With Zara founder Amancio Ortega now ranked as the world’s third richest man after Carlos Slim Helu and Bill Gates, it’s a good time to take a look at the disruptive growth strategy he used to build the company into a global retail juggernaut. If you are not familiar with the brand think of Zara as the European version of The Gap where you can find affordably-priced copies of the more expensive brand’s collections. Zara is known for “fast fashion” wherein the focus is on making a profit with many short run collections that often sell out within a month rather than the traditional model wherein a company introduces just one or two collections per year.
Zara’s parent company, Inditex, now has close to 6000 stores in 85 countries around the globe. About a third of these outlets are in Spain. The 20-year old company is based in northern Spain. It had $15.3 billion in sales and $2.16 billion in net profits for just the first nine months of 2012.
Now let’s move onto the business models of both Zara and the competition to see what works and why.
The Traditional Fashion Industry Model: Long Lead Times
When one thinks of the fashion industry one of the first thoughts that usually springs to mind are the long lead times involved. The traditional fashion industry calendar introduces two new collections per year. One is the spring/summer collection unveiled in January and February and the other is the fall/winter collection which unveiled in August and September. The actual design work often takes place a full year before the launch.
The main advantage of this approach is that costs controlled and kept down as much as possible. Obviously, booking a factory a year in advance to spend two full weeks producing your line is going to result in significantly cheaper product costs than sending it a steady stream small rush orders. Or so the common wisdom said.
The disadvantage is that once a collection has been committed to, it’s pretty much irrevocable because payment has been made in advance with an LOC (“Letter of Credit”) and the entire supply chain is locked into it. If a company discovers that it has committed to a collection that undersells it then has to slash prices, move the remainder to the discount racks, and accept a huge hit on its gross margin. The Gap (and other fashion retailers) is plagued by this problem as evidenced by the fact that the rear quarter of most if its stores is loaded with remaindered stock offered at reduced prices. Another disadvantage of this model is that designers can’t jump quickly on emerging fads. By the time they can the fad is most likely ancient history.
As a result of the long lead times and inflexibility of the supply chain this model is often compared to gambling. All that you can do is bet the farm and then pray that you come up a winner.
The Disruptive Zara Growth Strategy: Short Runs
In contrast to the traditional long lead times found in the industry Zara has evolved a growth strategy that stresses speed in order to use short runs that take advantage of fads and emerging opportunities. While competitors often require a full year to bring a new collection to market, Zara can do it in as little as two weeks. Zara achieved this state by switching from 100% long run production to a mix of both long and short run.
The short production cycle is realized by not relying entirely on distant manufacturers in China and India. Instead Zara works with local Spanish, and nearby Portuguese and Moroccan manufacturers to produce its short run collections. As a result a far lower percentage of Zara’s merchandise than the industry norm is produced in Asia.
Short run collections offer three huge benefits to the company. First, they create a sense of scarcity because customers understand that most items will be sold out within a week or two. So the shopper is constantly confronted by the choice of buy it now or lose it forever. Second, this scarcity also increases the frequency of customer visits to the store because customers fear that they may miss out on something truly wonderful. Zara customers visit its store 17 times per year in contrast to The Gap whose customers visit just four times. Third, the limited supply of short run collections means that they all sell out and nothing is left for the remainder racks where it impacts adversely on the company’s gross margin. Even if part of a short run collection remains unsold it’s not going to damage the gross margin due it being such a small percentage of total sales.
There are two other interesting facts about Zara’s business model. It doesn’t advertise. Indeed it’s been said that it doesn’t even have a marketing department. With the company it’s all about logistics and design. The other fact is location substitutes for advertising. The company strives to locate its shops in beautiful old buildings on high traffic shopping streets.
Now let’s zero in on Zara’s financial model. (If you are new to this topic the revenue model is a subset of the business model.)
Zara’s Revenue Model
With the traditional long run model, competitors often have to pay their offshore manufacturers up front with an LOC. This can tie up a substantial amount of capital as “restricted cash” on the balance sheet. While Zara may have similar payment arrangements with its Asian manufacturers, it enjoys a sweet deal with its local Spanish, Portuguese and Moroccan ones. In return for Zara’s steady stream of short run orders, they grant the company 60 days of trade credit. When you combine this with the fact that Zara receives its cash either at the time of a retail sale, or within a week if it was a credit card purchase, you can appreciate the tremendous cash float it enjoys.
While European supplied merchandise costs 15% more for labor, on average, than the Asian alternative, the short runs more than compensate for it because they result in minimal wastage, no markdowns, and an insignificant loss if one collection bombs completely.
As I was reading up on Zara’s growth strategy, I thought of the Moneyball story wherein a baseball manager decided to build a team that would rely on players who could be relied upon to hit singles and doubles instead of home runs. As with all things in any competitive environment it worked well for a while.
Before anyone jumps to the conclusion that Zara’s growth strategy is the Holy Grail of Success they should keep in mind that there are plenty of other companies doing well with the traditional long run fashion model too. However, there are always lessons that can be copied and applied to other businesses.