754 • Case 24 • ABC Chemical Company Goes Global The ongoing economic recession in Japan will continue to erode consumer purchasing power and confidence; luxury goods will suffer as consumers move toward cheaper products. This is already becoming evident: consumption of cognac and premium whisky is declining in Japan. Since TWO DOGS was launched in 1998, there has been massive growth in the sales volume of cheaper products, such as ‘‘Can Chu-Hi’’ and ‘‘Hyoketsu Chu-Hi’’. These locally made Japanese brands are, in convenience stores, almost half the price of fully imported TWO DOGS. DISCUSSION QUESTIONS 1. Should TWO DOGS maintain its premium price and thus risk losing volume growth to cheaper products during the recession? 2. What effect would lowering its price have on its brand positioning? 3. Would lowering its price require TWO DOGS to change to a licensing strategy? If so, should local production be in Japan? Or in nearby Asian countries with lower manufacturing costs, such as China or Thailand? 4. What other options does TWO DOGS have? Could the company change to a multi-brand strategy by introducing a new brand targeting the low-end segment?

C

ASE 24

ABC CHEMICAL COMPANY GOES GLOBAL
Driven by competitive pressures, and the attractiveness of the industry’s fastest growing market in the world, a U.S.-based chemical manufacturer, ABC Chemical Company (name changed to maintain confidentiality) considered expansion into Asia, specifically, China. William Smith is the International Marketing manager for ABC Chemical Company. William has been tasked with expanding ABC’s manufacturing and distribution to the Asia Pacific region. Many changes in the powder coating industry have forced ABC to reconsider their global strategy. To date, they have exclusively manufactured and exported from the Americas. Higher costs and tougher competition have forced ABC to look to the Asia Pacific region to reduce these costs (specifically shipping) and remain competitive. ABC Chemical Company is a U.S.-based business that manufactures and distributes specialty chemicals to various industries for use in manufacturing finished products. ABC Chemical Company’s powder coating division needs to expand into Asia to remain competitive. Many of the powder coating division’s customers are moving their plants to Asia in an attempt to expand their markets and lower their production costs. As well, all of ABC Chemical Company’s competitors are opening production facilities in Asia to meet their customer’s needs, to expand their markets, and lower their costs. For Asian and some European manufacturers, powder coatings are a commodity with no specific qualities or competitive advantages to differentiate one from another. ABC Chemical Company believes that in the future, many of these manufacturers will need more specialized products moving away from a commodity. Gaining a foothold in Asia at this time is critical to ABC Chemical Company’s future. As a commodity, powder coatings are purchased strictly based on price. Shipping costs to Asia have raised prices to a point where ABC Chemical Company would either lose money if they met their competitor’s price or lose customers if they did not. As an example it costs ABC Chemical Company $1.50 per pound to manufacture in the U.S. and ship to Asia and only $0.50 per pound to manufacture in Asia. Following the lead of many of their competitors, ABC has chosen to manufacture in China. Entering China has many benefits including a large relatively untapped market, lower overall costs, lower restrictions on production, and a central proximity to the rest of Asia. Many of ABC Chemical Company’s direct customers are either moving to or are already located in China. As well, China and Asia are underserved markets for ABC Chemical Company and many of their competitors. Moving to China is necessary to maintain market share as well as seek incremental business from new markets. One of ABC Chemical Company’s goals is to become a global supplier of specialty powder coatings. To achieve this goal, they must expand into Asia through China. ABC Chemical Company has chosen to build its own plant in China rather than to form a partnership or acquire an existing company. When seeking partners, ABC Chemical Company encountered a number of issues surrounding business practices in China. These business practices violated ABC Chemical Company’s code of conduct and ethical objectives. Although these specific business practices are common in China and have been accepted and adopted by competitors, ABC Chemical Company has chosen not to follow suit. Instead, ABC Chemical Company has chosen to build their own facility. While building has a number of advantages, there are a number of disadvantages to consider as well. Advantages include:

This case was prepared by Kevin Hendrickson, Roberto Mandanici, and Scott Solomon of the Fox School of Business and Management at Temple University under the supervision of Professor Masaaki Kotabe for class discussion rather than to illustrate either effective or ineffective management of a situation described (2003).

• Full control of the facility • Building to exacting standards rather than adapting an existing facility

Case 24 • ABC Chemical Company Goes Global

•

755

• Maintaining quality standards similar to other ABC Chemical Company plants

• Maintaining company code of conduct and ethical standards
Disadvantages include:

• One to two years to build a facility, slowing speed to market
(competitors already producing, including North American and European manufacturers who have partnered with local firms as well as thousands of small local competitors)

• Exporting from U.S. facilities at a loss • Lack of local partners and knowledge may impede entry into market While ABC Chemical Company builds their factory in China they will continue to supply Asian customers from their North American manufacturing facilities, at a substantial loss due to logistical and transportation costs. COMPANY OVERVIEW ABC Chemical Company is one of the world’s largest manufacturers of specialty chemicals—technologically sophisticated materials that find their way into applications in a variety of major markets. Consumers never see most of ABC’s products; rather, they are used by other industries to produce better-performing, high-quality end products and finished goods. The history of ABC Chemical Company has been a series of innovative technical contributions to science and industry, usually taking place behind the scenes. Markets where extensive use is made of ABC’s products include the paint and coatings industry, electronics, household products/detergents/personal care, water treatment, adhesives, plastics, and salt. In every corner of the world, ABC products are Quietly Improving the Quality of Life. In the late 1990s, ABC acquired two great companies—Ronlea (name changed), a maker of electronic chemicals, and Tomro International (name changed), a global producer of specialty chemicals and salt. ABC has sales of approximately $6 billion and more than 17,000 employees. It operates nearly 140 research and manufacturing locations in 27 countries. The company has more than one hundred ISO 9000 and more than twenty-five ISO 14000 EMAS registrations around the world. Worldwide headquarters are located in the United States. ABC is a Delaware corporation whose stock is traded on the New York Stock Exchange under the symbol ABC. ABC is committed to being a good neighbor and responsible corporate citizen. At various places on their web site there are discussions of a number of initiatives, including Responsible Care, Community Advisory Committees, and activities centered on the health and safety of employees, customers, the communities where they are located, and the environment. ABC CHEMICAL COMPANY’S CODE OF CONDUCT ABC Company stresses the importance of its code of conduct to each employee worldwide. The code is strictly embraced and enforced at all levels of the organization: from the CEO and the Board of Directors to each entry-level salaried staff position. In fact, once a year each salaried employee is asked to: 1) sign the Code of Conduct and certify that he/she has not violated any of the ethical provisions contained in it; and 2)

certify that he/she is not aware that any other employee has violated the code. Portions of the Purchasing section of the code of conduct are reported below: Relationships between ABC Company and its suppliers should be based on mutual respect and integrity. These relationships should be maintained at the highest standards of business ethics. [. . .] Under no circumstance may an ABC employee misrepresent a competitive situation to a supplier. ABC Company does not require nor does it expect any form of entertainment, promotional gifts or holiday cards as a condition for doing business. It is strictly prohibited for an ABC purchasing agent to solicit any gifts or entertainment or accept spontaneous nominal gifts valued in excess of $50; accepting any cash gift; traveling at a supplier’s expense or participating in a supplier-sponsored training seminar that is extravagant in nature. [. . .] Any supplier or employee who suspects that an ABC employee is not operating within the Code of Conduct, should promptly report their suspicion anonymously to the ABC Compliance Hotline at 1-800-123-4567. The General Code of Business Conduct repeats, in part, the provisions mentioned in the Purchasing Code, and adds the following: Gifts of cash or property may not be offered or made to any officer or employee of a customer or supplier or any government official or employee unless the gift is legal, nominal in value (less than $50) and approved in advance by a Director or Business Executive (in most countries it is illegal to make gifts to government officials). Conflicts of interest: any employee who has a financial interest or performs work for a company with which we do business or compete, must disclose such conflict to the respective Director or Business Executive. Securities Transactions: at times, some ABC employees may become aware of confidential information that has not yet been disclosed to the general public. In those cases, the information must be held in strict confidence. Those who became aware of such information may not buy or sell company stock, nor advise others to do so, until the information has been made available to the general public. Safety, Health and Environmental laws: ABC conducts its worldwide operations and manufactures its products in a way as to not harm the environment and the health and safety of its employees, customers and the public. ABC is also committed to complying with all local applicable laws and regulations. Accounting records: ABC’s financial statements and the books of record on which they are based must accurately reflect all corporate transactions. All receipts and disbursements must be accurately reflected on the accounting books, and ABC’s records must disclose the nature and purpose of all corporate transactions. [. . .] ABC employees are instructed to cooperate fully with both internal as well as external auditors and withhold no information from them. Other accounting and internal control provisions pertinent to the case study are as follows:

1. Bank accounts: the corporate treasurer must approve the establishment of all bank accounts. 2. Financial arrangements: the corporate treasurer must approve all financial arrangements with banks such as:

756 • Case 24 • ABC Chemical Company Goes Global loans, sales or purchases of securities; dealing in foreign currency; etc. 3. Cash disbursements: every disbursement (with the exception of petty cash) must be supported by an approved Purchase Order or Check Request. The full name of the payee must be recorded on the payment. Checks may not be made payable to ‘‘cash’’, ‘‘bearer’’ nor the individual approving the transaction. 4. Employee compensation: all payments to employees must be justified based on services rendered. Employees may not be asked to refund a portion of their compensation or spend it in an illegal or unethical manner. 5. Billing: all shipments must be billed promptly and accurately. 6. Cash receipts: all checks made payable to the Company must be deposited in an ABC checking account promptly. Checks received from customers may not be endorsed to a third party as a means of payment for our purchases. 7. Sales agents and commissions: only respected and competent agents or distributors may be hired to represent ABC Company. All commission payments must be properly recorded on the accounting books with full documentation including the name of the payee, the commission rate, the product sold and the customer orders involved. Cash payments, payments to unnamed individuals or disguised bank accounts are not permitted. 8. Consultants: all engagements with consultants and advisors must be based on ABC’s needs for technical or professional assistance. The background and professional ability must be scrutinized carefully before engaging a new consultant. All invoices received and paid must accurately describe the services rendered and the basis for the fees charged. 9. Unusual business transactions: all transactions outside the normal course of ABC’s business (sale of scrap material, leasing of buildings and equipment, entering into a new business activity, etc.) must be authorized by a Business Unit Manager or a Vice-President. 10. Accounting records: all corporate transactions must be reflected in the accounting records. Any fictitious or unauthorized entries are strictly forbidden. INDUSTRY OVERVIEW Powder Coatings (dry paint), a relatively new technology, is an economical and environmental improvement over the traditional liquid paint. It is mostly used by Original Equipment Manufacturers (OEMs) and by small custom ‘‘jobshops.’’ The application characteristics of powder coatings provide superior consistency and uniformity of finish. They provide extremely tough, durable coats, enhancing the high-quality, value-added image of consumer products. In general, performance properties such as impact resistance and corrosion resistance of powder coatings are better than liquid paints. Powder-coated parts resist cracking and peeling during handling and normal service use. In many cases, merchandise is specifically being advertised as ‘‘powder coated’’ because of the quality image it projects. ‘‘Environmental issues are of significant interest and importance to the government and general public today. Unlike many liquid paints, powder coatings are compliant with environmental regulations. Liquid paints often contain solvents, which can contribute to air pollution and, in some cases, ozone depletion. Powder coatings are free of such pollutants. Wet painting processes can generate sludge, which must be disposed of into hazardous waste landfills. Properly formulated powder coatings generate no such hazardous waste. The consumer can feel good about buying a powder-coated product, which is environmentally responsible.’’1 The global powder coatings market registered an estimated $3.5 billion in sales in the year 2002. The three major markets are Europe (with sales of $1.3 billion), North America (with sales of $1 billion), and Asia Pacific (with sales of $0.85 billion) (see Exhibit 1). The global powder market is dominated by three major players (see Exhibit 2):
1 Source:

ABC’s website.

EXHIBIT 1 GLOBAL POWDER COATINGS MARKET

$200

$150 $1,000
North America AGR 6-7% Europe AGR 3-4%

$850

Asia Pacific AGR 12-15% Latin America AGR 10-12% Rest of World AGR 10-12%

$1,300

Values are 2001 estimates in Millions of US$ and Estimated Annual Growth Rate (AGR) for the next 5 years

Case 24 • ABC Chemical Company Goes Global

•

757

EXHIBIT 2 GLOBAL POWDER MARKET POSITIONS
ABC Company 6% 1,000 Others 44% Wooden Shoes 13%

Delco 11%

F 5% P 4% G 2% H 3% B 3% J 3%

T 3%

V 3%

1. Wooden Shoes, a Dutch company, is the market leader commanding 13 percent of the worldwide market. Wooden Shoes is the leader in Europe and in Asia Pacific. 2. Delco, a U.S.-based corporation, owns 11 percent of the global market, with a second-place position in all three major markets, including Asia. 3. ABC holds a 6 percent global share, with a narrow number one position in the U.S., and the second position in Europe. ABC’s presence in Asia is negligible at 0.2 percent. 4. Eight other smaller producers own 26 percent of the market. These powder coatings manufacturers operate in select regional markets, concentrating their efforts on single-type customers and speed of delivery. 5. The remaining 44 percent of the market is composed of over 1,000 single-plant producers who serve a handful of local customers and specialize in a narrow line of products. They compete on speed and price, since their low-tech and high-volume production of similar products allows for economies of scale. Although Europe is the largest market, it represents a mature industry where margins are low and the powder coating product is considered a semi-commodity. Estimated growth rates for the next five years are approximately 3–4 percent per year, while customers are not willing to pay higher prices for improved technology. In fact, technological improvements are a means to retaining business rather than increasing prices and margins. ABC holds the number two position in Europe (behind Wooden Shoes) using low-cost, consistency, an established network of agents and distributors, as well as speedy delivery as its differential advantage. The North American market is a younger market, and benefits from larger margins, with estimated growth rates of 6–7 percent over the next five years. North American OEMs require a higher degree of technological innovations from their powder coatings suppliers, and thus are willing to pay a

higher price per pound. ABC Chemical Company is the market leader in North America, specializing in highly customized and specialty powders. ABC’s strengths are:

• • • •

Color-matching abilities Speed of delivery Innovation Low-temperature curing powders, which lead to energy savings able to cover more surface per pound

• Powders that can be applied with a thinner film, thus being • A highly skilled sales force
Asia Pacific is the smallest of the three major markets (with $0.85 billion sales) but offers a very attractive growth rate of 12–15 percent per year. Although this is the youngest market, it already shows signs of price and margins erosion. Customers consider powder coatings as a simple means for painting parts, and place little to no value on technological differentiation. The environmental benefits of powder coatings are also of little importance to the Asian market (due to less stringent environmental regulations). The Asian powder coatings manufacturers’ arena is dominated by over 1,000 small entrepreneurial businesses representing 78 percent of the market share (see Exhibit 3). Wooden Shoes and Delco control 9 percent and 4 percent of the market. Powder coatings are used mainly to cover small parts for export to the industrialized countries. Many American manufacturers that are moving their operations to Asia in order to capitalize on lower labor and raw material costs fuel the high degree of growth. ABC’s vision is that these manufacturers will require the same degree of service and technology that was demanded in their North American facilities, thus providing for higher margin sales in the future. While ABC decides on the course of action, it will supply powder coatings to the Asian market from its North American manufacturing facilities. Although this is a strategic choice to

758 • Case 24 • ABC Chemical Company Goes Global establish a presence in the new market, ABC faces losses due to shipping charges and tariffs, as well as having to lower price in order to compete against local Asian manufacturers capable of producing at a fraction of ABC’s costs. are access to cheap raw materials (petroleum-based resins), lower environmental regulations, competitors and customers are already there, and the access to cheap unskilled and semi-skilled labor. All of these factors would allow ABC to maximize its profit potential. ABC Chemical Company had been considering several sites in China, all along its populated and developed eastern shore (see Exhibit 4). Markets that met the final cut included Guangzhou, Shanghai, and Fuzhou. Each market had its strengths; Guangzhou benefited from its proximity to Hong Kong, which led to capitalistic laden tendencies in this part of China that might help ABCs business operations from a functional standpoint. The port provided access to major shipping routes to the rest of the world, which was attractive to ABC’s customers. Fuzhou had similar attributes and was close to Taiwan as well. Shanghai was a major port city and in the areas surrounding it, much manufacturing capability was present and much new construction was taking place. In the end, ABC chose to locate in the Shanghai region of China. While each market would serve ABC’s needs, management felt that Shanghai made the most sense based on their current needs and future expectations. Management guessed that many potential future customers would likely choose to enter China or expand their presence in China via a Shanghai area production facility. Thus, ABC would be close to many of its customers and be able to ship to them quickly at a low cost. Furthermore, the infrastructure between cities in China is quite poor. Shanghai is centrally located along the coast and thus if land-based transportation options broke down, ABC could utilize ocean-based shipping options to serve China. Another important benefit was that Shanghai provided good geographic proximity to most other Asian manufacturing and consumer markets in Japan, Korea, and Taiwan. BUSINESS PRACTICES IN CHINA Ideologically, China is a socialist country, but in an economic sense, the country is displaying some capitalistic tendencies. The country has been willing to embrace some concept of a free market in order to foster economic growth. Examples of

EXHIBIT 3 ASIA PACIFIC MARKET POSITIONS
ABC 0% Wooden Shoes Delco 9% 4% F 3% N 3% D 3% 1,000+ Others 78%

CHINA—SHANGHAI REGION The rationale to locate in Asia was driven by several factors, most notably the increasing size and importance of the powder coatings market in the Pacific region and the ability to enjoy lower labor costs. Additionally, the logistics of shipping U.S.produced powder coatings to Asia made selling to the Asian market in a profitable manner impossible. Since this region is home to much manufacturing as well as several developed and emerging markets, ABC needed to have a production facility in Asia in order to serve that region. In fact, its major competitors are already operating there! When choosing which country in Asia from which to operate, the answer quickly became obvious: China. China is home to the lion’s share of the manufacturing facilities that require powder coatings. Traits common to China that are not all present in most other Asian countries being considered

EXHIBIT 4 CHINA AND NEIGHBORING REGIONS

Case 24 • ABC Chemical Company Goes Global this relaxing of ideology may be seen simply in the fact that foreign multinational corporations (MNCs) are operating in the country. Despite the fact that China has opened somewhat, there are still systems (both stated and implied) in place, which restrict freedom for economic growth. In the more official sense, China’s equity markets are closed to private startups and there is widespread piracy, restricting economic growth. As well, the government maintains price controls in over twenty industries, censures the press, and does not allow full Internet access. Unofficial systems in place in the country, which tend to impede efficient markets, are the nuances of getting things done, namely bribery and facilitating payments. In China, there are many rules, but not necessarily laws. The rules are subject to change at anytime by anyone, provided you have the right access to government officials willing to alter their views. Additionally, there are multiple government agencies/ministries with overlapping jurisdictions. The main government body is known as the State Council, which is the highest administrative body in the country. Other government agencies that have an effect on commerce, particularly international trade, include the Ministry of Foreign Trade and Economic Cooperation (MOFTEC), State Administration for Industry and Commerce (SAIC) and the State Bureau of International Trade (SBIT). POLITICAL RISK IN CHINA Countries that lack political stability or are inconsistent in the application of laws create a reputation among international firms that they are more risky. While China has made great efforts to open its doors to international business, the country is still considered very risky. This is because China does not have an effective legal system, or reliable commercial code establishing rules of commercial interactions and obligations. This is due to the fact that situations often fall under the jurisdiction of multiple government bodies, which often contradict one another. These elements make firms less willing to invest large amounts of money. While the amount of foreign investment in China is large, metaphorically speaking, it amounts to no more than a toe in the water with respect to the value these firms would be willing to invest if the government were run differently. CODE OF CONDUCT IN CHINA Many nations have enacted legislation attempting to control the behavior of domestically based firms in their operations abroad. Such laws are meant to limit corrupt or immoral behavior in dealing with other countries. The laws were particularly expected to apply to dealings with second and third world countries. The most relevant international accords relating to this fact are

•

759

• The United Nations Code of Conduct on Transnational
Corporations Over time, these accords have set up a series of explicit guidelines for the behavior of international companies in countries in which they operate; outlining codes of conduct, basic obligations, and upholding policies benefiting basic human rights. The broad categories regulated are employment practices, consumer protection, environmental protection, political payments, and basic human rights. The political payments section is most germane to ABC’s entry into China. The various accords noted above speaking on this topic say the following:

• MNCs cannot pay bribes or make improper payments to public officials

• MNCs should avoid improper or illegal involvement or interference in the internal politics of host countries

• MNCs should not interfere in intergovernmental relations.
While these guidelines were expected to limit corruption, bribery remains pervasive. The United States went a step further than the U.N. dictates and passed the Foreign Corrupt Practices Act (FCPA) in 1977. The law specifically allows facilitation payments, but does not permit bribery. This law makes it illegal for a U.S. citizen to make a corrupt payment to a member of a government for the express purpose of having that office grant a contract or other business back to the firm. The law also includes making payments to intermediaries (who would in turn make bribes on the firm’s behalf). Penalties for individuals found guilty of the FCPA law include five years imprisonment and a fine of $100,000. Firms can be fined up to $2 million. Because bribery is often necessary to make things work in China, many U.S.-based firms could not legally do business there. POTENTIAL TARGET COMPANIES EVALUATED In order to evaluate potential Chinese firms that ABC may partner with, ABC hired the Shanghai office of PriceWaterHouseCoopers (PWC). PWC was hired to analyze the accounting and business practices of a number of companies. Two companies, Target #1 and Target #2 (names changed to protect confidentiality) rose to the top and a synopsis of PWC’s report follows. PWC reported that part of Target #1’s financial information was not reported to government authorities and tax liabilities were under-recorded and underpaid. In fact, Target #1 keeps two sets of financial statements. One set of financial statements is audited and used for external reporting purposes such as the basis for tax assessments. The second set is used for management reporting and includes revenue and assets not reported on the external statements. To understand the magnitude of this phenomenon, PWC provided documentation showing that in the year 2000 Target #1 reported only 33 percent of sales and 12 percent of revenue on the external statements. PWC advised that since a significant portion of the company’s revenue and expenses was not reported to government authorities, significant tax liabilities [Value Added Tax (VAT) and income tax] are underrecorded and underpaid. In addition, penalties arising from these unreported tax liabilities

• The United Nations Universal Declaration of Human
Rights—1948

• • • •

The European Convention on Human Rights—1950 The Helsinki Final Act—1975 OECD Guidelines for Multinational Enterprises—1976 The International Labor Office Tripartite Declaration of Principles Concerning Multinational Enterprises and Social Policy—1977

760 • Case 24 • ABC Chemical Company Goes Global may be incurred as the above activities violated the People’s Republic of China (PRC) accounting and tax laws. Local management further advised the PWC partner that over 60 percent of Target # 1’s sales were made to Taiwanese companies. Most of this revenue was not reported to PRC government authorities as sales invoices were not issued. As a common business practice in the Shanghai region, Target #1 has agreements with these customers under which the sales revenue will be collected by Target #1’s parent company in Taiwan in foreign currencies (Taiwan New Dollars or Hong Kong Dollars) from the customers’ parent companies in Taiwan. When Target #1 needs cash, management will bring foreign currencies from its parent company to China without declaring it to customs. Consequently, these foreign currencies will be exchanged into Yuan Renminbi (Chinese Currency, Rmb) in the black market. As these transactions violated the PRC foreign currency administration regulations, significant contingent liabilities exist. Another major issue is the treatment of the VAT. As required by certain customers, VAT invoices were not issued so that those customers can report less revenue and VAT liabilities to government authorities. Management advised that it is a common business practice in Shanghai that suppliers are requested not to issue sales (VAT) invoices to customers. In 2000, 67 percent of Target # 1’s sales did not have VAT invoices. This enables customers to exclude these purchases from their official accounting records and consequently exclude sales revenue from the official accounting records and report less tax liabilities to government authorities. As this practice is not consistent with ABC’s Code of Business Conduct, the risk of losing customers and sales revenue exist should ABC Chemical Company take over Target #1’s business and insist on issuing VAT invoices to customers. As a consequence, the following may occur: 1. Customers may terminate business with ABC Chemical Company as VAT invoices are audit trails that may raise the suspicion of the tax authorities and lead to the eventual discovery of the previous improper practices. 2. Customers may be unwilling to pay VAT for purchases from ABC Chemical Company as they do not need input VAT to offset their VAT liabilities. Accordingly, ABC may have to absorb the VAT as part of the cost of sales. This will lower ABC Chemical Company’s gross margin. (For example, if Target # 1 had to absorb VAT for customers in 2000, its gross margin would be lowered from 17 percent to 6 percent). Furthermore, during a plant visit, PWC noticed returned and obsolete inventories. However, no provision for inventory obsolescence was made. Management estimated the costs of these obsolete or returned inventories to be Rmb 640,000. These inventories either had quality problems or did not have market demands. As these inventories will be of little value to ABC, ABC may wish to consider excluding these aged inventories from the proposed acquisition. Local management acknowledged that Target #1 has been utilizing obsolete inventories in production and this could cause quality problems. Accordingly, sales returns and quality disputes may occur in the future. In 2000, sales returns accounted for 2.5 percent of total sales. PWC partners also found that Target #1’s management has also been understating the reserves for doubtful accounts, and overstating assets. Both accounting practices should be carefully examined by ABC company, as they have the effect of inflating the market value of the Target company. Additionally, in 1997, Target #1 purchased certain equipment and machinery from its investor in Taiwan. These assets were exempt from VAT or custom duties according to PRC tax regulations. However, the exempted VAT and custom duties would become payable if these assets are sold within the next 6 years. Other matters of concern are the following: 1. Target #1 provides kickbacks to customers to boost sales. Although management indicated that kickback payments to customers were not a key incentive to promote sales, as most of the customers are private companies, the amounts recorded over the previous two years would be considered material by government officials. 2. Over 60 percent of sales are made to Taiwanese companies. Management stated that Taiwanese firms prefer to do business with other Taiwanese firms due to cultural reasons and flexible payment arrangements and acknowledged that it was very difficult for non-Taiwanese companies to sell products to Taiwanese customers. Accordingly, the risk of losing Taiwanese customers may exist if ABC Chemical Company acquires Target #1. 3. A proper accounting system has not yet been established in Target #1. Some accounts do not have accounting ledgers and financial statements are prepared manually from vouchers at period end. Additional investments to improve working efficiency will be required if ABC Chemical Company acquires Target #1. PriceWaterHouseCoopers was also involved in analyzing the business practices of a second Chinese-based company named Target #2 (name changed to maintain confidentiality). Many of the issues found at Target #2 were similar to those affecting Target #1. Target #2 also keeps two sets of financial statements; one for external and tax purposes, and one for management. Furthermore, as seen with the first target company, this enterprise does not issue VAT invoices in their entirety. In fact only 20 percent of sales are invoiced. However, in early 2001, Target #2 issued more sales invoices and only 37 percent of its sales did not have VAT invoices. Management advised that the reason for issuing more invoices and paying more VAT was to make local tax authorities believe that it was a good taxpayer so as to avoid a comprehensive tax audit. This approach also led Target #2 to request its suppliers to invoice a higher percentage of their purchases in order to offset the VAT charged to its customers. This created some tension with Target # 2’s supplier base. As stated above, if ABC Company takes over the operations of Target #2 and insists on issuing VAT invoices in their entirety, customers may terminate their business relationship since VAT invoices are audit trails that may raise the suspicion of the tax authorities and lead to the eventual discovery of the previous improper practices. Another option would be for ABC Chemical Company to absorb VAT into their cost of sales, thus lowering the overall profitability of the operations.

Case 25 • DaimlerChrysler for East Asia As with Target #1, obsolete inventories and inadequate accounting systems were observed during the analysis of Target #2. Kickbacks, although in lower amounts, are also paid to employees of their customers as a way to attract and retain business. WILLIAM’S DILEMMA As William’s plane flies over the Bering Sea after two weeks in China, he reviews the independent auditor’s report on ABC’s two target companies. His meeting with the CEO is only 12 hours away and he is concerned about his presentation. William’s dilemma is that ABC must either enter at the sacrifice of their company code of conduct or delay entry by two years and lose money on current customers in that time. DISCUSSION QUESTIONS 1. Should ABC enter the Asian market?

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761

2. Because of the Code of Conduct that ABC adheres to, there were no appropriate joint venture candidates with which to partner. Why not operate in Taiwan or Korea and then export to China? 3. Is there anything that ABC can do to enter China with a joint venture partner and still operate within its Code of Conduct?

C

ASE 25

DAIMLERCHRYSLER FOR EAST ASIA
INTRODUCTION On May 6, 1998 the management board of Daimler Benz approved the $130 billion merger that created DaimlerChrysler. The merger leapfrogged DaimlerChrysler into the big league of global automobile manufacturers combining Daimler-Benz’s solid engineering and production techniques centered around one of the world’s greatest luxury brands with Chrysler’s famed resilience and creative design strength, especially in the light trucks, minivans, and sport utility vehicles (SUVs). The combined firm ranked fifth in worldwide automobile production. At some point during his attempt to successfully integrate DaimlerChrysler, Jurgen Schrempp, the CEO of DaimlerChrysler, must have realized that there were two large gaps in his strategy to create a truly global automotive manufacturer. The most obvious was the total lack of a significant presence in East Asia. The other gap was a standard vehicle to sell in East Asia and other growing markets. In the aftermath of the Asian financial crisis, Schrempp must have sensed both the opportunity and the threat that the situation presented: the opportunity to enter markets where cultures, legal restrictions, and ingrained competitors suddenly became loosened in wake of the crisis, and the threat of other strong competitors staking out a share of the same market with more marketable products before DaimlerChrysler could react. With the seismic shifts occurring in the industry, Schrempp wondered what sort of strategy to pursue. Whatever strategy DaimlerChrysler chose would have to take into consideration the ongoing worldwide consolidation, and existing industry relationships in East Asia. CONSOLIDATION IN THE WORLDWIDE AUTOMOBILE INDUSTRY Daimler-Benz in Germany and Chrysler in the United States made an announcement to merge on May 10, 1998. They
This case was prepared by Takashi Morishima, Gordon Stehr, and Hanaoka Yoshinori of Temple University in Tokyo under the supervision of Professor Masaaki Kotabe for class discussion rather than to illustrate either effective or ineffective management of a situation described (2001).

merged after a shareholders’ meeting in November to form DaimlerChrysler, the third largest automobile manufacturer in revenue after GM and Ford Motors, and the fifth largest in market share (see Exhibit 1). It was the largest industrial merger ever. The merger was clearly driven by the industrial logic and growth strategy to win in the global automotive market.

EXHIBIT 1
Rank/Company 1 General Motors 2 Ford Motor Co. 3 Toyota Motor Corp. 4 Volkswagen AG 5 DaimlerChrysler 6 Fiat Auto S.p.A. 7 Nissan Motor Co. 8 PSA Peugeot Citroen 9 Honda Motor Co. 10 Mitsubishi Motors Corp. 1997 World Market Share 16.2% 12.9% 9.0% 7.9% 7.4% 5.3% 5.2% 3.9% 3.8% 3.5%

Several industry trends propelled the large automobile makers towards consolidation. First, the worldwide market for automobiles was maturing. Total automobile production in the world was 54.7 million in 1997, 52.9 million in 1998, and 55.9 million in 1999 (see Exhibit 2). There was only a 2 percent increase in two years, although the growth potential was higher in the markets of developing countries such as Asian and Latin American countries. In a maturing market, competition among established companies tends to intensify because someone’s gain in share means someone’s loss in numbers. Second, all markets but the United States had far more production capabilities than required to satisfy domestic demand. According to 1999 statistics, every major