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Diversification occurs when a company decides to enter into a new market with new products. Countries across the world have limited resources and every country is now much dependent on international trade. Governments want investors to spend their money in their country either in the form of foreign direct investment (FDI) or by any other means. Despite wide ranging measures to liberalize trade and the resulting major growth in the world trade, there has been little globalization of services. Language differences and restrictions on population movement hamper the growth of international markets for labor, even when it is highly skilled. (Hung, 2000)
Since 1945, the volume of world trade has increased. Gradual globalization of markets is taking place because of the interplay of a number of forces. It is possible to isolate a simple chain of casualization here. Consumer tastes are becoming more homogeneous in such matters a clothes and entertainment. Companies don’t just get benefits while entering into global markets while there are also risks involves while entering into other countries. These risks include economical, technological, legal, political, business and other monetary foreign exchange risks which might make a company’s diversification a worst decision.
Factors and Reasons of Risks
Companies might seek to enter into other markets using different modes like direct and indirect exporting, overseas production, contract manufacturing or joint venture. When a company enters into other countries for starting business, the financial management of the company became complicated because of the complexity of operation. The risk of financial miss-management stands with the company. Business risk arises from the possibility that the business idea might be flawed. As with political risk, it is not unique to international marketing, but firms might be exposed to more sources of risk arising from failures to understand the market. Strategic risk, operational risk and organizational risks stands with the company while starting business operation overseas. Confidentiality issues stands with the company while undergoing decentralization. Some countries promote competition as there are a large number of small and large sellers thus price variations to get more return from the business might get harmful. This factor also increases competition between the market participants and thus limiting market share. (Ball, 2000)
Political risk is one of the risks the companies face while entering into different countries. There is a risk that political factors will invalidate the strategy and perhaps severely damages the firm. Political factors relates to factors as diverse as wars, nationalism, political chaos and corruption. The local government might be reluctant for a new entrance to enter the market thus imposing some restriction policies for international policies to come and invest into the country thus creating monopoly in the country. Government actions might make it hard to repatriate profits. A company cannot operate efficiently in a politically unstable country
A political risk checklist was outlined by Jeannet and Hennessey. Companies should ask following question while entering into new markets; how stable the host country’s political system is? How strong its commitment to specific rules of the business is? How long the government is likely to remain in power? What if the government changes and its effect on the specific rules of the business and company’s strategy. (Healy, 1999)
Another risk which the companies face while trading overseas is the monetary exchange risk. The risk arises out of the volatility of foreign exchange rates. Given that there is a possibility for speculation and that capital flows are free, such risks are increasing. Countries having unstable economies are more threatened to exchange rate risk. Here the local currency shows some abnormal fluctuations, thus affecting the profitability of the international businesses. The companies might earn a heavy return in these countries due to low production costs, but the unstable currency exchange rates might turn the profits into losses. E.g., an American company earns 10 million Dirham from its subsidiary in Dubai Exchange rate a year ago when the company places its subsidiary was 55Dirham/Dollar and now a year later the exchange rate is 78Dirham/Dollar. The expected return if the rate was not changed is $181818 while the actual return due to exchange rate fluctuation is 128205. The companies might overcome this risk by entering into some forward rate contract or using hedge accounting. (Hung, 2000)
Risk Averse Approach
Organizations which have diversified their operations are subject to high financial management risks and control risks. Diversity of operations and technological advancement contribute to complexity. Complexity is difficult to analyze. It may be that it is best dealt with a combination of experience and extensive decentralization. (Watts, 2003)
Risk management is concerned with identifying potential problems and taking actions to eliminate or reduce the damage that will result if the risk materializes. It is the responsibility of the management of the company to access and manage all those risks that can damage the financial health of the company and the way management does so is of crucial importance. Companies should make a global management team whose responsibilities include global human resource considerations, choosing the operating structure and implementing the operating structure.
Management ensures supply chain management of the company by making the company database up-to-date. A system of communication should be established in order to get the supplies on time and in the required quantity. A customer-driven pull model should be adapted where productions and distributions are demand driven. An awareness of the import and export policy is an important tool to avoid the supply chain miss-management.
Political cannot be eliminated; however it can be avoided to an extent by analyzing the political condition in a country. It can be done by keeping an eye on the country’s economic as well as political conditions. A chief risk officer should be employed, whose responsibilities include keeping an eye on the political climate and determining new legislations and elections. (Hung, 2000)
Exchange rate risk can be avoided by making some forward contracts with the suppliers. This can help out to mitigate the uncertainty about the future. Legally binding contracts between the two parties eliminate the risk of currency exchange. Another way of avoiding currency risk is to transfer the transaction exposure to another country by making all the transaction in local currency. E.g., an American company makes some transactions with a German country in dollar, thus transferring all the risk of currency exchange over the German company.
The most important risk which stands by the international companies is the manipulation of profit due to foreign exchange risk. This occurs if the currency of a country appreciates or depreciates. Although the risk cannot be eliminated, but it can be reduced to an extent by managing the level of imports and exports. However, it is not always the case as it is very difficult to avoid the risk of profit manipulation due to changes in the currency value. Moreover, it is the responsibility of the management of the company to conduct a comprehensive audit of the company’s international operations to identify the business as well as legal risk associated with the overseas business activities. (Healy, 1999)
Role of external auditor
The external auditor helps to ensure that the company has adequate policies and procedure in place to deal with the cross-border operation. Auditor ensures that the company is implementing and complying with the international laws on business procedures. External auditor reviews the current level of the compliance of the company with the foreign laws and then determining the required level of compliance to be followed by the company. External auditor highlights the main compliance standards and laws that are adequate to conduct an overseas business and thus mitigating the foreign risk.
If the company has already complied with the legislation and laws elated to foreign business, the external auditor then reviews the rules and procedures in place to handle the activities of the foreign operations. External auditors perform procedures to identify the efficiency and effectiveness of the diversified operations and control systems and thus presenting a letter of weaknesses to the management of the company. This helps the management to identify the flaws in the system and to take necessary steps in order to mitigate these weaknesses. (Ball, 2000)
Although the external auditor identifies the risk associated with business activities and issues a letter of management but the core responsibility to deal with these risks stands with the management of the company.
Every country has its risks and rewards factors. If the companies want to maximize their profits and minimize losses then an outlook of the business environment of the investing country must be taken in order to take decisions and formulate strategies. Poster’s five forces model can be used to mitigate diversification risks and to determine the profit potential of the industry as a whole.
Although companies face many challenges and risks associated with the foreign business activities but on the other hand diversification allows companies to achieve economies of scale. Many companies diversify their operations and activities for achieving economies of scale as well as to compete in the international markets.
Ohmae offers five reasons for globalization which are customer demands, search for economies of scale, competitiveness, exchange rate risks and exploitation of resources. Companies across the world are willing to diversify their business as the consumers are now brand conscious enough to spend their money on.
Ball, R. K. (2000). The effect of international institutional factors on properties of accounting earnings. . Journal of accounting and economics , 29(1), 1-51. http://www.sciencedirect.com/science/article/pii/S0165410100000124
Healy, P. M. (1999). A review of the earnings management literature and its implications for standard setting. . Accounting horizons , 13(4), 365-383. http://www.aaajournals.org/doi/abs/10.2308/acch.19188.8.131.525
Hung, M. (2000). Accounting standards and value relevance of financial statements: An international analysis. Journal of accounting and economics , 30(3), 401-420. http://www.sciencedirect.com/science/article/pii/S0165410101000118
Watts, R. L. (2003). Conservatism in accounting part I: Explanations and implications. . Accounting horizons , 17(3), 207-221. http://www.aaajournals.org/doi/abs/10.2308/acch.2003.17.3.207