A transaction cost analysis of the apparel industry

A peopleing cost depth psychology of the outfit manufactureThe slack desegregation of global economical grocerys bears many challenges for companies which continuously attempt to lay out to changes in their business environment in providing value to customers. In many industries and in particular the clothes assiduity the supply chains through which riotouss operate have become increasingly dispersed and global (Gereffi, 1999). With post crisis consumer spending restrained unstable and cotton prices1having increased by more than 160% since March 2010 (see figure 2 in auxiliary E) apparel retailers see their margins eroding. Simultaneously, short harvesting life cycles, volatile consumer preferences and fierce competition on price and quality through an increased availability of low cost manufacturing2make it difficult for retailers to defy a competitive advantage. Since the 1990s, 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 best in terms of cost and flexibility for retailers to source apparel from self-employed person 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 worlds largest apparel retailers The spreading and HM. At the same time, we see Zara and Benetton who partially produce merchandise at company-owned factories located in Spain and Italy, easterly Europe, Tunisia, India respectively. This is striking for two reasons whiz, the product cost in Europe are high than in most East Asian economies3towards where much of global apparel manufacturing has shifted (Gereffi, 1999). Second, straight desegregation is perceived to be a burden in an environment that requires a high class of operational flexibility (Richardson, 1996). So wherefore is it that those firms break with the rule of contracting out all output (CNN.com, 2001) that has developed everywhere the past decades?In this paper, I entrust analyze the motives and strategies that determine a retailers sourcing decision. Although the sourcing strategy defines both, the location and the organizational entity4, the focus of this composition is to explain why HM and Gap outsource production while Zara and Benetton are vertically merged into apparel manufacturing. In explaining vertical integration economic guess has considered varied aspects the neoclassical theory turns to efforts of firms to mitigate inefficiencies ca customd by market power or erect market power inwardly the vertical chain (Joskow, 2006, p. 1). From an organizational perspective, the advance adopted here, executing cost economics (trichloroethane) ties production, coordination and motivation be to the various forms of organizations economic agents attempt to minimize.I impart explain the basic trade-off underlying the decision of vertical integration, review the origins of trichloroethane and introduce a framework by Oliver Williamson. Williamsons framework foc pulmonary tuberculosiss on measuring the risk of opportunistic behaviour The analysis of the apparel industry shows that the risk of expropriation is mainly driven by theSourcing has become a central process in the context of coroporate functions (guericini)Fashion industry shows polar approachesTo be analyzed in terms of efficiency and transaction costIs in that location an optimal authorities structureHow have they changed over timeWhat are the implications and drawbacks to the theoryHow will this be in the futureUsing elusion studiesImplications for inclemency of TCIs it a matter of choice or a matter of searching for the unique best way?Vertical integration and its determinantsVertical integration and the make or buy tr ade-offA 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 exemplifyd in Figure 1 and described in more detail in Appendix D.Figure The vertical chain in the apparel industrySource self-made diagram, establish on Besanko et al. (2000) and Milgrom Roberts (1992)In mapping a firms boundary a utilitarian criterion is the degree of flexibility and authority of a firm to make investments, product-mix and employment decisions at the applicable 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 acquire an input, parties use anonymous market contracting (Joskow P. J., 1988, p. 101) and may non 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 be 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 victimization a cost-minimizing production process. This can be achieved through making investments in technology and engineering or sourcing from external suppliers who are change on the production of that input. Organizational efficiency refers to the minimization of coordination, motivation costs and the risk of opportunistic behav iour (Besanko, Dranove, Shanley, 2000). Through vertical integration a firm benefits from the authority to settle conflicts, control over the production and in initialiseion 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, cast down economies of shield in production, more bureaucracy, the risk of stinking management decisions5leading 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 run 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 high(prenominal) coordination efforts, misaligned incentives betwixt affair parties and inefficiencies arising from opportu nistic 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 ca employ 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 Williamsons framework which I will use in section 5 to analyze the apparel industry.Williamsons transaction cost frameworkThe origin of transaction cost economicsRonald Coases 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 focuse on the exchange mechanism of a good, a transaction, which can both 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 big 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 al locate 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 frameworkOliver 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 some other renter assume firm A owns a production asset and provides B with a service at a price of 5,000 (Bs maximum willingness to pay). befool 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 singingship with A. The price difference of 1,500 is the appropriable portion of the quasi rent that firm B will try to extract from A6(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 rationality7. Agents a re incapable to consider and specify all contingencies that force arise after engaging in a contractual relationship. As a result, incomplete contracts are the first best results. At the same time, it index 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 stand 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 firms governance structure based on variations in the splendor 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 restore 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 opportunism8. 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 de gree 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 integration10. (ZITATE Raus)Methodology, value, implications and limitationsIn t his 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 rejoinder to market imperfections11treating 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, HM, Gap, Inc. and the Benetton Group. It is useful to analyze a firms governance structure in terms of the control and authority borne by the two parties involved in the transaction at hand. T he 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 examine in this paper Gap and HM source all garments from nonparasitic suppliers. Zara and Benetton on the other hand purchase semi-finished products and manufacturing services like cutting and run up which are integrated with the firms 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, construct a strong global presence and managed to gain substantial profits throughout many years12it is appropriate to say with confidence that they are managing their trading operations through an effective governance structure. Thus, the main question that arises is what factors determine the decision for each firms g overnance structure. By mapping the firms 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 firms13, company reports from investment banks, business cases from Harvard Business Review and academician 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 gathe red through interviews with the retailers 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 tran saction 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 industryIn this section I am going to describe the cases of Zara, HM, 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 201014. All companies are close competitors but have positioned themselves other than with respect to vertical scope in manufacturing and in terms of pricing and fashion content15. I am going to describe each f irms 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.Gaps governance structure and coordination with manufacturersThe group controls design, merchandise, scattering, 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 countries16. In terms of costs 98% of merchandise is produced outside the US with South/ Southeast Asia representing approximately 50% of the milling machinery base17(The Gap Inc, 2008a). Overall no vendor accounted for more than 3% in 2010. The firms sourcing and logistic group along with buying agents coordinates with vendors around the world and stake orders. After the clothes are manufactured they are sent to the firms distribution centers18where the firm conducts quality audits (Wells Raabe, 2006, p. 21). The firm manages its vertical chain with lead times19of 3 to 8 months. (Quelle?)Since the 1990s 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 readying 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 strategy20 factories need to get the firms approval based on quality, price and delivery time21, factories are closely monitored22to 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 firms standards may lead to a termination of the supplier relationship but is attempted to be avoided by Gap23. Seldom, the firm issues conditional approval to a factory in case of a short-notice order.Benettons governance structure and coordination with manufacturersThe Benetton group operates through a sequential and integrated supply chain covering the steps from design, RD, manufacturing, distribution and sales24. 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 good example keeping automated and strategic activities in-house and outsourcing labour-intensive tasks25to SMEs (Benetton Group, 2011).Each plant is specialized in one type of p roduct and control, integrate and coordinate the production activities of contractors supplement26their 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 integral production cycles and controls parts of its upstream processes through a subsidiary27. The remaining 50% of merchandise are sourced from external suppliers with whom the firm coordinates through localized production offices28. Finished garments are distributed centrally through the firms logistic hubs29. 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 contractors activities into the production process. The group audited the compliance with the groups code of ethics30of 200 suppliers but did not enter formal contracts with suppliers since this was not felt by either party (Indu, 2008a, p. 4).Postponement strategy?HMs governance structure and coordination with manufacturersHM 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 HMs garments in around 2,700 production units in Asia and Europe31(HM, 2011). According to estimates, around one third of production is do in China, one third in residual Asia (e.g. Bangladesh) and one third in Europe (particularly Tur light upon) (jus t-style.com, 2011 Indu, 2008b Guericini Runfola, 2004). Finished garments are shipped to the central warehouse in Germany or one of the distribution centres. HM operates with lead times between twenty days and several months.The production offices keep in regular contact with suppliers, identify new suppliers, order orders and are responsible for monitoring suppliers compliance with the COC. Throughout an auditing cycle HM scores the suppliers management systems32aimed at preventing violations of the COC (HM, 2010a). When placing an order, buyers balance the factors quality, price, lead time and location of the supplier33(HM, 2011). To ensure quality HM carries out extensive testing34at the factories and after delivery. Order for high volume basic items were placed about sextet 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, b ut overall the firm focused on producing at low cost (Indu, 2008b).HM audits its suppliers compliance to the firms 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 suppliers35. HM 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 (HM, 2010a).Zaras governance structure and coordination with manufacturersThe business model of Zara36is 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 prod uces time-sensitive items at a dozen manufacturing subsidiaries in Spain estimated at 50% of total production37 or with suppliers whose processes are integrated with the groups dynamics (Tokatli, 2008, p. 34) located close to the firms 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 suppliers38managed 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 excogitation 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 sea son 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 firms distribution centre in Spain.Both, internal and external suppliers are re