H&M
The case describes the state of the fashion and textile industry, with particular orientation to the European market, and a Swedish company H&M. The discussion involves the merits of sourcing short lead time “fast fashion” clothes from either Romania or Asia.
Years of politically-motivated quota restrictions distorted the normal market processes. These restrictions, called the Multi Fibre Agreement (MFA), were phased out in 2005. The MFA phase out gave new opportunities to formerly excluded countries like China, at the expense of formerly protected countries. Under MFA, there was an exception that benefitted countries like Romania, which did not have big quotas but were close geographically to the European market. The Outward Processing Trade (OPT) allowed raw materials to move temporarily for processing to a lower cost country, and then be reimported to the host country with very little tax penalty, and without violating MFA. Generally, the OPT work involved simple cutting and sewing steps, with semi-finished items being delivered back to the customer.
The end of MFA made OPT arrangements less attractive. More and more textile and clothing work went to Asia, with countries like Romania seeing decreased demand for their factories. Romania’s entry in the European Union (EU) made specific OPT import restrictions largely irrelevant, but the style of work still continued. In order to most quickly design and distribute rapidly changing fashions, it would be ideal to have a vertically integrated structure, where all design, sourcing, manufacturing, and distribution are carried out under the same roof.
In the case of H&M, the design center is in Sweden. For low technology manufacturing like textiles, Sweden has an impossibly expensive price structure. So H&M must embrace alternate organizational methods. The decisions about where and what to manufacture are based on lead time, cost, and quality. Because of the cost advantage, slowly changing styles like jeans can tolerate the slower deliveries from Asia. H&M can therefore allocate its durable styles to suppliers in Asia.
The past decade has experienced a growth in “fast fashion”, where styles change every couple of weeks. H&M needs a solution for this part of its product line. There is insufficient time to move semi-finished items between different factories if the time constraints are to be met. Romania is a low cost manufacturing country within the European Union. Historically Romania has had a good reputation for complex clothing fabrication.
With the phase out of MFA, and subsequent drop off in OPT work, Romania needed to react with a new business approach. Romania remembered its strong manufacturing skills, and factories reinvented themselves as “turnkey” sources for completely finished fast-fashion clothes. H&M has taken advantage of this new capability, and currently sources some 40% of its “fast fashions” from countries like Romania.
OPT and Free Trade
OPT is not philosophically incompatible with Free Trade. Generally tax costs are based on value added. So moving products between countries for different parts of the process should only have tax consequences on the value added in each location. Unfortunately, tax and custom laws are politically motivated and so often give unfair advantage to one party over another. In this case OPT can act as a restriction or quota. There should be level of regulation concerning working conditions. It is inconceivable that rich Europeans should wear jeans made by slave labor. Ideally such working condition rules should be the only restriction against Free Trade, but unfortunately there are still trade and tariff distortions.
Whether involving OPT or not, companies should be able to make rational decisions on sourcing, based only on cost and similar factors. The cost element, including import taxes, is very important. Other factors, such as quality and lead time are also an important part of the decision matrix.
OPT in Romania
OPT gives Romania a simple method of obtaining business based on the absence of EU inter-country transfer taxes, and geographic proximity. However, OPT is a fragile advantage. A minor change in circumstances could obliterate the Romanian OPT work. Such changes could include tax laws, air freight rates, fast trains from China to Europe through Russia, electronic transmission of cutting patterns, etc. There is no skill or style anchor that binds the OPT work to a Romanian factory. The Swedish customers know this fact, and will relentlessly press for lower prices and margins from Romanian OPT companies. OPT solidifies the status of Romania as a low wage, low skill neighbor. Maybe the OPT work seems comfortable, but that comfort condemns Romania to mediocrity and removes incentives for Romania to move itself up the value chain.
Romania should consider OPT to be a temporary source of revenue as the country transitions from a Soviet economy to be a full member of the European Union. Poland has made this transition and could be a good model for Romania (Androshchuk, 2006).
Romania’s Industrial Future
Romania has a Gross Domestic Product (GDP) per Capita of $7,939. The low cost textile competitor Bangladesh has a GDP per Capita of $797 (UN.org, 2013). It is obvious that Romania cannot compete on labor costs with Bangladesh. Romania has two avenues, both of which should be pursued:
- First, Romania should apply more capital to its existing industries, to overcome its labor cost disadvantage. This would include faster or more automated machinery and processes. The processes are extremely important. It is less useful to apply new equipment to old methods.
- Second, Romania should move its industries up the value chain. A simple step is to move from a “cut and sew” model to producing finished ready-to-wear fashions. More fundamentally, Romania needs to totally rethink the types of work in which it is best able to excel. This requires a tremendous leap n imagination. Romania does not just need to do a better job, making the same products. Maybe Romania should make aircraft parts rather than dresses.
These two avenues are best implemented at the individual company level, not by government central planning. Market economies in Europe have performed better than Soviet planned economies.
In the short term, these two avenues will require Foreign Direct Investment (FDI). FDI may be in the form of loaned or leased advanced equipment, or direct equity investments. Here the government has a huge enabling role to play by establishing a predictable legal and property rights system, free from corruption (Androshchuk, 2006).
H&M’s Future
The case emphasizes sourcing and logistical aspects. H&M can gain advantage by effective supply chain integration to high quality manufacturers in nearby low-cost Romania. As mentioned, the Romanian factories could finish high value complicated clothes within short lead times. However, it is easy for a company to get bogged down in operational and logistical details, and forget the core imperative of the business.
For H&M, style and design are the core qualities. H&M will be successful if its styles are attractive. All other considerations are secondary. Basically, H&M needs better styling than its competitor ZARA. Excellent styling can come from in-house talent, but H&M should not be reluctant to search out innovative fashion house partners. Then to be competitive, H&M should separate the different issues. The issues are low cost Asian competition, cheap “knock offs”, and mature European markets. It is probably impossible to combat low cost commodity clothing from China and Bangladesh, and perhaps H&M should let that sector go.
One important item is branding and intellectual property rights. Though it is difficult to copyright dress designs, it is certainly possible to copyright fabric graphics and logos. H&M should emphasize branding, and the enforcement of its intellectual property rights. Major retail chains are sensitive to this issue and will cooperate in rejecting “pirate” merchandise, especially if there is strong brand recognition.
Fast fashion is a growing sector, in an otherwise mature European market. Almost certainly, ZARA and H&M both have representation in most European clothing stores. To gain and keep market share in fast fashion, H&M needs to deliver more exciting clothes to stores, while the styles are still hot. The “exciting” aspect is mentioned above. The speed aspect can be best accomplished by more closely integrating with the supply chain, including companies in Romania. Such integration could be technological, such as machine to machine data transfer. Integration could also be logistical, where the Romanian company ships directly to stores in London, bypassing Swedish warehousing. However, H&M should not have tunnel vision, just trying to do the same thing better.
H&M needs new markets. Middle class people in Shanghai do not want to wear commodity clothing. European brands are highly prized in developing markets. H&M should consolidate excellent logistics to serve fast fashion in Europe, but more importantly H&M should shift its attention to where there is growth potential. The growth potential is in China and the Asian Tigers, and perhaps Brazil (BCG.com, 2011).
References:
Androshchuk, A. (2006). Transition Economies: A Look at Russia, Ukraine and Poland. Honors College Theses. Paper 32. Retrieved from: http://digitalcommons.pace.edu/honorscollege_theses/32
Boston Consulting Group. (2011 July). Capturing the Dynamic Growth of China’s Fashion Market. Retrieved from https://www.bcg.com/documents/file81362.pdf
United Nations Statistics Division. (2013 December). National Accounts Main Aggregates Database. Retrieved from http://unstats.un.org/unsd/snaama/selbasicFast.asp
