Sunday, December 29, 2013

Zara, Fast-fashion, Optimization and the OM Triangle

Zara is the dominant brand in the Inditex apparel portfolio, which Inditex has operated in ‘fast-fashion’ style for a few decades. Although other fast-fashion retailers such as H&M and Benetton have been successful, none have achieved Zara’s level of success. Driven by extraordinary revenue growth rates, Zara has overtaken Gap as the largest apparel retailer in the world and continues to expand into new geographies and new product lines such as intimate apparel (Oysho), home furnishings (Zara Home) and apparel for young women (Stradivarius).

The fast-fashion retail model uses drastically shortened production cycles to get apparel from concept to customer in weeks versus the month-long design and production cycles. This improvement in inventory turnover gets customers to return more frequently, “According to an online poll, the constant newness in Zara's stores means that customers visit an average of 17 times a year, up from five or fewer times for rival shops.” (Hall) (Ghemawat) But “…Zara can lay a strong claim to owning the most impressive manufacturing and distribution process in the apparel industry.” (IT)

Perhaps the greatest contradiction though, is that Zara’s culture favors “human intuition, vision and judgment (as opposed to analytical methods) for decision‐making purposes” (Caro) so their more recent collaborations with MIT’s Operations Research department were labeled as groundbreaking. While the 77 year old founder of Zara, Amancio Ortega Gaona, never completed high school he brought in Jose Maria Castellano, “who had a doctorate in business economics and professional experience in information technology, sales, and finance. In 1985, Castellano joined Inditex as the deputy chairman of its board of directors…” (Ghemawat) Castellano developed all of the logistics systems during the 80’s that paved the way for rapid growth in the 90’s. (Hall) It is therefore logical that despite the seeming non-quantitative nature of the apparel business that some groundbreaking practices would emerge given the background of its deputy chairman. Some of the most noteworthy practices are cited next.

Quantitative Methods

Utilization vs. Wait Times: Probably the greatest operational insight aiding Zara’s success, is that there is an inverse relationship between utilization (i.e. warehouses, production, or factories) and the wait times associated with those products. The operations research discipline of queueing theory has proven this mathematically (see the graphic) although few companies acknowledge this relationship as they seek greater operational efficiencies through higher utilization rates. “Even though there’s ample capacity in this distribution center during most of the year, Zara opened a [new logistics center]… [because] Zara’s senior managers follow a fundamental rule of queuing models, which holds that waiting time shoots up exponentially when capacity is tight and demand is variable. By tolerating lower capacity utilization in its factories and distribution centers, Zara can react to peak or unexpected demands faster than its rivals.“ (Ferdows) They effectively sacrifice capacity to reduce the amount of inventory. (Schmidt)

System Level Optimization: Zara also focuses on optimizing the system as opposed to local operations. “Few managers can imagine sending a half-empty truck across Europe, paying for airfreight twice a week to ship coats on hangers to Japan, or running factories for only one shift.“ (Ferdows) Just as most businesses would try to maximize the amount of inventory in their distribution center, rather than minimize it.

Inventory Allocation Algorithms: Zara partnered with faculty from MIT’s Operations Research department a few years ago to optimize the allocation of inventory across the store network. This involves regression forecasting the demand for each product at every store location, and then routing the items to the stores where they are the most likely to sell based on independent poisson process forecasts. The model “moves excess inventory away from low‐selling stores where it is not needed, and send it instead to high‐performing stores where it thus reduces missed sales due to stock‐outs.” (Caro) This also incorporates item requests from store managers, a ‘saturation effect’ to incorporate the amount of that product already sold in that location, actual sales, and auto-corrects for the credibility of store manager predictions. (Caro)

Small Batch Size: “Rather than chase economies of scale, Zara manufactures and distributes products in small batches.“ (Ferdows) This inspires customers to buy something if they like it, because it won’t be there later. (Ghemawat) This ‘climate of scarcity’ was deliberately created, on the assumption that customers can always find a different product that they would like to buy because of the greater variety of products and greater inventory turnover. (Ghemawat) (Caro) (Ferdows) This stands in sharp contrast to existing methods of batch size optimization such as Economic Order Quantity (Youngman) which balance the trade-off between inventory costs and setup time.

Instead, Zara sought advantage in smaller batch sizes than the industry for the associated speed benefits. “In actuality, reducing batch size simultaneously reduces queue time and wait time”, “[Reducing batch sizes doesn’t speed throughput] by speeding up machine or process time, but by reducing idle time when work sits on the workshop floor between process points.” (Youngman) Smaller batch sizes also imply that setup costs have been greatly reduced, if not eliminated. Otherwise, producing the variety of goods (44,000 items per year) would be cost prohibitive. This can alternatively be viewed as causing, “…operator skills atrophy (3), decreasing set-up frequency drives set-up proficiency down.” (Youngman) Perhaps Zara’s large variety of production gave them a tactical advantage in setup configuration and speed, which translated into a unique business model.

Non-quantitative Methods

Speed to Market: Zara can design and deliver a garment in 15 days, compared to several months at their competitors. (Ferdows) One of these speed improvements is highlighted in their decision to overnight air freight all deliveries despite the cost involved. Being vertically integrated also gives them a 40% speed advantage by avoiding the wholesale purchasing process. “Trends that fail are ditched, while production of those that do work can be increased.” (Hall)

Speed to market also reduces their working capital requirements, because inventory is rarely in transit and because they turn over their inventory 4x more often than other apparel retailers. (Ghemawat) The greatest advantage though, is that Zara can see the designs on the runway, and get the apparel in their stores weeks before the designer can. (Ferdows)

Manage Product Lines Independently to Avoid Bottlenecks: Zara operates the women’s, men’s, and children’s clothing lines almost completely independently (some people have multiple roles at smaller stores). “Though it’s more expensive to operate three channels, the information flow for each channel is fast, direct, and unencumbered by problems in other channels…“ (Ferdows)

Quantification of Benefits

• Location Growth: 21% CAGR in locations over the past 14 years, “while like-for-like sales growth had averaged 9% per year recently,“ (Ghemawat)
• Revenue Growth: “From 1991 to 2003, Inditex’s sales… grew more than 12-fold from €367 million to €4.6 billion...“ (Ferdows)
• "[Zara] overtook Gap [in 2008] as the number one fashion retailer.” (Hall)
• Implementing sophisticated distribution management algorithms “increased sales by an estimated 3‐4%, corresponding to an [impact] of approximately $233M and $353M in additional revenues for 2007 and 2008, respectively.” (Caro) This model also reduced shipments between stores, and it freed Zara from increasing the size of their Warehouse Allocation team as the business grew.
• Discount Avoidance: Zara collects “85% of the full ticket price on its retail clothing, while the industry average is 60% to 70%.” (Ferdows) (Hall)
• Speed to Market: “Zara isn’t just a bit faster than rivals such as Gap, whose lead time is 9 months, it is 12 times faster.” (IT)
• Less Inventory: “Zara has shown that… it can carry less inventory (about 10% of sales, compared to 14% to 15% at Benetton, H&M, and Gap).“ (Ferdows)
• Unsold Inventory: “In fact, Zara has an informal policy of moving unsold items after two or three weeks. This can be an expensive practice for a typical store, but since Zara stores receive small shipments and carry little inventory, the risks are small; unsold items account for less than 10% of stock, compared with the industry average of 17% to 20%." (Ferdows) (Deschamps)
• Bullwhip Effect: “The constant flow of updated data mitigates the so-called bullwhip effect—the tendency of supply chains… to amplify small disturbances… In an industry that traditionally allows retailers to change a maximum of 20% of their orders once the season has started, Zara lets them adjust 40% to 50%. In this way, Zara avoids costly overproduction and the subsequent sales and discounting prevalent in the industry.” (Ferdows)
• Failure Avoidance: Zara would wait to see customer demand for certain products before ramping up production. “As a result, failure rates on new products only 1%, compared with an average of 10% for the sector.”  (Ghemawat)


Disclosure: I was dumbfounded that Zara permitted MIT to disclose the $353 million dollar impact of the inventory allocation project. This seems like a valuable trade secret, but I presume that in their first dealings with academics they failed to restrict what was disclosed in the publication of their results. Zara’s is also collaborating with MIT on optimization of their purchasing and pricing processes, although the financial impact of those efforts is not disclosed. In all likelihood, because Zara’s locked down the publication of such important information in their subsequent collaborations.

Vertical Integration: Optimizing the supply chain in the apparel industry seems to require vertical integration. In particular, the wholesale purchasing process makes it difficult to rapidly change inventory estimates because larger batch sizes are needed to make the sales overhead a smaller component of each item. The bullwhip effect also leads each participant in the supply chain to overproduce so as to maximize local profits, while Zara deliberately leaves demand unsatisfied. This unsatisfied demand makes production more efficient, drastically reduces the expense of unloading unpopular items, and discourages planned subsequent purchasing by consumers.

Advertising: Zara spends less than 1% on advertising vs. 4% for their competitors. This money goes straight to the bottom line, which may help in part to explain their profitability. (Hall) (Ghemawatt) This is a difference in advertising strategy that gives them larger margins, but I haven’t heard of any experiments or testing that determine whether the traditional apparel advertising strategy is optimal so we just need to recognize this difference.

Logistics, Communications, Battles: I’ve quoted Patton before, “Wars are won by logistics, communications, and battles, in that order.” It is therefore interesting to see Zara dominate it’s industry based on logistics prowess, but to also emphasize communications in their operations. “Consider this detail: The sales clerks in Zara are obliged to communicate the requests of their customers [to management], including even the suggestions that customers make in fitting rooms,” (Wharton) They deliberately segregate the operations by the target consumers (women, men, children) so prevent a bottleneck in any one line from affecting others.

Speed is Paramount: “The Zara model may be unique, but at its heart is a perfectly simple principle: In fashion, nothing is as important as time to market – not advertising (which Zara does just twice a year in newspapers), not sales promotions (which Zara does only sparingly), not even labor costs.” (IT) It is therefore open to questioning, how much of Zara’s success is due to the single minded pursuit of speed to market vs. the deliberate engineering of their supply chain.

Always Simulate First: To quantify the impact of the inventory allocation models, they ran parallel testing to model the financial impacts. This represents a best practice, with both parallel testing and simulation comprising key steps in rollout best practices.

Works Cited

“Zara is now bigger than the Gap.” By James Hall. The Telegraph. August 17, 2008.

“Zara Uses Operations Research to Reengineer Its Global Distribution Process.” By Felipe Caro, Jérémie Gallien, Javier García Torralbo, Jose Manuel Corredoira Corras, Marcos Montes Vazquez, José Antonio Ramos Calamonte, and Juan Correa. February 23, 2009.

Wikipedia: Fast Fashion. December 20th, 2013.

“Zara: Fast Fashion.” By Pankaj Ghemawat and Jose Luis Nueno.  December 21, 2006. Harvard Business School Case.

“Rapid-Fire Fulfillment.” By Kasra Ferdows, Michael A. Lewis, and Jose A.D. Machuca. Harvard Business Review, November 2004 Issue.

“Zara and Inditex. Using Information Technology for Competitive Advantage.”

“The OM Triangle.” By Glenn Schmidt. 2005/ Operations Management Education Review 1: 87-104. Neilsen Journals Publishing.

“Fashion Forward: Zara, Spain’s most  successful brand, is trying to go global.” The Economist. March 24th, 2012.

“Zara’s Business Model and Competitive Advantages.” By Diana Isabelle.  September 8th, 2012.

“Inditex Dazzles Its Competitors Again.” Knowledge At Wharton. November 2, 2005.

“just-style management briefing: Fast Fashion’s competitive advantages.” By MS Deschamps. July 2nd, 2012.

“Clearance Pricing Optimization at Zara.” By Rodolfo Carboni Borose. Published by Massachussettes Institute of Technology. 2009.

“Demand Forecast for Short Life-cycle Products: Zara case study.” By Tatiana Bonefoi. Published by Massachussettes Institute of Technology. 2010.

“A Guide to Implementing the Theory of Constraints.”  Dr. K. J. Youngman