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Managing Global Transitions
International Research Journal
editor
Boštjan Antonˇ
ciˇ
c, University of Primorska,
Slovenia
associate editors
Egon Žižmond, University of Primorska,
Slovenia
Dušan Lesjak, University of Primorska,
Slovenia
Anita Trnavˇ
ceviˇ
c, University of Primorska,
Slovenia
Roberto Biloslavo, University of Primorska,
Slovenia
editorial board
Zoran Avramovi´
c, University of Novi Sad,
Serbia
Terrice Bassler Koga, Open Society Institute,
Slovenia
Cene Bavec, University of Primorska, Slovenia
Jani Bek ˝
o, University of Maribor, Slovenia
Vito Bobek, University of Maribor, Slovenia
Štefan Bojnec, University of Primorska,
Slovenia
Suzanne Catana, State University of New York,
Plattsburgh, usa
David L. Deeds, University of Texas at Dallas,
usa
David Dibbon, Memorial University
of Newfoundland, Canada
Jeffrey Ford, The Ohio State University, usa
William C. Gartner, University of Minnesota,
usa
Tim Goddard, University of Prince Edward
Island, Canada
Noel Gough, La Trobe University, Australia
George Hickman, Memorial University
of Newfoundland, Canada
Robert D. Hisrich, Thunderbird School of
Global Management, usa
András Inotai, Institute for World Economics
of the Hungarian Academy of Sciences,
Hungary
Hun Joon Park, Yon s e i Un i v e r s i t y, S o u th K o re a
Štefan Kajzer, University of Maribor, Slovenia
Jaroslav Kalous, Charles University,
Czech Republic
Maja Koneˇ
cnik, University of Ljubljana,
Slovenia
Leonard H. Lynn, Case Western Reserve
University, usa
Monty Lynn, Abilene Christian University, usa
Neva Maher, Ministry of Labour, Family and
Social Affairs, Slovenia
Massimiliano Marzo, Univer sity of Bologna,
Italy
Luigi Menghini, University of Trieste, Italy
Marjana Merkaˇ
c, College of Entrepreneurship,
Slovenia
Kevin O’Neill, State University of New York,
Plattsburgh, usa
David Oldroyd, Independent Educational
Management Development Consultant,
Poland
Susan Printy, Michigan State University, usa
Jim Ryan, University of Toronto, Canada
Mitja Ruzzier, University of Primorska,
Slovenia
Hazbo Skoko, Charles Sturt University,
Australia
David Starr-Glass, State University of New
York, usa
Ian Stronach, Manchester Metropolitan
University, uk
Ciaran Sugrue, Dublin City University, Ireland
Zlatko Šabiˇ
c, University of Ljubljana, Slovenia
Mitja I. Tavˇ
car, University of Primorska,
Slovenia
Nada Trunk Širca, University of Primorska,
Slovenia
Irena Vida, University of Ljubljana, Slovenia
Zvone Vodovnik, University of Ljubljana,
Slovenia
Manfred Weiss, Johan Wolfgang Goe the
University, Germany
Min-Bong Yoo, Sungkyunkwan University,
South Korea
Pavel Zgaga, University of Ljubljana, Slovenia
editorial office
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Faculty of Management Koper
Cankarjeva 5,si-6104 Koper, Slovenia
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Managing Editor: Alen Ježovnik
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c
Copy Editor: Alan McConnell-Duff
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Text D e s ign an d Ty p eset t i ng: Alen Ježovnik
Managing Global Transitions
International Research Journal
volume 7 ·number 1 ·spring 2009 ·issn 1581-6311
Table of Contents
3The Editor’s Corner
5What Drives Innovation? Causes of and
Consequences for Nanotechnologies
Ingrid Ott
Christian Papilloud
Torben Züls d o r f
27 A Model for Making Foreign Direct Investment
Decisions Using Real Variables for Political
and Economic Risk Analysis
Carl B. McGowan, Jr.
Susan E. Moeller
45 The Influence of Outsourcing and Information
and Communication Technology on
Virtualization of the Company
Massimo Manzin
Borut Kodriˇc
61 The Relationship between Working Capital
Management Efficiency and ebit
Azhagaiah Ramachandran
Muralidharan Janakiraman
75 A Strategic Household Purchase:
Consumer House Buying Behavior
Mateja Kos Kokliˇc
Irena Vida
The Editor’s Corner
The journal continues focusing on the transition research and emphasiz-
ing openness to different research areas, topics, and methods, as well as
international and interdisciplinary research nature of scholarly articles
published in the journal. The current issue covers topics of the impacts
of nanotechnologies, political and economic risk, outsourcing and vir-
tualization, working capital efficiency, and consumer house-buying be-
havior.
This issue begins with a paper written by Ingrid Ott, Christian Papil-
loud and Torben Zülsdorf, who investigate the impacts of nanotechnolo-
gies from the perspective of the overall innovation in downstream sec-
tors and further developments in nanotechnologies. In the second paper,
Carl B. McGowan, Jr. and Susan E. Moeller present the study of decisions
by using variables for political and economic risk analysis. In the third
paper, Massimo Manzin and Borut Kodriˇ
c study the influence of out-
sourcing, information and communication technology on virtualization
of an organization. In the fourth paper, Azhagaiah Ramachandran and
Muralidharan Janakiraman examine the relationship between working
capital management efficiency and ebit. In the fifth paper, Mateja Kos
Kokli ˇ
c and Irena Vida examine consumer house-buying behavior from a
consumer perspective.
Boštjan Antonˇ
ciˇ
c
Editor
Managing Global Transitions 7(1): 3
What Drives Innovation? Causes of and
Consequences for Nanotechnologies
Ingrid Ott
Christian Papilloud
Torben Zülsdorf
Nanotechnologies are expected to be the dominant general purpose
technology of the next decades. Their market potential is immense and
not only supply-side but especially demand-side arguments will have
far reaching consequences for innovations. The latter may occur as in-
creased miniaturization or via building completely new products, pro-
cesses or services. Innovations in the field of nanotechnologies do not
only affect productivity in downstream sectors but these feed back to
nanotechnologies thereby inducing circles of continuing innovation.
Demand for nano-components mainly arises from firms while private
demand is assigned to final products, processes or services that are
augmented by nanotechnologies. Due to the technology’s controversial
character, the consumer’s attitude towards risk and technology affects
private demand and this may either spur or hamper innovation. The
paper aims to unravel how these complex interdependencies and feed-
back mechanisms affect overall innovation in downstream sectors that
is induced by nanotechnologies and how this for its part affects further
improvements of nanotechnologies.
Key Words: general purpose technologies, controversial technologies,
determinants of innovation
jel Classification: o33,z13
Introduction
Future decades are expected to be largely dominated by increased utiliza-
tion and spread of nanotechnologies. This term broadly refers to tech-
Ingrid Ott is Head of the group ‘Innovation and Growth’
at the Hamburg Institute of International Economics, Germany,
and Research Associate at the Kiel Institute for the World Economy,
Germany.
Christian Papilloud is professor at the ufr des Sciences de l’Homme,
Université de Caen Basse-Normandie, France and invited professor
at the Leuphana University of Lueneburg, Germany.
Torben Zülsdorf is junior researcher at the Hamburg Institute
of International Economics, Germany.
Managing Global Transitions 7(1): 5–26
6Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
nologies and devices whose unifying theme is the control of matter at
an atomic and molecular scale, namely with critical dimensions smaller
than 100 nanometers. The manipulation of nanostructures leads to the
observation of completely new phenomena and with this prepares the
ground for considerable innovations. The goal of this paper is to give an
overview on some most important lines of argumentations relevant in
the context of the complex innovation process of nanotechnologies. In
doing so the paper provides a theoretical framework for discussing the
potential but also possible frictions of that newly emerging technology.
Permanent innovation is especially important for those countries that
are poorly endowed with natural resources in order to be competitive at
an international level and to realize ongoing growth (see e. g. Barro and
Sala-i-Martin 2004;Acemoglu2009 for a recent overview on the link be-
tween innovation and growth). A more precise look at innovation deter-
minants reveals that it is possible for most eras to identify a certain tech-
nology that has a key function for the generation of innovations in other
fields (see e. g. Rosenberg 1992). This has led to the distinction in dras-
tic and incremental innovations. Drastic innovations frequently spur in-
cremental innovations in complementary fields thereby introducing far-
reaching economic and societal effects. If drastic innovations have the
potential for pervasive utilization – as e. g. the steam engine, electricity
or the computer – they are called general purpose technologies (see e. g.
Bresnahan and Trajtenberg 1995 who coined that term).
Although they may basically be used in a variety of applications this
neither implies any automatism concerning diffusion nor that efficiency
considerations are the only determinant driving demand for the new
technology. This argument becomes strikingly obvious in the context of
so-called controversial technologies – a notion stating that it is not per se
clear whether, from an aggregate point of view, chances or possible risks
of the innovation dominate (biotechnology or nuclear power are some
prominent examples of such a kind of technology). Given this, individual
attitudes towards technologies and risk become important for the devel-
opment and diffusion of the innovation. In the extreme, failing public
acceptance may interrupt the innovation process.
One might conclude that usually innovation processes are driven by
demand-side as well as by supply-side arguments, in which each position
holds a certain role. Throughout this paper supply-side arguments will be
discussed in the context of general purpose technologies, thereby includ-
ing a microeconomic and a macroeconomic perspective. From the point
of view of single firms, the most important are externalities and feedback
Managing Global Transitions
What Drives Innovation? 7
effects that arise along the value chain. As a consequence too few inno-
vations are realized, and on top of that they arise too late. The aggre-
gate perspective adds further arguments, namely the impact of general
purpose technologies on total factor productivity. Following the logic of
the so-called productivity paradox, the implementation of a new general
purpose technology only enhances overall productivity in the long-run
whereas, due to costly adjustment processes, in the short-run even pro-
ductivity losses may arise. A second perspective focuses on demand-side
arguments mainly arising in the context of controversial technologies.
These approaches do not focus on pure technological aspects but lay em-
phasis on the needs, preferences and the utility of the users.
Several features qualify nanotechnologies as the future dominating
general purpose technology. One is pervasiveness, since the technology
may be utilized in lots of animate and inanimate fields. Due to their tini-
ness nanotechnologies are used at the origins of the value creation chain
and induce high technological dynamics. Improvements in nanotech-
nologies also affect productivity in the downstream sectors, which due
to technological dynamics, again spurs innovation in the upstream tech-
nology. As a consequence, not only production but also innovation pro-
cesses are vertically linked, at which the latter interdependency runs in
both directions along the value creation chain. But aside from this, nan-
otechnologies are also understood as representing a controversial technol-
ogy and great efforts are made to avoid interruptions in the innovation
process that might arise as a consequence of failing public acceptance.
The remainder of the paper is as follows: the second section presents
determinants and economic aspects of general purpose technologies.
The third section analyzes supply-side and demand-side arguments of
innovation in the case of controversial technologies. The fourth section
applies the arguments detailed before on the case of nanotechnologies.
The fifth section briefly concludes.
Economic Aspects of General Purpose Technologies
drastic versus incremental innovations
In the simplest form, technological progress arises as an incremental pro-
cess that improves the efficiency of resource deployment. It may not be
uniform across sectors or time, but the aggregate effects are relatively
smooth.¹In contrast are major inventions that have had far-reaching
and prolonged implications, such as the steam engine, electricity, or the
computer. The distinction between drastic and incremental innovation is
Volume 7·Number 1·Spring 2009
8Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
useful, since frequently incremental innovations – although taking place
in the regular course of business – follow drastic innovations. A drastic
innovation, however, introduces a discontinuity in the organization of
the economy in the sense that the innovation replaces an old technology
that played a significant role in an industry with new methods of pro-
duction. Or it replaces an old material that performed certain functions
with a new one.²
Note that a discontinuity in this sense does not automatically imply
a necessary discontinuity in the observed pattern of resource allocation
or the evolution of output. The introduction of a superior technology
can be gradual, starting with a negligible absorption of resources which
is followed by continuous expansion over time.³It is nevertheless helpful
to distinguish between drastic and incremental innovations since the lat-
ter frequently are triggered by drastic innovations. Put differently, drastic
innovations induce series of incremental (and often complementary) in-
novations.
The distinction between drastic and incremental innovations is also
helpful with respect to their emergence: It is possible that forces driving
incremental innovations are different from those that drive drastic inno-
vations. For example, incremental innovations are more susceptible to
standard profitability calculations, even when they involve externalities
and are subject to risk, simply because markets can evaluate their prof-
itability. In contrast, drastic innovations face much larger uncertainties,
producing risks that are much harder to evaluate by the market (see e. g.
Rosenberg 1996). As a result, drastic innovators can engage little in risk-
sharing and have to bear most of the risk themselves.⁴
peculiarities of general purpose technologies
A drastic innovation qualifies as general purpose technology if it has the
potential for pervasive use in a wide range of sectors in ways that dras-
tically change their modes of operation. To quote from Bresnahan and
Trajtenberg (1995), who coined the term general purpose technology and
provided a highly original discussion of its usefulness:⁵
Most gpts play the role of ‘enabling technologies,’ opening up new oppor-
tunities rather than offering complete, final solutions. For example, the
productivity gains associated with the introduction of electric motors in
manufacturing were not limited to a reduction in energy costs. The new
energy sources fostered the more efficient design of factories, taking ad-
vantage of the newfound flexibility of electric power. Similarly, the users
Managing Global Transitions
What Drives Innovation? 9
as11 as12 as21 as22 as31 as32
as1as2as3
gpt
IdeaResearch
Development
Production Diffusion
Idea Research Development
ProductionDiffusion
fig ur e 1 Generality of purpose and innovational complementarities (gpt – general
purpose technology; as – applying sector)
of microelectronics benefit from the surging power of silicon by wrap-
ping around the integrated circuits their own technical advantages. This
phenomenon involves what we call ‘innovational complementarities’ (ic),
that is, the productivity of r&din a downstream sector increases as a con-
sequence of innovation in the gpt. These complementarities magnify the
effects of innovation in the gpt, and help propagate them throughout the
economy.
The description makes clear two most important features of drastic
innovations that qualify as general purpose technologies: generality of
purpose as well as innovational complementarities.⁶When these effects
are particularly strong, as for example in the case of electricity, infor-
mation and communication technologies and the internet or henceforth
nanotechnologies, they lead to considerable changes in economic orga-
nizations. Sometimes they also affect the organization of society through
changes in working hours, constraints of family life, social stratification,
and the like.⁷
One immediate consequence of pervasiveness are strong interdepen-
dencies between lots of actors along the value creation chain. Figure 1
contains a technology tree that illustrates horizontal and vertical link-
ages, that arise between the general purpose technology (denoted by
Volume 7·Number 1·Spring 2009
10 Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
gpt) and downstream sectors (applying sectors, hence as)whichap-
ply the technology. The generality of purpose is indicated by the verti-
cal linkages while horizontal lines between the applying sectors illustrate
that also firms at the same level of the value creation chain are basically
interrelated. Figure 1also contains two innovation processes (from the
pure idea until diffusion) which are indicated by the outside arrows. One
innovation process begins at the level of the general purpose technol-
ogy and works downwards along the value creation chain. Diffusion then
takes places via utilization of the general purpose technology in down-
stream sectors in which the technology plays the role of an intermediate
input, and diffusion along the technology tree takes place in the form of
a cascade. Additionally, figure 1encompasses a second innovation pro-
cess which, in turn, comes from the applying sector and goes back to
the general purpose technology and hence runs upwards along the value
creation chain. This indicates that inherent to the general purpose tech-
nology there is the potential of technological improvement that runs in
two directions.⁸The utilization of the general purpose technology by the
downstream firms reveals potential for improvement and hence induces
innovation processes in the upstream sector, namely the general purpose
technology. This, in turn, induces improvements in the upstream general
purpose technology which again feed back to downstream sectors and so
forth.
As argued in the context of figure 1, numerous interactions exist be-
tween upstream and downstream sectors. These interdependencies do
not only arise in a production context but also during the innova-
tion processes within companies. They incorporate two fundamental
externalities:⁹
•Vertical externalities. Due to innovational complementarities, the
innovation activities in upstream and downstream industries are
related, and firms in upstream and downstream sectors have linked
payoffs. As long as each firm decides individually, it does not con-
sider the aggregate effects arising from its individual action. Con-
sequently, the well-known appropriability effect (namely the failing
to appropriate the entire returns of individual activities) arises (see
Helpman and Trajtenberg 1998). A familiar problem of imperfect
access to the social returns arises, except that in the context of gen-
eral purpose technologies it runs in both ways. This encompasses
a bilateral moral hazard problem which implies that not any side,
neither the upstream nor the downstream firm, will have sufficient
Managing Global Transitions
What Drives Innovation? 11
incentives to innovate. As a consequence, the innovation incentives
along the entire value creation chain are too little with respect to the
extent and arise too late.
•Horizontal externalities. Applying sectors include actual and possi-
ble users of the general purpose technology. Their demand depends
positively upon the quality and negatively upon the price of the
general purpose technology. At the same time, quality within the
general purpose technology sector depends on marginal produc-
tion costs and on the (aggregate) technological level of all applying
sectors. Hence, if one single applying sector innovates to increase its
own technological level (with the goal of reducing own production
costs) also the aggregate level of all applying sectors will increase.
This leads to improvements within the general purpose technology
and hence to reduced costs not only in the originally innovating
sector but also in the other (non-innovating) downstream sectors.
However, as argued before, again the appropriability effect comes
into action, and again this induces a moral hazard problem: Why
should any applying sector innovate if it could benefit at zero costs
from the innovation in another sector?
To sum up: As Bresnahan and Trajtenberg (1995) noted, general pur-
pose technologies introduce two types of externalities: one between the
general purpose technology and the application sectors (vertical); an-
other across the application sectors (horizontal). The former stems from
the difficulties that an inventor of the general purpose technology may
have in appropriating the fruits of the invention. When institutional
conditions prevent full appropriation, the general purpose technology
is effectively underpriced and therefore undersupplied. The latter occurs
since the application sectors are not coordinated and each one conditions
its expansion of the available general purpose technology. If in contrast
they coordinated a joint expansion, they would raise the profitability of
the general purpose technology and encourage its improvement. A bet-
ter general purpose technology fits them all. Consequently, coordination
of a joint expansion – and with this the conditions of demand – are of
major importance for the diffusion and thus improvement of the general
purpose technology, which in the end benefits all.
general purpose technologies and aggregate growth
From an economic point of view, general purpose technologies are not
only interesting from a microeconomic perspective but they have also
Volume 7·Number 1·Spring 2009
12 Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
some peculiarities with respect to their aggregate effect or, to be more
precise, for aggregate growth. As has been widely shown by economic
historians, in any given period, there exist some technologies that play
a far-reaching role in the sense that they bring about sustained and per-
vasive productivity gains and which, in consequence, widely foster eco-
nomic growth. Some examples are the steam engine during the industrial
revolution, electricity during the first decades, or microelectronics in the
second half of the 20th century. Nanotechnologies are expected to induce
the next long-run wave.¹⁰ The basic argumentation is as follows: As an
improved version of the general purpose technology becomes available
it gets adopted by an increasing number of application sectors which, in
turn, are accompanied by further advances, thus raising the attractive-
ness of further adoption. This increases the demand for the general pur-
pose technology, thereby inducing improvements of the general purpose
technology, which then prompts a new round of advances in the applica-
tion sectors, and so forth. As the effects become significant at an aggre-
gate level, the general purpose technology finally affects overall growth.
However, even if substantially important in the long-run, new technolo-
gies may at first have no significant impact on actual growth, since they
have to await for the development of a sufficiently large amount of com-
plementary assets in the applying sector. Moreover, these assets use up
resources and hence, in the short nun, growth may even be negatively
affected.
This latter aspect of the so-called ‘productivity paradox’ has been for-
malized e. g. by Helpman and Trajtenberg (1998)whodevelopagrowth
model which allows for studying the economy-wide dynamics that the
emergence of a new general purpose technology may generate. Within
this paper we just present a short sketch of the model’s simplest version
without going into formal details, thereby assuming that advances in the
general purpose technology are exogenous. Hence we abstract from ana-
lyzing the implications of innovational complementarities illustrated be-
fore. To keep the discussion simple we focus on the role of complemen-
tarity in the sense that the downstream sectors, which provide compo-
nents that are complementary to the general purpose technology, and
their incentives for innovation are of primary interest.¹¹ Figure 2pro-
vides a simple illustration of the relevant interdependencies.
Figure 2contains a stylized sequence of the emergence of a new general
purpose technology which contains three cycles. Each cycle is denoted by
Δand describes a phase in which a certain general purpose technology,
Managing Global Transitions
What Drives Innovation? 13
λ1λ1λ2λ2λ3λ3
λ0λ1λ1λ2λ2λ3
Δ1Δ2Δ1Δ2Δ1Δ2
Ti−1TiTi+1Ti+2
ΔΔΔ
r&d
fps
Phase
Cycle
fig ur e 2 Theimportanceofcomplements(T1– availability of gpt1,startof
development of components for gpti+1,Ti+Δ
1–switchinthefps to
gpti+1,Δ– phase in which a general purpose technology is available; Δ1–
phase with productivity decline; Δ2– phase with productivity growth; λi–
general purpose technology at work; fps – final product sector; r&d–
research and development)
denoted by λi, is at work. The positive parameter iis ordinal and indi-
cates the consecutive number of the current general purpose technology.
The parameter λis assumed to exceed unity, hence a newer gpt implies
higher values of λi.
Since the general purpose technology is not a lonely standing tech-
nology but is applied to a variety of uses we distinguish the utilization
within the final product sector (denoted by fps) and in the component
sector (denoted by r&d). Each cycle is divided in to two phases, Δ1and
Δ2; both may be distinguished as follows: Within the first phase, Δ1,fi-
nal output is manufactured with the old general purpose technology, λi,
while innovators already develop components for the new general pur-
pose technology, λi+1. Consequently, the number of components for λi+1
rises over time. Note that the development of components for the next
technology comes at the cost of negative output and productivity growth,
stagnating real wages, and declining profit shares. In the second phase,
Δ2,afterasufficient amount of components for the new general purpose
technology has been developed, manufacturers of final output switch to
the new technology, λi+1, while innovators still continue to develop com-
ponents for this technology. Then the benefits of an advanced general
purpose technology manifest themselves. As a consequence, output, real
wages, and profits rise.
In figure 2this becomes apparent while looking at the general purpose
Volume 7·Number 1·Spring 2009
14 Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
technology at work within the separate sectors, namely the sectors for
final goods production and the one for the development of components:
While during Δ1two different general purpose technologies (e. g. λ1and
λ2)affect economic activity in the respective sector, Δ2is characterized
by the overall utilization of the most recent general purpose technology
(e. g. λ2) in both the component and the final product sector.
To sum up: Within each cycle, the analysis shows the centrality that
complementary investments play in the aggregate growth process. Above
it is shown how the sequential and cumulative nature of such comple-
mentary investments may induce different phases along each cycle, each
of them exhibiting very different features. Of special interest is the ini-
tial phase of negative or below average growth. This results from the fact
that there exists a threshold level of complementary inputs that needs
to be developed before the general purpose technology at work in final
goods’ production can be displaced by the newest one. Hence one has to
carefully consider the time line in assessing the growth impact of general
purpose technologies: while aggregate growth increases in the long-run
due to productivity gains of the improved gpt and the complementary
components (second phase), productivity initially declines as a conse-
quence of parallel use of two gpt during the first phase.
Innovation and International Competitiveness
supply and demand side arguments
Until here the argumentation referred to the interdependencies between
upstream and downstream sectors, the arising coordination problem
that ends up in too little and too late innovation, and delayed growth
effects induced by the general purpose technology. This perspective al-
ready underlines the fundamental point of the development of general
purpose technologies, namely the role of demand. As we argue along the
technology tree, not only demand for final products but also firms’ de-
mands that arise along the value creation chain gains importance.
As argued before, those theories that focus on the supply-side fre-
quently stress the implications of knowledge as (at least a partial) pub-
lic good. Innovative firms are not able to appropriate all returns that
are generated by their innovation activities while they have to cover the
entire costs. Consequently the incentive for innovation is sub-optimally
low and the innovation process is accompanied by market failures. This
justifies governmental intervention in the innovation process frequently
Managing Global Transitions
What Drives Innovation? 15
in the form of direct or indirect subsidies.¹² In addition, supply of new
products, processes or services is also affected by national tax systems,
the availability of qualified labor or other input factors, as well as by co-
operation possibilities with component suppliers or other firms.
In contrast to this a relevant impact for continuous innovation stems
fromambitiouscustomers,themarketstructureaswellasfromecono-
mies of scale and scope in production. Picking up this argument, other
approaches emphasize the role of the demand-side for the generation of
knowledge, innovation and international competitiveness (see e. g. Lin-
der 1961; Blümle 1994;Fagerberg1995). These approaches do not focus on
pure technological aspects but lay an emphasis on the needs and the util-
ity of the users. Summarizing these arguments, Beise and Cleff(2004)or
Gerybadze, Meyer-Kramer, and Reger (1997)focusonsocalledlead mar-
kets that enable promising technologies to emerge. Lead markets arise if
there exists a critical amount of users, whose needs determine the quality
of demand. Lead users (in contrast to ‘normal users’) may be character-
ized as follows: (i) they are precursors of a broad commercial market and
hence early anticipators of global trends, (ii) they expect high utility from
new products, processes or services, (iii) they claim for the implantation
of ideas and inventions in final products, processes and services, and (iv)
fall back on local resources. Aside from private individuals or firms, also
governments may become lead users, e. g. by buying special products or
services or by issuing research orders for them. Typically, the government
is especially important in the field of cutting edge technologies, such as
information and communication technology, aerospace industry or mil-
itary technology.
lead markets and competitiveness of local firms
The existence of a domestic lead market and hence high demand with
respecttoquantity,butalsotoquality,allowssupplyingfirmsfirstto
meet local demand, then to activate exports and eventually to provide
products, processes and services to a broad range of users and on inter-
national markets.¹³ Due to the market proximity local firms will be the
first to notice the demand of new lead users. In detail the advantages can
be grouped into:
•Cost advantages. Research and technology intensive industries are
frequently characterized by economies of scale and scope. Hence,
to benefit from the corresponding scale and scope effects in the
form of cost degression, not only the current volume of domestic
Volume 7·Number 1·Spring 2009
16 Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
demand but also the corresponding dynamics (the growth of de-
mand) are important to assure international competitiveness. The
positive scale effects are then magnified by the market volume.
•Export advantages. This summarizes effects such as representativity
of domestic preferences for the world market, sensibility compared
to changes of the demand conditions on the world market, the ex-
port ratio, but also linguistic and social compatibility with the ad-
vised market. Hence export advantages may arise if consumers on
the home market prefer products and processes that have the po-
tential to be successful also on other markets (see e. g. Beise 2001).
Firms in lead markets are the first to benefit from these advantages and
this continuously secures a competitive advantage for innovative domes-
tic firms (see e. g. Morrison, Roberts, and Midgley 2004)
on the role of private demand for controversial
technologies
Inherent in innovative products and services is uncertainty. Therefore,
individual risk attitude and risk perception become crucial for the actu-
ally existing private demand. The individual attitude towards technology
and science also affect the preferences of domestic consumers. Individual
openness towards new technologies is significantly affected by both an-
ticipated utility and perceived risks. Slovic (1999) emphasizes that most
notably the risk potential, its possible way to control it, the familiarity
with risks and the public recognition determines how private individ-
uals perceive innovations and hence drives demand for new products,
processes or services. The following arguments gain especial importance:
•Openness towards technology and science. Inglehart (1997)statesthat
apositiveclimateforinnovationisthemoreprobable,themore
open-minded and tolerant a society is, since openness affects pri-
vate demand for new products and services. Demand is at least in
part affected by individual attitudes (openness towards new tech-
nologies, risk attitude – see below) as well as by norms that shape
human interaction.¹⁴ Basically, the society’s openness is crucial for
the innovation climate in certain regions and it also differs if con-
sidering certain types of technologies. Typically, differences may be
identified with respect to controversial and non-controversial tech-
nologies. While for the latter, utility clearly dominates possible risk
it is unclear in the case of controversial technologies whether risks
Managing Global Transitions
What Drives Innovation? 17
or opportunities prevail.¹⁵ As a consequence these technologies are
deeply ambivalent in the sense that strong opportunities go along
with large risks.
•Individual risk attitude. Innovations are more likely to arise if the
individuals are open-minded with respect to uncertainty. To oper-
ationalize the feature ‘risk attitude’ of private individuals usually
the results from the Eurobarometer are used.¹⁶ It regularly moni-
tors on behalf of the European Commission the public opinion. In
this context, positive indicators for innovation are preparedness to
carry risks and preferences for self employment.
•Trust in innovation actors (science, firms, and politicians). Science
and research are especially credible in countries having the fol-
lowing attributes: objective and differentiated commentatorship
on risks and opportunities, high public acceptance of institutional
frameworks, if people trust in and cooperate with other citizens and
if politicians are perceived to follow rules of good governance.
Observe that a differentiated perception and assessment of opportu-
nities and risks of new technologies is not per se negative for the devel-
opment of new technologies. In contrast: A critical discussion may help
develop the technology in a promising way. If doubts or reservations with
respect to special applications are carefully considered by science, indus-
try and policy and if the social and economic framework is chosen ade-
quately it is possible to shape a climate that is open-minded and hence
helps propagate innovation (see Hüsing 2002). As will be discussed be-
low, this aspect gains especial importance in the context of controversial
technologies.
An Application to Nanotechnologies
nanotechnologies as general purpose technologies
We now apply the argumentation detailed before on the case of nan-
otechnologies. They are perceived as being the next most important gen-
eral purpose technology, and with this they are expected to affect eco-
nomic and social life significantly within the next decades. The analysis
begins with a brief illustration of why nanotechnologies actually qualify
as general purpose technology, not only from a technological but also
from an economic point of view. We then focus on the impact of de-
mand, thereby relying on the argumentation carried out before.
Volume 7·Number 1·Spring 2009
18 Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
Pervasiveness and technological dynamics. The generic function pro-
vided by nanotechnologies is its pervasiveness and the possibility to ar-
range single atoms. Nanotechnologies have huge potentials for improve-
ment at the beginning of their development, are open to a multitude of
possible uses, have an impact on nearly every part of economy and soci-
ety, and can be embedded in already existing technologies. This causes
major changes thereby affecting production structures, network rela-
tionships, and social differentiation. As such, nanotechnologies form
part of technological platforms that organize future actions, and enable
and constrain them (see research and development; also Robinson, Rip,
and Mangematin 2006,4ff.). Figure 1demonstrates the interdependen-
cies between several sectors, firms, and/or actors that utilize nanotech-
nologies within the production process. Looking at the simplest case,
the hierarchical interdependencies as well as the network character are
most suitably illustrated by a technology tree. Nanotechnologies repre-
sent the field of the general purpose technology. Since nanotechnologies
are still at the very beginning of their technological development, further
improvement is mostly provided by universities or research centers. This
tempers the consequences of the appropriability effect discussed above in
the sense that basic research in the field of nanotechnologies is financed
by the public.¹⁷ Both universities and research centers frequently provide
the basis for spin-offs which end up in the development of components
that may be used as inputs in the applying sector (as). Hence apply-
ing sectors reflect the downstream industries that actually or potentially
make use of the general purpose technology or augmented products as
intermediates. Note that remarkable efforts are being made to close the
gap between science and application. One prominent way is the foun-
dation of institutions that act as a bridge between universities/research
centers and firms.¹⁸ Aside from vertical relationships, horizontal linkages
exist between actors at the same level of the value chain.
In order to depict the development and implantation logics of nan-
otechnologies, let us give an example of a possible technology tree ap-
plication. Nanotechnologies have many of applying sectors, such as, the
chemical industry (as1), microelectronics (as2)orpharmacy(as3).
New materials could be demanded by further downstream sectors such
as aviation industries (as11, which use fire-resistant materials for in-
board equipment), or automobile industries (as12, which use scratch-
resistant lacquers).
Innovational complementarities. Additionally, ict industries make
Managing Global Transitions
What Drives Innovation? 19
use of nano components to augment the calculating capacity of com-
puters. Again, these are used by information technologies which have
contributed significantly to the emergence of nanotechnologies. All il-
lustrations of nano-scale effects and structures are based on digitally-
constructed pictures. For more than thirty years, the capacity of com-
puters has doubled every 12 to 18 months (Moore’s law). However, within
the next several years, physical boundaries will put an end to this devel-
opment because, at nano-scales, the technological characteristics of solid
state physics cease to hold and the usual transistor will be unusable. At
this point, quantum physics will become relevant and molecules – ma-
nipulated by nanotechnologies – could replace the transistors known to-
day. Consequently, technological progress in nanotechnologies becomes
a precondition for future innovations in microtechnology, which anew
spurs technological progress in the nanotechnologies sector.
Reorganisation of work-life processes. Applied to nanotechnologies, this
argument is still diffuse because today these technologies are still at the
very beginning of their development. But just to get a vague idea, one
could imagine how, for example, intelligent materials that measure func-
tions of the human body and transmit the results directly to medicine
could enable people suffering from chronic illnesses to live their daily
lives much less dependent on regular health checks or hospital visits.
These examples show quite plainly what one can easily observe within
the field of nanotechnologies: the concrete and possible interactions
within the technology tree require a lot of coordination, and conse-
quently failures may arise.
demand for nanotechnologies by applying sectors,
and consumers and aggregate effects
Although nanotechnologies are used at the very beginning of the value
creation chain, at the end it is demand for final products that drives
the demand for nano-intermediates. To facilitate the discussion we sep-
arate the two most important factors influencing demand, namely on
the one hand, the price and the quality of the general purpose technol-
ogy, and, on the other hand the utility derived by consuming a prod-
uct that has been enhanced by nanotechnologies or that includes nano-
intermediates.
Firm demand. As argued before innovations are too few and they ar-
rive too late as a consequence of the prevailing externalities. Possibilities
for internalization are at least twofold: At a vertical level the enforcement
Volume 7·Number 1·Spring 2009
20 Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
of property rights gains importance. Here nano-patents may be a solu-
tion to spur innovation activities of firms along the entire value creation
chain. On the other hand, horizontal externalities could be internalized
by coordination of firms’ demands that act at the same level of the value
creation chain, e. g. firms in the aviation and the dockyards sectors could
use the same scratch-resistant surfaces. Platforms for demand coordina-
tion could basically be provided by regional institutions.¹⁹ If successful,
demand in downstream sectors increases, thereby allowing for making
use of economies of scale in the field of the upstream nanotechnology.
Private demand. Like biotechnology also nanotechnologies are contro-
versial technologies. Hence it is not per se clear whether, from an indi-
vidual point of view, chances or risks prevail. The individuals’ attitude
towards technology therefore is central. Werwatz et al. (2006;2007)pro-
vide a ranking of attitudes and technology acceptances of citizens over
17 countries that could be used as a country’s indicator for having the
potential to become a lead market in a certain technology field.²⁰ Taking
an overall look at attitudes and acceptance of all technologies, the fol-
lowing becomes obvious: Denmark, Sweden and Finland dominate the
first three ranks, except for risk attitude, where Ireland, South Korea and
the usa are ranked first. For most indicators, Austria, Ireland and Spain
bring up the rear.
With respect to controversial technologies – and hence also with re-
spect to nanotechnologies – the following conclusions can be drawn:
Nearly 90% of the citizens in the considered countries assign a positive
effect to non-controversial technologies, whereas with respect to contro-
versial technologies this rate declines to 60%. It is also possible to differ-
entiate between single countries: While people in the us are optimistic
with respect to both controversial and non-controversial technologies,
citizens in the Netherlands, Belgium, Sweden, Germany, Finland or uk
strongly differentiate with respect to certain technology fields. Within
these countries non-controversial technologies achieve the highest ac-
ceptance rate, with Germany being the leader. This means that Germans
are very optimistic with respect to low-risk technologies, but this opti-
mism clearly decreases in case of controversial technologies. This may
hamper the development of nanotechnologies in the critical countries.
In contrast, observe that this differentiated attitude may become an ad-
vantage in the long-run since a critical discussion may provide the design
of new products or even political or institutional frameworks that foster
future innovation activities. Thus, the critical scepticism in the short run
Managing Global Transitions
What Drives Innovation? 21
may provide the basis for becoming a lead market in the long run if, as
a consequence of the initially detailed discussion, products are created
that fit the needs of a large amount of consumers. Hence, this disad-
vantage with respect to regional competitiveness may turn to a future
advantage.²¹
That attitudes towards technologies diverge across societies has also
been extensively discussed in the context of the debate on the so-called
nbic (Nano-Bio-Info-Cogno) convergence:²² nbic-Convergence for
Improving Human Performance is the name of a prominent agenda
for converging technology research in the United States. In Canada, Bio-
Systemics Synthesis suggests another agenda for converging technology
research, whereas Converging Technologies for the European Knowl-
edge Society (cteks) designates the European approach. It prioritizes
the setting of a particular goal for converging technology research. This
presents challenges and opportunities for research and governance alike,
allowing for an integration of technological potential, recognition of
limits, European needs, economic opportunities, and scientific interests.
Long-run effects of nanotechnologies: Nanotechnologies are expected
to introduce the next long-run wave, thereby providing continuous in-
centives for incremental innovation. As discussed before, it is inherent to
general purpose technologies that their impact on overall productivity
becomes significant only after sufficient complements are in the mar-
ket and after the completion of important adjustment processes. Hence,
although the recent market potentials of nanotechnologies are already
immense, it will probably take several years or even decades until overall
productivity has increased as a consequence of the use of the new general
purpose technology.
Summary and Conclusions
This paper investigates the implications of innovation processes in the
context of nanotechnologies. The focus as well as the corresponding dis-
cussion is twofold: nanotechnologies and their implications are analyzed
as controversial and as general purpose technologies, thereby disentan-
gling supply-side and demand-side arguments. As a drastic innovation,
nanotechnologies induce innovation processes in downstream sectors
which – due to feedback effects – in turn affect productivity and with
this innovation in the upstream nanotechnologies. The analysis is carried
out with special attention to supply-side and demand-side arguments.
Since nanotechnologies are utilized at the very beginning of the value
Volume 7·Number 1·Spring 2009
22 Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
creation chain it is necessary to disentangle different parts of total de-
mand into firms’ demand for nano-components and private demand for
final products. With respect to the firms’ demand the following gains im-
portance: Innovation processes are interrelated along the value creation
chain, and feedback mechanisms work in both directions: upstream and
downstream. Due to the appropriability effect, innovating firms are not
able to appropriate all benefits that are induced by their innovation ac-
tivities. As a consequence, innovations arise too late and their extent is
too low. On the other hand, nanotechnologies are highly controversial
among consumers and it is not per se clear whether opportunities or
risks in the use of final products that are augmented by nanotechnolo-
gies dominate. This again may hamper innovations in the fields of nan-
otechnologies, and the individual’s attitude towards risk and technology
becomes especially important. Both individual and firm’s demand hence
may be sub-optimally low with respect to a harmonized innovation pro-
cess. However, interventions in the innovation process carefully have to
consider at which level of the value chain they are realized.
Acknowledgments
The authors gratefully acknowledge financial support from the Volkswa-
gen Foundation, funding initiative Innovation Processes in Economy and
Society, grant no. ii/83 568. Constructive comments by two anonymous
referees helped improve the paper significantly.
Notes
1The incremental nature of technological process has been well docu-
mented by economic historians (see e. g. Rosenberg 1992).
2Examples for an exchange of technology could be the replacement of horse
power by electricity or, in the case of products, the replacement of rubber
or steel by plastics.
3However it is not trivial to identify possible discontinuities in the empiri-
cal data. A recent discussion about the state of the art and possibly arising
problems can be found e.g. in Christiansen (2008).
4Hence governmental demand is most important to spur innovation in the
field of drastic innovations, while private demand may well suffice for in-
cremental innovations. However, this paper refrains from dealing with a
sophisticated discussion of the role of governmental demand.
5In the following parts the abbreviation gpt stands for general purpose
technology.
Managing Global Transitions
What Drives Innovation? 23
6Note that other authors, e.g. Lipsey, Bekar, and Carlaw (1998) define gen-
eral purpose technologies slightly different. For example these authors
stress the importance that at their emergence general purpose technolo-
gies are characterized by a wide potential of improvement, hence inducing
technological dynamics.
7The emergence of electricity, e.g., made people independent from day-
light. This had far reaching consequences for the organization of work life
– and hence also affected the daily routines not only of firms but also of
families.
8Bresnahan and Trajtenberg (1995) call this ‘dual inducement hypothesis’.
9See Bresnahan and Trajtenberg (1995) for a formal presentation of these
interdependencies.
10 Note especially the literature in the context of so called basic innovations
which induce long-run waves which sometimes are also called Kondrati-
effcycles; observe also the argumentation in Rosenberg (1996)orDavid
(1990).
11 Observe that one could basically extend the analysis also with respect to
the role of complementary investment of any kind.
12 This topic is discussed in detail within the literature on industrial organi-
zation. An overview can be found e. g. in Tirole (1990). The correspond-
ing impact on aggregate growth is discussed e. g. by Aghion and Howitt
(1998), Grossman and Helpman (1990) or Barro and Sala-i-Martin (2004).
13 Some typical examples for lead markets are the us for personal com-
puters or drugs, Japan for fax and video, or Scandinavian countries for
mobile telephones. Germany is a typical lead market in automobile or
process technology. The latter includes mechanical engineering, measure-
ment technology, environmental technology and technical components.
The lead position is based on a strong industrial basis as well as mostly on
the preferences of industrial customers.
14 For some technologies, e. g. telecommunication or the internet, network
effects also gain importance. Then the level of individual utility increases
with the number of people using the same technology.
15 Non-controversial technologies are solar energy, new propulsion tech-
nologies or medicine. Controversial technologies are biotechnology, nan-
otechnology or high-tech agriculture (see e. g. Werwatz et al. 2007).
16 Central features of the Eurobarometer include questions about health,
culture, information technologies, environmental protection, the Euro or
national defense. More information can be found at http://ec.europa.eu/
public_opinion/index_en.htm.
17 A detailed discussion about financing details in the context of basic re-
search and applied research can be found in Klodt (1995).
Volume 7·Number 1·Spring 2009
24 Ingrid Ott, Christian Papilloud, and Torben Zülsdorf
18 Examples for such institutions are can in Hamburg or minatec in
Grenoble.
19 See e. g. Ott and Papilloud (2007) for an analysis of a regional institution’s
impact on the development of nanotechnologies.
20 The following countries are included: Sweden, Finland, Denmark, The
Netherlands, usa,uk, Canada, Belgium, Japan, South Korea, Ireland,
Spain, Germany, Switzerland, France, Italy and Austria. The indicators fo-
cus on questions with respect to: (i) openness towards technology and sci-
ences, (ii) basic attitudes according to Inglehart (1997), (iii) risk attitude,
(iv) trust in innovation actors, and (v) women’s participation rate.
21 Observe that more knowledge and scientific understanding does not gen-
erally lead to higher acceptance of technologies and innovation. While
knowledge increases acceptance of non-controversial technology, this re-
sult does not hold for controversial technologies. Evans and Durant (1995)
show that more knowledge raises the acceptance gap between different
technology fields. Hence increasing knowledge does not automatically
spur acceptance rates of controversial technologies.
22 See Nordmann (2004,19), and also Roco and Bainbridge (2002,282). De-
fending a strict technological classification of the expression converging
technology, Roco and Bainbridge (2002,282) refer it to the combination
of four major nbic proveniences of science and technology, namely, (1)
nanoscience and nanotechnology; (2) biotechnology and biomedicine, in-
cluding genetic engineering; (3) information technology, including ad-
vanced computing and communications; and (4) cognitive science, in-
cluding cognitive neuroscience. For a broader application of this expres-
sion, compare the description given by Wood, Jones, and Geldart (2003,
23): ‘Many of the applications arising from nanotechnology may be the
result of the convergence of several technologies.’
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Managing Global Transitions
A Model for Making Foreign Direct Investment
Decisions Using Real Variables for Political
and Economic Risk Analysis
Carl B. McGowan, Jr.
Susan E. Moeller
The Foreign Investment Risk Matrix (firm) developed by Bhalla (1983)
uses political and economic risk measures for foreign direct investment
decision making. firm may be used to develop a matrix that catego-
rizes countries based on political risk and economic risk as acceptable,
unacceptable, or uncertain for investment. We demonstrate using polit-
ical and economic risk variables that are available on the internet in an
expanded model using three measures of political risk and three mea-
sures of economic risk. After determining the group of countries that
would be acceptable for fdi, the multinational companies can focus on
further analysis of acceptable countries.
Key Words: political risk analysis, economic risk analysis, foreign
direct investment, multinational corporation
jel Classification: g2,f2
Introduction
In this paper, we show how a multinational firm can use readily avail-
able measures of political and economic risk to create a two-dimensional
model for foreign direct investment (fdi) analysis. Bhalla (1983)de-
scribes a four-step process that can be used for political and economic
risk analysis and step one is called the Foreign Investment Risk Matrix
(firm). fir m allows a multinational corporation to assess the political
and economic risk of countries and allows the decision maker to classify
countries into multiple risk groupings. In this paper, we demonstrate
how to use an expanded version of Bhalla’s model for a multinational
corporation to execute country risk analysis in-house, which reduces the
need to purchase political and economic risk information from either
consultants or from analysis services and permits the multinational cor-
Carl B. McGowan, Jr. is a Professor of Finance at Norfolk
State University, usa.
Susan E. Moeller is a Professor of Finance at Eastern
Michigan University, usa.
Managing Global Transitions 7(1): 27–44
28 Carl B. McGowan, Jr. and Susan E. Moeller
poration decision maker to create a model for a specific company or fdi
project.
Over the last two decades, the amount of direct foreign investment
overseas has increased substantially. us direct investment abroad grew
from $208 billion in 1982 to $1,789 billion (valued at historical cost) in
2003 which is an annual growth rate of 10.3% (Borga and Yorgason 2004).
In 2003,us direct foreign investment was largest in the United Kingdom
at $273 billion or 15.2%oftotalus direct foreign investment, followed by
investments in Canada and the Netherlands at $192 billion and $179 bil-
lion, respectively, which is 10.8% and 10.0%ofthetotalus direct foreign
investment (Borga and Yorgason 2004). While most us direct foreign in-
vestment is in countries in Europe and North America, the amount of in-
vestment in Africa and the Middle East grew by 16%, followed by Europe
(14%), Canada (10%), Asia and the Pacific Region (7%), and Latin Amer-
ican and the Rest of the Western Hemisphere (7%). It is advantageous
to be an early entrant in an emerging market for a multinational cor-
poration. Early entry provides market power which yields monopolistic
profits resulting from new sources of demand, acquisition of cheaper raw
materials, and economies of scale.
From 2001 to 2002,us direct foreign investment in industrialized
countries grew at a rate of about 8%. The largest growth, however, was
in countries classified as emerging market countries. Growth in us di-
rect foreign investment in Africa and the Middle East exceeded 10%in
2002 and 16%in2003, although the absolute dollar amount invested still
remains small (Borga and Yorgason 2002;2004). These trends provide
evidence for the need for multinational corporations to have access to a
reliable model for predicting country risk as the risks of entering a new
foreign market directly are not only higher, but are also difficult to fore-
cast. Obtaining reliable and accurate forecasts of country risk is necessary
for any multinational corporatation (mnc) decision maker. Country risk
relates to the likelihood that changes in a foreign business environment
will occur and will reduce the profitability or riskiness of an overseas
fdi. The two main components of country risk that investors need to
consider are political risk and economic risk for a country. Butler and
Joaquin (1998) define political risk ‘as the risk that a sovereign host gov-
ernment will unexpectedly change the ‘rules of the game’ under which
businesses operate.’ The authors show how political risk can affect the
future cash flows of a fdi and how political risk can be factored into the
required rate of return. Political risk refers to the risk that the politics
within a country will affect a multinational’s fdi in that country.
Managing Global Transitions
A Model for Making Foreign Direct Investment Decisions 29
Butler and Joaquin (1998) develop a model of political risk that shows
how political risk impacts the cost of capital for an investment. In the
Butler-Joaquin model, the impact of a political risk change on the cost
of capital of the investment depends on the impact of the political risk
change on the expected return of the investment and the covariance of
the return on the investment and the return on the market. If the ex-
pected impact of the change in the political environment on expected
future cash flows is negative and if the covariance between the expected
future cash flows from the investment and the return on the market is
negative (positive), the effect of a political risk change is to increase (de-
crease) the cost of capital for the investment. If the expected impact of
a change in the political environment has a positive impact on expected
future cash flows and the covariance between the cash flows from the in-
vestment and the return on the market is positive (negative), the effect
of a political risk shock is to increase (decrease) the cost of capital for the
investment. The impact of a political risk change is determined by the
impact of the change on the expected rate of return and the covariance
of the return on the investment and the return on the market.
Bhalla (1983) shows that a change in political risk can result from po-
litical changes due to elections, revolts, recessions, or wars, and the resul-
tant change in political risk can lead to expropriation, higher taxes or tar-
iffs, reduced fdi incentives, local ownership requirements, local content
requirements, or currency inconvertibility. The net effect may be the loss
of assets, the termination of operations, reduced after-tax income, higher
import costs, reduced revenue, management restrictions, higher opera-
tional costs, or an inability to repatriate funds. Macro-economic mis-
management by the government can lead to higher inflation and higher
interest rates leading to higher costs, planning difficulties, and higher
interest costs. Other types of political difficulties such as labor unrest or
strikes can lead to higher production costs and production interruptions.
mncs need to determine future risks to an fdi from political risk and
future risks from the country’s economic environment, both of which
affect the profitability and riskiness of fdi.Twotypesofeconomicfac-
tors affect mnc fdi: macro-economic factors and micro-economic fac-
tors. Macro-economic factors would include fluctuations in a country’s
inflation rate, exchange rate, tax rate, and interest rates, while micro-
economic factors would include demand for a firm’s products, the avail-
ability of local labor, local wage rates, and employment laws.
It is important that the mnc planning to invest overseas be able to
analyze a country’s political and economic risk. The mnc can purchase
Volume 7·Number 1·Spring 2009
30 Carl B. McGowan, Jr. and Susan E. Moeller
country risk information from a consulting service and/or the mnc can
create their, own in-house analytical model. When mncs purchase a
consulting service, the model developed may not reflect the specific en-
vironment of the country and the specific fdi project since consulting
services provide general ratings for country political and economic risk
and may not provide specific industry, firm, or project information and
details in the analysis. If mncs create country political and economic
risk analyses for specific fdi characteristics, they can tailor the fdi risk
analysis with less uncertainty.
Literature Review
Erb, Harvey, and Viskanta (1996b) describe country risk analysis using
five measures: political risk, economic risk, financial risk, a composite
risk, and a country credit rating. The first four variables the authors use
are taken from Political Risk Services’ International Country Risk Guide
(icrg; see http://www.prsgroup.com) and the fifth variable is from In-
stitutional Investor (see http://www.institutionalinvestor.com) The em-
pirical results indicate that the country risk measures are correlated with
each other, but the financial risk measures contain the most information
about future stock returns, and political risk measures contain the least
information about future stock returns. These findings support the use
of political and economic risk analysis by investors interested in foreign
stock market returns. But, mncs considering fdi need to be able to fore-
cast the effect of future political events and economic events for use in
fdi decisions.
Erb, Harvey, and Viskanta (1996a) findings support the use of political
and economic risk analysis using firm by multinational corporations.
Multinational corporations considering direct foreign investments of the
bricks and mortar type need to be able to forecast the effect of future po-
litical events as well as financial or economic events on their investments.
Using fir m will enable a corporation to assess this risk for a specific
project while differentiating between a numbers of countries.
Using annual data for the period 1980 to 1997, Bekaert, Harvey and
Lundblad (2001) find that emerging equity market liberalization leads to
an increase in real economic growth. Bekaert, Harvey and Lumsdaine
(2002) find that emerging equity market liberalization leads to increases
in market integration that leads to an increase in real economic growth.
The empirical breaks that the authors find do not correspond with an-
nounced liberalization dates, but reflect the date of actual liberalization
Managing Global Transitions
A Model for Making Foreign Direct Investment Decisions 31
such as the announcement of the first adr orthedatewhenthefirst
country fund is issued. Empirical liberalization effect dates generally oc-
cur after the official dates. The authors conclude that it is not enough
for countries to change the rules to permit foreign investment to bring
about market integration. Foreign investors must still be able and willing
to invest in the country with liberalized stock markets.
Stoever (2002a) states that there are numerous stimuli for economic
liberalization which will reduce political risk and shows the process by
which economic liberalization leads to economic development. As the
host country government liberalizes the political and economic environ-
ment, multinational corporations will be permitted an increased range
of economic activity. Economic liberalization leads to reduced restric-
tions on the actions of multinational corporations, which reduces the
costs and risks to multinational corporations making foreign direct in-
vestments. With reduced costs and reduced risks, the multinational cor-
poration requires a reduced rate of return that, in turn, provides greater
benefits to the host country since more of the excess cash flow is left in
the host country. Any country evolving policies for foreign direct invest-
ment should avoid inconsistency, develop clear priorities, evolve policies
over time, match the speed of deregulation with the rate of economic
growth, keep actions and statements consistent, make reforms genuine,
and avoid excess political influence in the liberalization process. Stoever
(2002b) develops a measure of openness for Korea over the period from
1962 to 2000. Data are provided for both foreign direct investment into
Korea and for Stoever’s measure of openness. These results show a pos-
itive relationship between economic openness and foreign direct invest-
ment, that is, reduced political risk leads to increased foreign direct in-
vestment.
Roll and Talbott (2001) analyze the determinants of wealth over the pe-
riod 1995 to 1999 for 162 countries. Roll and Talbott’s empirical results in-
dicate that variation in gni per capita across countries can be explained
by nine different measures of economic openness – property rights, po-
litical rights, civil liberties, press freedom, and government expenditures
positively influence gni per capita. gni per capita is negatively related
to excessive regulation, poor monetary policy, black market activity, and
trade barriers. Roll and Talbott find that positive democratic events are
followed by increases in growth in gni per capita in those countries,
while negative democratic events are followed by decreases in growth in
gni per capita in those countries.
Volume 7·Number 1·Spring 2009
32 Carl B. McGowan, Jr. and Susan E. Moeller
Additional empirical findings support the hypothesis that there is a
positive relationship between economic openness and economic growth
and development. Demirguc-Kunt and Maksimovic (1998) and Wurgler
(2000) analyze the relationship between the legal environment and eco-
nomic development and show that increasing the level of legal protec-
tion increases economic growth. A positive relationship between finan-
cial liberalization and economic growth is reported in Beck, Levine, and
Loayza (2000), Henry (2000), Jalilian and Kirkpatrick (2002), Jayaratne
and Strahan (1996), Kassimatis (2002), King and Levine (1993), Levine
and Zervos (1996;1998) and Rajan and Zingales (1998). Barro (1991),
Ryoo and Smith (2002) and Su and Fleisher (1998) show that govern-
ment intervention, in the form of day trading limits, reduces market effi-
ciency. Fischer and Sahay (2000) find that the former Communist coun-
tries economies that have performed the best are the countries that were
most committed to political and economic reform.
Empirical research indicates that country credit ratings are useful to
multinational corporations in evaluating the riskiness of foreign direct
investment in a particular country. Measures of political openness are
useful in evaluating the political environment of a particular country
and measure the foreign direct investment environment. Published re-
search of the World Bank indicates that gross national income per capita
describes the economic environment and potential in countries and is
highly correlated with other measures of economic development. These
research results support the hypothesis that country risk can be mea-
sured by country credit ratings and that country risk levels are further
related to political and economic risk variables.
Foreign Investment Risk Matrix
Bhalla (1983) provides a country risk analysis process to analyze a foreign
direct investment by a multinational corporation using a four-step pro-
cess. The first step is to create the foreign investment risk matrix to de-
termine which countries provide a stable political environment and have
the economic potential to give the country the potential to be acceptable
for foreign direct investment. The second step is to create a country risk
profile for each country selected in the first step that is a detailed anal-
ysis of the business environment in each country selected in step one.
The third step creates a foreign investment risk analysis for each project
for each country to determine if the proposed foreign direct investment
is compatible with the economic and political environment assumed in
Managing Global Transitions
A Model for Making Foreign Direct Investment Decisions 33
the country under analysis. The fourth step creates a foreign investment
risk audit that allows the multinational corporation to monitor and re-
evaluate the environment on a continuous basis to alert the multina-
tional corporation to avoid surprises that may arise from changes in the
economic and political situation in the country in the future.
Bhalla (1983) defines foreign investment risk management as the pro-
cess of evaluating the political stability and the market potential of a
particular country by a multinational corporation. Bhalla creates a two-
dimensional matrix with four categorical variables for each dimension
of political risk and economic risk called the foreign investment risk ma-
trix (fir m). Political risk is divided into four categories from A to D with
A being stable, B being moderately unstable, C being volatilely unstable,
and D being substantially unstable. Economic risk is divided into four
categories from one to four. Category one indicates acceptable risk, cat-
egory two indicates moderate risk, category three indicates major risk,
and category four indicates unacceptable risk. The specific political risk
measures used by Bhalla are government stability, the method and fre-
quency of changes in government, and the attitude of the public toward
government leaders and institutions. The specific economic risk mea-
sures used by Bhalla are defined in terms of the market potential for the
firm’s products. The economic risk measures used are the demographic
characteristics of the country, the infrastructure in the country, the eco-
nomic breadth of income, the per capita gnp, and the economic growth
potential.
Bhalla (1983) argues that income per capita and the distribution of
income per capita are the most important variables in determining both
economic and political risk because income per capita reflects both the
underlying economy and the effectiveness of the political management.
Both the level of income per capita and the distribution of income per
capita effect economic and political risk. More evenly distributed income
per capita reduces both economic and political risk.
The four different categories of income are graphed on the fir m.
Countries will have substantial political instability if they have low in-
come per capita with poor income distribution and a narrow economic
base. Countries have stable political risk if they have high income per
capita, even income distribution, and a broad economic base. Countries
with populations less than 5million or income per capita of less than
$500 were excluded from consideration because these countries lacked
sufficient market size for the product being considered. The four polit-
Volume 7·Number 1·Spring 2009
34 Carl B. McGowan, Jr. and Susan E. Moeller
ical risk rankings are influenced by population size, income per capita
growth rates and economic diversity. Economic risk is divided into four
categories from acceptable to unacceptable, based on demographics, in-
frastructure, economic diversity, demand characteristics, and economic
growth.
The firm is a graphic representation of these two dimensions. Four
categories of political risk by four categories of economic risk yield six-
teen different categories of countries. Countries that have political sta-
bility and have acceptable economic risk would be in the upper left-
hand cell. Countries with substantial political instability and unaccept-
able economic risk would be in the lower right-hand cell.
A multinational corporation would choose from the countries in the
cells that meet the first round of criteria. This first pass will substantially
reduce the number of countries under consideration. Stage two of the
political risk analysis process is the country risk profile. The country risk
profile is more detailed and is based on three sets of criteria: political
stability, social stability, and economic stability. A multinational corpo-
ration analyzes these variables to determine if any internal or external
problems exist that could substantially alter the firm created in the first
step. The country risk profile allows the multinational corporation to
eliminate any country that appears to have potential future economic or
political problems.
The investment risk analysis is conducted as stage three, in order to
ensure that the project can be structured to survive future risks such
as political risk, social risk, and economic risk. Political risk variables
would include political instability, expropriation, or acts of terrorism.
Social risk variables would include labor unrest. Economic risk variables
would include price controls, recession, inflation, devaluation, or foreign
exchange controls.
The fourth stage of analysis is the foreign investment risk audit. The
foreign investment risk audit is an ongoing process designed to allow
the multinational corporation to anticipate changes in the environment
that will affect the viability of the foreign direct investment project. The
foreign investment risk audit allows the multinational corporation to de-
velop appropriate strategies for adapting to changes in the environment
or to appropriate exit strategies. The foreign investment risk audit allows
the multinational corporation to develop an information data base of
variables that will allow the multinational corporation to monitor and
adapt the foreign direct investment project to future changes in the po-
litical and economic environment.
Managing Global Transitions
A Model for Making Foreign Direct Investment Decisions 35
Madura (2000)presentsthefirm in a continuous, variable framework
instead of using discrete categories. The Madura model uses a continu-
ous variable framework instead of providing only sixteen categories in
a four – by – four categorical matrix. Both economic risk ratings and
political risk ratings are continuous and described from low risk to high
risk allowing the multinational corporation decision maker to differen-
tiate countries in a continuous framework. The Madura model provides
three categories: countries that have acceptable risk levels, countries that
have unacceptable risk levels, and countries with unclear (uncertain) risk
levels. Countries in the uncertain area would need further analysis for an
acceptable or unacceptable decision to be made. McGowan and Moeller
(2003) demonstrate how to determine the empirical boundaries in the
political risk and economic risk space using multiple discriminant anal-
ysis. The authors use gni per capita and the Index of Economic Free-
dom to categorize countries as either acceptable for fdi, unacceptable
for fdi,oruncertainfor128 countries. McGowan and Moeller (2005)
create a similar model using the same variables but with multinomial
logistic regression.
In this paper, wedemonstrate how to conduct country risk analysis us-
ing readily available measures that can be easily found using the internet.
We extend Bhalla’s model from a categorical model to a continuous for-
mat model using three variables to measure the political risk dimension
and three variables to measure the economic risk dimension. We select
this set of input variables because these variables are available from in-
ternet websites that are easy to use and free. We develop the model using
three measures of political risk (the attitude of the host government to-
ward fdi, conflict, and perceived corruption) and three measures of eco-
nomic risk (gni per capita, fdi potential, and the inflation rate). Both
the variables and the weights are selected to demonstrate how to use the
model and should be modified by the mnc making the fdi decision to
fit the specific project, country, and mnc. These measures are used to
differentiate countries that are acceptable for foreign direct investment
from countries that are uncertain or unacceptable for foreign direct in-
vestment.
Input Variables
We select three variables to measure the political risk component: the
attitude of the government toward fdi, the degree of conflict for the
country, and perceived corruption within the country. We select three
variables to measure the economic risk component: gross national in-
Volume 7·Number 1·Spring 2009
36 Carl B. McGowan, Jr. and Susan E. Moeller
come per capita, inward fdi potential, and the inflation rate. Each of the
three variables measures a different aspect of the risk component. We use
three variables to demonstrate the model, even though a mnc could ap-
ply the model with only one variable or as many variables as needed by
the mnc to meet its goals. The specific variables are chosen because the
variables represent political and economic risk; even though alternative
variables may be available, these six variables are available for free on-
line. We try to provide example variables that are reasonable and readily
available.
The Attitude of Government toward fdi is measured using the Index
of Economic Freedom sub-index for Capital Flows and Foreign Invest-
ment. Beach and Driscoll (2002) provide a detailed discussion of how the
factors of the Index of Economic Freedom are constructed. Restrictions
on capital flows and fdi are measured by fdi codes, restrictions on for-
eign ownership of business, restrictions on the industries and companies
open to foreign investors, restrictions and performance requirements on
foreign companies, foreign ownership of land, equal treatment under the
law for both foreign and domestic companies, restrictions on the repa-
triation of earnings, and availability of local financing for foreign com-
panies.
The degree of conflict is measured using the Conflict Barometer which
is published by the Heidelberg Institute of International Conflict and is
available on the Institute’s web site (http://hiik.de). Conflict is defined as
‘the clashing of interests on national values of some duration and mag-
nitude between at least two parties that are determined to pursue their
interests and win their case.’ The Conflict Barometer has five levels rang-
ing in value from one to five. Level 1is latent conflict and non-violent
and low intensity. ‘A positional difference on definable values of national
meaning is considered to be a latent conflict if respective demands are ar-
ticulated by one of the parties and perceived by the other as such.’ Level
two is a manifest conflict which is non-violent and low intensity. ‘A man-
ifest conflict includes the use of measures that are located in the forefield
of violent force. This concerns for example verbal pressure, threatening
publicly with violence, or the imposition of economic sanctions.’ Level
three is defined as crisis and is violent and of medium intensity. ‘A crisis
is a tense situation in which at least one of the parties uses violent force
in single incidents.’ Level 4is defined as severe crisis and is high intensity.
‘A conflict is considered to be a severe crisis if violent force is repeatedly
used in an organized way.’ Level 5is defined as war and is violent and is
Managing Global Transitions
A Model for Making Foreign Direct Investment Decisions 37
high intensity. ‘Wars are a type of violent conflicts in which violent force
is used with a certain continuity in an organized and systematic way. The
conflict parties apply extensive measures, according to the situation. The
amount of destruction is vast and of long duration.’
Perceived corruption is measured using the Corruptions Perceptions
Index. The cpi is published by Transparency International on a yearly
basis. The index is a weighted average of a number of indexes and sur-
veys of perceived corruption. Political corruption is defined as ‘the abuse
of power by political leaders for private gain, with the objective of in-
creasingpowerorwealth.’
Gross national income per capita data are taken from Wor l d D e v el-
opment Indicators 2001 which is published by the World Bank and are
available on the web site (http://web.worldbank.org). Estimation of In-
ternationally Comparable Per Capita Income Numbers for Operational
Purposes published by the World Bank (see http://go.worldbank.org/
v4hs8zbud0) indicates that gni per capita is not a complete mea-
sure of economic growth and development, but most other measures of
economic growth and development are highly correlated with gni per
capita.
fdi Potential is measured using unctad’s Inward fdi Potential In-
dex which is an equally weighted average of the values (normalized to
yield a score between zero, for the lowest scoring country, to one, for the
highest) of 12 variables: gdp per capita, the growth rate of gdp for ten
years, exports to gdp, the average number of telephone lines per 1000 in-
habitants, commercial energy use per capita, r&dspending to gdp,the
proportion of tertiary students in the population, country risk, the world
market share in exports of natural resources, the world market share of
imports of parts and components for automobiles and electronic prod-
ucts, the world market share of exports of services, the share of world
fdi inward stock.
The Inflation Rate is measured using the Index of Economic Freedom
sub-index for Monetary Policy. The Monetary policy index is based on
the inflation rate for the previous ten years in the country.
The Attitude of the Host Government and the Inflation Rate are the
ief sub-indexes subtracted from five since the ief indexes are highest
at one and lowest at five. The Conflict Barometer value is taken directly
since the conflict barometer is valued from zero to five. The cpi is trans-
formed by dividing the published value by two. The gni per capita vari-
able is assigned a five for a high income economy, one for a low income
Volume 7·Number 1·Spring 2009
38 Carl B. McGowan, Jr. and Susan E. Moeller
tab le 1 United Kingdom
Political risk factors Rating Weight r×w
Attitude of host government 3.00 35%1.05
Conflict 2.00 35%0.70
Corruption 4.35 30%1.31
Total 100%3.06
Economic risk factors Rating Weight r×w
gni per capita 5.00 30%1.50
fdi Potential 4.67 35%1.63
Inflation rates 3.00 35%1.05
Total 100%4.18
Total risk factor Weight Value w×v
Political r isk 60%3.06 1.83
Economic risk 40%4.18 1.67
Total 3.51
notes Political risk variables are measured accordingly; (1) the attitude of the govern-
ment toward fdi is measured by the Index of Economic Freedom Sub-index for Capital
Flows and Foreign Investment, (2) the degree of conflict for the country is measured by
the Conflict Barometer published by the Heidelberg Institute, (3)theperceivedcorrup-
tion within the country is measured by the Corruption Perceptions Index published by
Transparency International.
Economic risk measures are measured accordingly; (1) gross national income per capita
data are taken from the World Development Indicators published by the World Bank,
(2)inwardfdi potential is measured by the Inward fdi Potential Index published by
unctad,(3) the inflation rate is measured by the Index of Economic Freedom Sub-
index for Monetary policy.
The weights from each index would be determined by the mnc decision maker based on
the relative importance of each variable. In the paper, we randomly selected weights.
economy, four for a high middle income economy, two for a low middle
income economy, and one for a low income economy. The fdi Potential
Index is scaled from zero to one and is transformed by multiplying the
published values by ten and dividing by two.
The Model Applied to Four Countries
Tabl e s 1,2,3, and 4show the values computed for each of the six input
variables for the United Kingdom, Brazil, Poland, and Russia. For the uk,
the scores for Attitude of the Host Government, Conflict, and Corrup-
tion are 3.00,2.00, and 4.35, respectively. The values for gdi per capita,
Managing Global Transitions
A Model for Making Foreign Direct Investment Decisions 39
tab le 2 Russia
Political risk factors Rating Weight r×w
Attitude of host government 2.00 35%0.70
Conflict 1.00 35%0.35
Corruption 1.35 30%0.41
Total 100%1.46
Economic risk factors Rating Weight r×w
gni per capita 2.00 30%0.60
fdi Potential 2.91 35%1.02
Inflation rates 2.00 35%0.70
Total 100%2.32
Total risk factor Weight Value w×v
Political r isk 60%1.46 0.87
Economic risk 40%2.32 0.93
Total 1.80
tab le 3 Brazil
Political risk factors Rating Weight r×w
Attitude of host government 2.00 35%0.70
Conflict 5.00 35%1.75
Corruption 1.95 30%0.59
Total 100%3.04
Economic risk factors Rating Weight r×w
gni per capita 4.00 30%1.20
fdi Potential 1.84 35%0.64
Inflation rates 3.00 35%1.05
Total 100%2.89
Total risk factor Weight Value w×v
Political r isk 60%3.04 1.82
Economic risk 40%2.89 1.16
Total 2.98
notes For explanation, see table 1
fdi Potential, and Inflation are 5.00,4.67, and 3.00, respectively. In this
paper, as a demonstration, the weights are arbitrary. The weights used
in the computation of the political risk factor and of the economic risk
Volume 7·Number 1·Spring 2009
40 Carl B. McGowan, Jr. and Susan E. Moeller
tab le 4 Poland
Political risk factors Rating Weight r×w
Attitude of host government 2.00 35%0.70
Conflict 5.00 35%1.75
Corruption 1.80 30%0.54
Total 100%2.99
Economic risk factors Rating Weight r×w
gni per capita 4.00 30%1.20
fdi Potential 2.56 35%0.90
Inflation rates 2.00 35%0.70
Total 100%2.80
Total risk factor Weight Value w×v
Political r isk 60%2.99 1.79
Economic risk 40%2.80 1.12
Total 2.91
notes For explanation, see table 1.
factor would be determined by the corporate decision maker based on
the importance of the individual variables to the specific company and
project. An overall total risk factor can be calculated by taking a weighted
average of the political risk factor and the economic risk factor. Again,
the weights are based on the judgment of the corporate decision maker.
The political risk factor for the United Kingdom is 3.06 and the economic
risk factor value is 4.18. In this case, the United Kingdom plots in the re-
gion defined as acceptable for fdi. The values for Brazil and Poland both
plot in the uncertain region, and the values for Russia plot in the unac-
ceptable for fdi region.
The model used in this paper is an extension of the Bhalla (1983) and
Madura (2000) models. A two dimensional grid is created where one di-
mension is economic risk and the other dimension is political risk. Both
dimensions are scaled from one to five, alternatively the scales could have
been from one to one hundred. In either case, the scale for all of the vari-
ables must be transformed to be the same. For a country to be accept-
able for fdi, the country must have values for political and economic
risk that plot in the area segmented by the minimum acceptable level of
both dimensions, both political risk and economic risk. Thus, in figure 1,
countries that plot in the upper right hand corner are acceptable for fdi,
Managing Global Transitions
A Model for Making Foreign Direct Investment Decisions 41
Unacceptable region Uncertain region
Acceptable region
1
2
3
4
5
12345
Political r isk
Financial risk
United Kingdom
Russia
Brazil
Poland
fig ur e 1 The Foreign Investment Risk Matrix is a graphical representation of the
values computed in tables 1to 4.Theuk is in the upper right corner that
represents the area of acceptable countries. Russia is in the lower left corner
that represents the area of unacceptable countries. Brazil and Poland are in
the uncertain area where countries might be acceptable or not depending
on further analysis.
and countries that plot in the lower left hand corner are unacceptable for
fdi. Countries that plot in the areas between the acceptable region and
the unacceptable region, are uncertain, that is, these countries require
further analysis for a final decision.
To demonstrate the use of the firm, we calculate values for both polit-
ical risk and economic risk for four countries: Brazil, Russia, Poland, and
the uk. These four countries are selected for illustration purposes only
since this set of countries provides plots in each of the three regions. We
estimate the political risk dimension with three variables: the attitude of
the host government toward fdi, the level of conflict in the country, and
the perceived corruption level in the country. We estimate the economic
risk dimension with three variables: gni per capita, the fdi Potential In-
dex, and the inflation index. Each variable is measured using a published
index that is available on the internet. Thus, an mnc can use the model
provided in this paper to facilitate the fdi decision by allowing the de-
cision maker to eliminate from detailed analysis countries that do not
meet minimum specified levels of political and economic risk.
Summary and Conclusions
Foreign direct investment has become increasingly important for multi-
national corporations. The level of foreign direct investment by us
multinational corporations outside of the United States and by non-us
Volume 7·Number 1·Spring 2009
42 Carl B. McGowan, Jr. and Susan E. Moeller
multinational corporations into the United States has increased dramat-
ically over the last twenty years. The need for political and economic
risk analysis has increased with foreign direct investment by multina-
tional corporations. Even as some countries and regions of the world
have steadily reduced barriers to and restrictions on foreign direct in-
vestment, other countries and regions of the world have become in-
creasingly hostile to foreign direct investment. Although political risk
assessment services are available, these services provide general ratings
rather than ratings specific to the actual project being considered by the
multinational corporation.
Political risk is the result of changes in the environmental circum-
stances for the multinational corporation. Although political risk gen-
erally results from governmental action, social factors can cause the en-
vironment to change. In either case, less political risk is desirable for
the multinational corporation. Economic risk changes can result from
changes in either the macro-economic or micro-economic environment.
Multinational corporations need to be able to determine which countries
provide the best economic conditions for the production and sale of the
multinational corporation’s products or services.
The Foreign Investment Risk Matrix provides a framework with which
an mnc can analyze the combination of both political risk and economic
risk for making fid decision. The firm uses values that are defined by
the mnc for their impact on the specific fdi project that can be collected
directly from the internet by the multinational corporation to evaluate
the political risk and economic risk for a specific country related to the
specific project under review. The six independent variables used in this
paper can be applied to the firm to allow the multinational corpora-
tion to divide countries under consideration into countries that are ac-
ceptable for foreign direct investment, countries that are unacceptable
for foreign direct investment, and countries that provide uncertain en-
vironments and need further study before an accept/reject decision can
bemade.Overall,thefirm process allows the multinational corporation
to focus attention on investment environments with higher likelihood of
success. That is, the mnc decision maker can eliminate countries from
further analysis that do not meet specified minimum levels of political
and economic risk. The model, as shown in this paper, can be tailored
to meet the specific needs of the mnc to evaluate a specific project in a
specific country.
Managing Global Transitions
A Model for Making Foreign Direct Investment Decisions 43
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Managing Global Transitions
The Influence of Outsourcing and Information
and Communication Technology on
Virtualization of the Company
Massimo Manzin
Borut Kodriˇ
c
In the article we investigate the field of virtual organizations, which in
the definition of many authors consists of two components: outsourc-
ing and information and communication technology. In the study we
have tried to determine which of the two, in the opinion of employees
working in the area of Slovene tourism, contributes to a greater degree
to virtualization of the company. We determine that outsourcing influ-
ences the virtualization of the company more strongly than does infor-
mation and communication technology, since it enables the company
to acquire new knowledge and know-how and increase its competitive-
ness in the marketplace.
Key Words: virtual organization, outsourcing, information
and communication technology
jel Classification: l22,d23
Introduction
The development of information technology and telecommunications is
changing the modern economic and social system. Economic subjects
are particularly confronted with an external environment that is con-
stantly changing, one which is characterized by an increasing complex-
ity. The clear and structured economic scenario of the 1980shasbeencast
offin a context in uncertainty, constant changes and, consequently, dif-
ficulties in general are forcing companies to adapt their competitive ap-
proach and to develop new capabilities. The globalization of the market-
place and the rapid spread of new technologies linked with the world of
information science and telecommunications have profoundly marked
the operating of the economic systems in every country. Rapid and sig-
nificant technological changes have led to decisive shifts in production
Massimo Manzin is a Senior Lecturer at the Faculty of Management
Koper, University of Primorska, Slovenia.
Borut Kodriˇc is an Assistant at the Faculty of Management Koper,
University of Primorska, Slovenia.
Managing Global Transitions 7(1): 45–60
46 Massimo Manzin and Borut Kodriˇc
techniques and the administering of technological, financial and human
resources, which has reinforced the high speed of transfer of innova-
tive processes, and has reformed consumption as well as the channels
through which information flows and is transmitted. Collectively, these
elements have profound economic implications for everyone involved
in the production and broader societal system (Ye, Xu, and Chen 2002;
Bavec 2002; Bauer and Köszgi 2003; Cooper and Rousseau 1999; Jansen,
Steenbakkers, and Jägers 1999).
As a response to such changes there has been a change in the organiza-
tion of processes within companies, and this had led to the phenomenon
of the virtual organization. Such an organization is characterized by the
use of both information and computer technology and outsourcing.²³
The degree to which one or the other is used varies. Companies use one
or the other, or even both simultaneously. As the research shows, the
use of both outsourcing and computer and information technology has
increased greatly (Sigala 2003; Sourenkova and Louvieris 2005; Lammin-
maki 2005). This study focuses on the tourist sector of the economy, and
aims to determine which of the two factor has a greater influence on the
degree of virtualization of a company. Directors of selected companies
from the area of tourism participated in the study. They were asked to
indicate the degree to which each factor contributes to the virtualization
of the company. Our conclusions are derived from a number of perspec-
tives related to each factor, including: competitiveness and competitive
advantage of a company, focussing on key competencies, knowledge and
know-how, more efficient use of sources, improved service and greater
customer satisfaction, and also fear of unemployment.
The article is structured into four main sections. In the introduction,
we present the area of research, the research problem, the purpose and
aims of the study. This is followed by the theoretical and empirical parts,
and then the conclusion. In the theoretical part we provide an overview
of the various definitions of virtual organization within the literature, as
well as a synthesis of various researchers’ viewpoints on the phenomenon
of virtual organization. The empirical section begins by providing a de-
scription of the methodology and the sample, before moving to an anal-
ysis of the study results. In the conclusion we summarize the most im-
portant outcomes of the study.
Definition of Virtual Organization
The term virtual organization was coined in the late 1990’s to denote a
new way of aligning business practices, core competencies, and product
Managing Global Transitions
The Influence of Outsourcing 47
and service delivery such that they would allow for a more effective way
to satisfy consumer demands (Southard 1998).
There are three generic types of accounts regarding virtual organi-
zations in the literature (Burn, Marshall, and Barnett 2002; Shao, Lee,
and Liao 2000; Shao and Liao 1996). The first regards organizations that
outsource some of their business activities, forming virtual alliances to
achieve organizational objectives. Virtual organizations may be formed
by integrating several companies’ core competencies and resources. A
virtual company, thus, is a collection of several companies organized
to behave as if it were a larger, multifaceted organization. Research re-
veals that there exist various definitions of this type of virtual orga-
nization.
Donlon (Southard 1998) defines a virtual organization as ‘. . . one that
focuses on its core competencies and engages in strategic sourcing and
partnership development to support its non-core activities.’
Strausak (1998) defines a virtual organization as a form of cooperation
involving legally autonomous companies, institutions and/or individu-
als delivering a product or service on the basis of a common business
understanding. The cooperating units participate in the collaboration
primarily with their core competencies and present themselves to third
parties as a unified organization when delivering the product or service.
Robbins (2005) defines a virtual organization as, typically, a small, core
organization that outsources one or more of its primary business func-
tions. In structural terms, the virtual organization is highly centralized,
with little or no departmentalization.
The most resounding view of virtualization that remains completely
neutral in terms of technology has been developed by Mowshowitz (1999;
2002), who introduced the concept of the ‘switching principle.’
He describes a virtually organized task as a goal-oriented activity that
is implemented by an appropriate assignment or reassignment of con-
crete satisfiers to the abstract requirement of the task. Switching de-
pends on the categorical separation of requirements from satisfiers. At
any given moment there is an allocation of satisfiers to requirements,
though the particular allocation can change over time.
The second type of descriptions pertains to organizations that are built
up by means of virtual links with information technology. Earlier work
in the area of ict and organizations points in the general direction that
ict contributes to organizational structures and provides an increasingly
virtual mechanism for realizing organizational objectives.
Chaffey (2002) defines a virtual organization as an organization which
Volume 7·Number 1·Spring 2009
48 Massimo Manzin and Borut Kodriˇc
uses ict to allow it to operate without clearly defined physical bound-
aries between different functions. Buchanan and Huczynski (2004)de-
fine a virtual organization as an organization where a large number of
the organization members use electronic channels as their main (or even
only) medium of contact with each other, as well as with the rest of the
organization.
According to Collins (2003), a virtual organization can be broadly
defined as an organization that forms, and/or maintains, some or all
of its internal or external relationships electronically. Its work products
are of an electronic rather than a paper nature. This broad definition
of virtual organization includes organizations whose relationships with
clients, customers, vendors, consultants, or joint venture partners are
maintained virtually.
Fulop and Rifkin (2004) define a virtual organization as an organiza-
tion that is usually highly flexible and often relies on internet businesses
or the use of technology in order to limit the importance of physical
space and location in favour of cyberspace.
The third approach to virtual organization is perhaps the most com-
plicated. This approach is an amalgam of the two approaches previously
mentioned, in which authors move almost interchangeably between the
virtual organization as an electronic or online organization, and the vir-
tual organization as a somewhat transient network of people, ideas, com-
petencies and resources which come together for a particular purpose.
The framework of understanding virtual organization is, in this case, of-
ten subjective and open to myriad interpretations. These interpretations
hinge on the particular manner in which the individual perceives orga-
nization.
An overview of the literature shows that there are three fundamental
standpoints on the concept of virtual organization. Two have a relatively
uniform view of virtual companies, whereas the third allows for vari-
ous viewpoints. Characteristic of this last viewpoint is that the authors
consider it to be a mélange of the other two viewpoints. They are not
in accord about which of the two factors, outsourcing or ict,ismore
typical of virtual organization; they are open to various views and inter-
pretations. The authors of this article also believe that both factors are
necessary to the virtual company, and it is for this reason that we chose
to examine the influence of both factors on the virtualization of a com-
pany. We are convinced that both are of paramount importance for the
transition from classical to virtual organization.
Managing Global Transitions
The Influence of Outsourcing 49
The Methodology
In accordance with the third approach, we defined the virtual organiza-
tion as an organization that outsources its non-core competence activi-
ties and maintains some or all of its internal and external relationships
electronically. The main purpose of our study was to discern whether or
not the two components – outsourcing and ict – are equally important
for the virtualization of companies in the tourism industry.
To do this, we developed a three-part questionnaire. The first part per-
tained to the general characteristics of the respondents (sex, type of or-
ganization, level and field of education . . .). The central part of the ques-
tionnaire contained 47 items that, on a five-point Likert-type scale, mea-
sured the degree to which the respondents agreed with several features of
outsourcing or ict and their importance for the (virtual) organization.
The items were defined according to various aspects of outsourcing and
ict found in past theoretical discussions and empirical research (Ben-
son and Ieronimo 1996;Buhalis1998;Gautreau2005; Lynch 2004; Lank-
ford and Parsa 1999; Ellram and Billington 2001, Wilding and Rein 2004;
Lewis, Semein and Talalayevsky 1998), which can be summarized as:
•Outsourcing/ict can contribute to the competitiveness and com-
petitive advantage of a company.
•Outsourcing/ict can help a company to focus on its core-compe-
tencies.
•Outsourcing/ict can help in the acquisition of new knowledge and
know-how.
•Business process re-engineering experienced due to implemen-
tation of outsourcing/ict can result in more efficient and cost-
effective use of resources.
•Outsourcing/ict improves the quality of service and contributes to
greater customer satisfaction.
•Implementation of outsourcing/ict is usually accompanied by em-
ployees’ fear of being made redundant.
The last part of the questionnaire contained our definition of virtual
organization, which was based on the two components already described
(outsourcing and ict). The respondents had to weight the degree to
which each component is important for the virtualization of the com-
pany – that is to say, they had to assign a value from one to five denoting
the level of importance of the given component.
Volume 7·Number 1·Spring 2009
50 Massimo Manzin and Borut Kodriˇc
tab le 1 Respondents by field of education
Field of education Number Percentage
Education 11.4
Humanities 11.4
Social sciences, business and law 36 50.0
Science 912.5
Engineering, manufacturing and construction 811.1
Agriculture 11.4
Health and welfare 34.2
To u r i sm 13 18.1
Total 72 100.0
The Sample
Four firms in the tourism industry, selected on the basis of their position
in the marketplace and on the basis of their profiles, were involved in
the study – namely 1hotel and 1spa (h55.100 according to the National
Standard Industrial Classification of all Economic Activities), 1casino
(o92.712 according to the National Standard Industrial Classification of
all Economic Activities) and 1travel agent (i63.300 according to the Na-
tional Standard Industrial Classification of all Economic Activities). The
subsequent state of the survey included all executives, managers, consul-
tants and skilled employees from these firms.
Altogether, 72 questionnaires were returned, making for a response
rate of around 40%. There were 64% men and 36% women included
in the study. The majority of respondents (90.3%) had finished the first
stage of tertiary education (level 5according to isced97), 6of them
(8.3%) had finished the second stage of tertiary education (isced97 level
6) and 1of them had finished only lower secondary education.
Most of them (50%) had finished a study program in the field of social
sciences, business or law (field 4according to isced97).
They were, on average, 36.6years old with an average work experience
of 12.8years.
Results
We began the analysis of the data compiled with the final survey ques-
tion, which asked respondents to indicate the importance of outsourcing
versus ict for virtualization of the company. The average weight for out-
Managing Global Transitions
The Influence of Outsourcing 51
tab le 2 Three categories of respondents
Category Number Percentage
Group 1: Outsourcing contributes more to virtualization 41 66.1
Group 2:ict contributes more to virtualization 711.3
Group 3: Both components are equally important 14 22.6
Total 62 100.0
sourcing was 61.8% and 38.2%forict, which indicates that, on average,
outsourcing contributes more to virtualization of a firm than does ict.
However, we can see rather large discrepancies among respondents. The
lowest identified weight for outsourcing was 30%(70%forict) and the
highest 90%(10%forict). The idea was to categorize all respondents
into three groups: those who think outsourcing contributes more to vir-
tualization (weight for outsourcing is larger than 50%), those who think
ict contributes more (weight for outsourcing is lower than 50%) and
the group which thinks both components are equally important (both
weights are equal to 50%).Wecanseethatthemajorityofthemconsid-
ered that outsourcing contributes more to virtualization of a firm (see
table 2), as just 7of them thought that ict is more important for virtu-
alization. Ten of them did not answer the question. In the next stage, we
tried to find significant characteristics for each category of respondents.
First, we tested whether education, age, work experience and job-type
had a significant impact on how respondents regarded the relative im-
portance of outsourcing versus ict for the virtualization. We performed
the contingency analysis²⁴ and found that the education level, age, work
experience and type of job were not significantly correlated with the cat-
egory of each respondent. On the other hand, the estimated contingency
coefficient 0.58 and the value of Chi-square test statistics equal to 31.8in-
dicated a significant correlation between the three categories of respon-
dents and their field of education (see table 3).
Most of the respondents who considered outsourcing to be more im-
portant for virtualization had finished studies in social sciences, business
and law or tourism. For the most part, those educated in the fields of
science or engineering, manufacturing, or construction fell within the
groupofrespondentswhoconsideredict more important for the virtu-
alization. In the group of those surveyed that does not give preference to
either outsourcing or information and communication technology, the
representation in terms of the area of education is more or less uniform:
Volume 7·Number 1·Spring 2009
52 Massimo Manzin and Borut Kodriˇc
tab le 3 Categories of respondents by field of education
Field of education (1)(2)(3)(4)
Humanities 00 1 1
Social sciences, business and law 27 0 4 31
Science 1359
Engineering, manufacturing and construction 2327
Health and welfare 2002
To u r i sm 91212
Total 41 7 14 62
notes Column headings are as follows: (1)group1(outsourcing > 50%), (2)group2
(ict >50%), (3)group3(50%–50%), (4)total.14 cells (77.8%) have an expected count
of less than 5. The minimum expected count is 0.11.
Contingency analysis Value df Asymp. Sig. (2-sided) Approx. Sig.
Pearson Chi-Square 31.830(a) 10 .000
Contingency Coefficient .582 .000
half come from the area of sociology, business, law and tourism, and half
from the area of science or engineering.
Second, we attempted to analyze how the respondents’ attitude to out-
sourcing and ict determines the three categories of respondents. Since
the central part of the questionnaire contained 47 specific items that,
on a five-point Likert-type scale, measured the degree to which the re-
spondents agreed with several features of outsourcing or ict and their
importance for the (virtual) organization, it would be quite difficult to
evaluate all of them separately. Instead, we attempted to describe their
attitude by means of more general evaluative dimensions. We performed
two separate factor analyses, one based on items related to outsourcing
features and the other based on items related to ict features.
The estimation of factor matrices commenced with all items included
in the analysis. However, some items were omitted, based on a low mea-
sure of sampling adequacy value and low communalities.²⁵ After several
steps of respecification and evaluation, we agreed on the models shown
in tables 4and 5. The final step was the computation of coefficient Alpha
(Cronbach 1951) for each of the dimensions to ascertain internal consis-
tency for each dimension. As we can see, almost all coefficients exceed
the value of 0.7– the generally agreed lower limit of coefficient Alpha
(Robinson, Shaver, and Wrightman 1991).
Managing Global Transitions
The Influence of Outsourcing 53
tab le 4 Employees’ attitude to outsourcing
Questionnaire item (1)(2)(3)
24. Outsourcing is a consequence of demands for higher share
profitability.
0.67
4. Outsourcing allows a company to control expenses. 0.63
6. Outsourcing allows a company to be more flexible. 0.62
20. Outsourcing reduces business risks. 0.57
10. Outsourcing allows a company to thoroughly transform itself. 0.56
23. Outsourcing is a consequence of globalization. 0.55
27. Outsourcing allows a company to become more productive. 0.51
3. Outsourcing allows a company to save on expenses. 0.49
1. Outsourcing allows a company to achieve a competitive
advantage.
0.47
15. Outsourcing means fragmenting a company. 0.75
25. It is important for a company that all its activities are carried
out in-house.
0.74
16. Outsourcing means losing a company’s identity. 0.73
22. Outsourcing is unnecessary. 0.62
21. All activities of a company can be successfully carried out
in-house.
0.57
19. Outsourcing means redundancies. 0.53
11. Outsourcing allows a company to concentrate on key activities. –0.50
26. Outsourcing grants a company access to specialists. –0.45
28. Higher standards of quality can be guaranteed for the activities
carried out within a company.
0.42
18. Contractors cannot be trusted. 0.39
Continued on the following page
According to the factor matrix in table 4,theattitudeofemployeesto
outsourcing can be explained through 3general dimensions or aspects
(factors):
•A competitional aspect – how can outsourcing contribute to the
competitiveness of a firm?
•An organizational aspect – what consequences does outsourcing
have for the organizational structure?
•A knowledge aspect – how can outsourcing help a firm to acquire
new knowledge and ideas for promoting development?
Volume 7·Number 1·Spring 2009
54 Massimo Manzin and Borut Kodriˇc
tab le 5 Continued from the previous page
Questionnaire item (1)(2)(3)
13. Outsourcing allows a company to acquire new ideas. 0.86
17. Outsourcing allows an increase in the quality of
products/services.
0.79
12. Outsourcing allows a company to acquire new knowledge. 0.73
7. Outsourcing allows a company to be more effective. 0.53
9. Outsourcing is required when a company has a low level of in-
novation.
0.46
2. Outsourcing allows a company to survive in the market. 0.40
Cronbach Alfa 0.82 0.68 0.79
notes Column headings are as follows: (1) competitional aspect, (2) organizational
aspect, (3) knowledge aspect. Factors were extracted by means of the principal axis fac-
toring method. The ‘Direct Oblimin’ factor rotation (oblique rotation) was used to sim-
plify the factor solution. Only factor loadings higher than 0.4(lower than –0.4)are
shown in the factor matrix.
When discussing their attitude toward ict,twoaspectsareevident
from the factor matrix in table 5:
•An economic aspect – how can ict contribute to the overall effi-
ciency and cost-effectiveness of a firm?
•A communicational aspect – how important it is to implement ict
in most parts of business activities?
In the last stage, factor scores were estimated for each of the five fac-
tors, and analysis of variance was used to test whether identified factors
(several aspects of outsourcing and ict)differ among different groups of
employees. The average scores for each factor and category of employees
are shown in table 6. The competitional and knowledge aspects referring
to outsourcing were the only dimensions showing significant differences
between categories. Interestingly, the aspect referring to ict did not dif-
ferentiate significantly between categories.
Competitional and knowledge aspect, both referring to outsourcing,
are most clearly present in the group of employees that considered out-
sourcing contributes relatively more to virtualization of the company,
and least present in the group of employees that considered ict to be
a major determinant of virtualization. Thus, the employees who agreed
with the statement that outsourcing contributes to a firm’s competitive-
ness – and helps it to acquire new knowledge and ideas to promote de-
velopment – considered outsourcing to be relatively more important for
Managing Global Transitions
The Influence of Outsourcing 55
tab le 6 Employees’ attitude to ict
Questionnaire item (1)(2)
4.ict allows a company to save on time. 0.88
5.ict allows a company to be more flexible. 0.80
3.ict allows a company to save on expenses. 0.80
8.ict is a great advantage in everyday tasks. 0.78
7.ict is unnecessary. –0.78
1.ict allows a company to achieve a competitive advantage. 0.75
6. The introduction of ict leads to a higher level of efficiency. 0.68
15. The appearance of a webpage reflects the organization and reputation
of a company.
0.66
12. A well-designed webpage can contribute to achieving better business
results.
0.60
2.ict allows a company to survive in the market. 0.59
18. Personal contact is very important in an industry such as tourism,
which limits the use of ict in the guest-institution relationship.
0.43
10. It is recommendable that all communication be carried out with the
help of information technology.
0.83
17. In order to avoid mistakes, any communication between a company
and a guest should be carried out through ict until the guest arrives.
0.75
16. It is important that all guests use the on-line reservations system. 0.51
11. It is important that all orders be carried out with the help of informa-
tion technology.
0.50
Cronbach Alpha 0.81 0.73
notes Column headings are as follows: (1)economicalaspect,(2) communicational
aspect. Factors were extracted by means of the principal axis factoring method. The ‘Di-
rect Oblimin’ factor rotation (oblique rotation) was used to simplify the factor solution.
Only factor loadings higher than 0.4(lower than –0.4)areshowninthefactormatrix.
virtualization, whereas those who disagreed with these statements con-
sidered ict to be relatively more important.
We can actually confirm on the basis of the results that in the group
which places more noticeable emphasis on information and communi-
cation technology as a factor of virtualization, there is no perceptible
presence of views showing their agreement with the positive contribu-
tion of information and communication technology on the virtualiza-
tion of the company. The results show that in this group there is not a
statistically significant difference between the individual viewpoints. In
effect, it is more a matter of this group not agreeing with the positive
Volume 7·Number 1·Spring 2009
56 Massimo Manzin and Borut Kodriˇc
tab le 7 A average factor scores by category of employees
Category Outsourcing ict
(1)(2)(3)(4)(5)
Group 1: Outsourcing contributes
more to virtualization
0.20 –0.11 0.22 0.07 –0.02
Group 2:ict contributes more
to virtualization
–1.03 0.02 –0.75 –0.05 0.10
Group 3: Both components are
equally important
–0.23 0.08 –0.03 0.13 –0.20
notes Column headings are as follows: (1) competitional aspect, (2) organizational
aspect, (3)knowledgeaspect,(4)economicalaspect,(5) communicational aspect.
contribution of outsourcing. We can thus conclude that those who do
not accept outsourcing as a beneficial factor believe that information and
communication technology is a more important factor of virtualization
than is outsourcing.
The study focused solely on companies from the area of the Slovene
tourist industry, which, of course, somewhat limits the research. There is
room for further studies to expand the focus to other business areas. For
example, it would surely be valuable to carry out a comparative analysis
among companies from various economic sectors, as that would deter-
mine the various degrees of virtualization within individual sectors. On
the basis of our study, it would also be possible for future researchers
to examine the role that various types of education play in understand-
ing the influence of outsourcing and information and communications
technology on the degree of virtualization. In any case, there are a num-
ber of possibilities for further study, especially since studies of virtual
organizations are a relatively new phenomenon.
Conclusions
The onset of the new millennium has given rise to many changes in busi-
ness operations, and these operations are indicating their responses to
the ever-greater demands of the marketplace. One of the changes issurely
the rapid implementing of information and communication technology
into work processes in order to accelerate their execution. Companies
have also recognized that they lack the requisite knowledge to be able
to compete successfully. In such cases, the decision to use outsourcing
therefore seems to be the most suitable option. The outsourcing market
is also developing in Slovenia, such that companies now have an increas-
Managing Global Transitions
The Influence of Outsourcing 57
ing number of options for finding a partner with whom to cooperate, or
outsourcing partners to carry out work on their behalf. We can confirm
that companies – also within the area of Slovene tourism – are becoming
all the more virtual.
Employees’ responses to virtualization of their company vary. In the
study we determined that the majority of employees believes that out-
sourcing can contribute more to virtualization of the company, whereas
information and communication technology does not have such a strong
influence. Employees who give preference to outsourcing are, in terms
of their area of education, primarily from the field of sociology. On the
other hand, those who prefer to emphasize information and communi-
cation technology are from the fields of the technical sciences.
When we tried to discern factors that would most noticeably char-
acterize respondents from each group, we determined that the inclina-
tion of employees to outsourcing is marked by three aspects, namely:
those of competition, organization, and, lastly, of knowledge. The incli-
nation of employees towards information and communication technol-
ogy is marked by the economic as well as the communicative aspect. On
the basis of factor analysis we also determined which of the viewpoints
is more present in the individual groups of employees. The results show
that employees who believe that outsourcing is more conducive to virtu-
alization of the company are convinced that the use of outsourcing leads
to greater competitiveness of the company and helps the company attain
a higher level of knowledge. In the group that places greater emphasis on
information and communication technology we found no statistically
significant differences, which leads us to conclude that they do not agree
with the positive contribution of outsourcing.
On the basis of the findings we can conclude that outsourcing is an
activity that more strongly influences the virtualization of the company
than does information and communication technology. Through the use
of outsourcing, the company attains knowledge that it otherwise would
not have, thereby increasing its range; all new knowledge contributes to
the competitiveness of the company.
Notes
1Outsourcing has been viewed as a form of predetermined external provi-
sion with another enterprise for the delivery of goods and/or services that
would previously have been offered in-house (Kakabadse and Kakabadse
2000).
Volume 7·Number 1·Spring 2009
58 Massimo Manzin and Borut Kodriˇc
2Age and work experience were not real metric variables, since the respon-
dents were categorized into groups by age and work experience.
3Variables with a measure of sampling adequacy values of less than 0.5and
variables with communalities of less than 0.5should be omitted from the
factor analysis one at a time (Hair et al. 2006).
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44.
Managing Global Transitions
The Relationship between Working Capital
Management Efficiency and ebit
Azhagaiah Ramachandran
Muralidharan Janakiraman
This paper is aimed at analyzing the relationship between Working
Capital Management Efficiency (wcme) and Earnings before Interest &
Taxe s (ebit) of the Paper Industry in India during 1997–1998 to 2005–
2006.Tomeasurethewcme three index values viz., Performance Index
(pi), Utilization Index (ui), and Efficiency Index (ei) are computed,
and are associated with explanatory variables, viz., Cash Conversion
Cycle (ccc), Accounts Payable Days (apdays), Accounts Receivables
Days (ardays), Inventory Days (invdays). Further, Fixed Financial
Assets Ratio (fix dfara), Financial Debt Ratio (findbtra)andSize
(Natural log of Sales) are consideredas control variables in the analysis,
and are associated with the ebit. The study reveals that the Paper In-
dustry has managed the wc satisfactorily. The apdays has a significant
(–)ve relationship with ebit, which indicates that by deploying pay-
ment to suppliers they improve the ebit. The Paper Industry in India
performs remarkably well during the period, however, less profitable
firms wait longer to pay their bills, and pursue a decrease in ccc.
Key Words: Working Capital Management Efficiency, Earnings
before Interest and Taxes, Current Assets, Current Liabilities,
Performance Index, Utilization Index, Efficiency Index
jel Classification: g30,g32
Working Capital (wc) is the flow of ready funds necessary for the
working of a concern. It comprises funds invested in Current Assets
(cas), which in the ordinary course of business can be turned into
cash within a short period without undergoing diminishing in value
and without disruption of the organization. Current Liabilities (cls) are
those which are intended to be paid in the ordinary course of business
within a short time. Every company has to make arrangements for ade-
quate funds to meet the day-to-day expenditure apart from investment
Dr Azhagaiah Ramachandran is an Assistant Professor of Commerce
in the Department of Commerce, Kanchi Mamunivar Centre
for Post Graduate Studies, India.
Muralidharan Janakiraman is a Research Scholar in the Department
of Commerce, Kanchi Mamunivar Centre for Post Graduate
Studies, India.
Managing Global Transitions 7(1): 61–74
62 Azhagaiah Ramachandran and Muralidharan Janakiraman
in Fixed Assets (fas). The internal resources of a business organization
often are insufficient for meeting all its needs. Also it is not always pos-
sible for the owners, promoters or the entrepreneurs to mobilize finance
from their personal resources. Resources, therefore, have had to be fi-
nanced through borrowing, keeping in view the short, medium and or
long term requirements of trade or industry for funds.
Statement of the Problems, Significance and Scope
OneoftheseriousproblemsfacedbythePaperIndustryinIndiaisthe
incidence of sickness. There are many reasons for the sickness of the pa-
per industry. One of the important reasons is low per capita consump-
tion of paper in India. The industry experiences frequent dwindling de-
mands and low ebit. The paper industry is highly capital intensive.
Some of the units that are installed in the backward areas suffer from
inadequate infrastructure facilities such as lack of trained manpower,
transportation and sustained power supply, the failure of industry in
maintaining adequate liquidity leading to imbalanced capital structure,
thereby affecting ebit.
Very few studies have been made in relation to Working Capital Man-
agement (wcm)especiallyinthepaperindustryinIndia.Therefore,the
present study is a maiden attempt to analyze the relationship between
wcm efficiency and ebit in the paper industry in India. The study cov-
ers only the listed paper companies on Bombay Stock Exchange (bse)in
India, for which an attempt is made to provide an empirical support to
the hypothesized relationship between wcm efficiency and ebit.
Objectives of the Study
The objective of the study is to examine the relationship between the
wcm efficiency and ebit of the paper industry in India.
The following are the specific objectives:
•To analyse the firm’s efficiency in wcm in the paper industry in In-
dia.
•To analyse the relationship between wcm efficiency and ebit in se-
lected companies in the paper industry in India.
Review of the Literature
Experts (William 1939)determinedthefactorsofwc and pointed out
that wc is an element to be considered in fixing the rate-base. Main-
Managing Global Transitions
Working Capital Management Efficiency and ebit 63
tenance of adequate wc is an essential condition for efficient finan-
cial management (Mohan 1991). wc offers huge cash opportunities that
could be released with sustainability within a relative short period of time
(Loneux 2004). Inventory, receivables, cash and working finance are the
four problem areas of wcm (Mishra 1975). Inventory represents more
than 61%ofthetotalcas of the firm (Swamy 1987).
wc has been financed from internal as well as external sources (Fazee-
ria 2002). Companies have increasingly been relying on short-term funds
particularly short-term bank credit and trade credit (Gupta and Sharma
2003). wc ratios are useful tools in appraising the financial strength and;
immediate solvency of a firm (Sagan 1955). Current and quick ratios reg-
istered insignificant associations whilst the comprehensive liquidity in-
dex indicated significant associations with return on investment (roi)
(Smith and Bahaman 1997). The lower the level of liquid assets, the
greater will be the risks of not being able to meet current obligations
(Van Horne 1969).
The major reason for slow progress of an undertaking is shortage or
wrong management of wc (Siddarth and Das 1993). Due to lack of a
proper plan for wc requirements most firms often experience excess wc
or shortage of wc (Agarwal 1977). Firms are able to reduce financing
costs/or increase the funds available for expansion by minimizing the
amount of funds tied up in cas. There is a significant difference among
industries in wc measures across time (Krueger 2002).
The way in which wc is managed will have a significant impact on the
profitability of companies. This is a significant (–)ve relation between
gross operating income and the number of days of accounts receivable,
inventories and accounts payables. The (–)ve relation between account
payables and profitability is consistent with the view that less profitable
companies wait longer to pay their bills (Deloof 2003). The chief ex-
ecutives properly recognize the role of efficient use of wc in liquidity
and profitability, but in practice they could not achieve it due to sub-
optimum utilization of wc (Prasad 2001). The Public Sector Enterprises
(psus) could improve the wcme by reducing their dependence on out-
side funds (Jain 1988).
Efficient wcm is necessary for achieving both liquidity and profitabil-
ity of a company. A poor and inefficient wcm leads to tie up funds in idle
assets and reduces the liquidity and profitability of a company (Reddy
and Kameswari 2004). Efficient liquidity management involves planning
and controlling cas and cls in such a manner that eliminates the risk of
Volume 7·Number 1·Spring 2009
64 Azhagaiah Ramachandran and Muralidharan Janakiraman
inability to meet due short-term obligations and avoids excessive invest-
ment in these assets. The ccc has been one of the more important mea-
sures of liquidity than the current ratio that affects profitability. There is
a (–)ve relationship between profitability and liquidity indicators such as
current ratio and cash gap (Eljelly 2004).
wcm could vitally affect the health of the firm (Sagan 1955). Industry
practices, company size, future sales growth of company, the proportion
of outside directors on a board, executive compensation (current por-
tion), and ceo share ownership significantly influence the wcme of a
company (Kieschnick 1960). For measuring wcme, performance, utiliza-
tion, and overall efficiency indices were used, instead of some common
wcm ratios (Gosh and Maji 2003).
There is a strong (–)ve relation between ccc and corporate profitabil-
ity of a large sample of listed American companies during 1975–1994
(Shin and Soenen 1998). There is a significant +ve relationship between
profitability, measured through gross operating profit, and ccc.Profit
can be created by handling correctly the ccc and keeping each of the dif-
ferent components (accounts receivables, accounts payables, inventory)
to an optimum level (Lazaridis and Tryfonidis 2006). There is a signif-
icant (–)ve relationship between wcm and profitability. The greater the
ccc the lesser will be the profitability. There is a significant (–)ve rela-
tionship between liquidity and profitability. There is also (–)ve relation-
ship between debt used by the firm and its profitability (Rehmann 2007).
h1
0There is no significant efficiency in the use of various components of
cas for enhancing sales in the paper industry.
h2
0The paper industry as a whole does not have the ability to utilise all
the cas for the purpose of generating sales.
h3
0The paper industry, as a whole does not have efficiency in wcm.
h4
0There is no significant relationship between wcm efficiency and ebit
of the paper industry in India.
Although ample research studies have been conducted in the field of
wcm, very few researches touched on the aspects of wcm and ebit.
Therefore, to fill this gap in the literature, the study has been undertaken.
Methodology, Sources of Data and Sampling Design
The study used only secondary data, which are collected from the cmie
prowess (package). The collected data from this source have been com-
piled and used with due care as per the requirements of the study. Orig-
Managing Global Transitions
Working Capital Management Efficiency and ebit 65
tab le 1 Sample procedure
Type of companies No. of companies No. of companies
listed in bse
Sample size
Paper 113 (78%) 66 (78%) 23
Paper product 33 (22%) 19 (22%) 7
Total 146 (100%) 85 (100%) 30
inally the sample for this study had been planned to choose from the list
of companies listed in National Stock Exchange (nse). Since the number
of companies listed in the nse is small (6companies in the paper and
paper product industry), the sample of 30 companies of paper industry
has been chosen from 85 listed companies in bse.
The Sample Interval (si) is calculated by N/n.si =85/30 =2.8333.
All the bse listed paper and paper product companies are considered
and every 3rd company is selected for the study by use of the Systematic
Random Sampling Technique. The data used for the analysis relate to the
selected paper companies for the period of ten years on a yearly basis
ranging from 1997–2006.
Variables Used for Analysis of Data
analysis i:wcm efficiency
The first part of the analysis is the measure of wcm efficiency for which
three indexes are used, viz., Performance Index (pi), Utilization Index
(ui) and, Efficiency Index (ei).
piwcm =Isn
i=1
Wi(t−1)
Wit
N,(1)
where Is= sales index defined as St/St−1,Wi= individual group of cas,
N=numberofcas group, and i=1,2,3,...N.
uiwcm =At−1
At
,(2)
where A = (current assets)/sales.
eiwcm =piwcm ×uiwcm .(3)
analysis ii:net ebit
The second part of the analysis is the measure of Net ebit,forwhichthe
following equation is formulated, based on the basic indicator.
Volume 7·Number 1·Spring 2009
66 Azhagaiah Ramachandran and Muralidharan Janakiraman
The general form of the model is:
ebitit =β1(piit )+β2(uiit)+β3(eiit )+β4(cccit)
+β5(ffarit )+β6(fdrit), (4)
where ebitit = Earnings Before Interest & Tax (iat time t;i=1,2,30
companies), ccc =CashConversionCycle=No.ofDaysa/r+No.of
Days Inventory – No. of days a/p;fdr = Financial Debt Ratio = (Fixed
Financial Assets)/(Total Assets); ffar = Fixed Financial Assets Ratio =
(Short Term Loans + Long Term Loans)/(Total Assets).
Too l s U s e d f or A n a l ys i s
To analyze the wcm efficiency of the paper industry in India, statistical
techniques viz Minimum, Maximum, Mean, Standard Deviation and Co-
efficient of Variation, Correlation, and Regression Matrix have been used.
To ascertain the linear trend and sign of growth in various components
of wc ratios, the simple regression technique has been extensively used.
Limitations and Scope for Further Study
•The study is confined to ten years data only, i.e. from 1997–2006,
therefore, a detailed analysis covering a lengthy period, which may
give slightly different results has not been made.
•The study is based on secondary data collected from the cmie
prowess (package), therefore the quality of the study depends purely
upon the accuracy, reliability and quality of the secondary data
source. Approximation, and relative measures with respect to the
data source might impact the results.
•The study is based on 30 companies of the Paper Industry in India
that are also drawn from the companies listed in bse. Therefore,
the accuracy of results is purely based on the data of sample units.
If one takes sample units from, say, nifty the results may go slightly
differently.
Further studies could be made by future researchers in the following
aspects and areas:
•by inclusion of extraneous variables like profitability ratios (g/pra-
tio, n/pratio, etc) and analyzing the inter-relationship between the
wcme and profitability;
Managing Global Transitions
Working Capital Management Efficiency and ebit 67
•by categorizing the firms into heterogeneous groups like Small,
Medium, and Large firms based on measures like assets, capital,
long term borrowings, and Net Worth.
Industry Analysis and Findings
An evaluation of wcm efficiency of the paper industry as a whole is done
here. It can be observed vide table 2that there are occurrences of the pi,
ui and ei values of above 1in 3,5and 4respectively out of 9years. In
many years, pi and ei values are < 1,butmeanvalueofpi is nearer to 1
(0.93) and ei value is 1.01. This shows that the Paper Industry has satisfac-
torily managed its wc while handling its cas for generating sales and has
adopted a moderate wcm policy. But, the incidences of the occurrence
of the most successful year (ei >1) followed by the most unsuccessful
one (ei <1), and vice versa, have exposed the fact that the industry has
been inefficient in adopting a very sound wcm policy. Moreover, the co-
efficient of variation (cv), which is very high at 49.12 when compared
to that of pi,ui and ei, elicits the high degree of inconsistency in the
wcm policy adopted by the paper industry. Further, Compounded An-
nual Growth Rates (cagrs) are (–)ve for all the indices.
This, in turn, reveals that the efficiency in managing wc required for
various components of cas relevant to augmenting the sales as well as
wcm policy has been kept weakening further over the period of study.
Overall, it can be inferred that the Paper Industry has shown low effi-
ciency in wcm relevant to manufacturing activities, and has been ineffi-
cientinadoptingasoundwcm policy on the whole during the period of
study.
Regression Analysis and Results
In order to measure the firm’s efficiency in achieving the targeted level of
efficiency during the study period, the ols model has been used. The es-
timated βvalue represents the speed of the individual firm in improving
the efficiency in achieving the industry norms in this regard.
Firm’s efficiency in the matter of managing wc is equal to the average
efficiency level of the industry as a whole. Similarly, <1 indicates the
need of the firm to further improve its efficiency in wcm.
Management of wc is an essential condition of financial management
(Reddy 1991). The wcm has highlighted the managerial aspects of in-
ventories, receivables and advances, and cash (Rao 1985). The wcme has
been tested through a hypothesis in terms of various components of cas.
Volume 7·Number 1·Spring 2009
68 Azhagaiah Ramachandran and Muralidharan Janakiraman
tab le 2 Average Performance, Utilization and Efficiency Indices showing the wcm
Efficiency of the Paper Industry
Financial Year Performance Index Utilization Index Efficiency Index
1997–1998 1.47 1.35 1.98
1998–1999 0.65 0.75 0.49
1999–2000 1.12 1.26 1.41
2000–2001 0.79 1.05 0.83
2001–2002 0.71 0.84 0.60
2002–2003 1.17 1.21 1.42
2003–2004 0.71 0.89 0.63
2004–2005 0.97 1.06 1.03
2005–2006 0.77 0.93 0.71
Minimum 0.65 (1999)0.75 (1999)0.49 (1999)
Maximum 1.47 (1998)1.35 (1998)1.98 (1998)
Mean 0.93 1.04 1.01
sd 0.27 0.20 0.50
cv 29.54 19.67 49.12
cagr –3.15 –1.67 –4.77
notes Computed from Financial Statements; figures in parentheses are years.
h1
0There is no significant efficiency in use of various components of cas
for enhancing sales in the paper industry.
The h1
0is rejected; numerically the overall pi (> 1) indicates efficient
wcm.Averagevalueofpi, as a whole, shows that the pi is > 1for 17
firms out of 30 firms. Thus, the performance of the industry as whole in
wcm was mostly efficient during the period of study. Similarly, from the
ols regression results for ui it is understood that 14 out of 30 firms (β
coefficients > 1) are successful in establishing their efficiency in the paper
industry in the matter of utilization of cas as a whole in generating sales.
The chief executives of the paper industry properly recognized the role
of efficient use of wc in liquidity and profitability, but in practice they
could not achieve it. Most of them followed the budgetary method in
planning wc, and wcm was inefficient due to sub-optimum utilization
of wc (Prasad 2001). The level of wc is a function of sales (Sagan 1955).
This statement has been tested in h2
0.
h2
0The paper Industry as a whole does not have the ability to utilise the
cas for generating sales.
Managing Global Transitions
Working Capital Management Efficiency and ebit 69
tab le 3 Regression Results showing the Relationship between Cash Conversion Cycle
and ebit of the Paper Industry
Explanatory variables Coefficient se of coeff.tvalue Pvalue
Intercept –88.388228.9779 –9.85 0.0000
fix dfa ra –266.6349290.5067 –2.95 0.0035
fin dbt ra –2.7995 14.2790 –0.20 0.8447
lnsales 27.253021.7090 15.95 0.0000
ccc –0.041610.0201 –2.07 0.0390
R20.4696
Adjusted R20.4625
Fvalue 65.312
Degrees of freedom 4,295
notes 1Significant at 5%level.2Significant at 1%level.
The h2
0is rejected; numerically, the overall ui (> 1) indicates efficient
wcm. The average value of ui,asawhole,showsthattheui is > 1for
15 firms out of 30 firms. Thus, the utilization of wc for the industry as a
whole was mostly efficient during the period of study. From the results
of ols regression for ei, it is evident that the > 1for 12 out of 30 firms,
i. e., these 12 firms have achieved targeted industry norms in respect of
adopting efficiency in wcm policy.
Efficient wcm is necessary for achieving both liquidity and profitabil-
ity of a company. A poor and inefficient wcm leads to tie up funds
in idle assets and reduces the liquidity and profitability of a company
(Reddy and Kameswari 2004). wc offers huge cash opportunities that
could be released with sustainability within a relative short period of time
(Loneux 2004). This has been tested in h3
0.
h3
0The paper Industry, as a whole, does not have efficiency in wcm.
The h3
0is rejected as the ei (> 1)showsefficient wcm.Theaverage
value of ei shows that the ei is > 1for 12 firms out of 30 firms under
study for the study period.
Relationship between WCM Efficiency and EBIT
The relationship of Earnings before Interest and Taxes (ebit) of the pa-
per industry with efficiency of wcm is evaluated here. ebit is taken as the
proxy and ccc,apdays,ardays,invdays are considered as measures
of wcm efficiency in the analysis. Apart from these variables, fix dfara,
Volume 7·Number 1·Spring 2009
70 Azhagaiah Ramachandran and Muralidharan Janakiraman
findbtra and size (natural log of sales) are considered as control vari-
ables in the regression model. First, correlation among all selected vari-
ables is worked out and ols regression is run, the results of the regression
are presented in table 3.
From the regression results, it is apparent that apdays has a signifi-
cant (–)ve association with ebit, which indicates that a more profitable
firm delays its payment to its suppliers. The other three wcm efficiency
measures, ccc with +ve in sign, ardays and invdays with (–)ve in
sign have an insignificant one to one relationship with ebit in the paper
industry. The +ve relationship of ccc shows that more profitable firms
under paper industry failed to reduce the ccc.
From the results of regression between ebit and ccc it can be inferred
that ccc has a significant (–)ve relationship with ebit.Also,allthethree
control variables are related significantly with ebit.Therelationships
of fixdfra and findbtra are (–)ve and that of the lnsales is +ve
with ebit. The results show that larger firms with less fixed financial
assets and financial debt ratio earned more ebit by decreasing the ccc
remarkablyunderthepaperindustry.
The regression results between ebit and apdays show that apdays
has a significant +ve coefficient with ebit. Further, among the control
variables, the coefficient of fixdfra is significant at 1per cent level and
that of the findbtra is insignificant. On the other hand, size of firms is
highly related to ebit with +ve in sign.
From the results, it is well established that the larger firms under the
paper industry with less fixed financial assets earned more ebit by delay-
ing the payment to their suppliers. Regarding the relationship between
ebit and ardays, the results of regression shown in table 5reveal that
the coefficient of ardays is significant +vely, and coefficients of all the
control variables are significant but with a different sign. While firm size
is +vely related, fixdfra and findbtra are (–)vely related to ebit of
the firms under the paper industry. In sum, it is found that the larger
firms with less fixed financial assets and financial debt have generated
more profit (after operating cost) by increasing the credit period granted
to their customers under the paper industry.
With regard to the impact of number of days in inventory (inventory
cycle) on the ebit of the firms under the paper industry, the regression
results disclose that invdays has an insignificant (–)ve co-efficient with
ebit. On the other hand, the coefficients of fixdfra with (–)ve in sign
and that of lnsales with +ve in sign are significant at 1per cent level.
Managing Global Transitions
Working Capital Management Efficiency and ebit 71
tab le 4 Regression Results showing the Relationship between Number of Days
Accounts Payable and ebit of the Paper Industry
Explanatory variables Coefficient se of coeff.tvalue Pvalue
Intercept –93.838529.1316 –10.28 0.0000
fix dfa ra –259.6095289.8865 –2.89 0.0042
fin dbt ra –9.0700 14.8742 –0.61 0.5425
lnsales 27.682921.7380 15.93 0.0000
apdays 0.050910.0210 2.43 0.0159
R20.4724
Adjusted R20.4653
Fvalue 66.052
Degrees of freedom 4,295
notes 1Significant at 5%level.2Significant at 1%level.
tab le 5 Regression Results showing the Relationship between Number of Days in
Accounts Receivables and ebit of Paper Industry
Explanatory variables Coefficient se of coeff.tvalue Pvalue
Intercept –99.746229.9563 –10.02 0.0000
fix dfa ra –232.8214289.8986 –2.59 0.0101
fin dbt ra –7.3206 14.6625 –0.50 0.6180
lnsales 27.499821.7180 16.01 0.0000
ardays 0.168610.0709 2.38 0.0180
R20.4720
Adjusted R20.4649
Fvalue 65.942
Degrees of freedom 4,295
notes 1Significant at 5%level.2Significant at 1%level.
However, the findbtra has an insignificant +ve coefficient with ebit.
Overall, the regression results exposed the fact that the larger firms un-
der paper industry, which earn more ebit, have fewer inventories, but
decrease in inventory level does not influence the increase in ebit sig-
nificantly. At the same time these firms have gained more ebit with less
fixed financial assets and by increasing the financial debt insignificantly.
There is a strong (–)ve relationship between variables of the wcm and
profitability of the firm (Reheman 2007). This means that as the ccc
increases it will lead to a decrease in the profitability of the firm, and
Volume 7·Number 1·Spring 2009
72 Azhagaiah Ramachandran and Muralidharan Janakiraman
tab le 6 Regression Results showing the Relationship between Number of Days in
Inventory and ebit of the Paper Industry
Explanatory variables Coefficient se of coeff.tvalue Pvalue
Intercept –86.262429.3964 –9.18 0.0000
fix dfa ra –255.2521290.7656 –2.81 0.0053
fin dbt ra 5.6502 14.0239 0.40 0.6873
lnsales 26.473421.6602 15.95 0.0000
invdays –0.0622 0.0537 –1.16 0.2474
R20.4644
Adjusted R20.4571
Fvalue 63.942
Degrees of freedom 4,295
notes 2Significant at 1%level.
managers can create a +ve value for the shareholders by reducing the
ccc to a possible minimum level. This has been tested in h4
0.
h4
0There is no significant relationship between wcm efficiency and ebit
of the paper industry.
The h4
0is rejected as apdays (Fvalue 66.05), ccc (Fvalue 65.31), and
ardays (Fvalue 65.94) and Number of Days in Inventory (Fvalue 63.94)
are significantly related to ebit of the paper industry. Therefore, it is
inferred that there is a significant relationship between wcm efficiency
and ebit of firms in the paper industry in India.
Conclusion
Theimportanceofefficient wcm is indisputable. Moreover, adequate
wcm is essential as it has a direct impact on ebit and liquidity. An at-
tempt has been made in the present study to investigate the relationship
between wcm efficiency and ebit of Indian paper companies. In the
matter of wcm, three indexes and net ebit have been computed for all
the firms over the period of study – ten-years.
From the study it is concluded that the Indian paper firms perform
remarkably well during the period. Industry overall efficiency index was
>1in 3out of 9years for the study period. Though some of the sample
units had successfully improved efficiency during these years, the exis-
tence of a very high degree of inconsistency in this matter clearly points
out the need for adopting sound wcm policy in these firms.
Managing Global Transitions
Working Capital Management Efficiency and ebit 73
There is found to be a (–)ve relationship between ebit and the cash
conversion cycle (ccc) which was used as a parameter, therefore it seems
that operational ebit dictates how to manage the wc of the firm. Fur-
ther, it is found that lower gross ebit is associated with an increase in
the apdays. This could lead to the conclusion that less profitable firms
wait longer to pay their bills, taking advantage of credit period granted
by their suppliers. The +ve relationship between ardays and firms ebit
suggests that less profitable firms will pursue a decrease of their ardays
in an attempt to reduce their cash gap in the ccc.
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Managing Global Transitions
A Strategic Household Purchase:
Consumer House Buying Behavior
Mateja Kos Kokliˇ
c
Irena Vida
The aim of this study is to examine consumer house-buying behavior
from the consumers’ perspective. In view of the existing literature ex-
ploring consumer decision making, the purpose of this research was
threefold: (a) to propose a conceptual model of consumer decision
making within the frame of consumer behavior; (b) to gain knowl-
edge of factors impacting this process from the empirical standpoint
with the focus on prefabricated house purchases; and (c) to offer im-
plications for beneficial purchases of prefabricated houses. The results
of our in-depth interviews with recent owners and potential buyers of
a custom-made prefabricated house suggest that cognitive and ratio-
nal factors do not offer sufficient explanation of consumer behavior in
the case of a high-involvement product such as a house. In addition to
the idiosyncratic characteristics of the customer, his/her personal situ-
ation and environmental factors, the role of feelings, experience, sub-
conscious factors, needs and goals should to be taken into account to
better understand this kind of decision making.
Key Words: consumer decision-making, strategic purchase,
prefabricated house, qualitative research
jel Classification: m30,m31
Introduction
The field of consumer research is mostly focused on two major ques-
tions: how consumers go about making decisions (descriptive theories),
and how decisions should be made (normative theories) (Edwards and
Fasolo 2001). Research directives, aimed at researching how consumers
should decide, have been emerging lately. Several critiques have ap-
peared against the existing literature which focuses almost exclusively on
the marketing perspective and neglects consumers and their difficulties
in decision making (Bazerman 2001; Gronhaug, Kleppe, and Haukedal
Mateja Kos Kokliˇc is an Assistant at the Faculty of Economics,
University of Ljubljana, Slovenia.
Irena Vida is a Professor at the Faculty of Economics,
University of Ljubljana, Slovenia.
Managing Global Transitions 7(1): 75–96
76 Mateja Kos KokliˇcandIrenaVida
1987). Brief and Bazerman (2003,187) developed the idea that ‘creating
truevaluefortheconsumerand,thus,addingvaluetosocietyisoneof
the most obvious ways business organizations make the world a better
place’. This notion of a consumer-focused approach is also supported by
Bargh (2002), who believes consumer research should balance studies
of how to influence consumers with studies of how consumers could
defend themselves against and control such influences.
One of the most influential areas within consumer behavior is con-
sumer decision – making (Bargh 2002;Simonsonetal.2001; Bettman,
Luce, and Payne 1998). At the conceptual level, various consumer deci-
sion-making models have been proposed in the literature in recent
decades. However, many researchers believe that a specific, situation-
and product-oriented model is needed in studying purchasing (Eras-
musm, Boshoff, and Rousseau 2001). Apart from this, investigating deci-
sions, that can change lives of consumers, such as car or house purchase,
can make an essential contribution to consumer behavior knowledge
(Wells 1993). According to Erasmus, Boshoff, and Rousseau (2001), an
exploratory approach with the intention to unfold the truth may pro-
vide opportunities for an understanding of the complexity of specific
decision-making circumstances, such as first-time house buying.
In view of the existing literature exploring consumer decision mak-
ing when purchasing high-involvement and emotionally charged prod-
ucts, the purpose of this research was threefold: (a) to develop a con-
ceptual model of decision – making for a prefabricated house purchase;
(b) to gain knowledge of factors impacting this process from the em-
pirical standpoint; and (c) to offer implications for beneficial strategic
household purchases. Strategic decision making refers to the process of
decision making with long-term commitments of resources and affect-
ing the budget available for other goods and services (Gronhaug, Kleppe,
and Haukedal 1987,242). Based on the existing literature, we assume that
this process involves a certain amount of perceived risk, especially since it
represents large financial obligations (Gibler and Nelson 2003; Mitchell
1999; Gronhaug, Kleppe, and Haukedal 1987; Beatty and Smith 1987).
Ourgoalisalsotooffer implications for consumers, real estate marketers
and consumer researchers. The specific product selected in this study was
a prefabricated house. The house is the most important durable good in
the household and requires high involvement as well as complex deci-
sion making. Some similarities can be drawn with other durable prod-
ucts, particularly cars. Hence, the empirical literature in this area and the
Managing Global Transitions
A Strategic Household Purchase 77
real estate literature serve as a basis for conceptual and empirical work in
this study.
Theoretical Background
Consumer behavior has been an important research topic for decades. A
review of existing theoretical efforts indicates a clear shift from rational
to psychological and social decision factors. However, even the recent
models have not managed to embrace all the knowledge in the field of
consumer behavior: subconscious processes, the role of needs, goals and
emotions (Bargh 2002). Apart from leaving out these important find-
ings the existing literature also lacks studies of decisions that consumers
are most concerned about, termed ‘big’ or ‘strategic decisions’ (Bazer-
man 2001,500; Gronhaug, Kleppe, and Haukedal 1987,242). Specifically,
Bazerman (2001) urges researchers to further explore the most impor-
tant and challenging consumer decisions, which include house and car
purchases, dealing with a building contractor etc.
As mentioned in the introduction, strategic decision making refers
to the process of decision making when buying strategically important
goods. The following characteristics define the strategic importance of
a purchase: high involvement in the process; long-term commitment
of resources; truncated budget available for other goods and services.
Strategic purchases imply several important categories of decisions, in-
cluding:
•decisions with regard to allocation of the household budget, namely,
how the household’s economic resources are influenced, e. g. for
travelling, visits to restaurants etc.;
•categorization of alternatives means choosing either from various
product groups (e. g. apartments or houses) or defining a more nar-
row product category (e. g. houses of a given size);
•decision making within the defined product category takes place
once the product group is specified.
The purchase of a house may be considered as a good example of
such a purchase decision. Strategic decisions are being made in a range
of fields, including when consumers decide about health issues (Henry
2001) or financial investments (Henry 2005).
Considering the focus of this study on consumer behavior with re-
spect to a very specific product, i. e., a prefabricated house, empirical
research in the area of durable goods needs to be examined to support
Volume 7·Number 1·Spring 2009
78 Mateja Kos KokliˇcandIrenaVida
existing theoretical knowledge. Empirical research conducted in the field
of durable goods purchase behavior can be useful for at least two rea-
sons: (a) the house is the most important durable good in the household
(Hempel and Punj 1999); and (b) many studies of consumer decision
making for a car or household appliances indicate that there are sim-
ilarities among the buying processes related to different durable goods
(Punj 1987). The majority of literature researching individual and orga-
nizational customers is dealing with buying processes of durables (e. g.
Bayus 1991; Cripps and Meyer 1994; Grewal, Mehta and Kardes 2004;
Hauser and Urban 1986;McQuinston1989; Punj and Brookes 2002).
Compared to buying convenience products, consumers perceive these
kinds of ‘large ticket’ purchases as riskier, sometimes even ‘traumatic’
(Bauer 1960;Chaudhuri2001; Mitchell 1999). Outcomes of such pur-
chases are unknown in advance and some of them are likely to be un-
pleasant. A common attribute of durables is that the buying decision is
complex, especially when the price is perceived as high.
The strongest parallel can be made with a car purchase, particularly as
the car is the second most important durable acquisition in the house-
hold. Buying a house or a car highly involves the consumer, as this
decision binds their economic resources in the long run (Arndt 1976;
Gronhaug, Kleppe, and Haukedal 1987; Grewal, Mehta and Kardes 2004;
Rosenthal 1997). Both product categories offer a rich variety of price and
quality, are complex and relatively well known to consumers (Brucks,
Zeinthaml, and Naylor 2000; Bayus and Carlstrom 1990). Similarly, the
buying decision for real estate as a subgroup of durables is also com-
plex and demands high involvement (Gibler and Nelson 2003). In most
cases, consumers consider several possibilities, compare them and ulti-
mately make a selection (Bayus and Carlstrom 1990). In comparison to
frequently purchased items, learning on a basis of trial-error is uncom-
mon when buying expensive, complex products (Bazerman 2001).
Prior to model building efforts, however, characteristics of the prod-
uct in question need to be identified. A prefabricated house differs from
other fixed property (i. e., a traditional built house) in one major char-
acteristic – it is movable up to the point when it is set up in a selected
location. Other attributes of this product are that its components are
prepared in advance in specialized companies, and put together on the
construction site at a later time. Manufacturers offer a variety of pre-
fabricated houses. The house typically consists of standardized prefab-
ricated components which are later adapted to customer specification.
Managing Global Transitions
A Strategic Household Purchase 79
With the support of an architect, customers can custom design their
house by changing the layout of the house, selecting the materials, size of
the house, etc. (bdf 2004).
Development of a Conceptual Model
In this study, a conceptual model of consumer behavior and the buying
process was developed for the means of conducting exploratory research
in the later stages. Our aim is to propose a model that can enhance our
understanding of consumers from their point of view.
Recent findings in consumer behavior research conducted by psychol-
ogists and sociologists suggest that the following perspectives be ac-
knowledged in the development of new conceptual consumer buying
behavior models (Hansen 2005;Erasmus,Boshoff, and Rousseau 2001;
Loewenstein 2001; Peter and Olson 2002):
•the role of subconscious factors should be taken into consideration;
•the context and the product should define the decision-making re-
search;
•alternative decision-making strategies should be allowed;
•types of heuristics used by consumers should be explained;
•the role of feelings affecting the decision-making process should be
considered, and
•the interplay of consumer’s cognitive and affective skills should be
included.
Based on these recommendations, Peter and Olson’s (2002)cognitive
processing model appears to be the most appropriate theoretical basis
for consumer decision making and behavior with respect to the prod-
uct investigated in this research. These authors suggest that the ‘con-
sumer decision-making process is a goal-directed, problem-solving pro-
cess’ (Peter and Olson 2002,168). The major advantage of this model is
that it accounts for the weaknesses of previous models by considering
cognitive, affective as well as environmental factors. Nevertheless, this
model is of a general nature, accounting for neither the specific char-
acteristics of the product in question nor the context of the purchase
situation.
Against these theoretical and empirical backgrounds, a conceptual
model of the buying process is proposed in figure 1. Its components
consist of the cognitive processing model by Peter and Olson (2002)set
within the general consumer behavior model (Hawkins, Best, and Coney
Volume 7·Number 1·Spring 2009
80 Mateja Kos KokliˇcandIrenaVida
External factors
•Culture
• Subculture
• Reference groups
•Family
•Socialclass
•Demography
Inter nal factors
•Involvement
• Feelings
•Experience
•Knowledge
•Motivation
•Personality
Lifestyle
self-concept
(extended
self)
Goals
Needs
Prefer-
ences
Desires
Attention
Stimulus selection
Comprehension
New knowledge,
meanings, and beliefs
Interpretation
Linking
Old + new =
consideration set
Evaluation
Attitudes toward alter-
natives using criteria
Behavioral intention
Decision-making
Integ ration
Behavior –housepurchase
Usage – residence
Memory
known alternatives
and criteria
Environmental stimulus
(Dis)satisfaction =⇒good/bad reference
Buying
process
fig ur e 1 A conceptual model of the buying process
2003). The latter can be described as external and internal factors con-
tributing to the formulation of self-concept and lifestyle, which affect
the consumer decision process. During this process, experiences and ac-
quisitions update the original external and internal influences. The con-
ceptual model is discussed in the next paragraphs.
While the buyer believes that the characteristics of a certain product
should fulfill his/her goals and needs, the choice of a product will also
reflect a person’s self-concept and his/her lifestyle. In figure 1,itcanbe
seen that lifestyle and self-concept influence goals through needs, desires
and preferences, and the goals define the decision making.
As indicated in figure 1, the antecedents of the purchasing process in-
clude two groups of determinants which influence a buyer’s lifestyle and
his/her self-concept, which through his/her needs, desires, preferences,
Managing Global Transitions
A Strategic Household Purchase 81
and goals determine buying behavior pictured in the right box of the
model in figure 1. The group of internal factors includes the level of an
individual’s motivation, involvement, his/her personality, feelings, atti-
tudes, perception, knowledge, learning and memory. The external fac-
tors indirectly impacting the buying process account for social factors
such as characteristics of the culture of the buyer, an individual’s social
class and subculture, household characteristics of the buyer, his/her ref-
erence groups and demographic factors.
The model suggests that an individual’s lifestyle and the meaning a
person wants to acquire by owning a product influence his/her needs
and desires concerning this product. In the case of buying a prefabri-
cated house, the choice of the materials and layout directly reflects the
lifestyle of a household unit or a family. It is believed that in the early
stage of the buying process, decision makers usually do not have suffi-
cient information. Therefore, they continuously gather new information
and adapt their desires and goals accordingly. The ultimate goal is to own
the product. Since the buyer’s involvement is high, the ultimate goal is di-
vided into a hierarchy of sub goals which lead the consumer to the end
goal. According to Belk (1988), a house presents a strong source of per-
sonal identity. The extended self as part of the self-concept plays a major
role. Hence, we posit that a custom-made house will reflect its owners’
individuality and their personal style
The source of information related to the product purchase can be
internal (memory) or external (environment); in both cases, informa-
tion can be acquired by coincidental find and/or intentional search. The
search is influenced by several factors divided into three categories: situ-
ational determinants, product determinants and consumer characteris-
tics. Also, an interesting question to be explored empirically is how con-
sumer knowledge about available alternatives in the market and about
product criteria is created. For a complicated product such as a house,
the information stemming solely from a buyer’s memory is generally in-
adequate (Gibler and Nelson 2003). Factors such as experience, market-
ing communication, distribution and individual goals all influence the
evoked set formation. The choice of criteria for evaluation evolves in
a similar fashion. Factors such as a buyer’s specific goals, his/her mo-
tivation, involvement, product knowledge and similarities among alter-
natives may play a role. Context specific criteria (for a prefabricated
custom-made house) include objective physical properties specified by
a manufacturer, e. g., quality, warranty, isolation, price per square meter.
Volume 7·Number 1·Spring 2009
82 Mateja Kos KokliˇcandIrenaVida
Other features such as the house size, its ground plan and location are
not decisive criteria for a custom-made prefabricated house as they are
defined by the buyer.
As indicated in the right box in figure 1, the stages of the buying pro-
cess are as follows: attention, comprehension, evaluation, decision mak-
ing, behavior and usage. The goal ‘to own a product’ leads the consumer
to a conscious interpretation of information linked to this goal. New in-
formation is interpreted and linked to existing knowledge. As a result,
new attitudes towards the alternatives are formed. The buyer usually does
not get to know all the alternatives simultaneously; rather, new alterna-
tives are gradually added. Therefore, the customer experiences the pro-
cess of interpretation and integration over and over again. The evalua-
tion takes place for both the new and the known alternatives.
As far as the specific product in the study is concerned, we dealt
with prefabricated house purchase, since this presents a good example
of strategic purchase or decision making. There is a higher level of com-
plexity in this process. This is usually associated with high involvement
on the buyer’s side, and high perceived risk, therefore the decision pro-
cess is more deliberative and the external information search is more ex-
tensive (Beatty and Smith 1987). A custom-made prefabricated house is
a product not bound to any specific location. Hence, the location itself
is not a consequence of the purchase, although it may notably influence
the choice of criteria in the buying process. The decision making process
will also depend upon the situation, available alternatives in the market,
a buyer’s motivation, his/her involvement and prior knowledge with the
product (Hawkins, Best, and Coney 2003). In addition, product specifi-
cation offered by the producer may be of major importance to the po-
tential buyer. Along with the objective physical properties of the prod-
uct, the level of service offered by the company as well as adaptability
of the basic house design offered may play a role in consumer decision
making.
Methodology and Data
The second stage of this research involved exploratory research of the
conceptual model of the buying behavior with respect to a custom
made prefabricated house. A number of factors prompted us to uti-
lize qualitative research methods, i. e., in-depth personal interviews with
consumers. First, the qualitative approach enables researchers to gain a
deeper understanding of consumer behavior in the context of complex
Managing Global Transitions
A Strategic Household Purchase 83
tab le 1 Demographic data for the selected sample
Owners Potential buyers
(1)su1 su2 su3 su4 su5 su6
(2)– – 6years 1month;
2.5years
5years 14 years
(3)840–1260 840–1260 above 1670 1260–1670 840–1260 above 1670
(4)f66 21 35 30 36 43
m70 28 43 35 37 43
(5)fGraduate Highschool Graduate Graduate Highschool Graduate
mGraduate Highschool Graduate Graduate Highschool Graduate
(6) Bled Krško Brezovica Ljubljana Ljubljana Celje
notes Row headings are as follows: (1)sampleunit,(2) age of children, (3) monthly
household income (in eur), (4)age,(5)education,(6) settlement.
and empirically unexplored product purchase. Second, due to the nature
of the product, the buying process is rather complicated and requires
high involvement on the part of a consumer. Third, results of a quali-
tative study can yield useful directions for further quantitative research
(Kumar et al 1999; McDaniel and Gates 1998; Miles and Huberman 1994).
As our conceptual model suggests, a variety of different factors influence
the process, which gives the selected methodology additional relevance.
In this research, six semi-structured in-depth interviews were carried
out; three interviews with recent owners of a custom-made prefabricated
house and another three interviews with potential buyers of the same
product. Consequently, we avoided biasing toward house-ownership on
the one hand, and on the other hand we collected data from highly in-
volved potential buyers. Given the limited population of informants rela-
tive to the specific objectives of this research, our sample was selected on
a non-random basis. More specifically, we used a referral method, start-
ing with a couple who were opinion leaders for prefabricated houses.
First, an appointment was made with potential respondents by tele-
phone. Subsequently, interviews were carried out in the participants’
households. One or two decision makers in the household participated
in the interview. Topics of discussion followed the established interview-
ing protocol. The interviews lasted from 45 to 90 minutes and they were
audio- taped. The sample was composed of households with 2to 4mem-
bers from different areas of Slovenia. The basic characteristics of the re-
spondents are presented in table 1.
Volume 7·Number 1·Spring 2009
84 Mateja Kos KokliˇcandIrenaVida
Data Analyses and Findings
In the analytic stage of our research, we followed the procedure for ana-
lyzing qualitative data by Miles and Huberman (1994). These guidelines
enable investigators to produce compelling analytic conclusions and en-
hance the internal validity of the study. The analyses involved three types
of activities: data reduction, data display and conclusion drawing. The
data reduction process began with compiling the literature review, de-
veloping the conceptual framework for the study and setting up the pro-
cedures for data collection (e. g., respondent selection, interview guide-
lines). Audio tapes with interviews were transcribed and reviewed sev-
eral times by the researchers. According to Berg (2007), content analysis
is the most appropriate technique for analyzing interviews. The conclu-
sion drawing was based on the cross-case (i.e., household) comparisons,
reference to previously reviewed empirical studies and to the theoretical
framework developed in this study. Examination of patterns, themes and
regularities provided the basis for drawing conclusions.
The results of our analyses confirm the notion that the house is a prod-
uct closely related to the human self-concept. While the product has dif-
ferent meanings to different people, a custom-made house carries a sub-
jective message of its residents and presents a strong source of personal
identity. This is consistent with the literature in the field (i. e., Belk 1988;
Downs 1989). With the exception of a single sample unit, all respondents
view the house as a part of their personality or the extended self. The
house ownership enables them to express their personality and lifestyle.
Relative to the house owners of the house, the sample group of poten-
tial buyers of the house expressed a stronger desire for homeliness and
warmth. In general, women and men perceived a house differently. While
women ‘feel’ the house and relate to it on the emotional level, men tend
to evaluate the house more on the rational and functional level. How-
ever, both women and men believe that ‘the feeling of wellness’ in the
house is an important choice criterion.
Conceptually, we posited (figure 1) that lifestyle exerts a certain in-
fluence upon buyers’ needs and desires as well as upon indirect exter-
nal and internal determinants of the buying process. The households
included in this research proved to lead quite different lifestyles, and
most of them wanted the custom-made house to reflect their lifestyles.
Reasons behind the respondents’ decision to buy/search for a custom-
made house are similar across the sample units. Namely, the household
Managing Global Transitions
A Strategic Household Purchase 85
members are intimately familiar with their desires and lifestyles which
lead to their house design preferences. On the other hand, the manufac-
turers/producers have little knowledge of this aspect of their individual
customers’ lives. In contrast to the owners, potential buyers emphasized
the existence of a continuous tradeoffbetween their desires and needs
in their decision making for the house. Table 2provides an overview of
the main common themes and quotes, reflecting each theme in a more
detailed manner.
Based on the empirical findings of this study, it is our contention
that people want to have a house designed according to their ideal self-
concept while taking into account realistic limitations. This result is con-
sistent with Gibler and Nelson’s (2003) position that people want a house
to reflect their actual or ideal self-concept. We found that the ground
plan and the choice of materials in the house directly indicate the ten-
ant’s lifestyle, either actual or ideal. Respondents mentioned various cir-
cumstances as reasons for their home purchase; however, they all related
this purchase to a higher quality of living.
Our findings confirm that the buying process in the case of a custom-
made prefabricated house is influenced by both internal and external
factors. Along with previously discussed general determinants, factors
frequently mentioned by our respondents were: marketing communica-
tions in the housing market, other people’s opinions, time pressure, and
the seller’s (manufacturers’) behavior. By analyzing qualitative data gath-
ered in this study, it appeared that most respondents form their attitudes
toward the manufacturer/company at the moment when they contact the
seller.
Our interviews reveal that recommendations provided by friends
or other house owners with experiences and information about the
custom-made prefabricated house were very important. It seems that
word-of-mouth recommendations might be even more important in
a house buyer’s information gathering and evaluation stages than the
seller/company’s behavior. Moreover, we found that the owners of the
sample house played a major role in making potential buyers enthu-
siastic. That is, they honestly shared their experience about living in a
wooden prefabricated house, and the potential buyers see for themselves
what it is like to live in such a house.
Alongwithmakingafavorablefirstimpression,theseller/company
also needs to follow its customers after the purchase. Consistent with
the literature suggesting that the external factors exert an important in-
Volume 7·Number 1·Spring 2009
86 Mateja Kos KokliˇcandIrenaVida
tab le 2 Common themes and quotes from the in-depth interviews
Lifestyle, needs and desires, self-concept
m5: ‘Brand of prefabricated house and wood show your thinking, your attitude
toward nature, environment. It depends on what type of person you are. With the
house you want to show your personality, how you think, how you live.’
m5: ‘You slowly build the whole picture and when it is done, you know what you are
looking for and what you want. If you decide too quickly, your “dream house” falls
down like a castle in the air, because you find out that your needs are different, that
the optimal house is different.’
f6: ‘I’m drawing the plan for our house by myself. I hope it’s ideal. I’ve done my best
and have tried to take into consideration as many factors as possible to make the
plan ideal.’
Attitude formation
f1: ‘We visited one company and a lady received us. I believe she had a terrible
headache that day and completely ignored us. Her behavior was intolerable, there-
fore we said to ourselves, let’s go, they even don’t want to sell houses here. One visit
was enough.’
External factors (word-of-mouth)
f1: ‘Our friend architect recommended us this house saying it has the best isolation
and that we will be most satisfied with this one. And this is the reason we chose it.’
m2: ‘We have gathered most information from people who have already purchased
house. Such people share information in the best way.’
f3: ‘A coworker recommended this house to my husband, and after we collected
some information about the producer, we saw they are really good. I trusted this
company because of the recommendation.’
m4: ‘What other people told us about their experience was the most valuable infor-
mation for us. People who tell us their honest opinions, although they are not our
close friends.’
Internal factors (emotions)
f1: ‘A house is very emotional. People build a house with lots of emotions. It’s not
just about money and reason.’
f3: ‘Because the house is wooden, for us at the time an unknown material, we felt
quite some fear. You get into this with some fear. But after we had visited several
houses, we got the feeling that a wooden house is very pleasant.’
m4: ‘There is a lot of emotion involved in buying a house. Reason starts later. First
there is emotion, and then you start with reason. But all the time the two parameters
interact.’
f4: ‘I try to consider my emotions, I don’t want to forget about them.’
fluence, particularly for less experienced customers (Gibler and Nelson
2003), we also probed into the role of social factors in the respondents’
buying process for the house. The influence of culture can be identified
in the buyers’ desire to own a custom-made house, i. e., based on their
Managing Global Transitions
A Strategic Household Purchase 87
tab le 3 The main external factors, which influence sample units
su1 su2 su3 su4 su5 su6
• Reference
groups
•Time
pressure
•Company’s
behavior
•Family
•Marketing
communi-
cation
• Reference
groups
•Income
•Company’s
behavior
• Reference
groups
•Time
pressure
•Company’s
behavior
• Reference
groups
•Income
•Company’s
behavior
•Marketing
communi-
cation
• Reference
groups
•Income
•Company’s
behavior
• Reference
groups
•Family
•Income
individualistic preferences. In their study, Gibler and Nelson (2003)sug-
gested that the value placed on individualism as a part of culture is re-
flected in the demand for customized homes. Table 3summarizes the
main external factors for each sample unit interviewed.
As suggested by our conceptual model for the study (figure 1), the
group of internal factors which mostly influences the decision/making
process, includes an individual’s motivation, involvement, personality,
self-confidence, knowledge, affect, and prior experience. Findings of our
empirical work seem to corroborate the notion that a custom-made
house requires high involvement and strong motivation. This was re-
flected in an intensive search for information about various produc-
ers/sellers in the housing market. Our respondents actively engaged in
information gathering, mostly because they found their existing knowl-
edge insufficient. This stage was followed by comparing and evaluating
identified alternatives of the product. In the buying process for a house,
an individual’s affect played an important role. This was reflected in
the feelings aroused when imagining the house, meeting with company
representatives, and when inspecting a sample house. This conclusion
is consistent with Bargh’s (2002) suggestion that researchers should fo-
cus more attention on subconscious processes, needs, goals and affect.
In comparison to existing house-owners, potential buyers much more
strongly expressed their feelings with respect to their future house. Also,
women emphasized their feelings more than men. Table 4provides the
main internal factors, which could be identified during the interviews.
However, considering a house purchase is financially demanding for
most buyers, cognition also plays an important role, particularly with
respect to evaluation of its price and its functionality. High involvement
is reflected in an intensive information search about different house pro-
Volume 7·Number 1·Spring 2009
88 Mateja Kos KokliˇcandIrenaVida
tab le 4 The main internal factors, which influence sample units
su1 su2 su3 su4 su5 su6
•Emotion
•Self-
confidence
•Experience
•Involvement
•Emotion
•Self-
confidence
•Experience
•Involvement
•Emotion
•Self-
confidence
•Involvement
•Emotion
•Self-
confidence
•Experience
•Involvement
•Emotion
•Self-
confidence
•Experience
•Involvement
•Emotion
•Self-
confidence
•Experience
•Prior
knowledge
•Involvement
ducers. While most of our respondents had no previous experience or
knowledge related to house purchase, they gradually gained sufficient
self-confidence in making decisions on their own.
Our conceptual model (figure 1) suggests that the consumer decision-
making process is composed of several stages, strongly intertwined with
each other. As our sample consisted of two groups, i.e., the potential
buyers and the owners, the two groups experienced different stages.
While the group of potential buyers only reached the stage of evalua-
tion of the alternatives, the group of house owners was in the stage of
having bought and using the house.
Our findings suggest that the purchase criteria used by individual
households include product characteristics or specific consequences of
buying a certain alternative. Five respondents went through a cyclic pro-
cess of improving already established criteria with additional new knowl-
edge, gained from producers, building experts, and prefabricated house
owners. The criteria used for choosing a house among the respondents
in this study can be ranked as demonstrated in table 5featuring the es-
sential criteria for each individual sample unit and ranked based on their
importance. The most commonly used criterion was that the house is
custom-made. The second most often used selective criterion is com-
pany’s behavior, namely, how the representatives of the house producer
communicated with the potential buyers. Two significant choice criteria
with respect to a house as a product were also quality of the product and
its price. What respondents mentioned several times was feeling confi-
dent about the company. This means that potential buyers need to have
trust in the company’s process of production and delivery of their house.
Taking into consideration the fact that different house producers offer
different architectural solutions, four respondents also mentioned the
importance of this characteristic.
Managing Global Transitions
A Strategic Household Purchase 89
tab le 5 The most important criteria of individual sample units (su) for choosing a
producer of a prefabricated house (ranked according to their importance)
su1 su2 su3 su4 su5 su6
• Wooden
house
•Prefabri-
cated house
•Isolation
•Construc-
tion
•(5)Archi-
tectural
solutions
•(2)Com-
pany’s be-
havior
•(3)Quality
•Isolation
• Natural
materials
•(1)Custom-
made house
•(4)Confi-
dence in the
company
•Fastcon-
struction
•Custom-
made house
•Quality
•Architec-
tural solu-
tions
•Biohouse
•(3)Price
•Quality
•Warranty
•Architec-
tural solu-
tions
•Confidence
in the com-
pany
•Fastcon-
struction
•Architec-
tural solu-
tions
•Quality
•Isolation
•Warranty
•Company’s
behavior
•Custom-
made house
•Qualityof
materials
•Technical
suggestions
notes Numbers in front of criteria present ranking: (1) as the most often used crite-
rion, (2) as the second most often used criterion, etc.
Decision making in the case of house buying is a complex process,
composed of several minor processes. While respondents used different
criteria for evaluating alternatives, no more than ten alternatives com-
posed the consideration set of an individual household. Moreover, less
than five alternatives were included in the final stages of respondents’
decision making.
Our results indicate that consumers use two approaches or principles
when evaluating the alternatives, (a) gradual concentration and evalu-
ation of separate alternatives, and (b) simultaneous evaluation of sev-
eral alternatives. The first principle is much simpler to use as it only fo-
cuses on one alternative at a time. This result is consistent with Loewen-
stein’s (2001) research, indicating that people have limited capabilities
and knowledge, which in turn prompts them to simplify their informa-
tion processing.
The choice criteria mentioned earlier carry different meanings to dif-
ferent decision makers. If a producer/company and its offering meet
the most important criterion, it is considered in further stages – this is
the evaluation principle called ‘elimination by aspects’. Peter and Olson
(2002) describe this mode of integration as a non-compensatory pro-
cess whereby salient beliefs about positive and negative consequences do
not balance or compensate for each other. This principle has been doc-
umented in other empirical studies as well, e. g., choice of ground coffee
Volume 7·Number 1·Spring 2009
90 Mateja Kos KokliˇcandIrenaVida
(Fader and McAlister 1990), choice of road and rail freight (Young et al.
1982), choice of fictitious cars (Isen and Means 1983), career decisions
(Gati 1986), and choice of washing machine (Lee and Geistfeld 1998). Af-
ter forming a positive attitude toward a certain company (its offering)
on the basis of previously formed criteria, the buyer forms a behavioral
intention which leads either to a purchase or to a search for additional
information/ideas.
Finally, our analysis suggests that a house buyer’s consideration of a
specific manufacturer/company depends on two major factors, (a) infor-
mation kept in memory, and (b) the word-of-mouth recommendations.
Once the potential buyer actually buys the house, he/she experiences ei-
ther satisfaction or dissatisfaction. This, in turn, creates grounds for rec-
ommendations to other people. The results of this exploratory research
with in-depth interviews can be graphically depicted by exposing those
factors in the conceptual model, that could be explored more in detail in
future studies (figure 2).
Discussion and Implications
In the previous sections of this paper, consumer house purchasing be-
havior was analyzed from theoretical and empirical perspectives. Both of
these provide a sound basis for a deeper understanding of the factors un-
derlying the consumer buying process for a custom-made prefabricated
house.
The conceptual model of the buying process for a custom-made pre-
fabricated house developed in this study consists of three main groups of
variables: the buying process itself, the external and the internal factors
indirectly impacting the buying process (through a buyer lifestyle and
self concept constructs). The results of our empirical research confirm
the notion that cognitive and rational factors alone do not offer a suffi-
cient explanation of consumer behavior in the case of high-involvement
products being purchased only a few times in a person’s lifetime. In ad-
dition to the idiosyncratic characteristics of the customer, his/her per-
sonal situation and environmental factors, the role of feelings, experi-
ence, subconscious factors, needs and goals should to be taken into ac-
count when analyzing the buying process. Our empirical work suggests
that the following evaluative criteria should be exposed as decisive in the
evaluation stage of the buying process: that the house is custom-made,
professionalism and reputation of the seller/company, quality, price, and
architectural solutions. Along with the emotionally charged internal fac-
Managing Global Transitions
A Strategic Household Purchase 91
External factors
•Culture
• Subculture
•Reference groups
•Family
•Socialclass
•Demography
•Marketing communications
•Time pressure
•Company’s behavior
Inter nal factors
•Involvement
•Feelings
•Experience
•Knowledge
•Motivation
•Personality
Lifestyle
self-concept
(extended
self)
Goals
Needs
Prefer-
ences
Desires
Attention
Stimulus selection
Comprehension
New knowledge,
meanings, and beliefs
Interpretation
Linking
Old + new =
consideration set
Evaluation
Attitudes toward alter-
natives using criteria
Behavioral intention
Decision-making
Integ ration
Criteria: custom-made house,
company’s behavior, quality,
price, and confidence
Behavior –housepurchase
Usage – residence
Memory
known alternatives
and criteria
Environmental stimulus
(Dis)satisfaction =⇒good/bad reference
Buying
process
fig ur e 2 Main factors in the conceptual model of the buying process
tors, which carry heavy weight in initiating the purchase, other factors
identified in our qualitative analysis include his/her experience (with the
product and the seller) and his/her prior knowledge. Significant external
factors impacting the buying process in our qualitative study included
recommendations from from people’s buyer trust, the seller/company’s
behavior and marketing communication in the housing market.
The findings of this study offer implications for consumers who are
making a strategic purchase, such as buying a house. Gronhaug, Kleppe,
and Haukedal (1987) have warned that households may have serious
problems in making wise strategic purchase decisions. Buying a house
is a long-term decision from at least two aspects: it is financially bind-
ing, and it is the sort of product ‘consumed’ in the long run. We suggest
Volume 7·Number 1·Spring 2009
92 Mateja Kos KokliˇcandIrenaVida
that the first significant step for consumers is to define the needs and
goals they want to achieve by purchasing the house. The next step is to
gain as much information about different available alternatives and cri-
teria as possible. Importantly, external information search is a way to in-
crease knowledge, and reduce perceptions of risk and uncertainty (Dowl-
ing and Staelin 1994; McColl-Kennedy and Fetter 2001; Mitra, Reiss, and
Capella 1999). This was also confirmed in our empirical study. Several
studies have shown that consumers exhibit limited prepurchase infor-
mation search, even for expensive durable goods (e. g. Beatty and Smith
1987; Ozanne, Brucks, and Grewal). Furthermore, our empirical research
suggests that consumers have a very limited knowledge about houses and
the buying process. We emphasize that gaining additional knowledge is
of critical importance. Namely, knowledge should include both dimen-
sions, knowledge by acquaintance (emotion) and by description (rea-
son) (Chaudhuri 2000). Sources should vary from producers to exist-
ing owners, sample house-owners, and independent expert evaluations
(sample house owners and independent expert evaluations are the most
valid sources). We suggest that consumers experience the house inde-
pendently of its producer. The findings of this study indicate that experi-
ence with company’s representatives immensely contributes to consider-
ation set formation and decision making. Nevertheless, potential buyers
should give less emphasis to this factor, as quality of the house does not
depend on the skills and behavior of the seller. Our observation is that a
long-term view is required: the consumers will be living in the house far
longer than the duration of their contact with the seller. Decisions should
be made based on direct comparison of evaluated alternatives regarding
previously discussed goals and needs in order to find the best match.
Implications for real estate marketers can also be drawn from the
stated findings. Understanding individual decision making can greatly
contribute to improved explanations and predictions in the real estate
context (Gibler and Nelson 2003). This knowledge enables the real es-
tate companies to be able to better match their customers’ desires with
their offer. Consumers’ needs for information have to be satisfied in the
pre-purchase process. Given the high level of buyer involvement, hous-
ing and real-estate companies should focus on building confidence and
satisfaction in their potential and existing house owners. Our results also
suggest that offering a pre-purchase experience with the house is desired
as well. In this way intangibility, which is one of the antecedents of per-
ceived risk, can be diminished (Laroche, Bergeron, and Goutaland 2003).
Managing Global Transitions
A Strategic Household Purchase 93
Attitudes based on direct experience with the product are much firmer
than those based on indirect experience (Berger 1992). An additional step
companies could take is to provide information about ‘product usage’ in
a brochure form for the buyers. In conclusion, awareness is required that
consumers are not buying just a house, but a home.
In view of the fact that the conceptual model developed in this study
includes the role of external environmental factors, including the culture
and market factors, it can be applied to cross-cultural markets. When the
product-buyer relationship characteristics are similar, (i. e., high involve-
ment in the process, motivation to search for information, and experi-
ence), the model may be applied to any geographical area. It is believed
that cross-cultural differences may lie primarily in the weights that buy-
ers assign to individual factors impacting their buying process. Also, fur-
ther qualitative and quantitative empirical efforts are required in order
to gain knowledge of the interactive effects of various factors impacting
the buying process in the case of a custom-made house, and to determine
how buyers assign weights to various evaluative criteria in their decision-
making process.
The results of this research should be viewed from the perspective of
limitations inherent in this qualitative inquiry. As our goal was to exam-
ine buying behavior for custom-made prefabricated house, the available
population was rather limited. We focused on one brand with quite a
few unique characteristics. Due to the confidential nature of the data, the
company was not allowed to dispose its customers’ data, which would al-
low for a more systematic selection of the study participants. However, it
is hoped that by proposing a conceptual model of buyer behavior with re-
spect to house purchase and testing it empirically, this study contributes
to a better understanding of the buying process for a strategic product.
The results of this research may offer a springboard for future research
in this field.
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Managing Global Transitions
Managing Global Transitions
International Research Journal
aims and scope
The journal Managing Global Transitions
is aimed at providing a forum for
disseminating scholarship focused on
transitions. The journal seeks to publish
ground breaking work in management
research that will provide integrated and
diverse perspectives on the processes of
change and evolution in a broad range of
disparate fields, including systems theory,
leadership development, economics,
education, industrial relations, law, sociology,
informatics, technology, decision-making
theory, and action learning. To further the
understanding of transition environments
internationally the journal aspires to enhance
the availability of case studies and analysis of
data from different cultural environments in
public, non-profit, and corporate contexts.
information for authors
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•The title page must list full title,
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Reference Style
The author-date system of citation for
references should be used in the text, followed
by page number if a direct quotation is given,
e.g., (Jackson 1979,181). The alphabetized
reference list should be titled ‘References’
with entries in the following format:
Beech, M. H. 1982. The domestic realm in the
lives of Hindu women in Calcutta.
In Separate worlds: Studies of purdah in
South Asia, ed. H. Papanek and G. Minault,
110–38. Delhi: Chanakya.
Jackson, R. 1979. Running down the
up-escalator: Regional inequality in Papua
New Guinea. Australian Geographer 14 (5):
175–84.
Lynd, R., and H. Lynd. 1929.Middletown:
A study in American culture. New York:
Harcourt, Brace and World.
University of Chicago Press. 2003.The
Chicago manual of style. 15th ed. Chicago
and London: University of Chicago Press.
copyright notice
Copyright for all articles published in
Managing Global Transitions is held by
individual authors.
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indexing and abstracting
Managing Global Transitions is
indexed/abstracted in the International
Bibliography of the Social Sciences,
EconLit, repecanddoaj.
The journal is supported by
the Slovenian Research Agency.
Printed in Slovenia. Print run: 2000.
