Zara’s Business Model, Information and Communication Technologies, and Competitive Analysis

Zara’s Business Model, Information and Communication Technologies, and Competitive Analysis

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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.

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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
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