Considering offshore manufacturing operations?

If your company were considering the establishment of an offshore production unit as a market-entry channel, you would face a number of key policy decisions. These include:

• How much to invest initially
• Whether to manufacture abroad (you must decide where to locate the production facility)
• Whether to establish a full manufacturing operation or to opt for an assembly plant
• Whether the operation is to be wholly-owned or a joint venture
• Choosing between acquiring an operation already in existence or establishing a new facility

The initial international investment decision

This is one of the most difficult decisions to make because of the relatively high level of uncertainty and risk involved. Not only are you likely to be hampered by a lack of familiarity with the foreign environment, but you are also faced with the prospect of high political and exchange risks.

Calculating the likely rate of return on such an investment includes:

• Estimating both current and future market potential
• Estimating the share of the market the company is likely to acquire, as well as the resultant sales volume
• Estimating both current and future production costs
• Arriving at an anticipated profit margin by comparing sales revenue with costs; this profit margin should at least be equal to the domestic profit margin and should be high enough to compensate for the increased risk and uncertainty
• The various areas of concern that might influence the decision to invest should then be investigated.

Location of investment

The decision regarding where to locate your manufacturting facilities will normally be closely linked to the initial decision to invest because of the multitude of factors relating to a specific foreign market that will affect that initial decision. Apart from investigating the suitability of already identified target markets for the positioning of a manufacturing unit, the advantages of establishing the plant in a third country might be worth considering. Apart from possibly giving the exporter free access to the identified target markets; it may also offer lower tax rates, lower wage rates and special incentives to foreign investors.

Foreign assembly operations

If opting for a foreign assembly operation, you would produce all or most of the product’s ingredients or components domestically and then ship them to the assembly plant where the final stages of the manufacturing process would be completed.

A local government requirement of most assembly operations, however, is that a significant portion of value must be added to the product in the market in which the assembly plant is located in order to enjoy ‘country of origin’ accreditation.

There are numerous advantages to establishing an assembly plant. These include:

• Lower freight costs
• Lower import duties
• Easier modification of the product to suit local market requirements
• Possible cost advantages – wage rates may be lower for the assembly operation and it may also be possible to purchase cheaper components from local sources
• The ability of the company to create a national image in the target market
• Access to government contracts and tenders
• Foreign assembly operations allow exporters the opportunity to gain the initial experience in a market that they may later wish or be required to establish a full manufacturing operation

International joint ventures

An international joint venture in assembly or manufacturing is an operation in which two or more companies in different countries combine resources, not merely for manufacturing purposes but also to acquire marketing, financial and management advantages. All the participants in a joint venture have a share in the equity and a say in the management of the operation. However, no one participant holds a sufficient shareholding to exercise effective management control.

Joint ventures are usually entered into when:

• Total foreign equity ownership is not permitted by local law because governments feel their nations benefit more from profits and technology if their local nationals have a share in the business
• Finding a partner in the target market may be the only way to invest in a market that is too competitive or too crowded to admit a totally new operation
• It is important to quickly acquire either local marketing expertise or an established distribution network
• The company does not have sufficient capital to fully exploit all potential markets
• Managerial and other human resources are limited, e.g. In the case of small companies
• The company fears expropriation or other risks of a financial nature
• A company wishes to protect its sources of supply of raw materials

Conflict can often arise between the partners in a joint venture because of differences in culture, business practices and management styles, as well as inadequate communication resulting from the problems of distance and language. Disputes are usually about the composition of the product line, the market coverage of the joint venture and whether not earnings should be paid out or ploughed back into the operation.

To minimise conflict:

• Carefully evaluate the prospective joint venture partners
• Negotiate a joint venture agreement to the benefit of all concerned
• Ensure that the agreement covers all eventualities that could possibly give rise to disputes and that it includes an arbitration clause or similar mechanism whereby unforeseen disagreements can be resolved

Acquisition of a foreign company

The acquisition of a foreign company involves the purchase of all or a majority of the shareholding of that company. The advantages of acquiring an already-established operation are considerable and include:

• The company immediate gains entry to the foreign market, thus earning revenue from its investment immediately.
• The company’s initial investment provides not only manufacturing facilities but also established distribution arrangements, market knowledge and customer contacts, as well as trained and experienced local staff.
• Be aware that local government incentives, often available for investment in totally new operations, are not generally available in the case of an acquisition. In addition, problems will invariably be encountered in the integration of a newly acquired foreign company with the cultural and management workings of the domestic firm.

You may want to consider the following factors when deciding on whether to go the contracting route.