Amsterdam Business School

MBA International Business, part-time

Assignment week 4, November 18th, 2013

Case: PALLISER FURNITURE LTD.: THE CHINA QUESTION

Should we expect Palliser to engage in FDI in China right now, or not?

Michelle Donovan 10429859

Kivanc Ozuolmez 10429832

Palliser Furniture Ltd.’s main strategies are cost leadership, quick delivery and value enhancement.

The eclectic paradigm

The eclectic paradigm, by combining many theories from different authors, attempts to explain when and why a company will engage in foreign direct investment. Its three components are Ownership (O), Location (L) and Internalization (I). If a company would gain advantages in all three areas, it will engage in FDI.

Ownership

As far as we know from the case, Palliser is not seeking to invest in China (or elsewhere) in search of new markets. The O advantages they may have by investing in China (or elsewhere) are resource-seeking and efficiency seeking, for example reducing labour, supply and friction costs. Friction costs would be $2 lower per sofa coming from China than Mexico, labour costs would be lower, and some components would also be cheaper (leather, wood, foam and packaging). The risks associated with trading in a different currency would be reduced because of the Chinese yuan being pegged to the US dollar. However, it is not clear from the case whether these advantages could also be gained by doing more contracting work with Chinese partners and/or suppliers, rather than building or buying its own factory in China.

Although the intellectual property and specialist knowledge is important for Palliser, a more critical aspect is the length and trustworthiness of the operational investment. Palliser’s hesitation about Chinese OEM suppliers and contracting might be a valid concern in terms of the combination of the product life cycle, product designs and production uniqueness. Therefore, direct ownership in China brings advantages over contracting.

Location

Palliser is already aware of some of the advantages and disadvantages of location due to its existing plants in Canada and Mexico and the associated friction costs, and due to its experience in China, Indonesia, Thailand, etc. They already have offices in China and Taiwan.

Risk diversification and follow my leader theories may be the most relevant and guiding theories for Palliser’s decision.

Besides cost efficiencies, lower shipment and transaction costs and labour related benefits, starting production in China will help Palliser to benefit from the pegged exchange rate, which it currently does not enjoy in the Indonesia and Mexico locations, which therefore are more vulnerable. In addition, efficient Chinese workers, constitutionally structured and attractive rules and regulations for FDIs make China a good place in which to diversify exchange rate, government and labour related risks, relative to other Asian countries.

As many large North American and European furniture manufacturers moved their manufacturing to China, follow my leader theory might also be a directive for Palliser’s decision. According to the article, and Palliser’s estimations, currently their competitors that manufacture in China enjoy the results of their strategic move, and target larger market shares by price leadership. If there is no hidden magic in furniture manufacturing FDIs in China, Palliser can benefit from similar supply and labour market. In addition, if the furniture manufacturing moves increasingly to the same location, Guangdong province, we can expect that the local supply and skilled labour market will mature, and offer better and wider options

with lower costs. This means; in the longer run, the local (Chinese) supply market will be more attractive to Palliser.

Internalization

By owning its own plant in China, Palliser could lower transaction costs, lower the unit cost of production and benefit from economies of scale.

Perhaps Palliser could benefit from knowledge sharing, especially in the area of motion products, which are quite new for them. If they based their new plant in Guangdong as above, there may be a local pool of workers who have already been trained in the design and/or construction of motion products and Palliser could make us of that.

However, it is worth noting that Palliser has not yet tried to rationalize the Mexico plant and it is likely that they could save some costs there by creating efficiencies.

Conclusion based on Dunning article

All three elements needed for FDI are present, so DeFehr can and should go ahead with FDI. However, at the same time, a reationalization program in Mexico should be carried out.

The Uppsala Internationalisation Model

Johanson and Vahlne’s article is more focused on the way companies become internationalized (the “how”, not the “why” or the “when”). The mainly Swedish firms they discuss were almost all market-seeking, which Palliser is not. They believe internationalization happens step-by-step, first by exporting via agents, then setting up a subsidiary sales office, then later producing in the host country. Furthermore they saw firms expanding internationally first into countries where the culture, language, etc are more familiar to them and therefore appear less risky. As knowledge and experience of the market and the network of contacts increase, firms become more willing to expand to less familiar regions.

Palliser has internationalized gradually and into more familiar countries first, as the model predicts; the company started in Canada and exports to the USA, and the production plant in Mexico was opened in 1998. Of course, Canada, the USA, and Mexico are all members of NAFTA, which should make trading between the three countries easier and more attractive. They also produce in Indonesia, contract work to China and Thailand, and have sales offices in China and Taiwan. However, the CEO DeFehr seems to be more familiar with Asian countries and culture, as he has travelled and lived in Asia, than he is with Mexico. Doing business in Mexico was not without risks due to lack of knowledge and/or experience, as the company discovered over time, for example regarding the tax laws in Mexico and the difficulties and extra costs associated with trucks crossing into the USA from Mexico. Perhaps for DeFehr, had he been familiar with the Uppsala model, would have chosen China over Mexico in 1998 for his production facility.

The fact that the company already has offices and contacts in China means that Palliser already has a head start on the “advantage cycle” described by Johanson and Vahlne (p21), should he decide to start FDI in China. However, DeFehr should also be aware that opening a plant in China “will change the power balance within the corporation”; presumably this is why he insists that the Chinese operation would have to be a full-owned subsidiary and not a joint venture.

The conclusion is that Palliser should go ahead with FDI in China.

Internalization theory

Internalization theory aims to explain why a multinational enterprise is more efficient when it owns and controls firm-specific advantages, but admits that other methods of foreign expansion are possible, such as joint ventures and licensing, and that these can even be more advantageous depending on the situation. Rugman asserts that the two most important deciding factors regarding FDI are country-based factors (country-specific advantages, CSAs) and firm-specific advantages (FSAs). Rugman takes a critical view of the OLI paradigm and points out that it is based only on perceived opportunities in host countries and does not consider the home situation.

Palliser’s FSAs are its brand and its knowledge of and efficiency in designing and manufacturing its furniture to create value. However there are many similar companies who are able to compete with Palliser so we believe their FSAs are low according to Rugman’s definition. The high CSAs of China are the cheaper manufacturing costs (including low labour and material costs). Using Rugman’s matrix we can see that Palliser falls into cell 1 which means they should proceed with FDI.

Conclusion

DeFehr seems to be ambivalent about owning in China. On one hand he says that he does not want to participate in a joint venture, he only wants to be the sole owner. On the other hand, he is not sure if he feels comfortable owning anything in China. Based on the literature, we advise him to go ahead with FDI in China.

References

Dunning, J. (2000). The Eclectic Paradigm as an Envelope for Economic and Business Theories of MNE Activity, International Business Review, 9, 163-190

Johanson, J. & Vahlne, J-E. (1997) The Mechanism of Internationalization. International Marketing Review, 7 (4): 11-24

Rugman, A. (2011) Reconciling internalization theory and the eclectic paradigm. Multinational Business Review, 18 (1): 1-12.