Foreign Direct Investment
The purpose of this paper is to provide an examination of foreign direct investment and the benefits that it can bring over other forms of investment in other countries. The issue of why foreign direct investment would be chosen over exporting, licensing, and franchising will be presented. For each of the alternatives, the downsides that are present as compared to foreign direct investment will be discussed to illustrate why foreign firms might choose to forego these types of investments and entry into other countries. At the end of this examination, it should be clear that foreign direct investment is often considered a superior means of entry into a foreign country over the alternative methods that are present because it provides a company with a greater level of control over the foreign operations, as well as a way to more easily overcome local laws that may be present.
What is Foreign Direct Investment
Before actually discussing the downsides of exporting, licensing or franchising as compared with foreign direct investment, it is necessary to explain what is meant by the term and its concept. Foreign direct investment occurs when individuals or companies in one country purchase ownership of assets in other country. The purchase of the assets occur in a way that allow the foreign individuals or companies to control the means of production, the distribution, or other activities associated with a good or service in the foreign country. In very simple terms, a company in the United States might purchase the production facility that is used to manufacturer automobiles in China. By owning the production facility, the company from the United States is able to control the production process to ensure the quality of the vehicles, as well as the process that is used to turn raw materials into the final product.
The real issue that must be understood when discussing foreign direct investment is the ability of control. People that buy stock in a company partially own the company, but they likely have no control over the actions and processes of that company. In the case of foreign direct investment, an individual or company is purchasing assets that given them direct control. Rather than just investing money in the hope that the investment will grow in value, the company or individual making the foreign direct investment controls the asset. This means that direct input is possible over the processes that occur in relation to the assets that are owned.
As the examination of foreign direct investment is provided in this paper, the issue of control will be important in relation to the process of exporting, licensing, or franchising for the company that is attempting to sell a product in a foreign country. With each of the three alternatives that are evaluated, the real that foreign direct investment is often favored is because it offers the greatest level of control that is possible. Companies are not giving up control in the hopes that another individual or organization is able to use the resources that they are provided.
Exporting is the process of sending products that are produced in one country to another country for sell by local businesses. While this may seem like a relatively easy process, it can become very problematic when products are being exported to countries that may not be friendly with the country of origin for the products. For example, many countries are know to place large import tariffs on products from foreign nations. This makes it very difficult for foreign producers to be able to compete in foreign countries because their products have higher retail prices as compared to the same products that are produced in the country in question. Even worse, it is not uncommon for countries to completely prevent the import of certain types of products, even if the import of such products was allowed in the past. If this occurs, a company that once derived a great deal of revenue from exporting a product to a specific country can quickly find its primary market has been closed (de Jong 1993, 358).
However, if a company owns the assets related to the production of a product in the foreign country, then it has the ability to overcome any limitations on imported products. Because the company is producing the product in the country of question, the product is not being imported at all. This means that any restrictions that occur in the form of import tariffs or even the limitation of the number of products that can enter the country become irrelevant.
Foreign direct investment is essentially a way to overcome any restrictions that are placed on products that are not produced in the country in question. The products are produced in that country, and the country in which the products are being sold are benefiting because local workers are making the products. Any negative issues that may arise because of the idea of foreign products flooding a particular country's market are able to be overcome. The end result for the company making the investment is that they are not only able to control the manufacturing or distribution process, but they are also able to have a hedge against any political or social changes that might occur in a country resulting in the inability for its products to be exported to the country in question.
Licensing is the process by which a company signs a contract with another company to allow it to have access to its intellectual property (Markusen 2004, 287). An example of this might be a company in the United States that has a patent on a specific type of computer technology. The license agreement might allow the foreign country to use the patented technology to produce a similar product, or even act duplicate product. Another example of the use of a license agreement might be a company allowing its tooling process in a manufacturing operation to be used to produce similar types of products in a foreign country. The key to understanding licensing is that an agreement is created that allows one party's patents or other intellectual property to be used for a specific amount of money in return.
In both of the situations that have been described, the real issue that is present is that the company licensing its product or service is giving control over its product or service to another company. While the licensing agreement may expressly state specific types of controls that will be present, and even specific processes that must be used in the manufacturing or distribution process, the licensor in the agreement is still giving control to the licensee. There is no guarantee that the licensee will fully comply with the license agreement. Even more, there is no agreement that the licensee will have the skills and knowledge to handle problems that may arise in order to preserve the highest reputation of the product, as well as for the licensor's reputation within the business community.
On the surface, licensing does have many financial benefits for a company. Licensing does not require any direct investment on the part of a company. The burden of finances for the foreign operations and the burden of overseeing the foreign operations are transferred to the licensee. However, with the transfer of burdens is also the transfer of control. The use of foreign direct investment allows the company to regain control because it owns the means of production or distribution. The foreign operations can be changed when problems arise to prevent any problems with the reputation of the product or the company. In addition, the company can impose strict oversight in regards to the foreign operations because it owns those operations. In a license agreement, this is not the case and the level of control is not the same (Feenstra 1989, 58).
Franchising is very similar to the process of licensing. However, the difference lies in the fact that franchising is the process of gaining the right to use a company's trademark or brand name. Rather than an agreement being established for intellectual property, such as computer technology, an agreement is established for the use of a name, such as being able to use the McDonald's brand name to open a fast-food restaurant in a foreign country. For the ability to use the trademark or the brand name, a fee is paid by the franchisee to the franchiser.
As with licensing, the franchising option might appear to have many benefits for the company allowing fort the franchising of its name or other trademarks. The franchising pays a fee for the use of the rights. In addition, most or all of the costs of opening the business using the trademark falls to the franchisee. The franchiser shifts all of the financial burden to the franchisee while collecting franchise fees. In most cases, the franchisee fees are established at the outset of the agreement. What this means is that he franchiser collects the fees regardless of whether the franchisee makes any money at all in the agreement.
The downside in this type of agreement, however, is that the franchiser loses a great deal of control over the franchise operations. While most franchise agreements include specific details about the way in which the trademark or brand name can be used, there is no guarantee that the franchisee will conduct its operations to the same standards that the franchiser has established for its own operations. Again, an example of this can be a fast-food restaurant. A McDonald's restaurant in one location may have the highest standards for customer service and food quality. However, a McDonald's restaurant in another location that is operated by a different franchisee may place very little emphasis on customer service or food quality. The end result is that the company runs the risk of losing customers and having its reputation ruined because of the way in which franchisees use, and even abuse, their trademarks (Lashley & Morrison 2000, 1958).
These potential problems are why many companies favor foreign direct investment instead of franchising. If the company controls the assets related to production and operation, then it can control the standards for customer service and product quality. It does not have to worry about trying to monitor the operations of individual franchisees only to find that they are meeting the requirements of the franchise agreement, even if those standards are at the minimum level of the agreement.
Instead, direct investment, along with direct ownership, provides the level of control that is possible in any situation where assets are owned and controlled in the business world. While this may involve greater costs at the outset, it can also prevent greater problems related to disgruntled customers or a tarnished brand name or trademark in the future.
The information that has bee presented in this paper has demonstrated why many companies would choose to use foreign direct investment to enter a foreign market as opposed to exporting, franchising, or licensing. These methods of gaining a presence in a foreign market typically involve lower costs for a company as compared with buying direct control of operations in a foreign country. However, reduced costs also require that a company give up a great level of control over the foreign operations. The company must trust that the foreign licensee, franchisee, or distributor will operate with the highest standards and with the greatest respect for the product.
In the end, foreign direct investment allows a company to enter a foreign market with the ability to overcome the problems associated with licensing and franchising. Even more, the problems that are associated with import tariffs and with the perceptions that a foreign company is attempting to take over a market to the detriment of local companies can be overcome. The assets associated with the local operations may be owned by a foreign company, but the operations are still local. Residents of the country are employed and the products that are manufactured are local products. Finally, the company making the foreign direct investment can control the local operations and ensure that those operations meet the standards it has set for how it interacts with customers, as well as the quality of the products that customers receive, regardless of where they may be in the world when they by one of those products.
Bradford, C. I. & Branson, W. H., 1988. Trade and Structural Change in Pacific Asia.
Chicago: University of Chicago Press.
De Jong, H. W., 1993. The Structure of European Industry. Norwell, MA: Kluwer Academic Publishers.
Feenstra, R. C., 1989. Trade Policies for International Competitiveness. Chicago: University of Chicago Press.
Froot, K., 1993. Foreign Direct Investment. Chicago: University of Chicago Press.
Hill, C. W. L., 2007. Global Business Today. New York: McGraw-Hill.
Johnson, D. & Turner, C., 2003. International Business. London: Routledge.
Lashley, C. & Morrison, A., 2000. Franchising Hospitality Services. London:Butterworth-Heinemann.
Markusen, J. R., 2004. Multinational Firms and the Theory of International Trade. Boston: MIT Press.
Moosa, I. A., 2002. Foreign Direct Investment. New York: Palgrave.
Wall, S. & Rees, B., 2004. International Business. London: Prentice Hall.