January 23, 2007. ❚ 73For more details, see http://wiki.laptop.org/go/News, accessed June 14, 2007.

❚ 74Eric Lai, “OLPC eyes experimental battery for $100 laptop,” Computer World Hardware, March 29, 2007, http://wiki.laptop.org/ images/0/0a/OLPC_eyes_experimental_battery_for_%24100_ laptop.pdf, accessed June 6, 2007. ❚ 75Surowiecki. ❚ 76John Markoff, “U.S. Group Reaches Deal to Provide Laptops to All Libyan Schoolchildren,” The New York Times, October 11, 2006, via Factiva, accessed September 8, 2008. ❚ 77Surowiecki. ❚ 78“Negroponte OLPC and Intel,” Exclusivo Domino Digital TV, November 29, 2006, http://www.youtube.com/watch?v= HK90TnOQE0E, accessed January 21, 2007. ❚ 79Stecklow. ❚ 80MacMillan.

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234 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

know me,” explained Negroponte. “It’s almost easier for me to get in the door than Michael Dell, or Steve Jobs, or Bill Gates, even though they’re more famous, richer or more important. It’s easier for me to get in because I’m not selling something.”86

Technology and Emerging Markets

Despite best intentions and innovative technology, the success of the $100 Laptop was far from guaranteed, as demonstrated by the checkered history of technol- ogy introductions to emerging markets.87 With cell phones, for example, despite rapid subscriber growth, pricing had long remained a concern, and was seen by some as the biggest obstacle to broader adoption. Investcom, which ran cell phone networks in Africa and the Middle East, estimated that the number of users would double in those markets if the cheapest handset were priced at $30 instead of $60.88 Lower handset prices would build subscriptions in develop- ing regions, where prohibitively high hardware costs were blamed for low adoption rates in areas where network coverage was available.89

In early 2006, as part of a program to facilitate economic growth in developing nations, the GSM Association (GSMA), a lobbying group made up of hundreds of wireless service providers who sought to make GSM the world’s dominant mobile phone standard, sponsored a bid to develop a handset that would wholesale below $40, including follow-up shipments of sub-$30 handsets, with the ultimate goal of attracting 100 million new users.90 Motorola won the contract.91 Even though the handsets’ low

of the box, it’s not going to be $100, it’s going to be $138, $137, $142, who knows? The important thing is, the price floats. . . . It’s like a spot market for lap- tops. And the reason the price floats is [because of] currency changes, memory cost float, nickel [pric- ing]. Our batteries are nickel-metal hydride [and we need] 100 million batteries . . . The price of nickel went up 20% between April and May [of 2006.] So clearly, those things float the price [but] we will guar- antee that it [the price per unit] will keep going down. Our target is to hit $100 by the end of 2008 and to hit $50 by 2010. So that’s actually more important—it’s the slope, not the out-of-the-gate price. And what we promise not to do is to keep adding features. We’re going to keep the features constant and watch the [production] price go down.81

However, convincing the developing country governments that acquiring OLPC machines was indeed “the very best investment” they could ever make had proven challenging. “Governments are hard [to negotiate with],” Negroponte explained, “large governments are harder, [and] ministries of education are harder still.”82 The process required lobbying relevant officials in nations with large and fickle bureaucracies.83 Governments or donors were expected to buy individual laptops for children to own, as well as the associated server equipment to be kept in schools. There had been some false starts. India’s government, for example, had originally ex- pressed interest in the $100 Laptop but later backed out, opting instead to put its resources toward tradi- tional methods of education.84

Despite the challenges, some observers believed that selling products to larger, institutional clients could be easier for a nonprofit organization such as OLPC whose motives might not be questioned.85

“Bringing the idea to national leaders had been easy, partly because I know some of them, or they

❚ 81“$100 Laptop . . . Billion-Dollar Idea,” video, eSNTV, available from Dennis Pierce, “Educators Salute $100 laptop’s architect,” eSchool News Online, July 7, 2006. ❚ 82Surowiecki. ❚ 83Surowiecki. ❚ 84“Encore Set To Bag Brazilian Laptop Order,” Economic Times, December 19, 2006, via Factiva, accessed January 15, 2007. ❚ 85Surowiecki.

❚ 86Kevin Poulsen, “Negroponte: Laptop for Every Kid,” WIRED, November 17, 2005, at www.wired.com, accessed January 10, 2007. ❚ 87“Laptops: Easy Fix For Global Education?” The Christian Science Monitor, January 5, 2007, via Factiva, accessed February 5, 2007. ❚ 88”Calling An End To Poverty,” Economist, July 9, 2005, via Factiva, accessed on January 18, 2007. ❚ 89For more details, see Susmita Dasgupta, Somic Lall and David Wheeler, “Policy Reform, Economic Growth and the Digital Divide,” Oxford Development Studies, Volume 33 (Routledge: June, 2005). ❚ 90Kevin Fitchard, “Cheaper by the Globalization,” Telephony, November 6, 2006, via Factiva, accessed January 21, 2007. ❚ 91Mike Slocombe, “‘Ultra-Low Cost’ Mobile Handsets Announced by GSM Association,” Digital-Lifestyles, February 15, 2005, at www .http://digital-lifestyles.info/2005/02/15/ultra-low-cost-mobile-handsets- announced-by-gsm-association/, accessed February 13, 2007.

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cost, made possible by economies of scale, would not be cross-subsidized by high-margin handsets or by any “corporate social responsibility” program, Motorola expected to earn a small margin on each handset sold. Motorola planned to use its factories in mainland China to produce the six million low-cost phones in half a year. By January 2007, Motorola had shipped six million sub-$40 handsets, as well as an additional six million sub-$30 handsets, to mobile telephone operators in emerging markets including India, Pakistan, Bangladesh, Indonesia, Philippines, Malaysia, Thailand, Turkey, South Africa, Nigeria, Egypt, Algeria, Russia, and Ukraine.92 In the early stages of the rollout, executives acknowledged that the low pricing in emerging markets had been nec- essary to build market share.93 “The pricing that we did in those [high-growth] markets was to maintain our share position,” said a Motorola executive. “It was a brutal market from a pricing perspective.”94

These moves eventually took a toll on Motorola’s earnings.

Importantly, however, low pricing and simpler products were not a guarantee of market success. Because people in poor countries spent a far larger fraction of their income to buy even the cheapest handsets, a Nokia manager explained, phones were a status symbol, so brand and appearance mattered.95

Intended beneficiaries had been known to reject cheaper phones, viewing them as inferior and sub- standard. “We assume that the poor will not accept technology,” explained University of Michigan Professor and author of The Fortune at the Bottom of the Pyramid, C. K. Prahalad.

“The truth is they will accept technology in some ways even more easily than we will, because they have not been socialized to anything else. They

accept technology rapidly, as long as that technol- ogy is useful. We have a very long forgetting curve. They don’t. They have only a learning curve.”96

Regardless of the challenges, Nokia manage- ment believed that by 2008, there would be more than three billion people (half the world’s popula- tion) using mobile communications, and that al- most all growth, even in the next three years, would stem from emerging markets.97 The company had teamed up with the Grameen Foundation of Bangladesh to develop less expensive cell phones to be used in Africa that were durable, dust-resistant, and had flashlights, a useful added feature for re- gions without electricity.98

Some philanthropists and technologists, includ- ing Microsoft cofounder Bill Gates and chief re- search and strategy officer Craig Mundie, argued that developing countries and their benefactors should be leveraging existing communications infra- structure such as mobile telephony to accelerate learning and modernization efforts, instead of deploying PCs. They agreed with scholars who argued that emerging markets were likely to be wireless-centric, rather than PC-centric.99 For this reason, Gates advocated distributing Internet-enabled cell phones to children and parents rather than trying to assemble Wi-Fi-enabled mesh networks with do- nated or subsidized laptops. “The phone itself is going to be the low-cost computer,” said the chair- man of handset chip-maker Qualcomm.100 Many saw developing nations such as India and Uganda “leap-frogging” past standard technologies, such as land-line phones, for cell phones. In most emerging markets, mobile phone use had increased more rapidly than Internet use, but both technologies were on the uptake worldwide.101

❚ 92“One of Four Handsets Shipped in 2011 Will Cost Less Than $20, Says ABI Research,” Business Wire, January 22, 2007, via Factiva, accessed February 16, 2007. ❚ 93“Motorola to cut 3,500 jobs,” AFX Asia, January 21, 2007, via Factiva, accessed February 16, 2007. ❚ 94 “Motorola Inc. Analyst Meeting—Final,” Voxant FD Wire, January 19, 2007, via Factiva, accessed February 16, 2007. ❚ 95 “Calling an end to poverty,” Economist, July 9, 2005, via Factiva, accessed February 13, 2007.

❚ 96Surowiecki. ❚ 97Ibid. ❚ 98Tavia Grant, “World’s Poorest Nations New Frontier For Cellphone Giants,” The Globe and Mail, November 14, 2006, via Factiva, accessed January 21, 2007. ❚ 99“Calling an end to poverty,” The Economist, July 9, 2005, via Factiva, accessed January 18, 2007. ❚ 100Bruce Einhorn, “Intel Inside the Third World,” BusinessWeek, July 9 and 16, 2007. ❚ 101World Bank World Development Indicators database, 2007.

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digital divide using yesterday’s technology,” sug- gested Intel president and CEO Paul Otellini, in a thinly veiled swipe at OLPC.106 The $285 model cost more than OLPC’s price tag of $175 per laptop, but the Classmate PC offered enhanced capabilities and the ability to run stripped-down versions of Linux or Windows XP. Intel hoped to reduce the price below $200 once mass production began.107

Negroponte took Intel’s entry into the fray in stride: “Intel copied [us],” he said.108 “When Intel made their laptop, that was a wonderful thing for children because if there’s more than one opportu- nity, that’s good. . . . The difference is that Intel’s ap- proach is much more teacher-centric [while] ours is much more child-centric, and that is a philosophi- cal difference, not a technological difference.”109 At the 2007 World Economic Forum, Intel’s [Craig] Barrett argued that Intel’s efforts to train teachers to use PCs was a more helpful approach than the wholesale supply of laptops to children and the concurrent expectation that they would intuit their functionality and use.110 OLPC had been criticized for discounting the value of teacher training and curriculum development using the devices.111

Another competitor was India-based Encore Software, whose “Mobilis” PC had attracted the in- terest of both the Indian government and Brazil’s education ministry.112 Mobilis ran on Linux, was easy to use, and featured regional Indian languages like Hindi, Kannada, and Marathi.113 In 2006, Encore Software provided 40 evaluation units to the Brazil- ian government for inspection, expecting feedback

The idea of a multifunctional phone had gained traction among a handful of hardware developers. For example, in June 2006, the Israeli technology firm Fourier introduced the Wi-Fi-capable Nova5000, a touch-screen PDA equipped with the handheld ver- sion of Microsoft’s operating system, Windows CE, and a number of basic computing applications often found in more expensive “smartphones” such as the Blackberry Pearl or the Palm Treo.102 In July 2006, Microsoft’s Mundie unveiled a prototype of a Microsoft phone, called FonePlus, that would even- tually allow users to read e-mail, run stripped down versions of Microsoft applications, and surf the Web, in addition to its regular functions. Microsoft also intended to connect the phone to a TV and key- board to form a stripped-down Web computer.103

“Suggesting that cell phones are an alternative to laptops is like saying we can use postage stamps to read textbooks,” Negroponte retorted. “Books have a purposeful size based on how the eye works and the ability to [simultaneously read and browse]. It was not by chance that atlases are bigger than timeta- bles.”104 While connecting a Web-enabled cell phone to a TV and keyboard could yield what amounted to a rudimentary Web computer, as Gates had suggested, few families in developing nations owned televisions, nor did many remote villages or rural classrooms have electricity to power TVs. Televisions also lacked the laptop’s inherent benefit of mobility.105

Competing Options

In May 2006 Intel launched its own cheaper laptop (the Classmate PC) targeting developing nations as part of its “World Ahead” program. The day after announcing plans to invest $1 billion in education and training as part of its program, Intel underlined its commitment to closing the technology gap be- tween rich and poor nations with a device that used flash memory instead of a hard drive and ran Microsoft Windows XP. “No one wants to cross the

❚ 102MacMillan. ❚ 103Surowiecki. ❚ 104Surowiecki. ❚ 105Surowiecki.

❚ 106Tom Krazit, “Intel Builds $400 Laptop For School Desks Worldwide,” CNET News.com, May 3, 2006, via Factiva, accessed January 21, 2007. ❚ 107“Which laptop per child?” Guardian Unlimited on the Web, May 31, 2007, http://technology.guardian.co.uk/weekly/story/0,,2091248,00. html, accessed June 17, 2007. ❚ 108”Negroponte OLPC and Intel,” Exclusivo Domino Digital TV, November 29, 2006, http://www.youtube.com/watch?v=HK90TnOQE0E, accessed January 21, 2007. ❚ 109Ibid. ❚ 110Markoff. ❚ 111Markoff. ❚ 112“Encore Set To Bag Brazilian Laptop Order,” Economic Times, December 19, 2006, via Factiva, accessed January 15, 2007. ❚ 113Ibid.

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and possibly an initial order by February 2007.114

Finally, AMD was also developing its own low-cost laptop, the “Personal Internet Communicator,” a de facto fourth competitor to OLPC’s product.115 AMD had boldly announced that it could bring half of the world’s population online by 2015 with the device.116

After Gates questioned whether the $100 Laptop concept was “just taking what we do in the rich world” and assuming it was something good for de- veloping nations,117 Negroponte responded, “Bill Gates has come out against it. . . . Intel keeps slam- ming it. . . . [W]hen people like that don’t like it, you must be doing something right.”118

Educating the Poor119

As the debate raged about alternative products and visions, education problems in the developing world persisted despite a broad consensus among international organizations, ministries of education, and grassroots organizations that improving educa- tion would alleviate hardship in developing nations. Common challenges shared by countries in the de- veloping world were a lack of teachers, classrooms, and textbooks.120 For example, in the Mwanza dis- trict of Malawi, there were only six qualified teach- ers in four classrooms teaching 772 students.121 By some estimates, sub-Saharan Africa needed to recruit at least 1.6 million more teachers to provide univer- sal primary education by 2015, with a ratio of 40 pupils to one teacher.122

Since 1990, the World Bank had spent $12 billion on primary education in developing countries.123 In addition, UNESCO reported that participation in primary education had increased by 27% in sub- Saharan Africa between 1999 and 2004; however, the report added that net enrollment ratios remained low, at 65% in 2004.124 To boost literacy and increase classroom attendance, some countries abolished school fees and saw a consequent surge in school enrollments. For example, in 2003, primary school enrollment in Kenya grew from 5.9 million to 7.2 million, and a similar boost in attendance was recorded in the primary schools of Uganda and Tanzania.125 Waiving school fees helped more poor students gain access to education, but whether they stayed in school and benefited from the programs depended on other factors, such as health, nutrition, family support, good textbooks, and qualified teaching staff.126

The education crisis in the developing world was even worse among women. UNICEF estimated that, on average, only 43% of eligible girls in the develop- ing world attended secondary schools.127 Young girls were often forced to either drop out of school or not go to school at all because of their parents’ inability to care for them.128 In rural Malawi, many young girls never completed primary school since families placed a greater emphasis on working in the fields, caring for the elderly, and marriage than education.129 Teenage pregnancy, high birth rates, and scarcity of contracep- tion in most developing nations also affected the ability of young women to attend school. By some

❚ 114Ibid. ❚ 115Tom Krazit, “Intel Builds $400 Laptop For School Desks Worldwide,” CNET News.com, May 3, 2006, via Factiva, accessed January 21, 2007. ❚ 116Hille. ❚ 117Markoff. ❚ 118“Transcript of Negroponte’s Presentation,” One Laptop Per Child page, July 7, 2006, https://www.newman.ac.uk/Students_Websites/ ~j.e.england/olpct2.htm, accessed June 17, 2007. ❚ 119This section draws from Kevin Clarke, “Troubled Waters,” U.S. Catholic, February 1, 2007, via Factiva, accessed February 4, 2007. ❚ 120Rachel Maser, “Lessons from Malawi: Obstacles to Education Abound in Rural Malawi,” Edmonton Journal, February 3, 2007, via Factiva, accessed February 5, 2007. ❚ 121Ibid. ❚ 122“Early Childhood Education Missing: UNESCO,” Xinhua News Agency, November 26, 2006, via Factiva, accessed February 4, 2007.

❚ 123Kristi Heim, “Gates donates $40 million to improve education in poor countries,” Seattle Times, December 18, 2006, via Factiva, accessed February 5, 2007. ❚ 124“Early Childhood Education Missing: UNESCO,” Xinhua News Agency, November 26, 2006, via Factiva, accessed February 4, 2007. ❚ 125Andrew Mitchell, “We Must Do More To Help Street Children,” Birmingham Post, December 20, 2006, via Factiva, accessed February 5, 2007. ❚ 126Kristi Heim, “Gates donates $40 million to improve education in poor countries.” ❚ 127“Study: Children Caught In Vicious Circle of Sexism,” Mail and Guardian, December 14, 2006, via Factiva, accessed February 5, 2007. ❚ 128Abubakr-Sadiq Braimah, “Child Sex Market in Ghana,” All Africa, January 21, 2007, via Factiva, accessed February 5, 2007. ❚ 129Ibid.

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Rethinking the Concept?

In June 2007, an OLPC spokeswoman reported that “OLPC [was] in talks with Argentina, Brazil, Uruguay, Peru, Nigeria, Thailand, Pakistan, Russia, Rwanda and many other countries—but nothing definite just yet.”138 The Inter-American Develop- ment Bank was supposedly considering purchasing Negroponte’s laptops for multiple Central Ameri- can countries.139 (See Exhibit 4 for a status of OLPC negotiations around the world, Exhibit 5 for main OLPC milestones, and Exhibit 6 for the latest OLPC specifications.) In the prior month, OLPC had do- nated 160 laptops to a public elementary school in Uruguay, making the small town of Villa Cardal the first Latin American recipient of the computers. While the laptops were donated by OLPC, Uruguay has budgeted $15 million for the project. The ar- rival of the computers invigorated this small com- munity of only 1,300 residents. Students would use the laptops in class, since the machines were loaded with electronic versions of their school books and encyclopedias. But the learning and experience ex- tended beyond the classroom. Because the laptops were owned by each child, they could be taken home and shared with family and friends.

While Negroponte acknowledged the challenge that confronted poorer governments in justifying the expenditure of large portions of their education budgets on laptops,140 he was not willing to venture into production until he had firm commitments from governments outside the U.S. to buy at least five million of his machines.141 By late May 2007, with Brazil reportedly planning to order Classmate PCs instead of OLPC laptops, Negroponte described Intel’s push as “predatory.”142 “The world is a big

estimates only 14% of women in Uganda, for exam- ple, used modern methods of contraception, and 33% of the population completely lacked access to meth- ods of birth control.130

Furthermore, in many parts of Africa, young boys and girls under the age of 18 were forced to fight in regional conflicts.131 As many as 300,000 children worldwide were used not only as fighters, but as messengers, spies, porters, and in some cases, ser- vants and concubines.132 Drug use, combined with severe urban poverty, a rising cost of living, few job opportunities, and no laws for compulsory education all contributed to the growing ranks of so-called street children around the world.133

In Nigeria, large numbers of children did not at- tend school or were forced to drop out for reasons re- lated to inaccessibility.134 In Malawi, food scarcity and unemployment were seen as barriers to educa- tion. During the “hungry season” from December to April, many families had only one meal each day in the late afternoon, meaning children would often have to walk to school, attend class for five hours, and then walk home on an empty stomach.135 Millions of children of both genders in developing nations spent the bulk of each day searching for food and drinking water, often foraging for recyclable materials in garbage dumps. Poor health associated with water and sanitation deficits undermined productivity and economic growth.136 Poor living conditions were fre- quently exacerbated by lack of running water, elec- tricity, limited medical care, and local violence.137

❚ 130Glenna Gordon, “No Option But Abortion,” All Africa, November 21, 2006, via Factiva, accessed February 4, 2007. ❚ 131Genevieve Swart, “Africa’s Children Brought to Life, Brutally,” The Sun Herald, April 30, 2006, via Factiva, accessed February 5, 2007. ❚ 132Ibid. ❚ 133Waheed Khan, “Pakistan Street Kids Plagued by Glue Sniffing,” Reuters, January 8, 2007, via Factiva, accessed February 5, 2007. ❚ 134Aisha Lemu, “Education Should Be Priority of All Muslim Women,” All Africa, January 21, 2007, via Factiva, accessed February 5, 2007. ❚ 135Rachel Maser, “Lessons from Malawi: Obstacles to Education Abound in Rural Malawi,” Edmonton Journal, February 3, 2007, via Factiva, accessed February 5, 2007. ❚ 136Kevin Clarke, “Troubled Waters,” U.S. Catholic, February 1, 2007, via Factiva, accessed February 4, 2007. ❚ 137Martin Miller, “Trading the good life for a life of doing good,” Los Angeles Times, July 27, 2005, via Factiva, accessed February 4, 2007.

❚ 138“Laptops projects for poor states draws big competition,” Agence- France Presse on the Web, May 28, 2007, http://www.afp .com/english/home/, accessed June 19, 2007. ❚ 139“Low-Cost Laptop Could Transform Learning,” January 3, 2007, AFX Asia, via Factiva, accessed January 8, 2007. ❚ 140Surowiecki. ❚ 141Surowiecki. ❚ 142“Which laptop per child?” Guardian Unlimited on the Web, May 31, 2007, http://technology.guardian.co.uk/weekly/story/0,,2091248,00 .html, accessed June 17, 2007.

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Case 3-1 Marketing the “$100 Laptop” (A) 239

place and there’s room for lots of these,” retorted an Intel manager.143 Meanwhile, other countries such as Nigeria, Pakistan, and Thailand were also weigh- ing their options, since every week seemed to bring announcements of low-cost machines.

Indeed, since the announcement of the $100 Laptop, the category had been transformed by falling prices and surging demand. Prices for basic notebook machines fell from $2,000 in 2005 to less than $800 in early 2007.144 In 2006 global notebook sales grew

by 26%, and desktop sales grew by only 2%. Analysts estimated that by 2011, portable PCs would outsell desktops. Further, resale values for relatively brand new machines were low.145 Meanwhile, desktop prices continued to drop, with HP introducing in June 2007 the rp5700 Business Desktop PC, which was 95% manufactured from recyclable components, priced at $648.146 In June 2007, Taiwan-based Asus announced its plans to manufacture cheap note- books for sale to developing as well as developed

Exhibit 4 Status of OLPC Negotiations in Selected Countries, June 2007

Source: OLPC, http://www.laptop.org/en/vision/progress/maps.shtml, accessed July 29, 2007.

those countries we plan to pilot

those countries we plan to include in the post-launch phase

those countries who have expressed interest at the ministry-of-education level or higher

those countries who are currently seeking government support

❚ 143Tom Bawden, “Intel targets developing world with basic laptop for children,” The Times on the Web, June 6, 2007, http://business .timesonline.co.uk/tol/business/industry_sectors/technology/article 1890168.ece, accessed June 19, 2007. ❚ 144Angus Kidman, “Notebooks sweeping the desktop,” The Australian, April 10, 2007, via Factiva, accessed June 6, 2007.

❚ 145Ibid. ❚ 146Geoff Duncan, “HP’s New PC So Green, It’s Gold,” Digital Trends News, June 5, 2007, http://news.digitaltrends.com/news/ story/13190/hps_new_pc_so_green_its_gold, accessed June 6, 2007.

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240 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

Exhibit 5 OLPC Milestones, January 2005–May 2007

Date Event

May 2007 Autonomous mesh operates during suspend; First B3 machines are built and deployed; Peru announces it will participate in OLPC.

Apr. 2007 First school server deployed. Mar. 2007 First mesh network deployed. Feb. 2007 B2-test machines become available and are shipped to developers and the launch countries. Jan. 2007 Rwanda announced its participation in the project. Dec. 2006 Uruguay announced its participation in the project. Nov. 2006 First B1 machines are built; IDB and OLPC formalize an agreement regarding Latin American

and Caribbean education. Oct. 2006 B-test boards become available; Libya announces plans for one laptop for every child. Sep. 2006 UI designs presented; integrated software build released; SES-Astra joins OLPC. Aug. 2006 Working prototype of the dual-mode display. Jun. 2006 500 developer boards are shipped worldwide; WiFi operational; Csound demonstrated over the

mesh network. First video with working prototype.

May 2006 eBay joins OLPC; display specs set; A-test boards become available; $100 Server is announced. Apr. 2006 Pre-A test board boots; Squid and FreePlay present first human-power systems. Mar. 2006 Yves Behar and FuseProject are selected as industry designers. Feb. 2006 Marvell joins OLPC and continues to partner on network hardware. Jan. 2006 World Economic Forum, Switzerland.

UNDP and OLPC Sign Partnership Agreement. Dec. 2005 Quanta Computer Inc. to manufacture Laptop. Nov. 2005 WSIS, Tunisia.

Prototype unveiled by UN Secretary-General Kofi Annan; Nortel joins OLPC. Aug. 2005 Design Continuum starts design of first laptop. Jul. 2005 Formal signing of original members of OLPC. Mar. 2005 Brightstar and Red Hat come on board. Jan. 2005 Laptop initiative officially announced at World Economic Forum, Davos, Switzerland; AMD,

News Corp. and Google agree to join OLPC.

Source: OLPC, http://wiki.laptop.org/go/milestones, accessed September 5, 2008.

nations.147 The chairman explained that the $189 laptop, measuring 120 � 100 � 30 mm and weighing only 900 grams, would be the lowest-cost and easi- est machine to use. This machine, called EeePC,

would use a custom-written Linux operating system, but unlike OLPC, would offer a conventional Win- dows interface. Asus attributed the low estimated price to its design choices, primarily a flash-based 2GB hard disk.148 These new alternatives meant that purchasing computing power for education was

❚ 147Asus was a Taiwan-based technology company that manufactured motherboards, graphics cards, optical drives, PDAs, notebook computers, networking products, mobile phones, computer cases, computer components, and computer cooling systems. The company’s motherboards were in one-third of all desktop PCs sold in 2006. ASUSTek Computer Inc., “About ASUS.” ASUSTek Computer Inc. website, http://usa.asus.com/aboutasus.aspx?show=1, accessed June 19, 2007.

❚ 148Doug Mohney, “Foleo, UMPC and OLPC all killed off in one week,” The Inquirer, June 6, 2007; and Clive Webster, “Asus stuns Compux with 100 laptop,” PCPro, June 6, 2007, http://www.pcpro.co.uk/news/114773/computex-2007-asus-stuns- computex-with-100-laptop.html June 6, 2007.

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Exhibit 6 Photos and Specifications of OLPC Laptop, June 2007

Physical dimensions: • Dimensions: 242 mm � 228 mm � 32 mm (approximate—subject

to change) • Weight: Less than 1.5 KG (target only—subject to change) • Configuration: Convertible laptop with pivoting, reversible display;

dirt-and moisture-resistant system enclosure

Core electronics: • AMD Geode LX-700 @ 0.8w (data sheet) • CPU clock speed: 433 Mhz • Compatibility: Athlon instruction set (including MMX and

3DNow! Enhanced) with additional Geode-specific instructions (X86/X87-compatible)

• North Bridge: PCI and Memory Interface integrated with Geode CPU • Chipset: AMD CS5536 South Bridge (datasheet) • Graphics controller: Integrated with Geode CPU; unified memory

architecture • Embedded controller (for production), ENE KB3700 • DRAM memory: w56 MiB dynamic RAM • Data rate: Dual—DDR333—166 Mhz • Open Firmware bootloader; 1024KB SPI-interface flash ROM • Mass storage: 1024 MiB SLC NAND flash, high-speed flash controller • Drives: No rotating media

Display: • Liquid-crystal display: 7.5” Dual-mode TFT display • Viewing area: 152.4 mm � 114.3 mm • Resolution: 1200 (H) � 900 (V) resolution (200 DPI) • Mono display: High-resolution, quincunx-sampled, transmissive

color mode • Special “DCON” chip, that enables deswizzling and anti-aliasing in

color mode, while enabling the display to remain live with the processor suspended.

Integrated peripherals: • Keyboard: 70� keys, 1.2 mm stroke; sealed rubber-membrane

key-switch assembly • Keyboard layout details • Keyboard layout pictures—international, Thai, Arabic, Spanish,

Portuguese, West Africa, Urdu, French • Cursor-control keys: five-key cursor-control pad; four directional

keys plus Enter • Touchpad: Dual capacitance/resistive touchpad; supports written-

input mode • Audio: Analog Devices AD1888, AC97-compatible audio codec;

stereo, with dual internal speakers; monophonic, with internal micro- phone and using the Analog Devices SSM2211 for audio amplification

Physical Dimensions

Prototype-A Motherboard

eToys

(continued)

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242 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

Exhibit 6 Photos and Specifications of OLPC Laptop, June 2007 (continued)

Keyboard Detail

Connectors

Battery

• Wireless: Marvell Libertas 88W8388+88W8015, 802.11b/g com- patible; dual adjustable, rotating coaxial antennas; supports diver- sity reception

• Status indicators: Power, battery, WiFi; visible lid open or closed • Video camera: 640 � 480 resolution, 30FPS

External connectors: • Power: 2-pin DC-input, 10 to 20 V usable, –50 to 39 V safe,

one-time fuse for excessive input • Line output: Standard 3.5 mm 3-pin switched stereo audio jack • Microphone: Standard 3.5 mm 2-pin switched mono microphone

jack; selectable sensor-input mode • Expansion: 3 Type-A USB-2.0 connectors; MMC/SD Card slot • Maximum power: 1 A (total)

Battery: • Pack type: 4 or 5 Cells, 6V series configuration • Fully-enclosed “hard” case; user removable • Capacity: 22.8 Watt-hours • Cell type: NiMH (or LiFeP) • Pack protection: Integrated pack-type identification • Integrated thermal sensor • Integrated polyfuse current limiter • Cycle life: Minimum 2,000 charge/discharge cycles (to 50% capacity

of new, IIRC). • Power Management will be critical.

BIOS/loader • Open Firmware is used as the bootloader.

Environmental specifications: • Temperature: somewhere in between typical laptop requirements and

Mil spec; exact values have not been settled. • Humidity: Similar attitude to temperature. When closed, the unit

should seal well enough that children walking to and from school need not fear rainstorms or dust.

• Altitude: –15 m to 3048 m (operating), –15 m to 12192 m (non-operating) • Shock: 125 g, 2 ms, half-sine (operating) 200 g, 2 ms, half-sine

(non-operating) • Random vibration: 0.75 g zero-to-peak, 10 Hz to 500 Hz,

0.25 oct/min sweep rate (operating); 1.5 g zero-to-peak, 10 Hz to 500 Hz, 0.5 oct/min sweep rate (nonoperating)

• 2 mm plastic walls (1.3 mm is typical for most systems).

Regulatory requirements: • The usual US and EU EMI/EMC requirements will be met. • The laptop and all OLPC-supplied accessories will be fully UL and

is ROoHS compliant. Source: OLPC, http://www.laptop.org/en/laptop/hardware/specs.shtml, accessed August 1, 2007.

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Case 3-1 Marketing the “$100 Laptop” (A) 243

becoming more accessible not only to individuals in developing countries, but also to governments and aid organizations involved in the sector.

Meanwhile, Intel’s Classmate PC had been rolling off Chinese assembly lines since March 2007, at a plant owned by a Taiwanese manufacturer. Intel had trials under way in over 10 nations, with 25 planned by late 2007. Intel planned to have over one million machines manufactured before the end of 2007. In many countries, Intel bundled its Classmate lap- tops with education software and teacher-training support.149 Intel had also recently launched trials in California and Oregon and was said to be consider- ing a slightly more powerful Classmate PC for sale in the developed world in 2008.150

Observers noted that, as a marginal player in the cellular market, and faced with sluggish worldwide PC growth, Intel had to find a way to sell to the next class of yet-unwired billion consumers. This foray into education was seen as a potential Trojan horse. Instead of trying to reinvent the PC, an Intel man- ager explained, “we have chosen to ride the existing technology curve and drive down the cost.” Its pur- chasing clout, especially with Asia suppliers, al- lowed it to purchase components at close to cost,

and Intel had moved its Classmate PC model from concept to commercial production in less than 18 months. In early June, Intel announced that it was working with another Taiwanese firm to make an- other laptop based on the Classmate model, priced at $200.151 Negroponte remained critical. “[OLPC] is an education project,” he explained, “not a laptop project.”152 “[Intel] look(s) at it as a market. But primary education in the developing world is not a market, it’s a human right. And I don’t think Intel is in the human rights business.”153 “We don’t compete with Intel,” he added. “They tell me all the time they are very interested in the next billion users and I say, ‘I’m interested in the last billion users.’These are very complementary projects. They really go together.”154

However, in the meantime, some U.S. school systems had started dropping laptops. “After seven years, there was literally no evidence it had any im- pact on student achievement,” said the president of a school board that had been an early laptop-in-the- classroom adopter. “The teachers were telling us that where there’s a one-on-one relationship be- tween the student and the laptop, the box gets in the way. It is a distraction to the educational process.”155

❚ 149Bruce Einhorn, “Intel Inside the Third World,” BusinessWeek, July 9 and 16, 2007. ❚ 150Einhorn.

❚ 151Ibid. ❚ 152Fildes. ❚ 153Einhorn. ❚ 154Ibid. ❚ 155Winnie Hu, “Seeing no progress, some schools drop laptops,” New York Times, May 4, 2007.

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purchase of the Hoegaarden brewery in 1989 and the Belle-Vue Brewery in 1990.

Interbrew then entered into a phase of rapid growth. The company acquired breweries in Hun- gary in 1991, in Croatia and Romania in 1994, and in three plants in Bulgaria in 1995. Again in 1995, Interbrew completed an unexpected major acquisi- tion by purchasing Labatt, a large Canadian brewer also with international interests. Labatt had opera- tions in the United States, for example, with the Latrobe brewery, home of the Rolling Rock brand. Labatt also held a substantial minority stake in the second largest Mexican brewer, Femsa Cervesa, which produced Dos Equis, Sol, and Tecate brands. Following this major acquisition, Interbrew went on, in 1996, to buy a brewery in the Ukraine and en- gaged in a joint venture in the Dominican Republic. Subsequently, breweries were added in China in 1997, Montenegro and Russia in 1998, and another brewery in Bulgaria and one in Korea in 1999.

Thus, through acquisition expenditures of US$2.5 billion in the previous four years, Interbrew had transformed itself from a simple Belgian brew- ery into one of the largest beer companies in the world. By 1999, the company had become a brewer on a truly global scale that now derived more that 90 per cent of its volume from markets outside Belgium. It remained a privately held company, headquartered in Belgium, with subsidiaries and joint ventures in 23 countries across four continents.

The International Market for Beer

In the 1990s, the world beer market was growing at an annual rate of one to two per cent. In 1998, beer consumption reached a total of 1.3 billion hectolitres (hls). There were, however, great regional differences in both market size and growth rates. Most industry analysts split the world market for beer between growth and mature markets. The mature markets were generally considered to be North America,

In April 2000, Paul Cooke, chief marketing officer of Interbrew, the world’s fourth largest brewer, contem- plated the further development of their premium product, Stella Artois, as the company’s flagship brand in key markets around the world. Although the long-range plan for 2000–2002 had been approved, there still remained some important strategic issues to resolve.

A Brief History of Interbrew

Interbrew traced its origins back to 1366 to a brew- ery called Den Hoorn, located in Leuven, a town just outside of Brussels. In 1717, when it was pur- chased by its master brewer, Sebastiaan Artois, the brewery changed its name to Artois.

The firm’s expansion began when Artois acquired a major interest in the Leffe Brewery in Belgium in 1954, the Dommelsch Brewery in the Netherlands in 1968, and the Brassiere du Nord in France in 1970. In 1987, when Artois and another Belgian brewery called Piedboeuf came together, the merged company was named Interbrew. The new company soon acquired other Belgian specialty beer brewers, building up the Interbrew brand portfolio with the

Case 3-2 The Global Branding of Stella Artois Paul W. Beamish and Anthony Goerzen

❚ Professors Paul W. Beamish and Anthony Goerzen prepared this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. ❚ Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. This material is not covered under authorization from any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208, fax (519) 661-3882, email [email protected] ❚ Copyright © 2000, Ivey Management Services

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Case 3-2 The Global Branding of Stella Artois 245

Western Europe and Australasia. The growth markets included Latin America, Asia, Central and Eastern Europe including Russia. Although some felt that Africa had considerable potential, despite its low per capita beer consumption, the continent was not considered a viable market by many brewers be- cause of its political and economic instability (see Exhibit 1).

Mature Markets The North American beer mar- ket was virtually stagnant, although annual beer consumption per person was already at a sizeable 83 litres per capita (lpc). The Western European market had also reached maturity with consumption of 79 lpc. Some analysts believed that this consump- tion level was under considerable pressure, forecast- ing a decline to near 75 lpc over the medium term. Australia and New Zealand were also considered mature markets, with consumption at 93 lpc and 84 lpc, respectively. In fact, volumes in both markets, New Zealand in particular, had declined through the 1990s following tight social policies on alcohol con- sumption and the emergence of a wine culture.

Growth Markets Given that average consump- tion in Eastern Europe was only 29 lpc, the region appeared to offer great potential. This consumption figure, however, was heavily influenced by Russia’s very low level, and the future for the large Russian market was unclear. Further, some markets, such as the Czech Republic that consumed the most beer per person in the world at 163 lpc, appeared to have al- ready reached maturity. Central and South America, on the other hand, were showing healthy growth

and, with consumption at an average of 43 lpc, there was believed to be considerable upside. The most exciting growth rates, however, were in Asia. Despite the fact that the market in this region had grown by more than 30 per cent since 1995, consumption levels were still comparatively low. In China, the region’s largest market, consumption was only 16 lpc and 20 to 25 lpc in Hong Kong and Taiwan. Although the 1997 Asian financial crisis did not immediately affect beer consumption (although company profits from the region were hit by currency translation), demand in some key markets, such as Indonesia, was reduced and in others growth slowed. The situation, however, was expected to improve upon economic recovery in the medium term.

Beer Industry Structure

The world beer industry was relatively frag- mented with the top four players accounting for only 22 per cent of global volume—a relatively low figure as compared to 78 per cent in the soft drinks industry, 60 per cent in tobacco and 44 per cent in spirits. This suggested great opportunities for con- solidation, a process that had already begun two decades prior. Many analysts, including those at In- terbrew, expected that this process would probably accelerate in the future. The driver behind industry rationalization was the need to achieve economies of scale in production, advertising and distribution. It was widely recognized that the best profit margins were attained either by those with a commanding po- sition in the market or those with a niche position. However, there were several factors that mitigated

Exhibit 1 The World Beer Market in 1998

% of Global Growth Index Per Capita Region Consumption (’98 Vs 92) Consumption

Americas 35.1% 112.6 57 Europe 32.8% 97.7 54 Asia Pacific 27.2% 146.2 11 Africa 4.6% 107.7 8 Middle East/Central Asia 0.4% 116.0 2

Source: Canadean Ltd.

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246 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

including Mexico). Concurrently, a significant milestone for the company was achieved by 1999 when more than 50 per cent of its total volume was produced in growth markets (including Mexico). Interbrew had shifted its volume so that the Americas accounted for 61 per cent of its total volume, Europe added 35 per cent, and Asia Pacific the remaining four per cent.

Taken together, the top 10 markets for beer ac- counted for 86 per cent of Interbrew’s total volume in 1998 (see Exhibit 2). The Mexican beer market alone accounted for 37 per cent of total volume in 1998. Canada, Belgium, the United States and the United Kingdom were the next most important markets. However, smaller, growing markets such as Hungary, Croatia, Bulgaria, and Romania had begun to increase in importance.

Adding to its existing breweries in Belgium, France and the Netherlands, Interbrew’s expansion strategy in the 1990s had resulted in acquisitions in Bosnia-Herzegovina, Bulgaria, Canada, China, Croa- tia, Hungary, Korea, Montenegro, Romania, Russia, the Ukraine, the United States, in a joint venture in South Korea, and in minority equity positions in Mexico and Luxembourg. Through these breweries, in addition to those that were covered by licensing

the trend towards rapid concentration of the brew- ing industry.

One factor that slowed the process of consolida- tion was that the ratio of fixed versus variable costs of beer production was relatively high. Essentially, this meant that there was a limited cost savings po- tential that could be achieved by bringing more op- erations under a common administration. Real cost savings could be generated by purchasing and then rationalizing operations through shifting produc- tion to more efficient (usually more modern) facili- ties. This approach, however, required large initial capital outlays. As a result, in some markets with “unstable” economies, it was desirable to spread out capital expenditures over a longer period of time to ensure appropriate profitability in the early stages. A second factor that may have had a damp- ening effect on the trend towards industry consoli- dation was that local tastes differed. In some cases, beer brands had hundreds of years of heritage be- hind them and had become such an integral part of everyday life that consumers were often fiercely loyal to their local brew. This appeared to be a fact in many markets around the world.

Interbrew’s Global Position

Through Interbrew’s acquisitions in the 1990s, the company had expanded rapidly. During this period, the company’s total volumes had increased more than fourfold. These figures translated to total beer production of 57.5 million hls in 1998 (when includ- ing the volume of all affiliates), as compared to just 14.7 million hls in 1992. Volume growth had pro- pelled the company into the number four position among the world’s brewers.

Faced with a mature and dominant position in the declining Belgian domestic market, the company decided to focus on consolidating and developing key markets, namely Belgium, the Netherlands, France and North America, and expansion through acquisition in Central Europe, Asia and South America. Subsequently, Interbrew reduced its depen- dence on the Belgian market from 44 per cent in 1992 to less that 10 per cent by 1998 (total volumes

Exhibit 2 Interbrew’s 1998 Share of the World’s Top 10 Markets

Volume Market Rank Country (000 HL) Share

1 USA 3,768 1.6% 2 China 526 0.3% 3 Germany — — 4 Brazil — — 5 Japan — — 6 UK 3,335 5.5% 7 Mexico 21,269 45.0% 8 Spain — — 9 South Africa — — 10 France 1,915 8.4%

Total 30,813 3.6%

Source: Canadean Ltd.

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agreements in Australia, Italy, Sweden and the United Kingdom, Interbrew sold its beers in over 80 countries.

Interbrew’s Corporate Structure

Following the acquisition of Labatt in 1995, Inter- brew’s corporate structure was divided into two geographic zones: the Americas and Europe/Asia/ Africa. This structure was in place until September 1999 when Interbrew shifted to a fully integrated structure to consolidate its holdings in the face of industry globalization. Hugo Powell, formerly head of the Americas division, was appointed to the po- sition of chief executive officer (CEO). The former head of the Europe/Africa/Asia division assumed the role of chief operating officer, but subsequently resigned and was not replaced, leaving Interbrew with a more conventional structure, with the five regional heads and the various corporate functional managers reporting directly to the CEO.

Recent Performance

1998 had been a good year for Interbrew in terms of volume in both mature and growth markets. Overall, sales volumes increased by 11.1 per cent as most of the company’s international and local brands main- tained or gained market share. In terms of the com- pounded annual growth rate, Interbrew outperformed all of its major competitors by a wide margin. While Interbrew’s 1998 net sales were up 29 per cent, the best performing competitor achieved an increase of only 16 per cent. Of Interbrew’s increased sales, 67 per cent was related to the new affiliates in China, Montenegro and Korea. The balance was the result of organic growth. Considerable volume increases were achieved also in Romania (72 per cent), Bulgaria (28 per cent), Croatia (13 per cent), and the United States (14 per cent). While volumes in Western Europe were flat, duty-free sales grew strongly. In the U.S. market, strong progress was made by Inter- brew’s Canadian and Mexican brands, and Latrobe’s Rolling Rock was successfully relaunched. In Canada, performance was strong, fuelled by a two per cent increase in domestic consumption. Labatt’s

Case 3-2 The Global Branding of Stella Artois 247

sales of Budweiser (produced under license from Anheuser Busch) also continued to grow rapidly.

Given that the premium and specialty beer mar- kets were growing quickly, particularly those within the large, mature markets, Interbrew began to shift its product mix to take advantage of this trend and the superior margins it offered. A notable brand suc- cess was Stella Artois, for which total global sales volumes were up by 19.7 per cent. That growth came from sales generated by Whitbread in the United Kingdom, from exports, and from sales in Central Europe where Stella Artois volumes took off. The strong growth of Stella Artois was also notable in that it was sold in the premium lager segment. In Europe, Asia Pacific and Africa, Interbrew’s premium and specialty beers, which generated a bigger mar- gin, increased as a proportion of total sales from 31 per cent in 1997 to 33 per cent in 1998. This product mix shift was particularly important since intense competition in most markets inhibited real price increases.

Success was also achieved in the United States specialty beer segment where total volume had been growing at nine per cent annually in the 1990s. In 1998, Interbrew’s share of this growing market seg- ment had risen even faster as Labatt USA realized increased sales of 16 per cent. The other continuing development was the growth of the light beer seg- ment, which had become over 40 per cent of the total sales. Sales of Labatt’s Blue Light, for example, had increased and Labatt Blue had become the number three imported beer in the United States, with vol- umes up 18 per cent. Latrobe’s Rolling Rock brand grew by four per cent, the first increase in four years. Interbrew’s Mexican brands, Dos Equis, Tecate and Sol, were also up by 19 per cent.

Following solid volume growth in profitable market segments, good global results were realized in key financial areas. Net profit, having grown for each of the previous six consecutive years, was 7.7 billion Belgian francs (BEF) in 1998, up 43.7 per cent from the previous year. Operating profit also rose 7.9 per cent over 1997, from 14.3 to 15.4 BEF; in both the Europe/Asia/Africa region and the Americas, operating profit was up by 8.5 per cent

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and 4.9 per cent respectively. Further, Interbrew’s EBIT margin was up 58.1 per cent as compared to the best performing competitor’s figure of 17.0 per cent. However, having made several large invest- ments in Korea and Russia, and exercising an option to increase its share of Femsa Cerveza in Mexico from 22 per cent to 30 per cent, Interbrew’s debt-equity ratio increased from 1.04 to 1.35. As a result, interest payments rose accordingly.

Interbrew also enjoyed good results in volume sales in many of its markets in 1999. Although Canadian sales remained largely unchanged over 1998, Labatt USA experienced strong growth in 1999, with volumes up by 10 per cent. There was a positive evolution in Western European volumes as well, as overall sales were up by 6.5 per cent overall in Belgium, France and the Netherlands. Central European markets also grew with Hungary showing an increase of 9.6 per cent, Croatia up by 5.5 per cent, Romania by 18.9 per cent, Montenegro by 29 per cent, and Bulgaria with a rise of 3.6 per cent in terms of volume. Sales positions were also satisfac- tory in the Russian and Ukrainian markets. Further, while South Korean sales volume remained un- changed, volumes in China were 10 per cent higher, although this figure was still short of expectations.

Interbrew Corporate Strategy

The three facets of Interbrew’s corporate strategy, i.e., brands, markets and operations, were consid- ered the “sides of the Interbrew triangle.” Each of these aspects of corporate strategy was considered to be equally important in order to achieve the fun- damental objective of increasing shareholder value. With a corporate focus entirely on beer, the underlying objectives of the company were to consolidate its positions in mature markets and improve margins through higher volumes of pre- mium and specialty brands. Further, the company’s emphasis on growth was driven by the belief that beer industry rationalization still had some way to go and that the majority of the world’s major markets would each end up with just two or three major players.

Operations Strategy Cross fertilization of best practices between sites was a central component of Interbrew’s operations strategy. In the company’s two main markets, Belgium and Canada, each brewery monitored its performance on 10 different dimen- sions against its peers. As a result, the gap between the best and the worst of Interbrew’s operations had narrowed decisively since 1995. Employees contin- uously put forward propositions to improve processes. The program had resulted in significantly lower production costs, suggesting to Interbrew management that most improvements had more to do with employee motivation than with pure techni- cal performance. In addition, capacity utilization and strategic sourcing had been identified as two areas of major opportunity.

Capacity Utilization Given that brewing was a capital-intensive business, capacity utilization had a major influence on profitability. Since declining consumption in mature markets had generated ex- cess capacity, several of Interbrew’s old breweries and processing facilities were scheduled to be shut down. In contrast, in several growth markets such as Romania, Bulgaria, Croatia and Montenegro, the opposite problem existed, so facilities in other loca- tions were used more fully until local capacities were increased.

Strategic Sourcing Interbrew had begun to ratio- nalize its supply base as well. By selecting a smaller number of its best suppliers and working more closely with them, Interbrew believed that innovative changes resulted, saving both parties considerable sums every year. For most of the major commodities, the company had gone to single suppliers and was planning to extend this approach to all operations worldwide.

Market Strategy The underlying objectives of Interbrew’s market strategy were to increase vol- ume and to lessen its dependence on Belgium and Canada, its two traditional markets. Interbrew di- chotomized its market strategy into the mature and growth market segments, although investments were considered wherever opportunities to generate

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two mainstream pilsener brands, OB Lager and Cass, the two local premium brands, Cafri and Red Rock, and Budweiser, an international premium brand.

In Russia, Interbrew expanded its presence by taking a majority stake in the Rosar Brewery in Omsk, adding the BAG Bier and Sibirskaya Korona brands. Rosar was the leading brewer in Siberia with a 25 per cent regional market share, and held the number four position in Russia. New initiatives were also undertaken in Central Europe with acqui- sitions of a brewery in Montenegro and the Pleven brewery in Bulgaria, as well as the introduction of Interbrew products into the Yugoslavian market. Finally, although Interbrew had just increased its already significant investment in Mexico’s second largest brewer from 22 per cent to 30 per cent, Latin America remained a region of great interest.

Brand Strategy A central piece of Interbrew’s traditional brand strategy had been to add to its portfolio of brands through acquisition of existing brewers, principally in growth markets. Since its goal was to have the number one or two brand in every market segment in which it operated, Interbrew concentrated on purchasing and developing strong local brands. As it moved into new territories, the company’s first priority was to upgrade product quality and to improve the positioning of the ac- quired local core lager brands. In mature markets, it drew on the strength of the established brands such as Jupiler, Belgium’s leading lager brand, Labatt Blue, the famous Canadian brand, and Dommelsch, an important brand in the Netherlands. In growth markets, Interbrew supported brands like Borsodi Sor in Hungary, Kamenitza in Bulgaria, Ozujsko in Croatia, Bergenbier in Romania, Jingling in China, and OB Lager in Korea. In addition, new products were launched such as Taller, a premium brand in the Ukraine, and Boomerang, an alternative malt- based drink in Canada.

A second facet of the company’s brand strategy was to identify certain brands, typically specialty products, and to develop them on a regional basis across a group of markets. At the forefront of this strategy were the Abbaye de Leffe and Hoegaarden

sustainable profits existed. One of the key elements of Interbrew’s market strategy was to establish and manage strong market platforms. It was believed that a brand strength was directly related to a com- petitive and dedicated market platform (i.e., sales and distribution, wholesaler networks, etc.) to sup- port the brand. Further, Interbrew allowed individ- ual country teams to manage their own affairs and many felt that the speed of success in many markets was related to this decentralized approach.

Mature markets Interbrew’s goals in its mature markets were to continue to build market share and to improve margins through greater efficiencies in production, distribution and marketing. At the same time, the company intended to exploit the growing trend in these markets towards premium and spe- cialty products of which Interbrew already pos- sessed an unrivalled portfolio. The key markets in which this strategy was being actively pursued were the United States, Canada, the United Kingdom, France, the Netherlands and Belgium.

Growth Markets Based on the belief that the world’s beer markets would undergo further consoli- dation, Interbrew’s market strategy was to build sig- nificant positions in markets that had long-term vol- ume growth potential. This goal led to a clear focus on Central and Eastern Europe and Asia, South Korea and China in particular. In China, for example, Inter- brew had just completed an acquisition of a second brewery in Nanjing. The Yali brand was thereby added to the corporate portfolio and, together with its Jingling brand, Interbrew became the market leader in Nanjing, a city of six million people.

In Korea, Interbrew entered into a 50:50 joint venture with the Doosan Chaebol to operate the Oriental Brewery, producing the OB Lager and Cafri pilsener brands. With this move, Interbrew took the number two position in the Korean beer market with a 36 per cent share and sales of 5.1 million hls. The venture with Doosan was followed in Decem- ber 1999 by the purchase of the Jinro Coors brewery. This added 2.5 million hls and increased Interbrew’s market share to 50 per cent of total Korean volume. Thus, the Interbrew portfolio in Korea consisted of

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brands and, to a lesser extent, Belle-Vue. In fact, both Hoegaarden and Leffe achieved a leading position as the number one white beer and abbey beer in France and Holland. The Loburg premium pilsener brand also strengthened its position when it was relaunched in France. Further, in Canada, Interbrew created a dedicated organization for specialty beers called the Oland Specialty Beer Company. In its first year of operation, the brands marketed by Oland increased its volumes by over 40 per cent. More specifically, sales of the Alexan- der Keith’s brand doubled and the negative volume trend of the John Labatt Classic brand was reversed. The underlying message promoted by Oland was the richness, mystique and heritage of beer.

To support the regional growth of specialty beers, Interbrew established a new type of café. The Belgian Beer Café, owned and run by independent operators, created an authentic Belgian atmosphere where customers sampled Interbrew’s Belgian spe- cialty beers. By 1999, Belgian Beer Cafés were open in the many of Interbrew’s key markets, including top selling outlets in New York, Auckland, Zagreb and Budapest, to name a few. The business concept was that these cafés were to serve as an ambassador of the Belgian beer culture in foreign countries. They were intended to serve as vehicles to showcase In- terbrew’s specialty brands, benefiting from the inter- national appeal of European styles and fashions. Although these cafés represented strong marketing tools for brand positioning, the key factors that led to the success of this concept were tied very closely to the individual establishments and the personnel running them. The bar staff, for example, had to be trained to serve the beer in the right branded glass, at the right temperature, and with a nice foamy head. It was anticipated that the concept of the specialty café would be used to support the brand development efforts of Interbrew’s Belgian beers in all of its important markets.

The third facet of Interbrew’s brand strategy was to identify a key corporate brand and to develop it as a global product. While the market segment for a global brand was currently relatively small, with the bulk of the beer demand still in local brands, the

demand for international brands was expected to grow, as many consumers became increasingly attracted to the sophistication of premium and super-premium beers.

The Evolution of Interbrew’s Global Brand Strategy

Until 1997, Interbrew’s brand development strategy for international markets was largely laissez faire. Brands were introduced to new markets through li- censing, export and local production when opportu- nities were uncovered. Stella Artois, Interbrew’s most broadly available and oldest brand, received an im- portant new thrust when it was launched through local production in three of the company’s sub- sidiaries in Central Europe in 1997. This approach was consistent with the company’s overall goals of building a complete portfolio in high growth poten- tial markets.

By 1998, however, the executive management committee perceived the need to identify a brand from its wide portfolio to systematically develop into the company’s global brand. Although the market for global brands was still small, there were some growing successes (e.g., Heineken, Corona, Fosters and Budweiser) and Interbrew believed that there were several basic global trends that would improve the viability of this class of product over the next couple of decades. First, while many consumers were seeking more variety, others were seeking lower prices. It appeared that the number of affluent and poor consumer segments would increase at the ex- pense of the middle income segments. The upshot of this socioeconomic trend was that eventually all markets would likely evolve in such a way that de- mand for both premium and economy-priced beers would increase, squeezing the mainstream beers in the middle. A second trend was the internationaliza- tion of the beer business. As consumers travelled around the world, consuming global media (e.g., CNN, Eurosport, MTV, international magazines, etc.), global media were expected to become more effective for building brands. A global strategy could, therefore, lead to synergies in global advertising

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Case 3-2 The Global Branding of Stella Artois 251

and sponsoring. In addition, the needs of consumers in many markets were expected to converge. As a result of these various factors, Interbrew believed that there would be an increasing interest in authentic, international brands in a growing number of coun- tries. Interbrew had a wide portfolio of national brands that it could set on the international stage. The two most obvious candidates were Labatt Blue and Stella Artois.

The Labatt range of brands included Labatt Blue, Labatt Blue Light and Labatt Ice. To date, however, the exposure of these brands outside of North America had been extremely limited and they were not yet budding global brands. Of the total Labatt Blue volume in 1998, 85 per cent was derived from the Canadian domestic and U.S. markets, with the balance sold in the United Kingdom. The Labatt brands had been introduced to both France and Belgium, and production had been licensed in Italy, but these volumes were minimal. The only real ex- port growth market for Labatt Blue appeared to be the United States, where the brand’s volume in 1998 was some 23 per cent higher than in 1995, be- hind only Corona and Heineken in the imported brand segment. The Labatt Ice brand was also sold in a limited number of markets and, after the appeal of this Labatt innovation had peaked, its total vol- ume had declined by more than 25 per cent since 1996. Total Labatt Ice volume worldwide was just

450,000 hls in 1998, of which 43 per cent was sold in Canada, 33 per cent in the United States, and 21 per cent in the United Kingdom.

Stella Artois as Interbrew’s International Flagship Brand

The other potential brand that Interbrew could develop on a global scale was Stella Artois, a brand that could trace its roots back to 1366. The modern version of Stella Artois was launched in 1920 as a Christmas beer and had become a strong market leader in its home market of Belgium through the 1970s. By the 1990s, however, Stella’s market posi- tion began to suffer from an image as a somewhat old-fashioned beer, and the brand began to experience persistent volume decline. Problems in the domestic market, however, appeared to be shared by a number of other prominent international brands. In fact, seven of the top 10 international brands had experi- enced declining sales in their home markets between 1995 and 1999 (see Exhibit 3).

Stella Artois had achieved great success in the United Kingdom through its licensee, Whitbread, where Stella Artois became the leading premium lager beer. Indeed, the United Kingdom was the largest market for Stella Artois, accounting for 49 per cent of total brand volume in 1998. Stella Artois volume in the U.K. market reached

Exhibit 3 Domestic Sales History of Major International Brands (million hectolitre)

1995 1996 1997 1998

Budweiser (incl. Bud Light until ’98) 69.48 71.10 72.43 40.00 Bud Light n/a n/a n/a 30.00 Heineken 3.87 3.78 3.85 3.78 Beck’s 1.68 1.71 1.72 1.78 Carlsberg 1.47 1.39 1.31 1.22 Stella Artois 1.08 1.00 0.96 0.92 Foster’s 1.48 1.11 1.40 1.43 Kronenbourg 5.65 5.53 5.35 5.60 Amstel 2.30 2.23 2.21 2.18 Corona 12.89 14.09 14.80 15.18

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2.8 million hls in 1998, a 7.6 per cent share of the lager market, and came close to 3.5 million hls in 1999, a 25 per cent increase over the previous year. By this time, over 32,000 outlets sold Stella Artois on draught.

Apart from the United Kingdom, the key markets for Stella Artois were France and Belgium, which together accounted for a further 31 per cent of total brand volume (see Exhibit 4). With these three markets accounting for 81 per cent of total Stella Artois volume in 1999, few other areas represented a significant volume base (see Exhibit 5). Beyond the top three markets, the largest market for Stella Artois was Italy, where the brand was produced under license by Heineken. Stella Artois volume in Italy had, however, declined slightly to 166,000 hls in 1998. Licensing agreements were also in place in Sweden and Australia, but volume was small.

Stella Artois was also produced in Interbrew’s own breweries in Hungary, Croatia and Romania, with very pleasing 1998 volumes of 84,000 hls, 120,000 hls, and 60,000 hls, respectively. After only three years, the market share of Stella Artois in Croatia, for example, had reached four per cent—a significant result, given that the brand was a premium- priced product. In all Central European markets, Stella Artois was priced at a premium; in Hungary, however, that premium was lower than in Croatia and Romania where, on an index comparing Stella’s

Exhibit 4 1999 World Sales Profile of Stella Artois

Other (611) 9%

Croatia (131) 2%

Romania (112) 2% Hungary (117) 2%

Sweden (24) 0.5% Aus/NZ (45) 1%

Italy (172) 3%

France (1,197) 18%

UK (3,377) 50%

Belgium (902) 13%

Total world volume: 6,691,000 HL

Exhibit 5 Stella Artois Sales Volume Summary (000 hectolitre)

1997 1998 1999

Production:

Belgium 965 921 902 France 1,028 1,110 1,074 Hungary 59 84 117 Croatia 54 120 133 Romania 17 60 112 Bulgaria — — 3 Bosnia-Herzegovina — — 2 Montenegro — — 0 Total Production 2,123 2,295 2,343

License Brewing:

Italy 162 166 172 Australia 6 11 22 New Zealand 7 11 22 Sweden 29 27 24 Greece 7 7 10 UK 2,139 2,815 3,377 Total Licensed 2,350 3,037 3,627

Export:

USA — — 7 Canada — — 5 Other Countries 92 49 202 Duty Free 245 389 507 Total Export 337 438 721

Overall Total 4,810 5,770 6,691

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Case 3-2 The Global Branding of Stella Artois 253

price to that of core lagers, the indices by country were 140, 260 and 175 respectively.

Promising first results were also attained in Australia and New Zealand. Particularly in New Zealand, through a “seeding” approach, Inter- brew and their local partner, Lion Nathan, had real- ized great success in the Belgian Beer Café in Auckland where the brands were showcased. After only two years of support, Stella Artois volume was up to 20,000 hls, and growing at 70 per cent annually, out of a total premium segment of 400,000 hls. Inter- brew’s market development plan limited distribution to top outlets in key metropolitan centres and priced Stella Artois significantly above competitors (e.g., 10 per cent over Heineken and 20 per cent over Stein- lager, the leading domestic premium lager brand).

The evolution of the brand looked very positive as world volumes for Stella Artois continued to grow. In fact, Stella Artois volume had increased from 3.4 million hls in 1992 to a total of 6.7 million hls in 1999, a rise of 97 per cent. Ironically, the only market where the brand continued its steady decline was in its home base of Belgium. Analysts sug- gested a variety of reasons to explain this anomaly,

including inconsistent sales and marketing support, particularly as the organization began to favor the rising Jupiler brand.

Overall, given Interbrew’s large number of local brands, especially those in Mexico with very high volumes, total Stella Artois volume accounted for only 10 per cent of total Interbrew volume in 1999 (14 per cent if Femsa volumes are excluded). Inter- brew’s strategy of nurturing a wide portfolio of strong brands was very different as compared to some of its major competitors. For example, Anheuser-Busch, the world’s largest brewer, focused its international strategy almost exclusively on the development of the Budweiser brand. Similarly, Heineken sought to centre its international business on the Heineken brand and, to a lesser extent, on Amstel. While the strategies of Anheuser-Busch and Heineken focused primarily on one brand, there were also great differ- ences in the way these two brands were being man- aged. For example, Budweiser, the world’s largest brand by volume, had the overwhelming bulk of its volume in its home U.S. market (see Exhibit 6). Sales of the Heineken brand, on the other hand, were widely distributed across markets around the world

Exhibit 6 Top 10 Brewers by International Sales

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254 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

Stella’s Global Launch

In 1998, Interbrew’s executive management com- mittee settled on Stella Artois, positioned as the premium European lager, as the company’s global flagship brand. In fact, the Interbrew management felt that stock analysts would be favorably disposed to Interbrew having an acknowledged global brand with the potential for a higher corporate valuation and price earnings (P/E) multiple.

As the global campaign got under way, it became clear that the organization needed time to adapt to centralized co-ordination and control of Stella Artois brand marketing. This was, perhaps, not unexpected

(see Exhibit 7). In this sense, Heineken’s strategy was much more comparable to that of Interbrew’s plans for Stella Artois. Other brands that were di- rectly comparable to Stella Artois, in terms of total volume and importance of the brand to the overall sales of the company, were Carlsberg and Foster’s with annual sales volumes in 1998 of 9.4 million hls and 7.1 million hls, respectively. While Foster’s was successful in many international markets, there was a heavy focus on sales in the United Kingdom and the United States (see Exhibit 8). Carlsberg sales volume profile was different in that sales were more widely distributed across international markets (see Exhibit 9).

Exhibit 7 1998 Heineken World Sales Profile

China (450) 2.3%

Hong Kong (380) 2.0%

Italy (910) 4.7%

Ireland (808) 4.2% Spain (702) 3.6%

Netherlands (3,780) 19.5%

Other (3,582) 18.5%

USA (3,655) 18.8%

UK (2,478) 12.8%

Total world volume: 19,400,000 HL

France (1,425) 7.3% Greece (1,240) 6.3%

Exhibit 8 1998 Foster’s World Sales Profile

UK (4,453) 62.8%

Australia (1,430) 20.2%

USA (672) 9.5%

Other (145) 2.1% Italy (28) 0.4%

UAE (60) 0.9%

New Zealand (80) 1.1%

Spain (43) 0.6%

Germany (70) 1.0%

China (50) 0.7% Ireland (48) 0.7%

Total world volume: 7,079,000 HL

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Case 3-2 The Global Branding of Stella Artois 255

given that Interbrew had until recently operated on a regional basis; the new centralized Stella brand management approach had been in place only since September 1998. In addition, there were often diffi- culties in convincing all parties to become part of a new global approach, particularly the international advertising campaign that was the backbone of the global plan for Stella Artois. Belgium, for example, continued with a specific local advertising program that positioned Stella as a mainstream lager in its home market, and in the United Kingdom, Whit- bread maintained its “reassuringly expensive” advertising slogan that had already proved to be so successful. For other less-established markets, a

global advertising framework was created that in- cluded a television concept and a series of print and outdoor executions. This base advertising plan was rolled out in 1999 in 15 markets, including the United States, Canada, Italy, Hungary, Croatia, Bulgaria, Romania, New Zealand and France (with a slightly changed format) after research suggested that the campaign had the ability to cross borders. The objective of this campaign was to position Stella Artois as a sophisticated European lager. It was intended that Stella Artois should be perceived as a beer with an important brewing tradition and her- itage but, at the same time, also as a contemporary beer (see Exhibit 10).

Exhibit 9 1998 Carlsberg World Sales Profile

Malawi (780) 8.3% Malaysia (606) 6.4%

Ireland (453) 4.8% China (270) 2.9%

Sweden (207) 2.2% Israel (183) 2.0%

Portugal (183) 2.0% Germany (180) 1.9%

UK (3,476) 37.0%

Denmark (1,217) 12.9%

Other (1,850) 19.7%

Total world volume: 9,405,000 HL

Exhibit 10 Global Positioning Statement

Brand Positioning

To males, between 21 to 45 years of age, that are premium lager drinkers, Stella Artois is a European premium lager beer, differentially positioned toward the product.

Stella Artois offers a modern, sophisticated, yet accessible drinking experience with an emphasis on the very high quality of the beer supported by the noble tradition of European brewing.

The accent is on the emotional consequence of benefit: a positive feeling of self-esteem and sophistication.

Character, Tone of Voice

Sophistication Authenticity, tradition, yet touch of modernity Timelessness Premium quality Special, yet accessible Mysticism European

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256 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

only through cash benefits from operational leverage of a global brand. There would be no “free lunch” simply for being perceived as having a global brand. In addition, in an era of tight fiscal management, it was an ongoing challenge to maintain the funding levels required by the ambitious development plans for Stella Artois. As a result, in early 2000 the pre- vailing view at Interbrew began to shift, converging on a different long-range approach towards global branding. The emerging perspective emphasized a more balanced brand development program, focus- ing on the highest leverage opportunities.

The experience of other brewers that had estab- lished global brands offered an opportunity for Interbrew to learn from their successes and failures. Carlsberg and Heineken, for example, were two com- parable global brands that were valued quite differ- ently by the stock market. Both sold over 80 per cent of their total volumes outside their domestic market, and yet Heineken stock achieved a P/E ratio of 32.4 in 1999 versus Carlsberg’s figure of only 17.1. According to industry analysts, the driving force behind this difference was that Heineken main- tained a superior market distribution in terms of growth and margin (see Exhibit 11). The key lesson from examining these global brands appeared to be that great discipline must be applied to focus resources in the right places.

In 1998, an accelerated plan was devised to in- troduce Stella Artois to two key markets within the United States, utilizing both local and corporate funding. The U.S. market was believed to be key for the future development of the brand since it was the most developed specialty market in the world (12 per cent specialty market share, growing 10 per cent plus annually through the 1990s), and because of the strong influence on international trends. Thus, Stella Artois was launched in New York City and Boston and was well received by the demand- ing U.S. consumer and pub owner. Within 1999, over 200 pubs in Manhattan and 80 bars in Boston had begun to sell Stella Artois on tap. To support the heightened efforts to establish Stella Artois in these competitive urban markets, Interbrew’s cor- porate marketing department added several million dollars to Labatt USA’s budget for Stella Artois in 2000, with commitments to continue this additional funding in subsequent years.

Current Thinking

Good progress had been made since 1998 when Stella Artois was established as Interbrew’s global brand. However, management had revised its expec- tations for P/E leverage from having a global brand. The reality was that Interbrew would be rewarded

Exhibit 11 A Comparison of Carlsberg and Heineken

Carlsberg = 19% Heineken = 2%

Carlsberg = 22% Heineken = 46%

Carlsberg = 56% Heineken = 2%

Carlsberg = 3% Heineken = 50%

Profit Exposure by Market Type

High

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Market Growth

High

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Thus, the evolving global branding develop- ment plan required careful planning on a city-by-city basis. Among the demands of this new approach were that marketing efforts and the funding to support them would have to be both centrally stewarded and locally tailored to reflect the unique local environments. A corporate mar- keting group was, therefore, established and was charged with the responsibility to identify top pri- ority markets, develop core positioning and guide- lines for local execution, assemble broadly based marketing programs (e.g., TV, print advertising, global sponsorships, beer.com content, etc.), and allocate resources to achieve the accelerated growth objectives in these targeted cities. To ensure an integrated development effort the com- pany brought all pivotal resources together, under the leadership of a global brand development di- rector. In addition to the brand management team, the group included regional sales managers who were responsible for licensed partner manage- ment, a customer services group, a Belgian beer café manager, and cruise business management group. Another significant challenge that faced the corporate marketing group was to ensure that all necessary groups were supportive of the new approach. This was a simpler undertaking among those business units that were wholly owned sub- sidiaries; it was a more delicate issue in the case of licensees and joint ventures. A key element of managing brands through a global organizational structure was that the head office team had to ef- fectively build partnerships with local managers to ensure their commitment.

Fortunately, much of the initial effort to estab- lish Stella Artois as a global brand had been done on a city-by-city basis and, as such, there was ample opportunity for Interbrew to learn from these experiences as the new global plan evolved. In the late 1990s, for example, Stella Artois was introduced to various Central European cities (e.g., Budapest, Zagreb, Bucharest and Sofia). In each of these cities, Interbrew’s marketing efforts were launched when the targeted premium market was at an early stage of development. Further, distribution and

In line with this thinking, a long range market- ing plan began to take shape that made use of a series of strategic filters to yield a focused set of at- tractive opportunities. The first filter that any poten- tial market had to pass through was its long-term volume potential for Stella Artois. This volume had to trace back to a large and/or growing market, the current or potential sizeable premium lager seg- ment (at least five per cent of the total market), and the possibility for Stella Artois to penetrate the top three brands. The second screen was the potential to achieve attractive margins after an initial starting period of approximately three years. The third filter was whether or not a committed local partner was available to provide the right quality of distribution and to co-invest in the brand. The final screen was the determination that success in the chosen focus markets should increase leverage in other local and regional markets. For example, the size and stature of Stella Artois in the United Kingdom was a sig- nificant factor in the easy sell-in of Stella Artois into New York in 1999.

Once filtered through these strategic market de- velopment screens, the global branding plans for Stella Artois began to take a different shape. Rather than focus on national markets, plans emerged with an emphasis on about 20 cities, some of which Interbrew was already present in (e.g., London, Brussels, New York, etc.). This ap- proach suggested that the next moves should be in such potential markets as Moscow, Los Angeles and Hong Kong. Some existing cities would receive focused efforts only when distribution partner issues had been successfully resolved to solidify the bases for sustained long term growth. The major cities that fit these criteria provided the right concentration of affluent consumers, who would be attracted to Stella’s positioning, thus providing scale for marketing and sales, invest- ment leverage, as well as getting the attention and support of motivated wholesalers and initial retail customers. These venues would thereby become highly visible success stories that would be lever- agable in the company’s ongoing market develop- ment plans.

Case 3-2 The Global Branding of Stella Artois 257

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258 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

corporate credibility, paving the way to introduc- tions in other U.S. cities as well as “opening the eyes” of other customers and distribution partners around the world.

To pursue this new global development plan over the next three years, a revised marketing budget was required. Given that the corporate mar- keting department was responsible for both the development of core programs as well as the selec- tive support of local markets, the budget had to cover both of these key elements. To achieve these ends, total spending was expected to more than double over the next three years.

While great progress had been made on the global branding of Stella Artois, Cooke still ru- minated on a variety of important interrelated is- sues. Among these issues was the situation of Stella Artois in Belgium—would it be possible to win in the “global game” without renewed growth in the home market? What specific aspi- rations should Interbrew set for Belgium over the next three years? Further, what expectations should Interbrew have of its global brand market development (e.g., volumes, profit levels, num- ber of markets and cities, etc.)? How should global success be measured? With respect to In- terbrew’s promotional efforts, how likely would it be that a single global ad campaign could be successful for Stella Artois? Was there a particu- lar sponsorship or promotion idea that could be singled out for global leverage? And what role should the Internet play in developing Stella Artois as a true global brand?

promotion was strictly controlled (e.g., product quality, glassware, etc.) and the development initia- tives were delivered in a concentrated manner (e.g., a media “blitz” in Budapest). In addition, results indicated that the presence of a Belgian Beer Café accelerated Interbrew’s market development plans in these new areas. These early successes suggested that brand success could be derived from the care- ful and concentrated targeting of young adults living in urban centres, with subsequent pull from outlying areas following key city success.

The key lessons of these efforts in Central Europe proved to be very valuable in guiding the market development plan in New York City. In this key North American city, the rollout of Stella Artois was perceived by the analysts as “one of the most promising introductions in New York over the last 20 years” and had generated great wholesaler sup- port and excitement. Among the tactics used to achieve this early success was selective distribution with targeted point of sale materials support. In ad- dition, a selective media campaign was undertaken that included only prestigious outdoor advertising (e.g., a Times Square poster run through the Millen- nium celebrations). Similarly, the sponsoring strategy focused only on high-end celebrity events, Belgian food events, exclusive parties, fashion shows, etc. Finally, the price of Stella Artois was targeted at levels above Heineken, to reinforce its gold standard positioning. This concerted and consistent market push created an impact that resulted in the “easiest new brand sell” in years, according to wholesalers. The success of this launch also built brand and

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Case 3-3 GE’s Imagination Breakthroughs: The Evo Project 259

As he prepared for the December 2006 meeting with GE’s CEO Jeff Immelt, Pierre Comte faced some difficult decisions. Only eight months into his job as chief marketing officer (CMO) of GE’s Transporta- tion business, Comte would be presenting Trans- portation’s recommendations on some of the most visible growth initiatives in its locomotive business— projects that had been designated “Imagination Breakthroughs.” IBs, as they were called within GE, were new projects with the potential to generate $100 million in new business within two to three years, and were a key part of Immelt’s organic growth strategy. At the IB Review, Immelt expected to hear how Transportation was progressing with each of its locomotive IBs and what plans they had for their future.

Within GE Transportation, however, the future of several IBs had been a source of considerable de- bate, with none more sensitive than the Hybrid lo- comotive. Launched two years earlier in the belief that it could become a disruptive technology that could redefine the industry, the Hybrid had strug- gled to develop cost-effective performance, and

some of its key sponsors were beginning to wonder if resources should continue to be committed to it. The ongoing debate had resurfaced in November at a growth review meeting in Erie, Pennsylvania, where Transportation’s CEO John Dineen asked Comte and Brett BeGole, head of Transportation’s Locomotive P&L unit, to describe how they planned to update Immelt on the Hybrid IB. Be- Gole, an experienced and effective business leader, explained that problems with the cost and perfor- mance of batteries had made the project’s future highly uncertain. Feeling it was sapping resources from more profitable growth opportunities, he won- dered whether it should be sidelined until the tech- nology was further developed.

Comte was uncomfortable with that proposition. He felt that the Hybrid represented a real opportu- nity for GE to lead fundamental market change, and that sidelining the project could cause it to lose the resources and attention it needed at this critical stage of its development. He also worried about Immelt’s reaction, especially since the Hybrid was one of his favorite IB projects. But while he knew that the IB process was designed to encourage risk- taking, Comte also realized that at the end of the day, it had to be commercially viable. In GE, the bottom line always mattered.

As Dineen listened to his direct reports, he under- stood the source of their differences. BeGole was responsible for the profitability and growth of the Locomotive P&L unit, and would be held account- able for its bottom-line results. But Comte, with his mandate to develop market knowledge and compet- itive intelligence, had been asked to challenge and stretch the existing organization. Indeed, Dineen recalled telling his new CMO, “Pierre, your job is

Case 3-3 GE’s Imagination Breakthroughs: The Evo Project

Christopher A. Bartlett, Brian J. Hall, and Nicole S. Bennett

❚ Professors Christopher A. Bartlett and Brian J. Hall and Research Associate Nicole S. Bennett prepared this case. Some company information and data have been disguised for confidentiality. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. ❚ Harvard Business School Case No 9-907-048, Copyright 2007 President and Fellows of Harvard College. All rights reserved. This case was prepared by C. Bartlett. HBS Cases are developed solely for class discussion and do not necessarily illustrate either effective or ineffective handling of administrative situation.

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260 Chapter 3 Developing Transnational Strategies: Building Layers of Competitive Advantage

stock price premium was due to the fact that Welch had built GE into a disciplined, efficient machine that delivered on its promise of consistent growth in sales and earnings. The results were achieved in part through effective operations management that drove a 4% per annum organic growth rate (much of it productivity driven), but primarily through a continuous stream of timely acquisitions and clever deal making. This two-pronged approach had re- sulted in double-digit revenue and profit increases through most of the 1990s.

But Immelt knew that he could not hope to repli- cate such a performance by simply continuing the same strategy. The environment in the new millen- nium had changed too much. The new CEO wanted to use GE’s size and diversity as sources of strength and to drive growth by investing in places and in ways that others could not easily follow. He began to articulate a strategy that would rely on technology leadership, commercial excellence, and global ex- pansion to build new business bases that would cap- italize on what he described as “unstoppable trends.”

Beginning in 2002, he challenged his business leaders to identify these new “growth platforms” with the potential to generate $1 billion in operat- ing profit within the next few years. In response, several opportunities emerged, and the company soon began engaging in new fields such as oil and gas technology, securities and sensors, water tech- nology, Hispanic broadcasting, and consumer fi- nance, all of which were growing at a 15% annual rate. “The growth platforms we have identified are in markets that have above average growth rates and can uniquely benefit from GE’s capabilities,” said Immelt. “Growth is the initiative, the core competency that we are building in GE.”2

Building New Capabilities: Investing in Technology and Marketing

To reposition GE’s portfolio to leverage growth, Immelt’s team lost little time in acquiring compa- nies such as Telemundo to build a base in Hispanic

to make marketing ‘the point of thespear’; to take us to places we don’t want to go.” Now, after listen- ing to the debate, Dineen wondered what Trans- portation’s position on the Hybrid should be in its upcoming IB Review with Immelt.

Immelt Takes Charge: New Demands, New Responsesa

On Friday, September 7, 2001, 43-year-old Jeff Immelt became GE’s ninth CEO in its 109-year his- tory. Four days later, two planes crashed into the World Trade Center towers. In the turmoil that fol- lowed, an already fragile post-Internet bubble stock market dropped further, and the subsequent down- turn in the economy resulted in a drop in confidence that spread rapidly around the globe.

Despite his many efforts to tighten operations while continuing to grow the business, the new CEO did not have an easy initiation as he tried to deal with the resulting economic downturn, the post- Enron suspicions of large corporations, and the growing global political instability. In 2002, after promising that earnings would grow by double dig- its, Immelt had to report a modest 7% increase in GE’s profits on revenues that were up only 5% on the 2001 sales, which had declined 3% from the prior year. (See Exhibit 1 for GE financials, 1996–2006.) By the end of 2002, GE’s stock was trading at $24, down 39% from a year earlier and 60% from its all-time high of $60 in August 2000. With considerable understatement, Immelt said, “This was not a great year to be a rookie CEO.”1

Driving Growth: The Strategic Priority Beyond this immediate market pressure, Immelt was acutely aware that he stood in the very long shadow cast by his predecessor, Jack Welch, under whose leadership GE had generated a total return to shareholders of 23% per annum for 20 years, representing an aston- ishing $380 billion increase in shareholder wealth over his two decades as CEO. Much of the company’s

❚ aThis section summarizes “GE’s Growth Strategy: The Immelt Initiative,” Harvard Business School Case No. 306-087. ❚ 1GE 2002 Annual Report, p. 5. ❚ 2GE 2003 Annual Report, p. 9.

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