A transaction cost analysis of the apparel industry

The gradual integration of global economic markets bears many challenges for companies which continuously attempt to adjust to changes in their business environment in providing value to customers. In many industries – and in particular the apparel industry – the supply chain’s through which firms operate have become increasingly dispersed and global (Gereffi, 1999). With post crisis consumer spending still unstable and cotton prices [1] having increased by more than 160% since March 2010 (see figure 2 in Appendix E) apparel retailers see their margins eroding. Simultaneously, short product life cycles, volatile consumer preferences and fierce competition on price and quality through an increased availability of low cost manufacturing [2] make it difficult for retailers to sustain a competitive advantage. Since the 1990’s, many retailers have shifted “the arena of competition to timing and know-how” – or simply put on supply chain management – in trying to reduce the risk of markdowns, stock-outs and high inventory levels inherent in the supply chain (Hammond & Kelly, 1991, p. 1; Richardson, 1996, pp. 400-401).

It is a general opinion that it would be optimal – in terms of cost and flexibility – for retailers to source apparel from independent suppliers – likely in low-cost countries. This seems to be valid for the mom-and-pop stores around the corner as well as for two of the world’s largest apparel retailers The Gap and H&M. At the same time, we see Zara and Benetton who partially produce merchandise at company-owned factories located in Spain and Italy, Eastern Europe, Tunisia, India respectively. This is striking for two reasons: one, the production cost in Europe are higher than in most East Asian economies [3] towards where much of global apparel manufacturing has shifted (Gereffi, 1999). Second, vertical integration is perceived to be a burden in an environment that requires a high degree of operational flexibility (Richardson, 1996). So why is it that those firms “break with the rule of contracting out all production” (CNN.com, 2001) that has developed over the past decades?

In this paper, I will analyze the motives and strategies that determine a retailer’s sourcing decision. Although the sourcing strategy defines both, the location and the organizational entity [4] , the focus of this composition is to explain why H&M and Gap outsource production while Zara and Benetton are vertically integrated into apparel manufacturing. In explaining vertical integration economic theory has considered different aspects: the neoclassical theory turns to efforts of firms “to mitigate inefficiencies caused by market power […] or enhance market power” within the vertical chain (Joskow, 2006, p. 1). From an organizational perspective, the approach adopted here, transaction cost economics (TCE) ties production, coordination and motivation costs to the various forms of organizations economic agents attempt to minimize.

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I will explain the basic trade-off underlying the decision of vertical integration, review the origins of TCE and introduce a framework by Oliver Williamson. Williamson’s framework focuses on measuring the risk of opportunistic behaviour The analysis of the apparel industry shows that the risk of expropriation is mainly driven by the

Sourcing has become a central process in the context of coroporate functions (guericini)

Fashion industry shows different approaches

To be analyzed in terms of efficiency and transaction costs

Is there an optimal governance structure

How have they changed over time

What are the implications and drawbacks to the theory

How will this be in the future

Using case studies

Implications for validity of TC

Is it a matter of choice or a matter of searching for the unique best way?

Vertical integration and its determinants

Vertical integration and the “make or buy” trade-off

A vertically integrated firm performs subsequent steps along its vertical chain – defined as the process that begins with the acquisition of raw materials and ends with a sale (Besanko, Dranove, & Shanley, 2000, p. 109) – internally. Those internally performed activities define the vertical boundary of a firm. The vertical chain in the apparel industry is illustrated in Figure 1 and described in more detail in Appendix D.

Figure : The vertical chain in the apparel industry

Source: self-made diagram, based on Besanko et al. (2000) and Milgrom & Roberts (1992)

In mapping a firm’s boundary a useful criterion is the degree of flexibility and authority of a firm to make investments, product-mix and employment decisions at the relevant stage (Richardson, 1996, p. 403). This is in line with Hart & Grossmann (1986) who define “a firm to consist of those assets that it owns or over which it has control”. The choice of performing an activity inside the firm is often called a “make or buy” decision. At the extreme end of buying an input, parties use “anonymous market contracting” (Joskow P. J., 1988, p. 101) and may not engages in further transactions. Contrary, vertical integration substitutes the contractual exchange through an internal process. For further use the form of organizing a transaction is called “governance structure”.

In determining the optimal governance structure organizational based theories help to link respective costs and benefits of organizing a transaction. According to TCE a firm must weigh technical, coordination and motivation cost in defining its vertical boundaries. A firm operates technically efficient if it is using a cost-minimizing production process. This can be achieved through making investments in technology and engineering or sourcing from external suppliers who are specialized on the production of that input. Organizational efficiency refers to the minimization of coordination, motivation costs and the risk of opportunistic behaviour (Besanko, Dranove, & Shanley, 2000). Through vertical integration a firm benefits from the authority to settle conflicts, control over the production and information process as well as stronger team incentives. Potential costs of vertical integration arise from a lack of competitive pressure and thus a potential lack of innovation, lower economies of scale in production, more bureaucracy, the risk of bad management decisions [5] leading to tied resources in possibly inefficient processes and coordination efforts to align interests among business divisions. The market has benefits from competitive pressure on the firms operating in the market, economies of scale facilitated by the possibility of demand pooling, technological efficiency since firms are specialists and the possibility of freely choosing a supplier. Costs of a market transaction are higher coordination efforts, misaligned incentives between trading parties and inefficiencies arising from opportunistic behaviour (Besanko, Dranove, & Shanley, 2000; Perry, 1989; Milgrom & Roberts, 1992: Joskow, 2006).

According to Ronald Coase and Oliver Williamson – considered to be the pioneers in the field of TCE – the main determinant causing frictions between parties involved in a transaction is the risk of expropriation by trading parties. In the next section I will review their work in the field of TCE and introduce Williamson’s framework which I will use in section 5 to analyze the apparel industry.

Williamson’s transaction cost framework

The origin of transaction cost economics

Ronald Coase’s motivation was to explain why firms would obtain a product from the market when it can produce the product itself. Coase saw the mechanisms for allocating resources as substitutes He criticized the view that resource allocation through the market “works itself” (Coase, 1937, p. 387) and the lacking concept for the existence of firms ince he saw the different resource allocation mechanisms as substitutes, not as complements. Coase focused on the exchange mechanism of a good, a transaction, which can either occur in the market or within a firm. His main contribution was the incorporation of costs linked to organizing a transaction into the analysis of vertical integration (Coase, 1988b, p. 17).

The comparative costs of organizing a transaction would determine the optimal governance structure. First, when organizing a transaction in the market a firm has to bear search cost in looking for relevant suppliers and prices. Negotiating over the terms of exchange and writing contracts – particularly when dealing with several suppliers and multiple transactions – bear cost. These “marketing costs” eventually become larger than the costs of coordinating transactions internally (Coase, 1937, pp. 390-391). Second, Coase identified costs corresponding to “diminishing returns to management” (Coase, 1937, p. 395). With an increasing number of transaction organized within the firm, the entrepreneur struggles to allocate resources to projects with highest payoffs. Simply put, the internal organization bears the cost of bureaucracy that must be weighed against transaction costs. Consequently, a firm expands its vertical scope until the costs of using the market equal the cost of internal organization.

The framework

Oliver Williamson, Oliver Hart and other economists used the insight that firms are economizing on the sum of “production and transaction costs” (Williamson O. , 1979, p. 245) and expanded this notion to a context where organizations adapt efficiently to “the ever-changing circumstances of the moment” (Hayek, 1945, p. 523). They focused on opportunistic behaviour and its effects on ex ante incentives and ex post performance as the main determinant for vertical integration whereas Coase saw “ink costs” (Klein & Murphy, 1997, p. 419) arising from searching a price and writing a contract as the limiting force on the use of the market (Joskow P. J., 2006, pp. 2-3). In understanding opportunistic behaviour it helps to illustrate the definition of “appropriable quasi rents” by Klein, Crawford & Alchian (1978): “The quasi-rent value of the asset is the excess of its value over […] its value in its next best use to another renter”: assume firm A owns a production asset and provides B with a service at a price of € 5,000 (B’s maximum willingness to pay). Assume that a third firm C with a maximum willingness to pay of € 3,500 is also interested in obtaining the service from A. Now, firm B would try to lower the price down to € 3,500 by threatening to terminate the relationship with A. The price difference of € 1,500 is the appropriable portion of the quasi rent that firm B will try to extract from A [6] (Klein, Crawford, & Alchian, 1978, p. 298). This is a simplistic example for the hold-up risk that can arise in a market transaction.

The presence of opportunistic behaviour relies on two behavioural assumptions. First, economic agents are simultaneously subject to bounded rationality [7] . Agents are incapable to consider and specify all contingencies that might arise after engaging in a contractual relationship. As a result, incomplete contracts are the first best results. At the same time, it might be too costly for the two parties to write a contract specifying all foreseeable contingencies since ex post alterations would be costly. The second assumption is that agents behave opportunistically and try to extract a maximum of rents from their trading partners (Williamson O. E., 1981, pp. 553-554)

Williamson developed a framework which explains a firm’s governance structure “based on variations in the importance of asset specificity, uncertainty, product complexity, and the constraints of repeat purchase activity” (Joskow P. J., 1988, p. 101). These attributes measure the risk of opportunistic behaviour in a trading relationship. Asset specificity measures the difference between the value of an asset in its pre-specified use and in its next best use outside the trading relation. It basically indicates whether there are “large fixed investments […that are] specialized to a particular transaction” (Williamson O. E., 1981, p. 555). An asset which has been modified and designed for a particular transaction leads to a lower outside value of the asset, creates higher appropriable rents and hence leaves more room for ex post opportunism [8] . This is what Williamson called physical asset specificity.

Site specificity deals with the mobility aspects of an asset. Once an asset has been positioned and installed there are costs of modification or removal. The trading partners try to economize on “inventory and transportation expenses” when “successive stations are located in a cheek-by-jowl relation to each other” (Williamson O. E., 1981, p. 555) [9] . Last, human asset specificity arises when workers develop knowledge which is idiosyncratic to a transaction. Williamson calls this “training and learning-by-doing economies” (Williamson O. , 1979, p. 240) . Thus, with an increasing degree of relationship-specific attributes of a transaction, it becomes more costly for trading parties to terminate their relationship such that they are locked-in to the transaction (Williamson O. E., 1981, p. 555). Hence a firm might want to protect itself from opportunistic behaviour by vertically integrating.

Of the other transactional attributes, complexity and uncertainty work in the same direction as asset specificity whereas frequency puts a constraint on the degree of vertical integration that a firm might choose. A transaction might simply occur too seldom that the cost of setting up a governance structure is greater than the risk of using the market. To review, the transaction cost framework predicts that with an increasing asset specificity, complexity and uncertainty, the optimal governance structure will move from a spot market transaction, to an intermediate solution and finally to vertical integration [10] . (ZITATE?? Raus??)

Methodology, value, implications and limitations

In this paper I am using TCE to analyse the trade-off between differing governance structures of four companies in apparel retailing by using a qualitative approach to measure the different dimensions of a transaction. I have dismissed the neoclassical theory in analyzing the apparel industry since it defines vertical integration as a strategic response to market imperfections [11] treating firms like a “black box” (Hart, 1988, p. 120). The empirics of the neoclassical theory are hence more concerned with the effects of vertical integration on consumer prices and welfare. In contrast, this paper is concerned with the motives and strategic concerns that determine the form of organizing manufacturing in the light of TAC.

The value of this paper is the linking the TCE framework to four case studies – Zara, H&M, Gap, Inc. and the Benetton Group. It is useful to analyze a firm’s governance structure in terms of the control and authority borne by the two parties involved in the transaction at hand. The degree of vertical integration is reflected by the ownership and control of assets in successive stages (Richardson, 1996, p. 403).

The sample has been designed to characterize the differing governance structures in apparel manufacturing. From the four companies studied in this paper Gap and H&M source all garments from independent suppliers. Zara and Benetton on the other hand purchase semi-finished products and manufacturing services like cutting and sewing which are integrated with the firm’s manufacturing capabilities (they produce 40% and 60% of apparel internally). Given the fact that each of the four companies has been in business for more than 30 years, built a strong global presence and managed to gain substantial profits throughout many years [12] it is appropriate to say with confidence that they are managing their operations through an effective governance structure. Thus, the main question that arises is what factors determine the decision for each firm’s governance structure. By mapping the firm’s business with the sourcing strategy I will show that a proper TAC analysis must consider those interdependencies in order to have valid implications.

In gathering data on the apparel industry and the case studies articles from business press, annual reports and other publicly available information provided by the firms [13] , company reports from investment banks, business cases from Harvard Business Review and academic research papers have been used as primary sources. I attempt to present the information on the cases in a consistent format whereas there are some differences due to the availability of information. It is for example not clear what the “strategic activities” are that Benetton keeps in-house (Benetton Group, 2011). In applying the TAC framework I have used this information and extended the analysis with my own evaluation – if procurable – on the different dimensions of the transaction (discussin Scott?).

Primary data, possibly gathered through interviews with the retailer’s production offices, were not collected but would add additional value to analysing the relationship between the apparel retailers and the manufacturers. This would help to understand how retailers manage their supplier relationships, how they negotiate over contracts and how they deal with contingencies that are not pre-specified in product orders. Such information would help to evaluate the degree to which relationship-specific investments occur in the apparel industry and – consequently – how the different dimensions of a transaction differ across and within firms. In particular, the potential hold-up risk created by the adversarial relationship between suppliers and manufacturers, would be easier to quantify.

Whereas I am using a qualitative approach to examining the relevance of relationship-specific assets in apparel manufacturing there is much empirical work – based on case studies and econometric analysis – devoted to the relevance of transaction costs. Scholars have managed to quantify the transaction attributes of asset specificity, complexity and contractual difficulties. Joskow (1987) for example provides evidence for the US coal industry that higher relation-specific investments encourage longer commitments of buyers and sellers to the terms of future trades. In general the “the empirical results are much more consistently supportive” for TCE (Joskow P. J., 2006, p. 27) than for the neoclassical theory on vertical integration.

Case studies from the apparel industry

In this section I am going to describe the cases of Zara, H&M, Gap Inc. and Benetton – trailblazers of “fast fashion” – operating in the middle priced casual apparel segment. The four firms accounted combined for approximately 3.0% of global revenues in 2010 [14] . All companies are close competitors but have positioned themselves differently with respect to vertical scope in manufacturing and in terms of pricing and fashion content [15] . I am going to describe each firm’s governance structure and coordinating mechanisms with manufacturers, background information on the apparel industry, the idea of fast fashion and the firms studied can be found in Appendix D.

Gap’s governance structure and coordination with manufacturers

The group controls design, merchandise, distribution, marketing and retailing of its own brands and also sells products branded by third parties. The group purchases all garments – private and non-private label – from independent vendors with approximately 700 factories in 50 countries [16] . In terms of costs 98% of merchandise is produced outside the US with South/ Southeast Asia representing approximately 50% of the factory base [17] (The Gap Inc, 2008a). Overall no vendor accounted for more than 3% in 2010. The firm’s sourcing and logistic group along with buying agents coordinates with vendors around the world and place orders. After the clothes are manufactured they are sent to the firm’s distribution centers [18] where the firm conducts quality audits (Wells & Raabe, 2006, p. 21). The firm manages its vertical chain with lead times [19] of 3 to 8 months. (Quelle?)

Since the 1990’s and particularly after the ATC expired in 2005 the group has increased efforts in building long-term relationships with suppliers attempting to get discounts and extend the sharing of planning and forecasting information through aligned IT systems at strategically-located factories (Wells & Raabe, 2006, p.12; Guericini & Runfola 2004, p. 311). To facilitate coordination the group pursues a factory engagement strategy [20] : factories need to get the firm’s approval based on quality, price and delivery time [21] , factories are closely monitored [22] to ensure they act according to the legal, social and environmental standards outlined in the COVC, the social performance of factories is evaluated such that problems can be resolved and factories are supported with building compliant and operationally effective management systems. The attention devoted by Gap to each factory depends on the specific requirements. Recently, the firm started to support factories with developing human resource management systems. Repeated violation of the firm’s standards may lead to a termination of the supplier relationship but is attempted to be avoided by Gap [23] . Seldom, the firm issues conditional approval to a factory in case of a short-notice order.

Benetton’s governance structure and coordination with manufacturers

The Benetton group operates through a sequential and integrated supply chain covering the steps from design, R&D, manufacturing, distribution and sales [24] . This approach is to balance efficiency with speed and is planned and coordinated from headquarters by the product department. For roughly 50% of its production Benetton uses a vertically integrated manufacturing model keeping “automated and strategic” activities in-house and outsourcing labour-intensive tasks [25] to SMEs (Benetton Group, 2011).

Each plant is specialized in one type of product and control, integrate and coordinate the production activities of contractors leveraging [26] their “network of skills” (Benetton Group, 2005). In order to adjust production to demand, Benetton had developed a process where the dyeing of the garment was postponed after manufacture. The firm further engages in full production cycles and controls parts of its upstream processes through a subsidiary [27] . The remaining 50% of merchandise are sourced from external suppliers with whom the firm coordinates through localized production offices [28] . Finished garments are distributed centrally through the firm’s logistic hubs [29] . Benetton runs operations with lead times of two weeks for continuative articles and up to four months for newly designed garments.

Through providing “production planning support, technical assistance to maintain quality” and “financial assistance to procure […] machinery” the group built close relationships with its approximately 200 contractors. This enables the group to smoothly coordinate the contractor’s activities into the production process. The group audited the compliance with the group’s code of ethics [30] of 200 suppliers but did not enter formal contracts with suppliers since “this was not felt by either party” (Indu, 2008a, p. 4).

Postponement strategy?

H&M’s governance structure and coordination with manufacturers

H&M operates in product research, design, merchandise, distribution and retailing. Product development and procurement is managed through the central buying office in Stockholm which coordinates with merchants at 16 production offices in Asia and Europe. Merchants – for the most part drawn from the local population – manage the interface with the 700 independent suppliers which produce all of H&M’s garments in around 2,700 production units in Asia and Europe [31] (H&M, 2011). According to estimates, around one third of production is done in China, one third in residual Asia (e.g. Bangladesh) and one third in Europe (particularly Turkey) (just-style.com, 2011; Indu, 2008b; Guericini & Runfola, 2004). Finished garments are shipped to the central warehouse in Germany or one of the distribution centres. H&M operates with lead times between twenty days and several months.

The production offices keep in regular contact with suppliers, identify new suppliers, place orders and are responsible for monitoring supplier’s compliance with the COC. Throughout an auditing cycle H&M scores the supplier’s management systems [32] aimed at preventing violations of the COC (H&M, 2010a). When placing an order, buyers balance the factors quality, price, lead time and location of the supplier [33] (H&M, 2011). To ensure quality H&M carries out extensive testing [34] at the factories and after delivery. Order for high volume basic items were placed about six months in advance while “in vogue” garments are designed, produced and sold within just a few weeks (Indu, 2008b). For the latter, proximity of the manufacturer to sales market was the prime consideration, but overall the firm focused on producing at low cost (Indu, 2008b).

H&M audits its suppliers compliance to the firm’s COC, helps to implement corrective actions, provides training and engages in knowledge sharing. The firm meets with suppliers to discuss their evaluation and attempts to minimise late changes on product orders by establishing capacity plans and purchasing orders where possible – most relevant for its key suppliers [35] . H&M attempts to contribute to the long-term improvement of its suppliers but may terminate its relation in the case of continued non-compliance but – in that case – commits to a reasonable phase-out period (H&M, 2010a).

Zara’s governance structure and coordination with manufacturers

The business model of Zara [36] is characterized by an integrated approach covering the design, manufacturing, distribution and retailing of apparel (Inditex, 2010). This allows the firm to adjust production to demand observed in stores and achieve lead times of minimum two weeks. Zara produces time-sensitive items at a dozen manufacturing subsidiaries in Spain – estimated at 50% of total production [37] – or with suppliers “whose processes are […] integrated with the group’s dynamics” (Tokatli, 2008, p. 34) located close to the firm’s distribution centre. Basic items tend to be outsourced mainly to Asia where – back in 2006 – 20 suppliers accounted for 70% of external purchase. Zara maintains relationships with 1,237 suppliers [38] managed through purchasing offices in Spain and Hong Kong attempting to minimize formal commitments (Ghemawat & Nueno, 2006, p. 11).

Zara operates automated and capital intensive tasks, specialized by garment type, of pattern design, cutting and finishing while outsourcing labour-intensive tasks to workshops in Northern Spain or Portugal. Those workshops have long-term relationships with Zara who provides them with technology, logistics and financial support (Ghemawat & Nueno, 2006, p. 11). Roughly 85% of in-house production is done during the selling season and the firm may leave open production capacity for short notice orders or changes, limits production runs and strictly controls inventory (Ghemawat & Nueno, 2006). Upstream, half of the fabric is purchased by a Spanish subsidiary as “gray” allowing in-season changes of production (Ghemawat & Nueno, 2006, pp. 10-11). All clothes are distributed through the firm’s distribution centre in Spain.

Both, internal and external suppliers are re