The impact of professional service firms' expansion ...

The Service Industries Journal Vol. 32, No. 10, August 2012, 1721 –1738

The impact of professional service firms’ expansion challenges on internationalization processes and performance Dina M. Abdelzaher∗ Department of Management and International Business, Florida International University, Miami, FL, USA (In final form 14 January 2012) In making the distinctions in the internationalization of capital-intensive service firms (CISFs) vs. knowledge-intensive service firms (KIFs), KIFs were found to realize financial gains in earlier stages of internationalization than CISFs. Should not this make them more likely to internationalize? Still, service firms are significantly more ‘home oriented’ than manufacturing firms. This paper explains why professional service firms (PSFs), a subcategory of KIFs, are likely to follow a more cautious internationalization process and proposes a spider web-like expansion process. Then, it explains how PSFs’ characteristics of (1) clients’ dependence (2) knowledge commoditization, and (3) executives’ hubris moderate the internationalization to performance relationship. Keywords: knowledge-intensive firms; professional service; internationalization; performance

Introduction The global expansion of service firms has increased more than five times since the 1980s growing from $400 billion to above $2.1 trillion in 2004 (Doh, Bunyaratavej, & Hahn, 2009). Yet compared with that of manufacturing firms, the internationalization of service firms has only recently gained scholarly attention, of which our knowledge is described to be very thin (Kundu, 1994; Merchant & Gaur, 2008). In acknowledgment of the heterogeneity of service firms, it is important to explore the distinctions between capital-intensive service firms (CISFs) (airlines and hotels) and knowledge-intensive service firms (KIFs) (advertising, research, and design) especially in their approach to internationalization (Kundu, 1994). Merchant and Gaur’s (2008) review of journal publications in the last 20 years reports that only 7% of studies focused on service firms’ features, describing this research area to be empirically standing on ‘very thin ice’. I build on the process theory of internationalization to explore how professional service firms (PSFs), a subcategory of KIFs, possess unique features that have prevented their otherwise expected rapid expansion as explained by International Business scholars (Contractor, Kundu, & Hsu, 2003; Lu & Beamish, 2004). In the first part of the paper, I explain how PSFs’ features will shape their process of internationalization leading to the proposition of a closely knitted cautious ‘spider web-like’ internationalization process that is distinct from that followed by CISFs, which do not face the same constraints. Furthermore, in the second part of the paper, I develop propositions as to how PSFs’ unique features are likely to impact the internationalization to performance relationship as depicted by key scholars ∗

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ISSN 0264-2069 print/ISSN 1743-9507 online # 2012 Taylor & Francis http://dx.doi.org/10.1080/02642069.2012.665901 http://www.tandfonline.com

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to follow a horizontal S-shaped curve (Ball, Lindsay, & Rose, 2008; Contractor et al., 2003; Lu & Beamish, 2004; Rugman & Verbeke, 2008). This paper is an attempt to respond to the call for scholarly work that brings a better understanding of PSFs’ internationalization process (Hitt, Berman, Uhlenbruck, & Shimizu, 2006; Løwendahl, 2000) and predictors of their performance. Insights revealed from understanding PSFs’ internationalization are likely to be important and valued by the growing segment of firms emphasizing more knowledge-intensive vs. capital-intensive capabilities, which is likely to be a growing feature of firms operating in a knowledge-based economy. Professional service firms Service firms can be divided into hard and soft services (Erramilli, 1990). Hard service firms, also known as CISFs, include transportation, construction, hotels and restaurants, and shipping and trucking services (Contractor et al., 2003; Erramilli, 1990). This paper focuses on PSFs, which fall under information-intensive soft services, whose production is dependent on simultaneous customer participation and interaction. PSFs ‘involve intangible actions directly for customers, through the provision of information-based solutions on the transformation of input information into output information . . . requiring the exchange of complex information, in order to define customer needs and provide individualized solutions’ (Ball et al., 2008, p. 415). PSFs are a subcategory of KIFs whose offerings are of ‘intellectual nature’ and knowledge is the most important input, relative to physical or financial capital (Alvesson, 1995; Starbuck, 1992; Swart & Kinnie, 2003). Their buyers are business organizations that may be local, multi-domestic, or global (Løwendahl, 2000). They are described as ‘organizations with relatively few transactions, highly customized, process-oriented, with relatively long contact time, with most value added in the front office, where considerable judgment is applied in meeting customer needs’ (Rhian, Fitzgerald, Johnston, & Voss, 1992, p. 73). Being a ‘people-based’ vs. an equipment-based service industry (Thomas, 1978), PSFs’ value lies in their professionals’ knowledge and capabilities at solving complicated problems using creative and innovative solutions (Sveiby, 1997) as well as personal discretion in evaluating the clients’ problems (Løwendahl, 2000). Well-educated and highly qualified employees constitute the bulk of employees at PSFs (Alvesson, 1995, 2000; Starbuck, 1992). They are ‘professionals that facilitate economic and commercial exchange by providing advice to business’ (Greenwood, Suddaby, & McDougald, 2006, p. 1). The examples of PSFs, which are the focus of this study, include companies such as marketing research, law and accounting firms, management consulting, and advertising agencies (Contractor et al., 2003; Greenwood et al., 2006). Scholars explain that service firms are expected to have a higher degree of globalization than manufacturing firms due to them having ‘lower required capital investments, more easily transferable intangible firm-specific advantages (FSAs), and more compelling first-mover advantages’ (Rugman & Verbeke, 2008, p. 399). PSFs can expand using lesser resource-intensive entry modes and do not have to worry about transportation costs (Løwendahl, 2000). They can also tightly control operations through management contracts and licensing agreements with partners in the host market (Ball et al., 2008), which allows for lower entry barriers, lower risk entry modes, and greater flexibility in international operations relative to CISFs. Furthermore, empirical findings have shown KIFs to realize financial gains at earlier stages of internationalization (Contractor et al., 2003) than CISFs. These are all advantages to encourage more expansion of PSFs and other KIFs, relative to CISFs. Nevertheless, in the global market reality, this is not the

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case. Compared with manufacturing or capital-intensive firms, service firms are significant latecomers in entering the global trade and are more ‘home oriented’ whether internationalization is measured in sales dispersion or asset dispersion (Rugman & Verbeke, 2004, 2007). This brings us to the research question of this paper which focuses on the PSFs’ challenges of entering global trade (Strom & Mattsson, 2006). This paper investigates the following: (1) how specific PSFs’ features can explain their lag in entering global trade, and have an impact on the PSFs’ internationalization process relative to CISFs? (2) What impact will these factors have on PSFs’ expected multinationality – performance (M – P) relationship? PSFs’ importance in the global marketplace Knowledge-intensive business service firms are recognized for ‘playing a critical role in national and regional innovation systems and as prominent features of the knowledgebased economy’ (He & Wong, 2009, p. 265) and yet regarded as being still in their ‘infancy and still evolving’ (Amar, 2002). Researchers have called for studies that provide KIFs with relevant insights that take into account that ‘knowledge’ is their main source of input (Swart & Kinnie, 2003). The growth of global PSFs is tremendous (Capar & Kotabe, 2003), and in western economies, they make up the fastest growing sector (Løwendahl, 2000). Nevertheless, their internationalization processes are understudied (Hitt et al., 2006). Despite the critical role played by PSFs in the global economy (Kotabe, Murray, & Javalgi, 1998), scholarly attention paid to this growing subcategory of KIFs has been significantly below what it should be, given their economic impacts (Løwendahl, 2000). Netland and Alfnes’ (2007) review reveals that only 31 articles have addressed the topic of PSFs and international expansion between 1999 and 2005. Although PSFs currently represent only a small sector of service firms, they play an important role because of their influence on the strategic actions of other firms, generating ‘knowledge-intensive inputs to business processes of other organizations’ (He & Wong, 2009, p. 265), and have an ‘unprecedented degree of influence over other business organizations’ (Suddaby & Greenwood, 2001, p. 933). PriceWaterHouseCoopers is an example of such a large PSF that operates in 148 countries and is quite an influential economic actor. These global PSFs indicate the capability of PSFs to be quite large and globally well established (Greenwood et al., 2006). Furthermore, with the trend of more and more firms planning to offshore their knowledge-intensive functions such as market research and advertising functions to a foreign-based provider (Levy, 2005), there comes the likelihood of PSFs gaining even increased presence in the global marketplace. This is in reaction to the increased demand of multinational corporations (MNCs) for foreign-based companies that can provide such complex, higher value-added, knowledge-based business processes. Many of these MNCs prefer the consistency of services delivered from giving the business to one PSF that has operations worldwide (Løwendahl, 2000). Thus, examining the internationalization of PSFs is indeed timely. PSFs that focus solely on domestic market clients are likely to miss out on the benefits of this demand for PSFs’ global presence. This study builds on PSFs’ importance in the global marketplace and provides insights into the challenges that PSFs are likely to face when seeking global expansion. The next section starts with a discussion of the process theory of internationalization. The following sections discuss the unique features of PSFs leading to the propositions of their cautious approach to internationalization relative to CISFs. The discussion then turns to address the relationship between PSFs’ internationalization and financial performance with

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propositions and a conceptual model showing the impact of PSFs’ features on the M – P relationships. The paper concludes with a summary of main points and managerial implications. Process theory of internationalization and PSFs’ features The concept of gradual expansion has been described as early as ‘Product Life Cycle’ theory (Vernon, 1966), which explained that foreign direct investment (FDI) follows a gradual process whereby the stage of the product’s life determines which market the MNC will enter. Similarly, the Uppsala model, also referred to as the ‘process theory of internationalization’, explained that as firms increase knowledge and familiarity about a market, they will commit more resources for foreign expansion (Johanson & Vahlne, 1977). This model discusses the gradual acquisition, integration, and use of knowledge about foreign markets to incrementally increase commitments to foreign markets. Internationalization is a process constrained by the lack of experience, risk aversion, and inertia. It is a complex process that requires gradual steps not only in how the internationalization occurs, but also in the gradual execution of expansion plans; this does not include the discussion of born global firms (Oviatt & McDougall, 2005). While incremental and cautious expansion, as highlighted by the Uppsala model, is a process that is not unique to KIFs, I argue that it is likely to occur at a greater degree for PSFs, whose greater reliance on tacit knowledge, customization of offering, and follow-the-client motivations to market entry are likely to increase their vulnerability and thus their cautiousness relative to CISFs before entering a foreign market. How PSFs’ features constrain internationalization? Industry factors have been shown to impact the firms’ international expansion in terms of both potential host market destinations and the approach used for expanding to these markets (Bain, 1951; Stopford & Wells, 1972). Service firms’ international expansion can be explained using our current FDI theories provided that scholars account for their unique characteristics (Boddewyn, Halbrich, & Perry, 1986; Erramilli & Rao, 1993) relative to manufacturing firms. Core features of (1) perishability (limited to an allowable time for consumption – cannot be stored), (2) simultaneity of consumption and production, (3) customization, (4) consumer participation in production (remote computer data processing), and (5) the use without ownership (car rental) all have implications on either facilitating or preventing the foreign expansion strategy (Boddewyn, Halbrich, & Perry, 1986). Because of these features, Rugman and Verbeke (2008, p. 403) concluded that ‘service firms again as compared to manufacturing firms are constrained in their location choices’. This paper discusses PSFs’ unique features of (1) key client dependence, (2) tacit knowledge concentration, and (3) inseparability of value chain to explain how they further intensify these constraints and are likely to shape their internationalization strategies into the proposed cautious ‘tightly knitted spider web-like’ approach relative to the more dispersed and bolder ‘octopus-like’ expansion process of CISFs. Tacit knowledge: One of the main motivations of FDI is the protection of its knowledge-based assets against free-riders when expanding into a new market. A firm engages in FDI because it is the most secure way that it can expand without jeopardizing the loss of its know-how to competitors (Buckley & Casson, 1976), which is even more critical when the core of the business is concentrated in tacit knowledge. While protection of this tacit knowledge is key for a firm’s survival, when expanding abroad, its transferability across borders is also key for its survival in the host markets. Compared with


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PSFs, CISFs have greater dependence on codification and standardization of processes, which facilitate their knowledge transfer across markets. Information technology has indeed facilitated CISFs’ codification of knowledge, which ‘has enabled the disassembly of service processes into a number of relatively separable activities; codifiable interfaces between these activities enable them to be allocated to legally independent organizations and placed in physically distant location’ Eden (2005, p. 2). PSFs’, on the other hand, core essence is in the tacit knowledge embodied in their professionals, which hinders the transfer of knowledge and thus the internationalization process of PSFs. These challenges also have implications for PSFs to be close to their clients, because such tacit knowledge is embodied not only in the humans (Swart & Kinnie, 2003) but in the context as well. Having their knowledge be very specific to a region or a country or a product group is referred to as ‘locationally sticky tacit knowledge’ (Vinding & Drejer, 2006), which limits the location options available for PSFs’ expansion to those host markets that match in context. PSFs need to be close to their clients because they gain competitive advantage from their ability to access and integrate knowledge from multiple markets (Løwendahl, 2000), but face complexities while integrating and distributing this knowledge (Swart & Kinnie, 2003). Building on the view of Kogut and Zander (1993) of the firm as a ‘depository of knowledge’, KIFs’ capabilities ‘must be developed through (1) close contacts with end customers and (2) high levels of professional skills, specialized know-how, and customization’ (Bouquet, Hebert, & Delios, 2004, p. 35). Therefore, codification is difficult because of the degree of customization that is required for successful client management. In fact, Cort, Griffith, and White (2007) found a negative relationship between the uniqueness of PSFs’ offering, that is, the need for customization, and managers’ perception of the likelihood of succeeding in the host market. To summarize, the degree to which PSFs can protect know-how, transfer knowledge, and enhance their absorptive capacity (Cohen & Levinthal, 1990) will affect the decision of where to expand (Rugman & Verbeke, 2008). Follow and customize to key clients: Firms internalize markets in order to maximize rents from their ownership advantages (Buckley & Casson, 1976). According to Dunning’s (1988) classic work, FDI can be driven by (1) market seeking: to search for market or demand base; (2) asset seeking: to acquire a natural resource or unskilled labor; (3) efficiency seeking: to gain access to lower costing resources, more efficient division of labor or specialization; and (4) strategic asset seeking/asset augmentation: to gain access to a strategic asset that further increases the firms’ ‘O’ advantages or reduces the competition. While manufacturing firms’ market entry can be driven by any combination of these motives, service firms’ expansion is driven mostly by access to serving a bigger market as well as ‘follow-the-client approach’ (Li & Guisinger, 1992). PSFs, like other KIFs, are often dependent on a set of key clients whom they are likely to follow into new markets (Erramilli, 1987). Contractor et al. (2003) gave the example of market research, advertising, and financial services as PSFs that follow their clients abroad. For PSFs, staying close to their clients is important because they build knowledge through continuous interactions with clients (Morris, 2001). While customization of offerings is a feature of most service firms, its impact on operations may vary between capital- and knowledge-intensive MNCs. For PSFs, customization is core (Rhian et al., 1992). Løwendahl (2000, p. 144) explained that PSFs ‘make a commitment to the delivery of client-tailored services based on careful and ethically sound professional judgment’. However, their ability to capture economies of scale is hindered by their need to customize (Doh et al., 2009; Hill, 1999).Consider this example: an advertising campaign to a client cannot be used to serve another client. By the same token, a research project on a specific

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client business problem cannot be used to build the business of another client, instead all knowledge-based output delivered is very much client specific. Had there been standardized offerings and processes like those in the restaurant business or hotel industries, economies of scale would be achieved as well as economies of scope, which again would encourage more aggressive expansion. In summary, because of the intellectual nature of their service offerings, key client dependence, and the importance of customization, it is important for PSFs to seek markets that speak the same language or share cognitive schemas as well as are geographically proximal (Doh et al., 2009; Kundu, 1994). Inseparability of value chain: The service sectors’ lag in foreign expansion is attributed to the challenges that they face in location choices, which are caused by joint demand- and supply-side constraints (Rugman & Verbeke, 2008). Unlike manufacturing firms and CISFs that can divide their value chain activities across different markets, PSFs suffer from inseparability of the value chain activities (Ball et al., 2008; Rugman & Verbeke, 2004). Rugman and Verbeke (2008) explained that when firms expand abroad, they usually have two options: (1) to focus on exploiting their existing firm-specific asset (FSA) bundles in locations where customers are likely to attribute a high value to these FSAs, which for most companies is likely to include countries in their home region and (2) to seek collaboration with existing multinational enterprises (MNEs) in the host markets and benefit from their location-bound FSAs. For service firms, ‘the decay of non-location-bound FSAs and the need for new, complementary FSAs depend largely upon the value chain activity considered’ (Rugman & Verbeke, 2008, p. 407). For PSFs, intellectual capital being both the input and the output offering makes such inseparability of upstream and downstream activity adaptations extremely difficult. The complexities of addressing both FSA decay and new FSA requirements are also higher for PSFs, which brings them to a state of inflexibility when seeking to diversify and expand geographically. To illustrate, consider PSFs in the marketing research or consultancy sector, although they may capitalize on network ties of international key accounts, they often find it difficult to separate components of the value chain across several countries. While it may be more cost effective, for example, to have data-processing functions offshored to India when the analysis is completed in Germany, from a quality of service delivered perspective, the client’s value may be compromised in such a separation. Consider this, how can a consultant in Europe advise about overcoming competitors in Tunisian market of household detergents? Professionals’ knowledge is the core of PSFs and it is through the accumulation of knowledge across the different activities of the value chain and not separating them that they can add most value. PSFs, like those in the fields of market research and business consultancy, build their competitive edge on the accumulated learning of their professionals, and this is more difficult to achieve when the learning process is cut into pieces and across different locations. This is important because PSFs’ earnings are ‘based on the professionals’ application of their expertise, in terms of a fixed fee for the service, sometimes on a “no cure, no pay” basis’ (Løwendahl, 2000, p. 144), so the production of their service needs to objectively contribute to their clients’ business. For PSFs to add value by delivering knowledge-intensive services, they must closely interact with the client from the stages of problem diagnosis to solution delivery and throughout the activities of the value chain. Process of internationalization Mauri (2009) explained that firms have options in determining their international configurations from concentrating in one market to maximum dispersion of operations in several markets. Configurations refer to the ‘tight constellations of mutually supported elements’


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of the international network which can also be referred to as the international hierarchy of subsidiaries (Birkinshaw & Morrison, 1995; Miller, 1981, p. 236). Although all KIFs face lower market entry cost barriers, as explained above, having knowledge be the core of the business limits their location choices. PSFs’ features of high human asset specificity and tacit knowledge transfer can act as tougher expansion barriers than what other CISFs may encounter (Rugman & Verbeke, 2008). I argue that the strategic importance of protecting tacit knowledge at their core input following key clients and the inseparability of the value chain raise PSFs’ risk of internationalization failure and also their risk aversion relative to CISFs, which have more codified knowledge, less of the human specificity, and can benefit from greater flexibility in location choices (Brock & Alon, 2009; Rugman & Verbeke, 2008). Expanding firms seek FDI alternatives that will allow them to (1) protect their know-how embodied in their tacit knowledge and (2) allow them to appropriate rents from such expansions of know-how into new markets (Buckley & Casson, 1976). For PSFs, both these motivations for market entry are challenged by their unique features as discussed above. Furthermore, for firms to gain from internationalization, they need to preserve the value of their FSAs in the new markets (Montgomery & Wernerfelt, 1988) by seeking markets that attach a similar value to their FSAs as the home market. For PSFs to capitalize on an FSA, which is mainly knowledge based, it must be either transferable or equally valuable in the host markets, which is challenging when PSFs’ tacit knowledge is often location bound and shaped by local contexts, making entry into unfamiliar highly geographic and culturally distant markets challenging. Because of the significant barriers of tacit knowledge transfer, PSFs are likely to operate with elevated cautiousness without wanting to venture out to unfamiliar territories relative to CISFs. Accordingly, I argue that PSFs’ international configuration is likely to be significantly different than CISFs’, because of the different constraints they face. Therefore, the below proposition suggests P1: PSFs’ internationalization process will be significantly different than the internationalization process of CISFs.

Spider web- vs. octopus-like internationalization process Johanson and Vahlne (1977) explained that firms start their foreign operations from culturally/geographically close countries and move gradually to culturally/geographically more distant countries. The time it takes to enter a new market is related to the psychic distance between the home and the host countries. When service firms enter markets with a high institutional, geographic and culture cognitive distance (CD) relative to the home market, they risk the quality of services delivered (Rugman & Verbeke, 2008). Li and Guisinger (1992) also found a negative relationship between culture distance and service firms’ internationalization. All firms seek to capitalize on their FSAs which are knowledge based (Rugman, 1981), and firms will seek markets where they can exploit their established advantages. Rugman and Verbeke (2008, p. 406) asserted that as ‘the distance from the home country increases, with its regulatory/institutional, cultural, and economic components, the non-location-bound FSAs become subject to decay, and the need increases to complement these FSAs with new, location-bound FSAs so as to overcome the liability of foreignness’. Kostova and Zaheer (1999) found that a lower institutional distance between countries will allow firms to (1) overcome entry barriers and (2) adapt quickly to local contexts. For PSFs to succeed, they need to be closely embedded within the host market and establish strong social ties with local partners to successfully serve their function as providers of knowledge-based solutions. It is through social capital, created from having

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commonalities of values and beliefs among the participating actors (Brass, Galaskiewicz, Greve, & Tsai, 2004; Milliken & Martins, 1996), that PSFs can build their knowledge capabilities and add more value to clients. Hitt et al. (2006) found a positive relationship between firms’ human and relational capital and internationalization of PSFs and found them to moderate the relationship between internationalization and financial performance. Being embedded in the market will not only allow PSFs to legitimize themselves, but also allow them access to more local resources and new client relationships. Therefore, when PSFs expand in countries that share similar cognitive/culture maps , they are more likely to build and benefit from social capital as a strategic resource and source for rent (Blyer & Coff, 2003). Both cognitive proximity and geographic proximity are important determinants of interunit learning within multinational firms. The greater these distances, the more the challenges present for the creation of a common understanding which is critical for PSFs, whose core resource is knowledge (Hautala, 2011). Therefore, it is important for PSFs to expand to geographically and culturally proximal locations. Because of these factors, I argue that PSFs’ features are likely to follow a cautious internationalization process that resembles a tightly knitted spider web-like approach characterized by following a gradual order to expansion. In this approach, subsidiaries that are more geographically and cognitively proximal as well as less diverse in scope are likely to be added first to the international network. The subsidiaries in this spider web-like configuration are closely spaced in terms of dimensions of (1) geographic distance (GD), (2) CD, and (3) similarity of product scope. PSFs are likely to launch foreign subsidiaries in an ordered fashion in accordance to the proximity of the dimensions of GD, CD, and diversity distance. This is in comparison to CISFs that are likely to face lower constraints to internationalization due to their (1) codification of knowledge, (2) market/efficiency-seeking motivations of FDI, and (3) separations of value chain activities. Therefore, I propose that CISFs follow a bolder octopus-like internationalization process described as having subsidiaries that are more spaced in terms of greater home/host GD and CD as well as interunit product diversity relative to PSFs on the international configuration map. The use of the term ‘octopus’ was first introduced by Bartlett and Ghoshal (1990) as the traditional view of the MNE strategy of having the ‘corporate brains’ or strategic resources centralized at the home market headquarters, while providing support to the tentacles (subsidiaries) in a foreign market. In this paper, the octopus-like conceptualization refers to the actual process or steps to internationalization, whereby the octopus head resembles the starting point of the firm and this is in the home market. Each tentacle or arm reflects the firm’s internationalization move which resulted in the creation of a foreign subsidiary. The sprouting of each of these arms does not follow a particular calculated and predetermined order, as in the case of PSFs. The length of these arms is measured by the dimensions of GD/CD and product diversity. Such that the longer the tentacle/arm, the more distant the subsidiary on these dimensions. The order by which the octopus (firm) sprouts or grows these arms is not predetermined by a prescribed rule of longer or shorter arms first. But rather they sprout according to location attractiveness. That is, the first arm or subsidiary may be the longest one reflecting a subsidiary that is highly geographically and cognitively distant as well as highly diversified. The second arm may emerge to be the shortest in length, reflecting lowest scores on these dimensions. In CISFs’ internationalization process, the subsidiaries are not necessarily tightly driven by a predetermined order of proximity on these mentioned dimensions. As shown in Figure 1, relative to PSFs, CISFs can launch subsidiaries at different orders, depending on other motivators of market entry, which can include market, efficiency or strategic asset-seeking motivations (Dunning, 1988). This conceptualization of octopus internationalization is similar to what Pangarkar (1998)


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Figure 1. Illustrates the proposed variation of the internationalization process of PSFs vs. CISFs.

refers to when explaining the unrelated international diversification of Asian multinationals in the late 1990s. Therefore, I propose P2: PSFs’ internationalization will follow a tightly knitted spider web-like process relative to an octopus-like internationalization process of CISFs.

Figure 1 attempts to explain the conceptual comparison of the internationalization process of PSFs relative to CISFs on dimensions of geographic dispersion, cognitive dispersion, and interunit diversification of scope. The number of subsidiaries shown reflects the order at which each subsidiary is launched. The arrows are used to explain the process by which the internalization will occur. In PSFs, it is a cautious small circular approach, similar to the spider web. For CIFs, the arrows stem directly from the home market but can vary in length depending on where the unit is located on the configuration map of geographic cognitive and product diversification dimensions. The next section reviews the literature on performance and internationalization. Then, it discusses how PSFs’ features can impact the relationship between performance and stages of internationalization with propositions on the impact of (1) client performance, (2) commoditization of knowledge, and (3) executives’ hubris. Internationalization and performance: the horizontal S-curve Firms capitalize on opportunities abroad via the exploitation of their core advantages (Buckley & Casson, 1976; Caves, 1971; Dunning, 1981; Hymer, 1976), which allows

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them to overcome associated liabilities of foreignness (Zaheer, 1995) and appropriate rents (Lall, 1980). Gomes and Ramaswamy (1999) found that increased internationalization is associated with positive firm performance to a certain optimal level after which the performance decreases due to higher costs, following an inverted-U shape. Contractor et al. (2003) presented the three-stage model depicting an S-shaped relationship with the degree of internationalization (DOI) on the horizontal axis and the performance on the vertical axis. Their sample was 14 service sectors firms across 12 countries, differentiating between CISFs and KIFs. As per Figure 2, which has been extracted from their study, the initial stage, stage 1, is characterized by a negative slope, since firms at this stage are investing heavily in the international expansion and setting up of operations. At this stage, firms must incur costs associated with acquiring new market knowledge and the liabilities of foreignness associated with entering a new market. They explained that internationalization will also ‘entail a large administrative overhead burden, which, if spread over just a handful of country markets, results in a high burden of overhead per nation burden’ (Contractor et al., 2003, p. 7). In stage 2, an inverted-U relationship is observed, whereby there is an increase in the performance up to a certain threshold of DOI after the firms gain efficiencies across markets and benefit from economies of scope. In this mid-stage, the overhead burden mentioned in stage 1 is spread across more markets (Kogut, 1985; Porter, 1985), making the additional benefit gained from expansion outweigh the costs. Then, comes stage 3 characterized by a steeper downward curve when compared with stage 1 because of having ‘international expansion beyond an optimal threshold’. In this stage, the further expansion leads to having the costs outweighing the benefits, referred to as ‘over-internationalization’, a state that not all companies may reach. Interestingly, Contractor et al.’s (2003) empirical findings on a sample of 43 firms across 6 years (254 observations) support that KIFs, compared with CISFs, are able to reach stage 2 characterized by positive performance (Return on Sales) at an earlier stage in their internationalization, that is, at a lower DOI when compared with that of CISFs. Interestingly, they also found that KIFs do reach stage 3 of ‘overinternationalization’, while CISFs do not. Figure 2 is an illustration of this base model of KIFs’ M–P relationship as shown in Contractor et al.’s (2003) study.

Figure 2. A three-stage sigmoid (S-shaped) hypothesis. The figure is as that shown in Contractor et al.’s (2003) study.


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These findings were supported by Lu and Beamish (2004), who showed that service industries classified as knowledge-based ones reached stage 2 of positive performance at an earlier stage of internationalization. Similar to the findings of stage 3, Katrishen and Scordis (1998) showed that firms achieve economies of scale from expansion up to a certain point, after which they have diseconomies of scale. The costs are attributed to higher costs of foreign operations: government regulation, coordination of operations, and value chain. These findings were also supported by Hitt et al.’s (2006) study of PSFs, where law firms were found to have decreased performance with ‘over-internationalization’. The first proposition builds on these studies above to explain that since PSFs are a subcategory of KIFs, as defined by Contractor et al. (2003), then the relationship is likely to be true for PSFs as well. Accordingly, proposition 1 suggests P3: PSFs will realize positive financial performance at an early stage of internationalization than CISFs.

PSFs’ moderators to the stages of the horizontal S-curve But how do the findings of these studies help us understand more of PSFs’ internationalization challenges? We do not know enough about how professional service sector-specific resources can facilitate or hinder expansion plans (Hitt et al., 2006; Tallman, 2001). The next section focuses on the examination of the industry factors behind the stages of internationalization as they relate specifically to PSFs. In an effort to better understand the relationships between PSFs and their performance, I raise the question will all PSFs behave equally as described by the horizontal S-curve? From what we have seen with global PSFs, some have reaped more gains from internationalization than others. I explore now how the incorporation of PSFs’ features can lead us to better understand the described M – P relationship. While others have found firm internal resources to moderate this relationship, such as R&D capabilities and marketing capabilities (Gomes & Ramaswamy, 1999; Kotabe, Srinivasan, & Aulakh, 2002; Lu & Beamish, 2004), I discuss below the proposed moderators of (1) key client performance, (2) commoditization of knowledge, and (3) executives’ hubris. Key client performance A majority of PSFs focus on a select number of key clients who represent the bulk of the revenue. For PSFs, adopting mostly a ‘follow-the-client’ strategy, their client’s business performance plays an influential role in determining when they will reach stage 2. PSFs’ performance is contingent on the amount of business they get commissioned from their clients. If the clients’ business is declining, they are very likely to decrease their budget on outsourced knowledge-intensive services, which includes PSFs such as advertising or marketing research, leaving PSFs with lower business volume. Compared with CISFs, PSFs’ key client dependence subjects them to higher sensitivity to fluctuations in their clients’ performance. PSFs’ services are naturally perishable and customized to specific clients, that is, they cannot be stocked to serve other clients, if not sold they will significantly hinder the smooth inflow of PSFs’ rents. To illustrate this point, consider the case of advertising and research companies that invest time and money in building their expertise in their key clients’ business. If this knowledge cannot be capitalized to serve other clients, then they are likely to be at loss if their clients do not commission a significant volume of projects. As explained by transaction cost economics (Williamson, 1981), the greater asset specificity increases transaction costs because the supplier offering the

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service cannot market the offerings to other purchasers in the market and the value of its offerings is defined by the demands of that specific client (Williamson, 1981). Therefore, the below proposition suggests P4: For PSFs, the relationship between performance and internationalization in stage 2 will be positively moderated by (a) financial performance status and (b) stability (non-fluctuation) of their key clients’ business in that host market, such that the more positive and stable their clients’ performance, the stronger the M–P relationship in stage 2.

Commoditization of knowledge According to knowledge-based view (Grant, 1996), knowledge is the most critical source of competitive advantage, behind its inimitability. In fact, scholars highlight the greater importance of tacit knowledge within the organization over other codified knowledge (Nelson & Winter, 1984). A firm’s survival depends on the level of learning it has inside it which is manifested in its established internal routines. Hannan and Freeman (1984) argued that firms that have established routines are more likely to survive because the environment favors those who possess a stable structure. But as discussed earlier, the other challenge to having tacit knowledge at the core of the business is its difficulty to articulate, codify and, therefore, transfer across the organization. The articulation of tacit knowledge is limited by time as well as physical proximity (Nelson & Winter, 1984). When a firm is expanding to foreign unfamiliar markets, this knowledge becomes even more important, because it is often hindered by the ambiguity of language/terminology as well as the inability to specify outcomes, which leads to communication barriers (Simonin, 1999). The conditions for adequate tacit knowledge transfer require the following: (1) the pace of the required task needs to be slow, (2) pace variations need to be tolerable, and (3) the performance as a whole needs to be reduced to a set of steps that relate to one another in very simple ways. This is not obviously the common case of a client servicing firm that is required to be not only flexible but also quickly responsive to the needs of its business clients which are not stagnant across different markets. Had there been more standardized offerings and processes like in the restaurant business or hotel industries, not only would knowledge transfer be facilitated but economies of scale and scope would also be achieved. I argue that PSFs that have found ways to standardize and codify a significant portion of their tacit knowledge will be able to more effectively transfer knowledge across their organization, benefit from economies of scale/scope, and be encouraged to expand. They will be more likely to efficiently start operations in foreign markets and achieve results. In an attempt to reach such economies across markets, many PSFs have actually started to adopt standardized business output solutions of their knowledge-based offerings to clients, which is not something natural to this industry (Rugman & Verbeke, 2008). Scholars refer to this as ‘knowledge commoditization’, which is an increasing trend among large PSFs such as the ‘Big Five’ accounting. Suddaby and Greenwood (2001, p. 934) described it as ‘the process by which managerial knowledge is abstracted from context and reduced to a transparent and generic format that can be more easily leveraged within PSFs and sold in the market place’. While conclusive evidence of the effectiveness of this approach is yet to be determined (Rugman & Verbeke, 2008), having a greater degree of codified knowledge is likely to facilitate international expansion. Furthermore, this will encourage more resource exchanges and synergy creation between foreign subsidiaries of PSFs. It is also likely to create an avenue for increasing initial and continuous support for newly launched foreign subsidiaries and eventually lead to overall better performance for the parent PSF. Accordingly, the below proposition suggests


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P5: For PSFs, the relationship between performance and internationalization in stage 2 will be moderated by PSFs’ commoditization of tacit knowledge such that the greater the commoditization of tacit knowledge, the more positive the M–P relationship in stage 2.

Executives’ hubris According to appropriation theory, the organization’s rents are often not realized by the firm, but are shared in accordance to the bargaining power of different internal stakeholders (Coff, 1999). In PSFs, colonizers of knowledge, in this case the professionals, represent a key significant group with significant influence. Knowledge ‘colonization involves the legitimation of specific social actors as the appropriate sources of management knowledge and the de-legitimation of others’ (Suddaby & Greenwood, 2001, p. 934). Executives at PSFs who have been servicing key clients over the years are likely to possess significant tacit knowledge and thus have significant bargaining and influential power on firms’ strategies as well as on strategies of their clients (Coff, 1999). Their influence stems from the close relationship with clients, which trust them as business advisors and have acknowledged their ‘expertise’. In fact, it is not uncommon for clients to terminate their contracts if their serving professional leaves the company. Sometimes, if that executive decides to join a competing firm, it is likely that the clients he or she serves will follow him or her, taking the business to the competing firms. This is understandable given the level of interdependence that arises between the clients and the professionals providing the knowledge/advisory offerings in PSFs. Because of this sense of professionals’ importance, it is quite likely that they will develop a degree of exaggerated self-confidence known as ‘hubris’ (Hayward & Hambrick, 1997; Hiller & Hambrick, 2005). The knowledge asymmetry resulting from the gap between what an executive professional knows and the knowledge of the PSF (Dou, Li, Zhou, & Su, 2010) is another source for the emergence of this executive’s hubris. Løwendahl (2000) gave the example of a PSF foreign subsidiary which was manned by a key executive, which shut down with the decision of that executive to move to another country. The impact of professionals’ hubris on key firm actions is critical. Hiller and Hambrick (2005) explained the impact of these psychological elements on firms’ strategies and specially risk-taking behaviors. Li and Tang (2010) found a positive relationship between executives’ hubris and risk taking, which becomes stronger when managerial direction increases. For PSFs, foreign expansion is a risky decision because of the multiple constraining factors as discussed in this paper. In fact, Løwendahl (2000, p. 142) advises that ‘professional service firms’ managers and owners should make sure a “devil’s advocate” has asked all the awkward questions and that they are capable of answering them well, before a global strategy is implemented’. Professionals’ possession of significant bargaining power and its impact on their sense of self-importance or self-worth in the company may lead them to push the firm into risky expansion decisions, like that of over-internationalization. This is likely to lead to internationalization decisions that are not driven by ‘follow-the-client’ strategy but more by where these professionals have social networks (Løwendahl, 2000). Bleby (2007) discussed the recent trend of PSFs expanding into new emerging markets without being connected to a ‘follow-the-client’ strategy. To that extent, it is very likely the professionals’ ‘influential role as drivers of the business is associated with greater sense of their exaggerated self-confidence, relative to professionals in CISFs. This is likely to drive them to push the PSF into more risky internationalization, which may not always be in the best interest of the firm as indicated by stage 3. Therefore, the below proposition suggests

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P6: For PSFs, the negative relationship between performance and internationalization in stage 3 will be moderated by the degree of the host market’s executives’ hubris such the stronger the executives’ hubris, the more negative the M –P relationship in stage 3.

Conceptual model The base model shown in Figure 3 is extracted from Contractor et al.’s (2003) study. This paper explored how PSFs’ unique features can moderate the shown M – P relationship at different stages of internationalization. These proposed relationships are depicted in the figure to moderate the M – P relationships in stage 2 and stage 3, respectively.

Figure 3. PSFs’ moderators of the M–P relationship. The proposed conceptual model is based on the empirical model presented by Contractor et al. (2003).

Summary and conclusion This paper sought to raise the question of will all KIFs realize gains at earlier stages of internationalization than CISFs? It investigated the case of PSFs to determine what impact will their unique features have on the M – P relationship and its stages? Previous work has shown that KIFs will earn gains at earlier stages of internationalization than CISFs, due to their lower entry barriers and associated entry costs; however, scholars have also documented that KIFs are lagging behind from entering the global arena. This paper presented an explanation as to why PSFs, as a type of KIFs, lag in internationalization and proposed them to follow a spider web-like highly cautious internationalization process relative to CISFs. It also explained how PSFs’ features of (1) client performance, (2) commoditization of tacit knowledge, and (3) professional executives’ hubris can moderate the relationships between internationalization and performance as indicated by the stages of the horizontal S-curve. In addition, it argued that (1) a


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follow-the-client expansion motive, (2) the non-transferability of tacit knowledge, and (3) the inseparability between upstream and downstream activities are unique PSFs’ features that are determinants of the more cautious slower paced internationalization process relative to CISFs. It sought to articulate this concept via the comparison of the spider web-like tightly knitted expansion process vs. the more aggressive less-restrained octopus-like approach that is likely to describe the process of CISFs that face lower constraints and have greater location options when examining dimensions of (1) GD, (2) culture/CD, and (3) product/scope diversification relative to PSFs. Without being able to protect their knowledge-based assets, stay close enough to their key clients, and enter geographically and cognitively proximal countries, they are likely to face difficulty in appropriating rent from their expansion. Implications Today, companies have realized that knowledge, knowledge management, and the professionals possessing this knowledge are the ultimate drivers of competitiveness and the key sources of sustainable business (Grant, 1996) and drivers of today’s knowledgebased economies (Dunning, 2000). This study sought to provide PSFs that are interested in expanding abroad some insights into how their core factors will shape their internationalization approach. Having this understanding, PSFs can possibly account for them before making the FDI decision in a new market. Perhaps by designing strategies that address the constraints brought about by these innate factors, PSFs are likely to have more successful foreign expansion strategies or identify for themselves alternate options to FDI, such as the pursuit of local partnership as a safer alternative. Further research can empirically examine the propositions which are likely to contribute to our understanding of PSFs’ and KIFs’ international expansion challenges. Acknowledgements I am very much grateful to the insightful and intelligent feedback provided by two anonymous reviewers for this special issue of SIJ. I would like to also thank Dr William Newburry and Dr Farok Contractor for their priceless advice. And I extend my sincere appreciation to the scholars at Academy of Management 2011 International Management Division Meeting. References Alvesson, M. (1995). Management of knowledge intensive companies. Berlin/New York: de Gruyter. Alvesson, M. (2000). Social identity and the problem of loyalty in knowledge-intensive companies. Journal of Management Studies, 37(8), 1101–1123. Amar, A.D. (2002). Managing knowledge workers: Unleashing innovation and productivity. Westport, CN: Quorum Books. Bain, J.S. (1951). Relation of profit rate to industry concentration: American manufacturing, 1936 –1940. The Quarterly Journal of Economics, LXV(3), 203–324. Ball, D., Lindsay, V., & Rose, E. (2008). Rethinking the paradigm of service internationalization: Less resource-intensive market entry modes for information-intensive soft services. Management International Review, 48, 413– 431. Bartlett, C.A., & Ghoshal, S. (1990). Managing innovation in transnational corporations. In C.A. Bartlett, Y. Doz, & G. Hedlund (Eds.), Managing the global firm (pp. 215–255). London: Routledge. Birkinshaw, J., & Morrison, A.J. (1995). Configurations of strategy and structure in subsidiaries of multinational corporations. Journal of International Business Studies, 26(4), 729–753.

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