Multinationality and profitability

J BUSN RES 1991:23:179-187

Multinationality

179

and Profitability

Yojin Jung North

Dakota

State University

Introduction The possession of firm-specific knowledge provides a competitive advantage to multinational enterprises (MNEs) operating in unfamiliar host country environments. For MNE investment to prove profitable, the firm must have some advantages over its local competitors. Firm-specific knowledge advantages enable MNEs to outperform their counterparts in host countries, as well as in home nations, and reap higher profits. Most empirical studies on the relationship between multinationality and profitability use multivariate analysis to examine the effects of an MNE’s size, advertising intensity, research intensity, and industry membership (e.g., Grant, 1987; Michel and Shakel, 1986; Siddharthan and Lall, 1982; Buckley et al., 1977; Horst, 1972). As Grant (1987) noted, however, surprisingly few authors have found a positive relationship between multinationality and profitability. Although MNEs tend to be more profitable than domestically based firms, multinationality tends to be either insignificantly or negatively related to profitability when the effects of other variables are taken into account. The purpose of this study is to revisit the issue by employing a different approach from prior studies in its examination of the data on multinationality and profitability. This study contributes to existing knowledge by identifying a positive relationship between multinationality and profitability. It also provides additional information as to the relative importance among firm-specific knowledge advantages in determining profitability, based on a relatively large sample of United States-based MNEs.

Hypotheses

and Econometric

Strategy

A theory of the multinational enterprise is concerned with the competitive advantage that enables multinational enterprises to be successful in multinational markets as well as at home, thereby reaping higher profits. According to Johnson (1970), the prototypical advantage is firm-specific knowledge or skill. Though it requires an investment of resources, the creation or development of new productive knowledge, if successful, is rewarded by monopoly profits. Once created, new knowledge has the characteristics of a public good, in the sense that use of such knowledge

Address correspondence Fargo, ND 58105.

to Yojin

Journal of Business Research 23, 179-187 (1991) 0 1991 Elsevier Science Publishing Co., Inc. 655 Avenue of the Americas, New York. NY 1010

Jung,

College

of Business

Administration.

North

Dakota

State University,

0148-2963/91/$3.50

180

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RES 1991:23:179-1X7

by one firm does not preclude use of it by another. While seeking to prevent the use of it by other firms, the firm attempts to maximize the benefits of its knowledge within the firm. Through foreign direct investment, the firm can increase its profits by applying the knowledge in an additional market. The knowledge can be exploited by subsidiaries of the parent firm with little, if any, additional cost to the parent company. Caves (1971, 1082) has argued that successful multinational enterprises possess one or more types of intangible knowledge assets. This intangible asset might take the specific form of a patented process or design, or might simply rest on knowhow shared among employees of the firm. The intangible might take the form of a marketing asset. The firm may possess special skills in styling or promoting its product, which makes it easy for the buyer to distinguish it from those of competitors. Such an asset has a revenue productivity for the firm. It signifies the willingness of some buyers to pay more for that firm’s product than from an otherwise comparable variety of the same good (assets of this type are closely akin to product differentiation). Therefore, an intangible knowledge asset gives rise to superior rates of profitability, partly because it generates monopoly rents to its owner and partly because it cannot be easily separated from the production process or sales activity of the firm. Firm-specific knowledge is created throughout the activities of the firm. Investments are made by the firm to create different types of information concerning innovative, production, and marketing activities of the firm. In this study, firmspecific knowledge is approximated by the following 3 advantages: R&D ability, product differentiation, and capital intensity. R&D ability results from expenditures incurred by a firm to create information for product creation and development or the development of the production function (Gruber et al., 1967; Hirsch, 1976). Capability for product differentiation is accumulated from the firm’s investment in differentiated products and their market creation (Caves, 1971). Capital intensity is a measure of firm-specific knowledge embodied in the machinery and equipment used by the employees of the firm. Firm size, relative to the market, could be a source of higher than normal rates of return. Larger firms usually have influence over the markets and, therefore, are operating in imperfect markets. Through the employment of monopolistic or oligopolistic power, higher profits can be generated. Furthermore, big companies may be able to borrow in the capital market at lower cost or to operate at lower cost because of risk spreading. They can also reap economies of scale in R&D, marketing, finance, and other managerial functions. Direct evidence of the size effect is obvious in that multinational enterprises usually are big corporations and vice versa (Horst, 1972). The hypotheses of this empirical work are 2-fold; first, the main determinant of profitability for multinational enterprises is firm-specific knowledge and second, multinational enterprises increase profits by entering multinational markets. This study employs a 2-step approach in an empirical examination of data on multinationality and profitability. First, profitability is regressed on firm-specific knowledge advantages. Then, the difference bctwecn actual profitability and projected protitability from the regression is related to multinationality. The estimating equation is as follows:

Multinationality

.I BUSN

RES lYY1:23:17Y-187

and Profitability

P = b,, + b, RD + b2 AD

+ b, KL + b, DI + u

181 (1)

where P stands for the firm’s profitability, RD the firm’s research and development ability, AD the firm’s product differentiation, KL the firm’s capital intensity, and DI industry dummies. The estimators of b,, b,, and b, are expected to be positive. The error term u represents the effect of unmeasured firm-specific knowledge whose mean is implicitly assumed to be zero. However, the data set is likely to exhibit systematic heteroscedasticity, since the error term is hypothesized to include the effect of multinationality and firm size on profitability. To that extent, our estimators of the Regression (1) are biased. Next, the difference between actual profitability and projected profitability from Regression (1) is regressed on multinationality to estimate the effect of multinationality on profitability. Note that the difference between actual and projected profitability also reflects scale and size effects. In dealing with the effect of scale and size, this study also employs a 2-step approach. First, a size variable is included along with multinationality as follows: P - F = a,, + a, M + a, SZ + e

(2)

where P stands for the firm’s actual profitability, p the firm’s projected profitability from Regression (l), M the firm’s multinationality, and SZ the firm’s size. The estimators a, and a, are expected to be positive. Second, the result of Regression (2) is adjusted for size effects to net out the effect of multinationality. In order to control for size effects, the regression including only firm size as an explanatory variable is analyzed: P - p = b,, + b, SZ + e

(3)

Based on the above estimated results, we computed the adjusted R2 which is one minus the ratio of the error sum of squares of Regression (2) to the error sum of squares resulting from Regression (3). The adjusted R2 represents the fraction of the variance of the dependent variable (profitability) explained by multinationality after controlling for size effects.

Empirical

Findings Estimations were done on U.S.-based multinational enterprises for 1976 and 1980. The firms were selected from the United Nations publication, Transnationaf Corporations in World Development: A Reexamination, 1978 and 1983. Samples of U.S.-based multinational enterprises were selected from 24 2-digit industrial classifications. For 1976 and 1978, sample sizes were 223 and 178, respectively. Most of the data came from the UN’s surveys of multinational corporations for 1976 and 1980. Supplementary data were obtained from a number of other sources. For detailed definitions and sources of the data, see the appendix. Table 1 presents the simple correlation between the variables in the equation. The explanatory variables RD and KL have the expected sign with the dependent variable P. But AD has a negative sign with P, contrary to our expectation. In fact, AD also shows negative correlations with RD and KL. Bivariate plots of the explanatory variables against the dependent variable P

182

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Y. Jung

1991:23:179-187

Table 1. Correlation

Coefficients,

1976 and 1980

RDh

66 21

KL

27 47

-03 -08

AD

- 14 - 18

-09 -08

SZ

90 72

57 49

26 35

-12 ~ 14

M

82 75 P

36 33 RD

36 31 KL

- 13 - 12 AD

-28 -26

89 94 sz

“In each cell, top numbers represent 1976; lower numbers, 1980; all decimals omitted bRD = R&D ability measured by the firm’s R&D expenditures; KL = capital-to-labor ratio for embodied knowledge measured by dividing total assets by total employment of the firm; AD = product differentiation measured by the firm’s advertising expenditures; SZ =size variable measured by the firm’s sales; M = multinationality measured by the proportion of sales attributable to production abroad; P = profitabiity measured by the ratio of (after-tax) net

income to total assets.

indicate that the simple correlation is, in some cases, affected by a few extreme observations. The after-tax net income (P) is plotted against R&D expenditures (RD) for 1980 in Figure 1. The automakers such as GM, Ford, and Chrysler are identified to be influential observations. Figure 2 plots P against advertising expenditures (AD) and illustrates another case in which these 3 firms are influential observations in 1980. The U.S. automakers were big spenders in terms of R&D and advertising, but they still suffered from significant losses in 1980. As often is a case with an econometric study of a cross-section of firms (or houses and countries for that matter), individual observations can exert an uncomfortably large influence on the estimates. Including the automotive firms in the analysis may produce spurious results. Table 2 shows the estimated results of the Regression (1) for 1980 (the estimators of 23 industry dummy variables are not statistically significant and are not reported in the table). The results in Row 1 were generated from the whole data set. The estimated parameters of RD and KL confirm our expectations. The AD parameter does not. Product differentiation appears to have a significantly negative effect on P. As mentioned above, however, the visual impression left by Figure 2 (and Figure 1) casts doubt on the results of the regression. To cope with the problem, the informal approach of deleting influential observations from the data set was selected (Belsley et al., 1980). Rows 2, 3, and 4 in Table 2 report the consequences of deleting outliers from the data set. The second row shows the results with GM excluded. The third row excludes both GM and Ford. Finally, Row 4 excludes GM, Ford, and Chrysler. With these large outliers excluded, we produced statistically significant results that conformed to our expectations. Table 3 reports the result of the Regression (1) for 1976. Estimated coefficients are not equal to zero and their signs are well determined by our data set. The effect on profitability of firm-specific knowledge advantages is concentrated in the positive side of origin as witnessed by large positive t-statistics. Formally speaking, there is less than 2.5% chance that the estimated signs of the coefficients change.

Multinationality

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183

? T03C

-

zcoo -

iCOC

-

1000

! 1.. i

-1coo

__

. . .

L I Chrysler

0

200

ICC

GOC

900

1300

1200

lCO0

1600

1300

2000

220s

IiD

Figure 1. Bivariate plot between net income and R&D. Note: 42 observations values; 84 observations hidden.

had missing

Thus, we can conclude that our data set is informative about the signs of the coefficients. In the case of the U.S. multinational firms for 1976, about 60% of the profitability of firms is explained by firm-specific knowledge advantages. This is similar to the heteroscedasticity-adjusted figure for 1980. Which variable, among firm-specific advantage, is the most important in explaining the profitability of the firm? Because the variables in the equation differ in the unit of measurement, the usual regression coefficients can be made more comparable by expressing them in terms of the beta coefficients. A beta coefficient is the estimated regression parameter after all variables have been standardized to

J BUSN RES 1991:23:17Y-187

Y. Jung

? i 7000

*

I

I 6500

+

5000

i

4000

-

1000

-

1000

1

+ I

j.::.: I ............ 0 + ........ I .

-1000

a

......

..

: ... :.

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.

! Ford

Chrysler -2000

f _~_____----*__-_____-c__________________~*~~___~~~~*~~~~~~___

0

200

400

600

Figure 2. Bivariate plot between net income missing values; 107 observations hidden.

800

and advertising.

1000

1200

Note: 5 observations

had

have unit variance. In applied econometric studies, beta coefficients are used to rank variables, though it is much more common to rank variables by their t-values rather than their beta values. Beta coefficients are used here for a comparison purpose to simply measure the change in the dependent variable for unit change in each explanatory variable. As shown in Table 4, the most important variable in 1976 was RD, but it changed to KL in 1980. The contribution of KL to the profitability of the firms more than doubled between the 2 points in time, while that of RD steadily increased over the

Multinationality

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and Profitability

Table 2. Results

of Regression

(l),

RD

Const.

(1)

4.69 (85.99) (2) -79.38 (90.69) (3) - 337.50 (x2.22)*** (4) -336.58 (76.06)***

1980 KL

0.89 (0.25)***h 1.08 (0.25)*** 1.91 (0.24)*** 1.97 (0.22)***

185

8.49 (l.ll)*** 8.62 (1.09)*** 8.87 (0.90)*** 8.62 (0.84)***

AD

df

ii’

F

-1.65 (0.54)*** - 0.92 (0.60) 1.17 (0.57)** 1.44 (0.53)***

127

0.350

24.49

126

0.369

26.37

125

0.548

53.21

124

0.591

62.55

“Numbers in parentheses are standard errors. be** a*, and * indicate significance at the 1, 5, and lO%, respectively.

On the other hand, the contribution of AD decreased slightly during the period. The second hypothesis of this study is that multinationality itself improves the profitability of firms. To test this hypothesis, Regression (2) was utilized. The systematic heteroscedasticity from Regression (1) is assumed to be a function of the multinationality of the firm. The regression results, along with the effect of firm size, are given in Table 5. The effect of multinationality is not substantial. Though multinationality shows positive contributions, both in 1976 and in 1980, it barely reaches a significance level of 90% in 1980 only. On the other hand, firm size has significant and positive effects on the profitability of the firm. Table 6 presents R2 values for the regressions both before and after an adjustment

period.

Table 3. Results

of Regressions RD

KL

0.99 (0.16)***

2.67 (0.43)***

Const. - 84.23 (40.72)“**b

(2), 1976 AD

df

1.21 (0.31)***

104

E’

F

0.61

57.44

~~*u~rn~ in parentheses are standard errors. > , and * indicate significance at the 1, 5, and 10% respectively.

Table 4. Beta Coefficients

RD KL AD

Table 5. Results

of Regression

Const. 1980 1976

-331.48 (110.72)“**b - 193.66 (70.21)***

1980

1976

0.66 1.15 0.29

0.63 0.50 0.32

(2) A4 5.34 (3.56)* 2.77 (2.13)

sz

df

ii2

F

0.02 (0.004)*** 0.02 (0.003)***

120

0.237

20.11

90

0.358

26.92

;F*u*rntfrs in parentheses are standard errors. 2 3and * indicate significance at the 1, 5, and 10% respectively

.I BUSN

RES lYY1:23:179-187

186

Table 6. R’ Values Including 1976 1980

size effects

Excluding

0.358 0.237

size effects 0.018 0.018

for size effects. The size adjusted R’ is quite small; it is less than 2% for both 1980 and 1976. For U.S. multinational firms in 1980 and 1976, the net contribution of multinationality strategies to profitability is approximately 2%.

Summary

and

Conclusions

For U.S. multinational enterprises in 1976 and 1980, the large bulk of their profits results from their firm-specific knowledge advantages such as R&D, product differentiation capabilities, and capital intensity. Approximately 60% of profits are explained by such advantages. Among firm-specific knowledge advantages, the contribution of capital intensity to profitability increased significantly between 1976 and 1980, whereas other advantages maintained stable contributions for the period. There seems to be weak evidence suggesting the positive relationship between multinationality and profitability. Approximately 2% of the firms’ profits is explained by the firms’ multinationality itself. On the other hand, firm size contributed to the firms’ profitability by about 30% in 1976 and 20% in 1980. Size itself was a significant source of additional profits to the larger firms. Earlier drafts of the paper have been profitably discussed with R. Stan Herren and Won W. Koo. wish to thank Attila Yaprak and anonymous referees for helpful comments and suggestions. Karen MacDonald provided excellent editorial assistance.

Data

I

Appendix The data for individual Transnational

firms were taken

Corporations

in World

for the most part from United

Development:

1983. In a case where data were unavailable indicated under the specific variable headings M P SZ KL RD AD

above, below.

A Reexamination,

other

sources

were

Nations, 1978 and

used as

is an index of multinationality measured by the proportion of sales attributable to production abroad. is an index of profitability measured by the ratio of after-tax net income to total assets. is a size variable measured by the firm’s sales. is an index of embodied knowledge measured by dividing total assets by total employment of the firm, which is the capital-to-labor ratio. is R&D ability measured by the firm’s R&D expenditures. Data were obtained from Business Week’s surveys “R&D Scoreboard.” is an index of product differentiation measured by the firm’s advertising expenditures. Data were obtained from Leading National Advertisers, Inc., LNA Multi-Media Report Service, New York.

Multinationality

J BUSN RES 1991:23:179-187

and Profitability

187

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