Discuss about the Contractual Entry Mode in the foreign market.

Contractual-Entry-ModeAnswer: Profitability analysis requires estimation of both international revenue and incremental costs. Licensing is used when exporting or equity investment cannot use. As a result, licensing is considered its marginal activities of manufacturers. This causal approach encourages 2 bad decisions;

  1. Under licensing—manufacturer ignores licensing when it is more profitable (should do).
  2. Over licensing—Manufacturers enter into licensing without assessing all revenue and costs over the duration of those agreements (should not).

Mangers can rationally choose licensing only when they compare the expected profitability with other alternative entry modes. Mangers can apply profitability analysis is following ways;

  1. Projected incremental revenue: Licensing revenues are dependent mainly on the ability of a prospective license to manufacture and market the licensed product over time. Hence the licensor first need to resear4ch foreign market to ascertain market potential. Next to estimate the sales potentials (market-share potential).

Sales potential is the basis of estimating royalty revenues as percentages of sales. Then manufactures need to identify other kinds of licensing revenues including;

  • Lump-sum royalties.
  • Technical assistance
  • Engineering or construction fees
  • Equity shares in license firm
  • Dividends on equity shares, profit from sales to license (machinery, equipments etc.).
  • Profit from purchase and resale of goods manufactured by license.
  • Savings from use of licensed products in licensor’s own operation.
  • Commissions on purchase or sales made for license.
  • Rental payments on licensor-owned machinery or equipment.
  • Management fees, and
  • Patents, trademarks, and know-how received from license (grant backs).

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These revenues are estimated on the basis of the agreement, manufacturer plans to negotiate. After estimating the all revenues the manufacturer projects the aggregate cash inflow for licensing.

  1. Projected incremental cost: The next step in probability analysis is an estimation of all costs incurred in transferring technology and related services to prospective license over the arrangement’s life. The possible costs are classified as

Opportunity costs: The licensor’s opportunity costs are the revenues that are forsaken if the enters the prospective licensing venture. Such as—Loss of current export or other net revenue, or loss of prospective revenues.

Start-up-costs: All transfer costs incurred by the licensor to establish the licensing venture and to get license into volume production and marketing of the licensed product. It includes—

  • Investigation of target market.
  • Selection of prospective license.
  • Acquisition of local patent/trade marks protection.
  • Negotiation of licensing agreement.
  • Preparation and transfer of blueprints, drawings, and other documents.
  • Adaptation of technology for license.
  • Training license’s employees, Engineering, construction and plant installation services, and
  • Contribution of machinery, equipment and inventory to license.

Ongoing costs: All costs incurred by the licensor to maintain the licensing agreement as a profitable venture over its duration. (Ordinarily 5-10 years). It includes:-

  • Periodic training and updating of licensee.
  • Maintaining local patent/trademark protection (including policing and litigation costs).
  • Quality supervision and tests.
  • Auditing and inspection.
  • Marketing, purchasing, and other nontechnical services.
  • Management assistance.
  • Corresponding with license.
  • Resolution of disputes and maintenance of licensor staff.

The manufacturer is now ready to calculate the profit contribution of the proposed licensing venture by subtracting aggregate costs from aggregate revenues. The resulting figure should then be compared with the estimated profit contribution of alternative entry modes to help managers decide most suitable the entry mode.

Contractual Entry Mode—Franchising:

Definition: Franchising is a form of licensing in which a company (franchisor) licenses a business system as well as industrial property to an independent company or person franchisee.

The franchisee does business under the franchisor’s trade name and follows the policies and procedures laid down by the franchisor. Essentially, therefore, the franchisor licenses a way of organizing and carrying on a business under this trade name. In return, the franchisor receives fees, running royalties, and other compensation from the franchisee.

International franchising: International franchising is particularly attractive under following three reasons
company when it has a product that cannot be exported to a foreign target country, it does not want to invest in that country as a producer, and its production process (business system) can be easily transferred to an independent party in the target country.

Advantages of international franchising
The principal advantages are the following;

  1. Rapid expansion into a foreign market with low capital outlays.
  2. A standardized method of marketing with a distinctive image.
  3. Highly motivated franchisees, and
  4. Low political risks.

Disadvantages o f franchising

  1. Limitations on the franchisor’s profit.
  2. Lack of full control over the franchisee’s operations.
  3. The possible creation of competitors and
  4. Restrictions imposed by governments on the terms of franchise agreements.

Establishing franchising
The steps to establish franchising systems abroad resemble those of traditional licensing.

  1. Assessing sales potential in the target market.
  2. Finding suitable franchisee candidates.
  3. Negotiating the franchise agreement, and
  4. Building a working partnership with the franchisee.

Contractual entry mode –Management Contracts:

Definition: A Management contract is an agreement whereby one company provides management personnel, who perform general or specialized management functions to another company for a fee. It is used primarily when the foreign company can manage better than the owners. The management talents the company transfers internationally, primarily to its own foreign investment.

Advantages of management contracts:

  1. Low risk entry into foreign market.
  2. It is used mainly to supplement joint venture agreement or turnkey contract. And
  3. International company obtains management control over non-equity investment.

Disadvantages of management contracts:

  1. The income is limited to fees for a fixed duration of time.
  2. It does not allow the foreign company to build a permanent market position for its product, and
  3. It is a time-consuming negotiation and the commitment of scarce management talents.

Contractual Entry mode—Contract manufacturing:

Definition: Contract manufacturing is a cross between licensing and investment entry. In contract manufacturing, the international firm sources a product from an independent manufacturer in a foreign target country and subsequently markets that product in the target country and elsewhere.

To obtain a product manufactured to its specifications, the international, firma ordinarily transfers technology and technical assistance to the local manufacturer.

Advantages of contract manufacturing:

  1. It requires only a comparatively small commitment of financial and management resources, allows for quick entry into the target foreign market, and avoids local ownership problems.
  2. It permits international company to exercise control over marketing and after-sales services.
  3. It is especially attracted when the target market is too small to justify investment entry and when export entry is blocked by restrictions, or simply too costly.

Disadvantages of contract manufacturing:

  1. It may be difficult or impossible to find a suitable local manufacturer.
  2. Once found suitable, substantial technical assistance may be required to bring him up to the desired quality and volume levels and to keep him at those levels.
  3. Finally, the international company runs the risk of crating of future competitors.

Contractual entry mode—Turnkey construction contracts:

Definition: Turnkey construction contracts is a project in which a firm agrees to set up an operating plant for a foreign client and handover the “key” when the plant is fully operational.

Turnkey operations are a type of collaborative arrangement in which one company countries another to build complete, ready-to-operate facilities. In turnkey contract, a foreign client is handled over the “key” to plant that is ready for full operation. They brings a foreign project up to the point of operation before it is turn over to the owner. Hence, it is termed turnkey.

The turnkey operations are mainly performed construction and industrial equipment companies and often performed by government agencies.

The foreign clients are basically industrial-equipment manufacturers, construction firms, and in some cases consulting firms. However, manufacturers can also enter through turnkey contract.

A further step is the contractor’s obligation to provide services, such as management and worker training, after construction is completed in order to prepare owner to operate the project, such an arrangement sometimes called “turnkey plus”.

Advantages of turnkey operations:

  1. It is suitable where the know-how is required to assemble and run a technologically complex process.
  2. This is also suitable where FDI is restricted but technologically poor, for example oil refinery project is Middle east countries. And
  3. It is of course less risky.

Disadvantages of turnkey operations:

There are three main drawbacks are associated with a turnkey strategy
a. The firm that enters into a turnkey deal will have no long-term interest in the foreign country if the country proves to be a major maker and exporter of those outputs.

b. The firm that enters into a turnkey project may inadvertently create a competitor, for example, many western refinery companies sold their technology to middle east and now finds them as competitors, and
c. If the firm’s process technology is a source of competitive advantage, then setting this technology is also selling the competitive advantages to potential/actual competitors.

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