assi. final int. bus

8/2/2019 Assi. Final Int. Bus.

1/24

INTERNATIONAL TRADE THEORY

Mercantilism holds that a government can improve the economic well-being of the country by

encouraging exports and stifling imports. The result is a positive balance of trade that leads to wealth

(gold) flowing into the country.

For example, under President Mitterrand in the late 1970s and early 1980s, France sought to revitalize its

industrial base by nationalizing key industries and banks and subsidizing exports over imports. By the

mid-1980s the French government realized that the strategy was not working and began denationalizing

many of its holdings. More recently, China has proven to be a strong adherent (support) of mercantilism,

as reflected by the fact that it tries to have a positive balance with all of its trading partners.

A more useful explanation of why nations trade is provided by trade theories that focus on specialization

of effort. The theories of absolute and comparative advantage are good examples.

Theory of absolute advantage

The theory of absolute advantage holds that nations can increase their economic well-being by

specializing in the production of goods they can produce more efficiently than anyone else.

A simple example can illustrate this point. Assume that two nations, North and South, are both able to

produce two goods, cloth and grain. Assume further that labor is the only scarce factor of production and

thus the only cost with make other things constant.

Labor cost (hours) of production for one unit

Cloth Grain

North 10 20

South 20 10

Thus lower labor-hours per unit of production means lower production costs and higher productivity perlabor-hour. As seen by the data in the table, North has an absolute advantage in the production of cloth

since the cost requires only 10 labor-hours, compared to 20 labor-hours in South. Similarly, south has an

absolute advantage in the production of

grain, which it produces at a cost of 10 labor-hours, compared to 20 labor-hours in North.

Both countries gain by trade. If they specialize and exchange cloth for grain at a relative


2/24

price of 1:1, each country can employ its resources to produce a greater amount of goods.

North can import one unit of grain in exchange for one unit of cloth, thereby paying only

10 labor-hours for one unit of grain. If North had produced the grain itself, it would have used 20 labor-

hours per unit, so North gains 10 labor-hours from the trade. In the same way, South gains from trade

when it imports one unit of cloth in exchange for one unit of grain. The effective cost to South for oneunit of cloth is only the 10 labor-hours required to make its one unit of grain.

The theory of absolute advantage, as originally formulated, does not predict the exchange ratio between

cloth and grain once trade is opened, nor does it resolve the division

of the gains from trade between the two countries. Our example assumed an international

price ratio of 1:1, but this ratio (Pcloth to Pgrain) could lie between 2:1 (the pretrade price

ratio in South) and 1:2 (the pretrade price ratio in North). To determine the relative price

ratio under trade, we would have to know the total resources of each country (total labor hours available

per year), and the demand of each for both cloth and grain. In this way we could determine their relative

gains from trade for each country.

Even this simple model of absolute advantage has several important implications for international trade.

First, if a country has an absolute advantage in producing a product, it

has the potential to gain from trade. Second, the more a country is able to specialize in the

good it produces most efficiently, the greater its potential gains in national well-being.

Third, the competitive market does not evenly distribute the gains from trade withinone

country. This last implication is illustrated by the following example. Prior to trade, the grain farmers in

North work 20 hours to produce one unit of grain that could be exchanged for two units of cloth. After

trade, those who remain can exchange one unit of grain for only one unit of cloth. Thus, the remaining

grain producers are worse off under trade. Cloth producers in North, however, work 10 hours, produce

one unit of cloth, and exchange it for one unit of grain, whereas previously they received only a half unit

of grain. They are better off. If grain producers in North switch to cloth production, then 20 hours of

labor results in the production of two units of cloth, which they can exchange for two units of grain.

Thus, international trade helps them. As long as North does not specialize completely in cloth, there will

be gainers (cloth producers and grain producers who switched to cloth) and losers (those who continue

as grain producers). Because the nation as a whole benefits from trade, the gainers can compensate the

losers and there will still be a surplus to be distributed in some way. If such compensation does not take

place, however, the losers (continuing grain producers) would have an incentive to try to prevent the

country from opening itself up to trade. Historically, this problem has continued to fuel opposition to a

free trade policy that reduces barriers to trade. A good example is Japanese farmers who stand to lose

their livelihood if the government opens up Japan to lower-priced agricultural imports. A more

complicated picture of the determinants and effects of trade emerges when one of the trading partners

has an absolute advantage in the production of both goods.


3/24

However, trade under these conditions still brings gains, as David Ricardo first demonstrated in his theory

of comparative advantage

Theory of comparative advantage

The theory of comparative advantageholds that nations should produce those goods for

which they have the greatest relative advantage. In terms of the previous example of two

countries, North and South, and two commodities, cloth and grain, Ricardos model can be

illustrated as follows:

Labor cost (hours) of production for one unit

Cloth Grain

North 50 100

South 200 200

In this example North has an absolute advantage in the production of both cloth and grain, so it would

appear at first sight that trade would be unprofitable, or at least that incentives for exchange no longer

exist. Yet trade is still advantageous to both nations, provided their relativecosts of production differ.

Before trade, one unit of cloth in North costs (50/100) hours of grain, so one unit of cloth can be

exchanged for one-half unit of grain. The price of cloth is half the price of grain. In South, one unit of

cloth costs (200/200) hours of grain, or one grain unit. The price of cloth equals the price of grain. IfNorth can import more than a half unit of grain for one unit of

cloth, it will gain from trade. Similarly, if South can import one unit of cloth for less than

one unit of grain, it will also gain from trade. These relative price ratios set the boundaries for trade.

Trade is profitable between price ratios (price of cloth to price of grain) of 0.5 and 1. For example, at an

international price ratio of two-thirds, North gains. It can import one

unit of grain in return for exporting one and a half units of cloth. Because it costs only 50 hours of labor

to produce the unit of cloth, its effective cost under trade for one unit of imported grain is 75 labor-hours.

Under pretrade conditions it costs North 100 labor-hours to produce one unit of grain. Similarly, South

gains from trade by importing one unit of cloth in exchange for two-thirds unit of grain. Prior to trade,

South spent 200 labor-hours to produce the one unit of cloth. Through trade, its effective cost for one

unit of cloth is or 133 labor-hourscheaper than the domestic production cost of 200 labor

hours.

Assuming free trade between the two nations, North will tend to specialize in the production of cloth, and

South will tend to specialize in the production of grain.


4/24

This example illustrates a general principle. There are gains from trade whenever the relative price ratios

of two goods differ under international exchange from what they would be under conditions of no trade.

Such domestic conditions are often referred to as autarky/economic self seficient/, which is a government

policy of being totally self-sufficient. Research shows that free trade is superior to autarky. In particular,

free trade provides greater economic output and consumption to the trade partners jointly than they canachieve by working alone. By specializing in the production of certain goods, exporting those products for

which they have a comparative advantage, and importing those for which they have a comparative

disadvantage, the countries end up being better off.

The general conclusions of the theory of comparative advantage are the same as those for the theory of

absolute advantage. In addition, the theory of comparative advantage demonstrates that countries jointly

benefit from free trade (under the assumptions of the model) even if one has an absolute advantage in

the production ofbothgoods. Total world efficiency and consumption increase.

As with the theory of absolute advantage discussed previously, Ricardos theory of comparative

advantage does not answer the question of the distribution of gains between the two countries, nor the

distribution of gains and losses between grain producers and cloth producers within each country. No

country will lose under free trade, but in theory at least all the gains could accrue to one country and to

only one group within that country.

Factor endowment theory

In recent years more sophisticated theories have emerged that help clarify and extend our knowledge of

international trade. The factor endowment theory holds that countries will produce and export

products that use large amounts of production factors that they havein abundance, and they will import

products requiring large amounts of production factorsthat they lack. This theory is also known as the

HeckscherOhlin theory (after the two economists who first developed it).The theory is useful in

extending the concept of comparative advantage by bringing into consideration the endowment and cost

of production factors. The theory also helps explain why nations with relatively large labor forces, such as

China, will concentrate on producing labor-intensive goods, whereas countries like the Netherlands, which

has relatively more capital than labor, will specialize in capital intensive goods.

However, the factor endowment theory has some weaknesses. One weakness is that some countries

have minimum wage laws that result in high prices for relatively abundant labor.

As a result, they may find it less expensive to import certain goods than to produce them internally.

Another weakness is that countries like the United States export relatively more labor-intensive goods

and import capital-intensive goods, an outcome that appears surprising. This result, discovered by

Wassily Leontief, a Nobel Prize economist, is known as the Leontiefparadox and has been explained


5/24

in terms of the quality of labor input rather than just labor hours of work. The United States produces

and exports technology-intensive products that require highly educated labor. The Leontief paradox not

only shows one of the problems with factor endowment theory, but also helps us understand why no

single theory can explain the role of economic factors in trade theory. Simply put, the subject is too

complex to be explained with just one or two theories.

International product life cycle theory

Another theory that provides insights into international theory is Vernons international

Product life cycle (IPLC) theory

This theory addresses the various stages of a goods life cycle. In particular, the theory helps explain why

a product that begins as a nations export often ends up becoming an import. The theory also focuses onmarket expansion and technological innovation, concepts that are relatively de-emphasized in

comparative advantage theory. IPLC theory has two important tenets:

(1) technology is a critical factor in creating and developing new products; and

(2) market size and structure are important in determining trade patterns.

The IPLC has three stages: new product, maturing product, and standardized product. A new product is

one that is innovative or unique in some way. Initially, consumption is in the home country, price is

inelastic, profits are high, and the company seeks to sell to those willing to pay a premium price. As

production increases and outruns local consumption, exporting begins.

As the product enters the mature phase of its life cycle, an increasing percentage of sales are achieved

through exporting. At the same time, competitors in other advanced countries will be working to develop

substituteproducts so they can replace the initial good with one of their own. The introduction of these

substitutes and the softening of demand for the original product will eventually result in the firm that

developed the product now switching its strategy from production to market protection. Attention will

also be focused on tapping markets in less developed countries.

As the product enters the standardized product stage, the technology becomes widely diffused and

available. Production tends to shift to low-cost locations, including less developed countries and offshore

locations. In many cases the product will end up being viewed as a generic, and price will be the sole

determinant of demand.

Example :- Personal computers and the IPLC

In recent years a number of products have moved through the IPLC and are now in the


6/24

standardized product stage. Personal computers (PCs) are a good example, despite their

wide variety and the fact that some versions are in the new product and maturing product

phases. For example, the early version of PCs that reached the market in the 1984 to 1991

period were in the standardized product stage by 1995 and sold primarily on the basis of

price. Machines that entered the market in the 1996 to 1998 period were in the maturingstage by 1999. PCs with increased memory capability that were in the new product stage in

1999 quickly moved toward maturity, and by 2002 they were being replaced by even better

machines with faster processors and more multimedia capabilities. Today, diskettes are

standardized and rarely used while standard components include CD writers, DVD ROMs,

DSL and wireless Internet connectors, USB ports, advanced graphics and sound, flat LCD monitors, and

digital photography capabilities.

Desktop computers are increasingly being replaced by laptop models that are lighter, faster, more

sophisticated, and less expensive than their predecessors. In turn, these machines are being replaced by

notebooks with advanced Pentium chips, long-term battery capability, and storage capable of holding

billions of bytes complete with wireless equipment and serve as a complete communications center from

which the international executive can communicate anywhere in the world. These machines will first be

manufactured locally and then in foreign markets. Thus, computers will continue to move through an

international product life cycle.

The IPLC theory is useful in helping to explain how new technologically innovative products fit into the

world trade picture. However, because new innovative products are sometimes rapidly improved, it is

important to remember that one or two versions of them may be in the standardized product stage while

other versions are in the maturing stage and still others are in the new product phase.

Exporting is a strategy in which a company, without any marketing or production organization overseas,exports a product from its home base. It is the most traditional and well established form of operating inforeign markets. Exporting can be defined as the marketing of goods produced in one country intoanother. Whilst no direct manufacturing is required in an overseas country, significant investments inmarketing are required. The tendency may be not to obtain as much detailed marketing information ascompared to manufacturing in marketing country; however, this does not negate the need for a detailedmarketing strategy.

The advantages of exporting are:manufacturing is home based thus, it is less risky than overseas basedgives an opportunity to "learn" overseas markets before investing in bricks and mortarreduces the potential risks of operating overseas.

The disadvantage is mainly that one can be at the "mercy" of overseas agents and so the lack ofcontrol has to be weighed against the advantages. For example, in the exporting of African horticulturalproducts, the agents and Dutch flower auctions are in a position to dictate to producers.


7/24

It is interesting to note that Korey 1986 warned that direct modes of market entry may be less and lessavailable in the future. Growing trading blocks like the EU or EFTA means that the establishment ofsubsidiaries may be one of the only ways forward in future. Indirect methods of exporting include the useof trading companies (very much used for commodities like cotton, soya, cocoa), export managementcompanies, piggybacking and countertrade.

Indirect methods offer a number of advantages including:Contracts - in the operating market or worldwideCommission sates give high motivation (not necessarily loyalty)Manufacturer/exporter needs little expertiseCredit acceptance takes burden from manufacturer.

Piggybacking

Piggybacking is an interesting development. The method means that organizations with little exportingskill may use the services of one that has. Another form is the consolidation of orders by a number ofcompanies in order to take advantage of bulk buying. Normally these would be geographically adjacent orable to be served, say, on an air route. The fertilizer manufacturers of Zimbabwe, for example, could

piggyback with the South Africans who both import potassium from outside their respective countries.

Franchising: Franchising is a special form of licensing in which the franchiser makes a total marketingprogram available including the brand name, logo, products and method of operation. Usually thefranchise agreement is more comprehensive than a regular licensing agreement in as much as the totaloperation of the franchisee is prescribed. It differs from licensing principally in the depth and scope ofquality controls placed on all phases of the franchisee`s operation. The franchise concept is expandingrapidly beyond its traditional businesses (such as service stations, restaurants and real-estate brokers) toinclude less traditional formats such as travel agencies, used car dealers, the video industry andprofessional and health improvement services. About 80 percent of all McDonald`s restaurants arefranchised and as of 1999 the firm operated about 24,500 stores in 116 countries.

Licensing is an agreement that permits a foreign company to use industrial property (i.e., patents,trademarks, and copyrights), technical knowhow and skills, architectural and engineering designs, or anycombination of these in a foreign market.

It is quite similar to the "franchise" operation. Coca Cola is an excellent example of licensing. InZimbabwe, United Bottlers have the license to make Coke.

Licensing involves little expense and involvement. The only cost is signing the agreement and policing itsimplementation.

Licensing gives the following advantages:

Good way to start in foreign operations and open the door to low risk manufacturing relationshipsLinkage of parent and receiving partner interests means both get most out of marketing effortCapital not tied up in foreign operation andOptions to buy into partner exist or provision to take royalties in stock.

The disadvantages are:Limited form of participation - to length of agreement, specific product, process or trademarkPotential returns from marketing and manufacturing may be lostPartner develops know-how and so license is short


8/24

Licensees become competitors - overcome by having cross technology transfer deals andRequires considerable fact finding, planning, investigation and interpretation.

What is Contract Manufacturing?

Contract manufacturing is a process that establishes a working agreement between two companies. Aspart of the agreement, one company custom produces parts or other materials on behalf of their client.In most cases, the manufacturer also handles the ordering and shipment processes for the client. As aresult, the client does not have to maintain manufacturing facilities, purchase raw materials, or hire laborin order to produce thefinished goods.

The basic working model used by contract manufacturers translates well into many different industries.Since the process is essentiallyoutsourcingproduction to a partner who privately brands the end product,there are a number of different business ventures that can make use of a contract manufacturingarrangement.

Examples:pharmaceutical contract manufacturingcurrently functioning today, as well as similar

arrangements in food manufacturing, the creation of computer components and other forms of electroniccontract manufacturing. Even industries likepersonal careand hygiene products, automotive parts, andmedical supplies are often created under the terms of a contractmanufacture agreement.

In order to secure contract manufacturing jobs, thecontract manufacturerusually initiates discussionswith the potential client. The task is to convince the prospective customer that the manufacturer can usetheir facilities to produce quality goods that meet or exceed the expectations of the customer. At thesame time, the manufacturer demonstrates how the overallunit costof production to the customer willbe less than any current production strategies in use, thus increasing the amount of profit that will beearned from each unit sold.

Advantages to a contract manufacturing arrangement. For the manufacturer, there is the guarantee ofsteady work. Having contracts in place that commit to certain levels of production for one, two and evenfive year periods makes it much easier to forecast the future financial stability of the company. For theclient, there is no need to purchase or rent production facilities, buy equipment, purchase raw materials,or hire and train employees to produce the goods. There are also no headaches from dealing withemployees who fail to report to work, equipment that breaks down, or any of the other minor details thatany manufacturing company must face daily. All the client has to do is generate sales, forward orders tothe manufacturer, and keep accurate records of all income and expenses associated with the businessventure.

The general concept of contract manufacturing is not limited to the production of goods. Services such astelecommunications, Internet access, and cellular services can also be supplied by a central vendor andprivate branded for other customers who wish to sell those services. Doing so allows the customer toestablish a buy rate from the vendor, then resell the services at a profit to their own client base.

Contract manufacturingservices refer to theoutsourcingof some or all of a company's actualmanufacturing process to asubcontractor. The different types of contract manufacturing services includeelectronic manufacturers services, pharmaceutical manufacturing services,medical contractmanufacturing, and contract manufacturing agencies. Companies interested in outsourcing some of theiractivities can either contact the subcontractor directly or go through an agency.
http://www.wisegeek.com/what-are-finished-goods.htmhttp://www.wisegeek.com/what-are-finished-goods.htmhttp://www.wisegeek.com/what-are-finished-goods.htmhttp://www.wisegeek.com/what-is-outsourcing.htmhttp://www.wisegeek.com/what-is-outsourcing.htmhttp://www.wisegeek.com/what-is-outsourcing.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-personal-care.htmhttp://www.wisegeek.com/what-is-personal-care.htmhttp://www.wisegeek.com/what-is-personal-care.htmhttp://www.wisegeek.com/what-is-a-contract-manufacturer.htmhttp://www.wisegeek.com/what-is-a-contract-manufacturer.htmhttp://www.wisegeek.com/what-is-a-contract-manufacturer.htmhttp://www.wisegeek.com/what-is-a-unit-cost.htmhttp://www.wisegeek.com/what-is-a-unit-cost.htmhttp://www.wisegeek.com/what-is-a-unit-cost.htmhttp://www.wisegeek.com/what-is-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-outsourcing.htmhttp://www.wisegeek.com/what-is-outsourcing.htmhttp://www.wisegeek.com/what-is-outsourcing.htmhttp://www.wisegeek.com/what-is-a-subcontractor.htmhttp://www.wisegeek.com/what-is-a-subcontractor.htmhttp://www.wisegeek.com/what-is-a-subcontractor.htmhttp://www.wisegeek.com/what-is-medical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-medical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-medical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-medical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-medical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-medical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-a-subcontractor.htmhttp://www.wisegeek.com/what-is-outsourcing.htmhttp://www.wisegeek.com/what-is-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-a-unit-cost.htmhttp://www.wisegeek.com/what-is-a-contract-manufacturer.htmhttp://www.wisegeek.com/what-is-personal-care.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-outsourcing.htmhttp://www.wisegeek.com/what-are-finished-goods.htm


9/24

Electronic manufacturing services are commonly outsourced by the original equipment manufacturer(OEM). An OEM is the company that originally designed and manufactured a specific product. As thecompany grows, the manufacturing component of the business may take a secondary role to themarketing or research and development. With a greater emphasis on the core areas of the business, acompany may recognize that acontract manufacturercan build the product for less cost than it would beto manufacture it in-house.

Contract manufacturing services in theelectronics industryare widespread and range from printed circuitboard design to end of life management. An OEM can opt to outsource only the specific productmanufacturing or employ the additional services of various subcontractors to help in the distribution orlogistics of getting the product to the end consumer. Regardless of what types of contract manufacturingservices the OEM chooses to use, the design and ownership of the product still resides with the OEM andnot the subcontractor.

Pharmaceutical manufacturing services is another area of contract manufacturing. The most commonpractice in this industry is to have the actualdrug manufacturingprovided by a subcontractor while theresearch and development is solely with the original pharmaceutical corporation. Other contractmanufacturing services in the pharmaceutical industry include warehousing, distribution, packaging, andquality control audits.

Medical contract manufacturing is a combination of electronic andpharmaceutical contractmanufacturing. The products being manufactured are medical devices that may include electronics. Somemedical contract manufacturing involves providing dispensers for medicine such as an electronic insulinpump. When a company subcontracts out the medical device, it may also require the subcontractor tocoordinate with other pharmaceutical contract manufacturers to provide complete distribution of both thedevice and the pharmaceuticals to the end customer.

For companies new to outsourcing, contract manufacturing agencies are helpful in finding the rightsubcontractor to work with. The agency will meet with the company to understand what level ofoutsourcing it needs and the types of services required. The agency will then research, interview, andnarrow the list of possible subcontractors who can meet the company's demands. The company can then

simply choose from the list of candidates.

Contract Manufacturing Companies

If a business has designs for a medical device but lacks the facilities or knowledge tomanufacture the items, they will typically retain the services of a medical contractmanufacturingcompany. The entire production phase can be outsourced in this manner,including sterile packaging that conforms to applicable regulations and testing.

If a company that sells pharmaceuticals is unable to produce either medicines or theirpackaging in their own facilities, or if making their facilities capable of mass production would beexpensive, then that company is likely to look into contractmanufacturing. Pharmaceuticalcontractmanufacturingcompanies are already set up to produce large amounts ofpharmaceuticals and can do so cheaply.
http://www.wisegeek.com/what-is-a-contract-manufacturer.htmhttp://www.wisegeek.com/what-is-a-contract-manufacturer.htmhttp://www.wisegeek.com/what-is-a-contract-manufacturer.htmhttp://www.wisegeek.com/what-is-the-electronics-industry.htmhttp://www.wisegeek.com/what-is-the-electronics-industry.htmhttp://www.wisegeek.com/what-is-the-electronics-industry.htmhttp://www.wisegeek.com/what-is-drug-manufacturing.htmhttp://www.wisegeek.com/what-is-drug-manufacturing.htmhttp://www.wisegeek.com/what-is-drug-manufacturing.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-pharmaceutical-contract-manufacturing.htmhttp://www.wisegeek.com/what-is-drug-manufacturing.htmhttp://www.wisegeek.com/what-is-the-electronics-industry.htmhttp://www.wisegeek.com/what-is-a-contract-manufacturer.htm


10/24

More about Contract Manufacturing

With many businesses facing high-start up costs and limited resources, companies often turn to contractmanufacturing, also known as outsourcing. Contract manufacturing allows a company to use the productsor services that are manufactured by another external production company, vendor or third-party. Theclient will then take that product or service and use their own customer service, marketing and packaging

to sell the goods. Since there is less labor and fewer resources to rely on, contract manufacturing is oftenthe answer to many companies.

Many companies may choose to use the method of contract manufacturing to save money, time and toimprove quality of a product. The business may simply use this method because that product or service isnot the companys core business. The company can rely on the expertise and reliability of the third-party.Contract manufacturing also allows clients to free their resources for other activities within theircompany, especially if they have limited knowledge of the product or service and limit space forproduction. By working with multiple providers, companies can often get the highest possible quality forproducts while at the same time, managing costs.

Contract manufacturing can take many forms. A company may choose to hire service or subcontractorsfor labor. They might also use contract manufacturing to use a certain product or may even use a facility.The term might also refer to a business using oversea products or services, such as labor and thenimporting it to sell using their own name or label.

The method of contract manufacturing can prove quite beneficial to companies looking to provide theirconsumers with their own services or name recognition, while relying on the top-quality and often lowerproduction costs that other companies can offer. Outsourcing offers companies many ways to use cost-effective alternatives to help manage, staff and run their businesses.

Advantages and Disadvantages of Contract Manufacturing

When working with contract manufacturing there are advantages and disadvantages. The advantagesare lower costs, flexibility, access to outside expertise in selling the product, and lower capitalrequirements, since there is no need to produce anything. Contract manufacturing works if the company

gets involved with the right company. If the company were to get involved in the wrong company, thewhole process will not work. Or, the company engaging in the contract with the manufacturer mayassume too much or make the wrong assumptions. For one thing, it is hard to track prices when themarket changes, because the emphasis may be placed on the wrong company. Another problem that canoccur is the company may need to deal with suppliers for the products they are selling. However, thesupplier may only want to do deal with the original manufacturer. This may limit the company fromobtaining supplies.

In order to gain the benefits of using contract manufacturing, it is best to take a strategic approach. Hereare there areas you can focus on that will help you better prepare manage contractmanufacturing:

Timing and reason: In order for contract manufacturing to work, the timing has to be right. Is it theright time to get involved in contract manufacturing? What is the reason for getting involved with

contract manufacturing? Did you analyze your position and see the need to get into outsourcing? Doesthe company you want to get involved with offer a product that is well received? Right mindset: In order to enter into a contract manufacturing deal, the company that wants to getinvolved must have the right mindset. They may want to look at the deal as if it is really an in-housearrangement. The basic precise here is the company wants to have a certain amount of control with theproduct. They want products that are known to sell and can be predicted as to what areas or territoriesthe products will sell well at, so as to engage in affective marketing. Effective organization: To handle contract manufacturing, the business has to be developed and beeffective in selling the product that he is contracted to sell. This is very important or the whole process


11/24

will not work. There has to be stability in place along with the ability to keep grow and expand as theneed arises.

Advantages & Disadvantages of Contract Manufacturing

Contract manufacturing is a business model in which a hiring firm approaches a contract manufacturerwith a design and requests a given quota of how many units to produce and at what cost. The contractmanufacturer quotes based on labor, material costs and the difficulty of the process whereas a hiring firmfocuses on the design, marketing and sales. Usually hiring firms will ask for quotes from multiple contractmanufacturers in a bidding process before ultimately choosing one.

1. Advantage: Can be Cost-EffectiveThe use of contract manufacturers means that the hiring firm does not need to purchase expensivemanufacturing facilities, equipment, machinery, raw materials or hire specialized labor. This not onlyallows the hiring firm to focus solely on sales, advertising and marketing, it allows a firm that iscomparatively more efficient at manufacturing to carry out the process. As a result, hiring firms often

benefit from economies of scale and the purchasing power of large manufacturers. All of these factorslower production costs.

Advantage: Divides Risk

Another benefit of contract manufacturing is it spreads the risk of developing a new product acrossmultiple companies. Were a company to carry out all aspects of production single-handedly, it would betaking a huge gamble on the success of that product. As companies would essentially live or die on thesuccess of a new product, risk-taking and innovation would be disincentivized.

Disadvantage: Binding Contracts

oOnce a contract is signed with a manufacturer, the hiring firm essentially calls all theshots. This can lead to serious problems for the reputation of the manufacturer if thewrong firm is partnered with. Differences in quality standards can lead to disputes. Cost-cutting behavior on the part of the hiring firm (who cannot control labor costs) can resultin the use of lower quality materials, which can compromise the overall quality of theproduct. Consequently, through no fault of their own a manufacturer can be linked to aninferior product, possibly damaging their future business prospects.

Disadvantage: Job Losses

Contract manufacturing is essentially a form of outsourcing, much of which occurs overseas. The practiceof global outsourcing is commonly criticized by both economic nationalists and domestic labor advocates.Critics accuse transnational firms of moving jobs overseas that would otherwise be filled by domestic

workers.

Example: The shift in U.S. manufacturing from factories in the beltway to cheaper labor markets inMexico, China and India has been sharply criticized as it has put many workers out of the job--many ofwhich are too old to be retrained in new sectors.

Management contract


12/24

Management contract is a strategy used by a company with management experience with the idea ofmanaging the business or investment of a foreign owner/government for a fee.

DefinitionAgreementbetweeninvestorsorownersof aproject, and amanagement companyhired for coordinatingand overseeing acontract. It spells out theconditionsanddurationof the agreement, and themethodof

computingmanagement fees.

A management contract is a written agreement between the owner of a business and a third-partymanagement company. The details of the agreement are spelled out in the contract and can include theamount of control given to the management company, the terms of payment and the reasons underwhich the contract may be terminated. There are pros and cons to management contracts and their uses.

The Advantages of Contract Management

Contract management is an activity businesses engage in to enhance and improve their businessoperations. This process often includes using a bid or negotiation process to create a specific business

relationship with vendors or suppliers. Some industriessuch as construction, manufacturing orelectronicsuse contracts to improve their market share and the goods or services sold to consumers.

1. Lower Costso Contract management helps companies lower their business costs, whether they relate to

producing goods and services or running ancillary/suportive business operations.

Construction and manufacturing companies often contract with companies who supplyraw materials for their production process. These contracts allow companies to create ahedge against a future increase in materials costs.

Companies also use contracts to purchase or lease facilities and equipment to ensure

they receive the lowest cost possible. The bid process in particular allows companies toreceive numerous contracts and select the best one available.

2. Business RelationshipsCompanies can use contracts to create lasting business relationships. These relationshipsallow companies to develop revenue streams by consistently purchasing goods orservices from a company.

Companies can also use these relationships to find new partners for producing goods andservices.

For example, construction companies often use subcontractors to complete variousprocesses in construction projects. A subcontractor who builds a good workingrelationship with a general contractor may become the go-to company for certainprocesses.

Competitive Advantage

o A competitive advantage is the ability to produce or distribute goods and services betterthan other companies in the business environment. Using contracts can help companies
http://www.businessdictionary.com/definition/agreement.htmlhttp://www.businessdictionary.com/definition/agreement.htmlhttp://www.businessdictionary.com/definition/investor.htmlhttp://www.businessdictionary.com/definition/investor.htmlhttp://www.businessdictionary.com/definition/investor.htmlhttp://www.businessdictionary.com/definition/owner.htmlhttp://www.businessdictionary.com/definition/owner.htmlhttp://www.businessdictionary.com/definition/owner.htmlhttp://www.businessdictionary.com/definition/project.htmlhttp://www.businessdictionary.com/definition/project.htmlhttp://www.businessdictionary.com/definition/project.htmlhttp://www.businessdictionary.com/definition/management-company.htmlhttp://www.businessdictionary.com/definition/management-company.htmlhttp://www.businessdictionary.com/definition/management-company.htmlhttp://www.businessdictionary.com/definition/contract.htmlhttp://www.businessdictionary.com/definition/contract.htmlhttp://www.businessdictionary.com/definition/contract.htmlhttp://www.businessdictionary.com/definition/condition.htmlhttp://www.businessdictionary.com/definition/condition.htmlhttp://www.businessdictionary.com/definition/condition.htmlhttp://www.businessdictionary.com/definition/duration.htmlhttp://www.businessdictionary.com/definition/duration.htmlhttp://www.businessdictionary.com/definition/duration.htmlhttp://www.businessdictionary.com/definition/method.htmlhttp://www.businessdictionary.com/definition/method.htmlhttp://www.businessdictionary.com/definition/method.htmlhttp://www.businessdictionary.com/definition/computing.htmlhttp://www.businessdictionary.com/definition/management-fee.htmlhttp://www.businessdictionary.com/definition/management-fee.htmlhttp://www.businessdictionary.com/definition/management-fee.htmlhttp://www.businessdictionary.com/definition/management-fee.htmlhttp://www.businessdictionary.com/definition/computing.htmlhttp://www.businessdictionary.com/definition/method.htmlhttp://www.businessdictionary.com/definition/duration.htmlhttp://www.businessdictionary.com/definition/condition.htmlhttp://www.businessdictionary.com/definition/contract.htmlhttp://www.businessdictionary.com/definition/management-company.htmlhttp://www.businessdictionary.com/definition/project.htmlhttp://www.businessdictionary.com/definition/owner.htmlhttp://www.businessdictionary.com/definition/investor.htmlhttp://www.businessdictionary.com/definition/agreement.html


13/24

maintain their advantage by limiting the amount of economic resources in the businessenvironment.

For example, a construction company that contracts with a supplier to purchasesignificant amounts of 2-foot by 4-foot pieces of wood may prohibit other companiesfrom using this supplier. Competitors must find another supplier for this size of wood,

which can lead to using inferior lumber for construction projects.

Disadvantages of Contract Management

In contract management, businesses, government agencies and nonprofit organizations use contractorsto deliver professional services to clients. Contract management is a cost-effective way to provide moreservices than the organization has the personnel to perform itself. A contract governs what services thecontractor will provide and what compensation will be received for services rendered.

Loss of Control

o A major disadvantage of contract management is that the organization gives up aconsiderable amount of control over the services that will be provided to customers.

For example, when an IT firm contracts out the website support for its clients, its ownemployees will no longer provide day-to-day troubleshooting. This loss of control canresult in the perception of a lower level of customer service among clients.

Time Delays

o Another potential drawback of contract management is that the contractor might not beable to meet the deadlines spelled out in the contract. The business or organizationdepends on the contractor to provide important services. When established deadlinesagreed on by both parties are not met, the contracting organization loses money and

time. Some people would also call the time delay a hidden cost that is associated withthe unpredictability of this type of business relationship.

Loss of Flexibility

o Flexibility is an important part of doing business in a global economy. When theorganization outsources work to third parties, the organization reduces its capacity toadapt its internal business processes to meet the needs of clients in a dynamic businessenvironment. The most ideal contractual relationship is one in which the contractor canalso be flexible in meeting the needs of the contracting organization it serves.

Loss of Quality

o When a parent organization provides a certain level of quality in its products and services,the result is a professional reputation gained in the industry. If individuals in thecontractor company are delivering products or services on behalf of their client, a loss ofquality could have disastrous effects on the reputation of the client firm. Before usingcontract management, the firm should use a dependable request-for-proposal process tofind the most reliable contractor with a demonstrated track record of quality performance.

Compliance


14/24

o Although a service contract between client and contractor is generally viewed as a legalagreement, the client can face huge legal costs to enforce this document in the courts.The contract should include teeth, or mechanisms for ensuring that the contractor willprovide services as agreed. However, large firms should plan for unforeseencircumstances and legal costs for contractual relationships in which the contractor fails todeliver the agreed-upon products and services.

Responsibility

If you own more than one business, you may benefit from hiring a contract management company tohandle the day-to-day details of your company, leaving you time to focus on the big picture.Responsibilities you can turn over to the management team include recruiting, hiring and training yourstaff. Terminations also can be turned over to the outsiders. Instead of relying on an in-house manager,you'll be bringing on the expertise of an entire management team that usually brings to the tableexperience in a number of management areas, such as employee tax codes, marketing and accounting.

Privacy

You do give up some of your privacy and may enter into confidentiality disputes when you hand overmanagement of your company to a third party. Agreements made with vendors necessarily become opento the managers for a number of uses, ranging from ordering to price negotiations and inventory control.Employee records, including pay, insurance and personal information, become part of the managementteam's responsibility. Your own financial information also becomes accessible to the outsiders, leavingyou potentially vulnerable to fraud, ethical breaches and public exposure.

Continuity

While managers may come and go, leaving you without a consistent team in place to run youroperations, a management contract firm can change the players without affecting the continuity of yourbusiness model. The contract company may experience employee turnover, but it won't affect yourbusiness as much because of the contract you have in place that specifies how your business is to bemanaged. The contractor must maintain a level of accuracy and efficiency as spelled out in your contractthat usually is backed up by an experienced home office.

Conflicts

It can be difficult to foresee the number of conflicts that could occur with an outside contractor. Forexample, you may hire a management company to run your business and it in turn takes on themanagement of one of your suppliers. Price changes, discounts and forecasts could be compromised.Many contract management companies use a home office to handle back office duties, such as payrolland accounting. Conflicts could ensue if the company manages competitors or clients of your business.Make sure your contract provides a legal way out if you find such conflicts develop.

An assembly operation involves producing parts or components in various countries in order to gain eachcountry's comparative advantage and the subsequent assembly of these parts into a finished product.

Joint ventures

A joint venture is a partnership at corporate level formed for a specific business purpose by two or moreinvestors (from more than one country) sharing ownership and control.


15/24

Joint ventures can be defined as "an enterprise in which two or more investors share ownership andcontrol over property rights and operation".

Joint ventures are a more extensive form of participation than either exporting or licensing. In Zimbabwe,Olivine industries has a joint venture agreement with HJ Heinz in food processing.

Advantages:sharing of risk and ability to combine the local in-depth knowledge with a foreign partner with know-

how in technology or process

Joint financial strength

May be only means of entry and

May be the source of supply for a third country.

Disadvantages:Partners do not have full control of management

May be impossible to recover capital if need beDisagreement on third party markets to serve andPartners may have different views on expected benefits.

Countertrade

By far the largest indirect method of exporting is countertrade. Competitive intensity means more andmore investment in marketing. In this situation the organization may expand operations by operating inmarkets where competition is less intense but currency based exchange is not possible. Also, countriesmay wish to trade in spite of the degree of competition, but currency again is a problem. Countertradecan also be used to stimulate home industries or where raw materials are in short supply. It can, also,give a basis for reciprocal trade.

Estimates vary, but countertrade accounts for about 20-30% of world trade, involving some 90 nationsand between US $100-150 billion in value. The UN defines countertrade as "commercial transactions inwhich provisions are made, in one of a series of related contracts, for payment by deliveries of goodsand/or services in addition to, or in place of, financial settlement".

Countertrade is the modem forms of barter, except contracts are not legal and it is not covered by GATT.It can be used to circumvent import quotas.

Countertrade can take many forms. Basically two separate contracts are involved, one for the delivery ofand payment for the goods supplied and the other for the purchase of and payment for the goodsimported. The performance of one contract is not contingent on the other although the seller is in effect

accepting products and services from the importing country in partial or total settlement for his exports.There is a broad agreement that countertrade can take various forms of exchange like barter, counterpurchase, switch trading and compensation (buyback). For example, in 1986 Albania began offeringitems like spring water, tomato juice and chrome ore in exchange for a contract to build a US $60 millionfertilizer and methanol complex. Information on potential exchange can be obtained from embassies,trade missions or the EU trading desks.

Barter is the direct exchange of one good for another, although valuation of respective commodities isdifficult, so a currency is used to underpin the item's value.


16/24

Barter trade can take a number of formats. Simple barter is the least complex and oldest form ofbilateral, non-monetarised trade. Often it is called "straight", "classical" or "pure" barter. Barter is a directexchange of goods and services between two parties. Shadow prices are approximated for productsflowing in either direction. Generally no middlemen are involved. Usually contracts for no more than oneyear are concluded, however, if for longer life spans, provisions are included to handle exchange ratiofluctuations when world prices change.

Closed end barter deals are modifications of straight barter in that a buyer is found for goods taken inbarter before the contract is signed by the two trading parties. No money is involved and risks related toproduct quality are significantly reduced.

Clearing account barter, also termed clearing agreements, clearing arrangements, bilateral clearingaccounts or simply bilateral clearing, is where the principle is for the trades to balance without eitherparty having to acquire hard currency. In this form of barter, each party agrees in a single contract topurchase a specified and usually equal value of goods and services. The duration of these transactions iscommonly one year, although occasionally they may extend over a longer time period. The contract'svalue is expressed in non-convertible, clearing account units (also termed clearing dollars) that effectivelyrepresent a line of credit in the central bank of the country with no money involved.

Clearing account units are universally accepted for the accounting of trade between countries and partieswhose commercial relationships are based on bilateral agreements. The contract sets forth the goods tobe exchanged, the rates of exchange, and the length of time for completing the transaction. Limitedexport or import surpluses may be accumulated by either party for short periods. Generally, after oneyear's time, imbalances are settled by one of the following approaches: credit against the following year,acceptance of unwanted goods, payment of a previously specified penalty or payment of the difference inhard currency.

Trading specialists have also initiated the practice of buying clearing dollars at a discount for the purposeof using them to purchase saleable products. In turn, the trader may forfeit a portion of the discount tosell these products for hard currency on the international market. Compared with simple barter, clearingaccounts offer greater flexibility in the length of time for drawdown on the lines of credit and the types of

products exchanged.

Counter purchase, or buyback, is where the customer agrees to buy goods on condition that the sellerbuys some of the customer's own products in return (compensatory products). Alternatively, if exchangeis being organised at national government level then the seller agrees to purchase compensatory goodsfrom an unrelated organisation up to a pre-specified value (offset deal). The difference between the twois that contractual obligations related to counter purchase can extend over a longer period of time andthe contract requires each party to the deal to settle most or all of their account with currency or tradecredits to an agreed currency value.

Where the seller has no need for the item bought he may sell the produce on, usually at a discountedprice, to a third party. This is called a switch deal. In the past a number of tractors have been brought

into Zimbabwe from East European countries by switch deals.

Compensation (buy-backs) is where the supplier agrees to take the output of the facility over a specifiedperiod of time or to a specified volume as payment. For example, an overseas company may agree tobuild a plant in Zambia, and output over an agreed period of time or agreed volume of produce isexported to the builder until the period has elapsed. The plant then becomes the property of Zambia.

Khoury6 (1984) categorises countertrade as follows:


17/24

One problem is the marketability of products received in countertrade. This problem can be reduced bythe use of specialised trading companies which, for a fee ranging between 1 and 5% of the value of thetransaction, will provide trade related services like transportation, marketing, financing, credit extension,etc. These are ever growing in size.

Countertrade has disadvantages:

Not covered by GATT so "dumping" may occur

Quality is not of international standard so costly to the customer and trader

Variety is tow so marketing of wkat is limited

Difficult to set prices and service quality

Inconsistency of delivery and specification,

Difficult to revert to currency trading - so quality may decline further and therefore product is harder tomarket.

Figure 7.5 Classification of countertrade

Shipley and Neale7 (1988) therefore suggest the following:Ensure the benefits outweigh the disadvantages

Try to minimize the ratio of compensation goods to cash - if possible inspect the goods forspecifications

Include all transactions and other costs involved in countertrade in the nominal value specified for thegoods being sold

Avoid the possibility of error of exploitation by first gaining a thorough understanding of the customer'sbuying systems, regulations and politics,

Ensure that any compensation goods received as payment are not subject to import controls.

Despite these problems countertrade is likely "to grow as a major indirect entry method, especially indeveloping countries.

Mergers and Acquisitions:

An acquisition is a direct investment in a foreign country through the purchase of a local company.

Although international firms have always made acquisitions, the need to enter markets more quickly thanthrough building a base from scratch or entering some type of collaboration has made the acquisitionroute extremely attractive. This trend has probably been aided by the opening of many financial markets,making the acquisition of publicly traded companies much easier. Most recently even unfriendly takeovers
http://www.fao.org/docrep/W5973E/w5973e0f.jpghttp://www.fao.org/docrep/W5973E/w5973e0f.jpghttp://www.fao.org/docrep/W5973E/w5973e0f.jpg


18/24

in foreign markets are now possible. Nevertheless, international mergers and acquisitions are difficult tomake work.

A major advantage of acquisitions is that they can quickly position a firm in a new business. Bypurchasing an existing player, a firm does not have to take the time to establish its presence or developfor itself the resources it does not already possess. This can be particularly important when the critical

resources are difficult to imitate or accumulate. Acquiring an existing firm also takes a potentialcompetitor out of the market. Despite these advantages, acquisitions can have serious drawbacks. Firstand foremost, acquisitions can be a very expensive way to enter a market. In addition to the likelihood ofoverbidding, acquisitions pose a number of other challenges. Most targets contain bundles of assets andcapabilities, only some of which are of interest to the acquirer. Disposing of unwanted assets ormaintaining them in the portfolio is often done at significant cost, either in real terms or in managementtime. Although these obstacles are serious, a number of acquisitions fail on another account: the postacquisition integration process fails. Integrating an acquired company into a corporation is probably oneof the most challenging tasks confronting top management.

Distinction between Mergers and Acquisitions

Although they are often uttered in the same breath and used as though they were synonymous, theterms merger and acquisition mean slightly different things.When one company takes over another and clearly established itself as the new owner, the purchase iscalled an acquisition. From a legal point of view, thetarget companyceases to exist, the buyer"swallows" the business and the buyer's stock continues to be traded.

In the pure sense of the term, a merger happens when two firms, often of about the same size, agree togo forward as a single new company rather than remain separately owned and operated. This kind ofaction is more precisely referred to as a "merger of equals." Both companies' stocks are surrendered andnew company stock is issued in its place. For example, both Daimler-Benz and Chrysler ceased to existwhen the two firms merged, and a new company, DaimlerChrysler, was created.

In practice, however, actual mergers of equals don't happen very often. Usually, one company will buyanother and, as part of the deal's terms, simply allow the acquired firm to proclaim that the action is amerger of equals, even if it's technically an acquisition. Being bought out often carries negativeconnotations, therefore, by describing the deal as a merger, deal makers and top managers try to makethe takeover more palatable.

A purchase deal will also be called a merger when bothCEOsagree that joining together is in the bestinterest of both of their companies. But when the deal is unfriendly - that is, when the target companydoes not want to be purchased - it is always regarded as an acquisition.Whether a purchase is considered a merger or an acquisition really depends on whether the purchase isfriendly or hostile and how it is announced. In other words, the real difference lies in how the purchase iscommunicated to and received by the target company'sboard of directors, employees andshareholders.

SynergySynergyis the magic force that allows for enhanced cost efficiencies of the new business. Synergy takesthe form of revenue enhancement and cost savings. By merging, the companies hope to benefit from thefollowing:

Staff reductions - As every employee knows, mergers tend to mean job losses. Consider all themoney saved from reducing the number of staff members from accounting, marketing and otherdepartments. Job cuts will also include the former CEO, who typically leaves with a compensationpackage.
http://www.investopedia.com/terms/t/targetfirm.asphttp://www.investopedia.com/terms/t/targetfirm.asphttp://www.investopedia.com/terms/t/targetfirm.asphttp://www.investopedia.com/terms/c/ceo.asphttp://www.investopedia.com/terms/c/ceo.asphttp://www.investopedia.com/terms/c/ceo.asphttp://www.investopedia.com/terms/b/boardofdirectors.asphttp://www.investopedia.com/terms/b/boardofdirectors.asphttp://www.investopedia.com/terms/b/boardofdirectors.asphttp://www.investopedia.com/terms/s/shareholder.asphttp://www.investopedia.com/terms/s/shareholder.asphttp://www.investopedia.com/terms/s/shareholder.asphttp://www.investopedia.com/terms/s/synergy.asphttp://www.investopedia.com/terms/s/synergy.asphttp://www.investopedia.com/terms/s/synergy.asphttp://www.investopedia.com/terms/s/shareholder.asphttp://www.investopedia.com/terms/b/boardofdirectors.asphttp://www.investopedia.com/terms/c/ceo.asphttp://www.investopedia.com/terms/t/targetfirm.asp


19/24

Economies of scale- Yes, size matters. Whether it's purchasing stationery or a new corporate ITsystem, a bigger company placing the orders can save more on costs. Mergers also translate intoimproved purchasing power to buy equipment or office supplies - when placing larger orders,companies have a greater ability to negotiate prices with their suppliers.

Acquiring new technology - To stay competitive, companies need to stay on top of technologicaldevelopments and their business applications. By buying a smaller company with unique

technologies, a large company can maintain or develop a competitive edge. Improved market reach and industry visibility - Companies buy companies to reach new markets

and grow revenues and earnings. A merge may expand two companies' marketing anddistribution, giving them new sales opportunities. A merger can also improve a company'sstanding in the investment community: bigger firms often have an easier time raising capital thansmaller ones.

That said, achieving synergy is easier said than done - it is not automatically realized once two companiesmerge. Sure, there ought to be economies of scale when two businesses are combined, but sometimes amerger does just the opposite. In many cases, one and one add up to less than two.

Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal makers.Where there is no value to be created, the CEO and investment bankers - who have much to gain from a

successful M&A deal - will try to create an image of enhanced value. The market, however, eventuallysees through this and penalizes the company by assigning it adiscountedshare price.

Varieties of MergersFrom the perspective of business structures, there is a whole host of different mergers. Here are a fewtypes, distinguished by the relationship between the two companies that are merging:

Horizontal merger- Two companies that are in direct competition and share the same productlines and markets.

Vertical merger- A customer and company or a supplier and company. Think of a cone suppliermerging with an ice cream maker.

Market-extension merger - Two companies that sell the same products in different markets. Product-extension merger - Two companies selling different but related products in the same

market. Conglomeration- Two companies that have no common business areas.

There are two types of mergers that are distinguished by how the merger is financed. Each hascertain implications for the companies involved and for investors:

o Purchase Mergers - As the name suggests, this kind of merger occurs when one companypurchases another. The purchase is made with cash or through the issue of some kind ofdebt instrument; the sale is taxable.

Acquiring companies often prefer this type of merger because it can provide them with atax benefit. Acquired assets can be written-up to the actual purchase price, and thedifference between thebook valueand the purchase price of the assets candepreciateannually, reducing taxes payable by the acquiring company. We will discuss this further

in part four of this tutorial.o Consolidation Mergers - With this merger, a brand new company is formed and both

companies are bought and combined under the new entity. The tax terms are the sameas those of a purchase merger.

AcquisitionsAs you can see, an acquisition may be only slightly different from a merger. In fact, it may be different inname only. Like mergers, acquisitions are actions through which companies seek economies of scale,efficiencies and enhanced market visibility. Unlike all mergers, all acquisitions involve one firm purchasinganother - there is no exchange of stock orconsolidationas a new company. Acquisitions are often
http://www.investopedia.com/terms/e/economiesofscale.asphttp://www.investopedia.com/terms/e/economiesofscale.asphttp://www.investopedia.com/terms/d/discount.asphttp://www.investopedia.com/terms/d/discount.asphttp://www.investopedia.com/terms/d/discount.asphttp://www.investopedia.com/terms/h/horizontalmerger.asphttp://www.investopedia.com/terms/h/horizontalmerger.asphttp://www.investopedia.com/terms/v/verticalmerger.asphttp://www.investopedia.com/terms/v/verticalmerger.asphttp://www.investopedia.com/terms/c/conglomerate.asphttp://www.investopedia.com/terms/c/conglomerate.asphttp://www.investopedia.com/terms/d/debtfinancing.asphttp://www.investopedia.com/terms/d/debtfinancing.asphttp://www.investopedia.com/terms/b/bookvalue.asphttp://www.investopedia.com/terms/b/bookvalue.asphttp://www.investopedia.com/terms/b/bookvalue.asphttp://www.investopedia.com/terms/d/depreciation.asphttp://www.investopedia.com/terms/d/depreciation.asphttp://www.investopedia.com/terms/d/depreciation.asphttp://www.investopedia.com/terms/c/consolidationphase.asphttp://www.investopedia.com/terms/c/consolidationphase.asphttp://www.investopedia.com/terms/c/consolidationphase.asphttp://www.investopedia.com/terms/c/consolidationphase.asphttp://www.investopedia.com/terms/d/depreciation.asphttp://www.investopedia.com/terms/b/bookvalue.asphttp://www.investopedia.com/terms/d/debtfinancing.asphttp://www.investopedia.com/terms/c/conglomerate.asphttp://www.investopedia.com/terms/v/verticalmerger.asphttp://www.investopedia.com/terms/h/horizontalmerger.asphttp://www.investopedia.com/terms/d/discount.asphttp://www.investopedia.com/terms/e/economiesofscale.asp


20/24

congenial, and all parties feel satisfied with the deal. Other times, acquisitions are more hostile.

In an acquisition, as in some of the merger deals we discuss above, a company can buy anothercompany with cash, stock or a combination of the two. Another possibility, which is common in smallerdeals, is for one company to acquire all the assets of another company. Company X buys all of CompanyY's assets for cash, which means that Company Y will have only cash (and debt, if they had debt before).

Of course, Company Y becomes merely a shell and will eventuallyliquidateor enter another area ofbusiness.

Another type of acquisition is areverse merger, a deal that enables aprivate companyto get publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strongprospects and is eager to raise financing buys a publicly-listed shell company, usually one with nobusiness and limited assets. The private company reverse merges into thepublic company, and togetherthey become an entirely new public corporation with tradable shares.

Regardless of their category or structure, all mergers and acquisitions have one common goal: they areall meant to create synergy that makes the value of the combined companies greater than the sum of thetwo parts. The success of a merger or acquisition depends on whether this synergy is achieved.

Advantages

- quick market penetration

- synergy

Disadvantages- host country's resentment

- high acquisition costs

- unforeseen problems

Advantages

A merger does not require cash.

A merger may be accomplished tax-free for both parties.

A merger lets the target (in effect, the seller) realize the appreciation potential of the merged entity,instead of being limited to sales proceeds.

A merger allows the shareholders of smaller entities to own a smaller piece of a larger pie, increasingtheir overall net worth.

A merger of a privately held company into a publicly held company allows the target companyshareholders to receive a public company's stock, despite the liquidity restrictions of SEC Rule 144a.

A merger allows the acquirer to avoid many of the costly and time-consuming aspects of assetpurchases, such as the assignment of leases and bulk-sales notifications.
http://www.investopedia.com/terms/l/liquidation.asphttp://www.investopedia.com/terms/l/liquidation.asphttp://www.investopedia.com/terms/l/liquidation.asphttp://www.investopedia.com/terms/r/reversetakeover.asphttp://www.investopedia.com/terms/r/reversetakeover.asphttp://www.investopedia.com/terms/r/reversetakeover.asphttp://www.investopedia.com/terms/p/privatecompany.asphttp://www.investopedia.com/terms/p/privatecompany.asphttp://www.investopedia.com/terms/p/privatecompany.asphttp://www.investopedia.com/terms/p/publiccompany.asphttp://www.investopedia.com/terms/p/publiccompany.asphttp://www.investopedia.com/terms/p/publiccompany.asphttp://www.investopedia.com/terms/p/publiccompany.asphttp://www.investopedia.com/terms/p/privatecompany.asphttp://www.investopedia.com/terms/r/reversetakeover.asphttp://www.investopedia.com/terms/l/liquidation.asp


21/24

Of considerable importance when there are minority stockholders is the fact that upon obtaining therequired number of votes in support of the merger, the transaction becomes effective and dissentingshareholders are obliged to go along.

The disadvantages of mergers and acquisitions are:Diseconomies of scale if business becomes too large, which leads to higher unit costs.

Clashes of culture between different types of businesses can occur, reducing the effectiveness of theintegration.May need to make some workers redundant, especially at management levels - this may have an effecton motivation.May be a conflict of objectives between different businesses, meaning decisions are more difficult tomake and causing disruption in the running of the business.

Strategic Alliances

Strategic Alliances: A more recent phenomenon is the development of a range of strategic alliances.Alliances are different from traditional joint ventures in which two partners contribute a fixed amount ofresources and the venture develops on its own. In an alliance, two entire firms pool their resources

directly in a collaboration that goes beyond the limits of a joint venture. Although a new entity may beformed, it is not a requirement. Sometimes, the alliance is supported by some equity acquisition of one orboth of the partners. In an alliance, each partner brings a particular skill or resource-usually they arecomplementary-and by joining forces, each expects to profit from the other`s experience. Typically,alliances involve either distribution access, technology transfers or production technology with eachpartner contributing a different element to the venture. Alliances can be in the forms oftechnology-basedalliances, production-based alliances or distribution-based alliances.

Although many alliances have been forged in a large number of industries, the evidence is not yet in asto whether these alliances will actually become successful business ventures. Experience suggests thatalliances with two equal partners are more difficult to manage than those with a dominant partner. Inparticular, it is important to recognize that the needs and aspirations of partners may change over the lifeof an alliance and do so in divergent ways. Predicting what the goals and incentives of the various partieswill be under various circumstances is a critical part of effective planning. Furthermore, many observersquestion the value of entering alliances with technological competitors, such as between western andJapanese firms. The challenge in making an alliance work lies in the creation of multiple layers ofconnections or webs that reach across the partner organizations. Eventually such connections will resultin the creation of new organizations out of the cooperating parts of the partners. In that sense, alliancesmay very well be just an intermediate stage until a new company can be formed or until the dominantpartner assumes control.

Advantages And Disadvantages Of Strategic Alliance

When a company has built strategic business alliance with other partners, they are preparing the enjoy ofthe following benefits/advantages. (especially for foreign partners)

1. They gain better access to attractive country market from host countrys government to import andmarket products locally

2.Take advantage of partners local market knowledge and working relationships with key governmentofficials in host country. It is very important to get working relationship with local government officials,(social capitals).

3. Capture economies of scale in production and/or marketing, when they operate together, they can usethe same machine or equipment to produce products and use the same marketing channel for both


22/24

products.

4. Fill gaps in technical expertise or knowledge of local market; they will learn technical knowledge fromeach other.

5. Share distribution facilities and dealer networks, they can use the same agent or retailers to reduce

the logistic cost and penetrate the market more easily, they can use the put-together technical andfinancial resources to attack the rivals.

6. Direct combined competitive energies toward defeating mutual rivals

7. Useful way to gain agreement on important technical standards, it is easier to set up a standard forthe products with a joint effort.

8. Can reduce the cost and more efficient to penetrate the market by doing the followings:a. Joint research effortsb. Technology-sharingc. Joint use of production and distribution facilitiesd. Marketing/promoting one anothers products.

Is everything perfect for building partnership? Of course not! Everything comes with its own pros andcons.

Here are the drawback/disadvantages of partnership:

1.Overcoming language and cultural barriers

2. Dealing with diverse or conflicting operating practices

3. Time consuming for managers in terms of communication, trust-building, and coordination costs

4. Mistrust when collaborating in competitively sensitive areas

5. Clash of egos and company cultures

6. Dealing with conflicting objectives, strategies, corporate values, and ethical standards

7. Becoming too dependent on another firm for essential expertise over the long-term

Advantages of the Global Strategic Alliance

There are many specific advantages of a global strategic alliance. You can:

Get instant market access, or at least speed your entry into a new market. Exploit new opportunities to strengthen your position in a market where you already have a

foothold. Increase sales. Gain new skills and technology. Develop new products at a profit. Share fixed costs and resources. Enlarge your distribution channels.


23/24

Broaden your business and political contact base. Gain greater knowledge of international customs and culture. Enhance your image in the world marketplace.

Disadvantages of the Global Strategic Alliance

There are also some inevitable trade-offs to consider:

Weaker management involvement or less equity stake. Fear of market insulation due to local partner's presence. Less efficient communication. Poor resource allocation. Difficult to keep objectives on target over time. Loss of control over such important issues as product quality, operating costs, employees, etc.

For example, if you enter into a global strategic alliance with even a little less equity stake -- say, 49% --you lose managerial control. You may end up with that equity percentage because the host governmentonly allows up to 49% for an outsider, because you could only negotiate that amount, or because you

were willing to accept a minority stake in exchange for gains (e.g., responsibility for research anddevelopment) that you thought important during the negotiation phase. Whatever the reason, what areyou going to do if profits plummet, product quality deteriorates, or customers are dissatisfied? You do nothave enough interest in the venture to take action. Your 49% can swiftly depreciate when it comes toexercising any control. In any partnership, the majority interest holder tends to dominate, putting theirneeds first, their partner's last. The ideal situation is a 50-50 partnership which allows both parties toshare in mutual successes, but if you do settle for a minority interest, make sure you maintain enoughcontrol to accomplish your objectives in the target market.

It's also critical to explore all the legal and financial implications before entering into a partnership withan overseas company. Seek legal counsel that is well-experienced in international trade, acquisitions,joint ventures and divestitures to go over the best and worst-case scenarios with you. You should hirecounsel both in your own country and the host country for maximum protection of your rights. You arenot only seeking to ensure the fundamental integrity of the partnership, but to work out crucialentitlements and obligations such as copyrights, trademarks, patents, taxes, antitrust and exchangecontrols.

You will also need to keep informed about the host country's political and economic stability. Get in touchwith the local economic development offices within the host country. They should be able to assess thecountry's future investment climate, and to provide you with past, present and future growth trends. Thiswill give you a better idea of what kind of risks you will incur, if any, if you go ahead with the alliance.


24/24

assi. final int. bus

Documents