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 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 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) .

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 Coruña. 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 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. 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 Coruña, 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