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 Coruñ a, 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 this 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 Coruñ a 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) . Additionally, the
success of Zara can be demonstrated through their outstanding financial
performance. From 1996 to 2000, Inditex SA tripled their corporate profits and
in 2001, a year of overall economic downturn in the retail industry, Inditex SA
saw a 31% increase in profits. Intangibly, customer loyalty and brand
recognition have provided significant value to Zara. The number of consumers
they attract continues to rise and their brand is synonymous with the cutting
edge of fashion at affordable prices. The successful implementation of Zara’s
business model provides great value to stakeholders and differentiates their
business from their peers.

Competitive Advantage
Fundamental to Zara’s success is their commitment to rapid response in
customer trends in fashion, producing clothing often and with short life spans
(10 wears). Their commitment to this goal and the capabilities that they have
developed to achieve it, have provided significant competitive advantage to Zara
especially in the areas of product development, strategic partnerships and cost of
production, advertising and marketing, and information technology
infrastructure. 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.

Figure 1: Zara’s Business Model

Product Development
Zara’s unique approach to product development is instrumental to their success.
Zara gives store managers significant autonomy in both determining the
products to display in their stores and which to place on sale, and relaying
market research and store trends back to their headquarters in La Coruñ a. 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
maintains a design team of 200 people, all of which produce approximately
12,000 new styles per year for Zara. 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. This process is very different from its competitors. Many
competitors rely on a small elite design team that plans both design and
production needs well in advance. Stores have little autonomy in deciding which
products to display or put on sale because Headquarters plans accordingly and
ships quantities as forecasted. Zara’s speed to market in product development
exceeds the capabilities of its competitors. This in itself provides additional value
to stakeholders, customers, and stores in producing quality clothing at affordable
prices .Zara’s product development capabilities are essential to Zara’s business
strategy and future success.

Strategic Partnerships and Cost of Production

In comparison to competitors, Zara’s business strategy, in regards to strategic
partnerships and cost of production, provide for a strategic competitive
advantage. Zara, unlike its competitors such as Gap, Benetton, and H&M, does not
use Asian outsourcing. Eighty percent of Zara’s materials are manufactured in
Europe, with 50% made in Zara controlled facilities in the Galicia region of Spain
near headquarters. Most of Zara’s competitors have 100% outsourcing to cheap
Asian countries. Though the cost of production in Spain is 17-20% more
expensive than Asia, Zara does have a competitive advantage over its
competitors in regards to operations. 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. To make this happen, the company
designs and cuts its fabric in-house and it acquires fabrics in only four colors to
keep costs low. Zara postpones dyeing and printing designs until close to
manufacture, thereby reducing waste and minimizing the need to clear unsold
inventories. The proximity of these suppliers gives Zara great flexibility in
adapting their product lines based on up to date market trends and consumer
behavior. It also decreases costs of holding inventory. Zara’s competitors,
through outsourcing to Asian countries such as China, sacrifice the benefits of
proximity for low labor and production costs. Though there is a cost advantage in
their approach in regards to labor, the lack of flexibility in changing orders based
on current trends hinders their operational efficiencies. 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.
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.

Advertising and Marketing

Zara’s unique approach to advertising and marketing is an additional factor
within their business model that adds to their success. Zara spends 0.3% of total
revenues on advertising and marketing. This is significantly less then their
competitors who on average spend 3-4% of their total revenues on similar
expenditures. Hence, Zara maintains a cost advantage to their competitors in
marketing activities. In order to effectively complete with their peers Zara uses
location, store layout, and product life cycles to act as their marketing tool to
consumers. For instance, Zara strategically locates all of their stores in prime
retail districts for visibility marketing. Additionally, because of the product
development cycles mentioned earlier, customers are trained to visit Zara stores
often because new items are presented weekly and are often not restocked. This
feeling of scarcity encourages customers to come to the stores and buy
frequently. Lastly, in order to keep the stores looking fresh and trendy; Zara
invests heavily in their store layouts. They have a testing facility nearby their
headquarters in Spain where different types of store layouts are tested. Each
Zara store is remodeled every 5 years in order to keep up with current trends.
Zara does not invest heavily in direct marketing, though their efforts in
image/brand marketing do a great deal to attract a loyal customer base. 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.

Information and Communication Technologies

Zara’s information and communication protocols are significantly different from
its competitors. Zara spends less than 0.5% of total revenue on IT and IT
employees account for only 0.5% of Zara’s total workforce. This differs from
their competitors who spend on average 2% of total revenue on IT expenditures
and have 2.5% of their total workforce devoted to IT. 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. For example, managers at Zara
stores use handheld devices to send standardized information regarding
customer feedback and ordering needs directly to in-house designers. This not
only keeps Zara's designers informed of fast-changing customer trends and
demand, but also provides the company with insight on less-desirable
merchandise. Unlike Zara’s hybrid model (which incorporates human
intelligence and IT applications), competitors rely almost completely on
information technology. Zara’s unique approach of human intelligence assisted
IT solutions results in well-managed inventories, linkages between demand and
supply, and reduced costs from obsolete merchandise; however, there is still
room for improvement in their IT processes to realize more effective
management of inventory levels. Hence, 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.

Zara’s concept, capabilities, and value drivers, as demonstrated through their

business model, have proven to be extremely successful. Their resistance to
outsourcing, concentration on core operations and production capabilities, and
focus on the pulse of fashion have made them one of the most successful clothing
retails. In the event of future global expansion, their future success and
sustainability will be drawn into quention. They will need to adapt their business
capabilities of product development, strategic partnerships and cost of
production, marketing and advertising, and information and communication
technologies in order to adjust to increasing global operations.

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. However, there are certain issues that
need to be addressed here. 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. This information is
subsequently sent to the HQ. Although they are the decision makers in this case,
the order is still conditional. In the fulfillment phase of the operations, the
aggregated demand is ascertained and the supply is allocated according to past
performance of the various garments at the stores.

For the ordering of new garments, store managers have the same amount of
autonomy. However, a tailored order form (known as ‘the offer’) is first
transmitted to a PDA based on several factors such as garment availability,
regional sales patterns and forecasts. The store manager then determines what
should be ordered from this offer. 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. In every store the managers would divide
the offer into segments and delegate this to different employees. These
employees would then beam their segments after walking through the store
using their own PDA, to the store manager’s handheld device. It is important to
note here that this form arrives 24 hours before the order deadline, creating
substantial pressure. 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. Therefore, the store managers has full control over what should be
ordered from the new garments, however, this is based on the initial filtering
which is conducted from the HQ. It is fair to conclude that the store manager is
the preliminary decision maker in the case of replenishment, but this is subject
to availability as the next paragraph will make clear. For new garments, the
preliminary decision lays in the hands of the HQ commercial groups, although
there is a heavy reliance on historical information from the store manager. The
store managers are then responsible for submitting orders that are considered
necessary for their stores.

In the case of fulfillment of the orders, the situation is somewhat different. Store
managers are not involved in the process, instead, another group of commercials
are responsible to meet the orders of the various stores. 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, and therefore
cannot make a rational interpretation of how much should be allocated to its
own store. 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, however, a more information could offer some additional benefits. In
the case of a shortage in supply, 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. Again, since this is contingent upon the
local customer demands and ultimately local trends (past performance), the
store manager really does not have much control over the extent to which its
orders will be met. The true decision makers in this case are deemed to be the
commercials. It has to be noted, however, 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. Based on discrepancies
in demand and supply for different areas, forecasts can be made in terms of how
much the demand will be and therefore how much needs to be produced. They
are also considered to be key players in this area, though not so much decision
makers. Product managers indirectly rely on the information provided by store
managers’ orders. In addition, the commercials in charge of the fulfillment would
occasionally ship samples that were not requested by the store managers. This
again suggests where the true decision power lies.

The design and manufacturing division of Zara is based on a production network.

This network is made possible through the vertically integrated manufacturing
operations. Production commences at the local production facilities around La
Coruñ a 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. After going through the last phase at the Zara facilities, the
finished items are shipped to the DC. This three-phase production system
requires close interaction to ensure a short throughput time. The described
network is really responsible for only carrying out the requests of the HQ. They,
therefore, rely on the information that is provided by the commercials within
design teams who in this scenario are the decision makers. Their interpretation
on of how much needs to be produced is communicated to the factory network.

This circumventing of long-range forecasts can only be made possible by means

of a lean production approach. In this way any adjustment in production can be
easily made to match fluctuations in demand. Not only does this mean that short
lead times have to be maintained by the factories for flexibility, the entire supply
chain needs to support such a system. In this case, 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. Arguably,
another key player in this process is the store manager who transmits the orders
to the commercial. However, it might be short sighted to consider that they have
decision power in this cycle since their orders hinge on consumer fashion and
trends. Again, there is the reliance of commercials on accurate communication of
the required garments, and it must be reiterated that this information is subject
to store managers’ interpretation of replenishment needs.

By analyzing the decision makers in all parts of the operations and the flow of
information, stronger conclusions can be drawn as to where information is
urgently required in order to streamline procedures. In the next section of this
paper, exactly what information that could prove to be useful will be discussed.
Since the entire supply chain relies on the subjective orders that are placed by
the store managers, the accuracy of this information is elemental to Zara’s
operations. This so-called ‘theoretical inventory’ is required in order to keep the
supply chain robust without leading to excess supply. In the current system,
store managers’ order information is taken to be sacred, and these figures are
subsequently used for shipment and production.

At the moment, store managers have to manually assess their inventory. This is a
relatively slow procedure and suggests that there is room for improvement.
Resources are wasted since managers’ are preoccupied with a somewhat
administrative task. Admittedly, this is done to ensure that the manager gains an
insight of the inventory so that correct decisions can be made for the quantities
that need to be replenished. Information would probably help to speed up this
process, so that the managers can focus on employees and customers, instead of
having to roam the shops twice a week. Similarly for new garments, store
managers currently have 24-hour window of opportunity in which, in
cooperation with employees, a breakdown of the required garments has to be
made. Again, this is not only time consuming since information needs to be
entered into a relatively small device, at the store level it is logistically a complex
procedure. Only this time, it is not only the manager who is distracted, it also a
part of the employees who are involved. This poses the question as to whether
the provided service to the customer is in any way offset by the complex
logistics, and if so, to what extent, for example, sales have been missed due to a
lack in assistance. At the moment, store managers have no clear idea of how
much inventory is at the distribution centers. Information could prove to be
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 chance that it this order does not come through (due to a lack of
information from the distribution centers), could be potentially damaging for
Zara. Information from the distribution centers and from the production
facilities, for that matter, will give store managers a better overview of the
garment availability, in order to adjust their orders and pass on this information
on to the customers. This would overcome the current blind order system.

Accurate information to commercials within design teams in charge of

production would also benefit from more frequent information. Replenishments
orders at the moment are made on a bi-weekly basis. Given Zara’s proven track
record, the lean production based on this information have made it a flexible
retailer, but looking forward, it might want to consider further upgrading the
collection of information. For this reason, if information were provided on a daily
basis, for example, it could adjust its production output accordingly. This would
push its current production to match demand even more closely, it might in
actually speed up the total time to delivery, which is really what Zara is striving
for. This also applies for the distribution. If the production would be leaner as a
result of the more frequent information on orders, the supply to the distribution
centers would match the actual demand more closely. If this were true, then the
chance that an order by a store manager would not come through – as a result of
a stock out, or reallocation- would be decreased even further. At the HQ,
commercial could also do with more frequent and recent information. Assuming
that there is no discrepancy between the order and sales, 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.

By and large, more, and more frequent information at the stores, production
facilities and distribution centers would allow Zara to match demand and supply
more closely. Efficiency within stores can be improved and in production and
fulfillment, the speed and chance of delivery can be improved. The result is a
tighter control of Zara’s operations allowing for more an even more proactive
approach. Fast changing and unpredictable tastes of its target customers would
be anticipated even sooner and would enable Inditex to have an even more
effective cost control in accordance with its overall corporate strategy. The next
question will explore how a new Operating System could patch the gaps that
have been identified thus far.

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. DOS is considered to be an
outdated system and few companies are still using it. The question of changing
the OS has therefore been raised. 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. To assess whether a new OS investment
would reap the benefits that are being sought after, this section will conduct,
firstly, an intangible and tangible costs/benefits analysis followed by a risk
analysis. The cost benefits analysis will be carried out by analyzing the Zara
business processes along the supply chain, between the shops and the
headquarters and among the shops. 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. By means of an
integrated network, these data are then presumed to be accessible by the
production facilities, the HQ and all Zara stores.

Tangible benefits analysis

From a strategic perspective, although Zara’s advantage over its competitors is
not so mush a result of its IT leverage, the sustainability of its competitive edge
might be at risk due to a lack in IT investment. This is the foremost problem with
its current IT situation. 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. Coming back to a more resource-based view, a new OS
would enable the installation of modern software applications which could allow
Zara to develop its capabilities. Various business processes of Zara could be
enhanced and orders could be made much more efficiently. Referring to the
information requirements that have been previously identified, 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, but throughout the
entire supply chain. If all POS terminals would be interlinked, store managers
would have an online overview of the theoretical inventory order in the store to
help determine order requirements. Sales would not have to tallied as is
currently the case, since the inventory could be made available from any POS
terminal in the store. 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. If this were considered on an annual basis,
personnel resources would be saved which instead could be directed towards
customers. Moreover, a tailored POS application for the new OS could ensure
that orders, which form the basis of the shipment and the production facilities,
would be made based on theoretical inventory in effect giving more accurate
orders. At present, 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. If
Zara would have the right software, this functionality of the PDA would be
rendered useless.

If indeed the automated POS terminals would update the theoretical levels with
sales at the end of the day, then in principle orders could be made on a
continuous basis. The bottleneck in this case would then not be measurement of
inventory levels, but rather the frequency at which shipments arrive. Assuming
that orders would then occur on a daily basis, other tangible benefits would
include the optimisation of the inventory at the distribution centers. By using
modern e-supply management software, 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. This would allow the
demand and supply to be matched even more closely though a more flexible
delivery system. This is not only because store managers would make orders
based on inventory levels at the distribution center, but also because HQ could
then more accurately align the supply to the stores’ demand. Production could be
adjusted on a daily basis by monitoring the orders that would come in, making
the production process even leaner. These adjustments would still need to be
made based on order quantities, since this would ensure store managers’
autonomy. In contrast to the current system, however, 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, to meet customer demands, whilst minimizing the
cost of inventory. 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, without
compromising autonomy. Further savings can be made if voice over IP software
would be installed to make calls between shops free. New OS could also support
wireless applications, which will be discussed in further detail later. In addition,
if the distribution centers would be connected to the network on the OS, store
managers could then place their orders after viewing whether the required
garments are available or not. The order could then be made to keep the
inventory level at the store updated, and a signal could get sent online to the
distribution centers and the production facilities. This would offer Zara stores
indirect benefits in the forms of extra sales due to more efficient customer
service, since more attention can be paid to the customer and more informed
orders could be made. Periodical checks would still need to be made to ensure
that the theoretical inventory levels match actual levels, since garments could go
missing or get stolen.

At the HQ, enterprise-wide software would allow designer to follow the sales of
test garments more closely, instead of relying on manual orders from store
managers. This would prevent any discrepancy to arise between orders and sales
as a result of manual calculations. Moreover, 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. Further benefits from an IT network
could be derived. For example, if all stores would have online access to other
stores, a particular store manager could direct a customer to another local Zara
store in case of a stock out. Conversely, the system could be set up in such a way
that shipments could be made from another local store, further reducing the
ordering period. To sum up, merging data into one system can enable the sharing
of sales information, ordering information and returns information leading to a
more precise measurement of the stocks and to a real time measurement.
Furthermore, regarding the current OS, an upgrade would prevent any hold up
from its terminal vendors. Indeed at the moment Zara has no insurance that its
supplier can provide terminals supporting DOS for a long term. Zara’s bargaining
power toward its supplier would increase.

Intangible benefits analysis

At the store level, some intangible benefits could be derived from a new OS. A
salient point here is that the pressure for employees and store managers could
be alleviated. The current 24-hour time frame for new garments, for example,
could be eliminated. Regarding the HR function, the new OS can create more of
community feeling which is might at the moment seems be lacking in this system.
If indeed all the employees of Zara would use the same system, it would be a way
of connecting the autonomous stores. Store managers could learn about trends
and development at each others stores, which is currently not possible in this
decentralized group. The gain in operation and the creation of new innovative
applications described above can have an effect on employee satisfaction as well.
Higher efficiency in itself could stimulate motivation.

Tangible costs analysis

According to McAfee et al. , the following costs in upgrading the current OS can
be identified. Figure 3 offers a comparison of the costs of three leading network
OS providers. As can be seen, for the first year, Linux offers the cheapest
implementation costs for Zara, although the difference relatively speaking is only
marginal (Cost = €21,032,916). It must be noted, however, that despite the
absence of one-time licence costs for Linux, the ongoing costs, in this case the
service contract costs, are higher (please refer to Appendix). The annual costs for
Zara with Windows, Unix and Linux after implementation are approximately
€207,090, € 193,815 and € 326,565 respectively. Given that the functionalities of
all three OS are more or less the same, Unix is considered to be most suitable for
upgrading Zara’s IT system. The cost of implementation might be the dearest of
the three (€21,324,966), after two to three years, however, Unix will outweigh
the cost of the premium. The cost of implementation makes up roughly five
percent of Zara’s net income in 2002, which is relatively low, considering the
potential return on investment in the future. However this quantification does
not include the cost of a business continuity plan or a system-failure plan, nor
does it cover any other intangible costs. Figure 4 illustrates the breakdown of the
technical costs related to the new OS in the first year, in addition to the
implementation of the hardware, the programming of the software, internet
connection at every store and the training of employees. 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.

Intangible costs analysis

For successful implementation of a new OS, other non-tangible factors have to be
considered. The financial figures do not incorporate the acceptance rate of the
new system and the potentially new functionalities by the personnel. To quantify
this goes beyond the scope of the paper, however, it is important to bear in mind
that habits are extremely difficult to change, and different cultures would cope
with these changes at different rates. If any numerical value would have to be
assigned to this, it would probably fall under the training of staff, and even then,
there are no guarantees that people would take this new information on board.
Some conservative people might find it cumbersome to use new technology
despite its potential benefits, and could consequently feel less motivated under
new circumstances, causing friction in operations.

Under normal circumstances, a new OS should not fundamentally change

business processes or structure, but rather facilitate this. The objective should be
to optimise the current supply chain beyond its current state. Chances are that
due to experience, conflicts in adapting from old to new OS can be eased with the
help of competent IT suppliers. However, giving shops, for example, access to
each others stock level could very well lead to unforeseen problems. If the HQ
decides to allocate garments in a particular manner due to a shortage in supply,
information asymmetry no longer exists. Shops could then find out that when a
certain order has been made but has not been delivered, another and when
another local shop might have received it instead. This could cause political
problems and as a result compromise the psychological contract. Zara culture is
defined by a decentralized and informal organization. If too many standardized
tasks are required by the new system, such as ordering from another shop, for
example, the relationships, the creativity and autonomy of the personnel could
dissolve over time. This is an issue that as HQ manager is extremely difficult to
anticipate or control.

Risks analysis
L.M. Apelgate et al. identified three important project dimensions which
determine project implementation risk: project size, technology experience and
project structure . Using these dimensions, the degree of risk associated with
changing from a DOS to a new OS was evaluated in the following manner.

Based on a technical estimate for the upgrade decision, including cost of

hardware, software, porting, and installation and training, this is expected to
total over €21 million in investments (please refer to Appendix). Considering the
geographical extent of Zara’s stores, this projected scope of investments is likely
to have other potential tangible costs. These estimates, for example, do not
include the cost of removing old POS terminals. Installation of new POS terminals
may require changes to the current store cabling and may, therefore, entail store
redecorations. In addition, the IT support required may be underestimated.
Other risks that have not yet been accounted for relate to a further
institutionalisation of the IT department. This will be discussed in further detail,
however, for now it is worth mentioning that as IT systems become more
complex, they might very well increase the administration costs of the internal IT
assistance when there are flaws in the system. Lack of experience with the
system can have detrimental effects. Zara has no guarantee that the conversion
of the OS will run smoothly and that there will be no clashes with the current
system. Extra costs might be incurred to facilitate the conversion. Training costs
and outside technical support are usually underestimated in such global IT
implementation projects. For a smooth implementation and avoidance of any
downtime in the store as a result of switching, unforeseen issues need to be
addressed in a swift and professional manner. To mitigate this risk, Zara would
also need to re-train the existing IT staff and most probably hire external
consultants to assist in this matter. Cash reserves would have to be held in case
of unforeseen costs. Furthermore, (financial) planning and budgeting with a new
OS would demand a more rigorous process which could well affect other areas in
the company, besides IT. Other risks that would have to be dealt with are the
related to the costs which are hardest to quantify, namely the intangible costs.
Since personnel are going to be the end users of the new POS terminals, the
degree and speed of their acceptance of the new system would also affect the
level of the project risk. Due to unfamiliarity with the new system, which would
probably require a change in routine, it would not be easy to accurately estimate
the time and money required for all the stores to optimally make use of the new
system, that is, until external help is no longer necessary.

Another factor impacting the degree of risk is structure of the project. The nature
of the project enables Zara to fully and clearly define the outputs of the project.
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, therefore enabling a focused approach of all the parties
involved. These are characteristics that typify a highly structured project.
Nonetheless, Zara should not discard dynamics in the environment since they
could upset the timing of the project or even determine the success of it. The
project involves technology which is relatively modern to Zara. Peculiarities of
each store (for instance, availability of instant IT support, learning abilities of
staff), political and cultural environment in the country of operating unit,
reliability of the vendor(s) for new POS terminals, etc., could make the project
vulnerable to delays and task alterations, and also challenging to manage.
Furthermore, although the IT investment relative to net income not substantial,
it is equivalent to Zara’s annual IT expenditure, making it a significant decision.
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 size of
the project is deemed to be large. However, realistic planning of the project, a
thorough understanding of store individualities and tight monitoring of project’s
progress, can eliminate potential frustrations and largely contribute to a
successful implementation.

To summarize the above, the dimensions have been plotted on a matrix to assess
the degree of implementation risk (please refer to figure 5). Zara’s project of
upgrading the POS terminal operating system with the characteristics described
above falls under a medium implementation risk category. For new system
testing and training purposes Zara should take advantage of its 1,500-square-
meter pilot store used to test store layout and design. This opportunity would
help to understand possible complications with cabling and could serve as an
excellent training facility for staff. More importantly, 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. 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. Finally, Zara must have a contingency plan
in place for unforeseen circumstance that may affect the success of the project,
including an exit plan if circumstances do not allow Zara to complete the project
as planned.

Let us assume that all of the additional costs (tangible and intangible) that have
been identified, other than the costs in figure 4, amount to an extra 20%. This
would increases our initial estimates of expenditure to €25.6 million (assuming
we choose Unix), which still constitutes only 0.64% of Zara’s revenues, on top of
the usual IT costs of 0.5%, whereas the industry average was 2% of annual
revenue . This is still well below the industry average. Although the investments
needed to implement this project are considerable in absolute terms, it does not
seem to be a make-or-break decision for Zara. The geographical extent of the
project, however, would make it a significant project. All stores in an area at the
last stage of the project would have to be upgraded quasi simultaneously, which
could prove to be a difficult task for management.

While there are various factors that contribute to the risk of the project these can
be mediated through careful management. Taking into consideration the
intangible costs discussed earlier, it can be concluded that this project has a
moderate risk to Zara. In terms of costs the risk is low, but in terms of project
coordination, the risks are slightly higher. There is no guarantee that if the
conversion run smoothly in one place, it will do so as well in another. The project
is a sizable one which affects all employees’ work. A thorough top down policy
would be required here, preceded by a pilot test in stores in different areas. The
costs of the change are reasonable and if a back-up plan is produced, the
identified risks could be contained. As the cost and benefit analysis suggests, the
project would safeguard Zara against its competitors and enable substantial
operational gains, through providing shop managers with valuable information.
In addition, the pending threat from the POS terminal supplier would be
mitigated. An upgrade of Zara’s OS is therefore recommended.

Question 4 - In-house Software Design and Single Supplier for POS Terminals

Historically, Zara has been able to keep software development in-house and
successfully meet requirements of the Zara Empire. Using POS terminals based
on an advanced operating system would open doors for more sophisticated
software needs and opportunities. This could make Zara reconsider maintaining
an in-house software development department. Alternatively, Zara could also
use standard applications or even outsource entirely. This topic takes us to the
discussion of transaction costs and the effect of IT on this theory. This can also
assist in guiding whether Zara should have only one POS terminal provider.

Transaction costs literature provides argumentation that firm boundaries are

determined by a trade-off between production cost advantages. These costs
generally arise as a result of environmental uncertainty, infrequent exchange
situations, bounded rationality and potential opportunistic behavior. The
electronic markets hypothesis (EMH) examines the effect of IT on transaction
costs in the supply chain. Malone et al., argue that this is because it lowers
communication and information processing costs, facilitates description of
complex products and reduces investment in specific assets amongst firms.
Although this theory acknowledges that internalizing economic transactions
(into the hierarchy) is desirable when product complexity and asset specificity
are high, it suggests that the overall impact of IT will lead to increased
outsourcing (toward markets). The move-to-the-middle hypothesis (MMH) is
also well known in IT and relevant to this discussion. It posits that the use of
electronic markets would combine with the formation of long-term relationships
with a few suppliers.

There are a number of reasons why Zara can consider outsourcing software
development, which conversely represents the disadvantages for in-house
application development. Firstly, outsourcing IT could provide opportunities for
cost reduction as it allows Zara to select the least expensive and most efficient
software vendors. Through a process known as reverse auction, Zara can post its
purchasing requirements and select suppliers based on the lowest bid offered.
The main argument here would be that if Zara could find an external vendor that
reduces it production and transaction cost, it would be the most favorable
option. 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. The result would be less
coordinating costs, since Zara would not have to monitor activities in-house as
this would be included in the service through a Service Level Agreement (SLA).
By using responsibility matrices the duties and rights can be mapped under
different circumstances. This would entail certain service level goals for the
supplier to adhere to and penalties in case of failure to meet these. If there were
a problem with the IT system, the supplier would therefore be legally obliged to
solve it immediately. Zara’s core competence, its speed to market, however,
would not be allowed to suffer under an outsourcing arrangement, and
considering Zara’s global presence, this raises the question as to whether
outsourcing forfeits flexibility. The issues of transaction and coordinating costs
are the main drivers in the trend of companies taking their IT activities
elsewhere. For Zara, this could entail less heavy investment in extensive projects
for keeping the IT system up-to-date, provided this is part of the contract or
switching costs are low enough. Moreover, outside suppliers might be more
specialized and be able to achieve greater economies of scale over in-house
production, provided the service is standardized. Recently, application software
providers even offer companies the possibility to store information remotely. If a
problem occurs with the connection however, this would entail a crash in the
entire supply. There are also security issues that cannot be overlooked. Even if a
company signs a confidentiality agreement, it does not ensure that sensitive
information will not be passed on to other parties. 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.

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. Undoubtedly, cost reduction is one of the main
driving forces for outsourcing. If pursuing cost reduction as the outsourcing
objective, it would be more beneficial to consider offshoring (typically to China
or India), as this offers reduced labour costs. However, this option may have
serious implications due to possible cultural differences and political instability
in the outsourced country. Language barriers and communication problems may
further enhance complications of this decision. One must bear in mind that if
Zara is to outsource its software, the desired specifications also need to be
contractible. This is a major issue in outsourcing, referred to as bounded
rationality. Incorporating and agreeing upon factors such as quality of IT service,
innovation, information sharing, supplier responsiveness (accommodating
buyer’s non-contractual requests), and flexibility is very difficult to stipulate in a
contract in advance. Furthermore, including all the possible future states of
nature that could have an impact on the SLA is naturally infeasible. With further
reference to transaction cost theory, outsourcing only makes sense if complexity
of a product description and asset specificity are low. In Zara’s case, the asset
specificity is relatively high. This is because its success is partially built upon a
robust supply chain and flexibility, so time specificity is an issue which hinders
outsourcing. In addition, as a result of Zara’s widespread network, the
complexity of the IT solution would be relatively high. If something goes wrong
in any of the stores, an outside IT supplier might not be responsive enough to
meet immediate needs in the same way in-house software designers would.
Figure 6 offers a graphical representation of the situation. Although EMH
suggests that IT will generally lead to a shift towards markets for economic
transactions, this is not believed to be sufficient to offset the high specificity and
complexity of the Zara’s IT requirements. Another pitfall can be in the tender
through reverse auction. Although the potential suppliers will be tempted to
offer the lowest price, this might not bode well for the promised services. Having
a supplier for the lowest price might not guarantee the services that Zara
requires. Moreover, suppliers can make offers without being aware of the full
scope of the project.

Zara’s secret, according to CEO Jose Castellano, is its reliance on communication,

and the way it uses existing technology to take control of almost every aspect of
design, production and distribution. “This ‘fast fashion’ system depends on a
constant exchange of information throughout every part of Zara's supply chain—
from customers to store managers, from store managers to market specialists
and designers, from designers to production staff, from buyers to subcontractors,
from warehouse managers to distributors, and so on.” Zara has made enormous
efforts to ensure that operational procedures, performance measures, and even
store and office layouts are designed to make information transfer easy. It can
therefore be concluded that information management is one of core activities for
Zara to leverage its ‘fast fashion’ system. Using a standard ERP application (from
SAP or Oracle), linking all of Zara’s operations worldwide and automating
processes, would be a possible solution. However, there is no guarantee that this
application would be entirely compatible to Zara’s supply chain. Such system are
often based on sector specific demands and in that respect, Zara has shown to
differ substantially from its peers. Zara’s operations heavily rely on prompt
information flow. Standard ERP applicationw are also extremely expensive to
purchase and would probably bring up IT expenditure to levels far beyond the
current 0.5% of net income. To ensure fast reaction to procedural changes, in-
house software development will probably ensure flexibility in terms of existing
software or in developing new applications upon short notice. Own software
developers will be able to uninterruptedly communicate with software users,
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.
Risks that under the outsourcing policy would not be contractible would be
mitigated if the software provider would be internalized. In-house software
development will minimize possible security risks and eliminate holdup
possibilities between Zara and the outsourcer. Through an integrated IT function
and own software development staff, 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, CEO
of Oblicore).
The upgrading to a new OS entails an complete refurbishment of all the POS
terminals in the stores. The issue that that relates to this is whether Zara should
engage in bilateral agreements, instead of dealing with multiple vendors. 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. At the moment Zara
has very low bargaining power with respect to its IT vendor. Zara faces
difficulties in making its IT supplier guarantee DOS specifications for the
terminals in future. Even after an upgrade having a contract with a single
supplier is still potential hazardous. Moral hazard is always an issue with any
contract, albeit internal. Contract cannot prevent other parties from behaving
opportunistically, and this is always a risk when relying on a single supplier.
Outsourcing to a single vendor is especially risky considering Zara’s needs for
global coverage and support services. There is no guarantee that one vendor will
provide adequate service since every business case is unique. This forms a
fundamental argument for a company to choose several suppliers to spread the
risk. Again, there are costs related to this.

The basic premise for EMH is that by and large, IT would lead to lower
transaction costs that would in turn lead to greater reliance on arm’s length
relationships with many suppliers. In contrast, MMH coincides with EMH in
terms of outsourcing but predicts a move towards long-term relationships with a
smaller set of suppliers. In spite of the risks related to the dependency, 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. It would also allow Zara to economize on search costs
which would be a result of having several suppliers. 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. Chances are that this will
be more realistic with fewer suppliers, as it would provide the vendor with
greater incentive to be of service than with multiple suppliers. The current POS
supplier is still servicing Zara, and although there were reluctant to ensure
contractually service in the future, it served as a strong motivation to consider
the benefit of upgrading its system. If there would have been several suppliers in
the current story, it could well have been an excuse to only partially upgrade the
terminals or negotiate with other providers to expand the outdated terminals. In
short, the benefits from diversification in this context does not necessarily lead
to greater efficiency and might lead to complacency. Considering the benefits of a
new OS identified in this paper, the hold up position is therefore not necessarily
negative. Again, 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. Zara needs fast after sales services with a POS supplier that it can
rely on. If Zara would have to opt between a single supplier or several, the
former would be probably more suitable.

Being a part of the key instrument in the value chain, it considered best for Zara
to retain software development in-house. 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 Coruñ a, who are
responsible for the entire Inditex group of companies. Empowerment of
employees adopted in Zara gives a sense of ownership to the software
developers with regards to the produced applications, which increases
productivity and job satisfaction. Software developers are involved in a creative
process as opposed to the IT staff needed to only monitor outsourced activities.
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,
despite the coordination costs that are involved in internalizing IT suppliers.
Zara’s core competence is at stake, and it is believed that by retaining a internal
designer would be the best way to preserve it, provided the supplier can meet
Zara’s global needs. Similarly for its POS terminals, although Zara has slipped
into to a hold up position it could prevent this in future by maintaining a more
stringent company IT program. Although the chance of a hold up exists, the
downside to having multiple suppliers could potentially threaten its speed.
Having a single supplier for the POS terminals will lead to an accumulated
knowledge in customization of equipment and services, and result in closer
match to Zara’s preferences. Zara needs to ensure a continuous link between
overall corporate strategy and the IT strategy. For that reason it is deemed
important that Zara retain bilateral agreements with its POS suppliers.

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. A stock option can let someone
make a small investment today in order to reduce our risk in the future. At the
same time, it keeps the possibility open of making a bigger investment at a later
date, if the situation unfolds as we expect. A financial option gives the owner the
right at a certain time to buy or sell a stock at a given price, without the
obligation to do so. If the option is not exercised, the only cost that is incurred is
the price we paid for the option, the upside potential, however, can be large. This
flip-side nature of an option, (i.e. the protection from the downside risk with the
possibility of a large upside gain) is what makes it so valuable in business. The
idea is similar with real-options analysis. When this reasoning is applied to
Zara’s IT project, a relatively new approach can be derived which could lead to
better risk assessment, project valuation, capital budgeting, and strategic
decision making. The more uncertain times are and the longer-term the
investments are, the more valuable a real option approach becomes. The
manager identifies options, and their premium/value, within a project. If the
future looks good, the option is exercised and the project goes ahead. Conversely,
if the situation were unfavourable, the only loss would be the price of the option.
This makes an option considerably different from the traditional discounted cash
flow approach. In order to evaluate the feasibility of a real option, 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, that is, the upside and downside
possibilities and their probability of occurrence in order. This preliminary
review, if it has not been done previously, would offer significant insight into the
company’s strategies, even if real option analysis has not yet been implemented.
2-Search for options: After developing the scenarios, the project should be
examined to see which type of option is most appropriate. There are numerous
types of options. 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). Fundamentally, they all involve a choice which is
contingent upon the future state of nature. This provides the investing firm with
a flexibility value. A very interesting type of option for Zara’s purposes is the
stage option. It is widely used for IT projects and allows for the project to be
divided up into several stages, 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,
but instead are staged and sequential. This would probably apply as well to the
Zara’s global IT project (+€21m). 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. Figure 7 gives an example of how to geographically stage the project
in Europe. 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, Stage 1). If this goes according to plan, 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).
Interaction with the production facilities and distribution centers could also be
incorporated at this stage. Next would be a nation-wide roll out of the IT project
(stage 3) followed by a European implementation (stage 4). The last stage could
be the global implementation. The way in which this is done can be left to the
discretion of management, the purpose is merely to illustrate successful
execution of the stage option. There is obviously some hesitation within the
company related to the leveraging of ‘fancy’ technology, so the key issue, is
therefore to choose the stages and time periods in such a way that any risks are
mitigated. A more conservative approach might be to have pilot stores in every
country to account for the different cultures and learning curves. The next step in
our analysis is determining what information is necessary to value the option
premium. 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. This depends on the
outcome of the option valuation of that particular phase and incorporates the
investment required. A positive value indicates the premium therefore making it
worthwhile to proceed. The valuation procedure for the stage option is explained
below. Conversely, 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.

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. In the case of financial options, the stock price,
expiration date, and strike price all are known and function in well-developed
financial markets. Volatility of the stock can usually be estimated accurately
based on past data, although this offers no guarantee for the future. In the case of
real options, the aforementioned parameters are more difficult to determine. In
the case of Zara, in order to evaluate the investment using the real option
analysis, the correct parameters are needed to plug into a formula known as
Black and Scholes. It is important to note here that in contrast to the traditional
NPV model, which incorporates interest rate and risk in the discount figure, this
is a risk formula on its own which calculates the value of an option. 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 analogous to the spot price in
financial options and is not easy to determine. In the case of Zara, the main
drivers of the after-investment cash flow could be the separated into an increase
in sales and a decrease in costs. It is believed that balanced supply and demand
in and between stores would result in less stock out and more reliable
availability. The result could be less missed purchases and more satisfied
customers, which translates into higher sales and an increase in cash inflow. The
best way to estimate the extra sales generated would be through experimenting
with pilot stores, creating the right conditions through making the IT investment
and then observing sales operations. The pilot store chosen should therefore be
an accurate representation of Zara’s entire sales coverage. 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 other side affecting
future cash flows are the cost drivers. 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. Given the costs and revenue
data as a result of the IT project, the expected cash flows can be derived.
Following this staged project approa