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ARTICLE OF THE WEEK

Risk Intelligence: An Integrated Approach

Typically, different functions with a company conduct individual risk assessments that address such issues as internal controls, physical security, data security, legal and regulatory reviews, and financial performance. Each of these assessments provides a partial view of the risks facing a company. Yet, often these individual assessments are not integrated to provide a comprehensive picture of all the risks a company faces. In addition, companies can overlook how different risk types can interact, creating problems or losses that are more than simply the sum of the individual risks.

In fact, only 47 percent of the executives said the individual risk assessments at their company were well integrated before they invested in an emerging market, while 46 percent said they were substantially integrated for existing operations. Even among companies with more than $1 billion in annual revenues, just over half of the executives described their individual risk assessments as well integrated. The leading manufacturers interviewed in depth said their individual risk assessments were brought together, employing a variety of approaches. At a U.S. manufacturer, individual risk assessments for each area of the company all flow into a single corporate vice president for that area. Johnson & Johnson employs an internal methodology that integrates the separate risk assessments across the company into a single view. Executives at companies that had successfully integrated their diverse risk management efforts were much more confident about their ability to manage the risks they faced in emerging markets. Fully 87 percent of executives at companies that had a very integrated risk management process before entering an emerging market said they were very confident about their companies' ability to manage risks, compared to 60 percent at companies where risk management was not well integrated (Exhibit 14). Similarly, when asked about risk management for ongoing operations, 91 percent of executives at companies with a well integrated approach were very confident about their companies' abilities, compared to 62 percent of the other executives surveyed.

Selecting the Right Structure: Operating Models

As manufacturers expand around the world, they have fundamental decisions to make regarding which operating structures they should choose whether to build a new subsidiary ("greenfield investment"), acquire a local company, create a joint venture, or enter into an agreement with a vendor or other third party. This is a complex decision that takes into account such factors as the extent to which the operation involves advanced or proprietary processes or technology, the investment required, the potential market opportunity, and whether the company needs to quickly acquire local knowledge or relationships.

Many companies are using all of these models, depending on the characteristics of the particular operation and the emerging market. Yet, there is a clear trend towards greenfield investments, as companies gain more experience and comfort in emerging markets. While greenfield operations typically require larger investments and take longer to implement, they also offer more control, less IP risk, and greater upside potential.


Global Operating Approach

When executives were asked about their company's overall operating approach, half said it was more centralized in its decision making, while another 40 percent employed an approach that was a mix of centralization and decentralization. Only 10 percent described their company as primarily decentralized.

Major manufacturers bring the advantage of their global capabilities, along with substantial economies of scale. Even when they decentralize some decision making, they typically continue to enjoy the efficiency of having the parent company provide corporate functions such as IT, accounting, procurement, logistics, and legal. Companies want to provide local autonomy, but avoid having dozens of account payable or ERP systems around the world.

Companies can organize their global operations by business unit, by region, by business function, or a combination of these approaches. For each of these approaches, roughly half of the executives said it was an important organizing principle at their company. Larger companies, however, were much more likely to organize around business units (Exhibit 15).

Johnson & Johnson provides an example of a manufacturer that places significant decision making in their individual operating companies. Each operating company has primary responsibility for developing and executing its strategy globally. However, they also use a matrix management structure with regional heads who are responsible for sales, marketing, and overall business growth in their region. The company is now working to retain the flexibility of organizing by operating company, while increasing economies of scale and sharing knowledge across their multiple business units. Several Johnson & Johnson operating companies will share the new facility being constructed in the Suzhou Industrial Park so they can go through the learning process together of operating in China.

Siemens is another example of a company organized around operating companies. Each of these companies is a separate legal entity, with its own chief executive officer and board of directors. Their activities are coordinated by a central executive committee comprising the top management for the parent company. This committee examines the overall strategy, suggests potential business opportunities, and reviews performance against targets.

In emerging markets, Siemens typically creates a single legal entity with a chief executive for all their activities in the country. This entity has service-level agreements with the individual operating companies to provide corporate functions, such as finance, accounting, sales, marketing, and R&D. When an operating company is manufacturing products for export to other counties, however, Siemens creates a separate legal entity just for that business unit, which is managed centrally by the global head of the business unit.

Choosing an Operating Structure

Executives were asked which operating structures they used in their emerging market operations-greenfield investments, acquisitions of local firms, joint ventures/strategic partnerships, or outsourcing/third-party arrangements (such as distribution agreements). Of course, many companies use more than one approach depending on the situation. Nonetheless, there was a clear preference for organizing emerging market operations as a greenfield investment, with roughly 60 percent of the responses about individual emerging markets saying this approach was used, both for production and for sales and distribution operations (Exhibit 16). In contrast, for each of the other operating structures no more than about one-third of the responses about individual markets said they were being used. This was true both for companies that took a centralized approach to their global operations as well as those that had a mixed approach. Executives from larger manufacturers who were interviewed in depth said their companies used a variety of operating approaches depending on the situation. Yet, all the executives interviewed, both from large companies and from mid-sized companies, said they preferred to use a wholly-owned subsidiary since this provides full control.

Although such a subsidiary could be the result of an acquisition, in most cases, a suitable target was not available so they built it from the ground up.

In China, a major U.S manufacturer interviewed for the study indicated that they originally used joint ventures, then in the 1990s created start-ups, but often with foreign partners. But now they are comfortable with the business environment and favor wholly-owned subsidiaries, either greenfield investments or acquisitions. In India, they were engaged in a joint venture, but eventually bought out their partner.

In fact, companies that employed greenfield investments in emerging markets were more likely to report success in achieving their operational goals, both for production operations, and also for sales and distribution operations. For example, 67 percent of the executives at companies that used newly-created subsidiaries in emerging markets considered that they had been extremely or very successful in achieving their operational goals, compared to 50 percent among companies that did not use this approach (Exhibit 17). Similarly, for sales and distribution operations, 65 percent of those at companies using greenfield investments reported that they had been extremely or very successful in achieving their operational goals in these emerging markets; only 46 percent of executives at companies that did not use this operating approach reported this level of success.

The picture is reversed for the other operating approaches. For example, 49 percent of executives at companies that used outsourcing or third-party arrangements in their sales and distribution operations said they had been extremely or very successful in these markets in achieving their operational goals; this contrasts with 62 percent of executives at companies not using this approach who said they had achieved this much success in emerging markets where they outsourced.

Making the Decision

What factors drive these decisions? The single most important factor is operational costs, which 58 percent of executives, and 72 percent of those at larger companies, described as important when choosing an operational structure in an emerging market (Exhibit 18). But there are a long list of additional factors that approximately one-third of executives described as important including time-to-market, legal/regulatory issues, local knowledge, need for maintaining adequate levels of control, and the amount of capital required.

A key issue in deciding how to structure operations is whether the process or technology involved is proprietary and considered a core element of a company's value proposition. Where a company considers an operation to be unique and central to its strategy, it is more likely to use greenfield investment. For example, since Soitec's production processes are unique, when locating in Singapore it didn't want to share its proprietary processes with a joint venture partner or vendor, and it couldn't find a suitable acquisition target. André-Jacques Auberton-Hervé, chief executive officer and president of Soitec, summed it up, "No other firms really do what we do."

Companies are reluctant to joint venture or outsource a proprietary process since they are concerned about losing their IP and their competitive advantage. They are more willing to use these approaches for more routine operations or older production processes. In considering whether to outsource, Johnson & Johnson looks at their core competencies and which intellectual assets they need to protect. In the past, each of their operating companies made this "build vs. buy" decision on its own, but now they are developing corporate guidelines.

Even when a company has decided that a product incorporates proprietary processes or technology and should be manufactured in an emerging market through a wholly-owned subsidiary, it still faces the decision how best to structure sales-through an in-house sales force or instead through third-party distribution. The distribution decision requires addressing a number of additional questions including the following.

• How large is the business opportunity? The expense of building an in-house sales force is more likely to be justified if the market is large and the company has a good opportunity to achieve high penetration.
  
  
• How much investment is required? If the investment required to build the necessary distribution infrastructure is substantial, a company would be more inclined to use a third party. In part this is a function of how concentrated or dispersed the potential customers are.

For example, although the Eastern European markets are each relatively small, they are also densely populated, which makes sales efficient.

• How is the product sold? If existing relationships are especially important in a market, companies may decide to contract with a third-party vendor that has already established them, rather than trying to build an in-house sales network. For example, Bayer Healthcare's products in South Korea are largely sold through retail stores, where shelf space is at a premium. Since existing distributors largely "own" this channel, the company chose to use a third-party distributor rather than build its own network.
  
  
• How important is it to get to market quickly? Creating an internal sales force takes longer than employing third-party distribution. This was one key factor in the decision of AstenJohnson to develop agency relationships for its products in China, Indonesia, and India.
  
  

• How complex is the sale? Third-party distribution is easier to use when a company has a well known brand and its product characteristics are well understood. If a company is not well known or the sale is technically complex, then it can be easier to use in-house employees. Although AstenJohnson has a complex product, they wanted to use third-party distributors in order to enter several emerging markets quickly. To address this issue, they provide training to their agents, and also have company product managers travel with the agents to answer any technical questions that arise.
  
  
• How fast is the market changing? Some markets are changing so rapidly that companies find it helpful to hedge their bets. With the retail landscape in India in flux and its future structure still unclear, Bayer Healthcare has decided to use both in-house and vendor sales while it monitors developments.
  
  

These are some of the key considerations as companies decide how to structure their sales and distribution operations, and each company will assess additional factors that are specific to its unique situation.

The decision process for other types of operations is just as complex. Yet, as manufacturers become more experienced and knowledgeable about the many emerging markets in which they now do business, there is a trend to rely increasingly on wholly-owned subsidiaries, often greenfield investments, for operations considered core to their competitive position.


Final Thoughts: Meeting the Challenge

Emerging markets loom ever larger in the business strategies of global manufacturing companies. But they are now competing with dynamic companies headquartered in emerging markets, such as Tata Motors in India, CEMEX in Mexico, and Lenovo in China, to name a few. These companies enjoy an intimate knowledge of their local markets. But many have also leveraged their expertise and competitive cost structures to become major players on the global stage as well. While leading manufacturing companies in developed markets have traditionally enjoyed the advantages of strong brands, some emerging market competitors are fast building brand equity as well.

To succeed in developed markets, these emerging market companies have been building or acquiring a deep understanding of U.S., Western European, and Japanese business practices, labor force requirements, and customer needs. The question for manufacturers from developed markets is whether they can be equally nimble as they compete around the world. "Global manufacturers can't simply transplant their home-grown operating approaches and business models into emerging markets," says Rolf Classon, Former Chairman of the Board of Management, Bayer HealthCare. "But this realization is slow in coming for many companies." Deep insight and sensitivity into local conditions, and the ability to adapt quickly to these realities, will be essential to take advantage of the enormous opportunities these markets offer.

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