A currency exchange rate-driven vs. strategy-driven analysis of global sourcing

Murray, Janet Y

In the past decade, multinational firms have been adopting global sourcing strategy to remain competitive in the global market. This study employs product-level data in examining domestic vs. foreign sourcing activities of U.S. subsidiaries of foreign multinational firms. The results concluded that, among manufacturers with extensive international experience, the level of domestic vs. foreign sourcing used might be associated with strategy-related factors, rather than with currency exchange rate.

Effective global sourcing is generally recognized to enhance a firm’s competitiveness, so the concern for multinational firms is not whether to use global sourcing, but how to select an appropriate global sourcing strategy in achieving their business objectives. Firms make sourcing decisions in each of the two phases of production–component sourcing and assembly. In either phase, firms can choose to use domestic or foreign sourcing (the locational aspect), and internal or external sourcing (the ownership aspect). “Domestic sourcing” is when the sourcing firm and its suppliers are located in the same country (e.g., Honda in the U.S. sources from Nippondenso in the U.S.), while “foreign sourcing” involves sourcing from abroad (e.g., Honda in the U.S. procures from Nippondenso in Japan). A firm uses “internal sourcing” when it procures or assembles parts and components within the corporate system, either a parent from its subsidiaries, or subsidiaries from their parent or from other subsidiaries (e.g., Honda in the U.S. sources from its parent in Japan, or from other Honda subsidiaries located in the U.S.). “External sourcing” occurs when sourcing originates from independent suppliers on a contractual basis (e.g., Honda in the U.S. procures from ABC Company in the U.S., or from XYZ Company in Japan). These activities often cross national boundaries.

While many studies report dramatic increases in foreign sourcing by U.S. multinational firms [Machinery and Allied Products Institute (MAPI) 1986; Monczka and Guinipero 1984], others report the significant level of domestic sourcing used by these firms when serving overseas markets. In 1990, U.S. multinational firms generated $1.48 trillion in foreign sales through huge investments made in plants and operations overseas (i.e., domestic sourcing) [O’Reilly 1992]. Similarly, foreign multinational firms, in penetrating the U.S. market, often employ domestic (i.e., U.S.) sourcing as a means to overcome tariff and non-tariff barriers. Recently, more domestic sourcing has been used by these foreign multinationals, which is a result of their foreign direct investment in the U.S.– either by establishing manufacturing plants or buying existing businesses. As of 1990, Britain had the largest total investment of over $120 billion in the U.S., and Japan, the second largest of over $70 billion [Fortune 1990].

According to macroeconomic theories, decisions related to domestic vs. foreign sourcing are greatly affected by currency exchange rates. However, recent economics literature [Baldwin 1988; Baldwin and Krugman 1989; Dixit 1989] suggests that microeconomic, firm-level strategic decisions have weakened currency exchange rate effects on domestic vs. foreign sourcing decisions. Consistent with these researchers, Swamidass [1993] recognized the diminishing importance of the role of cost and the increasing significance of strategy factors in influencing global sourcing decisions. Other researchers [Kotabe and Murray 1990; Kotabe and Omura 1989], in examining sourcing issues using micro-level (product) data, concluded that a product’s market performance is positively related to the extent of which major (i.e., nonstandardized) components are sourced internally (i.e., within the corporate system). Major components often involve proprietary technology; therefore, sourcing these crucial components internally can enable the firm to maintain its competitive edge over its rivals. However, the sourcing of standardized (i.e., offthe-shelf) components does not have a significant impact on market performance.

Given the unique characteristics of major components and their critical influence on a product’s market performance, their sourcing decisions mandate the firm to ensure the quality, technology, and dependable supply of these crucial components. This argument is consistent with Swamidass’ [1993] assertion that, during the advanced stage of import sourcing, firms would likely source based on strategy, rather than cost factors. Although previous studies [Kotabe and Murray 1990; Kotabe and Omura 1989] concluded that internal sourcing of major components influences a product’s market performance, there is no available research on the effects of domestic vs. foreign sourcing of major components on market performance. Consequently, we do not have a complete understanding of the strategic decisions relating to the sourcing of major components, which is critical to achieving the firm’s or its products’ performance objectives.

This study examines the locational aspect of global sourcing (domestic vs. foreign sourcing of major components). Specifically, this study addresses the following three exploratory research questions:

(1) among manufacturers with extensive international experience, is currency exchange rate change related to the level of domestic vs. foreign sourcing used because of the benefit of cost minimization?

(2) among manufacturers with extensive international experience, are decisions on domestic vs. foreign sourcing related to strategy factors in order r to maximize the firm’s competitive advantage?

(3) given the potential cost advantage derived from using the appropriate sourcing strategy (domestic vs. foreign sourcing) due to a depreciation/an appreciation of the home currency, what is the relationship between domestic vs. foreign sourcing with market performance? As foreign sourcing is simply a mirror image of domestic sourcing, it is sufficient to examine domestic sourcing only. As the subjects of the study were U.S. subsidiaries of foreign multinational firms, domestic sourcing means procuring from U.S. suppliers.

HYPOTHESES DEVELOPMENT CURRENCY EXCHANGE RATE AND DOMESTIC SCOURCING

In 1973, the International Monetary System changed from a fixed-rate to a floating-rate system. Under the floating-rate system, frequent fluctuations in currency exchange rates occur [Shapiro 1992]. These fluctuations expose multinational firms to a type of risk called real operating exposure that is caused by real exchange rate change. Real operating exposure is very broad in scope, and it poses a significant threat to multinational firms by changing their competitiveness across various markets and products. Specifically, real operating exposure arises because currency exchange rate changes, together with price e changes, alter a firm’s future operating cash lows (i.e., its revenues and costs). A firm, in protecting itself from real operating exposure, has to engage in long-term planning that may cover a ten-year period. Because hedging can be used to reduce currency exchange rate risk only in the short-term, the risk arising from real operating exposure has to be reduced by adopting appropriate strategies (e.g., component sourcing decisions, plant location, market selection, etc.) [Srinivasulu 1982; Shapiro 1989].

Whether a firm uses domestic or foreign sourcing partially depends on the cost advantage derived from the relative prices of goods and labor in various countries, which in turn, are partially influenced by currency exchange rates. From the perspective of U.S.-based firms, sourcing from suppliers outside the U.S. (i.e., foreign sourcing) yields cost savings if the U.S. dollar appreciates. On the other hand, domestic (i.e., U.S.) sourcing is more advantageous with a dollar depreciation. However, different types of product have different propensity to domestic vs. foreign sourcing. In a survey of 80 large U.S. manufacturing firms by the Machinery and Allied Products Institute (MAPI) [1986], more (81%) firms used foreign sourcing to procure component parts than for the procurement of materials (76%), machinery and equipment (69%), and services (16%). With the persistent depreciation of the U.S. dollar since 1985, we have witnessed a shrinkage of the U.S. trade deficit up to 1992 (partly a result of U.S.-based firms procuring more from the U.S. than from abroad). Since then, despite the continuous U.S. dollar depreciation, the U.S. trade deficit has increased drastically to $116 billion in 1993 [Economist, 1994], thus suggesting that other important variables influence the level of domestic vs. foreign sourcing, especially for the sourcing of major components. This is in concordance with recent economic literature [Baldwin 1988; Baldwin and Krugman 1989; Dixit 1989; Swamidass 1993] that microeconomic, firm-level strategic decisions have weakened currency exchange rate effects on domestic vs. foreign sourcing. Therefore, it is hypothesized:

H^sub 1^: With a depreciation of local (U.S.) currency, there is no significant change in the extent of domestic (U.S.) sourcing of major components used by U.S. subsidiaries of foreign multinational firms.

STRATEGY-DRIVEN FACTORS AND DOMESTIC SOURCING

As discussed earlier, recent domestic sourcing behavior of U.S.-based multinational firms suggests that sourcing decisions may not be determined by currency exchange rate. Furthermore, Swamidass [1993] suggested that, for manufacturers with extensive international experience, the level of domestic vs. foreign sourcing may be associated with strategy-related factors, rather than with currency exchange rate. The following are the strategy-related factors that are related to the level of domestic sourcing activities.

Product Maturity. Graham and Krugman [1989] observed the high level of import propensity (i.e., foreign sourcing) of Japanese multinational firms operating in the U.S. They noticed that affiliates of Japanese multinational firms imported almost two-and-a half times as much as other (e.g., European) foreign multinationals. This past phenomenon might reflect Japanese firms’ reluctance to use U.S.-made components [Fortune 1986]. Also, this might be attributed to the level and nature of Japanese foreign direct investment, which was lower in investment level and newer and less mature in nature than that of European investment. But, as these Japanese firms gain more experience in manufacturing in a foreign market, they tend to source more from local suppliers. An example is what we observe in the Japanese automobile industry, Honda and Nissan in the U.S. initially had local content of 30 and 47 percent, respectively. However, in 1987, their local content increased to 60 and 63 percent, respectively, because the product is maturing and these firms have established relationships with suppliers in the U.S.

H^sub 2^: There is a positive relationship between product maturity and the extent of domestic (U.S.) sourcing of major components used by U.S. subsidiaries of foreign multinational firms.

Region. Multinational firms in different regions tend to make sourcing decisions differently. Davidson [1989, p. 147] suggested that “there exists a strong correlation between the nationality of a corporation and its operating strategy.” In serving the U.S. market, Kotabe and Omura [1989] concluded that European firms were more likely to invest in production facilities in the U.S., while Japanese firms were more likely to export to the U.S. However, due to the persistent appreciation of Japanese yen against the U.S. dollar and pressure from the U.S. public to reduce the trade deficit with Japan, Japanese multinationals have been changing their sourcing behavior in serving both the U.S. and the Japanese markets by setting up production facilities in the U.S. In 1990, Japanese multinationals accounted for 46.5 percent of the $37.2 billion direct investments in the U.S. [Fortune 1991a]. Because of the drastic increase in Japanese direct investments in the U.S ., we have also seen a much higher level of U.S. sourcing. According to Japan Automobile Manufacturers Association, purchases of U.S. parts and materials by Japanese automakers have steadily increased from approximately $2 billion in 1986 to $15.5 billion in 1993. The $15.5 billion purchases in 1993 represented a 14% increase from those in 1992 [Gerdel 1994]. Although the sourcing behavior of European and Japanese multinationals operating in the U.S. may be converging, the components sourced by Japanese companies from U.S. suppliers are often standardized components. Kotabe and Omura [1989] concluded that Japanese multinational firms engage more extensively in the coordination of their sourcing activities on a global scale to achieve economies of scale in production and maximize the firm’s competitive advantage. Major components are often designed and manufactured in the parent’s country by the parent and/or its subsidiaries, therefore, subsidiaries that are located in a foreign country often internally source these major components from the parent’s country (i.e., foreign sourcing). For example, Honda’s core competencies are in combustion engines and power trains. These critical items are internally sourced by its subsidiaries because its ability to design and manufacture them is critical to the firm’s competitive advantage [Prahalad and Hamel 1990; Cavusgil et al. 1993].

H^sub 3^: There is a significant difference in the extent of domestic (U.S.) sourcing of major components used by U.S. subsidiaries aries of European and Japanese multimultinational firms.

Global Sourcing Strategy (Internal Component Sourcing and Domestic Assembly). Internal vs. external sourcing represent the ownership aspect of global sourcing, regardless of whether the components are sourced domestically or from abroad. The significant level of internal sourcing used by multinational firms is well documented n the international business literature. According to a survey by the United Nations Centre on Transnational Corporations, internal sourcing accounts for about 30% of U.S. exports and about 40% of U.S. imports. For both Japan and Western Europe, internal sourcing accounts for approximately 30% of their total trade flows (exports and imports combined) [United Nations Centre on Transnational Corporations 1988]. Recent empirical studies [e.g., Kotabe and Murray 1990; Kotabe and Omura 1989; Kotabe and Swan 1994] concluded that global sourcing of major components influences a product’s market performance, provided that these activities are carried out on an intra-firm basis (internal sourcing). This is because major components often involve highly proprietary technologies. By sourcing these crucial components internally, the firm can maintain its competitive advantage by keeping the proprietary technologies within the corporate system without having the risk of disseminating the technologies to independent suppliers, as would be the case if external sourcing were used (Buckley and Casson 1976).

Domestic vs. foreign sourcing represent the locational aspect of global sourcing, regardless of whether the components are sourced internally or externally. Multinational firms, in addition to maintaining their competitive advantages, exploit nations’ comparative advantages by establishing subsidiaries around the world to coordinate and integrate operations on a global scale [Kogut 1985; Porter 1986]. As the change in the design and manufacture of major components due to model or technology changes are mostly performed in the headquarters and/or subsidiaries located in the parent’s country, we would expect those major components that are internally sourced to come from locations other than the local market. Therefore, when internal sourcing of major components is used, we would expect foreign sourcing to be utilized because of the importance of flexibility and the avoidance of duplicating investments by multinational firms.

However, Kotabe and Omura [1989] concluded that assembly locations are generally major components sourcing locations also. This means that if foreign multinational firms choose to perform assembly of the final product in the United States, the sourcing of major components tends to come from the United States. In most cases, these major components were found to be mostly sourced using external sourcing. The reasons for performing final assembly of a product and sourcing major components domestically may range from a reduction of transportation costs and the perceived benefits against nationalism by using high local content.

H^sub 4a^:There is a negative relationship between the extent of internal sourcing of major components and the extent of domestic (U.S.) sourcing of major components used by U.S. subsidiaries of foreign multinational firms.

H^sub 4b^: There is a positive relationship between the extent of domestic assembly of the product and the extent of domestic (U.S.) sourcing of major components used by U.S. subsidiaries of foreign multinational firms.

MARKET PERFORMANCE AND DOMESTIC SOURCING

A small number of empirical studies have examined the relationship of global sourcing and market performance. However, most of these studies use aggregate data, so the influence of global sourcing on performance typically is investigated at a firm-, industry-, or countrylevel [Kim 1986; Moxon 1975]. As different products, possessing unique characteristics (i.e., technology, product life cycle, industry structure, etc.), may require different competitive strategies, the study of the relationship between global sourcing strategy and market performance is most appropriate and precise at the product-level. Previous studies [Kotabe and Murray 1990; Kotabe and Omura 1989], in using a product-level analysis, concluded that internal sourcing of major components is positively related to a product’s market performance; however, neither the locational (domestic vs. foreign) nor the ownership (internal vs. external) aspects of assembly affect market performance. These findings on internal sourcing of major components are consistent with the prediction of internalization theory [Buckley and Casson 1976]. When markets for intermediate products (such as components) and proprietary technology are imperfect, the firm is more likely to create an internal governance structure within the corporate system.

As mentioned in an earlier hypothesis, given the proprietary technology involved in major components of a product, the production of major components tends to be internalized within the corporation, especially in those manufacturing facilities located in the parent’s country. Consequently, it is expected that internal sourcing of major components from the parent’s country (i.e., foreign sourcing) would influence market performance positively. Therefore, it is hypothesized:

H^sub 5^: A product’s market performance is negatively related to the extent of domestic (U.S.) sourcing of major components by U.S. subsidiaries of foreign multinational firms.

RESEARCH METHOD

Sample

A sample of U.S. subsidiaries of foreign multinational firms was selected. The foreign parent firms selected were those listed in the Fortune Global 500 Directory 1991 [Fortune 1991b]. Only “Fortune Global 500” firms were included because they dominate global sourcing activities (domestic vs. foreign sourcing).

Moreover, these firms have subsidiaries around the world, thus facilitating the investigation of the impact of internal vs. external sourcing on domestic vs. foreign sourcing. The International Directory of Corporate Affiliations 1991 [IDCA 1991] was used to identify U.S. subsidiaries, and they were limited to manufacturing firms in the following industries: electronics, transportation equipment, scientific and photographic equipment, motor vehicles and parts, aerospace, computers and office equipment, industrial and farm equipment, and metal products. These industries manufacture products that are made of easily identifiable and separable components, which facilitated the identification of the information on component sourcing.

A preliminary questionnaire was pretested and revised via personal interviews with subsidiaries of six multinational firms located in the U.S. midwest. The final questionnaire was mailed to chief executive officers/presidents of 509 U.S. subsidiaries of foreign multinational firms. They were asked to identify one major product for their company and to complete the questionnaire or redirect it to the person having knowledge of, or responsibility for, component procurement for the product. Steps taken to decrease non-response included personalized addresses, pre-mailing letters, and follow-ups. Also, respondents were provided stamped, selfaddressed return envelopes. In addition, survey results were offered to respondent firms, upon request.

Of the 509 firms contacted, 42 were dropped due to unforwardable addresses, or because they reported that they were no longer engaged in manufacturing. Of the remaining 467 firms, 111 returned completed questionnaires, yielding an effective response rate of 24%. Several characteristics (country and sales volume of parent company, and type of product) of responding firms were compared between earlier and later respondents to provide an indication of non-response bias. Analysis showed no significant difference in the two samples. This finding offers some assurance about the representativeness of the responding firms [Armstrong and Overton 1977].

Respondents were divided between top management and middle management. Over 70% of responding firms’ parents were Western European, and the remaining Japanese. Firms from Sweden and Switzerland comprised nearly one-half of the European firms, with British and German firms constituting an additional onethird. More than one-third of the firms were part of corporations that had 1991 sales volume of $20 billion and over, and one-quarter had corporate family sales of $2.9 billion or less. Approximately 80% of the products were industrial durables, with one-half in the industrial and farm equipment and electronics industries.

MEASURES

The measures used in this study were either developed based on the previous studies cited earlier or by the authors. In addition to the variables contained in the hypotheses, the following control variables were also included in the analysis: number of suppliers, number of substitutes, switching costs, and management’s attitude toward domestic sourcing. The variables and their measurements used in this study are presented in Table 1.

ANALYSIS AND RESULTS

Most of the hypotheses were supported. The results are reported as follows:

H^sub 1^ To test the hypothesis that the extent of domestic sourcing of major components is not related to the U.S. dollar depreciation, a t-test was employed to compare the extent of domestic sourcing of major components in 1986 – 1991 with that used during 1980 – 1985. The mean percentages for the periods 1980 1985 and 1986 – 1991 were 73.47% and 73.04%, respectively. As expected, there was no significant change (p-value = .85) in domestic sourcing of major components during 1986 – 1991 (a period when the U.S. dollar depreciated) from the previous period. The result supported H^sub 1^.

H^sub 2^-H^sub 4^ Because there were both quantitative and categorical strategy-related factors, analysis of covariance was used to test these hypotheses. The results of the analysis of covariance for H^sub 2^ through H^sub 4^ are reported in Table 2.

H^sub 2^ investigates the relationship between product maturity and the extent of domestic sourcing of major components. Product maturity was highly significant (p-value = .00) in determining the level of domestic sourcing of major components used, thus supporting H^sub 2^. H^sub 3^ explores the similarity in sourcing behavior of major components by European and Japanese multinational firms. Region was insignificant (p-value = .73) in determining sourcing behavior. Therefore, the finding did not support H^sub 3^. H^sub 4a^ examines the relationship between the extent of internal sourcing with that of domestic sourcing of major components. The result showed that the relationship was marginally significant (p-value = .10) with a negative coefficient. The hypothesis of the higher the level of internal sourcing, the lower the extent of domestic sourcing of major components received marginal support. H^sub 4b^ evaluates the relationship between the extent of domestic assembly with domestic sourcing of major components. The relationship was significant (p-value = .01), thus supporting H^sub 4b^.

H^sub 5^ The relationship between each of the four indicators of market performance and the extent of domestic sourcing of major components was examined through the correlations of these variables. The results showed that market share (p-value = .02) and sales growth rate (p-value = .03) had a significantly negative relationship with the extent of domestic sourcing of major components, but not for return on sales and return on investment. Thus, H^sub 5^ was partially supported.

It was noted that all the control variables were found to have an insignificant relationship (number of suppliers: p-value = .53, number of substitutes: p-value = .19, switching costs: pvalue = .17, and management’s attitudes: pvalue = .22) with the extent of domestic sourcing of major components.

CONCLUSIONS AND IMPLICATIONS

All the hypotheses (except the one examining the relationship between region and domestic sourcing of major components) are supported, regardless of the industry characteristics and management’s attitude toward domestic sourcing. The findings strongly suggest that multinational firms coordinate their sourcing activities of major components globally based on strategy-related factors, rather than with currency exchange rate. Furthermore, domestic (U.S.) sourcing of major components by U.S. subsidiaries of foreign multinationals is negatively related to a product’s market share and sales growth rate.

Strategic Implications of Domestic Sourcing and Market Performance

The findings are consistent with our hypothesis that among manufacturers with extensive international experience, the decisions relating to domestic vs. foreign sourcing mainly related to strategy-related factors, rather than with currency exchange rate. Therefore, we observed that domestic sourcing of major components is negatively related to a product’s strategic market performance (market share and sales growth rate), but not related to financial market performance (return on sales and return on investment).

The strategic implications of major components can be explained by internalization theory [Buckley and Casson 1976; Dunning 1977; Rugman 1982]. Major components often involve high product technology and expertise; by internalizing highly proprietary technologies, a firm can keep them within its corporate system without passing them on to competitors or suppliers as if they were “public” goods. Also, the firm can reap the full economic rent of its technologies rather than receiving less by relying on market mechanisms, which may be imperfect. This is consistent with Cho’s [1990] findings that the higher the technological content of a product, the more likely it is for manufacturing multinational firms to source the product through internal sourcing. Because product innovations are easily reverse-engineered and improved upon, the design and manufacture of highly technological items tend to be internalized within the corporate system in the parent company’s (home) country. Furthermore, because of the ability of multinational firms to coordinate production activities globally to reap the benefits of economies of scale and the learning effect, different subsidiaries are assigned the responsibility of producing particular items to avoid the duplication of production-related investments and expenses.

Since continuous advances in the design and manufacture of crucial components in the product are mostly performed within the corporate system in the parent company’s (home) country, the sourcing of major components due to model or technology changes can be carried out with more flexibility from the home country. This strategic emphasis is consistent with our finding that internal sourcing of major components is negatively related to domestic sourcing of major components. In addition, the flexibility and lead time involved in sourcing crucial components with improved design and technological change is critical to a product’s ability to differentiate itself from its competitors. Consequently, sourcing major components from domestic (U.S.) suppliers by U.S. subsidiaries of foreign multinational firms may be negatively related to a product’s strategic market performance (market share and sales growth rate).

Diminishing Effects of Currency Exchange Rate on Domestic Sourcing and Market Performance

The study shows that a depreciation of a nation’s currency is not associated with a higher level of domestic sourcing of major components. As mentioned earlier in our discussion, major components are often sourced from the parent company’s (home) country due to the flexibility and strategic importance involved. Although the lower value of the U.S. dollar in recent years should provide cost savings to the sourcing firm by using domestic (U.S.) sourcing, we have not detected any significant change in the level of domestic sourcing of major components used by the multinationals firms in this study. This further supports our earlier finding that multinational firms, in sourcing critical components, focus on strategy-related factors, rather than with currency exchange rate. Consequently, we found that domestic sourcing of major components is not related to a product’s financial market performance (return on sales and return on investment). In summary, in the case of major components, the perceived cost benefits of using domestic sourcing when the U.S. dollar depreciates may be detrimental to a product’s strategic market performance, while at the same time, may not contribute to a product’s financial market performance.

The perceived vs. the actual cost benefits derived by using domestic (U.S.) sourcing due to U.S. dollar depreciation have important public policy implications. In 1985, through the Plaza Accord, the U.S. requested the G-5 nations to agree on the devaluation of the U.S. dollar, with the objective of shrinking the increasing U.S. trade deficit. This policy was based on the assumption that global procurement decisions are solely based on currency exchange rate. This assumption is contrary to our finding that strategy-driven factors, rather than currency exchange rate, important determinants in sourcing crucial components that are critical to a product’s market performance and in achieving its business objectives. Because of the strategic implications of major components, U.S.-based firms may have to continue to source them from overseas suppliers, despite the increased costs of these components because of the dollar depreciation. Consequently, public policy makers, in an attempt to boost procurement activities within the U.S., may hinder the ability of U.S.-based firms to coordinate their global sourcing activities effectively.

LIMITATIONS

This study has its limitations. First, U.S. subsidiaries of foreign multinational firms were chosen as subjects of this study; therefore, results may not be generalizable to U.S. multinational firms. Second, due to the scope of the present study, the potential interaction effects between currency exchange rate and strategyrelated factors were not examined.

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