Why Shared Financial Risk is the Key to Radically Transforming the Fashion Industry

The litmus test for knowing whether an intervention fundamentally transforms the incentives is simple: will it systematically guarantee that the losses associated with unsold products are distributed equitably?

As a disillusioned consumer, former garment factory manager, and concerned citizen, I’ve been trying to re-imagine sustainable fashion. What does doing fashion more sustainable really look like?

And the thing I keep come back to is shared risk. The reality is that in an industry where financial risk is not shared, unsustainable behavior like choosing to subcontract to a sweatshop or canceling purchasing orders, make a lot of sense for the individual actors involved. And it’s not because they’re nefarious. It’s because the absence of shared risk makes it exceedingly difficult to do otherwise.

So we can keep auditing. We can create worker hotlines. We can pass due diligence laws. We can get better at forecasting. We can support unions. We can even ask suppliers for feedback on brand behavior. But frankly, I’m over it: though they may make a bad situation marginally better, they don’t fundamentally transform the incentives.

The litmus test for knowing whether an intervention fundamentally transforms the incentives is simple: will it systematically guarantee that the losses associated with unsold products are shared, are distributed equitably?

Why the absence of shared risk creates the wrong incentives

The financial risk inherent to anybody in the business of fashion is that products don’t sell. In other words — variability in market demand.

In the face of a global pandemic, brands coped with this unpredictability (as they also did long before the pandemic) by pushing inventory back onto their suppliers. They leveraged their privileged position within the supply chain to protect themselves from the risk of products not selling. And really, why wouldn’t they? When brands don’t front the costs for materials or worker salaries, refusing inventory doesn’t cost them anything.

Meanwhile, this creates a strong incentive for factory managers to be able to expand and contract their workforces quickly and cheaply. As a former factory manager, it was unexpected deviations from forecast (idle workers and materials, too many fixed costs relative to volume sold) that affected my bottom-line the most.

For example, say the most efficient way to make a shirt is to divide it into 20 steps. A factory has 20 different people doing each step. The output per hour is 100 shirts. In that month, the factory also has demand for 100 shirts per hour. Life is good. But the next month, demand suddenly drops to only one shirt per hour (maybe because of a global pandemic). If the factory still has 20 people on staff, each step will be completed efficiently, but the factory must also pay for a lot of idle time. At the end of the month, the revenue from that one shirt sold per hour must cover the cost of 20 people. Variation in demand, in factory load level, causes the real cost per piece sold to fluctuate significantly.

In other words: when the supplier fronts the cost of production, success depends on their ability to keep their orders and capacity in equilibrium. Cue reports of short-term contracts, subcontracting, etc. The absence of shared risk means that brands and suppliers alike have an extremely strong incentive to behave in ways that prioritize their self-interest over collective goals.

The true meaning of partnership

I’m tired of moral appeals. I’m tired of warm and fuzzy talk of partnership, of calls for honesty, empathy, and promise-keeping. Shared risk does not mean pledging to behave differently. It does not mean getting better at forecasting. The problem with forecasting isn’t that we’re bad at it. Until we have a crystal ball that allows us to see into the future, forecasts will always be wrong. The problem is that the losses associated with getting forecasts wrong aren’t distributed equitably.

Shared risk means partnership, co-dependence. It means having a vested interest in each other’s successes and failures. The only acceptable definition of partnership is the straight-up Investopedia definition: “an arrangement between two or more people to oversee business operations and share its profits and liabilities.” The sharing of risk should be relative to the margins or value added at each step in the chain.

For example: say a brand forecasts that it will buy products worth 100 labor hours from a supplier. The supplier books this capacity. But due to changes in market demand, the brand only orders products equivalent to 80 labor hours. Instead of the supplier bearing the cost of those 20 unused hours alone, they should be split. Ten are paid by the brand, and ten are paid by the supplier.

In other words: there must be consequences for deviating from forecast. Price should even hinge on consistency relative to forecast.

How shared risk changes the incentives

Shared risk fundamentally changes the incentives because it creates trust, and trust is a prerequisite to collaboration. It ensures that all actors push in the same direction.

For example, if risks were shared brands would be motivated to keep their suppliers loaded. Not out of the goodness of their hearts. But because idle workers or unused raw materials now cost them, too. A more consistently loaded factory greatly reduces the supplier’s incentive to subcontract, to rely on cheaply flexible labor. Had the risks been shared more equitably prior to the pandemic, its impact would have played out very differently. We probably wouldn’t have seen such sweeping order cancellations because this would have cost brands, too.

Supply chains also would have been shorter; there wouldn’t have been as much inventory in the system to begin with. Why? Because shorter supply chains mean shorter lead times. And shorter lead times mean reduced forecasting horizons. And reduced forecasting horizons mean more accurate forecasts. And when risks are shared, more accurate forecasts mean reduced risk for everyone. Gone is the incentive for brands to cover their asses through over-ordering (which, as my podcast co-host Jessie Li likes to point out, is the more apt term for over-production).

And finally, supplier cashflows would have been less precarious. Meaning that in the face of an unprecedented drop in consumer demand they may not have prioritized the short-term goal of collecting payment for unjustly canceled orders. Instead, they may have taken the long-term view: pushing brands to take on inventory they cannot sell ultimately will not help suppliers and their workers, either.

Transparency, remixed

Co-dependence requires thinking differently about transparency. When risk is shared, brands require visibility over factory load so that they can pro-actively support factories with balancing it. In exchange, suppliers require visibility over customer inventory levels, insight into how well the brand is managing to sell its products.

This begs the existential question: should we even have supply chains at all? Is vertical integration the way to go? Maybe. But even in a world of partnership, there are still reasons to outsource — for example, expensive capital investments that would not be justified by one firm’s demand alone. Or technical expertise — whether that’s knowledge of how to make products, or knowledge of the diverse local contexts in which peoples’ livelihoods, for better or worse, now depend on the global fashion industry.

As sustainability advocates, we must keep our eyes on the prize. Any sustainability initiative requires collaboration. Collaboration requires trust. Inequitable distribution of risk makes trust impossible. More frequent talk of purchasing practices and forecasting is not inevitably or necessarily the same thing as shared risk.

While we celebrate people “doing the right thing” like paying for cancelled orders or pledging to behave differently — we risk missing that these actions continue to be driven by shaky voluntarism. They have not fundamentally changed the incentives. This sort of caution will never be transformative. It will never be an adequate substitute for going all in, for co-dependence, for partnership.

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