Could localized manufacturing be the solution to endless markdowns?

Today, two questions are top of mind for many physical goods brands: 1) How do we end the catastrophic parade of endless sales and markdowns?; and 2) Is there a way to bring back domestic manufacturing in some capacity?

In the current environment, brands are producing products that might be marked down weeks after they are released, as many are forced to compete when competitors go down the markdown rabbit hole. This race to the bottom has disastrous effects, from tangibly ruining a brand's bottom line to training customers to only buy things when discounts are high and prices are low.

At the same time, the vast majority of physical goods production, especially in the apparel and accessories space, takes place overseas. Around 3% of apparel sold in the U.S. is produced here. In 1960, 95% of apparel was produced domestically.

Since then, a lot has changed. For many companies, most of this change is for the better, with wider access to customers, materials, and labor at lower prices. But one of the worst developments for a brand's bottom line is the horrid cycle of overproducing, overbuying, and then, with too much product lying around, over-discounting. This virtuous cycle has consumed everyone from department stores at the high end and the low end, to brands themselves, in addition to online marketplaces. A product drops, a few weeks pass, and then the morphine-like discounting binge kicks in.

In the past few decades, as fast-fashion brands took off, the optimum supply chain started to look very different than what it used to. Instead of taking nine to twelve months to make 100,000 of the same t-shirt, these brands might take a few months or even a few weeks to make 1,000 of one hundred different t-shirts. They would then test the success of each and only then decide how to proceed and double down if necessary. To make this a reality, these brands built supply chains that enabled them to quickly produce products and respond to demand. A brand's ability to respond to changing trends is directly linked to how fast it can design, produce and sell the latest thing. As such, supply chains from fast fashion brands sped up drastically.

Sell through rate is the common term that measures the percent of goods sold at full price over a given period. The rate is the units sold divided by the total number of units purchased. If a brands buys 100 pairs of pants and sells 50, the product has a 50% sell through.

With these new responsive supply chains, the industry's sell through rate bifurcated into two different paths. Since fast fashion brands generally produce a wider variety of products but less of each individual product, they were able to substantially increase sell-through rates while traditional brands saw their sell throughs stay flat or decline.

Most inventory—especially products that are cater to trends—is like food. It has a shelf life and the longer it sits on the shelf the sooner it rots. One of the core ideas of fast fashion is that the faster a product moves the more the brand can respond and the more money it can make. Sell-through data provided by EDITED shows the correlation between faster supply chains and greater sell through.

The graph above looks at the number of days it took each company to sell through 50% of its products. Zara, which is the black bar in the graph above, only took 41 days in 2014 and 26 days in 2015 to sell through 50% of its product. H&M, ASOS and Boohoo, which are considered competitors from a market segment and supply chain perspective, took between four and five times longer to sell through the same amount of their product.

Zara has been growing steadily and gained significant ground on H&M in 2016. Higher sell through and a faster supply chain means fewer reasons to discount, which has propelled Zara forward.

Are speed and domestic manufacturing linked?

While over-discounting and poor sell through is rarely part of the same conversation as domestic manufacturing, there's increasing proof that they are deeply connected. Localized production might be the solution to increasing sell-through rates and improving the bottom lines for brands and retailers.

Once again, Zara leads the way. The company produces over 60% of its products in Spain (where the company is headquartered) or in neighboring countries throughout Europe. This enables very quick feedback loops, as the company can move from design to production to distribution radically quickly. From there, the company puts it in a store and gathers daily feedback, constantly tweaking and optimizing its outputs. If a product looks like it has a lasting future, only then will Zara use a more distant supply chain, working with other third-party factories around the world.

Zara realized that sell through rates are directly linked to production lead times, and has built its supply chain around this reality. Even though the unit costs of the products are more expensive when producing in Spain, the net cost is much cheaper because the company holds much less inventory and turns what it does hold quickly.

This is a classic example of a company thinking long term over short term. Many other brands are quick to drive unit costs down in a vacuum, even if it substantially elongates the lead time, which ties up even more cash. But it's increasingly clear that this is the wrong choice. For manufacturing to come back domestically, manufactures need to showcase how important speed is both in the short term and the long term.

A case study

To make this idea tangible, it helps to look at a sample case study. Below are two scenarios, one for a dress made in the US with a higher cost of goods (COGS) and a faster lead time, and one for a dress made overseas with lower COGS but a much slower lead time. There are assumptions around COGS, lead times and sell through percents.

(Rotate your phone to see the full table on mobile)

Production Type Products Made COGS Retail Margin Lead Time Potential Revenue Potential Profit Sell Through Sell Through x Profit
US Dress 1000 $50 $120 58% 55 days $120,000 $70,000 70% $49,000
Overseas Dress 1000 $20 $120 83% 175 days $120,000 $100,000 45% $45,000

What you can see above is that even though the dress made overseas is much cheaper to produce than the one from the US, the overseas lead time and slower sell-through is significant enough to make the entire operation less profitable. But in the US, with faster lead times, higher COGS and lower margin, the operation can be more profitable. This model also does not take cost of capital into account, which is the opportunity cost for having money tied up for much longer because of the long lead times when producing overseas.

While this model is theoretical, it should be clear that longer-term thinking can make brands and retailers more profitable. Short term costs might be higher but the speed and longer term benefits should not be ignored.

Two seemingly unconnected problems might be the solution for each other. This should encourage a revitalization of domestic production. Offshore will always win on short term price, but there's a domestic opportunity to win on speed and long term profitability. The entire ecosystem, from brands to retailers to factories and suppliers should embrace it.