IEOR 153 Final Project - Zara Case PDF

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IEOR 153 Final Project: ZARA Case Ryan McCormick, Priyan Sathianathan, Kathy Kong, Ryan Scholes, Nikhil Kuppuswamy, Claire Liu  arvard Business Publishing, 21 Case: Ghemawat, Pankaj and Jose Luis Nueno. ZARA: Fast Fashion. H Dec. 2006. Case Study.  Given the structure of the retail apparel market, what are the weaknesses of Zara’s vertical integration business model? What would Zara lose by engaging in upstream markets more often rather than internalizing production and processing? Could Zara have gained much by franchising stores instead of owning all of them? Though, in general, there are a large number of benefits to a vertical integration business model, said model is often a great hindrance to operations. For one, the increased control Zara has over its supply chain comes at the loss of a price advantage over its competitors. Upmarket suppliers can invest a greater proportion of their profits into optimizing their whole operation, whereas Zara’s profits must be spread over the various levels of its entire vertically-integrated structure. This can be exemplified by Inditex’s personnel investments. On this topic, the study brings up that, “the experience off the older, better-established chains, particularly Zara, had helped accelerate the expansion of the newer ones. … Oysho … drew 75% of its human resources from the other chains,” (Ghemawat 8). The loss of price advantage also comes from the fact that Zara sacrifices some amount of economy of scale as a product of its centralized production. Its centralized structure reduces its flexibility, especially at scale. The case refers to this as “diseconomies of scale -- that what worked well with 1,000 stores might not work with 2,000 stores” (Ghemawat 12). What Zara lost in scale it gained in coordination and efficiency. For example, “vertical integration helped reduce the ‘bullwhip effect’ … Zara was able to originate a design and have finished goods in stores within four to five weeks… In contrast, the traditional industry model might involve cycles of up to six months for design and three months for manufacturing” (Ghemawat 9). This obviously improved Zara’s responsiveness to demand, and the shortened lead times would greatly reduce lead times and minimize unfulfilled demand. These improvements had real and clear results. Zara’s competitors had, “net margins … stuck at around 2% of sales, compared with the 10% in the case of Zara, largely because of … expenses that swallowed up about 40% of its revenues, verses about 20% for Zara” (Ghemawat 9). Losing their internalization of production and processing would forfeit the gains they made for themselves, and such a vertically integrated business model is central to Zara’s success. Zara’s centralized ownership of stores is an extension of this. “Stores were occasionally relocated in response to the evolution of shopping districts and traffic patterns” (Ghemawat 14). Zara exerts extensive control over its stores, offering store managers up to half their income in performance incentives to planning store locations as part of coordinated efforts to enter and dominate new markets for the company (Ghemawat 15,16). At every step, Zara maximizes return on all its investments from personnel to real estate, something made possible by its highly integrated business model.  Does Zara use push- or pull-based paradigm (or a mix of the two)? How does this differ with the competition, and what benefits does this offer Zara? Does this exacerbate or alleviate the Bullwhip effect, and how does Zara address this? Zara uses a push-pull mixed paradigm on their items, mainly sourcing fabric from their own supplier and ordering undyed fabric in bulk (Ghemawat 11). On their fashionable items, the 1

push-pull boundary occurs in the manufacturing phase, while basic clothing lines are outsourced to Asia for production. Zara utilizes the “just-in-time” production system where they receive goods only as they need them so that inventory is readily available to meet demand. This system allows Zara to minimize inventory, reduce response times, and increase efficiency. The short cycle time and lower working capital intensity allows Zara to continuously manufacture so they can commit late into the season and change design based on trends. This helps them bring fashion trends to stores in a few short weeks. Competitors such as Gap and H&M outsource almost all production, giving them longer lead times than Zara. Competitors can take 3 months to design new products and another 6 months to push production while Zara focuses on the latest trends in the market and progresses from design to finished goods in 5 weeks (Ghemawat 9). The design team is linked to store managers across the world, enabling Zara to adapt to trends and differences across markets. The designers test new products in small batches and scale items that consumers respond to, giving Zara a 1% fail rate compared to the industry 10% (Ghemawat 10). As seen in Exhibit 13, Zara reserves 85% of in-house production after the season has started, compared to 0-20% for other retailers (Ghemawat 9). This allows Zara to track customer preferences and utilize small batch production to design and manufacture time-sensitive fashion items in the middle of the season.  The pull-based strategy reduces the bullwhip effect because Zara can quickly recover from any design mistakes and meet demand with short lead times. Zara’s centralized distribution system has internal and external orders come into one center to then go out to stores 2x/week. The distribution center works at 50% capacity, making it flexible and able to respond to changes in market demand (Ghemawat 12). The center serves to move items, not hold them, reducing lead time and maintaining low inventories. Additionally, batches are small, so if a certain design fails, Zara can cheaply reverse it since there is “typically no more than two to three weeks of forward cover for any risky item” (Ghemawat 13). The impact can be seen in Zara’s discount sales percentage: only 15-20% of sales are at markdowns compared to 30-40% for competitors (Ghemawat 13-14).   What distribution strategy does Zara employ? What about Zara’s business operations allows this, and what benefits does it offer the company? Are there any examples of diversification or risk pooling inherent in this strategy? Zara relied on both internal and external suppliers to produce their ~11,000 distinct fashion items each year. Since Zara produced significantly more items compared to its key competitors (2,000-4,000 distinct items), it needed to ensure its distribution strategy simplified and minimized the total cost of delivering a product to its destination. Zara decided to allocate all of its production into a central distribution center (Ghemawat 9). From these central distribution centers, Zara directly shipped their products to stores in business-friendly locations. The central distribution centers functioned as coordination points for inventory rather than storage locations. This means that Zara used a cross-docking strategy while completely eliminating the need for storage in warehouses (Ghemawat 9). The constant flow of their products kept inventories low and allowed Zara to continuously pump out products, keeping production at a significantly higher level than any key competitor. The final component of Zara’s distribution strategy was its shipments, which were made to each store from the warehouse twice a week using a third-party delivery service. About three-fourths of Zara’s merchandise was shipped to stores all over Europe using a third-party delivery service’s truck (Ghemawat 12). Truck shipment was significantly less expensive than air shipment, which was the primary alternative.

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Zara managed every part of the production process- design, production, shipment, etc.- while sparingly relying on outsourcing to external suppliers, which means they are vertically integrated. Zara’s vertical integration approach offered numerous benefits. For one, it eliminated any fluctuation in final demand to intensify as it flowed up its supply chain, which is called the bullwhip effect (Ghemawat 9). The more critical benefit was that it significantly reduced the lead time (by ~8-9 months) of creating a design and having completed goods in stores. The short cycle time led to new merchandise continuously being manufactured even during biannual sales periods and less working capital needed per dollar of revenue (Ghemawat 9). The one drawback with Zara’s centralized logistics model was that Zara might encounter diseconomies of scale when scaling its distribution system up even further than it had up to this point. To combat this potential obstacle, Zara began construction of a second major distribution facility in the summer of 2003 in order to increase capacity. Zara’s centralized distribution system ensures that they can effectively risk pool. A centralized distribution center simplifies dealing with demand variability due to the allocation of products in one place. Reallocation of these products during the shipment stage occurred quickly since everything was taken from one place instead of multiple warehouses scrambling to locate products. Zara mitigates its risk through its diverse supplier base. Since Zara’s distribution center funnels both internal and external suppliers into the same place, it inherently diversifies its suppliers and reduces risk.  What are arguments for and against coordination across Inditex’s six retail chains? The sharing of sales & production data between the chains can provide a more complete picture of seasonality and shifts in the market across the variety of locations in which the chains operate. Predictive models are only as accurate as the data upon which they are built, so having more available data only serves to improve each chain’s ability to predict demand and react accordingly. This is particularly true if one chain has a stronger presence in a certain market- their data may be extremely beneficial to a chain that is just beginning to penetrate such a market, and as such, they have less of a presence and less complete data. To some degree, this benefit in penetrating new markets has already been proven by Oysho’s rapid spread (Ghemawat 8). This benefit can be expanded upon by further integrating the companies’ databases. The current “Top-Down” corporate control limits the operational synergies of these chains, and serves simply as a form of “strategic controller” (Ghemawat 7-8). By expanding the central access of data from summary earnings metrics to comprehensive operations and sales data, Inditex can significantly improve the operational efficiency and rapid reactivity of its various retail chains. Coordinating the chains’ supply chains can also benefit Inditex by utilizing each chain’s existing infrastructure for the benefit of the other chains. This would serve to reduce supply chain costs, and reduce the need for high capital investment in new infrastructure, especially for the more nascent chains, such as Oysho (Ghemawat 28). That being said, integrating the chains’ supply chains also leaves all the firms somewhat more vulnerable to failings anywhere along the supply chain. While separate, a breakdown in the supply chain of a firm would be crippling to that particular firm, but the other chains would be unaffected. If integrated, a breakdown anywhere would then have a negative impact on all 6 companies. Despite this, integrating would also lead to natural redundancies in the supply chain, so the overall impact would likely be significantly less severe. From a marketing perspective, increasing the level of association between a “house of brands” leaves all of the brands somewhat more at risk of negative shifts in public perception. Any 3

PR problems for one brand will then spread some level of this negative perception across the other brands. In this sense, isolation of the brands insulates them from the risk of receiving unwarranted negative publicity, thus protecting the brands from unexpected loss of sales outside of their control.  Describe Zara’s downstream markets. How does Zara adjust its marketing, store operations and international expansion strategy to accommodate the peculiarities of these markets? How susceptible are they to new entrants into the market (and does this differ across locations)? Zara downstream markets include its distribution/logistics system and retail stores. It owns a centralized distribution system, which consists of a large facility in Arteixo and smaller satellite centers around South America. All of Zara’s merchandise, from internal and external suppliers, pass through the distribution center in Arteixo. The warehouse is regarded as a place to move merchandise rather than to store it. Shipments from the warehouse are made twice a week to each store via third-party delivery services. Around 75% of Zara’s merchandise is shipped by truck by a third-party delivery service while the remaining 25% are shipped mainly by air. Products are typically delivered within 24–36 hours to stores located in Europe and within 24–48 hours to stores located outside Europe. At stores, merchandise is changed every 3-4 weeks to correspond to the average time between visits. A sense of scarcity is reinforced by small shipments and display shelves that are sparsely stocked. Because Zara has quick turnover on fashion items in its downstream markets, they utilize an international expansion pattern called an oil stain – Zara first opens a flagship store in a major city, and after developing some experience operating locally, they add stores in nearby areas. They use this method because it is cheaper for them to deliver to 67 shops than to one shop and they can increase awareness by having more stores. Moreover, because of higher prices at international stores (due to logistical costs), Zara changes its marketing mix (ie. positioning) to target the upper-middle class. Zara also has a limited marketing budget because of their large operating expenses. In fact, they only spend .3% of its revenue on media advertising, compared with 3-4% for most specialty retailers. Instead of devoting large resources to ads, Zara focuses on word-of-mouth promotion and focuses on making its operations/product turnover more efficient. At the stores themselves, the size, location, and type of store affect the number of employees in it. Because Zara’s downstream operations largely depend on fast fashion turnover and changing trends, store managers decide which merchandise to order and which to discontinue and also transmit customer data and their own sense of inflection points to Zara’s design teams. This allows design teams to quickly get direct feedback on what’s in style and make changes accordingly. Because store managers are so important, Zara invests heavily in training programs to help employees that are promoted and pays a salary based partially on performance. The commercial team at Zara conducts both macro and micro analysis when entering a new market– they look at sector-specific information about local demand, channels, available store locations, and competitors. The competitive information that is gathered includes data on levels of concentration, the format that would compete most directly with Zara, and their potential political or legal ability to resist/retard entry. Although unforeseen competitors could arise, Zara has built out one of the best vertical supply chains for “fast fashion” - something that smaller companies cannot compete with. If entrants are competing with Zara directly on price and rotating fashion, they will probably not be able to catch up. However, in the case that fashion trends or large 4

socioeconomic change happens (ie. people focus on higher quality clothing and not on runway clothing), Zara may be susceptible to new entrants in the market. In regards to international markets, Zara is more susceptible to competition because of longer lead times (ie. it takes time to ship clothing to the US), higher prices in foreign markets, and lack of cultural awareness. International stores that Zara franchises to are at more risk than stores it manages itself. Identify another company or business (aside from those mentioned in the case) that could benefit by adopting some or all of Zara’s business practices. Support your argument with facts and figures from the text, as well as articles from another reputable source (for facts on the other company). Although Zara’s business practices have created the reputable brand that we know today, these strategies don’t necessarily apply to all companies. For example, Zara must emphasize efficiency and control over its supply chain to account for the whimsical demand of the fashion industry, while other companies outside the fashion industry can increase scale and pay less attention to lead times. However, Zara’s strategies can potentially aid one struggling luxury fashion company - Ralph Lauren Corporation.  Ralph Lauren has experienced a large decline in performance in previous years, primarily due to an excess of unproductive stores, inefficient inventory management, and short production cycles. According to Forbes article, “What are the Challenges Facing Ralph Lauren,” lead times are an average of 15 months, leading to a mismatch of supply and demand. On the other hand, Zara’s vertical integration effect “helped reduce the bullwhip effect” and allowed them to have “finished goods in stores within four to five weeks” (Ghemawat 9). Zara practiced increased control over its supply chain and accomplished this due to its central distribution and pull-based system. Meanwhile, Forbes claims that Ralph Lauren has an “absence of centralized inventory control and optimization.” Furthermore, mismanagement of inventory has “driven up discounting” and increased transfer of products to outlets and off-price stores. If Ralph Lauren were to shift its strategies to match those of Zara’s, it could potentially experience Zara’s impressive “15-20% of sales at markdowns compared to 30-40% for competitors (Ghemawat 13-14). Zara enabled this by ensuring that the distribution center works at 50% capacity, maintaining low inventories and small batches to respond quicker to failed products and demand shifts. Finally, Ralph Lauren has struggled with marketing, spending too many resources on branding and diluting the marketing resources. According to Forbes, 65% of the styles are considered unproductive, and there’s not enough focus on core brand strength. Meanwhile, Inditex has practiced isolation of its six brands to counteract the risk of negative publicity. Ralph Lauren could adopt this branding strategy and mimic Zara’s minimized expenditures of 0.3% on media advertising, instead focusing on increasing the operational efficiency and product turnover to account for the high turnover on fashion items in its downstream markets.  Forbes Article: https://www.forbes.com/sites/greatspeculations/2016/06/14/what-are-the-challenges-facing-ralp h-lauren/#322199d610a1  

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