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Series: “Offshore Expansion by Small and Medium Enterprises” Part 4 Types of Local Operations: Wholly-Owned, a Joint Venture or Consignment manufacturing ? | Tatsuya Hoshino, Research Director Vietnam Economic Research Institute (VERI) [Date of Issue: 29/July/2011 No.0197-0804]

Date of Issue:27/July/2011

Series: “Offshore Expansion by Small and Medium Enterprises” Part 4
Types of Local Operations: Wholly-Owned, a Joint Venture or Consignment manufacturing ?

Tatsuya Hoshino
Research Director
International Exchange Department
Vietnam Economic Research Institute (VERI)

Local operations can take the form of wholly-owned firms, joint ventures, business cooperation contracts (BCCs), representative offices, or CMP. Recently, wholly-owned firms are the most popular choice. CMP, whereby no local firm is established and a local manufacturer is consigned instead, is common in the textile and miscellaneous goods industries. In this format, the foreign firm does not participate in local business management, but is usually involved in raw material procurement, facilities, technical guidance, inspections and other processes. Joint ventures are sometimes required by local governments, but it is vital to determine whether the local firm can be an effective partner. In all cases, the critical determinant will ultimately be choosing the right person to send out to run the local operation.

1. Types of Local Firms
As touched upon in Part 3, local operations can take the form of wholly-owned firms, joint ventures, business cooperation contracts (BCCs), representative offices, or Consignment manufacturing & processing(CMP)

(a) Wholly-owned
A foreign firm puts up all the capital to establish a local firm. Business operations are conducted locally by that firm, as is corporate accounting, with tax on any profit paid to the local government.

(b) Joint venture
Formed when there is merit in joining forces with a local firm.

(c) BCC
A BCC is concluded with a local firm for a particular investment project. If government permission is granted, the foreign firm can operate locally for that project alone.

(d) Representative office
A representative office is set up in the host country. Such offices cannot conduct business locally (no carry-on business). The sole activities of the office are to liaise between the parent company and host country companies and to conduct PR activities in the host country. Companies establish representative offices to undertake local market research and gain a solid knowledge of local firms, as well as to engage in PR for the company, in the run-up to establishing fully-fledged local operations.

(e) CMP
No company is established locally, with a company in the host country instead consigned to handle manufacturing. A processing fee is paid to the manufacturer, which passes back all the products it makes to the foreign firm. The foreign firm supplies the manufacturer with materials and raw materials, provides instruction on how to operate manufacturing technology, undertakes product inspections, buys up all products that pass those inspections.
The foreign company usually actively engages in the dispatch of technical guidance staff to the manufacturer and takes in trainees from the manufacturer. CMP is common in the textile and garment industry. In some cases, the foreign company leases production machinery to the manufacturer.
In some cases, for example, the manufacturer procures raw materials. Regardless of the specific details, however, the foreign company does not directly participate in the management of the local firm operated by CMP.

2. Key Points

(a) In the case of wholly-owned firms, management of the local firm is critical, as is the choice of who to send out to head the local firm. Many successful local firms have been headed by a top performer appointed from the parent company.

Case A: A young and energetic marketing sub-manager who was sent out to run the local firm focused solely on improving business performance, even if it meant vying with talented local staff. He also had limited management experience and didn’t know how to make full use of local staff capacities. Talented staff ended up leaving, and the local firm stopped functioning properly. (Replacing him with a senior officer with management experience subsequently put the company back on track.)

(b) Because representative offices can’t engage in business activities, they are limited in terms of establishing offshore operations, but they are useful as a prior step in that direction.

(c) Joint ventures often run into problems several years after operations have been launched. At the time of establishment, both parties often work toward the establishment goals and try to understand each other, or in some cases, the local partner firm leaves decisions entirely to the foreign firm and works to develop a close relationship without interference. After several years, however, rationality can be tainted by money problems and emotions and friction can arise.

Case B: A joint venture manufacturing, installing and repairing air conditioning ducts was set up in Vietnam. The local firm (49 percent of capital) left management to its Japanese partner (51 percent) and worked well with the Japanese partner, providing virtually no interference. Some years later, when the operation did not go as planned, the local firm’s accounts sank into the red and cash flow dried up, necessitating a cash injection. The joint venture contract stipulated that both parties should put that cash in according to their capital ratios, but the local partner could not find the money and in the end, the Japanese firm had to put in all the necessary funds. The local partner argued persuasively that the firms had worked well together to date, so there was no need to abandon the joint venture, and that it wanted to treat the portion of the cash injection which it should have made as a loan (without collateral). The situation became complicated, but ultimately the Japanese firm looked ahead to the future and put it a significant chunk of extra capital, buying up the partner firm’s capital to turn the local firm into a wholly-owned enterprise. Joint ventures often run into this kind of problem when business operations become bumpy. And where business operations are running smoothly, there are also differences in the management philosophies of local firms and Japanese firms regarding the handling of profits—whether they should be immediately distributed as dividends, or whether they should be held in reserve for the future.

Case C: A joint venture hotel business (60 percent of capital held by the Japanese partner, 40 percent by the local firm) appointed A, a Japanese living locally, to head the venture because he spoke the local language. No one at the Japanese firm knew him well, but the firm decided that his local relationships made him a good choice for the job. When the vice president of the local firm, the partner firm’s senior person in the venture, was the local entrepreneur B, an amiable yes-man, there was no problem. However, when B was replaced by C, son of a senior official in the Communist Party who actively expressed his views, things went downhill. A reported to the Japanese firm that everything was fine, but in reality, he kept management details from C, the joint venture’s vice president, and asked the Japanese firm to make the hotel wholly-owned because C was attempting a takeover. The head of the Japanese firm visited the local firm and asked C for his views, discovering that he was set on doing everything he could to make the hotel succeed and had no intention of staging a takeover. The head of the Japanese firm removed A from his post and sent out a high-flier from the Japanese firm, after which management proceeded smoothly.

(f) The following issues can arise with CMP:
Because the foreign firm cannot participate in local business, checking up on the CMP local manufacturer becomes tricky, giving rise to uncertainty as to whether the firm will be able to continue CMP. While disclosure of the real CMP firm status is usually required, it is difficult to gauge the real situation.
(g) CMP presents the risk of manufacturing technology and knowhow leaks. The local manufacturer will inevitably accrue the manufacturing technology and knowhow that build up through product manufacturing. Foreign firms need to be prepared for that possibility and have measures in place to deal with it.

Case D: A local firm was commissioned to manufacture 20,000 women’s garments. The material and accessories were supplied, along with a brand new design. Lawyers were used to develop a bulletproof CMP contract, which both parties signed. However, the Japanese side only sent engineers out for a few months, after which time everything was left up to the local manufacturer. The 20,000 garments were delivered as scheduled. At the same time, however, garments of exactly the same design began appearing cheaply in local markets. It was discovered that in the absence of inspections and surveys by the Japanese firm, the local manufacturer had made 25,000 garments and sold off the surplus 5,000 through the black market. This kind of situation is very common. Firms commissioning production (Japanese firms) usually conduct inspections, check quantities and have a representative present when goods are loaded for transport, but it is vital to make sure that these tasks are performed consistently and rigorously.

3. Conclusion

The first option in terms of heading offshore should be a wholly-owned firm. If your firm does not have a good understanding of local conditions and must seek the cooperation of a local firm, look at a joint venture, but give careful consideration to capital ratios (who has the ultimate decision-making authority) and the kinds of issues noted above. If acquiring permission to establish a firm will take an extended period of time, or too much government discretion makes the establishment process overly cumbersome, try CMP. The key with CMP is to look for a firm that can properly meet the foreign partner’s requirements. At the preliminary stage when the details of operations have yet to be determined and the key activities are ascertaining local conditions and conducting PR, a representative office is a good starting point. In all instances, selecting the right person to run the local operation is a critical issue, as highlighted by numerous actual cases.

(original article : Japanese)
(For the Japanese version of this article)

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