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Foreign subsidiaries internal network size and firm profitability:
Evidence from the Food and Beverage and Computer industries.
Master’s Thesis University of Groningen
International Business and Management
Irena Stojanoska (1635344)
Master’s Thesis Supervisor: Drs. H.C. Stek Master’s Thesis Referent: Dr. J.A. Neuijen
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Abstract
This study analyses the difference in profitability of firms that own a foreign subsidiary network and those that do not own foreign subsidiary network. Using a sample of 6586 firms from the food and beverage industry and 3088 firms from the computer industry statistically significant difference is found between them with the firms with foreign subsidiary network being more profitable. Furthermore, the relationship between the size of the foreign subsidiaries network that a focal firm owns and the profitability of the focal firm is hypothesized as an inverse-U-shaped, while controlling for ownership of the firm. Using a sample of 906 firms from the food and beverage industry and 777 firms from the computer industry strong statistical evidence supporting the U-curve relationship between the focal firm profitability and the foreign subsidiary network is found. There are evident differences between the two industries.
2 Contents
1. INTRODUCTION ... 3
2. THEORETICAL BACKGROUND AND HYPOTHESES ... 7
2.1 Introduction ... 7
2.2 Subsidiary creation and subsidiary development ... 8
2.3 The eclectic theory ... 12
2.4 The eclectic theory criticism and extensions ... 14
2.5 The competitive advantage of companies ... 15
2.6 Firms and networking ... 16
3. METHODOLOGY ... 19
3.1 Research model ... 19
3.2 Measurements and controls ... 22
3.3 Control variables ... 24
3.4 Data gathering and sample ... 25
4. RESULTS ... 29
4.1 Descriptive statistics ... 29
4.2 Comparison of the profitability results ... 30
4.3 Regression analysis results ... 31
5. SUMMARY AND CONCLUSION ... 35
5.1. Conclusion ... 35
5.2 Limitations and recommendations for further research ... 36
List of References ... 38
Appendix: A ... 44
3 1. INTRODUCTION
International firms excel as organizations through creating and shifting knowledge on a world scale. In line with this knowledge-based view of firms there has been a great interest in studying firms as inter-firm networks of the focal firms, the subsidiaries and other institutions with whom the different units of the firm interact (Ghoshal & Bartlett, 1990; Nohria & Ghoshal, 1997). The international network of firms‟ subsidiaries enables the firm to gather knowledge through experience-resulting learning from within the network of subsidiaries situated in various locations and industries (Johanson & Vahlne,1990; Chang, 1996). In a study researches stated that the main driving force behind the globalization trend has been the increase in the number of cross-border inter-firm contracts (UNCTAD, 2000). Networking allows the firms to gain knowledge through tapping into the skills base of the network partners (Tsang, 1999). Networking channels move information, finance, goods, and capital. They bind together and draw from the substantial pool of financial capital and resources available within (Rugman et al., 2006).
We can define international firm as one in which competitive actions in one country affect those taken in another location (Porter, 1980). Thus, the international firm links its position across its various country locations. Sources of competitive advantage for the firm can be international scale and scope economies as well as advantages that come as an outcome from operating in a specific country location (Porter, 1990). Achieving firm-level competitive advantage from these bases requires an efficient flow of resources between firms‟ subsidiaries and the focal firm made possible by the firm foreign subsidiary network. These flows are important in the integration necessary to develop and sustain international competitive advantage (Prahalad and Doz, 1987). Studies suggest that foreign subsidiaries networks are vital to the international competitiveness of the MNC as an important source of strategic resources (Birkinshaw, 1998; Roth and Morrison, 1992).
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more concentrated asset structure (McEvily & Zaheer, 1999) expecting that to have implication on profitability. Given the importance of the foreign subsidiary network on the focal firm performance, it is surprising that neither the strategic management nor the international business literature have attempted to further explore and explain the impact that foreign subsidiary network has on the focal firms profitability. Therefore the aim of this paper is to direct the focus on that relationship. In this paper the aim is to get an answer to the following question: what is the significance of an internal foreign subsidiaries network for the focal firm within that network?
For the purpose of this paper we make a distinction between domestic and foreign subsidiary internal network. Where internal networks are a set of relationship between subsidiaries or divisions of the same focal firm within that network, whether it is on domestic or international level. By focal firm we mean the actual analyzed firm that owns a certain percentage of the subsidiaries within the foreign subsidiary network. This study focuses on the foreign subsidiary networks. Within the line of network research this study aims to add value to the current research by studying the influence of the foreign subsidiaries network and its size on firm‟s profitability.
The paper will as first step draw initial yet inevitable parallel comparing firms with existing internal foreign subsidiaries network and without internal foreign subsidiaries network present as to see its influence on focal firm profitability. And in a second analysis more focused investigation will be done on the influence of foreign subsidiaries network size on the focal firm profitability. The focus of this paper is not on the identification of subsidiaries which have “critical capabilities”. As can be seen by the study done by Rugman and Verbeke (2001) which investigated the value-creating activities of the foreign subsidiaries of MNE‟s and they conclude that subsidiaries may be allied with more than one value-creating activity simultaneously. Therefore, the fact that the process of creating competitive advantage may occur in any foreign subsidiary makes the position that the subsidiary has within the internal network irrelevant.
5 degree of „closure‟ of the network. Burt (1997) claims that internal networks may increase the „social capital‟ of a company, by making it feasible to have access to new information, technical know-how and financial support. At the same time, these relationships may lead to „social liability‟ (risking spillover, and high co-ordination costs of the internal network-relations).In this study we will not measure the strength on the foreign subsidiary network but we presume that the strength will have an implication on the focal firm‟s performance. Indeed we can draw conclusion about this issue after the analysis is done. Therefore, this study investigates the impact of the size of the foreign subsidiaries network, without making a distinction for the position of the subsidiaries in the network and the strength of the relationships in the network.
This study does a pioneering venture to systematize the available theoretic underpinnings regarding foreign subsidiary internal network and focal firms, and empirically test these relationships. The first endeavor is to find empirical evidence for whether the profitability between firms with and without foreign subsidiary networks differs. In the existing body of literature similar comparisons have been made, for example, comparison of the productivity levels of firms from different country regions (e.g. Keay, 2000). Also, a comparison of the economic performances of firms that have domestic or foreign ownership has been done (see Bellak, 2001). Investigation of the potential difference of profitability of firms with and without foreign subsidiaries to my knowledge hasn‟t be done.
The second endeavor is to find empirical evidence on how the size of foreign subsidiaries network influences the focal firm profitability. Current literature has similar studies. Goerzen and Beamish (2005) investigated the network diversification and its influence on firm performance, using the size of the network as a control variable. This study investigated 580 Japanese firms with 13,529 subsidiaries in terms of the diversity of the network and how it influences the performance. The above mention study differs significantly from this paper in one important aspect. Our study examines the correlation between the size of foreign subsidiaries network and the profitability presuming an inverse-U-shaped relationship (see section 2.4) while the paper of Goerzen and Beamish suggests a positive linear relationship.
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7 2. THEORETICAL BACKGROUND AND HYPOTHESES
2.1 Introduction
There are few aspects in the field of strategic research where the utilization of network analysis gives added value and greater descriptive power (Gulati et al. , 2000) As first the application of the networking analysis in the field of industry analysis can give a better picture of the profitability of firms within the same industry. This is an alternative method next to the more traditional indicators such as size of the firm, market share and productivity. As second the networking analysis if applied can be of great value for understanding of the dynamics of an industry since the networks can play a crucial role. This is due to the fact that the past networks, that the firm has been imbedded into, has a great influence in the future networking choices regarding the internal and external networks. Third, the question why firms engage in networking can be answered by implementing the network theory in the transaction costs theory. That is due to the fact that it is more cost effective for firms to engage in new networks if they already have experience with networking, then for firms that are new in the field of networking. The fourth field suggested by Gulati, Nohria and Zaheer (2000) where the network theory will bring added value when implemented is the resource-based theory. In this case the network can be seen as a source of competitive advantage for the firm embedded in it, with unique characteristics for the firm.
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network diversification as a whole. The increasing number of studies performed in the field of networking highlights the significance of this field (see Gulati et al., 2000). As a result, this study proposes to identify another important aspect to the profitability of firms. Existing literature has dealt with different aspects of networks. However, the relationship between the size of a foreign subsidiaries network and its impact on the focal firm performance to my knowledge has not been investigated yet. This is due to the complexity of the topic and challenges that come with actually identifying and quantifying network relationship which are often tacit, unintended and unseen (see figure 1). The foreign subsidiary network size and its influence on firms‟ profitability may be considered as another theoretical dimension in the field of network research. If evidence is found of the presence of value for firms with a foreign subsidiary network relative to those without will have practical significance for autonomous firms that are striving for higher profitability. Finally, estimating the impact of various network sizes on profitability will help managers in making strategic decisions regarding the networks that their firms are embedded into.
2.2 Subsidiary creation and subsidiary development
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structure is a cluster of different organizations whose actions are coordinated by contracts and agreements rather than through a formal hierarchy (Jones, 2009).
When looking for the rationale of why international subsidiaries are created it can be tackled from two perspectives: the “traditional” versus “a born global approach”. The most frequently used model in the internationalization literature is the Uppsala model, which is taken to represent the traditional approach to internationalization. According to the Uppsala model firms incrementally acquire or create foreign subsidiaries because they lack experiential knowledge and because the decision to internationalize is risky. Thus as the company gains knowledge of the market it increases its market commitment: from no regular export, to export through agents, founding or acquiring of an overseas sales subsidiary, and overseas production (Johanson et al., 1975). A conclusion can be derived from above in the contest of the current study that while national subsidiaries are mainly created because of control, complexity and responsiveness concerns, the international subsidiaries are matter of entry choice mode of foreign market commitment ranging from agency to partial or fully owned subsidiary. In the case of born global internationalization firms have near-simultaneous and thus rapid engagement with multiple national markets; occurring early in the life of the firm, when the firm is still small and thus able to operate only in niche global markets or in emerging markets opening up to new technologies. These consequently require greater use of business networks to achieve global reach quickly (Madsen and Servais, 1997).
10 Figure 1 Focal Firm Profitability and Foreign Subsidiary Networking Development (FSND)
As can be seen from the theory presented above subsidiary networking most often comes to existence as an outcome of the structural evolution of the firm in the framework presented as the unintended component. Foreign subsidiary networking development can also have intended component. The move of finance, goods, and capital within the network of subsidiaries is in the most of the cases intended. Social relationships are in majority of cases intended but they can be particularly so strong that the firm is able to extend market prospects through this relationships
(Blankenburg and Johanson, 1992). As the figure above indicates, foreign subsidiary network development, intended or unintended, is embedded into the firm's strategic foundation as a significant element of its ongoing capability for market operations. Because parts of the foreign subsidiary network connections are unseen it is translated on the strategy as blind spot. The blind spot is a constituent of the firm's strategic foundation although not recognized yet is part of the company's competence. This is what Mintzberg and Waters (1985) call an "emergent strategy." Due to the inherent intangibility of networks, they are not evaluated in financial terms nor are they part of the criteria commonly listed in planning approaches and techniques (Bowman and Asch, 1987). Furthermore apart from their somewhat unseen character, networks are uncontrolled and over time may become a complex web of intricate relationships. As can be seen above the mere fact that if the FSND is unseen it doesn‟t mean that it doesn‟t have impact on profitability. Only the path of the influence on the focal firm profitability is different in the sense that its‟ influence is not strategically and deliberately
Focal Firm Profitability
Strategic planning and firms‟ structure evolution
Foreign Subs. Network Development
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planned but it has a spontaneous origin compared to the intended FSND. But many industrial firms have a strong acknowledgment of the value of their internal networks. Much of their activity consists of promoting and supporting of their internal networks (Ford, 1990). With this foreign subsidiary internal networking becomes an integral part of the firm's strategic management process, rather than simply a casual outcome. FSND can be initiated without intention (seen) but later, because of its positive contributions, can be recognized by the firm and find its way into the strategic planning cycle of the focal firm. Moreover internal networks provide strategic flexibility into market commitments in such a manner that there is an intrinsic capacity to respond to emerging conditions that cannot be fully anticipated during the planning cycle. Seemingly beneficial relationships can "confine" a company to the extent that management excludes other opportunities, so the costs of supporting that relationship can outweigh the benefits resulting in diminishing returns (Ford, 1990). Also there is a possibility that the foreign subsidiary network (FSN) becomes oversized requiring much more resources to be managed. In those cases there is possibility that the needed resources outweigh the benefits. Moreover a problem might arise where the FSN functions as unseen and unrecognized by the focal firm for longer period while growing in size and complexity. There might be a need for a “strategical support” by the focal firm in order to maintain and further develop the complex set of relationship within. If that need is not met there is possibility of “frustration in the relationship” where the ties are disconnected or are purely functioning. That will have negative impact on the firm profitability.
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other foreign subsidiaries of the focal firm. The ability to identify the valuable subsidiary resources and then transfer them across the firm makes internal foreign subsidiary network critical to sustaining of the international competitiveness of the firm. The foreign subsidiaries network facilitates the flow of activities or inputs in order the subsidiary to execute its role effectively. As mentioned above, crucial resources and knowledge upon which the firm's competitive advantage depends on exist at the subsidiary level. The effective flow of these resources to other foreign subsidiaries requires a foreign subsidiaries internal network which can result in a high degree embeddedness of firm's subsidiaries. In that sense the activities and outcomes of one foreign subsidiary is influenced by the actions of another foreign subsidiary within the foreign subsidiary network.
Furthermore one can also consult the subsidiary development stream which builds on the network perspective of the firm and focus more on the evolution of subsidiary activities over time. The firm is conceptualized as an „inter-organizational network‟ of loosely joined entities, rather than a hierarchical monolith. This loose union gives the subsidiary freedom to develop its own unique resource profile by connecting the internal network of the firm units and the external network (e.g. key suppliers and customers). Over time the subsidiary accumulates valuable competences through its network relationships, so their contribution to the focal firm performance becomes valuable. It reflects the reality that many subsidiaries have specialized competences on which the rest of the MNC is dependent and this allow the subsidiary to take more control of its own destiny. The subsidiaries are pursuing their own interest by engaging in the internal firm network (as well as the external network) and using their bargaining power to attract more internal resources from the firm rather than seeking autonomy and isolating themselves from other subsidiary-units (Pfeffer and Salancik, 1978).
2.3 The eclectic theory
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14 2.4 The eclectic theory criticism and extensions
The extension of the OLI paradigm enables its application to the current economy including the new age of alliance capitalism where networks have a significant role in the process of investigation of the company existence and profitability. Dunning stresses that the OLI paradigm should be extended to include the aspect of networks. More precisely, firms should not be analyzed only as separate entities, but the networking of the firms should also be taken into consideration. The adjustment of the OLI paradigm implicitly points out to the significance of firm networking as a base of creating competitive advantage. Therefore, with this criticism and proposed extensions Dunning states that the competitive advantage should not only be considered to arise from internal sources but also from the firm network. Helpman et al., (2004), also confirms the view that every industry is populated by heterogeneous firms that differ in productivity levels. With the result being that firms can be classified into different organizational forms according to their productivity. The less productive firms then exiting the industry because they cannot generate profits. The other firms are classified according to productivity levels as follows: the least productive that serve only the home market, the more productive that serve the home and foreign markets through exports, and the most productive firms serve both the home and foreign markets with FDI. Helpman states that firms that have subsidiaries network are the most productive ones. Moreover, networks are a source of knowledge and information, as stated by Dyer and Singh (1998) and Gulati (1999). Therefore, the network may be considered of as a unique and irreplaceable, valuable resource or a source of competitive advantage for the firm. To summarize the previous studies are the next points. First, the OLI paradigm is extended to take into consideration the network as a source of creating competitive advantage. Second, the model of Helpman explaining how the less productive firms are threatened with being forced to leave the market after some time while the most productive firms are those with a developed network. Third, networks might be a source of competitive advantage for the firm. Bundling these points, one may conclude that firms with networks are more profitable than firms without ones.
Based on the subsidiary development stream and on the extension of the OLI paradigm the first hypothesis is formulated.
15 2.5 The competitive advantage of companies
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such, the network can be described as an inimitable and irreplaceable resource of the firms, but at the same time as a possible restraint (Gulati et al., 2000). There is a related but distinct body of literature known as the „dynamic capabilities perspective‟ which is more focused on the dynamics of capability development then the stocks of resources and capabilities at a given moment (Teece et al., 1997). For example Tsai and Goshal (1998) have analyzed unit level outcomes such as innovation and time to market as a function of the network of relationships that the unit has with other internal units. In these cases it was obvious that while the system of governance of those relationships was changing the rent-generating capacity of the relationship remains.
For these reasons one may consider that the size of the network of subsidiaries may positively influence the profitability of the firm but may also have downside due to the network requirements. The network theory elaborates this relationship further.
2.6 Firms and networking
17 (Birkinshaw and Hagström, 2000). More specifically the firm is a network of relationships amongst sub-units, groups and individuals which is imbedded in a wider network with customers, suppliers, competitors and others. A firm‟s network, therefore, can be thought of as a unique and irreplaceable resource, or as a means of providing unique capabilities and competences for the firm, as stated by Gulati (1999). Hence, firms‟ network can be considered as a source for creating competitive advantage. Strategic literature has in the past typically viewed firms as autonomous entities searching for competitive advantage either in external industry sources (e.g., Porter, 1980), or within intra-firm resources and capabilities (e.g., Barney, 1991). In contemporary literature, researchers have shifted their views for firms as autonomous entities to researching also the relations that those firms have between them, thus the firm network. In the same line Gulati, Nohria, and Zaheer (2000:203) suggest that the performance of a firm is to a great extent influenced by the network that the firm is embedded in and that firms can be better comprehended by examining the networks that they are imbedded in.
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managerial and organizational effort. At the inflection point where the marginal costs of increasing the foreign subsidiary network size overpass the marginal benefits, and thus the the net effect of larger foreign subsidiary network size is negative and decreasing for the focal firm within the network. Here one may wonder why firms would go beyond the inflection point in the network size. This can be caused by various factors. One of them is because the business environment is very dynamic with intense competition. That is why managers are in permanent quest for fresh capabilities. So, they become involved in more network relationships with various firms expecting that if not all some of them will contribute positively (Harbison et al, 1998). The importance of network size is well established in several fields of investigation. The number of actors is said to pose problems such as coordination and safeguarding in internal networks, to promote upwards mobility within firms, to reduce the value of social capital of people doing similar work, and to increase the availability of resources to entrepreneurs (Staber, 1998). In some instances, network can be an enabling factor. Managing network relations requires special competencies, ongoing attention, and administrative resources, of which firms have limited amounts. From the neo-institutional perspective, network size may be positively related to reputation, visibility, and learning (Staber, 1998). Taking into consideration the above given arguments the second hypothesis is formed:
19 3. METHODOLOGY
3.1 Research model
Following the theory explanation and the hypotheses building the models that are used in this study are formulated. The model testing provides answer to the research question: what is the significance of an internal foreign subsidiaries network for the focal firm within that network? As seen from the first hypothesis in section 2.4 it suggests that firms with a foreign internal network of subsidiaries have a higher profitability than firms without a foreign internal network of subsidiaries. The first hypothesis testing is done with a comparison of the means of the two independent samples. Comparison of the means of firms’ profitability with foreign subsidiaries internal network (FSN) and firms without foreign subsidiaries internal network. The suggested relationship can be represented by the following equitation:
Profit margin mean of firms with FSN > Profit margin mean of firms without FSN
In order to investigate if firms that have FSN have higher profitability than those without FSN, the means from the two independent samples are compared. Firms are categorized into two groups: firms that have a minimum of one foreign subsidiary and firms that do not have any foreign subsidiaries. With the help of the SPSS software the calculation of the means of the profitability and the standard deviations is performed. To test whether there is significance in the means difference the t-test is used. The t-test technique takes into consideration the number of observations in the samples standard deviations of the two independent samples. The second hypothesis suggests that the size of the foreign subsidiaries internal network will have an inverse-U-shaped relationship with focal firm profitability. In order to test that the following model is constructed:
Profit margin = β0 + β1(number of foreign subsidiaries) + β2(number of foreign
subsidiaries)2 + β3 log(employees) + β4(debt-to-equity) + β5(cash flow) + β6(dummy
ownership >25%)+ β7(dummy ownership 25%-50%) + β8(dummy ownership >50%) +(ε)
Where β0 is a constant representing what the profit margin will be with all the other variables
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the next section. The term ε is an error that bundles the unexplained variations of the dependent variable profit margin. In this model the variable number of foreign subsidiaries is incorporated two times: once as the number of foreign subsidiaries and the second time as the number of foreign subsidiaries to the second power. Adding the variable to the second power is done in the course of an econometric technique used to test the expected inverse-U-shaped relationship. The mechanism behind this econometric technique is that adding the square term number of subsidiaries gives the model sensitivity for the profit margin to react with the changing size of the foreign subsidiry. For smaller number of subsidiaries the influence on the profit margin might be positive, for higher levels the influence on profit margin might be negative. In the formula below the variable profit margin will be marked as (PM) and the variable number of foreign subsidiaries will be marked as (foreign subs). In the model all other variables in the model are constant. With the first derivative of the regression equitation the reaction of the profit margin can be seen. Therefore:
Δ E (PM) / Δ foreign subs -∂ E (PM)/ ∂ foreign subs = β 1+ 2 β2 (foreign subs)
When foreign subs increases for one and the rest of the variables stay constant, E of profit margin will increase for β 1 + 2 β2 (foreign subs). In this study it is assumed that subsidiaries
increase performance, thus it can be expected that β1 > 0. Additionally, when diminishing and
negative returns are made after a certain level, the response of firm profitability to the number of subsidiaries starts declining and becomes negative as foreign subs increases. Consequently, it can be expected that β 2 < 0.
Moreover here it is important to mention that the power of any multiple regression model depends on five underlying assumptions. Four of these assumptions need to be fulfilled in order to get Best Linear Unbiased Estimators (BLUE). To get statistically consistent results it is necessary for the fifth assumption of homoskedasticity to be satisfied. The assumptions are as follows:
1. The for each value of x the value of y is Y = b0+ b1 x +b2 x2....+ εt
2. The random error average value is E (ε) = 0
3. The covariance among pairs of random errors is cov ( ε i, ε j ) = 0
4. The values of xtk are not random and are not highly correlated linear functions of the other explanatory variables.
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The first assumption, presumes that the relationship between the dependent and the explanatory variables is a linear relationship. In the equitation b0 is the intercept, and b1, b2 …
bn are the function slopes and εt is the error term that includes all the factors influencing Y.
22 3.2 Measurements and controls
This section explains how the variables are. The table below presents the measurement for each variable. Each variable in the model is classified as a dependent, independent or control variable. The expected influence of the variable is given with a sign.
Description, measurement, type, and expected sign of variables
Size of subsidiaries network2- indicates squared term
In this paper, profit margin is used as measurement of profitability. Recognizing the fact that firms can pursue multidimensional goals, it is still broadly acknowledged that the main goal of firms is generating profits. Profit margin represents the difference between the average output price per unit and the average marginal costs of producing an additional unit (Spanos et al., 2003). Therefore in the paper Sapnos claims that this measure of profitability captures the
Variable Measurement Type Variable Expected Sign
Profit margin ((Operating profit before tax + Financial Profit)/ (operating
revenue))*100
Dependent /
Size of the foreign subsidiaries network
Number of foreign subsidiaries Independent +
Size of the foreign subsidiaries Network2
(Number of foreign subsidiaries)2 Independent -
Size of the focal firm Log(number of employees) Control +
Debt-to-equity of the focal firm
((Non-current liabilities + loan)/ (shareholder founds)) * 100
Control -
Cash flow of the focal firm (Profit + depreciation) in thousands Euro
Control +
Ownership dummy below 25%
Dummy (value 1 if less than 25% of the focal firm is owned
by another firm)
Control +
Ownership dummy between 25% and 50%
Dummy (value 1 if between 25% and 50% of the focal firm
is owned by another firm)
Control +
Ownership dummy above 50%
Dummy (value 1 if more than 50% of the focal firm is owned
by another firm)
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ability of the firm to elevate the average price above its costs and/or to lessen average costs. The former situation representing the firm‟s monopolistic position or differentiated positioning, while the latter reflecting the firm‟s costs efficiency. For the above described effects to take place, the firm must have certain competitive advantage that will enable it to attain a higher profit margin compared to its competitors. As previously stated networking may play one of the crucial roles in the process of creating competitive advantage. Therefore in this study we will use profit margin as a measurement of the profitability of firms. Previous studies examining the impact on firms‟ profitability or performance have used various other measures that can reflect the firms‟ performance. Among the most common performance measurements being „return on assets‟ (ROA) and „return on equity‟ (ROE). These measurements confine the overall performance of the firm while the profit margin, captures more specifically the value of the competitive advantage of the firm. Thus, the impact of the size of foreign subsidiaries network on the profitability of the focal firm, captured as profit margin, will be investigated. However, profit margin is not a widespread measurement of firms‟ profitability in the strategic literature but is commonly employed in the industrial organization (IO) literature (e.g., Collins & Preston, 1969; Cubbing & Geroski, 1987; Uri, 1988). Also, many structural blocks in the strategic literature are originating from the IO literature. For example, the structure-conduct-performance (SCP) paradigm comes from the IO literature; it claims that the performance of a firm is dependent on its conduct in issues such as pricing policy or strategic decisions regarding competitors, and the market structure. In this study, the subsidiaries network size is considered as a constituent of the conduct of the focal firm. Moreover, Martin (1993) states that the profit margin index can be used to test for SCP relationships when differences in capital intensity is being controlled. Therefore, profit margin is a fitting measurement for exploration of the relationship between focal firm profitability and foreign subsidiaries network size.
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because many of these firms are not publicly listed and thus the market value is not publicly available. On the other hand return on equity and return on assets, main pitfall is them being unreliable. This is because of the existence of different accounting principles in different countries. Managers also may manipulate these ratios for avoidance of corporate or personal taxes, especially if the firm is small (see Sapienza, et al ,1988; Powell & Dent- Micallef, 1997).
In this study in order to measure the size of the foreign subsidiary internal network the number of foreign subsidiaries owned by the focal firm with any ownership percentage including indirect ownership is taken as a proxy. As mentioned in section 3.1, the variable number of subsidiaries is added a second time in the model for investigstion of the inverse-U-shaped relationship.
3.3 Control variables
The model used to test the second hypothesis presumes that the size of the foreign subsidiaries network influences the profit margin of the focal firm. There are also other factors that influence the profit margin. So that one can estimate the effect of the size of the subsidiaries network, these factors should also be taken into consideration. Therefore, these factors were defines as control variables in this analysis. The control variables are described below.
The size of the focal firm is of big importance. Larger firms are most often having better performance because of the economies of scale and scope. Other reasoning is that firm size may facilitate better performance through having a better access to cheaper capital, while at the same time decreasing risk (Chang and Thomas, 1989). Therefore, it is considered an important aspect included as a control variable in the current study.
Debt-to-equity ratio, or also known as financial leverage, is widely used in the research literature, since it influences the risk-return outcomes (Buhner, 1987). Jensen (1989) found that capital structure, measured by the debt-to-equity ratio, influences firm performance. This is because risk decreases when an optimal level of debt-to-equity is achieved. Therefore, firms' profit might be influenced by the debt to equity structure of the firm. Thus, debt-to-equity is considers as an important control variable.
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(Doukas et al., 1999) which influences profitability. Consequently, cash flow is an important control variable.
Among others, Bartlett and Ghoshal (1989) state that subsidiaries have the capacity to share knowledge and information created in the parent company or its „network. Looking from the opposite direction being owned by another firm, and thus being a subsidiary, is also a possible source of competitive advantage. Therefore, the benefit of competitive advantage creation is twofold. As explained so far, this study examines the impact of the size of the foreign subsidiary network of one focal firm. But one should keep in mind that some of the firms in the sample that own a network of subsidiaries may be themselves owned by another firm. Therefore, ownership dummies were used to control for if the focal firm of the network is owned by another firm divided into three levels:
1. Firms owned less than 25% by another firm dummy ownership <25%.
2. Firms that are between 25% - 50% owned by another firm dummy ownership 25%-50%. 3. Firms that are more than 50% owned dummy ownership >50%.
3.4 Data gathering and sample
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A is the full owner of B and B owns C with certain percentage than A is the owner of two subsidiaries (this being B and C), but B will not be listed as company with one subsidiary (being C) because B is 100% owned by A and is actually subsidiary itself (see Figure 2 in appendix A).
29 4. RESULTS
4.1 Descriptive statistics
Tables 1 and 2 in the appendix B show the descriptive statistics for the dependent variable profit margin and the independent and control variables. The mean value for the profit margin is higher in the computer industry compared to the food and beverage industry. That means that in average the companies from the computer industry are more profitable then the firms from the food and beverage industry. There is significant difference in the mean value of the cash flow, the food and beverage industry cash flow is significantly higher. Moreover the mean of foreign subsidiaries and the debt to equity ratio in the food and beverage industry is higher compared to the computer industry. By using Skewness and Kurtosis statistics it can be seen that the high frequency of the variables that is not necessarily concentrated around the mean value and is responsible for the absence of a normal distribution of the variables. The detailed descriptive statistics for all the regions can be seen in the appendix B, tables 1 and 2. Bivariate statistics. The pair-wise correlations of the variables from the food and beverage industry are presented in the table below. The highest correlation is 0.354, showing that in general the variables number of foreign subsidiaries and the cash flow are more correlated but not as large as to present a problem. It can be seen that there is no problem of multicolinearity for the food and beverage industry.
Table 3 Bivariate Correlations in the food and beverages industry
Size of the
focal firm Cash flow
Number of foreign subsidiaries Debt to equity Profit margin
Size of the focal firm 1
906
Cash flow ,257(**) 1
,000
Number of foreign subsidiaries ,156(**) ,354(**) 1
,000 ,000
Debt to equity -,060 -,009 -,021 1
,071 ,787 ,533
Profit margin ,054 ,151(**) ,070(*) -,081(*) 1
,106 ,000 ,034 ,014
30
The pair-wise correlations of the variables from the computer industry are presented in the table below. The highest correlation is between the number of the foreign subsidiaries and the size of the focal firm. But clearly from the table there is no problem of multicolinearity in the computer industry data.
Table 4 Bivariate Correlations in computer industry
Size of the focal firm
Number of foreign
subsidiaries Cash flow Debt to equity Profit margin Size of the focal firm 1
Number of foreign subsidiaries ,268(**) 1 ,000 Cash flow ,182(**) ,247(**) 1 ,000 ,000 Debt to equity ,053 ,047 -,007 1 ,141 ,193 ,838 Profit margin ,027 ,042 ,121(**) ,042 1 ,455 ,247 ,001 ,241
** Correlation is significant at the 0.01 level (2-tailed).
4.2 Comparison of the profitability results
The results from the empirical analysis of the profit margins comparisons of the firms with and without foreign subsidiaries network are presented below.
Table 5 Comparison of means of profit margins for firms with and without subsidiaries
Industry Firms with foreign subsidiaries
network
31
As can be seen from table 5, the profit margin for firms with foreign subsidiaries network is higher than that of firms without a subsidiaries network. The difference between the means is much larger in the food and beverage industry (1.92) than in the computer industry (0.57). Therefore the difference of the profitability between the firms with and without foreign subsidiary network is higher compared to the ones from the computer industry. This might be because the “born globals” from inception serve the international market. So even if the firms from the computer industry do not own foreign subsidiaries they are able to derive the benefits from the international market (also made possible by the service nature of the computer industry), and thus improve their performance (Zhang&Thanshuhaj, 2007). Therefore the difference in the profit margin mean is small compared to the firms from the food and beverage industry. On the other hand the food and beverage industry has focused consumption and distribution points, thus it is important to be present at the local geographic foreign market (Burt, 1992). Both industries show a significantly higher profit margin for firms with a subsidiaries network at the 1% level. This provides support for hypothesis one.
4.3 Regression analysis results
For the empirical test of the second hypothesis a multiple regression analysis was performed. The results from the analysis are given in the table below. The first table shows the results from the food and beverage industry.
Table 6 Results from the regression analysis for the Food and Bevarage Industry
Dependent Variable Profit Margin Profit Margin Profit Margin
Constant ,849 ,396
Size of the focal firm -,011 -,312 ,755
Cash flow ,123 3,396 ,001***
Number of foreign subsidiaries ,221 2,487 ,013**
Size of the subsidiary network -,199 -2,346 ,019**
32
It is apparent from the table above that the variables size of the focal firm and the Dummy variable 0-25% are not significant. The rest of the variables are significant at 5% and 1% level. The Adjusted R-square is 0.041, which means that 4.1% of the variation of the profit margin is explained by the dependent and control variables taken in the model. The variables that measure the effect of the size of the subsidiaries network (number of foreign subsidiaries and size of the subsidiary network) are as expected respectively significant with positive and negative sign confirming the inverse-U-shaped relationship as hypothesized. When the focal firm is over 50% owned by other firm it has for 0,089 higher profit margin compared to the firms owned below 50% by other firm. When the focal firm is owned between 0-25% by other firm it has for 0.049 lower profit margin compared to when the focal firm is owned by other firm above 25%. But since the dummy variable for the 0-25% is insignificant it can be stated that the result for that percentage ownership is inconclusive. The table below represents the results for the computer industry.
Table 7 Results from the regression analysis for the Computer industry
Dependent Variable Profit Margin Profit Margin Profit Margin
Constant -,849 ,396
Size of the focal firm -,007 -,192 ,847
Number of foreign subsidiaries ,134 1,914 ,056*
Size of the subsidiary network -,110 -1,668 ,096*
Cash flow ,105 2,824 ,005** Debt to equity ,033 ,931 ,352 Dummy 25-50% ,141 3,328 ,001*** Dummy >50% ,219 5,032 ,000*** Adjusted R-square ,041 Durbin-Watson 1.958
*significant at 10%; **significant at 5%; ***significant at 1% Source: The author‟s calculations
33
less than 50% by other firms. When the focal firm is owned between 25-50% by other firm it has for 0,141 higher profit margin compared to the focal firms that are less than 25% owned by other firms, but has lower profit margin in comparison to focal firms owned over 50% by other firms. The difference of the impact of foreign network subsidiary size on focal firm profitability between the two industries is also considerable. In the food and beverages industry there is a positive effect of 0.221, which for the computer industry is 0.134. It is clear that the focal firms in the food and beverage industry derive significantly more benefit from networking than focal firms in the computer industry. The same findings for the differences are established by Burt (1992), which states that some industries obtain higher benefits from their networks than others. We can seek the reasoning also back in the previously mentioned theory in section 2.2 and from figure 1. In the food and beverage industry firms follow the Upsala model of internationalization and in the computer industry the born global model. In the first case the FSN is more likely to be unintended and in the later the FSN is more likely to be strategically planned. Thus the FSN origin might be a crucial factor in the extend of benefits that it contributes, with the unintended originating FSN being more beneficial to the focal firms profitability. There is a negative effect from the large size of the foreign subsidiary network of 0.119 for the food and beverages industry, which for the computer industry is 0.110. This means that the declining slope in the U-curve of the food and beverage industry will be steeper compared to the computer industry.
34
crucial in order to be involved into the given country business network and later to be able to internalize those benefits within the foreign subsidiary network.
35 5. SUMMARY AND CONCLUSION
5.1. Conclusion
The relation between the networking and firms „profitability is of growing interest in the current literature. Current literature investigates various aspects from the firms‟ network and how it influences the firms involved in those networks. This study endeavors to give a new dimension comparing the profitability of firms with a foreign subsidiary network relative to those without a foreign subsidiary network. The empirical results corroborate that firms without foreign subsidiary networks are less profitable compared to the firms with FSN for the both industries. One must consider that the analysis is done by a comparison of independent samples with the help of means statistical technique, which by itself is not enough to prove that FSN are central in firms having better performance. In current literature there were similar findings. In a study done by Westney (1993), it was found that the foreign R&D subsidiaries of U.S. firms in Japan underperformed because they were not included in the local networks of the Japanese R&D units. In this way they cannot take advantage of the opportunities that rise within the network.
36
are not themselves connected) and with the bridge established over the structural hole with the help of network larger benefits van be derived. Secondly, this study shows that the size of the foreign subsidiaries networks in the food and beverage industry is significantly bigger compared to the size of the foreign subsidiaries networks in the computer industry. Moreover based on the empirical test results the focal firms from the food and beverage industry benefits to larger extend from the foreign subsidiary network compared to the computer industry. Therefore the focal firms within the foreign subsidiary networks take the role of tertius gaudens (“the third who benefits”) a unit who benefits from brokering the foreign subsidiary network buffering industries‟ “structural holes” (see Burt, 1992, p.30-32). However, networks prove to be beneficial for almost any foreign subsidiary embedded in it, with the computer industry subsidiaries receiving greater benefits compared to the subsidiaries from the food and beverage industry. Sufficient evidence was only not found when firms are owned up to 25% (and the sign was negative) by other firms in the food and beverage industry. This might be due to the food and beverage industry specific characteristic. Besides showing strategic managers the importance of the network, this study aims to highlight that the property of network size should be taken into consideration.
5.2 Limitations and recommendations for further research
The main curb of this study is the measurement of the size of the foreign subsidiaries network. More precisely, the two measurements that were taken as a proxy to measure the foreign subsidiary network size (number of foreign subsidiaries and number of foreign subsidiaries on second power) do not capture the intensity of the relationship between the focal firm and the foreign subsidiary. The main explanation round this limitation is the unavailability of more structured data, and the mere nature of intangibility of the network relationships. An attempt was made to minimize the possibility of non-existence of the foreign subsidiary network by taking the foreign subsidiaries number as proxy. The probability of the foreign subsidiary formation to be undertaken with the networking as a ground motive, or the networking to be born as a product from the internationalization and later to find its way in to the strategic planning process is greater in the case of the foreign subsidiaries in contrast to the domestic subsidiary units formation (see figure1 and part 2.2).
37
created/acquired subsidiaries within our data there is a huge possibility that they still haven‟t established a network that can have positive/negative impact on the focal firm performance. The newly acquired subsidiaries need time so that they can get embedded in to the existent foreign subsidiary network. In this study an attempt was done to minimize the impact of this pitfall by looking at the number of the foreign subsidiary development for the last five years for arbitrary selected few companies from the two industries. The result was that there were not significantly large deviations in the foreign subsidiary number for the past five years. However, notwithstanding these limitations, the empirical test results supported the two hypotheses. Therefore, these limitations can be used as points for further research. It might be interesting to study to what level of indirect ownership the benefit for the focal firm is significant. Likewise, it might be of interest to investigate whether the results vary when one considers the foreign subsidiaries that are geographically closer to the focal firm relative to the more distant foreign subsidiaries. The subject of whether different ownership levels of the foreign subsidiaries influences the benefits of the focal firm can also be investigated.
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44 Appendix: A
Figure 2
Firm that owns less than 25% of
the focal firm
Firm that owns between 25% and 50% of the focal
firm
Firm that owns more than 50% of the focal firm
Focal firm in the network Foreign subsidiary Foreign subsidiary Foreign subsidiary Foreign subsidiary Foreign subsidiary Foreign subsidiary Foreign subsidiary Foreign subsidiary Foreign subsidiary
Foreign subsidiary Foreign subsidiary
Foreign subsidiary
Foreign subsidiary
Foreign subsidiary
Network Length
(number of levels)
The foreign subsidiary network length of the focal firm in the AMADEUS database is up to the 10th. In this study the foreign subsidiary network indirectly owned up to 4th level is analyzed. The network breadth is not limited to certain level. To control for if the focal firm is owned by another firm three dummies are used.
