Question 1 Zara s Business Model and Competitive Analysis Zara, the most profitable brand of Inditex SA, the Spanish

clothing retail group, opened its first store in 1975 in La Coruña, Spain; a city which eventually became the central headquarters for Zara s global operations. Since then they have expanded operations into 45 countries with 531 stores located in the most important shopping districts of more than 400 cities in Europe, the Americas, Asia and Africa. Throughout this expansion Zara has remained focused on its core fashion philosophy that creativity and quality design together with a rapid response to market demands will yield profitable results. In order to realized these results Zara developed a business model that incorporated the following three goals for operations: develop a system the requires short lead times, decrease quantities produced to decrease inventory risk, and increase the number of available styles and/or choice. These goals helped to formulate a unique value proposition: to combine moderate prices with the ability to offer new clothing styles faster than its competitors. These three goals helped to shape Zara s current business model. Zara s Business Model Zara s business model can be broken down into three basic components: concept, capabilities, and value drivers. Zara s fundamental concept is to maintain design, production, and distribution processes that will enable Zara to respond quickly to shifts in consumer demands. José María Castellano, CEO of Inditex stated that "the fashion world is in constant flux and is driven not by supply but by customer demand. We need to give consumers what they want, and if I go to South America or Asia to make clothes, I simply can't move fast enough." This highlights the importance of th is quick response time to Zara s operations. Capabilities of Zara, or the required resources needed to exploit the opportunities and execute this conceptual strategy, are numerous for Zara. Zara maintains tight control over their production processes keeping design and manufacturing in-house or with some strategic partnerships located nearby Headquarters. Currently, Zara maintains 80% of its production processes in Europe, 50% in Spain which is very close to La Coruña headquarters. They have strategic agreements with local manufacturers that ensure timely delivery and service. Through these strategic partnerships and the benefits brought by this proximity of manufacturing and operational processes, Zara maintains the flexibility necessary to design and produce over 12000 new items annually. This capability allows Zara to achieve their strategy of expedited response to consumer demand. Value drivers for Zara are both tangible and intangible in the benefits that are returned to all stakeholders. Tangibly, Inditex, the parent company of Zara, has 11.02% net margin on operations and their market capitalization (Equity market value) is 13, 981 (in thousands) in 2002. Their net working capital (current assets current liabilities) is 133 (in thousands) . Add itionally, the success of Zara can be demonstrated through their outstanding financial performance. From 1996 to 2000, Inditex SA tripled their corporate profits and

and H&M. The efficiencies and processes developed in these four functions differ significantly from their competitors and stand out in providing additional value and profitability to Zara. a year of overall economic downturn in the retail industry. Strategic Partnerships and Cost of Production In comparison to competitors. The process of obtaining market information and relaying it to design and production teams expedites product development by shortening the throughput time of a product to 3 -4 weeks from design to distribution. and information technology infrastructure. Zara maintains a design team of 200 people. This in itself provides additional value to stakeholders.000 new styles per year for Zara. Intangibly. customer loyalty and brand recognition have provided significant value to 2001. does not use Asian outsourcing. producing clothing often and with short life spans (10 wears). Zara s business strategy. customers. have provided significant competitive advantage to Zara especially in the areas of product development. advertising and marketing. Eighty percent of Zara s materials are manufactured in . The number of consumers they attract continues to rise and their brand is synonymous with the cutting edge of fashion at affordable prices. Many competitors rely on a small elite design team that plans both design and production needs well in advance. in regards to strategic partnerships and cost of production. Their commitment to this goal and the capabilities that they have developed to achieve it. This process is very different from its competitors.Zara s product development capabilities are essential to Zara s business strategy and future success. strategic partnerships and cost of production. Figure 1: Zara s Business Model Product Development Zara s unique approach to product development is instrumental to their success. and stores in producing quality clothing at affordable prices . At headquarters there are teams of commercials who take this information into account to design and effectively plan and produce all of Zara s products. Zara s speed to market in product development exceeds the capabilities of its competitors. and relaying market research and store trends back to their headquarters in La Coruña. Inditex SA saw a 31% increase in profits. provide for a strategic competitive advantage. Stores have little autonomy in deciding which products to display or put on sale because Headquarters plans accordingly and ships quantities as forecasted. Zara gives store managers significant autonomy in both determining the products to display in their stores and which to place on sale. unlike its competitors such as Gap. The successful implementation of Zara s business model provides great value to stakeholders and differentiates their business from their peers. Zara. Benetton. all of which produce approximately 12. Competitive Advantage Fundamental to Zara s success is their commitment to rapid response in customer trends in fashion.

store layout. They have a testing facility nearby their headquarters in Spain where different types of store layouts are tested. customers are trained to visit Zara stores often because new items are presented weekly and are often not restocked. It also decreases costs of holding inventory. Zara maintains a cost advantage to their competitors in marketing activities.5% of total revenue on IT and IT employees account for only 0. Zara spends 0. To make this happen. Additionally. This differs from . This feeling of scarcity encourages customers to come to the stores and buy frequently. through outsourcing to Asian countries such as China. Zara strategically locates all of their stores in prime retail districts for visibility marketing. Lastly. Hence. Zara invests heavily in their store layouts. In order to effectively complete with their peers Zara uses location. This proximity effect and the flexibility that it gives Zara is fundamental to their basic concept to respond quickly to shifts in consumer demand and has provided them with a competitive edge in comparison to their peers. though their efforts in image/brand marketing do a great deal to attract a loyal customer base. Each Zara store is remodeled every 5 years in order to keep up with current trends. For instance. Their cost advantage and ability to maintain brand recognition and customer loyalty are essential elements of Zara s capabilities that build value in the company. with 50% made in Zara controlled facilities in the Galicia region of Spain near headquarters. the lack of flexibility in changing orders based on current trends hinders their operational efficiencies. Most of Zara s competitors have 100% outsourcing to cheap Asian countries.3% of total revenues on advertising and marketing. Zara postpones dyeing and printing designs until close to manufacture. This is significantly less then their competitors who on average spend 3-4% of their total revenues on similar expenditures. thereby reducing waste and minimizing the need to clear unsold inventories.Europe. The proximity of these suppliers gives Zara great flexibility in adapting their product lines based on up to date market trends and consumer behavior. Zara does have a competitive advantage over its competitors in regards to operations. the company designs and cuts its fabric in-house and it acquires fabrics in only four colors to keep costs low. s acrifice the benefits of proximity for low labor and production costs. Zara spends less than 0. Though the cost of production in Spain is 17 -20% more expensive than Asia. The local strategic partnerships that Zara maintains with manufacturers in Europe allow for a product throughput time of 3-4 weeks from conception to distribution. Inventory costs are higher for competitors because orders are placed for a whole season well in advance and then held in distribution facilities until periodic shipment to stores. in order to keep the stores looking fresh and trendy. Zara does not invest heavily in direct marketing. Zara s competitors. because of the product development cycles mentioned earlier. and product life cycles to act as their marketing tool to consumers. Though there is a cost advantage in their approach in regards to labor. Information and Communication Technologies Zara s information and communication protocols are significantly different from its competitors. Advertising and Marketing Zara s unique approach to advertising and marketing is an additional factor within their business model that adds to their success.5% of Zara s total workforce.

and value drivers. the hybrid information and communication system that Zara uses provides cost advantages to Zara s operations and helps to abide by their fundamental principle to have the ability to rapidly respond to changes in consumer demand. In the event of future global expansion. This not only keeps Zara's designers informed of fast-changing customer trends and demand. It is therefore essential that there is effective flow of information between the HQ and the distribution centers to ensure that store managers receive correct offers. Their resistance to outsourcing. Zara s unique approach of human intelligence assisted IT solutions results in well-managed inventories. managers at Zara stores use handheld devices to send standardized information regarding customer feedback and ordering needs directly to in-house designers. The store manager then determines what should be ordered from this offer. a tailored order form (known as the offer ) is first transmitted to a PDA based on several factors such as garment availability. as demonstrated through their business model. marketing and advertising. Question 2 Key Decision Makers and Information Management in Operations The key decision makers in the ordering process on the face of it are the store managers and the commercials at the HQ. there are certain issues that need to be addressed here. and reduced costs from obsolete merchandise. In the fulfillment phase of the operations. capabilities. This information is subsequently sent to the HQ. and focus on the pulse of fashion have made them one of the most successful clothing retails. have proven to be extremely successful. the aggregated demand is ascertained and the supply is allocated according to past performance of the various garments at the stores. but also provides the company with insight on less -desirable merchandise. For example. and information and communication technologies in order to adjust to increasing global operations. their future success and sustainability will be drawn into quention. For the ordering of new garments.their competitors who spend on average 2% of total revenue on IT expenditures and have 2.5% of their total workforce devoted to IT. Although they are the decision makers in this case. there is still room for improvement in their IT processes to realize more effective management of inventory levels. Zara utilizes human intelligence (from store managers and market research) and information technology (such as their PDA devices) in order to have a hybrid model for information flow from stores to headquarters. Hence. strategic partnerships and cost of production. regional sales patterns and forecasts. In every store the managers would divide . store managers have the same amount of autonomy. concentration on core operations and production capabilities. competitors rely almost completely on information technology. the order is still conditional. however. linkages between demand and supply. They will need to adapt their business capabilities of product development. Unlike Zara s hybrid model (which incorporates human intelligence and IT applications). However. Zara s concept. However. The store manager s decision influence on the replenishment of garments is limited to a single order (twice a week) based on manually auditing the quantities required for the store.

The design and manufacturing division of Zara is based on a production network. This network is made possible through the vertically integrated manufacturing operations. the situation is somewhat different. Store managers are not involved in the process. Production commences at the local production facilities around La Coruña followed by which the semi-finished fabrics are sent to another part of the network where they are processed at small workshops in Galicia and northern Portugal. The store managers are then responsible for submitting orders that are considered necessary for their stores. to the store manager s handheld device. and therefore cannot make a rational interpretation of how much should be allocated to its own store. creating substantial pressure. instead. this is based on the initial filtering which is conducted from the HQ. but this is subject to availability as the next paragraph will make clear. though not so much decision makers. This three-phase production system . the commercials in charge of the fulfillment would occasionally ship samples that were not requested by the store managers. however. In the case of fulfillment of the orders. however. the finished items are shipped to the DC. the store managers has full control over what should be ordered from the new garments. however.the offer into segments and delegate this to different employees. In addition. This again suggests where the true decision power lies. They are also considered to be key players in this area. It is important to note here that this form arrives 24 hours before the order deadline. For new garments. This is because the infrastructure is currently set up in such a way that the store manager has no overview of the consolidated demand of the stores in its area. although there is a heavy reliance on historical information from the store manager. The true decision makers in this case are deemed to be the commercials. another group of commerc ials are responsible to meet the orders of the various stores. the store manager really does not have much control over the extent to which its orders will be met. the commercial team at the HQ determines which stores have been most effective in selling an item recently in order to assign the production to the right store. These employees would then beam their segments after walking through the store using their own PDA. the preliminary decision lays in the hands of the HQ commercial groups. Product managers indirectly rely on the information provided by store managers orders. Again. a more information could offer some additional benefits. since t his is contingent upon the local customer demands and ultimately local trends (past performance). It is fair to conclude that the store manager is the preliminary decision maker in the case of replenishment. Based on discrepancies in demand and supply for different areas. After going through the last phase at the Zara facilities. Therefore. forecasts can be made in terms of how much the demand will be and therefore how much needs to be produced. It makes sense for a dedicated team to satisfy the orders according to the aggregated demand and supplies of the inventory at the distribution center in the area. In the case of a shortage in supply. that the future production for each Stock Keeping Unit (SKU defined as garment + fabric + color +size) order is determined in collaboration with the product managers. It has to be noted. The manager is dependent on the input of the employees in order to create an aggregated form (now called the order ) that gets sent back to the HQ.

This poses the question as to whether the provided service to the customer is in any way offset by the complex logistics. stronger conclusions can be drawn as to where information is urgently required in order to streamline procedures. Similarly for new garments. the entire supply chain needs to support such a system. exactly what information that could prove to be useful will be discussed. to what extent. this is done to ensure that the manager gains an insight of the inventory so that correct decision s can be made for the quantities that need to be replenished. in cooperation with employees. This so-called theoretical inventory is required in order to keep the supply chain robust without leading to excess supply. Resources are wasted since managers are preoccupied with a somewhat administrative task. the stores orders direct how relevant the initial orders of the commercials were and this feedback is extended through to the production in order to adapt to the sale of an item. This circumventing of long-range forecasts can only be made possible by means of a lean production approach. Information could prove to be . rely on the information that is provided by the commercials within design teams who in this scenario are the decision makers. However. a breakdown of the required garments has to be made. it might be short sighted to consider that they have decision power in this cycle since their orders hinge on consumer fashion and trends. In the next section of this paper. The described network is really responsible for only carrying out the requests of the HQ. and if so. Arguably. store managers have no clear idea of how much inventory is at the distribution centers. By analyzing the decision makers in all parts of the operations and the flow of information.requires close interaction to ensure a short throughput time. and these figures are subsequently used for shipment and production. therefore. store managers order information is taken to be sacred. and it must be reiterated that this information is subject to store managers interpretation of replenishment needs. for example. another key player in this process is the store manager who transmits the orders to the commercial. Only this time. the accuracy of this information is elemental to Zara s operations. In the current system. this is not only time consuming since information needs to be entered into a relatively small device. it also a part of the employees who are involved. In this case. store managers have to manually assess their inventory. They. sales have been missed due to a lack in assistance. Not only does this mean that short lead times have to be maintained by the factories for flexibility. so that the managers can focus on employees and customers. Their interpretation on of how much needs to be produced is communicated to the factory network. This is a relatively slow procedure and suggests that there is room for improvement. at the store level it is logistically a complex procedure. At the moment. Since the entire supply chain relies on the subjective orders that are placed by the store managers. In this way any adjustment in production can be easily made to match fluctuations in demand. Again. Again. it is not only the manager who is distracted. Information would probably help to speed up this process. instead of having to roam the shops twice a week. there is the reliance of commercials on accurate communication of the required garments. Admittedly. At the moment. store managers currently have 24-hour window of opportunity in which.

If this were true. At the HQ. DOS is considered to be an outdated system and few companies are still using it. To assess whether a new OS investment would reap the benefits that are being sought after. This would push its current production to match demand even more closely. the speed and chance of delivery can be improved. Accurate information to commercials within design teams in charge of production would also benefit from more frequent information. the chance that it this order does not come through (due to a lack of information from the distribution centers). firstly. for example. could be potentially damaging for Zara. The result is a tighter control of Zara s operations allowing for more an even more proactive approach. This would overcome the current blind order system. this section will conduct. This also applies for the distribution. It has been already acknowledged that staying so far behind in terms of technology can be risky but changing an OS in 531 shops would not be without risks either.would be decreased even further. more. it might want to consider further upgrading the collection of information. production facilities and distribution centers would allow Zara to match demand and supply more closely. if information were provided on a daily basis. will give store managers a better overview of the garment availability. which is really what Zara is striving for. or reallocation.useful for store managers to make smarter orders. If store managers assure a customers that a particular sold out garment is reordered and will arrive in two days. The question of changing the OS has therefore been raised. The next question will explore how a new Operating System could patch the gaps that have been identified thus far. then the chance that an order by a store manager would not come through as a result of a stock out. Information from the distribution centers and from the production facilities. the lean production based on this information have made it a flexible retailer. it might prove to be useful to determine the impact of the introduction of new garments by competitor on Zara s stores at the end of the day. the supply to the distribution centers would match the actual demand more closely. Assuming that there is no discrepancy between the order and sales. Fast changing and unpredictable tastes of its target customers would be anticipated even sooner and would enable Inditex to have an even mor e effective cost control in accordance with its overall corporate strategy. commercial could also do with more frequent and recent information. By and large. an intangible and tangible costs/benefits analysis followed by a risk . For this reason. in order to adjust their orders and pass on this information on to the customers. Question 3 Time to Change to a new Operating System? Zara and its IT partner have in the past opted to use DOS as their operating system for all the applications of the company. it might in actually speed up the total time to delivery. Efficiency within stores can be improved and in production and fulfillment. R eplenishments orders at the moment are made on a bi-weekly basis. but looking forward. and more frequent information at the stores. it could adjust its production output accordingly. for that matter. Given Zara s proven track record. If the production would be leaner as a result of the more frequent information on orders.

this functionality of the PDA would be rendered useless. new software could be used to automatically update the POS terminals for every sale that is made which would prove useful not only at the store level. Various business processes of Zara could be enhanced and orders could be made much more efficiently. but also because HQ could . Assuming that orders would then occur on a daily basis. other tangible benefits would include the optimisation of the inventory at the distribution centers. store managers would have an online overview of the theoretical inventory order in the store to help determine order requirements. This is the foremost problem with its current IT situation. these data are then presumed to be accessible by the production facilities. although Zara s advantage over its competitors is not so mush a result of its IT leverage. Coming back to a more resource-based view. The cost benefits analysis will be carried out by analyzing the Zara business processes along the supply chain. the sustainability of its competitive edge might be at risk due to a lack in IT investment.analysis. This would allow the demand and supply to be matched even more closely though a more flexible delivery system. We will assume that a new OS would allow for the installation of the latest software packages which can provide theoretical inventory measures to the stores and distribution centers online. which form the basis of the shipment and the production facilities. a new OS would enable the installation of modern software applications which could allow Zara to develop its capabilities. but throughout the entire supply chain. By means of an integrated network. PDAs are used by personnel to count the number of items required by the store and to make new orders based on the perceived demand. a tailored POS application for the new OS could ensure that orders. This is not only because store managers would make orders based on inventory levels at the distribution center. Sales would not have to tallied as is currently the case. By using modern e-supply management software. Moreover. Tangible benefits analysis From a strategic perspective. At present. between the shops and the headquarters and among the shops. This means that store managers would not have to conduct a manual audit twice a week which means less time and energy would be dedicated to administration. since the inventory could be made available from any POS terminal in the store. but rather the frequency at which shipments arrive. The bottleneck in this case would then not be measurement of inventory levels. If indeed the automated POS terminals would update the theoretical levels with sales at the end of the day. personnel resources would be saved which instead could be directed towards customers. orders could be linked through an in house developed Enterprise Resource Planning (ERP) system that would link orders made from stores to the rest of the supply chain. would be made based on theoretical inventory in effect giving more accurate orders. the HQ and all Zara stores. If this were considered on an annual basis. If Zara would have the right software. Other competitors could in due time develop automated solutions in their operations to such an extent that Zara s original speed to market might be outdone. If all POS terminals would be interlinked. then in principle orders could be made on a continuous basis. Referring to the information requirements that have been previously identified.

since this would ensure store managers autonomy. For example. The inventory level at which garments would have to be reordered (also known as the reorder point ) would provide store managers with a structured approach towards inventory management. These adjustments would still need to be made based on order quantities. New OS could also support wireless applications. the new OS can create more of community feeling which is might at the moment seems be lacking in this . a particular store manager could direct a customer to another local Zara store in case of a stock out. instead of relying on manual orders from store managers. to meet customer demands. Moreover. In contrast to the current system. At the HQ. some intangible benefits could be derived from a new OS. store managers could then place their orders after viewing whether the required garments are available or not. Intangible benefits analysis At the store level. ordering information and returns information leading to a more precise measurement of the stocks and to a real time measurement. could be eliminated. This would offer Zara stores indirect benefits in the forms of extra sales due to more efficient customer service. whilst minimizing the cost of inventory. since garments could go missing or get stolen. Production could be adjusted on a daily basis by monitoring the orders that would come in. which will be discussed in further detail later. Further benefits from an IT network could be derived. it would allow commercials to make fairer allocations of items in case demand does exceeds supply as they could base their decision on real and daily sales figures. however. making the production process even leaner. This would prevent any discrepancy to arise between orders and sales as a result of manual calculations. if all stores would have online access to other stores. without compromising autonomy. Regarding the HR function. since more attention can be paid to the customer and more informed orders could be made. Further savings can be made if voice over IP software would be installed to make calls between shops free. The current 24-hour time frame for new garments. Conversely. regarding the current OS. if the distribution centers would be connected to the network on the OS. enterprise-wide software would allow designer to follow the sales of test garments more closely. Zara s bargaining power toward its supplier would increase. The order could then be made to keep the inventory level at the store updated. In addition. an upgrade would prevent any hold up from its terminal vendors. To sum up. and a signal could get sent online to the distribution centers and the production facilities. Indeed at the moment Zara has no insurance that its supplier can provide terminals supporting DOS for a long term. the software could provide information on the Economic Order Quantity (EOQ) which dictates the most optimal quantities that buyers should order to ensure that there is just enough stock in the shops. for example. the system could be set up in such a way that shipments could be made from another local store. merging data into one system can enable the sharing of sales information. A salient point here is that the pressure for employees and store managers could be alleviated. Furthermore. Periodical checks would still need to be made to ensure that the theoretical inventory levels match actual levels. further reducing the ordering period.then more accurately align the supply to the stores demand.

Some conservative people might find it cumbersome to use new technology despite its potential benefits. it would be a way of connecting the autonomous stores. Linux offers the cheapest implementation costs for Zara. giving shops. Figure 4 illustrates the breakdown of the technical costs related to the new OS in the first year. and even then. Chances are that due to experience.090. however. Tangible costs analysis According to McAfee et al. for the first year. the ongoing costs. . in addition to the implementation of the hardware. the programming of the software. Unix and Linux after implementation are approximately 207. considering the potential return on investment in the future. It must be noted. after two to three years. Given that the functionalities of all three OS are more or less the same.966).916). that despite the absence of one-time licence costs for Linux. The objective should be to optimise the current supply chain beyond its current state. and could consequently feel less motivated under new circumstances. other non-tangible factors have to be considered. If indeed all the employees of Zara would use the same system. which is currently not possible in this decentralized group. it would probably fall under the training of staff . which is relatively low. access to . Intangible costs analysis For successful implementation of a new OS. and different cultures would cope with these changes at different rates. in this case the service contract costs. As can be seen. Unix is considered to be most suitable for upgrading Zara s IT system. a new OS should not fundamentally change business processes or structure. The annual costs for Zara with Windows.system. however.032. the following costs in upgrading the current OS can be identified.565 respectively. are higher (please refer to Appendix). 193. However this quantification does not include the cost of a business continuity plan or a system -failure plan.324. Unix will outweigh the cost of the premium. there are no guarantees that people would take this new information on board. Figure 3 offers a comparison of the costs of three leading network OS providers. The gain in operation and the creation of new innovative applications described above can have an effect on employee satisfaction as well. The cost of implementation makes up roughly five percent of Zara s net income in 2002. it i s important to bear in mind that habits are extremely difficult to change. Store managers could learn about trends and development at each others stores. but rather facilitate this. however. conflicts in adapting from old to new OS can be eased with the help of competent IT suppliers. for example. nor does it cover any other intangible costs. The financial figures do not incorporate the acceptance rate of the new system and the potentially new functionalities by the personnel. internet connection at every store and the training of employees. causing friction in operations. However. although the difference relatively speaking is only marginal (Cost = 21. This breakdown is percentage-wise approximately the same for all three OS. Whether the software needs to be designed in-house or not will be discussed later in further detail. The cost of implementation might be the dearest of the three ( 21.815 and 326. Under normal circumstances. To quantify this goes beyond the scope of the paper. Higher efficiency in itself could stimulate motivation. If any numerical value would have to be assigned to this.

porting. for example. This is an issue that as HQ manager is extremely difficult to anticipate or control.M. therefore. the creativity and autonomy of the personnel could dissolve over time. Zara would also need to re-train the existing IT staff and most probably hire external consultants to assist in this matter. If too many standardized tasks are required by the new system. Shops could then find out that when a certain order has been made but has not been delivered. the degree and speed of their acceptance of the new system would also affect the level of the project risk. such as ordering from another shop. information asymmetry no longer exists. Zara has no guarantee that the conversion of the OS will run smoothly and that there will be no clashes with the current system. Other risks that have not yet been accounted for relate to a further institutionalisation of the IT department. Since personnel are going to be the end users of the new POS terminals. namely the intangible costs. Based on a technical estimate for the upgrade decision. unforeseen issues need to be addressed in a swift and professional manner. technology experience and project structure . for example. identified three important project dimensions which determine project implementation risk: project size. besides IT. they might very well increase the administration costs of the internal IT assistance when there are flaws in the system. (financial) planning and budgeting with a new OS would demand a more rigorous process which could well affect other areas in the company. These estimates. Other risks that would have to be dealt with are the related to the costs which are hardest to quantify. the IT support required may be underestimated. To mitigate this risk. For a smooth implementation and avoidance of any downtime in the store as a result of switching. entail store redecorations. software. Furthermore. This will be discussed in further detail. the relationships. This could cause political problems and as a result compromise the psychological contract. Training costs and outside technical support are usually underestimated in such global IT implementation projects. Extra costs might be incurred to facilitate the conversion. Zara culture is defined by a decentralized and informal organization. Apelgate et al. including cost of hardware. Lack of experience with the system can have detrimental effects. this projected scope of investments is likely to have other potential tangible costs. Using these dimensions. Installation of new POS terminals may require changes to the current store cabling and may. and installation and training. do not include the cost of removing old POS terminals. Due to unfamiliarity with the new system. Con sidering the geographical extent of Zara s stores. If the HQ decides to allocate garments in a particular manner due to a shortage in supply. which would probably require a change in routine. this is expected to total over 21 million in investments (please refer to Appendix). In addition. Risks analysis L. it would not be easy to accurately estimate the time and money required for all the stores to optimally make use of the new . another and when another local shop might have received it instead. Cash reserves would have to be held in case of unforeseen costs. the degree of risk associated with changing from a DOS to a new OS was evaluated in the following manner. for now it is worth mentioning that as IT systems become more complex. however.each others stock level could very well lead to unforeseen problems.

Another factor impacting the degree of risk is structure of the project. could make the project vulnerable to delays and task alterations. availability of instant IT support.6 million (assuming we choose Unix). However. realistic planning of the project. To summarize the above. the dimensions have been plotted on a matrix to assess the degree of implementation risk (please refer to figure 5).500 -squaremeter pilot store used to test store layout and design. Notwithstanding the fact that project requires organizational changes and modifications to store employee work habits (as a result of automating information exchange and streamlining inventory control) the objectives of the project are unambiguous.5%. This would need to be done until the store is ready to serve its customers uninterruptedly with the new system to minimize the degree of risk. These are characteristics that typify a highly structured project. amount to an extra 20%. political and cultural environment in the country of operating unit. Nonetheless. other than the costs in figure 4. including an exit plan if circumstances do not allow Zara to complete the project as planned. reliability of the vendor(s) for new POS terminals. Zara must have a contingency plan in place for unforeseen circumstance that may affect the success of the project. Let us assume that all of the additional costs (tangible and intangible) that have been identified. it does not seem to be a make-or-break decision for Zara. etc. Although the investments needed to implement this project are considerable in absolute terms. can eliminate potential frustrations and largely contribute to a successful implementation. whereas the industry average was 2% of annual revenue . making it a significant decision. therefore enabling a focused approach of all the parties involved.64% of Zara s revenues. on top of the usual IT costs of 0. This would increases our initial estimates of expenditure to 25. Furthermore. More importantly. Given this and the fact that the project would have to implemented throughout all the 531 stores with a relatively new technology for the company. The project involves technology which is relatively modern to Zara. learning abilities of staff). Finally. Zara should not discard dynamics in the environment since they could upset the timing of the project or even determine the success of it. it is equivalent to Zara s annual IT expenditure. For new system testing and training purposes Zara should take advantage of its 1. a thorough understanding of store individualities and tight monitoring of project s progress. the size of the project is deemed to be large. Zara s project of upgrading the POS terminal operating system with the characteristics described above falls under a medium implementation risk category. This is still well below the industry average.. that is. although the IT investment relative to net income not substantial.system. until external help is no longer necessary. The nature of the project enables Zara to fully and clearly define the outputs of the project. it would be wise for Zara to have both the old and the new systems functioning simultaneously by carrying out a staged roll out which will be discussed later. Peculiarities of each store (for instance. and also challenging to manage. The geographical extent of the . which still constitutes only 0. This opportunity would help to understand possible complications with cabling and could serve as an excellent training facility for staff.

The move-to-the-middle hypothesis (MMH) is also well known in IT and relevant to this discussion. facilitates description of complex products and reduces investment in specific assets amongst firms. Transaction costs literature provides argumentation that firm boundaries are determined by a trade-off between production cost advantages. the pending threat from the POS terminal supplier would be mitigated. In addition. preceded by a pilot test in stores in different areas. This can also assist in guiding whether Zara should have only one POS terminal provider. Malone et al. Alternatively. Taking into consideration the intangible costs discussed earlier. Question 4 . Although this theory acknowledges that internalizing economic transactions (into the hierarchy) is desirable when product complexity and asset specificity are high. This topic takes us to the discussion of transaction costs and the effect of IT on this theory. The costs of the change are reasonable and if a back-up plan is produced. Firstly. All stores in an area at the last stage of the project would have to be upgraded quasi simultaneously. While there are various factors that contribute to the risk of the project these can be mediated through careful management. In terms of costs the risk is low. it suggests that the overall impact of IT will lead to increased outsourcing (toward markets). An upgrade of Zara s OS is therefore recommended.. which could prove to be a difficult task for management. the risks are slightly higher.In-house Software Design and Single Supplier for POS Terminals Historically. would make it a significant project. It posits that the use of electronic markets would combine with the formation of long-term relationships with a few suppliers. outsourcing IT could provide opportunities for . A thorough top down policy would be required here. Zara has been able to keep software development in-house and successfully meet requirements of the Zara Empire. There is no guarantee that if the conversion run smoothly in one place. Zara could also use standard applications or even outsource entirely. Using POS terminals based on an advanced operating system would open doors for more sophisticated software needs and opportunities. but in terms of project coordination.project. which conversely represents the disadvantages for in-house application development. the identified risks could be contained. it will do so as w ell in another. it can be concluded that this project has a moderate risk to Zara. There are a number of reasons why Zara can consider outsourcing software development. bounded rationality and potential opportunistic behavior. argue that this is because it lowers communication and information processing costs. through providing shop managers with valuable information. the project would safeguard Zara against its competitors and enable substantial operational gains. These costs generally arise as a result of environmental uncertainty. The electronic markets hypothesis (EMH) examines the effect of IT on transaction costs in the supply chain. however. The project is a sizable one which affects all employees work. This could make Zara reconsider maintaining an in-house software development department. infrequent exchange situations. As the cost and benefit analysis suggests.

There are also security issues that cannot be overlooked. application software providers even offer companies the possibility to store information remotely. this raises the question as to whether outsourcing forfeits flexibility. the desired specifications also need to be contractible. Furthermore. This is a major issue in outsourcing. and flexibility is very difficult to stipulate in a contract in advance. Zara can post its purchasing requirements and select suppliers based on the lowest bid offered. this would entail a crash in the entire supply. The main argument here would be that if Zara could find an external vendor that reduces it production and transaction cost. and considering Zara s global presence. cost reduction is one of the main driving forces for outsourcing. Language barriers and communication problems may further enhance complications of this decision. With further reference to transaction cost theory. as this offers reduced labour costs. By using responsibility matrices the duties and rights can be mapped under different circumstances. this option may have serious implications due to possible cultural differences and political instability in the outsourced country.cost reduction as it allows Zara to select the least expensive and most efficient software vendors. information sharing. the supplier would therefore be legally obliged to solve it immediately. Even if a company signs a confidentiality agreement. since Zara would not have to monitor activities in-house as this would be included in the service through a Service Level Agreement (SLA). outsourcing only makes sense if complexity . Moreover. it would be more beneficial to consider offshoring (typically to China or India). provided this is part of the contract or switching costs are low enough. The risk of competitors getting hold of this information and imitating essential processes such as Zara swift inventory management is real and must be taken into consideration. outside suppliers might be more specialized and be able to achieve greater economies of scale over in-house production. provided the service is standardized. supplier r esponsiveness (accommodating buyer s non-contractual requests). The result would be less coordinating costs. innovation. For Zara. including all the possible future states of nature that could have an impact on the SLA is naturally infeasible. Recently. it does not ensure that sensitive information will not be passed on to other parties. If there were a problem with the IT system. The issues of transaction and coordinating costs are the main drivers in the trend of companies taking their IT activities elsewhere. Zara s core competence. This would mean that Zara would not have to worry about the in -house staff with specific experience and skills for certain software pieces and could find the latest software suitable for it operations. These advantages still do not form a strong case in involving a third party in Zara s operations if it wishes to be certain that the service will be of sufficient caliber to meet its specific needs. If pursuing cost reduction as the outsourcing objective. referred to as bounded rationality. this could entail less heavy investment in extensive projects for keeping the IT system up-to-date. If a problem occurs with the connection however. Through a process known as reverse auction. However. One must bear in mind that if Zara is to outsource its software. Incorporating and agreeing upon factors such as quality of IT service. its speed to market. it would be the most favorable option. would not be allowed to suffer under an outsourcing arrangement. however. This would entail certain service level goals for the supplier to adhere to and penalties in case of failure to meet these. Undoubtedly.

Although EMH suggests that IT will generally lead to a shift towards markets for economic transactions. This is because its success is partially built upon a robust supply chain and flexibility. the complexity of the IT solution would be relatively high. and the way it uses existing technology to take control of almost every aspect of design. In-house software development will minimize possible security risks and eliminate holdup possibilities between Zara and the outsourcer. is its reliance on communication. and their solid knowledge of day-to-day processes and activities will allow them to go beyond set requirements and deliver the best possible software packages. suppliers can make offers without being aware of the full scope of the project. and so on. Using a standard ERP application (from SAP or Oracle). If something goes wrong in any of the stores. In addition. Risks that under the outsourcing policy would not be contractible would be mitigated if the software provider would be internalized. this is not believed to be sufficient to offset the high specificity and complexity of the Zara s IT requirements. in-house software development will probably ensure flexibility in terms of existing software or in developing new applications upon short notice. Figure 6 offers a graphical representation of the situation. Having a supplier for the lowest price might not guarantee the services that Zara requires. according to CEO Jose Castellano. Another pitfall can be in the tender through reverse auction. Although the potential supp liers will be tempted to offer the lowest price. Own software developers will be able to uninterruptedly communicate with software users. In Zara s case. the asset specificity is relatively high. Zara can maintain control over IT architecture and avoid downtime costs associated with an outsourcing contract (typically 1-3% of the value of the outsourcing contract as per Yuval Boger. . How ever. from buyers to subcontractors. from designers to production staff. Through an integrated IT function and own software development staff. as a result of Zara s widespread network.of a product description and asset specificity are low.5% of net income. performance measures. Standard ERP applicationw are also extremely expensive to purchase and would probably bring up IT expenditure to levels far beyond the current 0. Zara has made enormous efforts to ensure that operational procedures. It can therefore be concluded that information management is one of core activities for Zara to leverage its fast fashion system. would be a possible solution. This fast fashion syst em depends on a constant exchange of information throughout every part of Zara's supply chain from customers to store managers. from warehouse managers to distributors. there is no guarantee that this application would be entirely compatible to Zara s supply chain. an outside IT supplier might not be responsive enough to meet immediate needs in the same way in-house software designers would. Such system are often based on sector specific demands and in that respect. linking all of Zara s operations worldwide and automating processes. from store managers to market specialists and designers. To ensure fast reaction to procedural changes. Moreover. Zara has shown to differ substantially from its peers. Zara s operations heavily rely on prompt information flow. and even store and office layouts are designed to make information transfer easy. so time specificity is an issue which hinders outsourcing. CEO of Oblicore). production and distribution. this might not bode well for the promised services. Zara s secret.

having a single vendor might lead to long-term relationships which will allow Zara to enjoy economies of scale as a result of investments in IT required to coordinate supply relationships. Moral hazard is always an issue with any contract. This forms a fundamental argument for a company to choose several suppliers to spread the risk. it served as a strong motivation to consider the benefit of upgrading its system. In spite of the risks related to the dependency. The basic premise for EMH is that by and large. as it would provide the vendor with greater incentive to be of service than with multiple suppliers. It would also allow Zara to economize on search costs which would be a result of having several suppliers. Considering the benefits of a new OS identified in this paper. Again. the former would be probably more suitable. albeit internal. MMH coincides with EMH in terms of outsourcing but predicts a move towards long-term relationships with a smaller set of suppliers. Zara faces difficulties in making its IT supplier guarantee DOS specifications for the terminals in future. If there would have been several suppliers in the current story.The upgrading to a new OS entails an complete refurbishment of all the POS terminals in the stores. who are . and although there were reluctant to ensure contractually service in the future. If Zara would have to opt between a single supplier or several. In contrast. The current POS supplier is still servicing Zara. the benefits from diversification in this context does not necessarily lead to greater efficiency and might lead to complacency. Zara needs fast after sales services with a POS supplier that it can rely on. The issue that that relates to this is whether Zara should engage in bilateral agreements. Relying on a single supplier for the POS terminals means that there is a high dependency on that vendor which could present Zara with certain risks. Again. there are costs related to this. the hold up position is therefore not necessarily negative. In short. When a terminal breaks down it is probably better to have a solid relationship with one supplier to ensure swift response time to minimize the downtime. IT would lead to lower transaction costs that would in turn lead to greater reliance on arm s length relationships with many suppliers. Outsourcing to a single vendor is especially risky considering Zara s needs for global coverage and support services. Even after an upgrade having a contract with a single supplier is still potential hazardous. it could well have been an excuse to only partially upgrade the terminals or negotiate with other providers to expand the outdated terminals. Chances are that this will be more realistic with fewer suppliers. At the moment Zara has very low bargaining power with respect to its IT vendor. Contract cannot prevent other parties from behaving opportunistically. there are also security risks that play a role and when there is a lack of incentive there will also be a lack of mutual trust which in this situation is not desirable. and this is always a risk when relying on a single supplier. The IT department of Zara has a unique culture of a relatively small and highly motivated group of people (only 1 person left the department over the last 10 years!) based in La Coruña. it considered best for Zara to retain software development in-house. There is no guarantee that one vendor will provide adequate service since every business case is unique. Being a part of the key instrument in the value chain. instead of dealing with multiple vendors.

if the situation were unfavourable. The idea is similar with real-options analysis. capital budgeting. At the same time. which increases productivity and job satisfaction. (i. . provided the supplier can meet Zara s global needs. The benefits from outsourcing may not be sufficient to cover the costs that would be incurred as a result of the complexity of the product and asset specificity.responsible for the entire Inditex group of companies. the only cost that is incurred is the price we paid for the option. the downside to having multiple suppliers could potentially threaten its speed. would offer significant insight into the company s strategies. within a project. A financial opt ion gives the owner the right at a certain time to buy or sell a stock at a given price. Software developers are involved in a creative process as opposed to the IT staff needed to only monitor outsourced activities. that is. This preliminary review. and it is believed that by retaining a internal designer would be the best way to preserve it. the more valuable a real option approach becomes. Zara s core competence is at stake. Having a single supplier for the POS terminals will lead to an accumulated knowledge in customization of equipment and services. Empowerment of employees adopted in Zara gives a sense of ownership to the software developers with regards to the produced applications. although Zara has slipped into to a hold up position it could prevent this in future by maintaining a more stringent company IT program. If the future looks good. The more uncertain times are and the longer-term the investments are. For that reason it is deemed important that Zara retain bilateral agreements with its POS suppliers. however. the following steps are recommended: 1-Develop scenarios: The first step would be to consider the potential scenarios and outcomes of the IT project for Zara. if the situation unfolds as we expect. despite the coordination costs that are involved in internalizing IT s uppliers. The manager identifies options. This makes an option considerably different from the traditional discounted cash flow approach. Similarly for its POS terminals. even if real option analysis has not yet been implemented. When this reasoning is applied to Zara s IT project. it keeps the possibility open of making a bigger investment at a later date. the protection from the downside risk with the possibility of a large upside gain) is what makes it so valuable in business. if it has not been done previously. Conversely. Although the chance of a hold up exists. If the option is not exercised. without the obligation to do so. the only loss would be the price of the option. the upside potential. a relatively new approach can be derived which could lead to better risk assessment.e. This flip-side nature of an option. and their premium/value. and result in closer match to Zara s preferences. the option is exercised and the project goes ahead. and strategic decision making. In order to evaluate the feasibility of a real option. Zara needs to ensure a continuous link between overall corporate strategy and the IT strategy. can be large. A stock option can let someone make a small investment today in order to reduce our risk in the future. project valuation. the upside and downside possibilities and their probability of occurrence in order. Question 5: Real Option Valuation One alternative to ensure Zara is maximizing its IT opportunities is to value the project in a similar as financial stock options.

so the key issue. The reason why it is especially appealing for the IT implementation of Zara is because it will prevent Zara from having to launch a full-fledged project across the globe without being able to test the waters first. Eventually the decision options are either to go for the next stage in the project or to maintain course and stay with the old OS. Fundamentally. A very interesting type of option for Zara s purposes is the stage option. the stock price. and strike price all are known and function in well-developed financial markets. Conversely. There is obviously some hesitation within the company related to the leveraging of fancy technology. It is widely used for IT projects and allows for the project to be divided up into several stages. Interaction with the production facilities and distribution centers could also be incorporated at this stage. Stage 1). although this offers no guarantee for the future. A more conservative approach might be to have pilot stores in every country to account for the different cultures and learning curves. The last stage could be the global implementation. they all involve a choice which is contingent upon the future state of nature. 3-Valuing the investment There are significant differences between real and financial options that should be noted although in both cases the option value of a project becomes zero when the opportunity passes by. This depends on the outcome of the option valuation of that particular phase and incorporates the investment required. the project should be examined to see which type of option is most appropriate. Some allow for a project to expand (known as expand options) others allow for the projects to be suspended until the situation is favorable (known as defer option). Next would be a nation-wide roll out of the IT project (stage 3) followed by a European implementation (stage 4). The valuation procedure for the stage option is explained below. is therefore to choose the stages and time periods in such a way that any risks are mitigated. In the case of financial options. Volatility of the stock can usually be estimated accurately based on past data. the next step would be to choose a district in Spain and select five stores to act as a platform for the new OS and in-house developed software for another time period (stage 2). If this goes according to plan. the purpose is merely to illustrate successful execution of the stage option. A possible way of staging the project would be by starting with a pilot test at the HQ and production facilities for a predetermined time period (Please see figure 7. but instead are staged and sequential. This would probably apply as well to the Zara s global IT project (+ 21m). Figure 7 gives an example of how to geographically stage the project in Europe. if the option value is negative. this might be an indication that an IT upgrade might not offer the enough added value which could suggest that Zara should abandon the project and stick to its current system.2-Search for options: After developing the scenarios. where after each stage the investor has the option to abandon at virtually any predefined decision point of the project. Most investments are not made frivolously and do not entail a single up-front outlay. The way in which this is done can be left to the discretion of management. This provides the investing firm with a flexibility value. expiration date. In the case of . There are numerous types of options. The next step in our analysis is determining what information is necessary to value the option premium. A positive value indicates the premium therefore making it worthwhile to proceed.

In the case of Zara. creating the right conditions through making the IT investment and then observing sales operations. In the case of Zara. The sales data should be recorded for that period and then the percentage increase in sales can be reflected in total sales. The discrepancy from the current situation could be a good estimation for one part of the future cash flows. The present value of the expected cash flow from investment is one of the parameters that is needed in order to evaluate the real option. It is believed that balanced supply and demand in and between stores would result in less stock out and more reliable availability. The best way to estimate the extra sales generated would be through experimenting with pilot stores. the correct parameters are needed to plug into a formula known as Black and Scholes. in order to evaluate the investment using the real option analysis. which incorporates interest rate and risk in the discount figure. the aforementioned parameters are more difficult to determine. Following this staged project approa . the main drivers of the after-investment cash flow could be the separated into an increase in sales and a decrease in costs. this is a risk formula on its own which calculates the value of an option. It is analogous to the spot price in financial options and is not easy to determine. The result could be less missed purchases and more satisfied customers. The best way to estimate how much of the cost can be reduced is to estimate the inventory turnover and savings through greater efficiency that result from the investment. the expected cash flows can be derived. It is important to note here that in contrast to the trad itional NPV model. Given the costs and revenue data as a result of the IT project.real options. The other side affecting future cash flows are the cost drivers. which translates into higher sales and an increase in cash inflow. The pilot store chosen should therefore be an accurate representation of Zara s entire sales coverage.

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