In the global integration model, management power in the multi-national corporation is primarily centralized at the MNC headquarters (HQ). MNC subsidiaries have little flexibility or autonomy. In the localization model, on the other hand, the MNC HQs do not standardize the business activities of their subsidiaries, and the subsidiaries therefore enjoy more freedom and autonomy than that in the integrated model.
MNC global integration may cover various business activities. One of these is sourcing, where MNC subsidiaries receive inputs or supplies for their operations. Jarillo and Martinez (1990) assessed the global integration of MNC subsidiaries by measuring the percentage of inputs that the subsidiaries sourced from their parents and their networks. The more a subsidiary relies upon its parents for supplies, the more globally integrated is the subsidiary’s operations. Similarly, global integration can also be measured by the level of centralization of R&D functions, and the subsidiary’s autonomy in selling its products to local markets or through its parents’ integrated systems (Rugman and Verbeke 2001). Existing literature argues that global integration helps MNCs save costs and achieve global efficiencies. For example, global integration minimizes duplication, thus saving costs through standardization (Dunning 1998), and global integration creates efficiencies due to global economies of scale. Kogut (1985) argues that MNCs achieve high efficiency through two methods. Firstly, they rely upon supplies (sourcing) from low labor cost countries. Secondly, even if MNCs do not rely upon supplies from low labor cost countries, they can still enjoy high efficiency if they centralize their operations and/or aggregate their sourcing to enjoy global economies of scale. Similarly, Ghoshal (1987) indicates that MNCs gain efficiency advantages from national differences in labor costs (i.e., getting supplies from low labor cost countries), and from global economies of scale and scope, which are generated by the scale of operations/sourcing rather than by the low cost of some locations.
Although the preceding arguments are well documented, some questions remain. First, these arguments mainly take the perspective of the MNC corporation or HQ. It is not clear if the arguments apply to MNC subsidiaries. Because the economic interests and goals of MNC HQs are not always congruent with those of MNC subsidiaries, what is good for a MNC corporation may not benefit their subsidiaries. Secondly, the preceding arguments are mainly developed from MNCs competing in developed countries. Whether or not these arguments apply to MNCs competing in emerging markets remains a question. Emerging markets are characterized by lower labor costs than those of developed countries. In general, emerging markets also lack sophisticated industry infrastructure to supply advanced technologies and manufacture high quality products. Because of these differences, it is important to examine the validity of the preceding global integration arguments in emerging markets.
From the perspective of MNC subsidiaries in emerging markets, the preceding global integration arguments would predict that MNC subsidiaries in emerging markets gain low cost supplies from two sources: local and/or global sourcing. Local sourcing means that the subsidiaries source supplies from local (host) markets. Local sourcing saves costs because of the low labor costs in emerging markets. Alternatively, the subsidiaries can also gain low cost supplies from global sourcing (i.e., getting/sourcing supplies from parents’ integrated supplier channels). In fact, MNC supplier channels may not need to locate in low-cost countries to be cost competitive, because global economies of scale may lead to competitive costs (Kogut 1985). For example, as developed countries frequently have superior technology and human capital, sourcing from these countries may enable MNC subsidiaries in emerging markets to enjoy better quality and lower defect rates that result from these global economies of scale – thus reducing the overall sourcing costs.
Some scholars, however, disagree with these arguments. Theoretically, MNCs in emerging markets do not gain extra cost advantage over local firms through local sourcing because both local and multinational firms in such markets enjoy the same low labor costs from the local markets. As a result, global sourcing becomes an alternative source for MNC subsidiaries to gain cost advantages over local competitors because local competitors do not have the global sourcing opportunity as do MNCs. But even here, some scholars disagree. They argue that when using global sourcing, MNCs pay high monitoring, coordination and transportation costs (Miller and Parkhe 2002, Zaheer and Mosakowski 1997, Zheer 1995, Hymer 1976). Further, emerging markets frequently have high tariffs (Yip 2000). These factors make it unclear if MNC subsidiaries in emerging markers are able to gain cost advantages through global sourcing.
In addition to sourcing, the literature is not clear on the impact of other types of integration on subsidiaries’ costs. For example, will high level HQ control in subsidiary management, a type of operation integration, improve the efficiency of a MNC subsidiary in an emerging market? Similarly, different levels of integration by the parent may exist where some of MNC’s subsidiaries only sell to local markets while the MNC’s other subsidiaries sell their products through the parent’s global networks. It is not clear if and how such a difference affects the costs of the subsidiaries in emerging markets. Given that existing studies are inconclusive on global integration and its impact on costs of MNC subsidiaries in emerging markets, this paper will examine these issues.
Because the focus of the paper is not the global integration and local responsiveness framework, we will not discuss the characteristics and applicability of the framework in emerging markets, nor will we analyze the different integration and localization strategies of MNCs in emerging markets. Our focus is squarely on the impact on subsidiary costs of operations as a function of the global integration by their MNC HQs (please see table 1 on page 7).
In our study we found that MNC subsidiaries in emerging markets suffer from cost disadvantages when they source (or rely upon suppliers) from centralized corporate networks and when HQs exert control through sending expatriates to the subsidiaries. On the other hand, if the subsidiaries are able to use their parents’ networks to export products to foreign markets or to sibling subsidiaries, the subsidiaries are able to reduce their costs. We also found some relationships between the cost competitiveness of the subsidiaries and their performance. Table 2 (on page 8) summarizes the findings.
Integration in Supplies (Global sourcing)
Several subsidiaries in our study purchase components or raw materials from their parents’ networks located outside of China. For example, APPLIANCE sources its core components from a sibling subsidiary located in France. The supplies of hardware components to IT and SYSTEM are also controlled and coordinated by their respective HQs. These globally integrated supplies, though helpful to the subsidiaries in improving product or component quality, are very costly to these subsidiaries. These costs emanate from high government tariffs and higher labor and raw material costs in the supplying countries. Several managers indicated that “due to high sourcing costs from parents’ internal networks, the subsidiaries started to develop local supply sources.” EQUIPMENT is a good example of this behavior. As indicated in Table 2, its R-Chiller controlled 70 percent of market share in China while its C-Chiller only had 20 percent market share. Managers at EQUIPMENT indicated that the key reason for this difference was the different levels of local sourcing. 90 percent of R-Chillers’ raw materials and components come from local suppliers while C-Chiller only has 50 percent local supplies. One manager said that “for our R-Chiller products, I am not afraid of competitors using low prices to compete as our costs and prices are already competitive enough. But for our C-Chiller, it is much harder to face competition because of the high costs in importing components. For these imported components, we have to pay as high as 40 percent import tariffs”.
APPLIANCE’s case also supports this. In the late 90s, the prices of its microwave products were 20 percent higher than the leading local competitor. A manager said that this price gap is “too high, if the prices were 10 percent higher, the market would accept us easier.” To improve cost competitiveness, the subsidiary reduced its import components and developed more local suppliers. The company reached 60 percent localization (purchasing components from local suppliers) after two years of its entry into China. To further lower its costs, the company invested $240 million to build a manufacturing facility in China and by 2002 it reached more than 80 percent localization. This helped the firm to lower its price gap with the leading local competitor from 20 percent in late 90s to 10 percent in 2002.
Integration in management control – expatriates
We find that increasing expatriate control, another form of global integration, also negatively affects cost competitiveness of the subsidiaries. Expatriates, especially long-term expatriates, are important for HQs to control subsidiaries and implement HQ strategies; they are also good conduits for transferring HQ technologies and organizational capabilities to the subsidiaries. However, these managers represent large cost burdens for the subsidiaries. As a manager at EQUIPMENT mentioned, “..each of their expatriate’s salaries is equivalent to the salaries of 100 local employees”. IT managed to reduce these costs by reducing the number of expatriates from five in early 90s to two in late 1990s. All six subsidiaries gradually reduced the number of expatriates as they developed more local managers.
Integration in subsidiary sales (export)
We find that exports help subsidiaries to reduce their cost structure. Exports help the subsidiaries increase production volume, thus enabling them to achieve better economies of scale. In the case of APPLIANCE, for example, more than 50 percent of its microwave ovens manufactured in China were for export. ELEC also has more than 10 percent of its products for export, while IT’s exports accounted for 30% of its total sales. Managers in these subsidiaries indicated that exports allowed to them to use their facilities more efficiently and reduce costs. In some cases (e.g., APPLIANCE and IT), the export businesses are more profitable because the subsidiaries can sell products at higher prices in export markets. These benefits help the subsidiaries reduce their overall cost structure and become cost competitive in the Chinese market.
Factors affecting global sourcing
Several factors affect the purchasing/sourcing of components from corporate networks. First, quality is a primary reason for the subsidiaries’ reliance upon their corporate networks for sourcing. Because local suppliers in China frequently do not have the technologies or skills to meet subsidiaries’ standards in product quality and features, MNCs have to rely upon high-cost foreign suppliers. Second, product technology stability also affects subsidiaries’ ability to develop local supplies. For example, one of the key reasons that EQUIPMENT has 90 percent local sourcing in R-Chillers while only 50 percent local sourcing in C-Chillers is because the technologies found in the former product are more stable. This stability allowed the subsidiary to take time to learn and transfer the capabilities internally or to local suppliers. But for newer products (e.g. C-Chillers), new government regulations on ozone emission required that EQUIPMENT’s parent change its C-Chillers’ technology to meet the new regulations. This change made it harder for EQUIPMENT to accumulate its learning of manufacturing technologies and develop local suppliers. Similarly, APPLIANCE was able to quickly localize its component supplies because microwave oven and air conditioners are mainly stable technologies. A manager indicated that by 2002 APPLIANCE had transferred almost all manufacturing and R&D activities to China.
We also find that the timing of entry affects MNCs’ ability to develop local supplies in China. Although previous studies indicate that early entrants have advantages of finding good local suppliers in host markets, which made it easier for MNC subsidiaries to shift from global to local souring, our findings suggest that the opposite is true. COMPONENT and APPLIANCE both entered China very early but both encountered difficulties in finding good local suppliers. Because they are early entrants, they could not find good local supplies because these local firms have not had the opportunity to work with and supply to foreign companies in China in the past. In addition there were no foreign suppliers operating in China. As a result, they worked very hard in helping local suppliers to improve technologies. For example, COMPONENT worked with local suppliers to redesign their equipment to improve quality; the subsidiaries also helped local suppliers to set new quality control systems to improve production quality. Similarly, APPLIANCE bought high quality raw materials from abroad and gave them to the local suppliers that use the materials to manufacture components for APPLIANCE. But for subsidiaries that entered later in China, they faced fewer difficulties in finding local suppliers. This is because as more foreign companies enter China, they brought or lured their foreign suppliers to China, which made it easier for foreign companies to find good suppliers in China. Further, over time and greater experience working with MNC subsidiaries, local suppliers also improved their capabilities and technologies.
Other factors affecting costs
In addition to the above issues, other factors also affect the costs of MNC subsidiaries in China. Technology royalties are one factor. For example, ELEC is required to pay its HQ 3 percent of its revenue as a technology licensing fee. EQUIPMENT did not pay the technology license fee before 1997 but started to pay the fee after ’97. Such royalties increased the cost burden to the subsidiaries. Small scale or scope of operations is another factor. For IT and EQUIPMENT, small scale operations in China contributed to price and cost disadvantages. In the case of ELEC, although electric transformers include a wide range (from 25 kilo-voltage to 220 kilo-voltage), it only manufactures 25 kilo-voltage while high voltage electric transformers were manufactured by its sister subsidiaries in China. This reduced its opportunities to enjoy economies of scale and scope in manufacturing. Similarly, a manager at IT indicated that “our large competitors are able to share their resources across different product lines because they are big, but we are less able to do so due to our small size”. COMPONENT also indicated that small scale is a challenge. A manager pointed out that in its temperature-sensitive tube market, a Japanese competitor’s “volume is much bigger and they are able to charge lower prices than us”.
We find that productivity and operating efficiency also have a key impact on subsidiary’s costs (e.g. COMPONENT, SYSTEM). For example, from 1997 to 1999 ELEC increased its manufacturing productivity and reduced its production cycle. It cut operation costs such as entertainment and office equipment, and cut 7% percent of its employees and reduced interest payments. These efforts dramatically improved the subsidiary’s efficiency. Similarly COMPONENT dramatically improved its tube business through improving operating efficiency in 2002. In the past, the subsidiary used the equipment imported from the parent but the equipment is mainly suitable for producing high speed large size tubes. But in the Asian market, small size tubes are more popular and the parent’s equipment tends to have high defect rate when producing small tubes. Furthermore, the equipment from the U.S. was expensive and cost $1.5 million dollars per piece. To solve these problems, COMPONENT spent about $100,000 to develop its own equipment for small size tubes. This self developed equipment is not only cheaper, it increased productivity ten fold and has lowered the defect rate. This and other efforts helped the subsidiary to reduce its unit costs by 42%.
Costs/price competitiveness and subsidiary sales performance in China
We find that the impact of cost/price competitiveness on a subsidiary’s performance is contingent upon the types of competitors the subsidiary is facing. When MNC subsidiaries are competing with foreign competitors in the Chinese market, competitive prices are more important than when they are competing with local firms. For example, when IT was bidding its first major project in China, it out-competed foreign competitors because of their lower prices. The foreign competitors charged high prices because their software was developed by the engineers outside of China while IT developed its software locally. This is also true for SYSTEM. Its market was dominated by foreign firms and the market leader (a foreign company) offered very competitive prices. For its 300 kilowatt systems the market leader charge $120,000 less than that of SYSTEM, while for 600 kilowatt systems, $1 million less than that of SYSTEM. Similarly although APPLIANCE entered China two years after a large Japanese competitor, it surpassed the Japanese firm because APPLIANCE’s product prices were usually 20 percent lower than that of the Japanese firm. Higher efficiency and price competitiveness also helped COMPONENT to increase sales in China from 1998 to 2002.
When competing with local competitors, however, no subsidiaries were able to win through competitive prices. All subsidiaries in the study reported cost and price disadvantages compared with local competitors. We found that when competing with local firms superior product features and quality compensate the price and cost weakness of the subsidiaries The more superior the products, the less vulnerable the subsidiaries are on prices. For example, IT was doing very well in back-stage banking software (its market share exceeds the combined market share of the number 2 and number 3 firms) even though its prices were usually 30% higher than local competitors. This is because IT’s parent is a global leader in related sector and IT enjoys very good reputation in Chinese market. Similarly, the prices of COMPONENT’s underground cables were much higher than that of local competitors, yet the product was doing very well in China because of its superior quality. For example, in the 1990s when many Chinese cities experienced flood, those that did not use COMPONENT underground cables encountered cable breakdowns which caused communication disruptions and other problems while customers that used COMPONENT’s underground cables did not have face these difficulties. This high quality greatly helped COMPONENT to increase its sales in China. But when the product quality and features are not strong enough, high costs and prices hurt the performance of the subsidiaries. This is true for APPLIANCE’s microwave oven products, EQUIPMENT’s chillers and COMPONENT’s tube products. In sum, when competing with local firms, the product strengths of MNC subsidiaries need to be significant in order to offset their weakness in costs and prices.
These findings have important implications for the global integration and efficiency argument. Since the integration in inputs, in sourcing materials and in using expatriate managers are mainly on the “input” (or supply) side of subsidiaries’ operations, our results show that such “input” side integration does not help the cost competitiveness of subsidiaries in emerging markets like China. This finding is contrary to the predictions of well-established global integration and local response framework (Bartlett and Ghoshal 2000, Prahalad and Doz 1988). On the other hand, we find that if these subsidiaries are able to use their parents’ integrated networks to export their products/outputs, it would greatly help the subsidiaries to reduce costs because of its positive effect on economies of scale of the subsidiaries. Because such an export strategy requires that HQs coordinate among its subsidiaries on their product sales, we may call this output side integration. In short, our results show that for subsidiaries in emerging markets, output side integration help to reduce their costs. This finding is illustrated in figure 1.
It is important to note that this input and output integration is strictly from the perspective of cost (dis)advantages of MNC subsidiaries. We are aware that cost competitiveness is not the only factor affecting subsidiaries’ performance. Further, we acknowledge that individual subsidiary performance may not be the driving factor for MNC strategies in globally coordinating their networks. Still, we assert that individual subsidiary cost and performance factors should be taken into account for any MNC that intends to maximize the efficiency of its global network.
Our research has several limitations. First, this study is based on limited number of cases. The generalizability of the findings remains an empirical question. In addition, all the subsidiaries included in the study are joint ventures. Although our findings and arguments are not dependent upon equity structure of MNC subsidiaries (i.e., joint venture or wholly owned). It is important that future studies examine possible impacts of wholly owned and joint ventures. Second, our findings are mainly based on the cases where the subsidiaries receive (or leverage) HQ’s product capabilities or technologies. As a result, the findings may or may not apply to other situations where MNC subsidiaries leverage other types of capabilities from the HQs. For example when MNE subsidiaries receive (leverage) more efficient operational capabilities from their parents, the capabilities may reduce rather than increase the costs of the subsidiaries. In other words, the impact of leveraging HQ capabilities on the subsidiary efficiency may be contingent upon the types of the capabilities; more studies are needed to analyze this contingent relationship. Last but not least, emerging markets are very different than developed markets. This study only focuses on one of such markets-China. Future studies need to test our arguments in different emerging markets where institutional environments and cultural preferences are different.
This research may also have implications for government policy. We found that several firms, shortly after entering China, felt that they needed to begin sourcing components from local suppliers in order to be cost competitive with local firms in the industry. This signals that governments in developing countries may not need to mandate local sourcing from inward investing MNCs as these firms appear to quickly realize the necessity of this sourcing strategy for efficiency reasons. Further study in this area of political/economic policy may also help further illuminate this finding and its impact on government economic policy.