The Perfect Fit

The mid-1990s marked a major turning point for apparel companies confronted with the new retail landscape created by the Internet. Forced to devise Internet strategies almost immediately, some companies plunged into Web site development, while others discovered that existing distribution methods hindered their ability to respond to the e-commerce opportunity. New research shows that differences in organizational form can account for the speed with which firms in the apparel industry have adapted to the Internet and the success some of the firms have experienced.

Take the customer searching for a particular brand and style of khakis, perhaps Nautica or J.Crew. In the physical world, this customer can easily find the Nautica khakis at a department store such as Bloomingdale's, or shop at a company-owned store for the J.Crew khakis. However, if the customer prefers to shop online, there is a much larger divide between these two seemingly identical products. A quick search of the Bloomingdale's Web site may yield ten Nautica brand products, none of which are the right khakis, maybe none of which are khakis at all. Switching to the Nautica Web site, the customer may find product photos and store locators, but still no way to purchase the khakis online. After 10 or 15 minutes of frustration, the customer then looks up J.Crew's Web site and finds a dozen different styles of khakis, all of which can be immediately purchased online.

Robert H. Gertner, Wallace W. Booth Professor of Economics and Strategy at the University of Chicago Graduate School of Business, uses this example to illustrate the following question: For two products that seem to be very close substitutes for each other, why is one of them easily available online while the other is not?

In the study "Vertical Integration and Internet Strategies in the Apparel Industry," Gertner and Robert S. Stillman of Lexecon, an economics consulting firm, explore the speed with which different firms in the apparel industry began selling online and their success to date. Large differences among firms selling similar products with similar brand names made the apparel industry ideal for examining the relationship between organizational form and the ability of firms to adjust to changes in economic conditions.

For retail, as with all other industries, the vertical chain starts with the raw materials and ends with the consumer. Vertical integration is the extent to which there is common ownership of various parts of that chain.

Gertner and Stillman's findings suggest that vertically integrated specialty retailers, such as The Gap and J.Crew, tended to start selling online sooner than nonintegrated vendors, such as Nautica, and department stores. In addition, vertically integrated retailers offer greater breadth and depth of product choice online.

Adapting to E-commerce

In a 2000 survey by the National Retail Federation and Forrester Research, apparel ranked second in the number of small ticket items purchased online, just short of books, the number one seller. However, the Internet accounts for less than one percent of total sales of apparel in the United States. The importance of online sales is expected to grow, but brick-and-mortar stores remain the principal channel for apparel sales for the foreseeable future, and the predominance of traditional distribution channels greatly affects the e-commerce perspective of retail executives.

There are significant differences between vertically integrated and nonintegrated apparel companies, all of which affects their ability to adapt to e-commerce opportunities. Some brands are distributed through vertically integrated specialty retailers and catalog companies that handle these brands exclusively. Examples include Abercrombie & Fitch, Eddie Bauer, The Gap, J.Crew, Lands' End, The Limited, and L.L. Bean. Other apparel brands are distributed primarily on a nonexclusive basis through department stores and other nonintegrated retailers. These companies include Calvin Klein, Nautica, Polo Ralph Lauren, and Tommy Hilfiger. Many of these nonintegrated companies also operate their own retail stores, but typically do most of their business as vendors to department stores.

For the purposes of the study, the authors focused on the aspect of vertical integration that varies the most among the sample firms: the extent to which the firms own their own retail distribution systems.

In order to determine the reasons why vertically integrated specialty retailers, such as The Gap, decided to invest in online sales sooner than department stores and nonintegrated vendors, the authors examined a data set of thirty firms in the apparel industry. They based their findings on company reports, newspaper and trade press articles, consulting reports, phone calls, and interviews with company executives.

The authors built their sample around The Gap because it is widely regarded as a leader in online apparel sales. The rest of the sample was constructed by identifying vendors and retailers selling merchandise similar to that offered by The Gap.

Their results show that nonintegrated firms are approximately two years behind integrated firms in introducing online sales. The online product selection for most of the vertically integrated retailers in the study typically is the same or greater than the product selection available in their stores or catalogs. The selection is much more limited for the products of nonintegrated firms sold through department store Web sites.

Despite the fact that online sales account for only a tiny portion of total sales, all the retailers in the study emphasized the ways in which the Internet can complement their efforts to make shopping easier and to communicate better with their customers.

"One of the interesting things we discovered is that on some level, the opportunity for multichannel retailing was very attractive to a lot of these companies," says Gertner. For example, a customer who makes a purchase at a J.Crew store will walk out with a shopping bag stamped with "jcrew.com," thus promoting another distribution channel. If managed effectively, the Internet represents a new way to reach consumers that will complement traditional channels.

Apparel firms with catalog operations at the start of the e-commerce age had an important advantage when starting up online sales. Firms that operate catalogs almost always use the same systems to fulfill online orders. This level of synergy between online and offline operations is not easily replicated by nonintegrated firms, most of which are reluctant to use third-party companies to fulfill online orders. Given issues such as customer service and handling returns, multichannel retailing is much more difficult to implement for nonintegrated firms without a large network of stores or catalog operations. However, the study shows that the extent of vertical integration remains a significant determinant of Internet strategies even after controlling for the presence of catalog operations.

Transaction and Coordination Costs

Why can a firm such as The Gap seize e-commerce opportunities with greater speed and effectiveness? According to the authors, several factors affect the ability and incentive of firms to sell their products online.

For nonintegrated vendors, such as Nautica or Tommy Hilfiger, selling their products through a department store's Web site involves many coordination costs. The time and effort spent negotiating brand guidelines for a vendor's portion of the Web site is one such cost. For each new vendor that a department store wants to add to its site, a new set of negotiations is usually required for a variety of issues, such as the quality of product photographs and descriptions.

Vertically integrated firms must also coordinate online efforts with traditional retail channels, but a senior management team has the ability to force solutions on any problems that may arise. Their ability to make final decisions regarding online sales methods is the key reason why integrated firms have fewer coordination costs.

In addition to significant coordination costs, nonintegrated vendors may encounter difficulties, referred to as channel conflict problems, if they sell merchandise from their own Web sites. In several cases, the authors found that department stores objected to vendors selling to customers directly from their own Web sites, because such initiatives were viewed as direct competition for sales of the same products.

"In deciding whether to offer online sales capability, nonintegrated vendors need to assess how their department store partners are likely to respond to this threat and whether there should be changes in the terms of the contractual relationship between vendors and department stores," write Gertner and Stillman.

Issues of externalities, which refer to the effect of a decision on parties who are not part of the decision, also make it difficult for nonintegrated vendors to sell their products online. Since department stores only get a small fraction of the profits from selling a vendor's product online, they have less incentive to build the best possible online showcase for the vendor. Similarly, if vendors pay for part of the development of department store Web sites, the lack of brand exclusivity also becomes an issue, since many other brands will benefit from the improved site.

It's Only Temporary

Gertner points out that this research suggests a larger issue that all companies should take into account when considering any outsourcing decision. "Outsourcing often means giving up more effective coordination, which becomes most important when there is a significant change in the environment, such as the Internet, or a recession or boom," says Gertner.

"While all these transaction costs and coordination costs make it much more difficult for a company like Nautica to get online quickly, we don't think this will persist forever," says Gertner. Vertically integrated companies are able to respond faster and more effectively to the abrupt changes created by the Internet, but if enough people want to buy brands such as Nautica online, the authors believe that these companies will find a way to make it easy for consumers to do so.