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.

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 required to accept and obey the respective [39] COC which regulate the relationship with Zara (Inditex, 2009a). The COC is a formal declaration resting upon the principles of the Human Rights Declarations and the ILO. Through its compliance program Zara assesses the supplier’s COC compliance, conformity to health and safety protocols, quality, ability to deliver and prices. After an initial audit Zara rates suppliers, develops a plan for corrective actions in collaboration with factory managers and continuously verifies the implementation through monitoring audits [40] . In order to maintain “selective and lasting relationship with its suppliers” (Inditex, 2009a, p. 83) Zara clusters suppliers in geographically strategic areas into working groups [41] which help suppliers strengthen its business relationships. In 2009 Zara ruled out 145 suppliers for breaches of the COC or commercial reasons.

Transaction cost applied

In this section am using Williamson’s to evaluate the risk of opportunistic behaviour in the apparel industry to determine the optimal governance structure with regards to apparel manufacturing. Having described the governance structures of Gap, UCB, H&M and Zara the main question that arises is whether TCE justifies the differences. In section 6 I will discuss the interdependency between the business and sourcing strategy of retailers, its implications for TAC and the linkages through which retailers coordinate with suppliers.

Apparel manufacturing does not require investments in specialized production assets. The equipment and technology – such as cutting and sewing machines – is standardized, fairly stable and thus at low risk of obsolescence. This applies to modern, computer-aided machinery just as well to machinery of obsolete technology. Hence, production assets can be used for manufacturing apparel for other companies outside a specific transaction. Overall, the possibility of divesting or reorganizing the assets leads to a low risk of opportunistic behaviour (Richardson, 1996, p. 404). This holds since the four firms studied do product development and design their own not having to rely on the manufacturer’s development capabilities. However, the production of “fast-moving, flagship products of the retailer” often requires – compared to simple apparel products like underwear – “high levels of technology and engineering capabilities manufacturers usually keep proprietary and frequently undergo major innovations” (Prakash, Wetherbe, & Janz, 2006, p. 49).

Site specificity measures the risk of utilizing immobile assets. Production assets in apparel manufacturing can be easily removed – except for the factory – although it would be costly to actually displace the equipment. As retailers shifted their focus to reduce lead times the factory location matters with respect to transportation time and costs. Due to a strong fragmentation in global apparel manufacturing parties will unlikely be locked in “a cheek-by-jowl relation” (Joskow, 2006, p. 20).

Human asset specificity measures the amount of relation-specific knowledge required in the production process. Apparel manufacturing is characterized by high labour-intensity despite efforts in substituting capital for labour (Ghemawat & Nueno, 2006, p. 2). The skills in operating a cutting machine or sewing bundles of garments are not transaction-specific. Workers could easily produce apparel of a different style or for a different company. An “increasing availability and quality of factories in the Far East […] which were previously only available from European suppliers” (Just-Style Global News, 2010) further reduces the risk of opportunism by suppliers. However, there may be tendencies towards “mutual adaptation and mutual orientation” […] leading to situations of integration among the actors” (Guericini & Runfola, 2004, p. 309). This is facilitated by retailer’s efforts in supporting suppliers with capability building with regards to quality and compliance [42] . However, establishing long-term relationships and promoting good practice of suppliers (H&M, 2010a) allows retailers to manage the risk of opportunism. Further, a harmonization of compliance and quality standards leads to a lower specificity of human assets in this respect.

Retailers are exposed to great uncertainty in demand when creating new styles and planning production. Despite the implementation of fast fashion techniques and closer ties between operations this remains a big operational risk. In particular, when there is an increase in demand “there can be no assurance that additional manufacturing capacity will be available when required” (The Gap Inc, 2009, p. 11). This may lead to time-consuming interruptions in supply and a loss of potential profits. More important, the time-sensitivity of retailer’s flagship product let the design and sales planning quickly become obsolete leading to a strong interdependency among tasks (Prakash, Wetherbe, & Janz, 2006). To faster manage the supply chain retailers make invest to align the infrastructural links and are potentially exposed to opportunism by the supplier.

Second, cases of child labour, deaths in factory fires and similar incidents becoming public [43] have forced retailers “to clean up their supply chains” (Inditex, 2009a, p. 68). All four firms conduct compliance programs, support suppliers to implement corrective actions and monitor them thereafter. Inditex and H&M [44] for example report that suppliers improved compliance scores in the past years. This documents that manufacturers have an incentive to commit to compliance in order to sustain a stable relation with retailers. Retailers on the other side promote good practice and invest in building supplier’s management capacity to strengthen the relation. Since the firms studied pursue similar approaches in dealing with compliance and support suppliers in capability building this conclusion can possibly drawn for all four firms. At the same time it is important to point out that retailers monitor suppliers’ compliance closely knowing from “experience that what gets monitored gets managed” (The Gap Inc, 2008a, p. 27).

The inherent uncertainty about demand and short life cycles inevitably lead to an “elevated degree of complexity” in which retailer and manufacturers operate (Guericini & Runfola, 2004, p. 306). Despite the potential risk of forecast errors and more subsequent product introductions by retailers the content of a transaction is easy to define. When a garment is designed, suppliers are asked to provide samples – as fast as within 24 hours in the case of H&M (Indu, 2008b, p. 6). Job description orders specify a clear and structured approach to task execution. Contract negotiations about delivery scheduling, quality monitoring and inventory follow established procedures. Similar to above, an increasing complexity in the design and planning process flag-ship products exposes retailers to opportunism (Prakash, Wetherbe, & Janz, 2006, pp. 48-53).

Last, the iterative nature of the transaction does not constrain the firms in setting up an internal governance structure at the manufacturing stage. The Benetton Group for example produced more than 150 million garments in 2010 (Benetton Group, 2011).

The TCE analysis shows that the risk of opportunism varies with the characteristics of the product at hand. For apparel that is easy to plan in advance and requires little customization the transaction between manufacturing and retailing bears low risk of opportunistic behaviour and should be produced by independent suppliers. Potential issues arising from asset specificity, complexity and uncertainty appear to be resolved through long-term relationships with suppliers in which retailers engage in capability building and extensive monitoring procedures. For time sensitive products, increasing transaction cost arising from relationship-specific investments by retailers, greater complexity and uncertainty, the repercussive effects on the supply chain must carefully be assessed.

Discussion

Last, I will discuss each firm’s motives and strategies in defining its boundaries to validate the theory on TCE. I will use insights from the analysis and examine the interdependencies between the business and sourcing strategy with its implications for the comparative costs of organizing apparel manufacturing.

In the context of analyzing vertical relationships it is worth introducing the notion of self-enforcement mechanisms in. Parties that engage in a trading relationship may intentionally not specify all ex ante known contingencies in a contract to avoid the costs of altering the contract. This gives parties the flexibility to adjust the terms and conditions of their arrangement. The symmetrical possibility for parties to detect non-performance allows imposing a threat to terminate the relationship. The potential loss of future rents is going to assure performance, i.e. a “self-enforcing mechanism”, as long as the costs of being sanctioned for non-performance are larger than the benefits. This also applies to transactions in which relationship-specific investments are important to a certain degree. Basically, trading parties establish a relationship based on mutual trust and cooperation where the contract terms allow to “economize on reputational capital” (Klein & Murphy, 1997, pp. 416-420).

As discussed above, the transaction of organizing production for standardized apparel bears little risk of opportunistic behaviour. This allows retailers to focus on the cost component while both parties benefit from aligned incentives. As a consequence, retailers tend to outsource production of such items to low-cost countries. They place orders several months in advance of the season choosing from the suppliers offering the right balance between quality, price and delivery such that manufacturers benefit from secured capacity and planning reliability. The scope of the transaction is easy to define and task execution follows established procedures. Investments made by retailers in supporting manufacturers with achieving compliance or in supply chain links are relationship specific to some degree but help to sustain a stable relationship. Further, the localization of buying offices and employing local agents – as for H&M – helps to manage the costs of continuous communication with suppliers.

All firms studied emphasize the importance of establishing long-term relationships with their suppliers. Both parties, producers and retailers, can easily switch to alternative sources of supply but mutual cooperative behaviour and knowledge about the partner’s capabilities increase the value of collaboration. For example, Benetton and Zara do not formally commit to their external suppliers allowing them to flexibly choose the best supplier when placing an order. However, suppliers benefit from the retailer’s engagement and value the relationship. This has increasingly become important since the termination of ATC as Nick Cullen, Chief Supply Chain Officer of Gap, pointed out in 2005 (Wells & Raabe, 2006):

In the past, quota required that we spread our sourcing […] and in some ways our size was actually a disadvantage. We were forced to diversify and fragment our spend, and were limited [in] our ability to grow relationships with the best vendors. Our focus was diffused. Now we’re free to pursue strategic long-term partnerships

Such partnerships and a consolidation of vendor count would help the firm to reduce costs, improve the processes and increase efficiency and productivity (Wells & Raabe, 2006, p. 12). This supports the general notion that technical efficiency can be achieved by sourcing apparel from an independent supplier.

Downstream, Zara replenishes store inventory within four weeks with deliveries arriving two to six times a week. The underlying motivation is to continuously introduce new products at lower volume – up to 20,000 distinct items per year [45] (Businessweek, 2006) – complementing the two basic collections:

The vertical integration of the transactions allows cutting the manufacturing and delivery terms as well as reducing the stock volume, while the reaction capacity that allows the introduction of new products throughout the season, is kept. (Inditex, 2009a, p. 269)

Control over the manufacturing process as much as the integration and harmonization with the firm’s centralized distribution and sales process [46] allows Zara to implement this strategy. Interestingly, this strategy was driven by Zara’s founder and Inditex’ long-time executive, Amancio Ortega [47] , who had learned “the value of controlling all steps of the production and distribution process” (The Independent, 2011a) by having “five fingers touching the factory and five fingers touching the customer” (Tokatli, 2008, p. 22).

By limiting production runs, “running factories for only one shift” and a strict control of inventory Zara does not produce efficiently but “clearly values global responsiveness more than efficiency” (Tokatli, 2008, p. 31). This is in line with the transaction cost analysis: by integrating the production of its fashionable and time-sensitive Zara benefits from the investments in its information and distribution infrastructure producing nearby, avoids potential hold-up risks of a market transaction and solves the motivation conflict – manufacturers prefer working with forward order books – by retaining control. Simply put, the gains from flexibility allowing the firm to adjust supply to consumer’s demand and a reduced hold-up risk are greater than the cost of non-efficient production.

By outsourcing the “scale-insensitive activity of sewing” (Ghemawat & Nueno, 2006, p. 11) to workshops in Northern Spain and Portugal Zara benefits from their specialization by product type, relatively cheap and productive labour (data??) and the proximity to its production facilities and distribution centre. In many cases, Zara accounted for most of the workshop’s production, kept long-term relations with them and provided “technology, logistics, and financial support” (Ghemawat & Nueno, 2006, p. 11). This way, Zara managed the potential risk of being held-up by a workshop – despite having strong bargaining power as the largest buyer – in case of an urgent order: by securing their capacity and providing long-term support on business operations Zara nurtured a cooperative relationship.

Through its integrated business model Zara appears to have an advantage over its competitors in achieving lower lead times, less markdowns and lower inventories-to-sales ratio [48] . And yet, H&M – considerably Zara’s closest competitor in terms of pricing, lead-times and with a similar dedication to offering fashionable products – who is not vertically integrated into manufacturing recorded higher income margins over the years [49] .

The key differences between the firms are, from my point of view, a different product position and a diverging perception on the value of organizing manufacturing through the market. H&M pursues an aggressive pricing strategy [50] – prices were in the past 30 to 50% cheaper than Zara’s (Indu, 2008b) – whilst offering apparel of inferior quality. The firm’s main target was to achieve cost efficiency. With 60% of apparel produced in Asia, the firm accepted longer lead times in order to maintain its low-cost position. Trendy and time-sensitive items were sourced from Europe and Turkey owing to the proximity to the firm’s largest sales markets Europe and Nordic countries (Indu, 2008b) [51] .

This two-tier approach allows H&M to flexibly adapt its sourcing approach to the criteria price, quality and delivery time as desired. Put differently, H&M focuses on a different set of core competencies – design, distribution and retail of apparel – clearly profiting from outsourcing manufacturing. Potential transaction costs are managed through a “commitment to good communication” towards suppliers, supplier auditing, quality controls, rewarding “responsible partners” and long-term relationships (H&M, 2010a, pp. 52-54).

As described, Benetton is vertically integrated into apparel manufacturing and further upstream activities in the textile and raw material sector. The key components of the firm’s manufacturing model are a “networked manufacturing system” (Kong and Allan Consulting, 2007) and the postponement strategy. By supervising the various production steps Benetton can “leverage the best industrial capabilities, use the most appropriate production techniques and ensure rapid response times (and) product quality” (Benetton Group, 2005). In other words, specialization and a clear division of tasks within production networks allow the firm to exploit technical efficiencies and ensure “proper resource utilization” (Kong and Allan Consulting, 2007). Coordination with and among contractors

Overall, Zara’s strategy to integrate into manufacturing can be explained by the motives to avoid the risk factors inherent in the apparel industry, full internalization of investments in specialized production technology and infrastructure and control over production capacity, design changes and distribution.

Risk. A firm can reduce its risk by buying components from external suppliers rather than making them in-house because it avoids a potential situation whereby its investment does not earn an adequate rate of return.

Investments in Facilities, Technology, and People. Buying from external suppliers lowers a firm’s level of investment because, since the firm does not have to build a new factory or learn a new technology, a firm can free up capital for other uses. The text provides an example of how Honda capitalized on this type of situation.

Flexibility. A firm that buys from external suppliers has the flexibility to switch suppliers as circumstances warrant it. This flexibility is particularly important in situations where technology is rapidly changing or where inflation or exchange-rate costs are a factor.

Control. A firm that makes an input in-house increases its control over product quality, delivery schedules, design changes, and cost, as compared to a firm that buys from outside sources. Moreover, the decision to make-or-buy may be influenced by the firm’s ability to write an enforceable contract. The text notes that in countries where laws protecting intellectual property are weak, many firms prefer to make rather than buy inputs.

Conclusion

Transaction cost economics is a useful tool in determining the motives and driver affecting a firm’s governance structure. In assessing the comparative costs and benefits between vertical integration and a contractual, bilateral relationship TCE allows firms to understand the main constraints linked to the various organizational forms it can choose. In analysing the apparel industry I have shown that the risk of opportunistic behaviour is generally

Yet, in applying the transaction cost framework, I have shown that

This was regarded as evidence for the claim that succeeding in the world of global competition was still a matter of choices, not a matter of searching for the unique best way (Tokatli, 2008, p. 24)