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Venturing into foreign markets: the case of the small service firm.

The literature on foreign market entry behavior suggests that decisions on foreign market selection and entry-mode choice can significantly affect a firm's performance (Anderson & Gatignon, 1986). Research on foreign market entry behavior has been largely confined to large manufacturing firms. Still, three influential trends are making it necessary to refocus research efforts. First, academicians and practitioners have realized the vital role of the small firm in significantly increasing a nation's exports (Kedia & Chhokar, 1986; Kaynak, Ghauri, & Olofsson-Bredenlow, 1987). Second, exports and other forms of international sales are now being extolled as necessary ingredients in the survival and growth of small business firms (Edmunds & Khoury, 1986; D'Souza & McDougall, 1989). Finally, service firms are increasingly venturing abroad (Erramilli, 1990), and many of these firms are small and entrepreneurial. These developments suggest a need to devote more research to the international activities of small service firms. Still, there is little evidence to date of any systematic studies addressing these issues. The current study investigates the foreign market entry behavior of small service firms. In particular, it examines the selection of foreign markets and the choice of foreign direct investment (FDI) modes by small service firms and compares these decisions to those made by larger service firms.

LITERATURE REVIEW

Characteristics of Small Firms

The entrepreneurship literature highlights two very important interrelated characteristics of small firms: resource constraint, and resource commitment under conditions of uncertainty. Researchers have found that small firms suffer from severe resource constraints. Van Hoorn (1979) identified limited resources (especially capital resources) as an important factor that distinguishes the strategic behavior of small firms from that of large firms. Cooper, Woo, and Dunkelberg (1989) reported that capital availability was an important barrier to entry for the small firm. Lynn and Reinsch (1990) found that unlike large corporations, small businesses lack the financial resources to grow through acquisitions. Finally, building on Stinchcombe's (1965) work, Eisenhardt and Schoonhoven (1990) argued that resource constraint is a primary reason for failure of small and young organizations. They suggested that limited resources provide only a small margin of error to the firm. This limits the firm's ability to capitalize on opportunities that may develop in the environment.

The other relevant characteristic found in the literature is the effect of environmental uncertainty on the small firm's investment decision. Van Hoorn (1979) argues that increased environmental uncertainty makes small firms shy away from new investments and minimize resource commitment. He suggests that high levels of uncertainty force small firms to seek low-risk growth alternatives, like contracting and cooperative ventures, in preference to the traditional growth-through-internal-resources.

In summary, the entrepreneurship literature indicates that resource constraint limits the investments of small firms, and that environmental uncertainty forces these firms to approach new investments cautiously.

Selection of Foreign Markets

Normative studies have identified several factors believed to influence choice of foreign markets. Some of these factors are market size and market growth (Stobaugh, 1969; Davidson, 1980a), competition (Knickerbocker, 1973), servicing costs (Davidson, 1982), and the host country's social, political, and economic environment (Root, 1987; Toyne & Walters, 1989). Yet, Papadopoulos and Denis (1988) conclude that there is little empirical evidence that firms systematically incorporate these variables into their decision processes. Empirical research on business practices has consistently highlighted only one major determinant of market selection: market similarity. Market similarity refers to the similarity (particularly in language and culture) of the foreign market to the firm's current market.

Investigations involving U.S. multinational corporations found sharp preferences for English-speaking countries, preferences that were not warranted on economic grounds alone (Davidson, 1980b, 1982, 1983). Researchers have reported parallel findings in studies on service firms, such as banks (Khoury, 1979) and advertising agencies (Weinstein, 1977). Several studies show that U.S. exporters have a strong bias for markets such as Canada and the U.K. (see for example, Bilkey, 1978, Reid, 1981). Firms prefer similar foreign markets because they facilitate transfer of technology and managerial resources, assure ready demand for their products, and reduce uncertainty (Davidson, 1983). For example, Hisrich and Peters (1985) found that U.S. banks perceived less uncertainty about those Eastern European markets with which they were familiar.

There are indications in the literature that a firm's size may condition choice of foreign markets. While studying the international experiences of U.S. firms, Erramilli (1991) found that as service firms grow larger they increasingly enter culturally distant markets. Yet, no other empirical evidence exists on the relationship between a firm's size and its preference for similar markets.

Choice of Entry Modes

Like their manufacturing counterparts, service firms have a range of entry modes to choose from (Boddewyn, Halbrich, & Perry, 1986; Erramilli 1990). One alternative is to export (Kotler, 1991; Root, 1987; Hisrich & Peters, 1983). Some services can be produced in the seller's home country and "transported" (via paper, disks, film, or other appropriate media) to buyers in the foreign country. Such "exportable" services are found in industries such as computer software and motion pictures. The use of external agents and distributors is not uncommon for these services, although direct-to-customer export channels appear to be the preferred modes. In markets with considerable export potential, the establishment of overseas sales and marketing subsidiaries is also common.

Service firms also can produce their services in foreign markets. One approach to foreign production is contracting (Root, 1987; Hisrich & Peters, 1983). Many consumer services (e.g., fast food and auto leasing) can be marketed to overseas customers through contractual methods such as franchising. Foreign direct investment (FDI) is another approach (Kotler, 1991; Root, 1987). FDI includes establishing joint ventures or wholly owned operations. Professional services (e.g., management consulting) are often marketed this way.

As Figure 1 shows, entry modes differ from each other based on resource commitment and risk (Kotler, 1991; Hill, Hwang, & Kim, 1990; Anderson & Gatignon, 1986; Root, 1987). FDI modes, such as joint ventures and wholly owned subsidiaries, require more resource commitment than exporting and contractural transfer modes. They also involve higher levels of risk.

Although the relationship between firm size and entry-mode choice is theoretically evident, very little empirical evidence exists. Goodnow and Hansz (1972) observed that larger companies tended to choose high-resource, high-risk modes more readily than smaller firms. With a different twist, Gatignon and Anderson (1988) noticed that choice of wholly owned subsidiaries became less likely as the scale of foreign operations increased. This suggests that the firm's ability to marshall resources is a potential determinant of entry-mode choice.

HYPOTHESES

Service industries vary in the level of fixed investments required to produce and market their services. The impact of resource availability on the behavior of small firms should, therefore, be examined within the context of capital intensity (CI). For example, hospitals and airlines require higher levels of fixed investment than advertising agencies. Therefore, the small firm's relative disadvantage vis-a-vis larger firms (with respect to resource constraints) can be expected to be a greater challenge in higher-CI industries than in lower-CI industries. At lower levels of capital intensity, the difference in capabilities of small and large firms is modest; at higher levels, it may become substantial. So, one could expect small firms to resemble larger firms in industries characterized by lower capital intensity, and to deviate from them as CI increases.

Foreign Market Selection

Firms prefer similar markets to minimize resource commitments, risk, and costs. Because of resource constraint smaller firms can be expected to more strongly prefer similar markets than larger firms. But this preference is conditioned by capital intensity. At comparatively low levels of CI, small firms may not be significantly disadvantaged and resemble larger firms in their choice of markets. As CI increases and risk rises, small firms are likely to be at an increasing disadvantage, and will opt for similar markets more readily then their larger counterparts. Therefore, the differences in foreign market selection between small and large firms can be expected to be insignificant at lower levels of CI, but to become greater at higher levels. The following hypotheses are presented:

H1a: The differences in preference for similar markets between small and larger firms will not be significant when capital intensity is relatively low.

H1b: Small service firms will exhibit significantly greater preference for similar markets than larger ones when capital intensity is relatively high.

Entry-Mode Choice

Foreign direct investment by the higher-CI firm is expected to require greater resources than that by the lower-CI firm. For example, setting up a wholly owned foreign subsidiary by a hospital requires more resources than setting up a similar subsidiary by an advertising agency (whereas a hospital requires substantial fixed investments, the cost of establishing a wholly owned subsidiary by an advertising agency may be limited to buying some office space). So, resource constraints are expected to be more influential on FDI decisions by higher-CI firms. When capital intensity is low, small service firms may not be at a significant disadvantage establishing FDI modes of entry. However, the disadvantage is expected to grow as CI increases. The following hypotheses are presented:

H2a: The differences in preference for FDI modes between small and larger firms will not be significant when capital intensity is relatively low.

H2b: Small service firms will exhibit significantly lower preference for FDI modes of entry than larger firms when capital intensity is relatively high.

DATA COLLECTION AND SAMPLE

A mail survey of U.S. service firms engaged in international operations was conducted to collect data for this study. A sample of these service firms was drawn from three business directories (Dun and Bradstreet's Million Dollar Directory 1986; Consultants and Consulting Organizations Directory 1984; Standard and Poor's Register of Corporations 1986). Four hundred sixty-three companies, representing a variety of service industries, were included in the mail survey. Questionnaires were mailed to senior managers (e.g., CEOs and Presidents) most likely to be involved in the foreign market entry decision process in these firms. Each respondent provided data on one foreign market entry decision. We received 175 usable responses. Respondents did not significantly differ from nonrespondents in industry distribution, mean firm size (number of employees), or mean annual sales revenue. Thus, nonresponse bias, if any, is negligible. Thirty-four observations had to be dropped because of missing values on key variables used in the study. The 141 observations included in the present study are complete in all respects.

Small vs. Large Service Firms

The study uses the Small Business Administration's (SBI) most recent definition of "small businesses" to identify small service firms in the sample (Office of the Federal Register, 1991, pp. 320-338). The definition varies from SIC to SIC. For example, in the following industries the cutoff limit for small firms is defined using sales revenue (with the actual sales revenue cutoff in parentheses): advertising agencies ($3.5 million); computer services ($7.0 million); engineering and architecture ($2.5 million); management consulting ($3.5 million); hospitals ($3.5 million); accounting services ($4.0 million); eating places ($3.5 million); and hotels ($3.5 million). For banking services, the cutoff is $100 million in deposits. Based on the SBI's definition, 54 of the 141 service firms in the sample were classified as "small." The remaining 87 firms were designated as larger firms. Table 1 summarizes the salient characteristics of the 141 service firms included in the final sample.

VARIABLES

Dependent Variables: DISTANCE and FDI

DISTANCE represents the cultural distance between the home country (United States) and the host country. Hofstede (1980) developed indices to measure four dimensions of national culture: power distance, uncertainty avoidance, individuality, and masculinity/femininity. Employing these indices, Kogut and Singh (1988) compute cultural distances between the United States and other countries as follows:

|(DISTANCE).sub.j~ = ||(|I.sub.ij~ - |I.sub.iu~).sup.2~/|V.sub.i~~/4

where |I.sub.ij~ stands for the index for the |i.sup.th~ cultural dimension and |j.sup.th~ country, |V.sub.i~ is the variance of the index of the |i.sup.th~ dimension, u denotes the United States, and |(DISTANCE).sub.j~ is cultural distance of the |j.sup.th~ country from the United States. Smaller values of DISTANCE suggest cultural similarity with the United States; larger values signify increasing dissimilarity. Li and Guisinger (1991) and Erramilli (1991) have used the same measure of cultural distance.

The second dependent variable is FDINV. FDINV takes on a value of 1 if the company employed foreign direct investment (either joint ventures or wholly owned subsidiaries), or a value of 0 if it employed a contractual method or exporting. The variable therefore represents the company's choice between FDI and non-FDI modes of entry.

Independent Variable: SIZE

The principal independent variable of the study is SIZE. It is a dichotomous variable that contrasts small firms with larger firms (the parameters used to identify small firms TABULAR DATA OMITTED have been discussed earlier). It takes on a value of 1, if the firm is "small," and a value of 0 otherwise.

Covariates: EXPERIENCE and NONEXPORT

As evidenced in the literature, international experience influences the selection of foreign markets and entry modes (Erramilli, 1991). Table 1 (part C) reveals that small firms in our sample appear to be less experienced than larger firms. Unless the influence of experience is partialed out, it will be difficult to conclude that the behavior of small firms is attributable to resource constraints and not inexperience.

Another characteristic that can potentially distort the results is the inability of some service firms to export, because their services have to be produced and consumed simultaneously. These services can be termed nonexportable. Firms producing nonexportable services are therefore often forced to employ FDI modes for lack of alternatives. While nearly half the larger firms in our sample provide nonexportable services, only about 22% of small firms do so. So, the observed differences in FDI between small and larger firms may be attributed to the nonexportability factor unless these effects are partialed out.

TABULAR DATA OMITTED

Two variables, labelled EXPERIENCE and NONEXPORT, were created to control for international experience of the firm and nonexportability of the service. EXPERIENCE is operationalized as the number of years the firm was in international business at the time of the foreign market entry under investigation. Also, each respondent indicated whether the service they provided was exportable or nonexportable. NONEXPORT is operationalized as a dummy variable that takes a value of 0 for exportable services and 1 for nonexportable services.

Capital Intensity

Capital Intensity is operationalized as the ratio of fixed assets to sales revenue for the service firm's industry (as proposed by Kim & Lyn, 1987).(1) Capital Intensity ratios ranged from a low of about 0.04 for advertising agencies to a high of 0.76 for hotels. Service firms whose industry CI ratio was less than the sample median value for capital intensity were classified as "lower-CI" firms, and those for which this ratio was greater than the median were classified as "higher-CI" firms.

METHODOLOGY

Correlations

Table 2 shows correlations between the two dependent variables (DISTANCE and FDINV) and the three independent variables (SIZE, EXPERIENCE, and NONEXPORT). Although some significant correlations exist, none appears to be large enough to create potential multicollinearity problems. In addition, variance inflation factors (VIFs) were computed for the independent variables in all the models tested. Neter, Wasserman, and Kutner (1983) suggest that multicollinearity is indicated when VIF values exceed 10. In all the samples tested, VIF values were close to 1, suggesting multicollinearity is not a significant problem.

Models

To test H1a and H1b, we use the following multiple regression model to explain the selection of foreign markets in terms of their cultural similarity to the United States:

DISTANCE = bo + bI*SIZE + b2*EXPERIENCE + b3*NONEXPORT

This model is estimated for the (a) total sample, (b) sample of service firms characterized by lower capital intensity, and (c) sample of service firms characterized by higher capital intensity. As mentioned before, EXPERIENCE and NONEXPORT are included as covariates. The focus of our investigation is, however, on SIZE.

To test hypotheses H2a and H2b, logistic regression was used since (a) the dependent variable is binary, (b) there are qualitative and quantitative independent variables, and (c) underlying assumptions of multivariate normality cannot be met (Cox, 1970; Afifi & Clark, 1984; Kachigan, 1986).(2) The LOGISTIC procedure of the SAS statistical package (SAS, 1989) was used to estimate the models.

The probability that a service firm would choose the FDI mode over exporting and contractual modes (i.e., the probability that FDINV equals 1) can be modeled as follows:

P|FDINV = 1~ = 1/{1 + |exp.sup.|-Y~~}

where Y = bo + b1*SIZE + b2*EXPERIENCE + b3*NONEXPORT

As before, the model was tested separately for the (a) total sample, (b) sample of service firms from lower capital-intensive industries, and (c) sample of service firms from higher capital-intensive industries.

RESULTS

Foreign Market Selection

Table 3 reports the results on foreign market selection for the total sample and separately for samples comprising lower capital-intensive and higher capital-intensive firms.

Total sample. The F value (3.38) is significant at the 0.05 level, suggesting that the variables together explain a notable portion of the variation in DISTANCE, although the low |R.sup.2~ (0.069) suggests that this portion is small. The coefficients for the total sample are not interpreted since the hypotheses specify relationships within the context of lower and higher CI.

Lower CI sample. The F value (1.448) is not statistically significant even at the 0.1 level, suggesting that the model does not explain variation in DISTANCE. In particular, the statistically insignificant coefficient for SIZE suggests that small firms are no different from larger ones in their preference for culturally similar markets when capital intensity is relatively low. This is consistent with hypothesis H1a.

Higher CI sample. The F value (5.259) is large and statistically significant at p |is less than~ 0.01, suggesting that the predictors, as a group, explain the cultural distance of the chosen foreign markets. The |R.sup.2~ value (0.193) is also much larger compared to the other two samples. Among the two covariates, EXPERIENCE is significant and positively signed, implying that with increasing experience, firms choose countries that are increasingly dissimilar to their home country. This is consistent with findings reported in TABULAR DATA OMITTED the literature (Davidson, 1983; Gatignon & Anderson, 1988; Erramilli, 1991). More importantly, the coefficient for SIZE (-0.343) is significant at p |is less than~ 0.05 and negatively signed. This suggests that, compared to larger firms, small firms prefer countries with low values of DISTANCE, i.e. countries culturally similar to the United States. These findings support hypothesis H1b.

Entry-Mode Choice

Table 4 reports the results on entry-mode choice for the total sample and separately for samples comprising lower- and higher-CI service firms.

Total sample. The model chi-square is highly significant (||Chi~.sup.2~ = 55.384 with 3 df; p |is less than~ 0.001). This suggests that the three variables together explain a significant portion of the variation in FDINV, i.e., entry-mode choice. As before, we do not interpret the coefficients for the total sample since our hypotheses specify relationships in the context of lower and higher CI.

Lower CI sample. The model chi-square (||Chi~.sup.2~ = 33.628 with 3 df; p |is less than~ 0.001) is highly significant. However, the parameters suggest that only NONEXPORT is a significant predictor of FDINV. The large, positively signed coefficient implies that, compared TABULAR DATA OMITTED to exportable services, nonexportable services strongly favor FDI modes. This is because the options for nonexportable services are severely restricted to some form of FDI mode.

Turning to the study variable SIZE, the coefficient is statistically insignificant even at the 0.10 level. This finding supports hypothesis H2a that at lower levels of CI, differences in entry-mode choice among small and large firms are not important.

Higher CI sample. The model chi-square is highly significant (||Chi~.sup.2~ = 25.068 with 3 df; p |is less than~ 0.001), suggesting that the predictors as a group differentiate well between FDI and non-FDI modes. NONEXPORT continues to be a strong predictor of entry-mode choice. More pertinently, the coefficient for SIZE is now significant and negatively signed, confirming that the relative utility of FDI modes is significantly lower for small firms. This finding lends support to hypothesis H2b.

CONCLUSION

The present study suggests that the differences in foreign market selection between small and larger firms are insignificant at lower levels of CI. These differences become stronger at higher levels of CI. In particular, small firms seem to show greater preferences for similar markets when capital intensity is high. These results support H1a and H1b, and suggest that, contrary to conventional wisdom, in certain situations the behavior of small firms may resemble that of larger firms.(3)

The results on entry-mode choice appear to follow the same pattern observed for foreign market selection. Differences in choice of entry modes between small and larger firms, insignificant at lower levels of CI, become substantial at higher levels of CI. In particular, the results suggest that when capital intensity is high, small firms prefer FDI modes significantly less than larger firms. This finding is in tune with hypotheses H2a and H2b, and suggests that while the entry-mode choice pattern of small firms differs from that of large firms as expected, there are circumstances under which it may not.

In conclusion, the literature suggests that small firms lack the ability to commit resources and that they perceive greater risk compared to larger firms. These considerations drive the small firms' choices of foreign markets and entry modes. Small firms can be expected to show greater preference for foreign markets similar to the home country, and avoid entry modes that demand greater resource commitments. The current study provides empirical evidence to support this argument.

Even more importantly, the current study suggests that the relationship between firm size and foreign market entry behavior of firms is conditioned by the capital intensity of the industry to which the firm belongs. Based on the findings, it appears that when capital intensity is low, the disparity in the foreign market entry behavior of small and larger firms may be much smaller than expected. Much of the literature in entrepreneurship and international business highlights the uniqueness of small firms. Findings of the current study do not necessarily contradict any of this research, but emphasize the dangers in concluding that the behavior of small firms is always unique.

Researchers performing comparative investigations of small and large firms must pay attention to capital intensity. If this factor is not controlled for, it will distort results. In addition, the current study underscores the importance of controlling for the effect of experience and nonexportability (the latter having critical relevance for service firms) when conducting similar studies. As one of the first empirical studies on the foreign market entry behavior of small service firms, this study provides many insights into key issues that could help develop a better understanding of this phenomenon. Future researchers can extend these findings by investigating other aspects of the small firm's international business operation.

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1. Data for the computation of the ratios were obtained from Industry Norms and Key Business Ratios published by Dun and Bradstreet Information Services (1985-86 edition).

2. Many recent studies related to entry-mode choice have employed logistic regression models (Davidson & McFetridge, 1985; Gatignon & Anderson, 1988; Kogut & Singh, 1988; Terpstra & Yu, 1988).

3. Still, one caveat is in order. Although firms in our sample were all U.S.-based, we do not know the level of foreign ownership in these firms. Foreign ownership may lead to different perceptions of cultural distance of host countries. However, there are no a priori reasons to suspect that foreign ownership systematically affects either small firms or larger firms in our sample.

M. Krishna Erramilli is Associate Professor of Marketing at the University of North Texas.

Derrick E. D'Souza is Assistant Professor of Management at the University of North Texas.
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Author:Erramilli, M. Krishna; D'Souza, Derrick E.
Publication:Entrepreneurship: Theory and Practice
Date:Jun 22, 1993
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