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Budgeting for the Real Costs of International Expansion

Any company considering expanding into another country must first understand the target nation’s legal, regulatory, and cultural environment.

To use the phrase “global economy” these days is usually redundant. After all, our economy is, by definition, global. And the question many U.S. businesses now face is not if they will expand internationally, but when.

Each company’s motives for expansion will vary. But the potential benefits involved are usually pretty clear, and range from taking advantage of new and expanding markets for top-line growth, to gaining efficiencies by reducing expenses, and increasing a company’s global footprint to better position itself for an initial public offering.

However clear the strategy is, often far murkier are the costs and risks involved with establishing operations in a new country. It is critical for organizations to reasonably account for all the costs of a global expansion during the due-diligence process when they are evaluating an overall cost-benefit return, so they can compare expectations in different countries, make accurate P&L projections, hold people accountable for results, and, ultimately, justify their decisions to expand into a particular target country, look elsewhere, or even not to pursue a global initiative at all.

Businesses new to international expansion can fall prey to one understandable but costly mistake during the budget-planning process. That is, they assume that operating in another country is more or less the same as operating in the U.S. These newcomers typically begin their planning by drawing up a list of common domestic expenses, like corporate income taxes and office operating costs. Then they go online to find target-country rates, real estate costs, and other typical expenses. They make adjustments based on the target-country data and the domestic expenses and — voila! — they have the data they think they need to make reasonable cost projections.

Unfortunately, successful global expansion is rarely that simple. Each country has its own unique set of laws and regulations — and ways of doing business and interacting socially — that change constantly. Unfamiliarity with country-specific laws and cultural idiosyncrasies can lead to serious gaps in a business’s cost-benefit analyses, which in turn can provide unpleasant surprises if a company proceeds with an expansion based on false premises.

Even something seemingly as simple as opening a bank account in another country — often a legal requirement for establishing activities — can take months to accomplish. If a business fails to account for this fact, and its strategy demands setting up operations quickly, the whole project may be doomed before it really begins.

The good news is that budgeting, when done properly, doesn’t itself create success or failure. Rather, it eliminates the menace of surprise. A company well into the due-diligence stage of the expansion process will have explored the business-related questions it must ask — like whether it can sell its products or services at a good price, if it can sell enough, and if it can get an attractive return. Higher-than-expected establishment and operational costs will only rarely mean that the decision to expand was the wrong one. But it’s important to go into the budgeting process armed with the right questions, because no one likes budget surprises.

This article is intended to give a high-level understanding of some of the most important items to consider when budgeting for an overseas expansion, using some of the more popular destinations as examples.

Europe: U.K. and France

As a first example, let’s take the United Kingdom, which is a very common country for U.S. businesses when first testing the waters of global expansion. While the U.K. is generally business-friendly, it has a host of personnel-related costs to consider. When hiring locals, employers pay 13.8 percent of salary toward social security, with no cap. Compare this to the U.S., where the employer FICA of 6.2 percent and Medicare contribution rate of 1.45 percent are substantially lower in total, and the FICA contribution is currently capped at the first $117,000 of annual salary. Furthermore, pensions in the U.K. are mandatory, and companies must contribute at least 1 percent of salary (a figure that will rise, in stages, to 3 percent by October of 2018). Add to this another $1,000 to $4,000 for employer’s liability (the equivalent of workers compensation in the U.S.), plus health and safety obligations if a company employs five or more individuals in a U.K. office.

A company budgeting for overseas expansion should also understand the often considerable costs of sending home-country employees (also known as expatriates or “expats”) to a target nation. A good rule of thumb for the U.K. is that an expat will cost a company three times that employee’s base salary. Hiring locals can be considerably cheaper, but recruiting costs can be high. And companies should not underestimate the importance of hiring quality employees, whether in the U.K. or anywhere else.

 

The concept of at-will employment is almost nonexistent outside the U.S., and mandatory termination payouts can be significant no matter what the country of operation. And in the U.K., if there is any hint of discrimination or failure to follow proper employment guidelines, a company may find itself shouldering unfair dismissal costs that can exceed $100,000.

U.K. corporate income tax is lower than in the U.S., and effective April 1, 2015 U.K. authorities imposed a single rate of 20 percent. However, U.K. customs duties can range from 0.5 percent to 10.0 percent, and the U.K. also imposes an import value added tax (VAT) of 20 percent. Import VAT is set up to be a temporary tax liability that will be reversed when goods are sold onward to customers. However, it’s not uncommon for a foreign company to improperly follow U.K. customs clearing rules, in which case the “temporary” VAT liability becomes permanent.

Companies must also consider carefully the real estate costs associated with various target-country locations. A company establishing an office in London, for example, should expect to pay about 20 percent more than it would for equivalent space in a large U.S. city. Secondary U.K. business centers — like Birmingham, Bristol, Glasgow and Manchester — will be similar to their U.S. peers. However, rental tax rates, another important factor, tend to be higher in the U.K.

A company will save in translation costs if it is expanding to the U.K. from the U.S., Canada, Australia or New Zealand. Disregarding differences in spelling (e.g., “color” versus “colour”), there will be no need to pay for translation; however, there may be costs associated with reprinting business cards and stationary because of different standard document sizes.

Budget issues in France are similar to, but even more costly than, those in the U.K. Operating in France is notoriously expensive and time-consuming because of its statutory employee rights and entitlements. On the personnel side, employers pay 40 percent to 45 percent of base salary for social security, plus additional insurances, such as medical. These are dictated by federal law and collective bargaining agreements with unions. Unlike the U.S., both white- and blue-collar workers are typically unionized. These additional expenses will run at least $3,000 to $4,000 per employee per year. Add in extra pay for holidays, overtime and training. A word of caution about bonuses: Discretionary bonuses may become contractual based on perceived precedent. There’s also the pesky matter of the mandatory work week of 35 hours, and the liabilities that can arise when even senior managers are not guided properly to adhere to these limits.

France is one country where a company has little or no hope of cutting corners and running a lean ship — in all likelihood, a work council will monitor adherence to employment agreements and push hard for worker benefits.

Companies planning to hire locals must be selective in whom they bring on. Terminating employees in France is difficult, and will typically cost the equivalent of 12 to 18 months’ severance once they have been on board longer than their probationary period.

Real estate in France is comparable to that in the U.K. Typically, there will be a 10 percent to 20 percent premium over big-city U.S. real estate to locate in or near Paris. Provincial French cities will cost about the same as second-tier cities in the U.S.

Translation costs must also be considered when expanding into France. Many French businessmen and women speak English, but, realistically, for an operation to thrive, it must conduct business in French. Companies should also plan on conducting contract negotiations in French.

Latin America: Mexico and Brazil

Mexico doesn’t have strong private sector unions, but there are some unique personnel-related costs that expanding companies must plan for. All employers are required to offer profit sharing, and the minimum is 10 percent of annual entity profit. Employers must also contribute, for each employee, up to $38 per month towards a retirement fund and up to $64 per month for social security.

Mexico has an excellent public health system, and employers do not have to contribute to that system. However, supplemental coverage is becoming a common benefit for employers competing for quality staff. And while Christmas bonuses have been waning in the U.S., they’re often common overseas, including in Mexico, where giving one month’s salary at Christmas — the “13th month” — is standard practice.

While corporate taxes in Mexico are slightly lower than those in the U.S. — 30 percent — you will pay a standard 16 percent VAT rate.

Brazil has few government-mandated personnel requirements, but it does have very strong private-sector unions that have made rich benefits the rule. Recruiting top-notch people will mean playing by union standards for white- as well as blue-collar workers. Expanding companies can expect to offer unemployment and health care benefits, as well as “reimbursement” allowances for everyday items like restaurant, supermarket, gasoline, cellphone, and parking/transportation expenses. These allowances can add up. Transportation and food per diems, commonly as much as $20 each, will mean more than $10,000 per employee per year. Companies sending expat employees will need to provide housing in safe (read expensive) neighborhoods as well as transportation, and may even require personal security.

The issue of safety in Brazil is significant. Sao Paulo, the nation’s business center, doesn’t get the same bad press as Rio when it comes to urban crime, but crime is still a very big issue there. Expanding companies should plan on renting or leasing offices in safe neighborhoods near highways or public transit, which will mean paying a hefty premium. While space in these neighborhoods may be a little less than Manhattan or London, it will still be in the range of Boston or Chicago. Companies looking to save money should consider Curitiba or Porto Alegre, two up-and-coming cities an hour or two south of Sao Paulo by plane. The workforce in these cities tends to be relatively conservative and industrious, and real estate prices are closer to third-tier U.S. cities. Expanding companies must also account for the cost of occupancy and health permits, though they are bargains at around $500 each.

Corporate tax rates are 34 percent in Brazil, and the country also has an alphabet soup of indirect taxes. The main ones are federal VAT (IPI), state VAT (ICMS), and municipal services tax (ISS). ISS varies by municipality, with a cap of 5 percent. ICMS varies by state, averaging 17 percent. IPI ranges from 0 percent (essentials like rice) to 365 percent (luxuries considered superfluous). Given the extraordinarily long list of different taxes, compliance costs are very high even if the tax rates themselves may at times be reasonable.

Asia: Singapore and China

Singapore is rated one of the most business-friendly nations in the world. It’s also one of the most expensive. According to Mercer Consulting, it’s the fourth-most-costly city to live and work in. Expect real estate to be at least 50 percent higher than in the U.S. or Europe. And top-notch professionals will expect compensation packages equal to those in North America and Europe. Foreign companies sending expats should count on providing hefty housing allowances, as expats typically insist on living in international neighborhoods where rents can make Manhattan and Central London look modest. Companies planning to employ third-country nationals — and there’s a sizeable community of global professionals in Singapore — must establish a local corporation, with all of the attendant costs. On the positive side, Singapore corporate income taxes are only 17 percent.

China is another ballgame entirely. It’s more expensive than many might expect, given China’s popularity as a target country for foreign businesses. Its procedures are complicated and time-consuming. Think forms and documentation; think bureaucracy.

In China, foreign companies must establish a WFOE — a Wholly Foreign Owned Enterprise corporation. This entails providing “share capital” of roughly six months of expected operating expenditures. A small three-person office will equate to around $150,000 in share capital that must be injected into a Chinese bank account to start. Of course, this capital may be used in normal operations, but if reserves fall below the mark, that will mean more filings and delays. Setting up a WFOE generally takes six to nine months, and will typically require one home-office staff member to ride the application process almost daily. Expanding companies should also note that shutting down operations in China can take longer, and cost more, than the costs of opening up shop.

Some companies performing due diligence may find that China is not the bargain they expected. Shanghai is the world’s tenth most expensive city; for perspective, New York is 16th. And it’s not just real estate that’s pricey — staffing costs have been soaring. English-speaking local talent can be hard to find (and often even harder to keep), and non-locals will expect global salaries, with hefty accommodation allowances. Then there are contributions to government-run social security, pension, medical, maternity and housing funds. These can run 5 percent to 20 percent of annual salary each; fortunately, there are salary caps. Unfortunately, they vary by city. Expanding companies must take this into account, as additional branches may be needed to accommodate staff in more than one locale. It’s no wonder Chinese companies have begun to offshore manufacturing to Mexico.

Plan Carefully
So what’s the bottom line when budgeting for international expansion? Simply this: Any company considering expanding into another country must conduct a thorough due-diligence process to understand the target country’s legal, regulatory, and cultural environment before the expansion process begins. Without this research and understanding of the target country’s unique suite of costs, the company may discover down the line that it had not asked the right questions, and exposed itself to considerable financial and reputational risks that could have been otherwise avoided.

Larry Harding is chairman and executive director for corporate development, at Radius, where consults with organizations that are seeking to expand internationally.