How Retailers Structurally De-Risk Their Business 

This is adapted from a paper I wrote. 

In the fashion industry, the power to influence, create and reinforce critical structures rests at the top of the supply chain. In many cases, retailers hold this position. Some retailers are mono-brand retailers, meaning they design, produce and sell their goods in stores they control. Companies like Zara and H&M are common examples. But a large percentage of retailers in the fashion space buy their goods wholesale from other brands and then sell to the end customer. This can be very lucrative, since retailers capture the largest amount of value in the entire supply chain: the raw material suppliers capture the smallest amount of value, the factory captures a bit more, the brands captures a fair amount more, and then the end seller captures the most. These retailers continue to reinforce a longtime and problematic practice: they push the risk of their business—which they are supposed to deal with, since it’s their business—down the supply chain. This subtle practice has had a profound impact on how the supply chain operates and the often dismal economic outlook many emerging brands, and suppliers in general, face today.

This de-risking manifests itself in a sobering practice in the fashion world, and often in manufacturing more broadly, where buyers do not get paid when sellers receive their goods. It sounds crazy, but it’s standard practice. Instead, retailers extract “payment terms” from the brands, which means the brand will be paid on a later date. A common term is Net 30, which means the buyer must pay the seller 30 days after the goods arrive. The problem, however, is that the seller needs to manufacture the goods, and run her business, and now she can’t do that with the buyer’s money. Issues around payment terms are getting worse, as the average amount of time it took a corporation to pay an invoice increased from 35 days in 2009 to 46 days in July 2014. This practice is a fictive spatial fix, meaning it is a man made capital hole that has vast implications for emerging fashion brands today, which by definition are strapped for cash.

The prominence of payment terms often leads to one of two outcomes for a brand’s cash flow, which determines how much cash is available to spend on operations. If a brand can only stay within its means without much capital, it will have to grow very slowly or take on major investment to prop up early operations. The other, widely used option, is for a brand to use a factoring company to support their operations and temporarily fill in the spatial fix, so the brand can deliver product to retailers and hopefully build a successful business.

The premise of factoring is simple. A factorer uses an order from a store—say Barney’s is going to buy 100 dresses—and then loans the brand money to produce those 100 dresses.  Then, 75 days after the order arrives, Barney’s pays the factoring company who will in turn pay the brand. Any extension of money from a factorer is pure debt, and this debt trickles down across the entire supply chain. These practices “create deficits at suppliers that have to find financing, raise prices or squeeze other firms along the supply chain.” The spatial fix cascades down the supply chain touching every aspect of the process.  Supply chain financing, which includes factoring, is a massive business, estimated to be worth over $600 billion in volume per year.

Factoring vs Consumer Credit 

The methods behind factoring and how the risk is distributed is problematic. The easiest way to see the issue is by comparing the relationship between buyer and seller in the consumer space and a buyer and seller in the commercial space. A consumer’s credit is underwritten by a bank, meaning that if a consumer buys a sandwich at a store, the consumer gets the sandwich right away and the store will get paid in a matter of days. The credit company fronts the money for the sandwich to the consumer for basically no cost (assuming the credit card fee is zero) and then charges the merchant a small fee (often around 3%) to process the transaction and make sure it receives the revenue from selling the sandwich. Here, the merchant is charged by the credit company and as long as the consumer pays her bill on time, the transaction doesn't cost her anything on top of the cost of the sandwich.

Credit cards are everywhere because it’s a good deal for consumers and merchants. Consumers get their product right away and merchants get the payment shortly after, which they turn into working capital. Here, everyone takes on part of the risk. The merchant assumes the risk for fighting fraud, the credit company assumes the risk of the consumer paying her bill on time, and the consumer assumes the risk of only making purchases that she can afford. If any party miscalculates on this, they face consequences.

But in the commercial space this process is problematically different. Here, the retailer is the buyer and the brand is the seller. A retailer buys a product from a brand, but asks to receive the product before paying for it. This is the same as asking to buy a sandwich but saying you will pay for it later, without any credit company spotting you the money. This means that the seller now needs to come up with the money to make the product to sell, since they will be paid 30-75 days after the buyer receives the product. To fill this gap, suppliers often turn to factoring, which is expensive. Factoring firms sometimes ask for 15% interest on the loans if they are short term, or a lower but still not cheap interest rate if it’s a longer term loan.

The problem is that the commercial seller is being punished twice. The retailer makes the brand bear all of the risk: 1) the brand has to find for operating expenses to make the goods since it will not be paid on time; and 2) the brand then has to pay interest on this money. This means that the brand is being taxed for taking on risk that the retailer should have assumed. This explains the existence of factoring and why it differs from consumer credit.

Stores are de-risking themselves and pushing that risk down the supply chain, which is having drastic implications. Because of the prevalence of factoring, brands are often on quicksand, constantly trying to keep up with debt payments while having terrible cash flow. The British Fashion council produced a report called “Commercializing Creativity” in 2014 that looked at the treacherous path for a fashion brand to become sustainable. A fashion brand has to spend money constantly for ten months until they see the fruits of their labor, in which they have to start the process all over again. The graph is harrowing. The chances for a fashion brand to make money organically in this retail landscape is slim.

BFC Commercializing Creativity Report
BFC Commercializing Creativity Report

Neoliberal Roots

This relationship between the brand and the retailer is pure neoliberalism. Retailers act to free up as much capital as possible, pushing this risk down the supply chain, in the hopes of maximizing profit. Proctor and Gamble is a great example of this neoliberal transformation. P&G recently extended its payment terms for suppliers from 45 to 75 days, looking to free up over $2 billion in cash. This immediately put more pressure on their suppliers to fund their operations. The idea of paying people at a slower rate is a failure to uphold existing obligations, or, through a neoliberal lens, just another way to maximize profit.

Attempting to ease this greater burden for suppliers, P&G worked with banks to offer its suppliers funding options to get paid quicker. Now, a supplier submits an invoice to P&G who then hands it over to the bank, which then pays the suppliers promptly. Then, when the normal 75 day window comes to a close, P&G pays the bank the full amount of the bill plus a very low interest rate for loaning their supplier the money. The bank is fine with this because P&G has good credit, P&G likes this because it can free up loads of cash, and the supplier mostly is okay with it because they are getting paid rather quickly. This is called reverse factoring and is less harmful to the brand than normal factoring because the brand assumes less risk since P&G lined up the financing. This all sounds good as long as P&G can pay its bills and interest rates stay low. But once these pressures start to climb, the possibility of this unsteady foundation cracking grows since everyone is now operating on borrowed money. Here, cash flow for all three parties seems good, but can go wrong quickly if the underlying financials of the financing institutions falter.

Financialization and Factoring

The world got a peek at the underlying risk in factoring and the possible fallout in 2009. CIT Group is a financial holding company with more than $65 billion in assets. CIT Commercial Services was the commercial lending arm, which was one of the biggest factoring companies in the country. CIT’s clients ranged to small business to multinational corporations like Microsoft and Dunkin' Donuts. The National Retail Federation estimates that CIT provided factoring services for 2,000 manufacturers who supplied over 300,000 retail locations, exposing the vast network and reach of factoring. CIT’s finances ran into trouble after the 2008 recession, and it was forced to declare bankruptcy in 2009. Although the factoring business didn’t undergo bankruptcy (the holding company did), the volume of outgoing loans dwindled.

Like most of the financial institutions in the world today, CIT’s finances are highly complex. The money CIT loans out is not their own; it comes from investors and sometimes the government. Even the investors money is not their own, as the investors in CIT have investors in their own funds. When CIT loans out money and business become reliant on it, and then these business such as a brand pay a retailer with this money, the web of interdependence continues to grow, since no one is spending their own money. If one of the larger players in this value chain, such as CIT, goes under, the potential for a destructive domino effect cannot be understated.

When CIT went under, the Council for Fashion Designer of America (CFDA) issued a memo laying out the myriad of problems that might arise for businesses that rely on CIT’s services and the growing financialization of the industry. The memo surfaces the fact that other factorers could be affiliated with troubled financial institutions. “You may find that your factoring arrangement still exposes you to CIT risk, even though CIT is not a direct party to it.” Like the 2008 economic collapse, the consumers, more specifically the little guys, are taking on all of the risk of the games the big guys are playing. Just as the economy imploded and lost trillions of dollars of value in 2008, this could easily happen on a much smaller scale in the fashion industry if entities like factoring firms go under and business no long can fund their operations.

Informal and Unnatural Social Ties

The social ties prevalent in retailing build upon Andrew Brooks’ assessment of social relationships. “The social relationships, which are positions of power and dependency in economic transactions, are also in no way natural.” Many of the structural problems in the fashion industry are reinforced because retailers and other entities in power take them for granted and assume that are unchangeable. Payment terms and the leverage retailers exert on brands is yet another example. There is no material reason that a buyer has to exert more leverage and then win while the seller loses. Carl Menger’s Subjective Theory of Value implies that there doesn't need to be a winner and a loser in every transaction between a buyer and seller. Instead, both can produce value and walk away in good spirits. So the neoliberal race to the bottom and quest for pure maximization is, as Brooks says, unnatural. There is no need to extract the largest amount of surplus value, especially if a long-term relationship is the goal.

A report from the US Department of Commerce makes the case that payment terms and the buyer/seller relationship is actually a prisoner’s dilemma. The classic prisoner’s dilemma is two criminals deciding independently whether to confess their crimes to receive a lighter sentence. If they play as a team they are both better off, but they often opt to selfishly maximize because of the risks. The report argues that this has business implications as well. Firm A and Firm B can either pay each other slowly or quickly. As the dilemma explains, both firms are better off if they both pay quickly, since they are both winning. If one pays quickly but one pays slowly, only one firm is better off. The report highlights the ability for a win-win and encourages purchasers to take the initiative to improve the process. Only after accepting this can the industry approach ways to solve this structural flaw.

Casualization, which is the decoupling of normal relationships into more flexible but less reliable alternatives, also exists in in the retailer/brand relationship in the form of consignment. Consignment means that a brand will give a store their product with no guarantee to be paid. The brand only gets paid once an item sells. This is the riskiest type of payment term because the brand has to front all of the cost to produce the product, get it into a store, and then still has no guarantee that the item will be bought. Even if it is, tracking down the payment in a timely fashion is incredibly hard. Stores often have the upper hand and information asymmetry (finding out if an item sold) is hard. Sometimes designers have to walk into the shop and confront the owner after seeing the item no longer on the rack. The presence of consignment, even though it is discouraged by entities such as the British Fashion Council, which works with emerging and established designers, is growing. Retailers are wary of the growing inconsistencies and speed of the fashion cycles, and the rampant sales that are making the retail climate less and less profitable.

The implications of this casualization are profound. First, a brand now has even less certainty about their cash flow, and there’s a good chance that if their product doesn’t sell in a timely manner, they will earn no revenue and be stuck with the inventory. Second, fashion, for better or worse, has an expiration date on it because of the speed of fashion cycles, and the windows between each season are decreasing rapidly as more mini collections, such as pre-fall and resort, pop up in between the normal spring/summer and fall/winter collections. Stores often agree with brands to keep their items are full price for a specific term, such as 90 days. After 90 days the store can mark it down so they can clear their unsold inventory and prepare for the next season. However, some stores are now cutting this time in half, leaving only 45 days for items to sell before they go on sale. This shorter window is even more problematic for consignment because even if the items on consignment don’t go on sale, their ability to sell is greatly diminished relative to the now cheaper items sitting next to it.

Stores and some brands consider consignment a necessary evil, like unpaid internships—yet another step on the ladder to greatness in the fashion industry. But this casualization, like the social ties that govern it, is entirely fictive and unnatural. It does not need to be like this, and it shouldn't since brands are clearly hurting while retailers are operating free of all risk. This practice itself is a Taylorist method of operating. Consignment is an evolved form of de-risking, which maps the trend of apparel firms removing themselves from production and focusing solely on design and marketing. “The apparel companies were divesting themselves of the least lucrative and riskiest parts of the process.” This follows a grandiosity that exists in all forms of retail. A manager at Liz Claiborne once commented about putting more of the risk on the supplier: this “may not be profitable in the beginning, but mills need to ask themselves ‘do I want to be part of the future?’ ”

This is very much a story of retailers preying on vulnerable brands. Early on in a brand’s lifetime, the retailer holds all of the cards. A coveted retailer has an audience that a brand wants, and the brand will often bend over backwards to get into that store. Important retailers, which have a lot of power to accelerate a brand’s business, are pushing for consignment terms to hedge their risk even more. Even under consignment or fickle payment conditions, the brand will likely produce the order anyways because of the prestige of the store. This practice, although understandable, reinforces the structural flaw of the system. The designer Peter Pilotto put it succinctly: “On the one hand, you are so happy that they have placed an order, but then they don’t pay you, which creates a chain reaction because you have promised your manufacturers that you will pay them when the stores have paid.” He goes on to say that he would fulfill the order any way because of the prestige of the store.

Another problem is the long-term effects of long payment terms. A normal business seeks to build a long term relationship with its suppliers, creating a win-win situation. If a brand can grow its business, its cost per good drops, which means it can build a stronger business and a better relationship with the retailer. An analogy exists with payment terms and labor. “In the primary sector, firms offered high wages and secure employment to workers with whom they expected to have a long-term relationship. In the secondary sector, smaller, less-capitalized firms offered lower wages and poorer working conditions to a less privileged segment of the workforce.” But in retail and manufacturing, the opposite happens. Buyers try and extract more and more from sellers, leading to an unsustainable race to the bottom. Brands are often treated with the same lack of respect as workers are. “Retail is predominantly a low-wage ghetto, dominated by poorly paid positions.” Like the sales associate, whose job is plagued by casualization, the retailer treats some brands in similar ways, as if they were not important even though they are vital.

Retailers are quick to defend practices like elongated payment terms and consignment. Some deride designers for not delivering their goods on time and skipping on quality. “The problem the retailers face is that when they deal with young designers they are taking a risk: they are never sure that deliveries will be timely or that production will be up to standard,” says Maria Lemos, who owns a well-known showroom in London. Even if these issues are prevalent, the retailer’s payment terms are often the cause. If the brand doesn't have money to make the goods for a store, the chances their order will arrive late increases as they struggle to secure financing. The retailers are setting the brands up for failure and then shrugging off the blame when something that is expected goes wrong.

Possible Solutions

So how do we fix all of this? There have been some solutions that try to work within the industry structure. The biggest is President Obama’s SupplierPay initiative, which incentivizes big companies to pay their contractors faster, and in turn the government will pay the big companies faster. This initiative, launched in 2014, builds on the Federal Government’s QuickPay initiative, which Obama launched in 2011 to accelerate government payments to small business contractors to 15 days.

Now with SupplierPay, the simple idea is to tighten up the duration of payments at both ends of the spectrum in the private sector. The initiative is built on a pledge that businesses sign that encourages them to provide a working capital solution, share best practices, and implement a win-win solution. The two solutions the pledge suggests for working capital are to either shorten payment windows or for the buyer to provide a factoring solution to the seller, like Proctor and Gamble did. Two companies who joined the initiative, Intuit and Lockheed Martin, promised to offer 10-day and 15-day payment terms to many small suppliers respectively. The report from the Department of Commerce makes the case that paying suppliers faster does benefit the purchaser in the long term. “While faster payment of suppliers may make the [retailer’s] cash flow look worse, it provides working capital for suppliers to invest, which in turn increases supplier quality, innovation, and on-time delivery.” If purchasers take the long term view, the potential exists to make a difference and benefit economically as well.

Another idea, which is mentioned less but tucked into the same Department of Commerce report, is reverse factoring. In reverse factoring, it is now the buyers problem to figure out the factoring so the supplier can be paid quicker. The Proctor and Gamble is an example of reverse factoring, but it still relies on the solvency of the system. But these approaches work within the existing structures of the industry, and continue to reinforce the flawed apparatus.

Two more radical approaches come to mind. First, brands could seek to unionize and demand better payment terms. Second, brands could continue to shift over to selling direct to consumer, cutting out the retailer all together. When it comes to unionization, brands could learn from some earlier unionizing attempts in the labor sector. The earliest unions succeeded by controlling the labor supply. Because they controlled the supply, which was centralized, they were able to moderate demand. As a result, the unions were strong and had significant bargaining power. But this system started to flounder as labor started to fragment and business owners figured out ways, either through technology or dividing up labor processes, to break up the foundation of the unions. When the labor supply grows less centralized, the unions have a harder time controlling it.

But brands selling to retailers have a unique advantage: they are much less replaceable than the commoditized laborer. In fact, a brand’s goods are proprietary and unique. So if brands joined together they might be able to amass some bargaining power to push for better payment terms and treatment. If one forgets that a brand is a company, their treatment has many parallels to that of the laborer: low or later payment, fickle and inconsistent work, no contracts and an overextended power dynamic. The difference is that brands might be able to do something about it. If a dozen coveted brands unionized and demanded better terms, a retailer probably wouldn't stop selling their goods, the equivalent of shutting down the factory and moving it somewhere else. Since there is specific consumer demand for a brand’s goods (otherwise they wouldn't be stocked in the store) the brand has more leverage.

Selling direct to consumer is another solution. Selling direct is a growing practice across retail, and especially fashion. The general wisdom is that by owning the relationship with the consumer, the brand has more control and is able to make more money since they do not have to wholesale their product. Reality is much more complicated, since retailing is very expensive and requires a vastly different set of skills than running a brand that sells wholesale. But the tides are slowing shifting as brands learn how to run a direct to consumer business in the modern age. To some, this is a last ditch effort if working with retailers remains directly at odds with running a successful business. Brands sell to retailers because they want access to a retailers influential audience. Building this audience on your own is much harder and more expensive. Many brands even owe much of their audience to a retailer, so if they were to pull out of a given store there’s no guarantee their audience would follow them.

One brand succeeding and taking these structural issues into their own hands is Navabi. Founded in 2009, the plus size fashion retailer, manufactures every piece to order. This means a consumer pays for the item, Navabi manufactures the item, and then the payment is in their bank account a few days later. This also means they can avoid most factoring, since they can pay their factory on time, and the factory can then pay the workers on time. It is a win-win. Asked why they wanted to adopt this model, one of the founders said “The producer gives all the risks to the buyers or the retailers. There is no a fair share of risk… The customer ends up paying more because the companies need the margin and the company ends up not gaining the highest possible profit.”

For Navabi, the inefficiencies and biases of the industry drove them on a quest to change something. Implementing this model was not easy, since manufacturing items to order is often too slow or expensive. But interestingly enough, they were able to find a few manufacturers that were either on the verge of bankruptcy or the next generation was taking over from their parents, and they were open to trying something new. This didn't happen overnight. They spent a long time finding the factories, in addition to building technology to support these new operations. But the model seems to be working, with revenue of $100 million this year, an astounding amount for a new and ambitious retailer. The lesson is that effecting this change is not easy, nor cheap (the brand has landed $28 million of investment) but it is possible to make structural changes, and it’s even more possible for these changes to work in your favor and improve your bottom line.

Why This Matters

This all matters because the prevalence of factoring and prolonged payment terms can kill what would otherwise be some really amazing brands. Founded in 2004 by Scott Sternberg, a former Hollywood agent, Band of Outsiders quickly grew from a small line of mens shirts and ties to a full line of men’s and women's clothing, shoes, retail stores and the center of the fashion press for years. In 2010, annual revenues were at $12 million, a feat for an incredibly hip and expensive (dress shirts started at $275) brand that was at the time six years old. You could find Band (as those who knew it called it) in the best retailers in the world, starting with Barney’s and extending to international equivalents. But over the next few years, Band took on two rounds of investment to fund operations. The second one forced Sternberg to relinquish majority ownership of the firm, and it all ended this year when Band defaulted on a $2 million line of credit and had to shut down operations and auction off the remaining assets. The full details around this rapid downfall are still murky, but when anyone cites “financial difficulties” in the fashion industry, factoring and debt are often the cause.

A brand’s ability to operate is directly linked to how much cash it can pump into operation to continue designing and producing clothing. When retailers push the risk they should bear down the supply chain, it reinforces the problematic structures of the industry and in the long term will work against the retailers interest. None of the solutions outlined in this paper are easy to enact. But for an industry that is knowingly in trouble and on an uncertain financial footing, all parties, especially the ones in power, should be bending their back to restrengthen the industry. If brands had a solid financial backing and didn't have to rely on bandaids such as factoring, stores would be able to sell even more clothing at better prices to more people. At the end of the day, that’s why this industry is magical. When everything behind the scenes is working well, fashion has the power to transform anything in its path.


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