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International Business: Contract Manufacturing - Licensing and Franchising

VSAT 2023

What is Contract Manufacturing?

Last updated date: 24th Jan 2023
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Contract manufacturing is also called outsourcing. Contract manufacturing is when a firm enters into a contract with local manufacturers in foreign countries to get goods produced as per its specifications. It can be classified into three major forms-

  • Production of certain components like automobile components to be used for producing cars.

  • Assembling components into final products such as modem chips into computers.

  • Complete manufacture of the products for, e.g. garments.


Advantages of Contract Manufacturing

Contract manufacturing offers several advantages to both the international company and local producers in foreign countries. Some of them are discussed below-

  • Contract manufacturing permits international firms to get the goods produced on a large scale without requiring investment in setting up production facilities. These firms make use of the production facilities already existing in foreign countries. The company does not have to arrange for sources for the process of production.

  • Firms can get products manufactured at lower cost by approaching countries which have lower material and labour costs.

  • The company gets rid of the risk of investment in a foreign country

  • If the business does not prove to be successful, it can be easily closed.

  • Local manufacturers also get the opportunity to participate in international business and take advantage of incentives.


Disadvantages of Contract Manufacturing

The disadvantages of contract manufacturing are discussed below-

  • Lack of control over the production activity. 

  • The risk from prospective competitors.

  • Local firms that produce under contract manufacturing are not free to sell the produce at their own discretion. They have to follow the prices predetermined by international firms.


What is Licensing in International Business?

Licensing refers to the agreement to produce and market the product of the company of another country in exchange for a royalty or fee. Under the licensing system, Pepsi and Coca-Cola are produced and sold worldwide by local bottlers overseas. Licensing and franchising are examples of internalisation. 


What Do You Mean by Franchising?

  • Franchising refers to that special right which is given by a producer to a trader to start the same business at a particular place being done by the producer.

  • McDonald's, for instance, operates fast food restaurants all over the world through its franchising system.

  • Franchising is similar to licensing, but it is a term used in connection with the provision of services. 


Advantages of Licensing and Franchising

  • Inexpensive entry into international business.

  • Double income of franchiser.

  • Increases the goodwill of the franchiser.

  • Business can be run with comparatively less investment.


Limitations

The limitations of licensing and franchising are discussed below-

  • The reputation of a producer can be at risk if a franchiser does not fulfil the definite business standards.

  • Huge expense is made on research and specialists.

  • A franchisee gradually starts understanding the secrets of the success of the producer, and a time comes when he ends the contract with the producer, and himself becomes an independent competitor.

  • If the business does not run smoothly, the fees paid by the franchisee become a burden. 


Case Study

In March 2011, Tesco, the world's third largest British grocery and general merchandise retailer, signed a deal to build three more shopping centres in China. 50% of the project will be owned by a consortium of Asian investors, including Singapore-based Metro Holdings. The total value of the project to build shopping centres in Shenyang, Xiamen and Fuzhou is approximately £170 million, with Tesco and the consortium each investing approximately £30 million in equity.

1. Identify the mode through which Tesco is entering further into China.

2. State other modes of entry with respect to international business.

Ans.

1. The mode through which Tesco is entering China is a 'Joint Venture'. A Joint Venture refers to establishing a firm which is jointly owned by 2 or more independent firms for a defined period.

2. Other modes by which a business enterprise can enter into an international business are as follows:

  • Exporting and Importing: Export means producing goods in one’s own country and selling them to another country, whereas import involves bringing goods into the home country from abroad.

  • Contract Manufacturing or Outsourcing: In this mode, a company may enter into a contract with another company in a foreign country to manufacture goods or components as per the former’s specifications. It is also called outsourcing.


Summary 

International businesses are run by licensees/franchisees who are locals, so there is less risk of business takeovers and government interference. The manufacturing franchise model examples include Coca-Cola, Hyundai, Nestle, etc. All the major international companies such as Nike, Reebok, Levis and Wrangler today get their products or components produced in developing countries under contract manufacturing. 

FAQs on International Business: Contract Manufacturing - Licensing and Franchising

1. State any two points of distinction between Licensing and Franchising. 

The two distinctions between licensing and franchising are:

  • Franchising is a term very similar to licensing. The main difference between the two is that licensing is used in the context of manufacturing and marketing goods, whereas the term franchising applies to service businesses.

  • Another point is that licensing is relatively more stringent than franchising, which sets up the business unit and invests his/her own money in the business. Licensing/franchising is therefore seen as a more cost-effective way to enter the international business. Since no or little foreign investment is involved, the licensor/franchisor will not be involved in losses from foreign operations.

2. State some merits of contract manufacturing. 

The merits of contract manufacturing are-

  • Saving Cost- Contract manufacturing helps companies save huge amounts of capital required to set up production processes. Companies do not need to invest heavily in production equipment and various other types of equipment. This saves the company labour costs.

  • Easy Access to Markets- Contract manufacturing makes it easier for companies to expand into different countries. They award contracts to manufacturers in different countries to produce their products. It will help them enter different markets.

  • Economies of Scale- Contract manufacturing helps minimise the company's production costs, as when production activities are outsourced to other manufacturers, they produce large quantities of products. This allows you to get cheap materials in bulk and take advantage of economies of scale. 

3. What is cross-licensing?

Cross licensing is one of the most important terms in international business. A cross-licensing agreement is one in which two or more parties mutually grant licences to use subject matter claimed in one or more of their patents. Typically, this type of agreement is made between two parties to avoid litigation or to settle an infringement dispute. Patents held by each party often cover various important aspects of a particular product. Thus, through cross-licensing, each party retains the freedom to market its commercial products.

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