HBS Case Study : Interco 9-291-033

HBS Case Study : Interco 9-291-033

• Started out as shoe company – been around a long time
• •Business has spread to other consumer products / services through acquisitions
• •Fairly conservative financially, debt level is relatively low
• Interco has moved away from apparel and general retail (went from 59% to 40% of total sales) •
• Placed more emphasis on the footwear division. (acquired Converse in 1986) •
• Placed much more emphasis on the furniture division (sales rose from 20-33% of Interco’s total sales)

Current Scenario

• •Cheap imports hurting profitability of U.S. apparel manufacturers
• •Retailing industry profits reduced due to drop-off in consumer spending and deep discounting programs being offered by retailers in 1987
• •Furniture and home furnishings prospects appear bright given favorable demographic trends in family formations (success of firms like Home Depot proved this ex post!)
• •October 1987 stock market crash still in rear-view mirror

Operations

Currently has four major divisions

1. Apparel (e.g., London Fog)
2. General retail merchandising (Central Hardware)
3. Footware (Converse, Florsheim)
4. Furniture and home furnishings (Ethan Allen)

Interco's Goal

• •Improve long-term sales and earnings growth •
• •Earn increased return on assets and equity

Concern
Interco concerned stock price may be undervalued

• Management felt that bad performance in apparel group is unduly dragging down Interco’s stock price.
• Because of this “undervaluation,” Interco’s management afraid may be a takeover target.

Action taken by Interco

Following 1987 crash, Interco’s board authorized repurchase of 5 million shares (by end of fiscal 1988 over 4 million shares had been repurchased – over 10% of the equity)

7/15/88 Interco announces reorganization plan

–sell the apparel division that is dragging down rest of company
–take the money raised from this sale and return it to shareholders (via special dividend or repurchase)

Raise of new problem
Rales Brothers: they buy undervalued companies with strong brand-names

• City Capital (formed by Rales) has Interco in it sights
• Thinks currently that the sum of Interco’s parts exceeds Interco’s current stock price
• Plans to sell apparel division and also sell part of footwear division, focus on home furnishing

Offer for takeover

• City Capital has accumulated 8.7% of Interco’s stock
• Ups the ante on 7/27/88: City Capital proposes a merger/takeover of Interco and offers to buy Interco’s stock for $64 per share (price was $44.75 on 6/30/88)
• Morning of 8/8/88:Offer raised to $70 per share
• Offer is timed well – Interco happens to have a Board meeting scheduled for 8/8/88.
• Board wants their financial advisor, Wasserstein, Perella, & Co. to evaluate City Capital’s offer.

Solution:

WACC calculation:

discount rate for Interco’s free cash flows:

10-year Treasury bond returns 9%
10-year AAA bond returns 9.5%

Long-term Growth Rate Given multiple applied and discount rate assumed, can back out the implied long-term growth rate of free-cash flow. Way to check if value obtained using market data of competitors can be justified by DCF analysis.

Value of firm10 = FCF11 / (r - g) = FCF10 * (1+g) / (r - g)

Value of firm10 = 14*FCF10 (by assumption)

=> 14 = (1+g) / (r - g)

r = .10 => g = .027

r = .11 => g = .036

r = .12 => g = .045

r = .13 => g = .055

r = .14 => g = .064

Stock price at various discount rates

Discount rate	14 times	15 times	16 times
10.00%	$80	$84	$87
11.00%	74	77	81
12.00%	69	72	74
13.00%	64	66	69
14.00%	59	61	64

End of Interco

• •8/22/88 Wasserstein, Perella adjust valuation range to $74-87 •
• 9/10/88 City Capital raises offer to $72 per share •
• 9/19/88 Board adopts restructuring plan and rejects $72 offer •
• 10/17/88 City Capital raises offer to $74 •
• 10/19/88 Board declares large dividend financed by debt (and anticipation of proceeds from selling off divisions), rejects $74 offer •
• 11/16/88 City Capital $74 offer expires, Interco stock price falls closing at $63.375 •
• 11/16/88 group of shareholders file lawsuit against Interco and its Board in connection with Interco’s avoidance of the hostile tender offer by City Capital (breach of fiduciary responsibility) •Under 11/88 restructuring, Interco to pay $1.42 billion cash dividend
• Earnings were less than forecast during 1989-1990
• Proceeds from asset sales less than anticipated
• Spring of 1990, Interco pays $18.5 million to settle the shareholder lawsuit
• Spring of 1990, Interco begins to work with creditors to restructure its debt
• 6/15/90 Interco defaulted on bond payments
• 1/24/91 Interco filed for bankruptcy and sued Wasserstein, Perella, & Co. for negligence

Interesting side note (footnote 2 of the case): Wasserstein, Perella, & Co. get $1.8 million from Interco for its advice/services, however get a $3.7 million bonus if City Capital rescinded their offer to buy Interco and Interco then put in place its own restructuring plan.

Short notes on Option contract

Option contract

Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc.

Under Securities Contracts (Regulations) Act,1956 options on securities has been defined as "option in securities" means a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities;An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price.

Therefore, in the case of American options the buyer has the right to exercise the option at anytime on or before the expiry date. This request for exercise is submitted to the Exchange, which randomly assigns the exercise request to the sellers of the options, who are obligated to settle the terms of the contract within a specified time frame.

As in the case of futures contracts, option contracts can be also be settled by delivery of the underlying asset or cash. However, unlike futures cash settlement in option contract entails paying/receiving the difference between the strike price/exercise price and the price of the underlying asset either at the time of expiry of the contract or at the time of exercise / assignment of the option contract.

OPTIONS NOMENCLATURE


OPTION HOLDER; OPTION WRITER


The option holder is the person who buys the right conveyed by the option.

EXAMPLE: The holder of a physical delivery XYZ call option has the right to purchase shares of XYZ Corporation stock at the specified exercise price upon exercise prior to the expiration of the option. The holder of a physical delivery XYZ put option has the right to sell shares of XYZ Corporation at the specified exercise price upon exercise prior to the expiration of the option. The holder of a cash-settled option has the right to receive an amount of cash equal to the cash settlement amount (described below) upon exercise prior to the expiration of the option.

The option writer is obligated, if and when assigned an exercise to perform according to the terms of the option. The option writer is sometimes referred to as the option seller. An option writer who has been assigned an exercise is known as an assigned writer.

EXAMPLE: If a physical delivery XYZ call option is exercised by the holder of the option, the assigned writer must deliver the required number of shares of XYZ common stock. He will be paid for the shares at the specified exercise price regardless of their current market price. If a physical delivery put option is exercised, the assigned writer must purchase the required number of shares at the specified exercise price regardless of their current market price. If a cash-settled option is exercised, the assigned writer must pay the cash settlement amount.

No certificates are issued to evidence options. Investors look to the confirmations and statements that they receive from their brokerage firms to confirm their positions as option holders or writers.

CASH SETTLEMENT AMOUNT, SETTLEMENT CURRENCY and EXERCISE
SETTLEMENT VALUE

The cash settlement amount is the amount of cash that the holder of a cash-settled option is entitled to receive upon exercise. It is the amount by which the exercise settlement value of the underlying interest of a cash-settled call exceeds the exercise price, or the amount by which the exercise price of a cash-settled put exceeds the exercise settlement value of the underlying interest, multiplied by the multiplier for the option.

EXAMPLE: Assume that a holder of a cash-settled call on the XYZ index that has an exercise rice of 80 exercises it when the exercise settlement value of the index is 85. If the multiplier for XYZ index options is 100, the assigned writer would be obligated to pay, and the exercising holder would be entitled to receive, a cash settlement amount of $500 ($85 minus $80 multiplied by 100=$500).

The currency in which the cash settlement amount is payable is called the settlement currency. The settlement currency for all cash-settled options with standardized terms that are trading at the date of this booklet is U.S. dollars. It is possible that another currency will be the settlement currency for some options introduced in the future.

The manner of determining the exercise settlement value for a particular option series is fixed by the options market on which the series is traded. The exercise settlement values for options on a particular underlying interest traded in one options market will not necessarily be determined in the same manner as the exercise settlement values for options or futures on the same underlying interest that may be traded in other markets.

Options markets may change the method of determining exercise settlement values for particular options series on specified days or on all days. These changes may be made applicable to series outstanding at the time the changes become effective. Alternatively, an options market might phase in a change in the method of determining exercise settlement values by opening new series of options identical to outstanding series in all respects other than the method for calculating exercise settlement values. Such new series would trade alongside the old series until both series expire, but the two series would not be interchangeable. In the future, options markets may, subject to regulatory approval, introduce options whose exercise settlement values may not exceed a specified maximum amount.

ADJUSTMENT and ADJUSTMENT PANEL

Adjustments may be made to some of the standardized terms of outstanding options upon the occurrence of certain events. Adjustments that may be made to a particular type of options are discussed in the chapter relating to that type. The determination of whether to adjust outstanding options in response to a particular event, and, if so, what the adjustment should be, is made by a majority vote of an adjustment panel. Every determination by an adjustment panel is within its sole discretion and is binding on all investors.

PREMIUM

The premium is the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option. It is the price set by the holder and writer, or their brokers, in a transaction in an options market where the option is traded. It is not a standardized term of the option. The premium does not constitute a "down-payment." It is simply and entirely a non-refundable payment in full-from the option holder to the option writer-for the rights conveyed by the option. The premium is not fixed by the options markets. Premiums are subject to continuous change in response to market and economic forces, including changes in the trading conditions on the markets where the particular options are traded. The factors which may generally affect the pricing of an option include such variables as the current value of the underlying interest and the relationship between that value and the exercise price, the current values of related interests (e.g., futures on the underlying interest or other interests related to the underlying interest), the style of the option, the individual estimates of market participants of the future volatility of the underlying interest, the historical volatility of the underlying interest, the amount of time remaining until expiration, cash dividends payable on the underlying stock (in the case of stock and stock index options), current interest rates, current currency exchange rates (in the cases of foreign currency options and options whose premiums or cash settlement amounts are payable in a foreign currency), the depth of the market for the option, the effect of supply and demand in the options market as well as in the markets for the underlying interest and for related interests, the information then available about current prices and operations in the markets for the underlying interest and related interests, the individual estimates of market participants of future developments that might affect any of the foregoing, and other factors generally affecting the prices or volatility of options, underlying interests, related interests or securities generally. Also see the discussion below of "Intrinsic Value and Time Value." Readers should not assume that options premiums will necessarily conform or correlate with any theoretical options pricing formula, chart, last sale, or the prices of the underlying interest, related interests or other options at any particular time.

The currency in which the premium is payable is called the premium currency. The premium currency for most options is U.S. dollars. However, the premium currency for cross-rate foreign currency options is a foreign currency, and other options with premiums payable in a foreign

currency may be introduced after the date of this booklet.

OPENING TRANSACTION

This is a purchase or sale transaction by which a person establishes or increases a position as either the holder or the writer of an option.

CLOSING TRANSACTION

This is a transaction in which, at some point prior to expiration, the option holder makes an offsetting sale of an identical option, or the option writer makes an offsetting purchase of an identical option. A closing transaction in an option reduces or cancels out an investor's previous position as the holder or the writer of that option.

EXAMPLE: In June an investor buys a December XYZ 50 call at an aggregate premium of $500. By September the market price of the option has increased to $700. To seek to realize his $200 profit, the investor can direct his broker to sell an offsetting December XYZ 50 call in a closing transaction. On the other hand, if by September the market price of the option has decreased to $300, the investor might still decide to sell the option in a closing transaction, thereby limiting his loss to $200.

POSITION LIMITS

The rules of the options markets generally limit the maximum number of options on the same side of the market (i.e., calls held plus puts written, or puts held plus calls written) with respect to a single underlying interest that may be carried in the accounts of a single investor or group of investors acting in concert. These limits which are called position limits-differ for options on different underlying interests. Information concerning the position limits for particular options is available from the options market on which those options are traded or from brokerage firms.

COMBINATIONS; SPREADS and STRADDLES

Combination positions are positions in more than one option at the same time. Spreads and straddles are two types of combination positions. A spread involves being both the buyer and writer of the same type of option (puts or calls) on the same underlying interest, with the options having different exercise prices and/or expiration dates. A straddle consists of purchasing or writing both a put and a call on the same underlying interest, with the options having the same exercise price and expiration date.

LONG and SHORT

The word long refers to a person's position as the holder of an option, and the word short refers to a person's position as the writer of an option.

COVERED CALL WRITER

If the writer of a physical delivery call option owns or acquires the amount of the underlying interest that is deliverable upon exercise of the call, he is said to be a covered call writer

EXAMPLE: An individual owns 100 shares of XYZ common stock. If he writes one physical delivery XYZ call option-giving the call holder the right to purchase 100 shares of the stock at a specified exercise price-this would be a covered call. If he writes two such XYZ calls, one would be covered and one would be uncovered.

The distinction between covered and uncovered call writing positions is important since uncovered call writing can involve substantially greater exposure to risk than covered call writing. A call option writer who is not a covered writer may hold another option in a spread position and thereby offset some or all of the risk of the option he has written. However, the spread may not offset all of the risk of the uncovered writing position. For example, if the long portion of the spread has a higher exercise price than the exercise price of the short, or if the long has an earlier expiration date than the expiration date of the short, then the writer may still be exposed to significant risks from his uncovered writing position.

AT THE MONEY

This term means that the current market value of the underlying interest is the same as the exercise price of the option.

IN THE MONEY

A call option is said to be in the money if the current market value of the underlying interest is above the exercise price of the option. A put option is said to be in the money if the current market value of the underlying interest is below the exercise price of the option.

EXAMPLE: If the current market price of XYZ stock is $43, an XYZ 40 call would be in the money by $3.

OUT OF THE MONEY

If the exercise price of a call is above the current market value of the underlying interest, or if the exercise price of a put is below the current market value of the underlying interest, the option is said to be out of the money by that amount.

EXAMPLE: With the current market price of XYZ stock at $40, a call with an exercise price of $45 would be out of the money by $5 as would a put with an exercise price of $35.

INTRINSIC VALUE and TIME VALUE

It is sometimes useful to consider the premium of an option as consisting of two components: intrinsic value and time value. Intrinsic value reflects the amount, if any, by which an option is in the money. Time value is whatever the premium of the option is in addition to its intrinsic value. An American-style option may ordinarily be expected to trade for no less than its intrinsic value prior to its expiration, although occasionally an American-style option will trade at less than

its intrinsic value. Because European-style and capped options are not exercisable at all times, they are more likely than American-style options to trade at less than their intrinsic value when they are not exercisable.

EXAMPLE OF A CALL WITH INTRINSIC VALUE: At a time when the current market price of XYZ stock is $46 a share, an XYZ 40 call would have an intrinsic value of $6 a share. If the market price of the stock were to decline to $44, the intrinsic value of the call would be only $4. Should the price of the stock drop to $40 or below, the call would no longer have any intrinsic value.

EXAMPLE OF A PUT WITH INTRINSIC VALUE: At a time when the current market price of XYZ stock is $46 a share, an XYZ 50 put would have an intrinsic value of $4 a share. Were the market price of XYZ stock to increase to $50 or above, the put would no longer have any intrinsic value.

EXAMPLE OF TIME VALUE: At a time when the market price of XYZ stock is $40 a share, an XYZ 40 call may have a current market price of, say, $2 a share. This is entirely time value.

An option with intrinsic value may often have some time value as well-that is, the market price of the option may be greater than its intrinsic value. This could occur with an option of any style.

EXAMPLE: With the market price of XYZ stock at $45 a share, an XYZ 40 call may have a current market price of $6 a share, reflecting an intrinsic value of $5 a share and a time value of $1 a share.

An option's time value is influenced by several factors (as discussed above under "Premium"), including the length of time remaining until expiration. An option is a "wasting" asset; if it is not sold or exercised prior to its expiration, it will become worthless. As a consequence, all else remaining the same, the time value of an option usually decreases as the option approaches expiration, and this decrease accelerates as the time to expiration shortens. However, there may be occasions when the market price of an option may be lower than the market price of another

option that has less time remaining to expiration but that is similar in all other respects.

An American-style option's time value is also influenced by the amount the option is in the money or out of the money. An option normally has very little time value if it is substantially in the money. Although an option that is substantially out of the money has only time value, the amount of that time value is normally less than the time value of an option having the same underlying interest and expiration that is at the money.

Another factor influencing the time value of an option is the volatility of the underlying interest. All else being the same, options on more volatile interests command higher premiums than options on less volatile interests.

Time value is also influenced by the current cost of money. Increases in prevailing interest rates tend to cause higher premiums for calls and lower premiums for puts, and decreases in prevailing interest rates tend to cause lower premiums for calls and higher premiums for puts.

The following is a description of the terminology applicable to capped options:

CAP INTERVAL

The cap interval is a constant established by the options market on which a series of capped options is traded. The exercise price for a capped-style option plus the cap interval (in the case of a call) or minus the cap interval (in the case of a put), equals the cap price for the option. For example, if a capped call option with an exercise price of 360 has a cap interval of 30, then the cap price at which the option will be automatically exercised would be 390.

CAP PRICE

The cap price is the level that the automatic exercise value of a capped option must reach in order for the option to be automatically exercised. The cap price of a call option is above, and of a put option below, the exercise price of the option.

EXAMPLE: A 360 ABC capped call index option has an exercise price of 360 and a cap interval of 30. The call option has a cap price of 390.

EXAMPLE: A 310 XYZ capped put index option has an exercise price of 310 and a cap interval of 20. The put option has a cap price of 290.

AUTOMATIC EXERCISE VALUE

The automatic exercise value of a capped option is the price or level of the underlying interest determined in a manner fixed by the options market on which the option is traded for each trading day as of a specified time of that day.

EXAMPLE: A 310 XYZ capped put index option has a cap interval of 20, and therefore has a cap price of 290. Assume that the options market on which the option is traded has specified the close of trading on each trading day as the time for determining the automatic exercise value on the XYZ index, and that the index level reaches a low of 289 during a particular trading day, but is at 291 at the close. The automatic exercise value has not reached the cap price, and the automatic exercise feature of the option is not triggered, because the index level was not at or below the cap price at the time of day specified by the options market for determining the automatic exercise value.

CASH SETTLEMENT AMOUNT

This is the cash amount that the holder of a cash-settled capped option is entitled to receive upon the exercise of the option. In the case of a capped option that has been automatically exercised, the cash settlement amount is equal to the cap interval times the multiplier for the option, even if the automatic exercise value on the day that the automatic exercise feature is triggered exceeds (in the case of a call) or is less than (in the case of a put) the cap price. If the capped option is voluntarily exercised at expiration, the cash settlement amount is determined in the same manner as for other styles of cash settled options.

EXAMPLE: A 360 ABC capped call index option has a cap interval of 30 and a multiplier of 100. The automatic exercise value of the ABC index is 396 on a particular trading day. The call option is automatically exercised, and the cash settlement amount is $3000 (equal to the cap interval of 30 times the multiplier of 100).

EXAMPLE: A 360 ABC capped call index option has a cap interval of 30 and a multiplier of 100. The automatic exercise value of the ABC index never equals or exceeds the cap price of 390 during the life of the option, and the exercise settlement value of the option is 367 on the final trading day. Upon exercise of the option, the holder is entitled to receive a cash settlement amount of $700 (equal to the multiplier of 100 times the difference between the exercise settlement value of 367 and the exercise price of 360).

CPFR: Supply chain redefined

Introduction to CPFR

A highly recognized collaboration initiative used in the retail industry is Collaborative Planning, Forecasting, and Replenishment (CPFR). CPFR’s underlying premise is that broad integration of firms within the supply chain will lead to a better focus on customers through the development of a single shared forecast of demand and a reduction of lead times. The benefits resulting from a successful application of CPFR include reductions in stock-outs, improved inventory management, shorter cycle times, increases in sales revenues, stronger relationships between trading partners, better overall system visibility and customer service, and improved cost structures.

CPFR originated in 1995 as an initiative co-led by Wal-Mart and consulting firm Benchmarking Partners. With assistance from Benchmarking Partners and IT firms such as IBM, SAP, i2, and Manugistics, Wal-Mart and Warner-Lambert implemented the first pilot of CFAR to increase sales, reduce inventory, and improve the in-stock position of Listerine, the project’s pilot product.Since this project, CPFR has evolved and is a strategic initiative implemented by many companies throughout North America and Europe.

In 2003, it was estimated that in the United States alone, more than $15 billion in the supply chain is managed by CPFR. VICS created guidelines for CPFR in 1998. Since the development and publication of these guidelines, over 300 companies have successfully implemented CPFR. The implementation of CPFR has also extended to industry sectors beyond retail, including high-tech industries. Rosettanet, a non-profit consortium of high-tech firms, has developed a collaborative forecasting standard for applying CPFR practices to that industry. Today, the VICS CPFR Committee works “to develop business guidelines and roadmaps for various collaborative scenarios, which include upstream suppliers, suppliers of finished goods and retailers, which integrate demand and supply planning and execution.

According to the Gartner Group, “Enterprises that collaboratively integrate disparate forecasting systems…will improve revenue predictability by 10 to 25 percent and decrease inventory carrying costs by more than 30 percent over a three-year period.”

Unfortunately, the dream of inter-firm collaboration leading to supply chain improvement has yet to be realized on a large-scale basis. According to the Voluntary Inter industry Commerce Solutions (VICS) Association, this lack of adoption is due to the following challenges: (1) selecting the right partners and products with which to implement CPFR, (2) establishing discipline for regular and periodic performance measurements, (3) committing to implement CPFR on a broad scale, (4) aligning corporate philosophies with CPFR philosophies and (5) managing organizational changes that may be required.

CPFR has been generally limited to collaboration between a retailer and only one major supplier, providing evidence that the broad integration of the CPFR initiative set out to achieve has been unrealized.

Predecessors to CPFR

There have been a number of widely known initiatives started with the goal of increasing collaboration and information sharing. It is also likely that countless initiatives have been undertaken within many companies with varying practices and mixed results. The following initiatives are fairly well known and are basis of CPFR.

Vendor-Managed Inventory (VMI), introduced by Kurt Solomon Associates in 1992 is perhaps the most widely known system for managing supply chains.Under VMI, the buyer authorizes the supplier (i.e., vendor) to manage the inventory of a set of stock-keeping units (SKUs) at the buyer's site(s) under agreed-upon parameters (e.g., minimum and maximum inventory targets). The buyer provides the supplier with sales and/or inventory-status information; and the supplier makes and implements decisions about replenishment quantities and timings. VMI reduces information distortion, which is one cause of the bull-whip effect. In addition, VMI provides the supplier with the opportunity to better manage its own production, inventory, and transportation costs. In exchange, the buyer typically receives price discounts or improved terms of payment from the supplier.

Efficient Consumer Response (ECR) is a consumer goods (primarily grocery) initiative aimed at improving responsiveness to consumer demand and reducing inefficient practices, costs, and waste in the supply chain. This is basically an application of JIT to retail distribution.The consumer products industry was in the midst of a fundamental shift in attitudes concerning traditional business practices among its participants, particularly as those practices relate to trade promotions and replenishment of products across the supply chain. Contributing to this shift were significant advancements in information technology, growing competition, and global business structures, and changes in consumer demand. This shift in attitude crystallized in the formation of an industry-wide working group and the issuance of a report in late 1992 that set the stage for what has come to be known as the Efficient Consumer Response (ECR).

Quick Response (QR) or Rapid Response comes primarily from the fashion and textiles industry. It was innovated by Milliken & Company in the early 1990's and subsequently codified by VICS,the same organization that oversees the codification and standardization of CPFR practices. QR in the simplest sense is a next generation, codified version of ECR. Central to the initiative is flexible and responsive production that relies on customers along the supply chain to define when, where, and how much of a given product is needed. The initiative has four levels of application and technology. Levels 1 and 2, for example, involve retailer inventory-status information-sharing and automatic order-processing between retailer and supplier. Levels 3 and 4 include VMI and cross docking warehouses.

Although VMI and QR might be the best-known management systems among both practitioners and academics, perhaps the most highly regarded systems are proprietary systems developed by large retailers, such as Wal-Mart's RetailLink, Kmart's Workbench, and Target's Partners Online. Although the detailed inner workings of these systems are closely guarded secrets, they all have two common characteristics: (1) The sharing of transactions-level data among partners and (2) The use of agreed-upon metrics (e.g., in-stock, inventory-turnover, and on-time delivery measures) and targets to assess partner performance. Both characteristics are central to CPFR.

CPFR Model

The CPFR model offers a general framework by which a buyer and seller can use collaborative planning, forecasting, and replenishing processes in order to meet customer demand. To increase performance, the buyer and seller are involved in four collaboration activities that are listed in logical order, but companies often engage in these activities simultaneously.

The first collaboration activity is Strategy and Planning. In this activity, the buyer and seller come to an understanding about their relationship and establish product and event plans. The second activity is Demand and Supply Management in which customer demand and shipping requirements are forecasted. Execution is the third collaboration activity and involves placing, receiving, and paying for orders, and also preparing, delivering, and recording sales on shipments. The fourth and final activity is Analysis.

1. Strategy and Planning

The first collaboration task under this activity is Collaboration Arrangement, which is a method for defining the relationship in terms of establishing business goals, defining the scope, and assigning checkpoints and escalation procedures, roles, and responsibilities. The retailer task related to this collaboration task is Vendor Management, and the manufacturer task is Account Planning. The second collaboration task is Joint Business Plan. This task pinpoints the major actions that affect supply and demand in the planning period. Examples of these are introducing new products, store openings and closings, changing inventory policy, and promotions. The retailer task associated with this is Category Management and the manufacturer task is Market Planning.

2. Demand and Supply Management

Sales Forecasting, which projects point-of-sale consumer demand, is one of the collaboration tasks associated with this activity. The retailer task here is POS Forecasting and the manufacturer task is Market Data Analysis. The other collaboration task is Order Planning/Forecasting which uses factors such as transit lead times, sales forecast, and inventory positions to determine future product ordering and requirements for delivery. The associated retailer task is Replenishment Planning, and Demand Planning is the associated manufacturer task.

3. Execution

The first collaboration task under the Execution activity is Order Generation. This task transitions forecasts to demand for the firm. The retailer task related to this collaboration task is Buying/Re-buying, and the manufacturer task is Production and Supply. The second collaboration task is Order Fulfillment and this is the preparation of products for customer purchase through the process of producing, shipping, delivery, and stocking. In this case, both the retailer and manufacturer task is Logistics/Distribution.

4. Analysis

Exception Management, which oversees the planning and operations for conditions that are out-of-bounds, is one of the collaboration tasks associated with this activity. The retailer task is Store Execution and the manufacturer task is Execution Monitoring. The other collaboration task is Performance Assessment which calculates important metrics in order to discover trends, develop other strategies, and assess the attainment of business goals. The retailer task here is Supplier Scorecard and the manufacturer task is Customer Scorecard.

The model described here is a two-tiered model. However, this model can be extended to include more than two layers in the supply chain. VICS calls this N-tier Collaboration, which is a relationship that develops from retailers through manufacturers/distributors to suppliers.

Drivers & Barriers of CPFR Implementation

Trust between supply chain partners

“Retailers and manufacturers believe there is a fundamental lack of trust between trading partners that stymies collaboration.” Should a partner leak price points, strategy, or tactics to a competitor, the effectiveness of promotions would surely be undermined. However, the collaborative opportunity will not likely be met with conspirators looking to take advantage of trusting partnerships.

Measuring value and financial results

Wary of making big investments and seeing little or no returns, some companies don’t see CPFR as an imperative for their enterprise right now. They feel there is no guarantee that they will see the financial results necessary to get company-wide buy-in.

Insufficient organization/ process enablement

CPFR’s process intensive nature and the need to synchronize changes between participants make internal cultures, organization, and processes important to the success of the collaboration.

Study of supply chain @ Zara Fast Fashion

Zara Inc

With some 740 stores in 54 countries, the Spanish clothing retailer Zara has hit on a formula for supply chain management that works by challenging conventional wisdom. This excerpt from a recent Harvard Business Review profile on how Zara’s supply chain communicates, allowing it to design, produce, and deliver a garment in fifteen days.

Zara’s history began in 1963 when Amancio Ortega Gaona opened Confecciones GOA in La Coruña, to manufacture women’s pyjamas and lingerie products for garment wholesalers. In 1975, after a German customer cancelled a sizable order, the firm opened its first Zara retail shop in La Coruña. The original intention was simply to have an outlet for cancelled orders. However, the experience taught the firm the importance of a ‘marriage’ between manufacturing and retailing - a lesson that has guided the evolution of the company ever since.

From a starting point of six stores in 1979, the company established retail operations in all the major Spanish cities during the 1980’s. In 1985, Confecciones GOA created Inditex as the head of the corporate group. In 1988, the first Zara store outside Spain opened in Porto, Portugal, followed shortly by a store in New York City in 1989 and Paris in 1990. However, the real ‘step-up’ in foreign expansion took place during the 1990s when Inditex entered 29 countries in Europe, the Americas and Asia.

In parallel with its overseas expansion, Inditex diversified its retail offering by another adjacency expansion with new brands like Pull and Bear, Massimo Dutti, Bershka and Stradivarius to meet new customer segments. However, Zara still count for eighty per cent of Inditex’s revenue. Each of Inditex’s brands operates independently, but shares the commitment to supply fashion at affordable prices and all employ similar management models for the control of the total supply chain to maximize speed to market.

Fig 1 illustrates Inditex’s expansion. The figure imitates the stem of a tree, which gain a new circle for every year that goes by. The circles indicate the different expansion Inditex has accomplished, moving from being a fabric to opening its first store and to opening other clothing chains. These types of expansions justify as adjacency expansion. Adjacency expansion draws the skills in the core business to build a competitive advantage in a new adjacent competitive arena in order to target different customer segments.

Figure 1: Inditex’s adjacency expansion throughout its history

This adjacency expansion has lead to the need of changing Inditex’s core business. Inditex has shifted from being a fabric working towards several retailers, to becoming a big concern covering most parts of the production as well as the final sale.

To grow into a new adjacency around a once-successful core business is the critical factor in 75 per cent of today’s total business disasters. The American grocery chains Wal-Mart and Kmart illustrate an example on difficulties in adjacency expansion. They both open their first grocery store in 1962. Wal-Mart successfully moved into adjacency such as Sam’s Club, electronics and Mexico, one by one. Kmart however, struggled more with the expansion. They moved from books to sporting goods and even to a chain of department stores in Czechoslovakia. This drifted Kmart into bankruptcy. Showing that even though they started out equally, the different choose of steps in adjacency expansion lead one to be a big failure and the other to be one of USA most respected companies.

Another example is Nike versus Reebok, which in 1990 had almost equal revenue. While Nike had a clear strategy, consisting of a repeatable process it had developed and refined over a decade, to attack one sport after another with the help of different famous athletes, Reebok’s path was a mystery to those covering the company. They expanded in different directions and as their core shoe business was doing badly, they kept on expanding into new unconnected arias. In addition, Nike’s strong adjacencies expansion made it even harder for Reebok to increase the total sale and ended up decreasing its revenue.

It is not easy to know which expansion that is the right expansion. However, after studying adjacencies expansion in over 100 companies, Chris Zook presents primary six ways to expand the boundaries of business .Fig 2 illustrates these expansions. This is trough new businesses, forward integration, new geographies, new channels, new customer segments or new products.

Figure 2: Adjacency expansion throughout Chris Zook’s six steps.

In parallel to Inditex’s, Zara has accomplished several adjacencies expansions during its history. One of two main expansions is by moving from selling women’s underwear and pyjamas to regular clothes, shoes, handbags and even make-up. This signifies product adjacencies by marketing a new product or service to core customers. This is one of the most commonly pursued and highest potential adjacencies. The other main growth is by expanding into selling men’s wear and children’s wear. These customer adjacencies modifying a proven product or technology to enter a very new market segment and are a major adjacency move for most companies.

In addition, Zara continuously expand their business by successfully opening new stores around the world and at the same time enlarge their local industry by expanding the focused production in Spain. Geographic adjacencies move into new geographic areas, is a type of adjacency expansion that companies consistently underestimate in complexity.

Zara has also achieved new business adjacencies by opening Zara Home, a store that sell accessories to the home like kitchen wear and bedclothes. With this, it builds a new business around a strong capability and essentially repositioning it. This is the rarest form of adjacency move, and the most difficult to achieve success with. In addition, Zara has also expanded with channel adjacencies by offering a small proportion of its collection on Internet sale. Although this is more for promotion, it is still a channel adjacency expansion.

All of Zara’s different expansion fits into the primary six ways to expire the boundaries of business. Fig. 3 illustrated that Zara has expanded in every direction. Finding a repeatable method of moving into new adjacencies, one after the other has a clear benefit in the learning curve. This contributes to competitive advantage making the adjacencies better and faster each time.

Figure 3: Zara’s adjacency expansion throughout the six ways.

Zara’s supply chain

In an interview with CNN, Jose Maria Castellano, chief executive at Inditex, talked about Zara’s supply chain and indicated its unusual structure by saying:

"Investment banks used to say that this model did not work, but we have shown that it gives us more flexibility in production, sales and stock management,"

At a Zara store, customers can several times a week find new products. The whole collection is in limited supply and they achieve a tempting exclusivity by only displaying a few items, even though the stores are spacious. It makes the customer think, "This green shirt fits me, and there is only one on the rack. If I don't buy it now, I'll lose my chance."

Zara has built a concept around ‘fast fashion’. Moving away from the traditionally one collection per session, Zara continually design, produce and deliver new styles. They base their business on demand instead of forecasting. Picking up what people wear on the street, at the university or at a nightclub, Zara’s designer’s catches ideas for new styles and can present them in a Zara store only two weeks later, while most of the competitors has a lead-time over three months. This makes Zara always able to offer the latest fashion in it store, leading to more sale and fewer discounts.

Such a retail concept depends on the regular creation and rapid replacement of small batches of new goods. Zara’s designers create approximately 40,000 new designs annually and select 10,000 of them for production. Some of them resemble the latest fashion design creations. Zara often beats the high-fashion houses to the market and offers almost the same products, made with less expensive fabric, to much lower prices.

This fast fashion system depends on a constant exchange of information throughout every part of Zara’s supply chain. From customers to store managers, store managers to market specialists and designers, designers to production staff, buyers to subcontractors, warehouse managers to distributors, and so on. Most companies insert layers of bureaucracy that can bog down communication between departments. Zara's organization, operational procedures, performance measures, and even its office layouts, all are designed to make information transfer easy.

Zara's single, centralized design and production centre is in Inditex headquarters in La Coruña. It consists of three spacious halls, one for each of the three clothing lines, women, men and children. Unlike most companies, which try to remove unnecessary labour to cut costs, Zara makes a point of running three parallel, but operationally distinct, product families. Though it is more expensive to operate three channels, the information flow for each channel is fast, direct, and unencumbered by problems in other channels, making the overall supply chain more responsive. Each clothing line has separate design, sales, and procurement and production-planning staffs. A store may receive three different calls from La Coruña in one week from a market specialist in each channel; a factory making shirts may deal simultaneously with two Zara managers, one for men's shirts and another for children's shirts.

In each hall, floor to ceiling windows overlooking the Spanish countryside reinforce a sense of cheery informality and openness. Unlike companies that sequester their design staffs, Zara's cadre of 200 designers sits right in the centre of the production process. The designers are usually in their twenties and got the job because of their enthusiasm and talent, no prima donnas allowed. Split among the three lines, they work next to the market specialists and procurement and production planners. Large circular tables play host to spontaneous meetings. Racks of the latest fashion magazines and catalogues fill the walls. A small prototype shop has been set up in the corner of each hall, which encourages everyone to comment on new garments as they evolve.

The physical and organizational proximity of the three groups increases both the speed and the quality of the design process. Designers can fast and easy check initial sketches with colleagues. Market specialists, who are in constant touch with store managers and many of whom have been store managers themselves, provide quick feedback about the look of the new designs (style, colour, fabric, and so on) and suggest possible market price points. Procurement and production planners make preliminary, but crucial, estimates of manufacturing costs and available capacity. The cross-functional teams can examine prototypes in the hall, choose a design, and commit resources for its production and introduction in a few hours, if necessary.

Once the team selects a prototype for production, the designers refine colours and textures on a computer-aided design system. If the item is to be made in one of Zara’s factories, they transmit the specs directly to the relevant cutting machines and other systems in that factory. Bar codes track the cut pieces as they converts into garments through the various steps involved in production, including sewing operations, distribution, and delivery to the stores, where the communication cycle began.

Zara manufacture approximately fifty per cent of its products in its own network of 22 Spanish factories, 18 of which are located in and around the La Coruña complex, and use around 500 subcontractors located close to the head office for all sewing operations. Zara closely monitor these sewing operations to ensure quality, compliance with labour laws, and adherence to the production schedule. The subcontractors are responsible for picking up and deliver the production items to the factory. Here each piece is inspected during ironing, placed in plastic bags and sent to the distribution centre.

The other half of its products are procured from 400 outside suppliers, seventy per cent of which are in Europe, and most of the rest in Asia. Many of the European suppliers are located in Spain and Portugal, close to the headquarters. Zara exploits this geographical proximity in order to ensure quick response to Zara’s orders. From Asia, Zara procures basic products and those for which the region has a clear cost or quality advantage. Having the factories in and near Spain gives Zara a tremendous amount of control and flexibility. The location of the production can be seen as a cost trade-off with the cost saved on transportation. Although the increased cost in production will not be offset by the cost reduction in transportation concerning the labour cost is on average 17-20 times the cost in Asia.

For its in-house production, Zara obtain forty per cent of its fabric supply from another Inditex-owned subsidiary. The rest of the fabrics come from a range of 260 other suppliers, none account for more than four per cent of Zara’s total production in order to minimize any dependency on single suppliers and encourage maximum responsiveness from them. Most of the fabrics are ordered un-dyed and dyed in one of Inditex manufacturing facilities. By having its own dying facility Zara can quicker respond to demands and it gain less inventory by not storing every fabric in a range of colours. Moreover, if one fabric is not used it can easily be used next season independent of the colures of the next trend.

All products pass through Zara’s major distribution centre in La Coruña. In addition, it also has a smaller distribution centre in Zaragoza. The trucks, which run on a bus schedule, deliver to the stores twice a week, using a maximum of 24 hours to stores inside Europe and 48 hours in America. All in all this supply chain, as illustrated in Fig 4, is giving a lead-time on two to four weeks, with a price thirty per cent higher than its competitors and a need to discount only 18 percent of its production.

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Zara is careful about the way it deploys the latest information technology tools to facilitate these informal exchanges. Customized handheld computers support the connection between the retail stores and La Coruña. These PDA’s supplement regular, often weekly, phone conversations between the store managers and the market specialists assigned to them. Through the PDA’s and telephone conversations, stores transmit all kinds of information to La Coruña, such hard data as orders and sales trends and such soft data as customer reactions and the "buzz" around a new style. While any company can use PDA’s to communicate, Zara’s flat organization ensures that important conversations do not fall through the bureaucratic cracks.

The constant flow of updated data eases the bullwhip effect, the tendency of supply chains and all open-loop information systems to amplify small disturbances. A small change in retail orders, for example, can result in wide fluctuations in factory orders after transmitting through wholesalers and distributors. In an industry that traditionally allows retailers to change a maximum of twenty per cent of their orders once the season has started, Zara lets them adjust forty to fifty percent. In this way, Zara avoids costly overproduction and the subsequent sales and discounting prevalent in the industry.

The insistent introduction of new products in small quantities, ironically, reduces the usual costs associated with running out of any particular item. Indeed, Zara makes a virtue of stock-outs. Empty racks do not drive customers to other stores because the shoppers can always choose form new things. Being out of stock in one item helps sell another, since people are often happy to snatch what they can. In fact, Zara has an informal policy of moving unsold items after two or three weeks. This can be an expensive practice for a typical store, but since Zara stores receive small shipments and carry little inventory, the risks are small, unsold items account for less than ten per cent of stock, compared with the industry average of 17 to twenty per cent. Furthermore, new merchandise displayed in limited quantities and the short window of opportunity for purchasing items motivate people to visit Zara’s shops more frequently than they visit other stores. Consumers in central London, for example, visit the average store four times annually, but Zara's customers visit its shops an average of 17 times a year. The high traffic in the stores circumvents the need for advertising: Zara devotes just 0.3 per cent of its sales on ads, while its rivals spend three to four per cent.