factors affecting the choice of entry mode by mncs

CASIRJ Volume 5 Issue 5 [Year - 2014] ISSN 2319 – 9202

International Research Journal of Commerce Arts and Science http://www.casirj.com Page 4

FACTORS AFFECTING THE CHOICE OF ENTRY MODE BY MNCs

Assistant Professor, University of Delhi

Email Id: [email protected]

Assistant Professor, University of Delhi

Email Id: [email protected]

Abstract

The most crucial decision that an MNC has to make when entering a foreign market is the choice

of the most optimal mode of entry as it will have a bearing on the company’s success. A firm

must assess a number of internal and external factors while making the choice of entry mode.

The aim of this paper is to provide a deeper understanding of the various factors that affect the

selection of international entry mode from a theoretical viewpoint. This paper concentrates on

secondary sources of research regarding the internationalization of businesses. The conclusion

provides a short summary of identified key elements that need to be considered by the firm in

choosing foreign market entry modes.

Keywords: Factors, Entry Mode Choice

1. INTRODUCTION

When the multinational enterprises (MNEs) decide to enter a foreign market, the most crucial

decision they face is the choice of mode of entry i.e. selecting an institutional arrangement for

organizing and conducting international business transactions. The choice of entry mode has a

major impact on the firm’s performance as well as survival.

Firms can choose from a variety of entry modes. The various types of entry modes can be

classified into two categories namely equity and non-equity modes. Equity modes involve high

resource commitments, provide higher degree of control on operations and higher return on

investment. But at the same time, they have higher exit costs and carry a higher level of risk

exposure. On the other hand, the non-equity modes involve lower resource commitments,

provide lower degree of control over the operations and lower returns on investment. But they

have lower exit costs and carry lower level of risk exposure.

1.1 EQUITY MODES

First/Main Author: Priyanka Bedi

Corresponding Author: Ekta Kharbanda

mailto:[email protected]

mailto:[email protected]



The entry modes classified in this category are:

JOINT VENTURES: It represents an agreement between two or more firms to work

together on a certain project or to operate in a particular market by establishing a new

entity that is jointly owned by all the partners. The profits /losses, risks and the control of

the operations are shared by all the partners. It helps a firm to take the benefit of local

partner’s knowledge of the local market. But at the same time it involves the risk of

opportunistic behavior by the partner and chances of conflicts between the partners for

control are also high.

WHOLLY OWNED SUBSIDIARIES/ FOREIGN DIRECT INVESTMENT: It

refers to the direct ownership of facilities to produce or market a product in a foreign

country. Establishing a wholly owned subsidiary is the most costly method of serving a

foreign market and the firm has to bear the full capital costs as well as all the risks

associated with overseas operations. But at the same time it provides highest degree of

control over the operations. Wholly owned subsidiaries can be established in two ways

which are

GREENFIELD OPERATIONS: In this, the parent company starts a new venture

in a foreign country by constructing new operational facilities from the ground up.

It gives the firm the ability to build the kind of subsidiary it wants and also makes

the transfer of products, competencies, skills and knowledge from the established

to the new subsidiary easier. But greenfield operations are slower to establish.

ACQUISITIONS: In this, a company buys most or all of the target company’s

ownership stake in order to assume control of the target firm. Acquisitions are

quicker to execute and enables a firm to rapidly establish its presence in the target

foreign market. When a firm acquires an established host country firm, the risks

associated with doing business in a new culture are reduced. But on the other side,

the chances of clash between acquired and acquiring firms due to differences in

their cultural and values increase.

NON-EQUITY MODES

The entry modes classified in this category are:

EXPORTING: It refers to the marketing and sale of domestically produced goods in

another country. It helps the firms to reach foreign customers very quickly. The firms can

also benefit and learn from the experience of exporting which can eventually help them in

any future expansion. But the tariff barriers in host country and high transportation costs

can make exporting uneconomical. Exporting can be of two types namely

DIRECT EXPORTING: In this, the company takes the full responsibility of

making its goods available in the target market by selling directly to the

customers. The exporter himself handles every aspect of the exporting process.



INDIRECT EXPORTING: In this, the exporting company sells its products to

the intermediaries who in turn sell their products to the end users in the target

market.

LICENSING: It is a legal arrangement whereby a firm in one country (licensor) grants

the right to use its intellectual property to a firm in another country (licensee) in return for

a royalty payment. Intellectual property rights include patents, trademarks, copyrights,

designs, processes, inventions etc. This mode helps firm to expand into the foreign

market without committing substantial foreign resources. But it carries the risk of

dissemination of technological knowhow to potential foreign competitors.

FRANCHISING: It is similar to licensing but generally involves longer term

commitments than licensing. In this, a firm in one country (franchiser) authorizes a firm

in another country (franchisee) to utilize its intellectual property as well as its operating

systems. In return, the franchisor receives royalty payment, which amounts to some

percentage of franchiser’s revenue. The franchiser assists the franchisee to run the

business on an ongoing basis and the franchisee has to agree to abide by the strict rules as

to how it does business. Franchising also enables a firm to build a global presence

quickly and at low costs. The problem with this mode is that the foreign franchisees may

not be concerned about the quality and the resulting poor quality will result in decline in

the firm’s worldwide reputation.

MANAGEMENT CONTRACT: It is an arrangement under which operational control

of an enterprise is vested by contract in a separate enterprise which performs the

necessary managerial functions in return for a fee. It can involve a wide range of

functions, such as technical operation of a production facility, management of personnel,

accounting, marketing services and training. It does not involve as high risk and can yield

higher returns for the company. It is generally used when foreign government restricts

other entry methods.

TURNKEY PROJECTS: It is a type of project where the developer undertakes to take

care of all the aspects of the project for a buyer until its completion. The completed

product is than handed over to the buyer by the developer in a ready to use condition.

This strategy is particularly useful where FDI is limited by host government regulations.

OBJECTIVE The objective of this study is to review the existing literature on the factors that influence the

choice of mode of entry by the MNCs. On the basis of this review, we would be able to find out

different factors that affect the selection of the most optimal mode of entry. This study is

exploratory in nature and secondary data has been collected from various sources.

LITERATURE REVIEW The selection of international market entry mode happens to be one of the most extensively

researched areas. In this section, we present a brief overview of previous studies.

http://en.wikipedia.org/wiki/Business



According to Erramilli (1992) the lack of suitable host country partner leads the firm to adopt

integrated modes. On the other hand, when the host government restricts foreign ownership,

when uncertainty in the host country is high and when the firms have only limited resources,

then they tend to prefer non-integrated entry modes. However, the effects of market size, firm’s

desire to get rapidly established in the market and firm’s corporate policy on controlling foreign

operations were not evident. Firms which insist on control in order to customize their product

and have closer interaction with their customers will also prefer integrated modes. And the firm’s

desire to get rapidly established in the market will lead the firm to adopt non-integrated modes.

The findings, however, showed that these factors vary in importance according to particular

entry situation.

Brouthers et al. (1996) examined the influence of ownership and locational advantages on the

choice between independent (licensing, franchising, agency and contracting), cooperative (joint

venture and strategic alliance) and integrated (acquisitions and greenfield operations) modes of

entry by SMEs in the computer software industry. They found that with respect to individual

measures of ownership advantages, large firms having more experience will be more mature

globally and will be better able to utilize their ownership advantages and will thus choose

integrated entry modes. Similarly, the firms that sell a differentiated product or service will

prefer integrated entry modes in order to avoid the risk of losing its competitive advantage to the

local partner. With respect to the individual measures of locational advantages, they found that

the market attractiveness in terms of high current and high potential future demand provide firms

with long term investment potential, thus making them choose integrated entry modes.

Ahmed et al. (2002) used an integrated international risk framework to examine the influence of

international risk perceptions on the choice between non-equity/exporting mode, joint venture

and wholly owned subsidiary by firms based in emerging market of Malaysia. They found that

all types of risks in the market influence the firm’s entry mode choice and there is a negative

relationship between risk perception and level of international involvement i.e. when perceived

international risk is high, entry mode with lower resource commitment and lower control will be

selected and vice versa. Industry structure, customer taste and marketing infrastructure were

found to have the greatest influence over the entry mode choice.

Elango and Sambharya (2004) discussed the impact of industry structure on the choice between

greenfield investments, acquisitions and joint ventures by MNEs in manufacturing industries.

They found that firms prefer greenfield operations over joint ventures and acquisitions in

concentrated industries. In industries characterized by plant scale economies firms will prefer

acquisitions or JVs over greenfield operations because the creation of new capacity in such

industries would hurt all the firms including the new entrant. They found preference for

greenfield operations over acquisitions and JVs in industries characterized by high growth rates.

This is because an industry with growing demand will be able to absorb the additional capacity

created though greenfield investment.

Peinado and Barber (2006) examined the impact of uncertainty on the choice between high

control and resource commitment modes; and low control and resource commitment modes by

the firms in service sector by using ordinal logistic regression. They found that since capital



intensive firms require huge investments, they prefer to share control and investment (opting low

control mode) when the country risk in the host country is high and the cultural distance between

home and host country is large. On the other hand, since knowledge intensive firms have lower

exit costs, they are likely to choose higher control and resource commitment modes in order to

reap the benefit of obtaining a strong competitive position in a relatively unexplored market.

With respect to uncertainty of demand, they found that Changes in client’s needs do not affect

capital intensive firm’s choice but leads the knowledge intensive firms to adopt high control

modes. Risk of technological changes leads both capital intensive and knowledge intensive firms

to adopt low control modes.

According to Chang and Kao (2009) when the quality of governance is high and political

environment in China is stable, the firms will choose majority equity modes. They found that the

rule of law and regulatory quality have the most significant impact on the entry mode choice

whereas the control of corruption, government effectiveness, and voice and accountability do not

have significant impact on the entry mode choice. Political stability was shown to have the

largest impact followed by rule of law and regulatory quality. Thus, in countries with favorable

institutional environment, MNCs tend to favor high control entry modes.

Cui and Jiang (2009) examined the choice between wholly owned subsidiary (WOS) and joint

venture (JV) by linking the Chinese firm’s entry mode decision with both its strategic fit in the

host industry environment and its strategic intent of foreign market entry. They found that when

Chinese firms face severe local competition in a host industry, they will prefer to strengthen their

own competitive advantages in cost and quality control by opting for WOSs. Similarly, when

host industry market is characterized by high growth rate and growth potential, the Chinese firms

will prefer the JV entry mode as it provides fast track establishment as compared to WOS.

Lastly, the Chinese firms global strategic motivation of becoming formidable global player and

to establish integrated global business network makes them choose WOS entry mode.

Duarte and Suarez (2010) discussed the impact of the host country’s environment i.e. political

risk, cultural distance and language diversity on the choice between wholly owned subsidiary

(WOS) and joint venture (JV) by Spanish firms for the period covering 1989 to 2003. They

found that when external uncertainty derived from the interaction between cultural distance and

political risk is high, and language diversity between home and host countries do not exist, the

firms will prefer to invest through JVs rather than through WOSs. But such preference will take

place only when both partners share a common language which facilitates successful formal and

informal communication between them and avoids the costs and conflicts derived from language

diversity. When partners do not share a common language, the flow of information between

them is disturbed and the costs and difficulties related to their cooperation also increase and

therefore forming a JV with the local partner is no longer an effective way to reduce external

uncertainties. They suggested the existence of an interaction effect between cultural distance and

political risk and that the language diversity is an important component of psychic distance and

must be considered in entry mode decisions.

Chen and Chang (2011) examined the influence of transaction cost factors and state dependence

on the choice between wholly-owned subsidiaries (WOSs) and joint ventures (JVs) for

Taiwanese FDI in China for the period 2004-2007 using panel data set. They found that large



firm size, large size of the subsidiary relative to parent, threat of proprietary technology leakage,

vertical linkage between parent and subsidiary, and strong relational network results in

preference for wholly owned subsidiaries. On the other hand, greater international experience,

sourcing of materials from local suppliers, products intensive in resources to be obtained from

host country and diversification results in preference for joint ventures. The transactions cost

theory suggests that the choice of entry mode should be based on efficiency criteria i.e. the firm

should select that entry mode that minimizes the transaction costs.

Zekri and Angelova (2011) have outlined the various issues and challenges that influence the

choice of entry mode in international markets from a theoretical viewpoint. The paper has used

the secondary information in order to analyze the determinants for the choice of foreign entry

mode. They emphasized that firm’s analysis of various environmental factors determines its

choice of entry mode. They indicated that environmental scanning helps the firm to analyze the

influence of political and legal forces, economic forces, socio-cultural forces and technological

forces on the entry mode choice. Apart from these forces, a number of host and home market

characteristics also influence the entry mode choice. If the political risk in the host country is

low, macroeconomic condition is stable, market potential is high and legal restrictions are low,

then the firms will choose full ownership and control in the host market. Similarly, high

competition in the home country, and low home country restrictions on foreign market expansion

encourage the firms to adopt high ownership and control modes.

O’Cass et al. (2012) have integrated the resource based influences and environmental influences

to analyze their impact on the choice between equity and non-equity modes in a region-within-

country i.e. China-Hong Kong context. They found that firms that possess high level of specific

firm characteristics and whose products possess differentiated characteristics prefer equity entry

modes. The firm size was found to be unrelated to the entry mode choice. Both home market and

host market characteristics strongly influence the entry mode strategy of Hong Kong firms

entering China. The firms which operate in a dynamic home market where the customers are

highly demanding tend to exploit their current competitive advantage by the adoption of an

equity mode of entry. Similarly, when a host market is more dynamic and open to foreign

investment, firms prefer equity entry modes.

DETERMINANTS OF ENTRY MODE CHOICE In this section, we discuss the various factors that can influence the entry mode choice of an

MNC. These factors can be clubbed into two groups, namely, internal factors and external

factors. Internal factors relate to the company’s internal environment, whereas external factors

pertain to the conditions that are external to the company.



Figure 1: Factors affecting entry mode choice

INTERNAL FACTORS

FIRM SIZE: One of the most important factor that influences the entry mode choice is

the size of the firm. Smaller firms have limited financial and human resources at their

disposal and are therefore exposed to more risks as chances of failure of foreign

investment can lead to insolvency of the entire firm. On the other hand, larger firms

possess greater productive resources, greater market power, greater knowledge and

economies of scale. They are better placed than smaller firms to bear the risks

associated with foreign market entry. Therefore, firm size (larger firms) is positively

related to the adoption of equity entry mode.

INTERNATIONAL EXPERIENCE: As a firm ventures into foreign markets, it gains

the knowledge of dealing with local economic and environmental conditions. As the

experience increases, the firm’s potential to project the costs and returns, to gauge the

market demand, to assess the customer’s needs and to evaluate the true economic worth

of the foreign market also increases. It becomes more confident of their ability to

manage foreign operations and consequently are willing to greater resources. On the

other hand, firms with lesser experience tend to perceive greater uncertainty, and are

likely to wrongly estimate the risks and returns. They, therefore hesitate to commit

greater resources in the foreign market. Thus, the greater the international experience,

the more likely it is that the firm will go for an equity entry mode.

ENTRY

MODE

CHOICE

INTERNAL FACTORS

Firm Size

International

experience

Technological

capability

Product

characteristics

EXTERNAL FACTORS

Cultural distance

Market size and

growth

Country risk

Legal barriers



TECHNOLOGICAL CAPABILITY: Firms which possess high R&D capability face

greater risk of leaking proprietary technology to their rivals if they opt for lower control

modes or non equity modes. With non-equity modes, there is a risk of the firm loosing

the control of its technology to the local partner. So in order to prevent the

dissemination of technological know-how, the firms with greater technological

capability will prefer equity modes over non-equity modes.

PRODUCT CHARACTERISTICS: The product characteristics provide the firm with

the ability to differentiate its product offering from its rivals. It includes the attributes

like degree of product uniqueness, extent of product establishment, training needs of

sales force, and the degree of maintenance and service requirement for the product.

Products that are service intensive are hard to serve from a distant market. The

company needs to be close to the customer and therefore local production is appropriate

in such cases. Thus, in case of service intensive products equity mode will be preferred.

Similarly, innovative products possess highly intangible components in terms of

technological and marketing know-how. For such products, specialized training

programs for the employees must be put in place. Therefore, a high level of product

differentiation in product characteristics is associated with the adoption of equity entry

mode.

EXTERNAL FACTORS

CULTURAL DISTANCE: Perhaps, one of the most often talked about external factor

affecting the choice of entry mode is the cultural distance between the host and the

home country. Culturally close countries ought to have similar languages, similar set of

norms governing business and industry and also similar cultural characteristics. The

greater the cultural distance between the home and host country, the greater will be the

uncertainty and greater will be the costs of collecting information and communication.

Therefore, when the cultural distance is large the company will avoid using equity entry

modes and will us entry modes which require lower resource commitment.

MARKET SIZE AND GROWTH: Market size and growth are important host

country parameters affecting the entry mode choice. The larger the size of the market,

the greater is the potential for growth and the higher will be the inclination of the firm

to commit greater resources for its development. In smaller markets, firms tend to

reduce their commitment and will go for non-equity entry modes. Root (1987)

observed that in markets characterized by low sales potential, entry modes such as

indirect exporting and licensing are favored. Similarly, in declining markets firms tend

to prefer lower commitment or non-equity modes.

COUNTRY RISK: Country risk emanates from political and economic factors both of

which can significantly influence the potential attractiveness of a country. Unstable and

unpredictable political and economic environment increases the risk of doing business



in a particular country and discourages the firm to adopt entry modes which require

greater resource commitments. On the other hand, politically stable countries which

have free market mechanisms and where the macro-economic indicators are relatively

stable will induce the firms to adopt equity entry modes.

LEGAL BARRIERS: Imposition of tariffs and quotas on the import of foreign

products and excessive trade regulations encourages local production and will lead the

firm to go for an equity entry mode like wholly owned subsidiary or a joint venture.

Similarly, excessive restrictions on foreign ownership by host country governments will

push the firm to go for non-equity entry modes.

CONCLUSION

It can be seen that the entry mode decision is conditioned by a variety of internal and external

factors. Firms select their entry modes that can be supported by their resources, skills and

capabilities. A number of firm level factors dictate the entry mode decision such as firm size,

firm’s skills and resources, characteristics of firm’s products, firm’s desire to get rapidly

established, firm’ international experience etc. Larger firm size, greater access to productive

resources, greater international experience are all associated with the adoption of equity entry

modes.

The effects of a number of external factors on the entry mode choice have also been established.

Among them, the most frequently analyzed factors happen to be cultural distance between home

and host country and host country risk. High country risk and larger cultural distance is

negatively associated with high control or equity entry modes. Some other external factors

factors include legal restrictions, market potential, market size, and restrictions on foreign

ownership.

Thus, it can be concluded that firms choose entry mode in response to a variety of internal and

external factors so as to maximize profit and optimize their market position.

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factors affecting the choice of entry mode by mncs

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