Competitive Advantage: Cost Leadership through Vertical Integration using Zara as a model

According to Michael Porter there are two types of generic competitive advantage strategies: Cost Leadership or Differentiation (Product or Service).  A blended strategy of both is also possible, though requires much discipline to pull it off.

For each, one must understand their value chain* or value network, i.e inter-connectivity of linked services.  Within the value chain or network, every activity has an associated transaction cost.  If a firm identifies all its activities in the value chain to have a lower cost by performing them in house, then end-to-end vertical integration comes into play, else it's better to have the market provide the services.  In the end, it's a question of make vs buy.

Within vertical integration, there are two aspects:

1- Up Stream or Backward Integration.
2- Down Stream or Forward Integration.

Up Stream or Backward Integration:  These include buying raw material to manufacturing and distribution. 

Downstream of Forward Integration: Past distribution to selling the products through marketing and sales.

* Value Chain should not be confused with Supply Chain, as the former is controlled by the firm, while the latter is outside the firm.  Also, what Vertical Integration is not, are the administrative cost related to running a business, for ex: Paying your utility bills...etc.

ReadZappos' successful experimental approach to Innovation

Now to enforce the aforementioned, let's take a look at Zara (an Inditex Company), which has found a competitive edge in the fashion industry at a global scale, by leveraging the levers of the Vertical Integration.  My research colleagues and I did an analysis of Zara at UIUC and here are our findings:

Two of Zara’s internal transaction cost(s):

A substantial internal transaction cost for Zara is in-house “just-in-time” manufacturing of their fashion-sensitive products. Managing designs and production internally allows Zara to control inventory, reducing the need for warehouses and promoting quick response (QR) to adapt to consumer preferences more efficiently. With 85% of the in-house manufacturing occurring after the season begins, Zara can adapt quickly to produce only those items that are performing well in the marketplace, reducing costs across the firm. Zara also releases new designs 6 times/year as compared to 4 times/year like most of its competition. 

Additionally, Zara has vertically integrated design resources into the value chain to leverage their design capabilities and IT infrastructure for their fast fashion products. Competing apparel companies focus on translating runway fashions into mass market products or projecting sales trends. By incorporating design services in-house and designing limited product lines for a global market, Zara has reduced time to market and responded to sales trends within a season. Linking design with Zara’s sophisticated IT network shortens time from design to market. The effect of hierarchy costs are minimized because the design function is integral to Zara achieving their short cycle times and response to market demands. This provides competitive advantage by reducing waste, allows response to top selling items, and links designers and production.

Read: Prospect Theory - Understand your customers' willingness to pay for your product or service

Zara’s External transaction cost:

A substantial external transaction cost is the sewing of labor-intensive and scale-sensitive cut garments.  Zara worked with approximately 450 workshops who typically employed 20-30 people, with some having up to 100 laborers, to handle this portion of the sewing process (Reference : Page 11 of Case Study).  Zara’s internal factories were heavily automated and specially designed for pattern-cut processing and final quality inspection. Zara was not equipped from a process or labor perspective to handle the more labor-intensive cut garment business, and so for them, having long-term relationships with workshops to handle this portion of the business was important. It allowed Zara to keep their factories more streamlined and capital focused, and also allowed for lower administrative costs since the workshop labor force is not in-house.

Zara's secret sauce for success in Vertical Integration:

Zara has been able to retain its competitive advantage and minimize internal transaction costs by retaining and managing a majority of end-to-end capabilities within their value chain.

The global apparel industry has wide variability in distribution and demand, including significant local variation in customer attributes and different levels of price sensitivity. The generally accepted strategy for players is to compete on a singular-focused core competency and to enter international markets with minimal capital investments. Outsourcing and entering into partnerships is standard for organizations when it comes to production and global expansion.

Players in the apparel industry typically establish external contractual relationships as they outsource raw materials, manufacturing, distribution and retail. Market forces allow economies of scale to provide goods at lower prices as companies bargain in the open exchange. High asset specificity for the goods and services provided allow companies to minimize external transaction costs. Specialized companies then become the dominant players in their respective domains.

Key Zara competitors, such as Gap and H&M, own most of their stores but outsource all the production. Benetton invests heavily in production and manufacturing but licensees run most of its stores and it also outsources the labor intensive and scale-sensitive activities to subcontractors. Zara took a different approach to address the value chain complexity and created value by maintaining vertically integrated control from sourcing to all-the-way to retail. Zara has been the only company that has successfully achieved forward and backward vertical integration from Stage 1 through 4 as an organization capability as compared to rest of its peers.

A key capability used to control internal transaction costs was manufacturing logistics and IT infrastructure. The development of advanced systems allowed Zara to develop “just-in-time” manufacturing to connect cross-functional operations (such as executive and store management, designers, and manufacturing) with the warehouse that ultimately moves merchandise to stores. The company was deliberate in developing these logistical, retail, financial, merchandising and other information systems and did so internally as their complex requirements were not met by standard packages available in the market.

The vertically integrated IT system provided design teams with high-frequency information and rapid market feedback. The integration of designers into the supply and production chain allowed for efficiency in initial product development and launch. Additionally, designers could make rapid adjustments to current products based on consumer preferences, sales data and store feedback. Zara was thus able to maintain a very low (1%) failure rate on new products compared to the average failure rates of the sector (10% - reference Exhibits in case study) essentially offsetting the internal transaction costs by the value created through vertical integration.

Zara’s manufacturing strategy also created significant value and was integral to minimizing  internal transaction costs. They developed cutting-edge, fully-owned, just-in-time facilities and carefully evaluated products and services they would execute vs. those that would be outsourced. Specialized garments that were deemed “high-risk” with intricate pattern design, cutting and final finishing were kept in-house, while basic, price-sensitive items were outsourced. Sourcing decisions made by Zara also contributed to the efficiency in manufacturing. For example, 50% of fabric purchased was grey, and then dyed and patterned according to fashion trends. This manufacturing strategy allowed risk mitigation and rapid discontinuation of  unpopular items and increased production of popular garments.

Zara has aggressively expanded in the international markets which has led to some external interfaces in the retail domain. After bearing headquarter costs for the new market, their direct to store distribution channels allow it more efficient for them to have several stores in an international market. Commercial teams from headquarters conduct macro and micro analyses to evaluate the fit. Zara uses franchise models in countries that are small and are considered risky with respect to cultural and administrative barriers. Zara charges franchise fee between 5% to 10% of sales and offers full access to its corporate services including logistics. Zara has entered into joint ventures in larger markets with the interests split 50:50 between Zara and its partners. Zara has also ventured into international markets with its vertically integrated model where it retains store ownership. Zara transfers the cost of additional expenses incurred to customers through price mark-ups in international markets.

A management layer is developed and deployed in each country where Zara expands however, in some cases, clusters of smaller, neighboring countries have been grouped together under one management. The country manager bridges the gap between top- management at headquarters and the local store managers. Corporate and country managers use the same standardised reporting systems to enhance control over stores spanning large geographic territories.

All of Zara’s merchandise from internal and external suppliers passes through its centralized distribution system. The logistical and IT systems deployed at the distribution centers allow mobile tracking and automatic docking of garments in the appropriate barcoded areas. Hand-held computers from the stores transmit orders that were checked against the stock in the distribution center for forecasting of short supply and associated allocation decisions based on the historical sales levels. Such efficient coordination between the retail, distribution and supply domains allowed for fast moving stock which stayed in the distribution centers only for a few hours. The products were shipped both by trucks and air with delivery times of 24-36 hours to stores located in Europe and 24-48 hours to stores located outside of Europe. At time of case, Zara was in the process of building a second distribution center with better connectivity to air, road and rail transportation.

Zara manages to create a sense of freshness and scarcity around its products by engaging in rapid product turnover, with new designs arriving every two weeks. The merchandise on the display is changed frequently with 75% of the inventory completely rotated in three to four weeks. This has resulted into a Zara shopper visiting the chain 17 times a year compared to 4 times a year for competing chains.

Technology systems, design, store operations, distribution and manufacturing capabilities deployed through backward vertical integration have enabled success of Zara’s fast fashion strategy. By leveraging efficiencies across the organization they were able to focus on rapid merchandise turnover and responsiveness to consumer demand. Through careful identification of internal competencies that maximized efficiency and minimized cost of hierarchy, Zara has achieved a sustained competitive advantage.

Sustainable Competitive Advantage:

A Crystal balls that can accurately predict Zara's competitive advantage to be sustainable is yet to be found, though data analytics is next best thing.  So long as Zara is able to control the firms transaction costs through vertical integration, it can, but a single force shift can increase the complexity.  Will Amazon's "Made to Order" clothing or "On Demand manufacturing", break Zara's mold - time will tell!

Read: Why Strategy and Strategy Execution Need Move Beyond Table Top Exercises

Ref: ZARA: Fast Fashion Pankaj Ghemawat; Jose Luis Nueno.

Contributors - Mary Ales, Ankit Mishra, Joshua Szumski, Jaime Welch, Agam Vasani