For decades clothing multinational Gap Inc. has run a labour standards compliance program for its suppliers. Until 2016, factories that failed their audits were given extra support and education to implement corrective action plans.

But that approach made no real difference to their subsequent audit performance, new research has found. And it's only when Gap Inc. — whose retail brands include Gap, Old Navy and Banana Republic — changed tactics and started to cut off business with repeat offenders, in addition to its education and support outreach, that things changed.

In the face of such a serious penalty, violators were 22 per cent more likely to pass their next audit, estimates research from the University of Toronto. The strongest improvements were among suppliers based in highly competitive markets and those with long-term business relationships with the company.

"Gap Inc. is one of the world’s biggest clothing companies. Its supply chain employs hundreds of thousands of workers. But what made this an exciting setting for this study was that it pursued two different approaches to managing its non-compliant suppliers," says Greg Distelhorst, an associate professor of strategic management at the University’s Rotman School of Management and the Centre for Industrial Relations and Human Resources. He co-authored the research with Matthew Amengual of the University of Oxford. "We saw this as a great opportunity to compare the effects of these different approaches on the labour standards in their suppliers."

The researchers looked at in-person compliance audit records between 2010 and 2019 provided by Gap Inc. for 1,366 factories in 33 countries, based mostly in emerging markets such as China, India and Vietnam. They also analyzed labor audits conducted by the International Labour Organization, a United Nations agency independent from Gap Inc. The researchers also interviewed nearly two dozen Gap Inc. managers to understand how the compliance and audit system worked.

Gap Inc. assesses factories annually against 700-plus potential violations covering employment contracts, overtime, workplace safety and other areas. Its scoring formula is complex and confidential to discourage gaming of the system. Until late 2016 when Gap Inc. added the threat of losing their supply contract, every factory got an action plan for fixing violations and technical help from Gap Inc. but those that failed their audit received extra support. Failing factories had an average of 17 violations.

In the pre-penalty period, failing an audit showed "near-zero" effects on the chances of a supplier's future compliance, the researchers wrote. Still, not many companies threaten to cut off business to force compliance, partly, the researchers say, because there has been no definitive research based on in-person inspections and outcomes data until now.

After penalties were introduced at Gap Inc., the most improved suppliers focused on cleaning up their most severe violations, such as paying benefits and overtime and maintaining clear exit routes for their facilities.

With the new policy, Gap Inc. terminated its relationship with more than 40 per cent of factories that had failed two audits in a row in 2017 and 2018.

As a result of the findings, the researchers write that companies should "reconsider the role of appropriately scaled penalties" in their social compliance programs and that even stronger penalties than Gap Inc. used are probably needed to reach full compliance.

The study appears in Strategic Management Journal.