Outsourcing in garment manufacturing.

  1. A road to profit shareholders.

    Outsourcing can be stated as a real life implementation of the "Comparative Advantage Theory", since outsourcing, earlier has never been considered as significant, as it is in today's globalised business world. The process of sourcing goods at cheaper rates from developing countries, primarily attribute to a low cost of labour. This existed for a major portion of the past three decades, for example, in 2012 only 2.5% of apparels purchased in the U.S were produced locally as opposed to 1994 when this figure stood at c. 50%. Outsourcing in its basic form allows firms to focus on other critical business operations, that lead to higher value additions like R&D, distribution, retail and marketing. Be that as it may, retailers (apparel houses in particular) in or from developed economies often tend to sell merchandise at an astonishing markup in order to ultimately benefit their shareholders.

    Televisory's research indicates a broad-based markup of 5x - 6x on the actual cost of production. It has been broken down into two components, a 2x - 3x markup when merchandise is sold by the manufacturer to the retailer, followed by a 2x - 2.5x markup by the retailer when goods are finally sold to the end consumer. Considering this, now companies like H&M retailers tend to outsource a majority of their manufacturing operations.

    (Note: For the purpose of this blog we will focus only on the retail operations within the United States, thus the average price of a clothing product in H&M is c. $35 -$40. Additionally, it has been assumed that the clothes sold have been sourced from India and Bangladesh.)

    The cost Interpolation (using supplier data) H&M's revenue (2014) from the United States stands at c. $ 16.4Bn, 10% of total sales revenue. Thus, based on the average price previously calculated, we can deduce that c. 68 Mn items were sold during the same period in the United States. Further, at the same time, the average cost of producing 68 Mn items is c. $ 2Bn or Avg. $ 4.5 per item. On the other hand, considering the C.O.G.S declared by H&M on their website (assuming C.O.G.S for North America is similar to the revenue contribution) and dividing this by the derived 68 Mn items sold, we get an average cost of $ 13 per item. Now, consider, the aforementioned markup strategy and this helps to join the dots. A $ 4.5 cost per item is loosely translated to $ 13 if multiplied by a 3x markup ($4.5 * 3 = $ 13.5), arguably this could also include genuine costs like logistics and overheads. In the second leg, we further included the retailer markup of 2.5x to receive a value of $ 33.75 per item, near about the average price per item of $ 35 we formerly identified.

    Source: H&M Annual Reports
  2. What is intriguing, is the fact that the EBIT margin has remained more or less constant with an average of 29.02% (This is despite the fluctuation in the top-line and costs).

    The outsourcing has existed in some form or the other for a long period. However, globalisation has created distinct manufacturing capabilities and has largely led to lowering of the wages. This has often been cited as a reason for job losses in developed nations. But, the strategy of outsourcing has always been implemented by the companies across the globe in order to improve their bottom line and hence meet the expectations of their shareholders. The share price performance of H&M precisely depicts this character.

    H&M Stock Price (Bloomberg)


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