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What are the hidden costs? Zara, Next and Mango pay for a collapsed supplier

The London Evening Standard reports that unpaid workers hid secret messages in clothing they made for the Zara fashion brand, advertising their plight after an outsourced manufacturer where they worked abruptly closed in Istanbul (http://bit.ly/2lVzXhO).  The workers also made clothing for the Next and Mango fashion brands at the factory.

The workers’ plight must be front and centre in this story.  Retailers will also want to listen to the workers implied message about rising reputational risks for retail brands.  Just one indicator of adverse reputational effects in this case: some 20,000 consumers have signed a petition in sympathy for the workers.

The article does not make clear why a manufacturer of such well-known fashion brands would be unable to continue as an ongoing business and close overnight, owing three months wages and other compensation to workers.  What is clear is that stakeholders of three highly respected fashion brands must be asking senior management how they got into this mess and how they plan to manage brand reputational risk better in the future.

Reputational risk can arise whenever a supplier does not adhere to standards for employee safety and well-being, compliance with relevant legal and regulatory requirements, environmental sustainability, adherence to product and process quality standards, and other criteria that potentially affect brand image and reputation.

Retailing is a competitive, low margin business.  As retailers worldwide point out, managing reputational risk arising from supply chains is costly.  It would be foolish to think that a supermarket chain with bottom-line margins below 10% could afford to regularly audit thousands of suppliers of products appearing on the shelf.  So, to reduce reputational and legal risks, South African retailers generally require suppliers to provide updated information on company registration information, ownership, B-BBEE certification, tax registration and clearance, and other criteria, as indicators of good corporate citizenship—offsetting at least some of the administrative costs with listing fees in some retail sectors.

Astute retailers know that the risk reputational harm is rising in the digital age.  Zara is a respected international brand facing the same problem Nike, Apple and others faced a decade ago.  They are not alone.  In South Africa and other countries, activists are using social media and organising opposition concerning issues such as food additives, the use of words such as “locally made”, “free range” and “organic” on labels, animal cruelty, and social and environmental sustainability.  Retailers may not like it, but the outcome of these conversations with the marketplace is in their interest in the longer term and affects how consumers choose and use brands in various market segments.

The current crisis facing Zara in Turkey throws a spotlight on the hidden costs of reputational risk and two key equity metrics that affect stakeholder and shareholder value.

Brand equity is the sum of brand awareness, brand loyalty and consumer brand associations—good and bad—that determine the value of a brand.  When brand equity is higher, sales and profits usually are too.  Two of the most important brand associations are trust and quality.  Reputational harm has a negative impact on consumer trust in a brand, evaluations of its quality and brand loyalty.

Customer equity is the sum of all customers’ lifetime value.  That is, the sum of the profits that will be earned over the lifetime of customer purchases, measured in value in today’s Rands.  Reputational harm affects customer equity by reducing sales, which impacts on profit margins.  Lost customers may return but buy less than they might have before the crisis, for several reasons.  For example, they may split future purchases with another fashion retail brand they experienced in the interim.  Thus, the effect of reputational harm is complex and so are its outcomes.  Less sales can mean lower gross profits.  Lower gross profits may prompt price increases to cover fixed costs or cost-cutting that affects customer service and further reduces sales.  The problems of Sears and Macy’s in the USA illustrate some of these effects.  For Zara, Next and Mango, the current crisis means that some customers may stop buying from them or spend less and that may be more painful than it looks at face value, due to the hidden cost of reputational risk.

What’s the hidden cost of reputational risk?  We really don’t know in the current case, but we can illustrate the effects.  In practice, we simplify the complexities of multi-currency global retailing, but the numbers illustrate the expected effect well.

What if 1,000 former customers worldwide were to stop shopping at a retailer permanently because of a reputational crisis?  Let’s assume that a retailer is losing just R500 margin per customer annually for the next ten years.  Let’s further conservatively assume a 5% interest rate above the rate of inflation.  The discounted hidden cost that does not appear in the financial statements exceeds R6.6 million!  Alternatively, what if 20,000 customers worldwide reduce their spending by just 25% for the next five years, on average?  The hidden cost exceeds R54 million, after discounting the value of future profits!  These hidden costs represent an effect on the bottom line and lost shareholder value.

Retailers will be wise to consider carefully the reputational risk implied by every supplier relationship.  Current practices in most major South African retailers are very good, but it may be time to consider expanding supplier oversight practices, especially when outsourced manufacturers produce private label brands and in product categories where noncompliance with quality and ethical standards would reflect badly on a retailer brand.

South African retailers will realise the importance of labour issues, especially, at a time when there are repeated calls to expand supply relations in one of the world’s most highly concentrated retail marketplaces and help achieve national social transformation goals and broad-based black empowerment.  True partnership with emerging manufacturers can play an important role in social and economic transformation, while ensuring that retail brands and stakeholder value are supported by the supply chain.

Many manufacturers will not appreciate the likelihood of more frequent demands for documents and site visits from retailers to assure quality, legal and regulatory requirements and see shop floors first hand.  However, it is in their interest to willingly participate, as well.

Zara, Next and Mango will not like being in the news over this matter.  All are highly respected fashion brands that are considered to be exceptionally well-run businesses.  That is why this case in another emerging market should ring alarm bells in retailing around the world. 

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