Hoping to profit from a wave of investment in China by large multinationals, small and mid-sizedenterprises (SMEs) based in Germany flocked to that country in the 1990s. China’s government welcomed them: like many other countries, China was intrigued by Germany’s Mittelstand firms— usually stable, technologically sophisticated, family owned firm —and wanted to learn from them. But despite the welcome—or perhaps because of that desire to learn from the newcomers— China often required the newcomers to establish formal joint ventures with Chinese partners. This requirement did not diminish the German SMEs’ interest; indeed, many Mittelstand firms saw the joint ventures as a way to get acclimated in China.

Today, though, the partnership requirements have eased for the approximately 5,200 German firms invested in China. As a result, most German firms have decided to go it alone in the Chinese market. Turck Technology, a family-owned German industrial automation company with annual sales of around €500m, is a case in point. It established a wholly owned subsidiary in China rather than partner with a Chinese firm. Its aim was to maintain control, ensure consistent quality, and protect its designs. The firm’s Chinese sales are about €40m a year, “the same level as our competitors,” says Christoph Kaiser, Turck’s managing director.

By now, only 12% of the German companies invested in China use formal joint ventures, says Alexandra Voss, executive director of the German Chamber of Commerce in north China. “Where the former joint venture requirements no longer exist, German companies tend to purchase the joint venture shares from their former partner rather than extending the agreement,” she says.

JOINT-VENTURE “LIGHT”

Between the two extremes—a formal joint venture and a go-it-alone subsidiary—there is a wide range of looser partnerships possible between SMEs in different countries. Among the most popular such tie-ups are those involving licensing and technical co-operation agreements. The challenge for SMEs in these arrangements—as in full-fledged joint venture deals—is to preserve their proprietary information while benefitting from enhanced access to the local market.

For example, James Cropper, a family-owned UK paper maker, expanded internationally in recent years, to the point where around half of its £88m revenue now comes from export markets. In China, it signed a technical co-operation agreement with a local firm to design fibres for high-end carbon bicycles. Despite cooperating on adapting products for the local market, the agreement sets strict guidelines to protect James Cropper’s know-how. “We wanted to keep control of intellectual property,” says its CEO Phil Wild.

Licencing agreements are another way to boost foreign sales without requiring a formal joint venture. Under such agreements, a local company buys the rights to market (and sometimes produce and develop) the exporting firm’s brand or products. The local partner does not have equity rights, making such agreements popular among small exporters with limited capital.

Australian pharmaceuticals firm Suda and its Chinese partner Eddingpharm provide an example of a licencing agreement. Suda, with revenues of just A$6.3m a year, would have struggled to afford to expand into China in its own name, or to invest in a joint venture. In late 2015, it signed a licensing agreement with Eddingpharm to produce and sell its drugs in China. Among the sweeteners for Suda: an upfront payment of US$300,000 and another US$200,000 when its product is registered in China. For small companies, licencing can offer an immediate cash injection, as well as a way to enter new markets.

A “lighter” variant of a licencing agreement is a simple sales-representative deal, in which a local firm contracts to market, sell and distribute the exporting firm’s products in the target market. David Butler, CEO of the South African Chamber of Commerce in London, says many of his country’s food exporters take this approach in the UK, benefiting from the market reach of UK retail chains and specialist distribution firms.

Such arrangements can help to avoid the biggest danger inherent in full-fledged joint ventures: their high failure rate. McKinsey, the management consultancy, estimates that up to 60% of international ventures fail.1 Among the major problems: partners may have incompatible objectives, for example with one wanting to maximise long-term market share and the other wishing to make a quick profit. The US advisory firm Water Street Partners finds that around twothirds of joint venture CEOs say the owners are misaligned on long-term strategy and on budget issues.2 A more limited technical co-operation agreement can sidestep such fundamental issues.

MATCH-MAKERS

What all these partnerships—the full-fledged joint venture agreements and the “lighter” variants— share in common is the marriage of an exporting firm’s product know-how and a local firm’s market expertise. Regardless of the form that a partnership takes, the fundamental questions apply: how to find the right local partner, and how to structure the agreement to avoid common pitfalls.

“That’s the million dollar question,” says Mr Harris, the US lawyer. “[The answer] is usually based on the [specific] business involved. If you are an educational software company, you think about partnering with the top one or two companies in China that distribute or sell educational software. If you make high-end [technical] widgets, you may partner with the one or two best high-end widget companies in China—whose widgets, though high-end for China, are not nearly as good as yours, and therefore they could use your help. You find these companies yourself, or you hire a consultant to help you find them.”

The routes to finding foreign partners vary. James Cropper found its Chinese partner via the contacts it had made in the country by selling there directly. It sought out Chinese partners with expertise and complementary skills for its high-end fibres division. It also looked for Chinese firms with industry contacts and specialist expertise to sell to high-end bicycle manufacturers.

Indeed, the search for such partners is often mutual, with Chinese firms eager for foreign partnerships. Eddingpharm, the pharma company licensing products from Suda, first entered the business via licensing deals with multinational pharma companies Novartis and Baxter in the early 2000s. In 2012, backed by international investors, Eddingpharm established a US subsidiary to seek out other product lines for distribution in China, as well as deals to develop and market such products. Among its wins: an agreement with Suda to develop and market an insomnia drug which the small Australian company would have struggled to sell in China on its own.

Companies that lack contacts in a target foreign market often turn to consultants for help. Firms such as Prospect Chinese Services, which is staffed by Chinese nationals and has offices across the UK and China, advise clients ranging from hotels and universities to car manufacturers wishing to enter the Chinese market. It claims to offer a ‘one stop shop’ for UK companies, comprising market research and market entry strategy services, support with first contacts, and advice on negotiations.

Other match-makers include government export promotion agencies, which compile large databases of foreign companies and can put exporters in touch with potential foreign partners. Erin Butler of the US Export Assistance Centre says that US SMEs supplying the oil industry approached her for contacts in growth markets such as North Africa. Like James Cropper, the US oil industry suppliers also used their domestic sales forces to make initial contacts with potential foreign partners. The search criteria for finding the right local partners tend to be similar, across a range of businesses: that is, local partners who supply expertise, skills and contacts that are complementary to those of the exporting SME.

ACQUISITIONS-PLUS

Exporters making a long-term commitment to a foreign market often acquire a local company to establish a stable presence in that market. One example is Palfinger, an Austrian SME and construction-machinery maker, which bought companies across the world to access their markets and to diversify away from over-reliance on building mobile cranes. Its foreign plants gave Palfinger a lower-cost, more flexible production base to supply new markets, which in turn helped it to withstand a series of economic storms.

A buying spree was not Palfinger’s sole expansion tool, however. It also established joint ventures with local companies in some major export markets, particularly in China and Russia, using the partners’ local market dominance to boost its own sales. In 2012 Palfinger established two joint ventures with SANY, China’s biggest manufacturer of construction equipment. One of the ventures was established to sell Palfinger products in China, and the other to distribute SANY products outside of the country. In 2013 the companies agreed to a share swap, with SANY taking a 10% stake in Palfinger in exchange for an equal stake for Palfinger in one of SANY’s operating units. For Palfinger, this helped to cement a deep presence in China, while for SANY the deal boosted its own globalisation efforts.

In 2014, Palfinger set up two more joint ventures, this time with Russia’s largest truck maker Kamaz. One builds chassis to hold Palfinger’s mobile cranes, and the other produces cylinders for construction machinery. Under the deal, Palfinger agreed to invest in modernising the production plant. In return, Palfinger gained entry to Russia’s specialist construction machinery market. “We couldn’t buy them [SANY and Kamaz],” spokesman Hannes Roither says drily when asked why the firm chose joint ventures.

Significantly, the local ventures provided a buffer when local markets weakened, due to their strong local customer base. “There have been serious market crashes in both countries” in recent years, Mr Roither says. “But we were able to protect our own sales by increasing market share when foreign competitors withdrew from the country.”

Similarly, the German luxury hotel group Steigenberger set up a joint venture with a local company to accelerate its expansion into India. Steigenberger owns 116 hotels in 12 countries, generating 2013 revenues of €500m. In 2016 it announced a joint venture with MBD, an Indian hotel group, with Steigenberger retaining a controlling stake. MBD will manage the joint venture including sales, while the German company will manage international marketing, training and brand development.

The companies have complementary skills, with Steigenberger a leader in five-star hotel management and MBD an established player within India. Also, and equally crucially, they share the same aim: the rapid roll out of luxury hotels in India. The joint venture plans to open 20 hotels over the next 15 years. Managing Director Sonica Malhotra Kandhari says it would take between three and five years for either partner acting alone to open a single hotel.

KEYS TO SUCCESS

Structuring any type of partnership agreement with a foreign partner can be tricky, says Dan Harris, a founder of the US law firm Harris Bricken, which specialises in joint ventures in China. He advises clients to keep a majority stake in a joint venture, and to protect their intellectual property zealously regardless of the nature of the co-operation. He offers the cautionary tale of a US firm whose Chinese partner began to manufacture the US partner’s products under the Chinese firm’s name. Some remedies are simple: “Many times we find that the [US] company had not registered a patent in China,” Mr. Harris says.

Beyond that, a key to success is to look carefully at the fundamentals: ensuring that the partners’ skills and expertise are complementary to those of the exporting SME; establishing that the aims of both partners are aligned; and making long-term commitments to the target markets. These elements—complementary skills, similar aims, and long-term commitments—are as close as an SME can come to finding a recipe for success in forming international partnerships.

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American statesman and inventor Benjamin Franklin once famously said that nothing is certain in life except death and taxes. Nowadays, no one is more painfully aware of that—at least the part about taxes—than small and midsized enterprises (SMEs) entering foreign markets for the first time.

The complexity of foreign tax, regulatory and legal regimes is the most frequently cited reason why SMEs avoid foreign markets. The range of such barriers is wide, encompassing different tax treatment for similar products in different countries, varying product-composition and packaging rules, different standards for protecting intellectual property (IP), and complicated customs clearance procedures even within a free trade area. While the specific legal and tax barriers vary widely, they all represent essentially the same problem for SMEs: high compliance costs and the risk that, when implemented, regulations will be interpreted in unfavourable ways.

Such risks and costs are at the root of SMEs’ reluctance to export. According to the Confederation of British Industry (CBI), only one-fourth of European companies export. Dutch entrepreneurs’ association MKB-Nederland says that only 20% of Dutch companies export; according to a survey by logistics giant UPS, only 10% of French companies export.

Complex tax and legal issues also explain why SMEs that do export tend to do so only within a free trade area. A large-scale survey of SME owners and directors in seven European countries, carried out by UPS1 in 2015, found that, in four of the seven countries looked at, the complications of clearing customs or of complying with export regulations was among the top three reasons for not exporting outside of the European Union.

Overall, around 80% of EU-based SME exporters confine their exporting to the EU, according to Ben Digby, the CBI’s international director. Others venture farther afield, but to markets with which the EU has a free trade agreement, such as South Korea. An example is offered by UK pottery and tableware manufacturer Portmeirion: It says its export business to South Korea skyrocketed after the country signed a free trade agreement with the EU in 2010. By 2011, South Korea had surpassed the company’s home market in the UK, and became its second-biggest market after the US.

A LABYRINTH OF HEALTH RULES

Examples such as Portmeirion’s should not suggest that a free trade agreement sweeps away all legal and regulatory complications for exporters. Nothing could be further from the truth. Even within the EU single market, among countries with similar standards for products and services, legal and regulatory hurdles arise for exporters. An example is the maze of national rules that determine which pharmaceuticals qualify for medical prescriptions within the national health system.

Laboratoires Expanscience, a French pharmaceuticals SME specialising in skin cosmetics, faced such a problem in the UK. It entered the UK market a few years ago with, among other products, a range of skin creams under the Mustela brand; the creams are used for treating babies’ minor skin problems, among other uses. However, the firm’s UK sales are limited (currently below £1 million a year) because its products are not registered for prescription by the National Health Service (NHS). Registering with the NHS is an expensive and time consuming process: Raj Sandhan, the managing director of Expanscience’s UK distributor, Metro Health and Beauty, says that one of the French firm’s competitors had to wait five years to receive NHS approval. As a recent entrant to the market, Laboratoires Expanscience sells its products instead over-the-counter in independent pharmacies, which limits its sales volumes.

Family-owned with annual revenues of €272m, Laboratoires Expanscience is an active exporter, with subsidiaries in 14 of the 85 countries in which it sells. More than half its total revenue comes from foreign sales. Although it has not applied for NHS approval, its Mustela products are widely available on prescription in other countries. Its Bébé 123 Vitamin Barrier Cream has been classified a drug in the US, meaning that it can be sold on prescription, as well as through retail chains such as Walgreen’s. Obtaining such approvals can be a long process, the firm has found; but the resulting increase in sales that such approval brings makes that investment worthwhile.

INTRICACIES OF VAT

Registering for reimbursement of value-added taxes (VAT) also presents a hurdle for many exporters, even within the EU single market. National VAT rates for the same product vary considerably across the EU: the standard rate varies widely, from 19% in Germany to 21% in the Netherlands and 24% in Greece. Moreover, some states impose ‘additional’ taxes on imported products, leading to variations in tax treatment even within the EU. Belgium taxes imported bottled water and fruit juices, for example, whereas neighbouring France does not. All this causes headaches for importers, who must comply with a patchwork of European tax rules.

At company level, the VAT quilt in Europe causes other types of problems. To receive reimbursement for VAT paid, a company must register with national authorities. The threshold for VAT registration varies widely among EU member states, from €10,000 in Portugal to £83,000 in the UK. One SME dealing with the VAT registration rules is Emois Gourmands, a UK start-up selling French gourmet food in London. Emois Gourmands founder and CEO Cecile Faure says that her firm buys directly from producers in France, does not use middlemen and does not add a big mark-up, thus enabling it to sell products at lower prices than UK supermarkets charge.

But Ms Faure says her firm’s small size puts it at a disadvantage in the VAT department. Her firm is not large enough to qualify for VAT registration in the UK. To avoid paying VAT on imports without being able to offset the tax payment through sales, Ms Faure has to hire a freight forwarder to make the upfront payment. Details such as this can make even a deep free-trade area such as the EU less free than intended. “I applied for VAT registration several times but was repeatedly tuned down,” says Ms Faure. “It’s expensive for a small company.”

UNRAVELLING CUSTOMS CLASSIFICATIONS

A further complication for SMEs is finding a way through the thicket of regulations governing customs clearance and customs classification. An export product’s customs classification is more than just a number: it is a unique identifying code which determines the product’s tariff and VAT treatment, if applicable, and whether the product is permitted to be sold in the destination country in the first place. Some defence-related products, for example, are subject to both export- and import-restrictions. In theory, the World Trade Organisation’s standard product classifications take all the mystery out of identifying products. In practice, it is not so simple, since the WTO’s guidelines can be applied inconsistently across countries. This causes problems for all types of companies, but SMEs, with their relatively limited resources, can be hit particularly hard.

Varying classification of the same product can appear even within a single market such as the EU, according to Christine Debats, international development manager at Conex, a small French company that handles customs clearance for importers and exporters. Television set-top boxes are classified according to their main function, for example. If this is deemed to be recording broadcasts, then imported boxes are subject to a tariff of 13.9%. If the main function is considered to be internet access, then the duty is 0%. The ambiguity comes when the box does both things— leading to a WTO ruling that the EU’s customs treatment of set-top boxes was out of compliance with its rules. That ruling, in turn, forced the EU to issue a complex set of new rules for classifying settop boxes. This example shows how standardised customs classifications sometimes do not keep up with the rapid pace of product development, making it hard to predict the customs treatment of some goods.

But modernising customs classification and clearance can bring pitfalls of its own. In May 2016 the European Commission introduced the Union Customs Code as part of an effort to modernise customs. The initiative aims to enable traders to file all customs declarations remotely by 2020. This will require joining together all of the disparate IT systems used by EU countries—a hugely ambitious undertaking involving a host of detailed changes to the customs treatment of products. This is a huge challenge, considering that “customs classifications change constantly,” says Ms Debats.

PATENT ‘PROTECTION’: ENTER THE TROLLS

Other official attempts to promote efficiency and reduce the paperwork burdens of exporters and investors within the EU are causing a different set of problems. The EU’s planned Unified Patent Court, which is expected to start operating this year, will enable pan-European patent protection via a single filing, thereby cutting the cost of filing patents in multiple national jurisdictions. However, the unified system will also increase the risk of facing patent infringement challenges all across the EU rather than in individual countries.

That risk is increasingly a reality for exporters to and within the EU, as a result of the appearance in Europe of so-called “patent trolls”. These are firms that acquire patents to technologies that they have no intention of developing themselves, for the purpose of blocking others from using the technology. The patent trolls prevent the use of those technologies by threatening firms developing those technologies with patent infringement lawsuits.

The practice originated in the US, where patent trolling has become a big business. Specialist patent trolls are joined by multinationals that actively buy and police patents in their sectors. A surge in patent litigation has led the federal government, as well as some US states, to clamp down on the trolls. One result of the US clamp-down “is that the patent trolls have come over to Europe,” says Edward Borovikov, a lawyer in France with global law firm Dentons.

So far, many of the problems have centred on Germany, where the courts support patentholders’ rights vigorously (as they do in the Netherlands), Mr Borovikov says. However, the pan- European patent system increases trolls’ potential rewards if they win a case, since compensation will be calculated across the entire EU and not only in the affected country. “A case will cost at least €200,000-300,000, which SMEs simply can’t afford,” says Mr Borovikov. “Twenty years ago, intellectual property was not a huge concern in Europe. Now companies must check very carefully for possible patent infringements to avoid being sued by trolls.”

Patent trolls are a particular threat to SMEs. In the US, half of all patent troll lawsuits are against companies with revenues of US$10 million or less. The average cost of defending such lawsuits is US$3.2m—enough to put many SMEs out of business, according to Snapdragon, a consultancy offering intellectual property protections.

Similar cases are emerging against European SMEs. Toll Collect, a mid-sized German company with 600 employees, was targeted recently by such a case. It holds a government contract for a road-pricing system for trucks in Germany, with some terminals placed in neighbouring countries including the Netherlands. Toll Collect was sued by a German firm, Papst, which owns a European patent for road-pricing systems. The case was filed in the Netherlands among other places, and a Dutch court found in Papst’s favour.

Staying clear of patent trolls is not, of course, the only issue for exporters wishing to protect their markets. In many parts of the world, the issue is far simpler: enforcing the IP protections already on the books. In China, for example, “the problem is not necessarily with the legislation, but with the implementation” of IP rights, says Christoph Kaiser, managing director in China for Turck Technology, a family-owned German industrial automation company with annual sales of around €500m. Similarly, Dutch biotech firm Keygene has yet to set up a full subsidiary in China because of IP concerns. CEO Arhen van Tunen believes that IP rights for products such as his—innovative crop improvements—are weak in China. The company holds more than 500 patents, but these are only as good as local enforcement of property rights.

FINDING A WAY

Such concerns keep giant emerging markets such as China and India out of reach for many European SMEs. So, for instance, although most large Dutch companies such as Philips and ABN Amro are well established in both countries, few SMEs have followed their example. Fewer than 200 Dutch firms operate in India. A 2016 survey of Dutch companies active in China, carried out by the Dutch Ministry of Foreign Affairs,4 found only about 1,000 Dutch companies in the country, out of a total of 871,000 Dutch companies, most of them SMEs. “The barriers to doing business mentioned most often concern government relations and the Chinese regulatory environment,” the Ministry says. “Bureaucracy and the lack of transparency in legislation are the most common hurdles.”

Opaque rules and inconsistent application of regulations governing health products, among others, along with customs classification issues and variable VAT rules even within a single market create day-to-day problems for all exporters. These problems are felt most keenly by firms new to exporting and short on resources for figuring out the details of the regulatory, legal and tax systems in each of its export markets. Free trade agreements, along with various initiatives to reduce the paperwork burdens on exporters and cross-border investors, can help. But occasionally well-intended efforts, such as the pan-European patent filing system and the remote customs-clearance initiative, have unintended consequences that actually can increase the burden on exporters. It remains for policy makers to improve on these efforts, to avoid having newly internationalising SMEs turn back from their efforts to venture abroad.

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A small or mid-sized enterprise (SME) establishing a presence in a new foreign market faces steep learning curves on several fronts. It must familiarise itself with the needs and preferences of a new market, ensure compliance with a new set of laws, find and train local staff, arrange financing, and sometimes learn a new language at the same time.

In the excitement of establishing a foothold in unfamiliar terrain, small firms can overlook a less glamorous aspect of the process, but one that is crucial to success: ensuring that components, raw materials and finished products reach their destinations on time, in good condition and at competitive prices. That task—establishing supply chains and distribution channels—falls to logistics managers; the quality of their performance can make the difference between a successful international expansion and an expensive disappointment.

Logistics pitfalls abound even in an SME’s home market, and can be compounded when using an overseas manufacturer. One typical example, involving underestimating shipping costs, is related by Entrepreneur magazine1, a North American publication focused on small business. A small California supplier of wedding-cake toppers, Younique Boutique, received an order to ship wedding toppers to a television production set. When the order ballooned unexpectedly to 280 toppers and the television production set was belatedly revealed to be in Hawaii, the SME’s founder and CEO scrambled to fill the order using a manufacturer in China. Under time pressure, and without accurate information on the shipment method to be used by the Chinese plant or the added price of a rush order, the owner guessed that the added shipping cost would be $5 per item—an underestimation that ultimately cost the firm $800.

HIRING DELIVERY EXPERTS

Mistakes made under time pressure are hard to avoid, but the main lesson here for SMEs is clear: Regardless of where they operate, attention to the nuts-and-bolts of logistics is an important aspect of successful entry into a new market. 

To avoid costly logistical problems, many newly internationalising SMEs outsource the logistics function, both for inbound components and returns, and for outbound finished products. They look for experienced logistics services providers, using either partners they already employ elsewhere, or local firms, or a combination of the two. This enables them to concentrate on their core business and leaves the details of deliveries to firms with distribution expertise in the new market. 

Consider UK-based Childrensalon, which sells high-end children’s clothing via its website and through a shop in Tunbridge Wells, UK. It increased its sales tenfold over the past five years (to £63 million in 2016) by selling internationally via its web site. This expansion required a heavy investment in logistics, including building up the firm’s packaging staff and warehousing capacity, as well as updating its IT systems. For deliveries, however, Childrensalon relies on five international freight firms including UPS and DHL. “We found that some companies were more efficient than others for deliveries in certain parts of the world,” says human resources director Denise Hamilton, adding that selecting providers for each new market was a process of “trial and error”. These outside providers manage the paperwork, such as customs clearance, as well as the actual deliveries.

Childrensalon is hardly alone in outsourcing freight services in new markets. Toby Gooley, editor of the US-based Supply Chain Quarterly, says that most companies, large and small, outsource distribution to avoid devoting time and resources to a non-core activity. While freight services provided by a third party come at a cost, outsourcing this function means an SME saves on dedicated staff to deliver goods and to ensure legal compliance with import and export regulations, as well as saving the direct costs of buying and maintaining delivery vehicles.

For a largely web-based company such as Childrensalon, outsourcing freight operations has allowed it to sell, and source, worldwide: it now offers more than 270 different brands and sells to more than 120 countries, fuelling rapid sales growth in recent years. Given that complexity, outsourcing freight operations was a must—even if that meant paying the costs of both initial deliveries to customers and return deliveries when customers do not want an item they ordered. The cost of return deliveries, in particular, cuts into the margins of an online retailer, but is an unavoidable cost since customers cannot physically see or try the goods they order online.

So, for example, Childrensalon pays freight services providers such as UPS or Fedex £9.95 per delivery to an address in the United States, and a similar amount if the customer decides to return the item. The firm pays freight providers £3.95 for delivery to a UK address. Ms Hamilton says that the higher US delivery charges are passed on to US customers (who must also pay return postage costs themselves), who pay them because the charges are relative low compared to the high cost of the high-end products involved. While this works for Childrensalon, high delivery costs in export markets could hurt companies in more competitive industry segments by pricing their products out of reach.

In general, experts say distribution and logistics services can add 10%-15% to the cost of goods.2 One concern highlighted by Childrensalon is that SMEs often fail to shop around extensively among alternative freight suppliers, even though the cost of freight services can dent competitiveness. Jim Edmondson, CEO of the UK aerospace company Gilo Industries, a privatelyheld group with 2016 revenues of £3.2 million, is one example among many. His company is about to expand from a specialised to a wider consumer market, but so far is relying on a single supplier, UPS.

Gilo makes a very lightweight engine which can be carried in a backpack to create a powered paraglider (avoiding many of the stringent regulations for conventional aircraft), among other applications. With sales of a few hundred units a year of products costing thousands of pounds apiece, logistics has not been a great concern. Gilo has hired UPS to deliver worldwide, and will pass delivery costs on to customers. This is a practical solution for the firm at a busy time. But with sales expected to increase to the thousands of units when the new product is launched, logistics costs may become more of a factor in the firm’s profitability.

KEEPING CORE LOGISTICS IN-HOUSE

While some firms outsource product deliveries, they also keep some mission-critical functions in-house. As noted above, for example, Childrensalon invested in a made-to-order IT system to manage dispatching of products from a warehouse in its home town. Due to the surge in sales and international deliveries that followed its online expansion, the firm recently added two warehouses on the same industrial estate. It also increased its packing and fulfilment staff to 90 people, nearly one-third of its total staff. Centralised distribution makes sense for a company selling to so many different markets: the cost of setting up warehouses abroad would have been prohibitive. More importantly, the in-house central warehousing function allows Childrensalon to retain direct control over a critical service—dispatching products as specified in customers’ orders—and to provide direct customer support when needed.

The use of Childrensalon employees to answer customer queries and provide comprehensive product information before purchase has paid off by keeping return rates very low, the firm says. According to Ms Hamilton, only around 10% of orders are returned. This compares to an estimated returns rate of 25% for women’s fashion items in the UK, according to an executive of retailer John Lewis.3 Cutting the rate of returns translates into an improved bottom line. The consultancy Clear Returns says that returned orders cost UK retailers £60 billion a year, a third of which is generated by online retailers.

Managing returns is particularly important for companies trading internationally, where the cost of deliveries from and to the home base are typically higher than for domestic deliveries. Raj Sandhan, managing director of UK distributor Metro Health and Beauty, experienced the difference first-hand when it sourced cosmetics in the US. He says that freight charges of 8-10% on US imports, on top of import tariffs, cut deeply into profit margins. “Together, freight and tariff charges can easily wipe out half of an exporter’s margins,” Sandhan says. Metro turned instead to cosmetics manufacturers in France to reduce both tariff and transport costs, and deals with suppliers there directly.

The heavy capital cost of setting up foreign logistics centres (such as warehouses) mean that companies expanding into new foreign markets generally outsource this function at first. They are more likely to invest in such centres when they are well established in the foreign market and therefore can predict demand, says Christopher Van Riet, managing director of Russian logistics provider Radius Group. Metro’s Sandhan agrees, saying that firms tend to use external distributors for the first two to three years in a foreign market.

Van Riet cites the example of John Deere, a large American agricultural machinery maker that started local assembly of its products to facilitate sales to Russian dealerships. Initially, it leased a turn-key assembly plant built by Radius, which bolted together a small number of components imported from the US. Over several years, John Deere built up its own manufacturing operation to take on more complex work; it also started to use more Russian suppliers of components. Although it needed to assemble locally to avoid Russian import tariffs, John Deere built up its manufacturing and logistics operations gradually, to avoid heavy upfront investment in an unproven market.

This approach is different from that of retailers, who—due to the fast-moving nature of their business—are more likely than heavy-goods manufacturers to see warehousing as mission-critical. “Retail stores can open and shut,” says Van Riet. “The key for supermarket chains is [control over] warehousing and distribution, so that they can maintain and deliver goods to stores reliably.” 

For example, Auchan, the French supermarket chain, said in October 2016 that it will spend over US$100 million on a big logistics and distribution centre near Moscow. It used Radius to develop the project but has kept direct control over the facility. Initially, it will service Auchan’s existing 50 stores in the region. But with capacity to load and unload more than 200 trucks simultaneously, 

the warehouse is expected to help with future expansion of the retailer’s store network in Russia. Like Childrensalon, Auchan regards control of warehousing and stock as too crucial to outsource. 

Similarly, Ted Baker, a UK fashion brand with 2016 turnover of £456 million, plans to consolidate warehousing and distribution after a period of rapid international expansion. Previously, the firm used three separate distribution centres, which it combined into a single large warehousing and fulfilment centre in Derby, UK in May 2016. Centralising distribution into a single, highly automated, location open around the clock will save money, as well as giving it extra capacity to serve a growing international market, the firm says. On the other hand, in contrast to Auchan, which will manage its warehousing function with its own personnel, Ted Baker outsourced management of its new logistics centre to a logistics supplier. The provider not only bore the upfront cost of setting up the consolidated warehouse, but also provided the IT systems to manage inventories and deliveries.

Given the diversity of SME approaches to balancing in-house control and outsourcing of logistics functions, warehousing and logistics providers are offering increasingly sophisticated menus allowing SMEs to pick and choose the services they want. Some services involve only freightforwarding— organising shipments from the producer to the final customer or distributor. Others are broader, and might encompass, for example, managing online sales, arranging transport including documentation, and delivering goods to customers. The Royal Mail, the UK’s privatised postal services provider, has agreed on such a comprehensive system for Alibaba, the Chinese e-commerce web site. Under this arrangement, the Royal Mail will establish a sales web site for British firms selling via Alibaba, and will deliver the goods to UK customers. 

Choosing a supplier requires research into each supplier’s specific expertise. Ms Gooley of Supply Chain Quarterly says that certain logistics providers specialise in particular industries, others have a certain geographic focus, and still others perform the whole gamut of logistics functions worldwide.

MIXING AND MATCHING

It remains for SMEs to decide on the best balance between controlling their own logistics and outsourcing some of those functions. Some creative mixing and matching of logistics functions— some in-house and some outsourced—may be required. Matt McInerney, vice president of global forwarding sales at the US third-party logistics provider C.H. Robinson, gives the example of an upmarket US kitchen equipment maker that wanted to expand into the UK. C.H. Robinson set up this company’s warehousing operations in the UK, sparing the client a heavy upfront expenditure. However, the kitchen equipment maker kept many operational functions in-house, for example running its own fleet of 18 trucks to deliver products to a network of more than 100 dealers.

The same principle—choosing what functions to outsource, and avoiding over-reliance on an external supplier—applies as well to outsourced manufacturing and product-assembly services. Supply chains begin with suppliers—of finished products or components or various functions such as freight services—and therein lies a risk for SMEs entering a foreign market. The risk is that an SME will over-rely on a crucial supplier that later fails, causing knock-on problems for the SME.

UK toy-maker Hornby, which had 2016 revenues of £56m and is best known for its model railways, found this out the hard way. The firm had largely relied since the 1990s on a single Chinese supplier of manufacturing services, Sanda Kan. After a series of ownership changes from 2000, the Chinese firm encountered financial difficulties and was bought by Kader Holdings (owner of one of Hornby’s main competitors, Bachmann) in 2009. From 2012, Hornby found that supplies of its products became erratic, with many containers arriving without needed products, as the supplier could not fulfil orders. That hit Hornby’s sales and its bottom line. Hornby paid £500,000 to sever its contract with the Chinese company. To avoid a repeat of the problem, and to diversify its supply chain and reduce risk, it replaced Sanda Kan with ten different Asian suppliers.

CONCLUSION: THE TECHNOLOGY ADVANTAGE

The cost of logistics—sometimes overlooked amidst the challenges of entering a new foreign market—can prove dangerous to an SME’s profit margin. Some SME’s take this risk in stride, choosing to work for thin margins as part of the cost of establishing their brands abroad. The lucky few with a unique market niche, such as Gilo Industries or Childrensalon, can keep margins healthy by passing freight costs on to customers. But whether margins are thin or not, SMEs must find the right balance between hiring outside experts to provide supply management and logistics services and performing these functions themselves in an unfamiliar new market.

The bigger picture related to the cost of logistics is that the logistics function itself is undergoing a profound change, as sellers of a wide range of goods shift from distribution through physical stores and warehouses to global sourcing and fulfilment of orders via e-commerce web sites. Added to this transformation are potentially revolutionary changes in the nature of transport, such as the use of delivery drones or self-driving delivery vehicles. These innovations all rely heavily on information technology; it follows that SMEs with sophisticated IT systems will have an edge in securing the best and most cost-effective logistics support.

As a first step, advances in communication technology can help SMEs both in researching potential logistics suppliers and managing providers once they are chosen. Information technology can also simplify logistics functions, and can aid SMEs in taking advantage of technological advances in distribution and delivery. Childrensalon’s web site, for example, streamlines the sales and fulfilment process, in part by detecting where a customer’s computer is located and automatically translating product data and pricing into the local language and currency.

But automation only goes so far; sometimes firms have to intervene manually to fill logistical gaps. “One of our staff once flew over to the US to deliver a very expensive dress on time,” when delivery otherwise would have been delayed by a holiday, recalls Childrensalon’s Denise Hamilton. That is a shoe-leather approach to logistics: doing whatever is necessary, including wearing out one’s shoes, to ensure that products reach their destination on time. It is the sort of thing that modern logistics, backed by sophisticated communication technology, is designed to avoid. “Many SMEs see distribution and logistics purely as a cost,” says Ms Gooley. “In fact it is an investment.”

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