More and more companies nowadays decide to expand their business by crossing domestic borders and by (re)locating certain value chain activities abroad. There are several motivations for companies to do so. First of all, companies might be on the lookout for natural or strategic resources such as physical, financial, technological or human resources that are more attractive in foreign countries than at home. In other cases, the focal company might be simply looking for new customers and sees a foreign market as a way to expand business and sell more products. Finally it may be the case that the company seeks ways to increase efficiency in order to create economies of scale and to cut costs per unit. Whatever the reason might be, management will be faced with a tough decision: how are we going to enter a foreign country?
There is a wide variety of entry-mode strategies to choose from and they all have their own pros and cons. Often used strategies are exporting, licensing, franchising, forming a strategic alliance, creating a joint venture, acquiring, or starting from scratch with a greenfield investment. These last three involve large equity investment and are therefore considered forms of Foreign Direct Investment (FDI). A good way to at least exclude some of them is by using the so called OLI paradigm (also known as the eclectic paradigm). OLI is an acronym for Ownership-, Location- and Internalization- advantage. According to this paradigm, a company needs all three advantages in order to be able to successfully engage in FDI. If one or more of these advantages are not present, the focal company might want to use a different entry-mode strategy. Each of the three advantages will be elaborated on below:
First of all, a company needs an ownership advantage in order to overcome the liability of foreignness. Ownership refers to the possession of a certain valuable, rare, hard-to-imitate, and organizationally embedded resource that allows a company to have a competitive advantage compared to foreign rivals. The liability of foreignness however can be defined as the inherent disadvantage that foreign firms experience in host countries because of their non-native status. These disadvantages could vary from simply not speaking the local language to having limited knowledge on the local customer demands. The question that management should therefore ask itself is: does our firm have a certain competitive advantage that can be transferred abroad in order to offset our liability of foreignness? This could for example be a strong brand name with a great reputation, unique technological capabilities or huge economies of scale. Obviously the answer on this question should be YES in order to explain your motives for expanding abroad in the first place.
Secondly, there must be some kind of location advantage in the market the company is trying to enter. Again, given the well-known liability of foreignness, host countries must offer compelling advantages to make it worthwile to undertake FDI. These advantages can be simply geographical (e.g. the Netherlands is in between great economies like the UK and Germany and is moreover located next to the ocean) or are present because of the existence of cheap raw materials, low wages, a skilled labor force or special taxes and tariffs. A great tool to determine these location advantages is through Porter’s Diamond model. The question that management should ask itself here is: are any of these location advantages present in the market we are thinking of entering? If the answer on this question is NO, it might be wiser for management to keep production at home and export products instead – assuming that there is demand in the foreign market. If the answer is YES however, it might be interesting to perform certain value chain activities abroad either through licensing/francising or through FDI.
To choose between licensing and FDI management should look at the final advantage: internalization advantage. Is it more attractive to perform the value chain activity in-house than to have it performed by an external party? Reasons to outsource certain activities to different companies abroad might be because they are better at it, are able to do it cheaper, have more local market knowledge, or because management simply wants to focus on other activities in the value chain such as marketing or design. In this case management might want to license its product design to an independent foreign company or outsource production to an original equipment manufacturer (OEM). If the answer is YES however, the firm should keep control over its activities and engage in FDI. This could be done through forming joint ventures with local partners, acquiring existing local companies, or by starting from scratch through a greenfield investment.
After answering these three questions with the aid of the OLI paradigm, you should be able to at least exclude some entry-mode strategies. When all question have been asnwered with YES, it should be a good option to engage in FDI and stay in control over the activities yourself. In case you have difficulty choosing between acquiring an existing foreign company or to team up with a local player through an equity alliance, you might want to read this article about it.
- Dunning (1979) Toward an Eclectic Theory of International Production: Some Empirical Tests. Journal of International Business Studies.
- Dunning (2000) The Eclectic Paradigm as an Envelope for Economic and Business Theories of MNE Activity. International Business Review.
- Root (1994) Entry Strategies for International Markets. John Wiley & Sons.