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Case study: A

American Apparel: Vertical Integration and the Make-Or-Buy Decision

The production of any good or service generally requires many activities. The process begins with the acquisition of raw materials and ends with the distribution and sale of a finished product or service; the process by which this happens is known as the vertical chain. Organizing the vertical chain is essential to business strategy, and the question that firms face when deciding how to do so is whether all of the activities should be completed within the firm or if they should be performed by an independent firm in the market. A firm who decides to “make” performs the activity itself; a firm who decides to “buy” relies on another firm to perform the activity.
American Apparel is considered by many to be cutting-edge, not only in fashion but in business. Former Acting President Tom Casey describes the company as “one of the most innovative companies in apparel retailing with a unique business model, loyal customer base and commitment to American manufacturing.” Part of what makes American Apparel so unique is that their business model keeps the knitting, dyeing, cutting, and sewing of their product right in downtown Los Angeles, operating the largest garment factory in the United States(and does so in at a time when most apparel sold in the United States is produced offshore). The company also does their own photography, marketing, distribution, and design in-house. In contrast to firms that invest in fashion photography and famous models, it is not uncommon for founder and CEO Dov Charney to find and photograph advertisements himself – using friends, employees, or people on the street, as models.

In organizing the vertical chain, the firm weighs the cost of buying and benefits of buying against the advantages and disadvantages of making. The reasons a firm may choose to “make” instead of “buy” lie with the cost associated with buying. These include the costs associated with poor coordination between steps in the vertical chain, reluctance of partners to develop and share valuable information, and transaction costs. A firm may choose to “make” if they do not wish to disclose private information such as product know-how, product design, or customer information to an outside vendor, and “making” will keep this information in-house. Costs from coordination problems arise in situations such as one party failing to meet production deadlines, delivery dates, or other performance targets. Contracts are often used in an effort to prevent coordination problems, however, the contracts themselves incur transaction costs such as the time and expense used in negotiating and enforcing contracts; or costs incurred from parties acting opportunistically and the firm trying to prevent that.
The decision for a firm to “buy” is made primarily because it is more efficient. The independent outsourcing partner from which a firm “buys” is known as a market firm. Market firms are often able to achieve lower unit costs than a firm producing only for their own consumption because they are often supplying for many buyers and are therefore able to exploit an economy of scale. In doing so, market firms are able to take advantage of the learning curve, accumulating more experience and know-how than a vertically integrated firm that does not have an economy of scale or does not specialize in a certain function.
Another reason for a firm to “buy” is the elimination of bureaucracy, or avoiding agency and influence costs. When managers and employees knowingly do not act in the best interest of their firm, they are said to be slacking. This reduces the firm’s profitability and incurs many different costs, including those from administrative controls designed to deter slacking, and lack of productivity. Influence costs are another type of cost incurred when a firm organizes transactions internally. When firms allocate financial and human resources across internal divisions and departments they create “internal capital markets.” If the internal capital is limited, when resources are allocated to one division, there are fewer resources to be allocated to others. Inevitably, managers try to influence this resource allocation. Influence costs can be incurred from the time wasted trying to influence the allocation, to bad decisions made as a result of influence.
In 2008, American Apparel purchased the assets of a fabric dyeing and finishing facility from U.S. Dyeing and Finishing, Inc., with whom they had contracted work from for approximately ten years. American Apparel assumed the lease of two buildings and purchased machinery and equipment related to fabric dyeing and finishing, including industrial dyers, washers, compressors, and boilers. Marty Bailey, Chief Manufacturing Officer of American Apparel acknowledged the significant impact on American Apparel’s production capacity, stating that the “acquisition will further reduce our reliance on contract dye facilities, allowing us to expand our product offering, streamline our supply chain, lower costs, and ensure better quality control.” American Apparel made the acquisition with the goal of bring all almost all of its dyeing volume in-house.
The company’s motivation for keeping production in-house and domestic appears to be both noble and practical. While the company website proudly announces that their products are ‘sweatshop free’ and ‘made in the U.S.A.’, CEO Dov Charney points to operational advantages. Charney contends that he is not against globalization or free trade, but insists that his business model makes sense in the fast paced fashion industry. The example he cites is that if an item starts selling quickly over the course of a weekend, his workers in Los Angeles are informed by Monday morning and can immediately begin meeting the new demand. Furthering explaining the advantage he derives from the model, he states "I can cut on Monday, sew Tuesday through Thursday, and ship on Friday," he says. "If I used offshore labor, that would take me 90 days." The decision to “make” at American Apparel is an interesting one. Charney has eliminated a great deal of coordination problems and transaction costs involved with “buying”, but has certainly not cut costs in labor. The average factory worker at American Apparel makes (an unheard of for the industry) $12.50 per hour, and receives perks such as free English as a second language classes, generous stock options, subsidized lunches and transportation, and on-staff masseuses. Charney acknowledges that he could save with offshore production, but holds to the ideology that he is selling not only “Made in the U.S.A.” but the American dream, stating that if he were to open production facilities in Asia he vows to pay any foreign worker American wages. In deciding to “make”, American Apparel avoids other parties acting opportunistically. On the other hand one reason to “buy” is to eliminate bureaucracy and avoid influence and agency costs. It would appear that American Apparel has accomplished both of these goals simultaneously, creating employee loyalty and high productivity. Whether it is the wages, the perks, or the ideology - Charney implements an open-door policy in his personal office and encourages an atmosphere of stimulation and fun in his facilities - the company’s waiting list for employment has been upwards of 1,000 people. The business model of American Apparel seems to be successful. According to the website, the company operates more than 285 retail store in 20 countries, and employs 10,000 people globally – about 5,000 of those in Los Angeles. “American Apparel leverages art, design and technology to advance the business process, while continuing to pioneer industry standards of social and environmental responsibility in the workplace.”

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[ 1 ]. http://finance.yahoo.com/news/American-Apparel-Announces-bw-3247778698.html
[ 2 ]. http://americanapparel.net/contact/profile.html
[ 3 ]. http://investors.americanapparel.net/releasedetail.cfm?ReleaseID=310147
[ 4 ]. Ibid.
[ 5 ]. http://americanapparel.net/presscenter/articles/20040517usnews.html
[ 6 ]. http://investors.americanapparel.net/releasedetail.cfm?ReleaseID=310147