Case Analysis, Luxury 650

By Anna Cobb

Are You Going Out of Fashion?

Luxury 650, Professor Fabrizio Iorio

Part 1 – synthesis of the document

Executive Summary:
Main concept:
 There has been a shift in competitive forces dynamic for PC and fashion
industries; increased innovation pace and better-educated consumers gave suppliers
and buyers stronger bargaining power whereas the threat of substitutes became
stronger than ever. In order to survive, companies in those and other affected
industries need to implement creative solutions. Suggested by authors course of
action involves:
 Successfully managing lost sales and product obsolescence; this can
yield higher profit margins to companies facing shortening product
lifecycles, growing pressure from channels, and long suppliers’ leads.
 The challenges involved in establishing an efficient supply chain and
especially into management of these two variables are significant and
require full commitment from senior decision makers. This includes,
although isn’t limited to, a deep dive into understanding suppliers’
manufacturing process and channel sales’ specificities.
 Not each company has willingness and resources to dedicate to such
surmountable change; but those that do, will benefit in the long-term and
create a competitive edge that, in turn, could generate higher
shareholders’ value – the main goal of any major company functioning
in modern market space.
Supporting evidence:
 Examples are drawn from PC and fashion (really meaning “apparel”) industry
that are found to be similar in having “short-lived products… in the increasingly
dynamic market space” that dictate a necessity of excellent supply chain; both
industries are facing such similar challenges as “ever shrinking product lifecycles,
globalization of sourcing and manufacturing” and a threat of mushrooming
substitutes; alongside with that, industry forces dynamic also changes not in favor
of these players – bargaining power of buyers, such as retailers, is growing as they
become more sophisticated, whereas bargaining power of suppliers remains strong
with the long leads of over 3 months. This calls for adjusting a course in order to
survive and grow.
 What are the factors that led to such shift in competitive forces in the first
place? The article names ever increasing pace of technological innovation for PC
industry that results into much shorter lifespan of an average PC and unwillingness
of retailers to carry obsolete products on their inventory. For apparel industry, it
subtly points to the increased education level of the end consumer that demands
latest fashions in the shortest possible time, which gives retailers a strong
bargaining chip in dealing with manufacturers.
 Shifting dynamic of competitive forces affects other industries as well.
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By Anna Cobb

 Authors point out that traditional ways of growth that involved building strong
brands and high quality products are no longer effective; in order to achieve “next
quantum leap in competitive performance”, companies need to turn their attention
to effective management of lost sales and obsolescence.
Definitions:
 Lost sale is the one that didn’t occur due to manufacturer’s fault of not
producing enough high demand product; missing sales may cost PC manufacturers
around 25-30% on margin and between 40 and 50 percent to apparel producers.
 “Obsolescence costs are incurred when finished products or raw materials
become obsolete and need to be cleared out”. These costs are present in most
industries although for some they are “particularly rapid”. Within seven months a
PC looses over 50 percent of its value while apparel not sold during the season
becomes a subject of heavy markdowns between 30 and 70 percent.
The challenge is to develop a balance between these two factors that would generate
highest possible return on the company’s internal invested capital.
 Companies that excel in supply chain performance manage to control lost sales
and obsolescence. They do it by implementing five things (quote):
1. “Measure the “unmeasurable” – namely, obsolescence costs and lost
margins on missed sales, both their own and the channel’s
2. Minimize complexity while preserving the richness of offering
3. Rethink product development technology to cut time-to-market
4. Optimize risk-sharing with supply chain partners
5. Manage the operating cycle to mitigate forecast error”
 Then we learn about each of these principles step by step.
Conclusion:
With all due respect to the authors and their innovative ideas about creating
competitive advantage in ever changing dynamic market space, I respectfully disagree
with their position of portraying perfect supply chain and successful management of
lost sales and obsolescence as new panacea for achieving sustainable growth. I do not
believe that these measures alone will necessarily translate into increasing and
sustaining higher shareholder value, which should be an ultimate goal for a public
company, such as Gap or Limited or Hewlett Packard, or for any company that has
owners’ interest invested in it.
Growth achieves through many factors and supply chain management is just one of
them. We all remember when Gap just recently was struggling to revive its brand and
still is struggling, from what can be observed. Managing the obsolescence and lost sales
effectively didn’t translate into increased brand equity or stock price for that matter. It
is necessary to align all aspects of growth strategy together in order to achieve good
results. Efficient supply chain management is a core part of this equation but it is not
the only part. Effective cost management in all areas, creative brand strategy that is
built on understanding key consumer on a deeper, more personal level would
effectively yield a better growth and performance assuming core decision makers are on
board and lead the implementation of the course. Companies are valued based on the
net present value of their future cash flows. Revamping the supply chain and managing
 Case Analysis, Luxury 650
By Anna Cobb

lost sales play well in generating higher margins, which can positively affect the cash
flows, but these margins also might be killed if other controls such as managing the rate
of return on incremental capital, growth of working capital, level of capital
expenditures, etc., are not implemented. Ultimately, when a company introduces
changes in any of the operational or other areas, it hopefully does it to achieve higher
shareholder value, at least good ones do that. It is not clear from the case whether
authors even consider the complexity of generating higher shareholders’ value through
multiple steps. The proper growth strategy needs to be complex but also have a clear
vision where the company is going. It is not easy - in ever changing market space the
winning route would be similar to navigating a sail boat through the competition – the
intuitive and talented skippers that are supported by highly trained and synchronized
team, with a little bit of luck, usually win. It is a joint orchestrated effort. So the supply
chain improvement suggested in the case is just one of the turns on the way of the sail
boat – there will be plenty of others and the CEO/skipper should be ready to react or, if
he/she is truly the best, to anticipate those changes and adjust the course accordingly.
And let’s not even talk about thunderstorms that may hit on the way. Supply chain
management alone definitely not going to save the boat.

Part 2 – critical exposure of another industry

Asset management industry in the US is probably one of the most complex ones. Part of
the complexity is the big weight of intangibles in this industry, for example, investment
performance, price structure, goodwill and brand recognition but the issues of
optimization of supply chain, lost sales, and obsolescence of products are also very
important although may be not as critical as they are in IT and Apparel sectors.
Shift towards an educated consumer affected the asset management industry in the
similar way as it affected IT or Apparel – retail channel, such as brokers, banks, or
institutional consultants began to have stronger bargaining power in picking up
products they want to sell, such as a certain mutual fund, for example. Similar to IT and
Apparel industry, ever increased pace in financial innovations, especially in hedge fund
industry or in derivatives sector, represent a strong threat for traditional money
managers. Increased competition from low-cost producers like Vanguard or American
Funds negatively affected margins of higher-priced investment products and companies
that offered them needed to reconsider their pricing and long-term growth strategies.
New product development takes a long time in asset management industry, partially
due to slow innovation adoption curve but mostly due to regulatory environment that
subjects most of the investment products generated by mutual funds to long scrutiny of
approval process. That is why newcomers like hedge funds and private equity players
that are not as heavily regulated were able to achieve phenomenal growth during the
last decade while mutual fund industry grew at a much slower rate. Reducing the time-
to-market period therefore represents a challenge for lobbyist (that would convince
government to regulate the new products on a different, lighter basis) or creative
marketers that would suggest products that might require less approval time. This,
however, would be a very risky venture. Better recipes would involve investing in solid
consumer research to identify upcoming trends and megatrends in financial markets to
launch products by the time the identified trends grow strong.
However, the main part of the solution would involve implementing benchmarking
practices in hiring best talent, aligning brand strategy to reflect core competency, and
slashing the operational costs in the times of low-performance and asset outflows to
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boost growth. Major cost in asset management industry comes from executive
compensation and as revolutionary as it sounds, it needs to be cut down, especially
when the times are tough. This is an industry with very low entry costs – anhone can set
up a shop and proclaim that they are now investment advisors. However, only reputable
and strong-performing ones survive in the long run. Investing in a strong brand through
a focused PR campaign, not through advertising, becomes a critical point for survival
and growing in this industry. Those asset managers that don’t do “open” PR usually
implement a subtle but strategically focused and consistent channel management and
move resources to relationship building with most influential institutional sales
consultants. Part of success is also in having a product mix that fits neatly in
consultants’ boxes – such as large-cap, mid-cap, growth or value-style investment
products. Lack of diverse offering in these major areas represents lost opportunities.
Mixed offerings, when a manager shifts from one style to another, for example, when
he/she maneuvers between growth and value, create confusion and slows adoption
curve for institutional sales consultants that are the most profitable channel for the
mutual fund industry.

Part 3 – Attempt to formulate a solution

There is no real solution for having no obsolete items in the inventory or for not ever
having a lost sale. Human error in forecasting and ever changing tastes of consumers
are imminent and until people become 100% predictable (hopefully never) there will be
fashion and IT items in the unsold items category and there will be items that
consumers couldn’t purchase due to their absence from the stock. The question remains,
however, what percentage of these items represent a threat to the profitability and what
percentage could be tolerated. One of the possible factors to consider is a growth stage
of a company. “Many companies require higher levels of inventories and accounts
receivables as they grow” (Michael Mauboussin, “What you see is what you get: Why
cash flows are more important than earnings” July 23, 2007, Legg Mason Capital
Management, white paper, p. 2). If we believe this statement, we need to adjust the
level of severity of supply chain revamping to the growth stage of the company –
companies that grow faster should have bigger inventories, this will be compensated by
higher sales they generate due to their faster growth.
To minimize damage from lost sales and obsolescence of the products, computer
models need to be developed to create multiple probability scenarios and to find an
optimal realistic mix between the two components. These models would need to
analyze the opportunity cost of a lost sale in a similar way as opportunity cost is
analyzed in the asset management industry – looking at whether the lost sales cost the
company more in profit losses than investing the free capital that wasn’t used to
manufacture those sales at a current market rate of return. If all this doesn’t work, then
organizations like Santa Fe Institute can help test the billions of scenarios utilizing
enormous technological power of the computers they employ to solve highly complex
tasks.
Finally, for the remaining overstock there are several potential solutions.
To start with, there is Internet. Selling the remaining stock (that is assuming companies
did their best at achieving low levels of obsolescence and overstock) through auction-
based websites like Overstock.com or eBay or even Amazon.com may represent a low-
cost solution of getting rid of the items at the most profitable price. Establishing a non-
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By Anna Cobb

branded presence on those websites would cut down the intermediary costs even
further.
In United States, there are discount retailers that buy fashion items that became obsolete
or about to become obsolete (end-of-season supply, for example, that didn’t move from
the shelves) and they sell the items at their locations. Such retailers buy on huge
discount, of course, but some return from manufactured obsolete stock is better than no
return, usually (although it depends on the cost of sale to those discount players) so
such solution can work as well. Some fashion manufacturers insist on cutting down
labels from their discounted stock that they sell to companies like Loehmann’s, Kohl’s,
TJ Max, Burlington Coat Factory, etc, so that the brand would not face a potential harm
from being available at a discount store. Some major retailers like Nordstrom or Saks
Fifth Avenue, have their own locations where the discounted merchandise is available
at a lower price level. In that case it is up to the manufacturer to agree or not agree to be
marked down and sold at an outlet location. Some high-end luxury brands like Chanel
and Louis Vuitton are never marked down or sold through a lower-priced location even
of a reputable retail player. This needs to be decided by the brand manager and by the
senior executives of the company, whether they want to sell their obsolete merchandise
through a discounted location. All factors such as loosing the brand equity versus
maintaining the bottom line should be considered.
As for the IT overstock, this problem can be solved slightly easier as I see it. Computers
consist of parts, many of which probably don’t change from one machine to another.
Disassembling the overstock at global sourcing locations like China or Indonesia and
then reusing the still viable parts can be part of the solution. Donating the computers to
charity and writing off taxes can be another step. Selling the machines to emerging
economies at a higher price than would otherwise be paid at closeout sales in US or
European or Canadian locations is what I see as the most viable option. Russia, for
example, can certainly accommodate lower-priced slightly older PCs, as current prices
there for the same slightly obsolete technical products are very high (as well as
demand) but lower-end consumers cannot afford to own a PC. As practice showed,
having a PC and then being able to connect to Internet creates a networking effect that,
in turn, grows other markets, like online sales of regular consumer packaged goods,
consumer electronics, toys, books, games and music. So sending obsolete stock to
emerging economies at a bargain price can be beneficial to all sides. For better results,
it may be wise to have an auction system for obsolete lots of technical products that
businesses from emerging countries can bid on and buy. Or, perhaps, it is an
opportunity for an entrepreneur who would open a consolidator-type business and assist
IT companies and retailers in getting rid of obsolete products.
Same method can be used in selling the fashion items, although it is more challenging
due to increased education of global consumers and different tastes for fashion in
different countries. Understanding the foreign markets better may prove beneficial to
apparel manufacturers that want to sell obsolete merchandise. For example, there are
not enough fashionable clothes in big sizes in Russia and former Soviet Union. All
fashions arrive on time from Milan but they are all in sizes from zero to six and women
beyond this size range find themselves in a difficult situation. Therefore, selling bigger
size obsolete merchandise to Russia and smaller size to Asian countries (developing,
like Cambodia or other economies) may work. Of course, a statement like that is just a
wild suggestion as we would need to analyze financials for such solution and estimate
the risks involved, especially political, exchange, and logistical challenges.
 Case Analysis, Luxury 650
By Anna Cobb

By way of conclusion, I would like to emphasize that having properly managed supply
chain is certainly very important but it has to be part of the holistic growth strategy.
Innovations come at higher and higher pace and companies in most industries are
struggling to adapt to this pace. Only managers with vision and ability to navigate
through tough waters intuitively and skillfully would lead their companies to a long-
term sustainable growth. Only managers that can anticipate changes, prepare their
teams, motivate them and develop them would get through. This is not a direct path but
it is a path with a clear vision of the finish line.