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Today, companies have become increasingly competitive and driven by profits. This is an era of cut throat competition where every investor, including the smallest shareholders to the institutional buyers expects high dividends from the companies. To survive this kind of a competitive market, companies are increasingly trying to find a source of sustainable competitive advantage. It is an advantage or an edge over a competitor, which cannot be easily replicated by any other company and provides a kind of value for the customer which tends to satisfy their needs better than others. To do so, companies are now trying to find their speciality or niches within every industry sector. Some are also now trying to find out completely new sectors where development of a new market is possible. New technological innovations such as biotechnology, nanotechnology and cybernetics have led to a new breed companies which are still to establish their ground and contemplate a suitable strategy. All of this has been made possible with a lot of radical and incremental innovation. But the fact of the matter is, nothing of this scale would have been possible without strategy. Strategy defines how a company operates or the founders want it to operate. It highlights every important aspect of a company from its positioning to its target market to its competitive forces. This strategy is then used by the decision makers while taking any decisions related to achieving the organisation's short term and long term goals.
Any organisation has several departments working together to achieve these goals. To achieve those, companies tries to implement putting several systems and practices in place which would allow an organisation to work efficiently and effectively. But during the course of operation, any company experiences several constraints. Constraints of such nature provide competitive advantage to company. To do so, Dr. Eliyahu Goldratt came up with the concept of Theory of constraints and Throughput accounting. The basic idea around which TOC is based every company has some constraint which obstructs management to achieve goal on larger scale. Resolving such constraints would not only add value to the organisation but can also become a source of differentiation for it. The extension of this theory is the throughput accounting.
Statement of the problem:
Measurement systems serve as a mechanism for accessing both the progress and effectiveness of an organisation in achieving its goals. A measurement system includes both financial and operational measures. Financial measures such as profit and ROI provide information about the overall financial performance of the organisation in the previous periods. These financial performance hints towards the future performance of the organisation as a whole. Techniques such as ABC costing and Throughput accounting serve as techniques to only look at a firm via numbers. It is often said that ABC is long term and Throughput accounting is short term way of getting information about a firm's performance.
But the recent advent of differentiation within companies, these costing methods and ways to identify and resolve constraints are no longer sufficient. They show part of the picture and not the whole. This can be attributed to the fact that the strategy of all organisations has become so complex, the definition of a constraint for an organisation has also evolved with it. Now, companies no longer target only efficiency and cost effectiveness but also responsiveness, creation of maximum customer surplus, maximise value and alignment of every decision with the overall strategy of the firm.
Hence, it can be said that strategy is also a very important part to analyse the performance of any firm. But there is model or plan on paper till now to do so the TOC way.
Purpose of the study:
This study is an attempt at looking at the problem the TOC way. It tries to integrate strategy to the financial analysis of a firm. By doing so, any manager trying to look for improvements or an analyst accessing the performance of a firm will have a more clear idea as to what the firm is doing, why is it doing so, and is it correct. It can also be said that one of the objective of the study is to provide a more holistic and an integrated view of managerial, operational and financial aspects leading to a more sound and accurate decision making which would allow the firm to grow in long term and also increase the customer level of satisfaction.
Significance of the study:
This study can be used by managers while they look for improvements in their own companies. It will allow them to take correct decisions which will benefit them in achieving the long term goals of an organisation rather than going for short term gains only.
It can also benefit financial analyst of external firms by giving them a more fair idea about the company's performance by not just being biased towards the financial ratio analysis or costing of the firm. Since it is a more holistic approach, it will allow the analyst to analyse and observe whether the firm will perform well as a long term investment.
The research paper will examine the company "Zara clothing" from both financial and strategic perspective and evaluating its financial aspect and whether it is complaint with its overall strategy. Comparison between its performance and performance of similar companies will also be done to prove that such integration is possible.
Theory of constraints:
TOC is a concept designed by Dr. Eliyahu M. Goldratt which gives an organisation an overall management philosophy to achieve its final goal of more profit. "The strength of a chain is determined by the weakest link in the chain" is basic idea about which it is based. It means that even though u might improve the strength of any of the kinks in a chain, if the weakest link's performance is not improved then the strength doesn't improve. Suppose there is a manufacturing unit running at an overall efficiency of 55%. It best machine is 73% efficient and the worst is 32%. There is no point in this kind of efficiency because the actual overall efficiency of the entire plant is determined by the worst machine.
The basis of this concept is that any organisation or a manageable system has some constraints which hamper its growth prospects of efficiency of working. The TOC process identifies and resolves these constraints to give an organisation sustainable competitive advantage. The assumption in this theory is that any organisation can be measured and controlled by variations on three measures:
Throughput- it is the rate at which a system generates money through sales.
Operational expenses- it is all the money a systems spends in converting inventory to throughput.
Inventory- to avoid shortages companies purchase things extra and pile it up and here capital required for this is considered.
These three aspects together constitutes as THROUGHPUT ACCOUNTING which will be explained late in this section of the paper itself.
A constraint is anything that inhibits the organisation from attaining more of its objective. There are many ways that constraints can show up, but a core principle within TOC is that there are not tens or hundreds of constraints. There is at least one and at most a few in any given system. Constraints can be internal or external to the system. An internal constraint arises when market demand is more than company can supply. In such a case organisation should uncover the constraint and follow 5 step focusing model to remove it. An external constraint is a condition when the system can produce much more than required by market. In such a situation organization should focus on mechanisms to build demand in the market. Types of (internal) constraints
Equipment: The way equipment is currently used limits the ability of the system to produce more scalable goods / services.
People: when there is shortage of skilled people it becomes a critical constraint. And in many cases mental models held by people lead to constraint.
Policy: Policy can be written or unwritten but it stops system from making more.
TOC is different from constraints coming up in mathematical optimization, where as in TOC constraint is used as concentrating instrument for management. In optimization, the constraint is written into the mathematical expressions to limit the scope of the solution (X can be no greater than 5).
Now in this case constraint is thing which prevents an organisation from getting more throughput for ex. Breakdown is not a constraint, constraint can be people, policies, equipment etc.
Steps in TOC-
The five main steps of TOC are depicted in Fig 1. TOC is based on the principle that the rate of goal attainment is restricted by at least one constraining process. Only by maximising flow via the constraint will improve overall throughput. Consider goal of an organisation is expressed then the steps are:
Identify the constraint in terms of resources or policy that prevents increasing throughput.
Decide method to exploit the constraint so to get maximised capacity through that process.
Align all the processes to decision
Make changes to break the constraint i.e. to Elevate the constraint
Once constraint is removed go back to step one and remember not to let inertia become a constraint.
The five focusing steps aim to ensure on-going improvement efforts are cantered around the organization's constraints. In the TOC literature, this is referred to as the "Process of On-going Improvement" (POOGI).
The focusing steps, or thisÂ Process of On-going ImprovementÂ has been applied toÂ Manufacturing,Â Project Management, Supply Chain / Distribution generated specific solutions (refer Fig 2). TOC has applications not only in operations but in marketing, sales, finance etc. Applications in these areas are:
Operations- Within manufacturing operations andÂ operations management, TOC works on principle of PULL rather than PUSH. And method used is Drum-Buffer-Rope (DBR)Â and a variation called Simplified Drum-Buffer-Rope (S-DBR). This is a manufacturing execution technique, based on 3 components as theÂ drumÂ which is the physical constraint of the plant: the work centre or machine or operation that limits the ability of the entire system to produce more. The rest of the plant follows the beat of the drum. They make sure the drum has work and that anything the drum has processed does not get wasted. TheÂ bufferÂ protects the drum, so that it always has work flowing to it. Buffers in DBR have time as their unit of measure, rather than quantity of material. This makes the priority system operate strictly based on the time an order is expected to be at the drum. Traditional DBR usually calls for buffers at several points in the system: the constraint, synchronization points and at shipping. S-DBR has a buffer at shipping and manages the flow of work across the drum through a load planning mechanism. TheÂ ropeÂ is the work release mechanism for the plant. Orders are released to the shop floor at one "buffer time" before they are due. When extra work is pumped into system than its limits of buffer will generate too-high work-in-process and slow down the entire system.
TOC for supply chain focuses on o replenishment to consumption model, rather than a forecast model.
TOC-VMI (vendor managed inventory)
Finance and accounting- The solution for finance and accounting is to apply holistic thinking to the finance application. This has been termedÂ throughput accounting. It studies impact of investments and operational changes in terms of impact throughout the business which is an alternative toÂ traditional cost accounting. The primary measures for a TOC view of finance and accounting are: Throughput (T), Operating Expense (OE) and Investment (I). Throughput is calculated from Sales (S) - Totally Variable Cost (TVC). Totally Variable Cost usually considers the cost of raw materials that go into creating the item sold.
Project management- Critical Chain Project ManagementÂ (CCPM) is used which is grounded on the impression that all projects look like plants and all activities congregate to a final deliverable. So to protect the project, there must be internal buffers to protect synchronization points and a final project buffer to protect the overall project.
Marketing and sales- TOC has found its application in marketing and sales also. Here it is clearly acknowledged forÂ sales process engineering. As DBR can be applied to sales process in same way as it is applied to operations. (see reengineering the Sales Process book reference below). This is applicable when constraint is process itself or when it is need to improve efficiency of sales process which includes funnel managementÂ and conversion rates.
Accounting was invented to provide a fair answer to the question - how does one evaluate the performance of firm in a given specific time period? The question was complex as business of a firm is on-going and does not start and stop with the period start and end dates. The orders or projects at any point of time would be at various stages of maturity which means that order arrival, execution, closure, payments and revenues, can span across measurement periods. As a result there were following dilemmas:
If purchase of raw material is made in one period, which is then converted to finished goods and sold in next period. In which period should the revenues and expenses be accounted? Any error might give an incorrect assessment of the period performance of the firm.
If the actual money received for an order, sold in year 1, is in year 2, when should we account the sales to provide a fair picture about performance of the firm?
If the money to be given to a vendor, after receipt of the service and its use in delivery of end products in same period, is actually paid in the next period, when do we account for the expenses?
Improper expense accounting in above cases can lead to situations where a firm shows very high profits in one period ( period with all revenues but no expenses for the revenues) and then very low profits in next period (where all expenses are accounted without revenues). At the end we would not have any clue on how the firm performed in the period.
As to solve above difficulties and provide reasonable calculation for the period, following principles were invented
Matching principle indicates that the expenses should be matched with revenues. They are not recognized until the associated revenue is also recognized. Now consider the case that wages paid to manufacturing workers are not considered till they are actually realized. When the products are sold, the expenses are recognized as cost of goods sold. Similarly, depreciation was invented to spread the cost of purchasing a fixed asset is spread over the period in which it is expected to generate revenue.
Accrual Concept is used to enable the implementation of matching principle. For example if a supplier supplies material in month 1 but is paid in next month and the final goods are sold in first month, then accounting of material expenses in month 2 will show an abnormal profits. Accrual concept will help account the raw material costs in month 1. Similarly revenues are recognized when they are earned or are realizable, even though cash is not received.
The matching concept and the accrual concept solved some of the dilemmas and problems. This method allowed a reasonable evaluation of a firm. However, another mathematical problem cropped up during application of the Matching concept. Expenses are of two types:
Variable expense (like raw material costs) which can be easily traced to the per unit product sales.
Other form of expense belongs to a category, (like labour salary, maintenance expenses, rental etc.) not directly related to products. They are mostly period expenses. It was not possible to match period expenses with revenue.
In order to solve the problem, the period expenses was artificially allocated to the product using labour hours as a basis of allocation of period expenses to the product cost. This made it possible to measure profit margins or product profitability.
In the current era, labour salary has become a period expense. (Labour does not draw compensation on per piece basis.) So the period expense has become very significant in many organizations. When a significant portion of expenses is artificially allocated to a product, it creates many problems when these variables are used as measurements for decision making. People in organization behave in the way they are measured. Wrong measurements can lead to erroneous behaviour.
To tackle this issue, several popular accounting methods were developed which to satisfy the growing need or organisations to identify all its overheads and other expenses for further growth. The utmost widespread three concepts are:
Activity Based Costing
InÂ management accounting,Â cost accountingÂ establishes budget and actual cost of operations, processes, departments or product and the analysis of variances, profitability or social use of funds. It supports decision-making to reduce costsÂ and improveÂ profitability. CA is not based on any general accounting principles or any conventions as regular accounting as it is used by internal managers and what to compute is instead decided pragmatically. So no conventions are required for uniformity here getting a solution is more important.
Costs are measured in units of nominalÂ currencyÂ by convention. This is also viewed as translating theÂ supply chainÂ with the chain of events in the production system that will result in a product into financial values.
Inventory Profits in made to stock organisations: I such made organisations where products are manufactured to be stocked as inventory; matching concept says that this inventory should be showed as a part of assets until it is sold. Only after the sale has taken place, does this inventory enter P&L statement of the company. The problem here in this method s that irrespective of the quantity sold by a company, the effect of inventory of operating expenses is reduced by the fact that this inventory accounts for a significant amount of current asset for a company, and since this current asset is considered to be a source of fast liquid cash for a company, it actually depicts a wrong picture. Most products have a limited shelf life and prevalent write-offs. Many a times it also happens that the company tends to lose more money than it actually makes.
Production misalignment with sales: Production in many companies is measured by the efficiency of operation. This results in companies driven towards greater efficiency. To do this, the company tries to run its production at optimum capacity inspite of the demand in the market which finally tends to end up as inventory held by the company. This creates a conflict between marketing and production.
Poor reliability for made to order companies: In such companies, work in progress inventory is considered to be good for accounting. This is usually done to keep the cost of production low. But since the requirements of the customer are faster delivery, these companies tend to fail to achieve this. Workers tend to queue up to machines which are lesser expensive to manufacture on and tend to leave those machines empty which are more expensive thereby increasing production lead times significantly.
Erroneous Outsourcing decisions: Outsourcing decisions should not be based only on the fact that whether a product can be manufactured at a cheaper rate outside. Factors such as whether there is excess production capacity within the plant itself can tend to prove decisive. Since the excess capacity leads to overheads and also there are several fixed expenditure which are related to the plant which do not disappear even after having outsourced production. Sometimes it is possible to improve the overall profitability of the firm by producing a loss making product just to distribute the fixed expenses within the plant.
Erroneous investment decisions: Machine investment decisions are usually made based on comparisons of reduction in cost per part as compared with the investment, to calculate the payback period. The reduction in cost per part is almost a myth, if the equipment is a non-bottleneck machine. While for a bottleneck machine, the actual payback period is much less than what is calculated using the traditional method.
Erroneous product viability decisions: Usually companies tend to reject loss making orders on the premise that the overall profitability would reduce inspite of the excess capacity available with them. Accepting such orders allows the company to reduce their fixed expenses which in turn increases the overall profit for the firm even though the company incurs a loss on that particular order. In simpler terms, the loss from one deal is lesser than the profits obtained in terms of reduction in fixed costs for a company.
Activity Based Costing-
It is also known as ABC method of accounting. This is the more evolved method of accounting for overheads in companies. Companies today, have as much as half their expenses as overheads. Conventional methods of accounting are not sufficient to correctly identify and quantify them. In its crux, it tries to assign more indirect sots into direct costs and assists in depicting a more accurate picture of the actual resources involved in producing a product. The difference between ABC method and traditional method has been explained in Fig 3.
The accuracy of costing increases for products, customers, distribution channel and SKU.
Understanding of the actual overheads and the extent to which they affect the profitability increases drastically.
Reduces the communication barrier for an investor since it is easy to understand and analyse.
It tends to utilise unit costs
It has the ability of integrating with other management tools like Six sigma and Kaizen
It clearly identifies and distinguishes the non value adding activities and all forms of waste
It also facilitates bench marking.
Implementation process of ABC method in any organisation requires allocation of significant amount of resources. Data regarding several things need to be gathered and entered to obtain the result of adequate accuracy.
A bigger change is required in the attitudes of manager who are only familiar with conventional methods and abbreviations. Terms such as product margins don't appeal to them easily.
This method can be easily misinterpreted and can then lead to escalation of a problem. A company has to be careful as to how it analyses its ABC sheet
This method does not conform to General accepted accounting principles (GAAP).
In this method, certain overhead costs are difficult to assign such as a bonus system or a chief executive's salary.
It is also considered to be expensive and other leaner methods have been developed in places which are much cheaper and much more efficient to use.
It is an alternative method of cost accounting proposed by Dr Eliyahu Goldratt. It is an extension of theory of constraint and is considered to be dynamic, integrated, principle-based, and comprehensive management accounting approach that provides managers with decision support information for enterprise optimization. Unlike conventional a method which tries to reduce cost, this method focuses on increasing throughput. The three most important components of throughput accounting are:
Throughput: it is defined as the revenue generated by a system through the production of sold product. A product when produced and stored is considered to be inventory, but when the actual sale takes place, it becomes a part of throughput.
Operating expenses: This includes all the period expenses incurred including direct labour, manufacturing overhead as well as selling and administration cost. If any business has its operating expenses greater than its throughput, then that business cannot survive for very long, hence this method focuses on maximising throughput.
Inventory: in this method, unlike traditional methods, the value added aspect of inventory is removed to eliminate the accumulation of unneeded inventory. Inventory is viewed as cost incurred for items retained in the organisation. This includes materials as well as fixed assets. In TOC, inventory is viewed as a liability and should be minimised.
This concept of accounting has evolved from ABC costing method. The belief that ABC improves a company's long-term performance is a delusion!
Initially all cost based accounting system suffer because they only concentrate upon reducing costs. TOC has clearly demonstrated the pivotal role of constraints in determining Throughput, and the need to synchronize everyone's efforts to support the constraint. Throughput is only achieved from the coordinated efforts of all parts of the business:
Each and every one of these must do their jobs must all do their job to achieve Throughput. If any one "link" in this "chain" doesn't deliver, Throughput is in danger. The implication is that Throughput depends on the strength of the entire chain as a system, not on the isolated performance of a single "link." Since a chain's strength is only that of its weakest link, this "constraint" determines the Throughput of the entire system. Other resources by definition have extra capacity versus the constraint. Cost-based systems fail to recognize the critical role of constraints and treat all areas as equally important.
Net Profit = Throughput - Operating Expenses
Return on investment (ROI) = Net Profit/ Investment
Productivity = Throughput/Operating Expense
Investment Turns = Throughput/Investment
It is a more holistic approach to accounting.
It concentrates on sales rather than cost reduction only.
Inventory in today's scenario is a big expense, and only this method of costing considers it to be so.
Implementation process is easy and also gives a more effective picture of the health of an organisation.
Assigning of any type of cost is easy since the parameters for differentiation is significant.
Method is lean and efficient.
It is considered to be the same as direct costing
It is only valid when a bottle neck is in production
It is short term focused
All the methods mentioned above had their own advantages and disadvantages. It sometimes becomes difficult for analyst or managers of a company to correctly take a decision based on these hard core accounting methods and companies are known to make mistakes by just doing so. It hence becomes important to account for strategy of a company also.
For this research paper I have considered the two most basic and the most important elements of strategy. Both were suggested by Michael Porter himself. These are as follows:
Porter's Generic Strategy: According to Michael Porter, any company which manufactures or sells a product has to follow one of the three strategic schemes suggested by him. These are general strategies that are commonly used by businesses across to achieve and maintain competitive advantage. All three strategies have been defined along two dimensions which are strategic scope and strategic strength. Strategic scope is the demand side dimension which mainly looks into market composition and size which a company expects to target. Strategic strength is the supply side dimension which looks into strengths or core competency of a firm. The three strategies are as follows:
Cost leadership strategy- Companies following this strategy try to achieve the lowest cost in the business. Overall cost strategy target's the highest market and tries to scale its operations to achieve the lowest cost possible at the highest volume. So it can be said that it's a volume based business which a very high level of competition.
Differentiation- companies following this strategy usually try to achieve superior performance of features which distinguishes itself from the competition and hence targets a specific set of customers who are ready to pay the price for this differentiation.
Focus- here, the firms focus on a narrower segment usually of the basis of specific customer requirements. Products are customised to exactly the customer's need or they are supplied at the desired price of the customer.
Porter's five forces- It draws upon Industrial Organization (IO) economics to derive five forces that determine the competitive intensity and therefore attractiveness of a market. Attractiveness in this context refers to the overall industry profitability. An "unattractive" industry is one in which the combination of these five forces acts to drive down overall profitability. A very unattractive industry would be one approaching "pure competition", in which available profits for all firms are driven down to zero. Three of Porter's five forces refer to competition from external sources. The remainder are internal threats. The five main forces identified by porter are as follows:
Threat of new entrants: in any industry which is growing at a rapid pace, other companies also identify an opportunity and try to enter the same business. Thus, to do so they try to capture the market share of an existing company by giving several new offers at a cheaper rate. Hence existing companies try to keep the height of the barrier as high as possible to not allow this threat to grow.
Threat from competitors: existing competitors are always a threat. There is always a chance that a company's product of service will get replicated or a better product will be launched by a competitor, both of these cases are a threat for a company.
Threat of substitute: if competitors cannot compete for the same product, they can also affect a company's market share by launching substitute for that particular product. Sometimes, this can also happen by accident like in the case of mobile phones accidently replacing watches as a substitute.
Bargaining power of buyer: consumers or customers always expect very high value for a lowest cost possible. Although this is not always possible for companies, companies need to differentiate their products as much as possible for not falling into this trip and always satisfying the customers at the same time.
Bargaining power of the supplier: suppliers try to get the best price for their product, to control their bargaining power, a company must always do complete market research and always have other suppliers in option. As the number of supplier's decrease, consecutively their bargaining power increases.
To do this research, it was important to understand that how the definition of the constraints itself had evolved. When we consider any companies strategy, it follows a particular method for a reason. This reason is to satisfy its target customers. To do so, companies have to understand customer demand and provide them with the product accordingly. It can also happen that the company will have to do something which might increase its operational expenses but the customer is ready to bear this cost and hence, company has to follow this strategy. Although, this is not visible while doing the financial assessment of a firm, it is important and does come to light while doing the strategic audit.
For understanding constraints, the concept of trade-off has to be understood. Trade-off is the method of foreboding something for gaining something else in return of higher value. For example, more the excess capacity, lesser is the waiting time. Similarly higher the inventory, greater is the responsiveness of a company. So it all comes down to what is suitable to a firm's strategy. The following model was constructed on this basis.
Hence, it is important to have certain parameters set while evaluating whether something is actually a constraint for a company or a business necessity. And even if it is concluded that it is a constraint, then to a target must be set as to what has to be done with it.
To do this, a model has been shown in the figure below. The purpose of this model is to provide a basic framework for five things:
Identifying possible problem areas.
Evaluating whether they are constraints.
Setting a target value beyond which it would not be a constraint anymore.
For internal use, providing all possible solutions to break the constraint.
For an external entity, it provides a basis for evaluation of performance of the company.
Identify all possible problems
Parameters for evaluation
Porters generic strategy
Porters five forces
Throughput accounting (throughput, operating expenses, inventory)
Selection of appropriate constraint
Evaluation and screening
Sort by Priority
Broken and no inertia
The process followed in the model consists of the following stages:
Identifying Possible Problems: problem areas can be identified via various sources. The balance sheet and the P&L statements usually are used by both managers and analyst to evaluate. Ratio analysis generally presents the big picture and makes the identification process much easier and convenient.
Parameters of evaluation: to understand the company, its strategy has to be understood. The balance sheets just give one part of the information; the rest has to be evaluated on the discretion of the manager or analyst. Understanding the firm's strategy at this stage gives prospective to the examiner to evaluate all the problem areas. The parameters for evaluation are:
Porter's generic strategy
Porter five forces
It is important to note that all these parameters are internal to the organisation provide the picture for the strategy of the firm under the scanner only and not its competitors.
Evaluation and screening: based on the list of problem areas and combined with the knowledge of the strategy of the firm, it becomes easy for the evaluator to identify the actual Problems and eliminate those from the list which are actually compliant with the firm's strategy.
Selection of constraints: here these problems identified previously are now termed as constraints.
Sort by Priority: segregation of all these constraints is important. There are several methods which can be used. These constraints can be either prioritise according to cost to benefit ratio or even Pareto analysis leads to identification of the 20% constraints which are most important. This now gives an external evaluator or analyst a fair assessment of how the firm is performing and on what basis it should be evaluated, the next step is for managers of the organisation only.
TOC Process: the constraints identified can now be resolved using the TOC process as shown in the figure and explained in the literature. This is done using the five steps mentioned above.
Analysis of the Survey Data
Zara clothing is one of the most renowned names in the fashion industry for its clothing and accessories. Based in Spain, it is a flagship chain store of Inditex group. It is also know to launch the maximum number of products (approximately 10000) every year thereby offering its customers a very large variety.
I chose this company because when its competitors were outsourcing their own production which included companies like Versace and Emporio Armani and were drastically trying to reduce their operating expenses, this company was the only one to refrain themselves from doing so. This step in turn led to the increase in the brand equity of the company which will be explained later in this paper.
The balance sheet and P&L statement of ZARA clothing for the year 2009-2010 and 2010-2011 is given in Table 1 and table 2 respectively. Applying the model shown previously to this company, the result is as follows:
STEP1- Identifying Possible Problems:
The table below depicts all the important ratios which can be derived from table 1 & 2. Their analysis is as follows:
ACCOUNT RECEIVABLE TURNOVER
CURRENT ASSET TURNOVER
GROSS PROFIT MARGIN
OPERATING PROFIT MARGIN
NET PROFIT MARGIN
RETURN ON ASSETS
RETURN ON EQUITY
TOTAL DEBT TO EQUITY
TOTAL DEBT RATIO
LONG TERM DEBT TO EQUITY
FIXED ASSETS TO EQUITY
The ratios which highlight the problem areas in ZARA are as follows:
Current Ratio -
In 2009, the company had only 51 cents worth of current assets for every dollar of liabilities. This grew to 80 cents in 2010 indicating increasing trend on liquidity, however the company is still unable to support its short-term debt from its current assets and company have liquid problem. Since their current ratio to low, they may be able to raise it by;
Paying some debts.
Increasing your current assets from loans or other borrowings with a maturity of more than one year.
Converting non-current assets into current assets.
Increasing your current assets from new equity contributions.
Putting profits back into the business.
. In both years, Zara's quick ratio is lower than 1 and it means we they cannot pay their short-term liabilities, but their quick ratio is getting better from 2009 to 2010. They may increase their current assets or decrease the current liabilities. Zara is a manufacturing company, so that current assets should be greater than current liabilities.
Zara's working capital is too low but again they are getting better from 2009 to 2010. They must have more working capital. They should increase total current assets or decrease total current liabilities.
Their asset turnover is too low, however 2010 is better than 2009. They should try to increase their asset turnover.
Gross Profit Margin
Zara's gross profit is low, it may indicate that competition has increased or that the company's products have become less competitive or both. If gross profit margin increases, either they increase their sales or decrease their COGS. So, they should increase their number of sales items instead of increasing sales price.
Return on Asset
Zara's return on asset is very low. They have a liquidity problem and it causes troubles on profitability and solvency. However, total asset is growing from 2009 to 2010.
Total Debt to Equity
A high debt to equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If a lot of debt is used to finance increased operations (high debt to equity) the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earning by a greater amount, then the debt cost then the shareholders' benefit as more earnings are being spread among the same amount of shareholders. This can lead bankruptcy which would leave shareholders with nothing.
Fixed Assets to Equity
Zara's fixed asset to equity ratio is greater than 1, so that they finance their debts with fixed assets. This means that some of the fixed assets owned by Zara are financed by long term debt.
STEP 2- Parameters of Evaluation
Zara clothing is a premium clothing brand catering to a very small group of premium target customers. Hence it can be said that it follows focus differentiation strategies from the porter's generic strategies.
The company believes in having a very responsive supply chain. To do so, it controls most of the supply itself from production to logistics to shipping to even the retail stores which sell the products to the end consumer. It only outsource 25% of its production to other manufacturers that to the ones which are easy to make and don't need much customisation.
If evaluated on terms of throughput accounting, then the following can be calculated for 2010:
Throughput = Sales = $7.7 billion
Operating Expenses = OPEX (Balance sheet) + Direct labour + Manufacturing Expenses + Selling and administrative costs = 4.8 + 0.3 = $5.1 billion
Inventory = $200 million
STEP 3- Evaluation and screening
After having evaluated the ratios while considering the strategy of Zara, it can be said that since Zara tends to target responsiveness more, and as the customer demand so, the operating expenses will always tend to be high. Its low profit margin can be accounted for because of the threat from the competitors which shows that Zara needs to differentiate its products and not only its services even more.
Another major constraint for Zara is the long term debt which can affect its fixed assets and repayment of some of them has now become absolutely necessary. It current assets are lower because of low levels of inventory which is good for the company.
High operating expenses can be accounted for the fact that Zara produces complicated products and also tries to have a certain level of excess capacity to reduce waiting time, which is the trade-off it has to make.
STEP 4- Selection and sorting of Constraints
The two major constraints which are actually important for Zara considering its long term strategic plan are as follows:
Threat from competitors: although Zara provides high level of service and highest variety of products, it products have not differentiated themselves which is causing the company to reduce its profit margins.
Retained earnings- the company has been giving away all of its net profit to shareholders and has not kept any retained earnings for the past 2 years which doesn't allow the company to pay its short term obligations which would cause liquidity issues.
Long term debts- if the company is not careful with long term debts, it may have to repay those by selling its fixed assets thereby reducing the worth of the company.
Conclusion and limitations
After having completed this paper, I have come to the conclusion that strategy is an essential part for accessing the performance of a company. Strategy of a company can and should be linked to every aspect of business for correct evaluation and also before taking any decision within the organisation.
Companies are evolving and innovating in every way possible, in such a dynamic work environment, the importance of strategy increases. Looking at the firm only from a financial perspective is not enough; it also has to be accessed whether the firm or the company has the ability to perform in the long term
Fig 1- Theory of constraintsC:\Users\Amol\Desktop\TOC Steps.gif
Fig 3- ABC vs Traditional Costing
Fig 2- Applications of TOC
Fig 4- Porter's generic strategies
Fig 5- porter's five forces