7 Major Forms of Contractual Expansion Modes | International Business (2024)

This article throws light upon the seven major forms of contractual expansion modes of international business. The modes are: 1. International strategic alliance 2. International contract manufacturing 3. International management contracts 4. Turnkey projects 5. International leasing 6. International licensing 7. International franchising.

Contractual Expansion: Mode # 1.

International Strategic Alliance:

When a firm agrees to cooperate with one or more than one firm overseas, to carry out a business activity wherein each one contributes its different capabilities and strengths to the alliance, this is termed as an international strategic alliance. Such strategic alliances are long-term formal relationships for mutual benefit.

A firm has to be globally cooperative to be globally competitive. Rapid growth in global strategic alliance among large and small firms around the world highlights the significance of global strategic alliances. Perlmuter and Hennan term such strategic alliance as Global Strategic Partnership (GSP) in which.

i. Two or more companies develop a common, long-term strategy aimed at world leadership as low-cost suppliers, differentiated marketers, or both, in an international arena.

ii. The relationship is reciprocal. The partners possess specific strengths that they are prepared to share with their colleagues.

iii. The partners’ efforts are global, extending beyond a few developed countries to include nations of the newly industrialising, less developed and socialist world.

iv. The relationship is organized along horizontal, not vertical, lines; technology exchanges, resource pooling and other ‘soft’ forms of combinations.

v. The participating companies retain their national and ideological identities while competing in those markets excluded from the partnership.

The Dutch electronics giant Philips has made a major strategic shift in its 100-years old corporate culture of self-sufficiency, heavily relying on multiple strategic alliances with external firms, as given in Exhibit 11.1.

Such global strategic alliances are aimed at blunting the forces of American, Japanese and more recently, Korean and Taiwanese competition in high-quality electronics and reducing the company’s dependence on Europe, where one-half of its sales and almost two-thirds of its workforce and assets are located.

Philips mikes use of its global strategic alliance to have a balance of its business operations in major markets across the world.

The major advantages of international strategic alliances include the following:

i. The investment cost is shared.

ii. The internationalizing firm gets access to tangible and intangible resources of the alliance partner.

iii. There is reduction in individual risks while operating overseas.

iv. The alliance partners often cooperate so as to make use of their specific individual strengths.

v. Strategic alliances often promotes co-operation among competitors for mutual benefit.

However, the limitations of strategic alliance are that:

i. A firm has to share internal resources and information with its alliance partner

ii. Goal incompatibility with alliance partner leads to conflict

iii. Sharing resources may also nurture future competitors

Star Alliance (Fig. 11.5) launched on 14 May 1997, a strategic alliance in the airlines industry, is the largest in the world that runs about 18,100 daily flights to 975 airports in 162 countries, having a total fleet of 3,360, aircraft carrying about 510 million passengers annually.

It includes major airlines, such as Air Canada, USA Airways, United Airlines, All Nippon Airways, Lufthansa, Air New Zealand, Asian Airline, Austrian, BMI, South African Airways, Swiss International, Thai Airways, Singapore Airline, and Scandinavian Airlines.

The points of cooperation among the partner airlines in the Star Alliance are:

i. Frequent flyer programme integration allows airline miles to be earned and redeemed on all members of the alliance at the same level.

ii. Premium customers of the alliance have access to all members’ airport lounges.

iii. Flight schedules are coordinated to permit almost seamless travel which may include several different carriers within the alliance, on a single ticket.

iv. Special fares for round-the-world and similar travel using alliance members offer discounts over booking individual itineraries.

v. Customer service processes are harmonized in an effort to promote a consistent experience.

vi. There is cooperation in development of a common information technology platform.

The alliance developed the ‘regional’ concept in 2004 which helps it penetrate individual markets through regional carriers, which requires sponsorship from existing members. Star Alliance was voted the best airline alliance in the 2005 World Airline Award for the second time in three years.

Due to high level of R&D intensity and resources involved, worldwide strategic alliances are common in IT and other high-tech industries. Exhibit 11.2 illustrates Infosys’ global strategic alliance with leading IT firms around the world.

India’s largest pharmaceutical company Ranbaxy entered into a strategic alliance in 2005 with Nippon Chemiphar Ltd for joint-marketing their products in Japan.

Shilla Hotels and Resorts of Korea forged a marketing alliance with India’s Taj Hotels to develop cross-promotional opportunities for both companies to harness each other’s strengths in their respective markets of dominance. Taj Hotels also entered a marketing alliance in 2004 with Raffles Hotel in Singapore.

Contractual Expansion: Mode # 2.

International Contract Manufacturing:

In order to take advantage of lower costs of production, a firm may sub-contract manufacturing in a foreign country. International sub-contracting arrangements may involve supply of inputs, such as raw materials, semi-finished goods, components and technical know-how to a local manufacturer in a foreign country.

The contract manufacturer limits itself to production activities whereas marketing is taken care of by the internationalizing firm. A processing fee is paid to a foreign-based manufacturer who is primarily responsible for processing or assembly.

Overseas-based contract manufacturers are often expected to supply the goods directly to the firm’s clients and invoice for processing fee to the internationalizing firm, as elucidated in Fig. 11.6. The firm in turn directly raises invoice for finished goods to its customer.

Globalization of business technology and increasing pressure on international firms to be globally competitive in their costs, product offerings, speed in bringing new products into the market, quality, and customer service have been the primary driving forces of international contract manufacturing. A number of global companies outsource their manufacturing activities to low-cost locations.

A substantial part of manufactured exports comes from such activities. Contract manufacturing has also been used as a strategic tool for economic development in a number of countries, such as Korea, Mexico, Thailand, China, etc. For instance, Taiwan is a world leader in semi-conductor manufacturing.

China produces 30 per cent of air conditioners, 24 per cent of washing machines, and 16 per cent of refrigerators sold in the US.

Nike, the leading international shoe brand, does not own a single production facility and gets its manufacturing done through contract manufacturing throughout the world. It provides raw materials and manufacturing know-how to contract manufacturers for manufacturing shoes in Asian countries, such as China, Vietnam, Indonesia, Thailand, and Bangladesh for payment of processing fees.

However, Nike maintains its proprietary rights over materials and products, and exerts stringent control over production processes and product quality.

Indian pharmaceutical companies find contract manufacturing an effective tool for maintaining a high growth rate in view of limited resources for research and development. Ranbaxy and Lupin Laboratories were among the first Indian companies to get manufacturing contracts from multinational companies, Eli Lilly and Cynamid.

When Ranbaxy developed an alternative process for manufacturing Eli Lilly’s patented drug Cefaclor, the American company became concerned that the low-cost drug manufactured by the Indian company would take away its market share in countries which do not recognize product patents.

Subsequently, Wockhardt India, Cadila Health Care, Sun Pharma, and Dr. Reddy’s Laboratories Ltd have also entered into contract manufacturing with several overseas firms.

Contract manufacturing provides an excellent opportunity to firms located in developing countries, including India, to take advantage of their strategic strength of low labour cost and ample availability of skilled and semi-skilled human resources to make their product available in international markets.

This opens up new avenues, especially for firms with strong production bases but limited resources and skills to market the products internationally.

Contractual Expansion: Mode # 3.

International management contracts:

A firm that possesses technical skills or management know-how can expand overseas by providing its managerial and technical expertise on contractual basis. It has widespread acceptance in industries and countries that lack indigenous expertise to manage their own projects.

Under a management contract, a firm offers a variety of management or technical services, such as technical support to run a production facility, training, and management.

A management contract is a feasible option when a company provides superior technical and managerial skills to an overseas company, which needs such assistance to remain competitive in the market or to improve its productivity or performance.

For instance, Indian companies have a large reservoir of skilled manpower and a great potential to undertake international management contracts by way of transferring the technical expertise of their professional manpower to other countries. Management contracts are common in the hotel industry so as to take advantage of economies of scale, brand equity, and global reservation system.

International expansion strategy of Global Hyatt Corporation is primarily based on managing over 216 hotels across 44 countries through management contracts. In order to prevent dilution of quality and hence brand erosion, it ensures that all the properties under its management contract follow and maintain rules, regulations, benchmark practices, and standards as per its corporate policy.

Similarly, India’s Taj Hotels have also employed management contracts (Exhibit 11.3) for international expansion.

Engineers India Ltd (EIL) got a project management contract for providing project consultancy for the revamp and up-gradation of the Skikda Refinery in Algeria in February 2005 and for up-gradation of tank farm area in Abu Dhabi in August 2005.

Contractual Expansion: Mode # 4.

Turnkey Projects:

A company may expand internationally by making use of its core competencies in designing and executing infrastructure, plants, or manufacturing facilities overseas. Conceptually, ‘turnkey’ means’ handing over a project to the client, when it is complete in all respect and is ‘ready to use’ on ‘turning the key’.

International turnkey projects include conceptualizing, designing, constructing, installing, and carrying out preliminary testing of manufacturing facilities or engineering projects at overseas locations for a client organization. It often includes providing training to the chent’s personnel to operate the plant.

The major types of turnkey project include the following:

Build and transfer (BT):

The firm conceptualizes designs, builds, carries out primary testing, and transfers the project to the owner. Important issues negotiated with the overseas firm include design specifications, price, make and source of equipment, man specifications, performance schedules, payment terms, and buyer’s support system.

Build, operate, and transfer (BOX):

The internationalizing firm not only builds the project but also manages it for a contracted period before transferring it to the foreign owner. During the operational period, the functional viability of the project is established and the technical and managerial staff of the buyer may be trained during this period. However, the exporting company needs additional resources and competence to run such a project.

Build, operate, and own (BOO):

The internationalizing firm is expected to buy the project once it has been built, which results in foreign direct investment after a certain time period. For executing projects on BOO basis, the exporting company has to be highly integrated, providing technical and management services, besides having experience in owning and controlling infrastructure projects.

The global market leader in telecommunications, Nokia, used enterprise solution providing and networking to key players in emerging markets as strategic business expansion strategy.

It focused upon providing turnkey solutions to India’s state-owned telecom giant, Bharat Sanchar Nigam Limited (BSNL). In 2004, Nokia was awarded a US$284 million deal with BSNL for network expansion project in North India to tap about two million additional subscribers.

Besides, Nokia is likely to provide turnkey solution to Idea cellular to launch Nokia’s Intelligent Content Delivery System (ICDS) on all Idea mobile networks across India.

Construction and engineering projects are often highly capital-intensive, involving extremely in-depth engineering, and are usually cross-country in nature of execution. Therefore, such projects are carried out at turnkey basis. Besides, these projects also involve strategic alliances, international process/engineering licensees (in case of patented process), sub-contracting, management contracts, etc.

One of the world’s premier engineering, construction, and project management companies, Bechtel, with a fleet of 40,000 employees and 40 offices around the world has completed more than 22,000 projects on turnkey and contractual basis in more than 140 countries.

Overseas Construction Council of India is the nodal Indian export promotion agency for project exports. A number of engineering firms, such as Engineers India Ltd (EIL), Voltas, Larsen & Toubro (Fig. 11.7), Ircon International Ltd, and Balmer Lawrie & Company, have carried out several overseas projects on turnkey basis.

Contractual Expansion: Mode # 5.

International Leasing:

In low-income countries, manufacturers often do not possess enough financial resources or necessary foreign currency to pay for equipment and machinery. A firm can expand its business by leasing out new and used equipment to a manufacturing firm in such countries.

The ownership of the property retains with the leasing firm (i.e., lessor) throughout the lease period during which the foreign-based user (i.e., lessee) pays leasing fee.

Leasing provides international business opportunities by rapid market access using idle and obsolete equipment in an efficient manner. It also benefits low- income country-based manufacturers to reduce cost of getting machinery and equipment from overseas and reduces investment and operational risks.

International Lease Finance Corporation (ILFC), headquartered in Los Angles, is the largest aircraft lessor by value that had an inventory of about 1000 aircrafts by 2008. It leases Airbus and Boeing aircraft to airlines worldwide, such as Emirates, Lufthansa, Air France, KLM, American Airlines, Continental, Vietnam Airlines, etc.

Contractual Expansion: Mode # 6.

International Licensing:

In licensing, a firm makes its intangible assets, such as patents, trademarks and copyrights, technical know-how and skills (technical guidance, feasibility and product studies, manuals, engineering, designs, etc.) available to a foreign company for a fee termed as royalty.

The home-based firm transferring the intellectual property is known as the licensor whereas the foreign based firm is known as licensee. The licensee makes use of these intangible assets in production processes. International licensing is common in pharmaceuticals, toys, machine tools, publishing, etc.

Licensing serves as a powerful tool for international expansion with little financial commitment. A firm’s limited financial resources to invest in several countries and lack of foreign market knowledge influences a company to expand business overseas by way of licensing.

Besides, licensing is often adopted in view of environmental factors, such as country entry barriers, to curb product piracy and counterfeiting, and for expanding into countries where the market size is not large enough to justify higher investments.

Arrow, ‘America’s shirt maker since 1851’ follows the licensing strategy to expand worldwide. Presently, it has licensees in more than 90 countries, with a wholesale value approaching US$300 million.

It entered India in 1993 through licensing to Arvind Clothing, a wholly owned subsidiary of Arvind Mills Ltd. Arrow became the market leader in India in the premium man’s shirt category. Phillips Van Heusen was the licensee for Arrow shirts and sportswear in the US market and generated sales of up to US$170 million through licenses.

Licensing may involve either process or trade-mark licensing agreement, as discussed here.

Process licensing:

The licensee gets the right to manufacture, produce, and market the product in the defined market area.

Trade-mark licensing:

The licensee also gets the rights to use trade-marks/trade- names, besides using the process know-how. Trade-mark licensing is used as an effective strategy to control counterfeit products in the market. However, over-licensing may damage the firm’s interest in the long-run. For instance, the brand equity of Pierre Cardin was considerable affected adversely consequent to its licensing about 800 brands.

The licensee makes a payment of royalties to the licensor in exchange for intellectual property by any one or a combination of following methods:

i. A lump-sum payment is made in the beginning after initial transfer of intangible assets, such as know-how, drawings and designs, blueprints, spare parts, machinery, etc., not related to the output of production processes

ii. A minimum annual royalty guaranteed to the licensor

iii. Continued royalty computed as a percentage of sales revenue or amount per unit of output

While expanding to countries with unstable business environment by way of high political and economic risks, higher initial payment and shorter duration of agreement is preferred. International licensors need to adopt a competitive strategy to gain market share in relatively low-risk countries with sizeable markets.

Licensing arrangements from CIS countries do involve other forms of payments, such as technical and management fee, conversion of royalties into equity, etc.

International licensing facilitates foreign-based firms to access established products, processes, and brand names with little investment in in-house R&D. It also enables them to access the know-how and technology that is otherwise not available due to government restrictions on inward foreign investment.

The US firm Qualcomm owns the bulk of the intellectual property behind the Code Division Multiple Access (CDMA) standards and thus earns substantial profits from royalty when companies like Nokia make CDMA products.

The Indian pharmaceutical company Dr Reddy’s licenses its anti-diabetic molecules, DRF 2593 (Balaghtazone) and DRF 2725 (Ragaglitazar) to Novo Nordisk, a Danish firm that is the world leader in diabetes care. Asian Paints adopted technology and brand licensing for its international expansion (Exhibit 11.4).

The limitations of international licensing include problems related to maintaining product quality by the licensee, leading to sullying the brand image of the licensor. Licensing may also restrict the licensor’s future activities in the Country. Besides transferring know-how and technology outside the firm may nurture a future competitor, thus having an adverse impact on the firm’s long term interests.

Cross-licensing:

It is a form of licensing involving mutual exchange of intangible assets that may not involve a cash payment. In cross-licensing, companies swap their intellectual property for mutual benefit. Thus, cross-licensing is the mutual sharing of patents between two companies without exchange of licensing fee. It is used extensively by software companies to pile up more licenses.

Contractual Expansion: Mode # 7.

International Franchising:

Franchising is a special form of licensing in which an internationalizing firm (known as franchisor) provides intangible assets, such as trademarks, process know-how, etc., and methods of doing business in a prescribed manner in return for a franchising fee.

The term ‘franchising’ is derived from the French word francorum rex which means ‘freedom from servitude’. In franchising, the franchisor grants the franchisee the right to carry out business in a prescribed manner in a specified place for a pre-decided period of time.

Franchising is a low-risk low-cost business expansion mode enabling a firm to simultaneously expand in multiple countries with little financial commitments. It actively involves small independent investors who have adequate working capital but little or no prior business experience.

In legal terms, franchising as a business expansion mode has four distinct 12 characteristics:

i. A contractual relationship in which the franchisor licenses the franchisee to carry out business under a name owned by or associated with the franchisor and in accordance with a business format established by the franchisor

ii. Control by the franchisor over the way in which the franchisee carries on the business

iii. Provision of assistance to the franchisee by the franchisor in running the business both prior to commencement and throughout the period of contract

iv. The franchisee owns his/her business, which is a separate entity from that of the franchisor; the franchisee provides the capital and assumes risks in the venture

International franchising is beneficial as it:

i. Facilitates rapid country entry with low risk

ii. Requires low investment and overheads

iii. Avoids day-to-day hassles of business operations

iv. Makes use of local entrepreneurs as business partners and their skills

Apart from benefiting the franchisor, franchising is also advantageous to the franchisee because:

i. It facilitates speedy transfer of technology and business skills

ii. It provides access to well-established products and brand names

iii. It makes available standardized and tried and tested processes

iv. It benefits from shared responsibility

v. International market promotions by the franchisor help in marketing

vi. It involves legal independence

The internationalizing firm exerts much higher control over its franchisee so as to ensure quality standards across countries. Besides, transfer of business know-how is also an on-going process. Franchising is widely used in international business expansion of fast food chains and the hotel industry.

Franchising offers greater control over international business operations, involves longer commitment, and on-going transfer of intellectual property and know-how. The top global franchisors include Subway, Quiznos Sub, Curves, SPS Stone, the Pizza Hut Inc, WSI Internet, and KFC Corp.

Franchising is widely used in the service sector wherein transfer of intangible assets and other assistance is required for an extended period. Thus, a firm has a greater degree of control over its franchising operation compared to licensing.

However, franchising also has its own limitations for the internationalizing firm:

i. Restrictive host country regulations

ii. Problems in identifying and selecting right franchisees

iii. Franchisor gets ‘franchising fee’ rather than sharing the profits

iv. Lack of direct control over franchisee operations

v. It adversely affects the brand equity if quality is lowered by the franchisee

vi. There are uncertainties and conflicts in receiving franchising fee

vii. Franchisor does not gain market knowledge even after firm’s overseas presence for a considerable time

OSIM International Limited, the Singapore-based manufacturer of lifestyle products primarily expands internationally through franchising. OSIM has entered into a Master Franchisee Agreement (MFA) with an Indian manufacturer of surgical products. Paramount Surgimed Limited, to import and trade OSIM products in India and Nepal.