Economies of Scale
12chapter

opening case

W alk into an IKEA store anywhere in the world, and you would recognize it instantly. The warehouse-type stores all sell the same broad range of affordable home furnishings, kitchens, and accessories. Most of the products are instantly recognizable as IKEA merchandise, with their clean yet tasteful lines and functional design. The outside of the store will be wrapped in the blue and yellow colors of the Swedish flag. The store itself will be laid out as a maze that requires customers to walk through every department before they reach the checkout stations. Immediately before the checkout, there is an in-store warehouse where customers can pick up the items they purchased. The furniture is all flat, packed for ease of transportation, and requires assembly by the customer. If you look at the customers in the store, you will see that many of them are in there 20s and 30s. IKEA sells to the same basic customer set the world over: young upwardly mobile people who are looking for tasteful yet inexpensive “disposable” furniture.

A global network of more than 1,050 suppliers based in 53 countries manufactures most of the 9,500 or so products that IKEA sells. IKEA itself focuses on the design of products and works closely with suppliers to bring down manufacturing costs. Developing a new product line can be a painstaking process that takes years. IKEA’s designers will develop a prototype design—a small couch, for example—look at the price that rivals charge for a similar piece, and then work with suppliers to figure out a way to cut prices by 40 percent without compromising on quality. IKEA also manufactures about 10 percent of what it sells in- house and uses the knowledge gained to help its suppliers improve their productivity, thereby lowering costs across the entire supply chain.

It’s a formula that has worked remarkably well. From its roots in Scandinavia, IKEA has grown to become the largest furniture retailer in the world with almost 300 stores in 26 countries and revenues of more than 27 billion euros. IKEA is particularly strong in Europe, where it has 227 stores, but it also has around 50 stores in North America. Its strongest growth recently has been in China, where it had 17 stores in 2013, and Russia, where it had 14 stores.

IKEA

The Strategy of International Business

–continued

338 Part Five The Strategy of International Business

Look a little closer, however, and you will see subtle differences between the IKEA offerings in North America, Europe, and China. In North America, sizes are different to reflect the American demand for bigger beds, furnishings, and kitchenware. This adaptation to local tastes and preferences was the result of a painful learning experience for IKEA. When the company first entered the United States in the late 1980s, it thought that consumers would flock to their stores the same way that they had in western Europe. At first they did, but they didn’t buy as much, and sales fell short of expectations. IKEA discovered that its European-style sofas were not big enough, wardrobe drawers were not deep enough, glasses were too small, and kitchens didn’t fit U.S. appliances. So the company set about redesigning its offerings to better match American tastes and was rewarded with accelerating sales growth.

Lesson learned, when IKEA entered China in the 2000s, it made adaptations to the local market. The store layout reflects the layout of many Chinese apartments, where most people live, and because many Chinese apartments have balconies, IKEA’s Chinese stores include a balcony section. IKEA has also had to shift its locations in China, where car ownership lags behind that in Europe and North America. In the West, IKEA stores are located in suburban areas and have lots of parking space. In China, stores are located near public transportation, and IKEA offers a delivery service so that Chinese customers can get their purchases home. •

Sources: J. Leland, “How the Disposable Sofa Conquered America,” The New York Times Magazine, October 5, 2005, p. 45; “The Secret of IKEA’s Success,” The Economist, February 24, 2011; B. Torekull, Leading by Design: The IKEA Story (New York: Harper Collins, 1998); and P. M. Miller, “IKEA with Chinese Characteristics,” Chinese Business Review, July–August 2004, pp. 36–69.

Introduction The primary concern thus far in this book has been with aspects of the larger environment in which international businesses compete. As described in the preceding chapters, this environment has included the different political, economic, and cultural institutions found in nations; the international trade and investment framework; and the international mon- etary system. Now, our focus shifts from the environment to the firm itself and, in particu- lar, to the actions managers can take to compete more effectively as an international business. This chapter looks at how firms can increase their profitability by expanding their operations in foreign markets. We discuss the different strategies that firms pursue when competing internationally, consider the pros and cons of these strategies, and study the various factors that affect a firm’s choice of strategy. We also look at why firms often enter into strategic alliances with their global competitors, and we discuss the benefits, costs, and risks of strategic alliances.

The strategy of furniture retailer IKEA, which was discussed in the opening case, gives us a preview of some of the key issues discussed in this chapter. IKEA’s business-level strategy is to target young, upwardly mobile people and offer them affordable, tastefully designed, furniture and accessories. IKEA differentiates its offering by design. At the same time, the company does everything it can to lower the costs of the products it sells, thereby enabling it to underprice its rivals and still make good profits. IKEA developed its basic formula for competing in Scandinavia in the 1950s and 1960s. This formula, or business model, includes self-service warehouse-type stores, a maze-like store layout that funnels customers through every department and maximizes impulse purchases, the design of furniture so that it can be flat-packed, an in-store warehouse, and so on. IKEA initially expanded into other countries by using exactly the same segmentation strategy and retailing formula and selling the same set of products. We refer to such a standardized approach as a global strategy. One of its great

Chapter Twelve The Strategy of International Business 339

virtues is that it can help a company attain a low-cost position through the realization of economies of scale. However, as the opening case makes clear, while this worked in the west- ern European region, it did not work in North America where IKEA had to adapt its prod- uct design to the tastes and preferences of North American consumers. In other words, IKEA found that it needed to localize some of its offerings. As we shall see in this chapter, there is often a tension between the desire to standardize a product offering in order to attain low costs and the need to localize the offering to better match the tastes and prefer- ences of local consumers, which can make it more difficult to attain scale economies and raise costs.

Strategy and the Firm Before we discuss the strategies that managers in the multinational enterprise can pursue, we need to review some basic principles of strategy. A firm’s strategy can be defined as the actions that managers take to attain the goals of the firm. For most firms, the preeminent goal is to maximize the value of the firm for its owners, its shareholders (subject to the con- straint that this is done in a legal, ethical, and socially responsible manner—see Chapter 5 for details). To maximize the value of a firm, managers must pursue strategies that increase the profitability of the enterprise and its rate of profit growth over time (see Figure 12.1). Profitability can be measured in a number of ways, but for consistency, we shall define it as the rate of return that the firm makes on its invested capital (ROIC), which is calculated by dividing the net profits of the firm by total invested capital.1 Profit growth is measured by the percentage increase in net profits over time. In general, higher profitability and a higher rate of profit growth will increase the value of an enterprise and thus the returns garnered by its owners, the shareholders.2

Managers can increase the profitability of the firm by pursuing strategies that lower costs or by pursuing strategies that add value to the firm’s products, which enables the firm to raise prices. Managers can increase the rate at which the firm’s profits grow over time by pursuing strategies to sell more products in existing markets or by pursuing strategies to enter new markets. As we shall see, expanding internationally can help managers boost the firm’s profitability and increase the rate of profit growth over time.

VALUE CREATION The way to increase the profitability of a firm is to create more value. The amount of value a firm creates is measured by the difference between its

LO 12-1 Explain the concept of strategy.

Strategy Actions managers take to attain the firm’s goals.

Profitability A ratio or rate of return concept.

Profit Growth The percentage increase in net profits over time.

12.1 FIGURE Determinants of Enterprise Value

Sell more in existing markets

Add value and raise prices

Pro!tability

Pro!t growth

Enterprise valuation

Reduce costs

Enter new markets

340 Part Five The Strategy of International Business

costs of production and the value that consumers perceive in its products. In general, the more value customers place on a firm’s products, the higher the price the firm can charge for those products. However, the price a firm charges for a good or service is typically less than the value placed on that good or service by the customer. This is because the customer captures some of that value in the form of what economists call a consumer surplus.3 The customer is able to do this because the firm is competing with other firms for the cus- tomer’s business, so the firm must charge a lower price than it could were it a monopoly supplier. Also, it is normally impossible to segment the market to such a degree that the firm can charge each customer a price that reflects that individual’s assessment of the value of a product, which economists refer to as a customer’s reservation price. For these reasons, the price that gets charged tends to be less than the value placed on the product by many customers.

Figure 12.2 illustrates these concepts. The value of a product to an average consumer is V, the average price that the firm can charge a consumer for that product given competitive pressures and its ability to segment the market is P, and the average unit cost of producing that product is C (C comprises all relevant costs, including the firm’s cost of capital). The firm’s profit per unit sold (p) is equal to P 2 C, while the consumer surplus per unit is equal to V 2 P (another way of thinking of the consumer surplus is as “value for the money”; the greater the consumer surplus, the greater the value for the money the consumer gets). The firm makes a profit so long as P is greater than C, and its profit will be greater the lower C is relative to P. The difference between V and P is in part determined by the intensity of com- petitive pressure in the marketplace; the lower the intensity of competitive pressure, the higher the price charged relative to V.4 In general, the higher the firm’s profit per unit sold is, the greater its profitability will be, all else being equal.

The firm’s value creation is measured by the difference between V and C (V 2 C); a company creates value by converting inputs that cost C into a product on which consumers place a value of V. A company can create more value (V 2 C) either by lowering production costs, C, or by making the product more attractive through superior design, styling, func- tionality, features, reliability, after-sales service, and the like, so that consumers place a greater value on it (V increases) and, consequently, are willing to pay a higher price (P in- creases). This discussion suggests that a firm has high profits when it creates more value for its customers and does so at a lower cost. We refer to a strategy that focuses primarily on lowering production costs as a low-cost strategy. We refer to a strategy that focuses primarily on in- creasing the attractiveness of a product as a differentiation strategy.5 IKEA’s strategy is primar- ily about lowering costs, although you will note from the opening case that the company also tries to differentiate itself by design.

Michael Porter has argued that low cost and differentiation are two basic strategies for cre- ating value and attaining a competitive advantage in an industry.6 According to Porter, supe- rior profitability goes to those firms that can create superior value, and the way to create superior value is to drive down the cost structure of the business and/or differentiate the

Value Creation Performing activities that increase the value of goods or services to consumers.

12.2 FIGURE Value Creation

V P C

V – C

V – P

P – C

C

V = Value of product to an average customer P = Price per unit C = Cost of production per unit

V – P = Consumer surplus per unit P – C = Pro!t per unit sold V – C = Value created per unit

Chapter Twelve The Strategy of International Business 341

product in some way so that consumers value it more and are prepared to pay a premium price. Superior value creation relative to rivals does not necessarily require a firm to have the lowest cost structure in an industry, or to create the most valuable product in the eyes of consumers. However, it does require that the gap between value (V) and cost of production (C) be greater than the gap attained by competitors.

STRATEGIC POSITIONING Porter notes that it is important for a firm to be explicit about its choice of strategic emphasis with regard to value creation (differentiation) and low cost, and to configure its internal operations to support that strategic emphasis.7 Figure 12.3 illustrates his point. The convex curve in Figure 12.3 is what economists refer to as an efficiency frontier. The efficiency frontier shows all of the different positions that a firm can adopt with regard to adding value to the product (V) and low cost (C) assuming that its internal operations are configured efficiently to support a particular position (note that the horizontal axis in Figure 12.3 is reverse scaled—moving along the axis to the right im- plies lower costs). The efficiency frontier has a convex shape because of diminishing returns. Diminishing returns imply that when a firm already has significant value built into its prod- uct offering, increasing value by a relatively small amount requires significant additional costs. The converse also holds, when a firm already has a low-cost structure, it has to give up a lot of value in its product offering to get additional cost reductions.

Figure 12.3 plots three hotel firms with a global presence that cater to international travelers: Four Seasons, Marriott International, and Starwood (Starwood owns the Sheraton and Westin chains). Four Seasons positions itself as a luxury chain and emphasizes the value of its product offering, which drives up its costs of operations. Marriott and Starwood are positioned more in the middle of the market. Both emphasize sufficient value to attract international business travelers, but are not luxury chains like Four Seasons. In Figure 12.3, Four Seasons and Marriott are shown to be on the efficiency frontier, indicating that their internal operations are well configured to their strategy and run efficiently. Starwood is inside the frontier, indicating that its operations are not running as efficiently as they might be and that its costs are too high. This implies that Starwood is less profitable than Four Seasons and Marriott and that its managers must take steps to improve the company’s performance.

Porter emphasizes that it is very important for management to decide where the company wants to be positioned with regard to value (V) and cost (C), to configure operations accord- ingly, and to manage them efficiently to make sure the firm is operating on the efficiency

12.3 FIGURE Strategic Choice in the International Hotel Industry

Marriott

Strategic choices in this area not viable in international hotel industry

Low cost (C)High cost

In cr

ea se

d va

lu e/

di ffe

re nt

ia tio

n (V

)

Efficiency frontier Four Seasons

Starwood

342 Part Five The Strategy of International Business

frontier. However, not all positions on the efficiency frontier are viable. In the international hotel industry, for example, there might not be enough demand to support a chain that em- phasizes very low cost and strips all the value out of its product offering (see Figure 12.3). International travelers are relatively affluent and expect a degree of comfort (value) when they travel away from home.

A central tenet of the basic strategy paradigm is that to maximize its profitability, a firm must do three things: (1) pick a position on the efficiency frontier that is viable in the sense that there is enough demand to support that choice; (2) configure its internal operations, such as manufacturing, marketing, logistics, information systems, human resources, and so on, so that they support that position; and (3) make sure that the firm has the right organiza- tion structure in place to execute its strategy. The strategy, operations, and organization of the firm must all be consistent with each other if it is to attain a competitive advantage and garner supe- rior profitability. By operations we mean the different value creation activities a firm under- takes, which we shall review next.

OPERATIONS: THE FIRM AS A VALUE CHAIN The operations of a firm can be thought of as a value chain composed of a series of distinct value creation activi- ties, including production, marketing and sales, materials management, R&D, human re- sources, information systems, and the firm infrastructure. We can categorize these value creation activities, or operations, as primary activities and support activities (see Figure 12.4).8 As noted earlier, if a firm is to implement its strategy efficiently, and position itself on the efficiency frontier shown in Figure 12.3, it must manage these activities effectively and in a manner that is consistent with its strategy.

Primary Activities Primary activities have to do with the design, creation, and de- livery of the product; its marketing; and its support and after-sale service. Following nor- mal practice, in the value chain illustrated in Figure 12.4, the primary activities are divided into four functions: research and development, production, marketing and sales, and cus- tomer service.

Research and development (R&D) is concerned with the design of products and pro- duction processes. Although we think of R&D as being associated with the design of phys- ical products and production processes in manufacturing enterprises, many service companies also undertake R&D. For example, banks compete with each other by develop- ing new financial products and new ways of delivering those products to customers. Online banking and smart debit cards are two examples of product development in the banking industry. Earlier examples of innovation in the banking industry included automated teller machines, credit cards, and debit cards. Through superior product design, R&D can

Operations The various value creation activities a firm undertakes.

12.4 FIGURE The Value Chain

Primary activities

R&D

Company infrastructure

Support activities

Information systems Logistics Human resources

Production Marketing

and sales

Customer service

Chapter Twelve The Strategy of International Business 343

increase the functionality of products, which makes them more attractive to consumers (raising V). Alternatively, R&D may result in more efficient production processes, thereby cutting production costs (lowering C). Either way, the R&D function can create value.

Production is concerned with the creation of a good or service. For physical products, when we talk about production, we generally mean manufacturing. Thus, we can talk about the production of an automobile. For services such as banking or health care, “produc- tion” typically occurs when the service is delivered to the customer (e.g., when a bank originates a loan for a customer it is engaged in “production” of the loan). For a retailer such as Walmart, “produc- tion” is concerned with selecting the merchandise, stocking the store, and ringing up the sale at the cash register. For MTV, production is concerned with the creation, programming, and broadcasting of content, such as music videos and thematic shows. The production activity of a firm creates value by performing its activities efficiently so lower costs result (lower C) and/or by performing them in such a way that a higher- quality product is produced (which results in higher V).

The marketing and sales functions of a firm can help to create value in several ways. Through brand positioning and advertising, the marketing function can increase the value (V) that consumers perceive to be contained in a firm’s product. If these create a favorable impression of the firm’s product in the minds of consumers, they increase the price that can be charged for the firm’s product. For example, Ford produced a high-value version of its Ford Expedition SUV. Sold as the Lincoln Navigator and priced around $10,000 higher, the Navigator has the same body, engine, chassis, and design as the Expedition, but through skilled advertising and marketing, supported by some fairly minor features changes (e.g., more accessories and the addition of a Lincoln-style engine grille and nameplate), Ford has fostered the perception that the Navigator is a “luxury SUV.” This marketing strategy has increased the perceived value (V) of the Navigator relative to the Expedition and enables Ford to charge a higher price for the car (P).

Marketing and sales can also create value by discovering consumer needs and commu- nicating them back to the R&D function of the company, which can then design products that better match those needs. For example, the allocation of research budgets at Pfizer, the world’s largest pharmaceutical company, is determined by the marketing function’s assessment of the potential market size associated with solving unmet medical needs. Thus, Pfizer is currently directing significant monies to R&D efforts aimed at finding treatments for Alzheimer’s disease, principally because marketing has identified the treat- ment of Alzheimer’s as a major unmet medical need in nations around the world where the population is aging.

The role of the enterprise’s service activity is to provide after-sale service and support. This function can create a perception of superior value (V) in the minds of consumers by solving customer problems and supporting customers after they have purchased the prod- uct. Caterpillar, the U.S.-based manufacturer of heavy earthmoving equipment, can get spare parts to any point in the world within 24 hours, thereby minimizing the amount of downtime its customers have to suffer if their Caterpillar equipment malfunctions. This is an extremely valuable capability in an industry where downtime is very expensive. It has helped to increase the value that customers associate with Caterpillar products and thus the price that Caterpillar can charge.

Support Activities The support activities of the value chain provide inputs that allow the primary activities to occur (see Figure 12.4). In terms of attaining a competitive advan- tage, support activities can be as important as, if not more important than, the primary ac- tivities of the firm. Consider information systems; these systems refer to the electronic systems for managing inventory, tracking sales, pricing products, selling products, dealing with customer service inquiries, and so on. Information systems, when coupled with the communications features of the Internet, can alter the efficiency and effectiveness with

A Caterpillar motor factory in Germany helps to ensure product after-sales and service outside the U.S.

344 Part Five The Strategy of International Business

which a firm manages its other value creation activities. Dell, for example, has used its infor- mation systems to attain a competitive advantage over rivals. When customers place an or- der for a Dell product over the firm’s website, that information is immediately transmitted, via the Internet, to suppliers, who then configure their production schedules to produce and ship that product so that it arrives at the right assembly plant at the right time. These sys- tems have reduced the amount of inventory that Dell holds at assembly plants to under two days, which is a major source of cost savings.

The logistics function controls the transmission of physical materials through the value chain, from procurement through production and into distribution. The efficiency with which this is carried out can significantly reduce cost (lower C), thereby creating more value. The combination of logistics systems and information systems is a particularly potent source of cost savings in many enterprises, such as Dell, where information systems tell Dell on a real-time basis where in its global logistics network parts are, when they will arrive at an as- sembly plant, and thus how production should be scheduled.

The human resource function can help create more value in a number of ways. It ensures that the company has the right mix of skilled people to perform its value creation activities

effectively. The human resource function also ensures that people are adequately trained, motivated, and compen- sated to perform their value creation tasks. In a multina- tional enterprise, one of the things human resources can do to boost the competitive position of the firm is to take advantage of its transnational reach to identify, recruit, and develop a cadre of skilled managers, regardless of their nationality, who can be groomed to take on senior management positions. They can find the very best, wher- ever they are in the world. Indeed, the senior management ranks of many multinationals are becoming increasingly diverse, as managers from a variety of national back- grounds have ascended to senior leadership positions.

The final support activity is the company infrastruc- ture, or the context within which all the other value cre- ation activities occur. The infrastructure includes the organizational structure, control systems, and culture of the firm. Because top management can exert considerable influence in shaping these aspects of a firm, top manage- ment should also be viewed as part of the firm’s infrastruc- ture. Through strong leadership, top management can consciously shape the infrastructure of a firm and through that the performance of all its value creation activities.

globalEDGE Business Review

In Chapter 12, we are bringing you closer to running a globally oriented company based on the issues we have covered on country differences, global trade and investment environment, and the global money sys- tem. This is where many of you will “make your money” as strategic decision makers in corporations. This also means you need to know what is current, important, and strategic in the global marketplace; your company’s products or services; and your company’s uniqueness in satisfying the needs and wants of customers. The globalEDGE Business Review (gBR) is a leading source for cutting-edge global busi- ness knowledge with a main target audience of business executives

(globaledge.msu.edu/gbr). Note that gBR complements the overall glo- balEDGE site content by publishing cutting-edge articles dealing with a variety of international business issues facing managers in different world areas, industries, and management functions. With millions of visitors to the site and some 30,000 subscribers, gBR reaches farther and has more impact and visibility than any business journal in interna- tional business. One gBR article is titled “From Domestic to Interna- tional to Global Sourcing.” Based on this article, how much should a company engage in “international/global purchasing activities” versus “domestic purchasing only” to best operate a global strategy?

Is Education Creating Value for You? The concept of a value chain can be used to examine the role your education plays in your life plans, if you look closely at your personal development plans (education, internship, work, physi- cal and emotional fitness, and extracurricular activities) and think about them in terms of primary and support activities. If we use the logic that the amount of value you receive from your education is the …

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