CostBenefitAnalysis_OrganicCotton

Integrating Fair Trade Certified and Organic Cotton into L Brands Should Victoria’s Secret transition to 50% Organic and Fair Trade Certified?

Organic and Fair Trade Certified cotton have been successfully adopted into 6% of Victoria’s Secret’s (L Brands) intimate apparel and the management team is considering expanding the combination equal to 50% with conventionally sourced cotton. Other industry leading apparel companies such as American Apparel and The Gap have already undertaken similar transitions. This paper identifies current trends in price and consumer desire through a literature review and a revealed preference survey to derive a reasonable market expectation for organic or Fair Trade Certified intimate apparel. A cost-benefit analysis (CBA) was then constructed using the company’s 2013 performance and considers multiple primary costs and benefits for the L Brands shareholders. The CBA concluded that the benefits of improved reputation and market share do not exceed the cost to the company in annual revenues lost from increased costs incurred to procure and market the organic or Fair Trade Certified cotton.

SUMA K4020 Cost-Benefit Analysis May 8, 2014 Prepared by: Maria A Fernandez Besada (maf2253) Guy Tucker Brooks (gtb2108) Marjorie Lau (ml3384) Alexander M VandenBroek (amv2153)

Table of Contents

Introduction L Brands Corporation and Victoria's Secret Cotton: Traditional, Organic and Fair Trade Cost Benefit Analysis Introduction Issue Approach References CBA Components

Page 3 Page 4

Page 5 Page 6 Page 7 Page 8

Benefits Increase Market Share and Customer Base Reputation Legal Risk Mitigation Climate Change Environmental

Page 8 Page12 Page12 Page13 Page13

Raw Materials Marketing Supply Chain Disruption Certification and Auditing

Page14 Page14 Page15 Page15

Costs

Cost Benefit Analysis Sensitivity Analysis Net Present Value

Page16 Page17

Conclusions

Page18

Appendix Sources

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Introduction L Brands Corporation and Victoria's Secret Limited Brands The Limited was initially founded as a women’s apparel-based specialty retailer. It has evolved into the women’s intimate and other apparel, personal care and beauty categories. Victoria’s Secret is the flagship brand, representing 62% (Table 2) of L Brands’ sales and is sold through company-owned stores and hundreds of franchises and locations throughout the world. # Doors

2013 Net Sales ($ in Millions)

2012 Net Sales ($ in Millions)

% Change vs. YA

Victoria’s Secret USA

1,099

$5,165

$4,981

+4%

Victoria’s Secret Direct (Online & Catalog)

1

$1,516

$1,593

-5%

Total Victoria’s Secret

1,100

$6,681

$6,574

+2%

Bath and Body Works Total

1,638

$2,932

$2,902

+1%

Other (La Senza, Henri Bendel)

186

$1,160

$983

+18%

Total

2,924

$10,773

$10,459

+3%

Table 2. L Brands holdings as identified in 2013 10-K report

Victoria’s Secret At $6.7 billion dollars (net retail), Victoria’s Secret is one of the most highly recognized women’s intimate apparel brands in the world. Made famous by the live Victoria’s Secret Fashion Show, the brand is highly aspirational with accessible price points and has a loyal customer base. The brand is targeted to customers across a broad, worldwide economic and demographic spectrum. U.S. market share is estimated at 28% (source: University of Oregon Investment Group). The company’s sourcing function is Mast Global Fashions.

The Victoria’s Secret customer base is 18 to 49 years old, however, the core customers are teens and college-aged women. While bras and panties constitute the majority of the business, the brand also markets clothing, accessories, fragrances, personal care, swimwear and athletic attire.

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Cotton: Conventional, Organic and Fair Trade Conventional Cotton Conventional cotton is grown with genetically modified seeds that are treated with fungicides, pesticides and require fertilizer to increase yields. The growing process uses herbicides to control weeds, pesticides to kill or deter pests, and fertilizer to provide “nutrition” to highly degraded soil. Defoliants are used to remove cotton plant leaves and bleaches and toxic dyes are used to process and color the cotton. Cotton covers 2.5% of the world’s cultivated land yet uses 16% of the world’s insecticides. Most of these chemicals are listed as Category I or II, which the EPA classifies as probable carcinogens and thus, cotton has been considered one of the world’s ‘dirtiest’ crops. In addition, when soil becomes degraded, it becomes devoid of all organic matter, which makes it difficult for water to be absorbed into the soil causing extensive chemical run off which ends up in the rivers and fresh water sources. (source: http://livinggreenmag.com/2013/04/16/lifestyle-choices/choosing-health-organic-cotton-versusconventional-cotton/)

Organic Cotton Organic cotton is grown using methods and materials that have a low impact on the environment. Organic cotton growing systems and products reduces the use of toxic pesticides and fertilizers thus reducing the crops environmental impact. Third-party certification organizations verify that organic producers use only methods and materials allowed in organic cotton production. All cotton sold as organic in the United States must meet federal regulations regarding cotton production. Apparel companies are developing programs that either use 100 percent organic cotton, or blend small percentages of organic cotton with conventional cotton in their products.

According to the 2011 Organic Cotton Market Report there were about 219,000 farmers producing 693454 bales of organic cotton globally 4

(http://textileexchange.org/sites/default/files/te_pdfs/2011_Organic_Cotton_Market_Report_web size.pdf).

Fair Trade Cotton Fair-trade is primarily a social label and focuses on improving the working and living conditions of laborers and helps build sustainable businesses that positively influence communities. Fair trade standards include criteria that are linked to environmentally friendly agriculture. Combining fair trade and organic is a means by which to strengthen local communities, mitigate environmental degradation and sustainably source resources.

There was a 35% increase in organic production between 2008-2009 (McCracken, Vicki, 2012).

According to the 2011 Organic Cotton Market Report there were about 58,000 farmers producing 93091 bales of fair trade cotton globally (http://textileexchange.org/sites/default/files/te_pdfs/2011_Organic_Cotton_Market_Report_web size.pdf).

This production represented about 1% of the total cotton grown globally.

Currently, the demand is exceeds production.

Cost Benefit Analysis Introduction

Issue The management team at L Brands is considering whether to increase the amount of organic and Fair Trade Certified cotton in the Victoria’s Secret apparel line. Organic and Fair Trade Certified (FTC) cotton have already been successfully incorporated into 6% of the intimate apparel business and the management team is evaluating the feasibility of expanding the mix to a 50%/50% ratio with conventionally grown cotton. Other industry leading apparel companies such as American Apparel and The Gap have already successfully incorporated organic and 5

FTC cotton into their lines. To date, however, many companies, including Victoria’s Secret, have minimized their sourcing organic and FTC cotton due prohibitively high costs and limited availability.

Approach There are many stakeholders involved in moving forward with this transition, including: employees, shareholders, customers, competitors, suppliers, governments, community and NGOs. Although we considered all of them, since it is a publicly traded company, standing is limited to the L brands shareholders.

Cotton Price The cost analysis for incorporating 50 % Fair-trade and Organic certified cotton into the product line of limited brands is based on two primary aspects, the cost of sourcing Fair-trade and Organic cotton and marketing costs for promoting the new product line.

Basic cost of certified Fair-trade and Organic cotton for 2013 was sourced from Fair-Trade International with the costs being $0.4169, $0.3528, $0.3015 for Organic and Fair-Trade, Organic, and Fair –Trade respectively. These prices are based per pound and in addition to the market average price per pound of cotton. Certification costs and costs per pound vary depending on type of certification as well as location from which it is sourced. These prices reflect Burkina Faso’s price for cotton. As part of certification for Fair-Trade, cost of cotton has a set minimum price required to be paid for the product to farmers. The result is an increase price in addition to market prices.

The Market price for cotton used was based on an average market cost over the 2013 year. The average market cost per pound of cotton is $0.9040. (IndexMundi/Bloomberg)

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Proportion of Sources According to the L. Brands 10k report, the company already has begun using FTC and organic certified cotton. The assumption was made that this amounted to 6% of the total cotton sourced by the company.

As it is the company’s prerogative on how it chooses to source its 50% Organic and Fair-Trade cotton, various percentages of each, ranging from 2% to 42% Organic to Fair-Trade certified were used as well as 2% to 42% Fair-Trade to Organic certified as well as 44% Fair-Trade and Organic were assessed. This was done to encompass the entire spread of varying cost possibilities for the base case

Figure 1: Graphics with various percentages considered

References Academic, white paper and other literature reviews were conducted to identify current trends in consumer demand and pricing for organic cotton. In addition, a revealed preference survey was conducted among the Victoria’s Secret core customer demographic, 18 to 50 year olds (The Limited’s 10K, 2013) to derive the willingness-to-pay information specific to an organic or FTC bra.

The cost-benefit analysis (CBA) was constructed using the company’s 2013 performance and considers multiple primary costs and benefits including additional marketing and improved reputation. The CBA concluded that the company benefits of enhanced reputation and

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increased market share would be outweighed by the costs of lost revenue by the increased price for the raw materials, marketing and potential for future supply chain disruption.

CBA Components BENEFITS

Description

Indicators

Sources

Increase Market Share and Customer Base

Revealed customers preference

- Other companies’ experience - Survey - Academic documents

Reputation

Image of the brand

- 10k impact of reputation issues

Legal Risk Mitigation

Transparency in sourcing

- news about related legal issues

Climate Change

Environmental benefits

-Target new customers who shop organic and FTC

COSTS

Description

Indicators

Sources

Raw Materials

Increased cost of raw materials

- Market price for organic and FTC - Amount of material

- Cotton Index’s - 10k report - Certification organizations

Marketing

Public awareness, education programs

- 5% annual increase on marketing budget

- 10k report

Supply Chain Disruption

Increase in demand of certified cotton

Certification and Auditing

Aquitision

- Certified cotton trends -Year one -Annual

- Fair Trade, USDA

Table 2. Costs and benefits considered for the analysis

Benefits

Increase Market Share and Customer Base Market studies indicate that product demand for organic and Certified Fair-Trade products has shown an increased in recent years. Regarding organic and FTC produced cotton, there was a 35% increase from 2008-2009 alone (Ellis et al, 2012). Ellis et al. noted that consumer profiles 8

are key to understanding how an organic product sells based on a customer’s willingness to pay. Though studies indicate an increase demand and desire for socially responsible materials and sourcing practices with some companies such as Patagonia being a model, these groups and product lines are targeted towards a specific customer base which prioritizes and values sustainably sourced materials and is based on the nature of the product sold.

Few studies exist on the demand and willingness to pay (WTP) for underwear or lingerie.

Sourcing 50% FTC and Organic cotton will allow the company to remain competitive in a new market field that may have great potential for increased revenues as demand for such products increases. As this is an essential aspect of a cost benefit analysis it must be noted that due to the constraints of this study and not having knowledge on future product pricing, product demand, or size of increased and/or decrease in customer base, these benefits were not quantified in this report.

Market Analysis Consumers are becoming increasingly aware that their consumption decisions impact the environment and the workers who produce the products that they consume. This new classification of consumer is called the ethical consumer and they represent a growing market segment (Ellis, 2012). As a result, many apparel companies have considered the incorporation of organic and FTC cotton into their product lines. Many retailers are targeting ethical consumers as a means to building market share. Victoria’s Secret has minimized sourcing organic and FTC due to prohibitively high costs and limited availability. In an Organic Trade Association survey (2010), growers indicated their primary barrier to increased production in 2010 was finding a market that will pay value-added costs for organic cotton products.

Several companies like American Apparel, H&M and Nike have become the dominant market leaders in their respective genres. These companies have been major drivers in the 9

international demand. In the United States there was a 35% increase in demand for organic cotton globally (Textile Exchange, 2009). Companies like C&A, H&M, Nike and Puma have gone as far as to publicly disclose goals of reaching 100% organic by 2020.

Although there is reasonable amount of research available, obtaining a willingness-to-pay (WTP) for organic cotton vs. conventional cotton is not straightforward. A study by Ellis et al.

(2012) found that, on average, participants in the study were willing to pay a 25 percent premium ($5) for an organic cotton t-shirt over that of a similar style made from conventionally produced cotton. The same study also found that participants who make purchase decisions when alone were less willing to pay any premium.

In contrast, separate studies by Joergens (2006) and Carrigan and Attalla (2001) found little evidence that ethical issues played a role in consumer purchase decisions. Price, value, fashion trends and brand image remained the dominant influences over purchase choice. Carrigan and Attalla(2001). Ellis et al. sited a study by the Hartman Group (2007) that the attributed texture, style, color, fit, smell, price and durability as other important factors in selection. In the past, consumer complaints about organic apparel were that the available styles were too casual, limited in color selection Meyer (2001). Meyer went on to say that consumers tended to identify organic clothes shapeless, colorless and overpriced.

The most current research by Ellis et al (2012) suggests that retailers need to consider the perceptions and behaviors of their specific customer base. Research and findings for the organic cotton customer profile are still early in development and evolving constantly as national perspectives change.

Revealed Preference Survey for an Organic or FTC bra The consumer profile for a Victoria’s Secret customer is woman, age 18-50. On April 17, 2014, 10

surveyors from this working group were tasked to survey women on Columbia University’s Morningside Campus about their willingness to pay for an organic of FTC bra. The survey stated a brief introduction to the product, a standard $53.00 bra followed by the questions: 1. What is your age?

2. Do you purchase apparel at Victoria’s Secret?

3. Would you be interested in purchasing an organic bra?

4. Would you purchase the bra if it were the same price as the conventional bra?

5. What if the bra cost a 15% premium?

6. What if the bra cost a 25% premium?

The results from the 64 surveyed women were analyzed in Excel, organized by age brackets (18-25, 26-34, 35-50). In the first analysis of the revealed preference survey data indicated that 68% (44) of the women surveyed were current patrons of Victoria's Secret, the majority of which fell into the 18-25 year old bracket (24). In total, 23% of the responders indicated that they would not be willing topurchase an organic or Fairtrade bra, even if it had the same price as the traditional. The customer profile of a Victoria’s Secret patron favors other qualities of the bra more. We hold this to be one of the most important findings in this pape

50

16

45

14

40 35

Currently shops at V.S.

30 25

Doesn't currently shop at V.S.

12 10 8

20

WTP 0% increase for organic bra

15 10

Would be willing to purchase an organic bra

6 4 2

5 0

0 18-­‐25 25-­‐35 35 + Total

18-­‐25 25-­‐35 35 + Total

Figure 2. Survey results Current patrons who would purchase the organic or FTC bra at the same price Figure 3. Non Patrons of Victoria’s Secrets willingness to purchase and organic or FTC bra

The second analysis of the revealed preference survey data determined that 22% (14) of the women surveyed were not current patrons of Victoria’s Secret, the majority of which fell into the

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25-35 year old bracket (10). Of those surveyed, a total of five indicated that they would be interested in buying an organic or FTC bra. This analysis indicated that Victoria’s Secret could potentially increase its market share with an organic or FTC bra, particularly in the 25-35 year old demographic that trails off on the ‘typical’ customer profile spectrum.

Reputation As social media and information technology has increasingly become cheaper and widespread, company reputation is increasingly at risk from consumer as well as public opinion. As reporting and information transfer becomes easier amongst groups, risks arise from ‘watch dog’ groups for labor and environmental concerns. Sourcing increasing amounts of certified cotton may allow Victoria’s Secret to insulate itself against potential scrutiny for sourcing chemical intensive raw materials. Though increasing transparency is intended to increase positive public perception of the company’s image, this is often not that case as indicated by the report in 2012 whereby V.S. was accused of child labor in Burkina Faso. Though this event did not impact company earnings in 2012, it highlights areas of risk that the company is susceptible to regarding brand image.

Legal Risk Mitigation Increasing the amount of raw materials sourced as Organic and Fair-Trade Certified mitigates company legal risk, as both types of certification require strict standards and regular auditing of farms and storage facilities. These mechanisms are in place to prevent child labor, harmful agriculture practices, improve labor rights, and mitigates environmental and health impacts.

These mechanisms are in place to deter practices that are against company policy and regulation as well as conforming to international labor laws and rights. Being Organic and FairTrade Certified will reduce risk of lawsuits and rights violation as well as increasing company transparency with its shareholders and customers.

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Climate Change The Securities and Exchange Commission (SEC) has publicly stated that it thinks that for some businesses that the impact of climate change is material to investors. This makes the impact of climate change relevant to public company disclosure. In a study performed this year by Lawrence Taylor of 3,895 U.S. public companies, 27% mentioned climate change (Huskins, 2014). Climate change disclosure could extend beyond regulatory impacts like the cost V.S. would incur when complying with climate related legislation and international accords. This is increasingly important, as it is now known that cotton production contributes between .3% and 1% of total global Green House Gas emissions.

Additionally, demand for organic cotton is partly driven by its lower carbon footprint compared to traditional cotton produced with agrochemicals (ITC, 2011). Increased transparency could benefit the company in that it may demonstrate to its shareholders the company’s awareness of areas of risk and has taken the necessary steps to mitigate its impact and secure its raw materials with organic and Fair Trade Certified cotton. A review of several of Victoria’s Secrets’ peers 10-ks revealed that while every company lists climate change as a risk factor, none specifically mention climate change. Most of Victoria’s Secrets peers list this information to the Carbon Disclosure Project.

Environmental Benefits Organic and Fair-Trade Certified cotton have numerous environmental benefits. These include but are not limited to, increased soil fertility, reduced soil and water pollution, increase water quality, and improve biological diversity. Additionally production of Organic and Fair-Trade Certified cotton improves the health and livelihood of farm workers by reducing exposure to toxic chemicals found in fertilizers, herbicides and pesticides. These benefits have a substantial impact on local farms and regions where raw materials are sourced. These benefits are both 13

important and necessary and need be noted; however due to the scope of this CBA and its National Standing, these benefits are not quantified nor included. Additionally it should be noted that these benefits are difficult to quantify given their nature.

Costs

Raw Materials Based on the 2013 10k report put forth by L Brands, cost of materials was $ 88 million USD. The assumption was made that 30% of the cost of materials was for cotton. This included the 6% organic and Fair-Trade certified. This equated to $26.4 million USD, and at market price of $0.904 per pound, L Brands sourced approximately 29,203,001 pounds or 13,246,394 kilograms in 2013.

Marketing Based on the conclusions of the market analysis, intimate apparel customers are not willing to pay more (or even the same) for certified cotton bras. There is generalized idea that the sustainable bras will not be as sexy as the traditionally sourced bras. Therefore, Victoria's Secret will need to invest in marketing campaings in order to educate their customers and comunicate the benefits of these sustainable sources of cotton. They can also target this campaign to pregnant woman, which are most likely interested in health issues related with GM cotton.

For the purpose of this CBA, we assumed an extra 5% of the advertising budget. Based on the 2013 10k report, the total budget of advertising (not including shows and other marketing costs) for 2013 was $452 millions. In result, we are adding a cost of $22.6 million to the CBA. We believe that this percentage assumed is conservative. However, this marketing cost represents 14

the highest cost in the entire analysis.

Supply Chain Disruption Several brands have already announced ambitious 100% organic goals for 2020. Squeeze on an already squeezed industry

Certification and Auditing The costs of certification and auditing of a new farm are $19,250.00, $225,000.00, and $244,250.00 one time fee for certifying organic, Fair-Trade, and Fair-Trade and Organic respectively. Additional annual fees for auditing are $200,000.00, $175,000.00 and $375,000.00 respectively. The current costs of Certification and Auditing incurred are greater than the costs of purchasing from alternative pre-certified farms, however this places the company at risk of demand of market trends. As demand for certified cotton is and will likely continue to increase, an initial investment of certifying and auditing all additional farmers providing raw cotton to L.Brands will mitigate future sourcing costs as market prices increase due to demand.

Cost Benefit Analysis

Sensitivity Analysis It is widely reported and observed that cotton commodities are highly volatile in the market place due to numerous factors. The crop is heavily dependent on water and fertilizer supply for traditional cotton, and this can have substantial impacts on supply. Droughts and increased costs for fertilizer and pesticides impact both product quantity and quality and are reflected in the market. As the scope of the cost-benefit analysis for sourcing 50% certified organic and/or FTC being applied in three years time and adapted into the company’s operations as business as usual, it cannot be assumed that market prices will stay the same at $0.9040. Current trends indicate that due to demand, market prices over the next ten years are projected to steadily 15

increase and have already begun to do so in 2014. In order to address the price volatility for the CBA, a form of sensitivity analysis was applied.

Data The sensitivity analysis utilized 10 year, monthly historical data (IndexMundy/Bloomberg) on market commodity prices for cotton. A histogram was utilized to plot frequency ranges of prices, from historic lows of $0.35 to a high of $2.30. Price segments ranged from $0.35 - $0.60, $0.61-$1, $1.01 - $1.35, $1.36 - $1.75, $1.76- $2.00, and finally $2.01 - $2.30. This gave a frequency count of 124,215,13,5, 1, and 3 respectively. From this grouping a smaller spread was created to more accurately reflect primary trends and extreme case outliers. This resulted in a 35% probability of historical price occurrences being low, a 56% probability of prices ranged from $0.70 to $1.00, and a 9% probability that prices would be greater than $1.00 with a high of $2.30 per pound of cotton. This provided a more accurate price range based on historical market trends.

Probabilities Utilizing the probabilities from historical market values, two alternative cost cases were created for sourcing Organic and Fair-Trade cotton. The results of which can be seen in the following tables. It must be noted that these price variations are based on traditional cotton and do not reflect market trends of Organic or Fair-Trade cotton as historical data is not available. It should also be noted that these estimates are conservative as they assume a constant cost of for FairTrade Certified and Certified Organic. These prices are likely to increase as demand increases.

Additionally, the 35% probability is likely to be liberal as these price ranges occurred towards the beginning of the 30 year data frame while the 9% high is conservative. Market trends and demands are already pushing market prices higher over the past few years and are rapidly and steadily approaching the high price range. It is expected that these prices will continue to rise.

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Net Present Value We incorporated a range of various sourced percetages to reach 50% certified cotton. However, we chose the cost of 50% Fair Trande and Organic based on the current company's trend, which is 6% with both certifications.

Table 3. Overview of the CBA

For the Net Present Value calculation we considered a growth rate of 3% and an inflation rate of 1.9% (both stated in the 2013 10k report of the company). The time period considered is 10 years.

Table 4. Overview of the NPV - Best Case

Table 5. Totals for each case

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Conclusion

At this point in time, it is not cost effective for Victoria’s Secret to transition a larger percentage of its cotton products to a 50% blend of organic and FTC cotton. Though the costs for procuring the raw materials and certifying it’s farms and farmers may be negligible to the overall price of the apparel, The consumer preference survey revealed that customers of Victoria’s Secret’s intimate apparel would not be interested in paying more for a bra, while others indicated not being interested in one sold at the same price. Victoria’s Secret’s shareholders would have to swallow the additional raw materials costs along with the additional marketing funds. Though several benefits can be identified like legal and regulatory relief, and reputation, they are difficult to quantify in a pecuniary way. The results of the 10 year net prevent value analysis can be found in the appendix and corresponding Microsoft Excel file.

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