The New Supply Chain Lessons from Dell

Something quite extraordinary happened last week, and it has received relatively little
attention from the supply chain world.
The headline news is that Dell is closing its world famous Topfer PC plant in Austin, TX,
named for Mort Topfer, an ex-Motorola executive who in the mid-1990s became vice
chairman and helped lead Dell out of an earlier slump.

To put it simply, Dell is significantly revamping its entire supply chain strategy
and, in large measure, abandoning its make-to-order model. In addition, it will
begin to make much greater use of contract manufacturers for the first time.

The strategy was outlined in a presentation by Mike Cannon, President of Global

Operations – what is, in essence, a chief supply chain officer role. Interestingly,
Cannon was previously CEO of contract manufacturer Solectron. Also interesting
is that Cannon’s presentation started the meeting off – a pretty good indication
of how important and dramatic these changes are.

I must admit to feeling that I made a good call with my column Time for New
Supply Chain Icons in 2006, which said for many reasons we needed to look
beyond the always cited Wal-Mart and Dell.

As Cannon noted, the Dell build-to-order and “do it all ourselves” model served
the company well for almost 20 years, but “the environment has changed.”

I was debating whether to save this for the end, but I’ll say it now. It’s “Back to
the Future,” in a very real sense. Just a few years ago, Dell was positioned as the
supply chain place where most of us needed to be: almost no finished goods or
parts inventory; negative cash-to-cash cycle (paid by customers before paying
suppliers); “have it your way” flexibility/the epitome of mass customization;
sophisticated demand management techniques to drive buyers to what was
most profitable or available in terms of PC configs; cut out the middleman.

Now, it appears, Dell itself doesn’t want to be there.

“Our supply chain needs to change dramatically,” Cannon said.

So I guess we can stop chasing the vision too, in part. Dell will still operate that
model for the customers who value it, but obviously at very reduced levels (i.e.,
like a whole Austin plant’s worth), but its now more replicating the supply chains
of its competitors, which just a few years ago were lambasted by most for being
so far behind Dell: make-to-stock with some limited last minute config changes
before shipping, often by distributors; use of contract manufacturers and low-
cost country production; sales through retail channels.

Cannon certainly made a strong case.

Dell’s approach added a lot of complexity – and cost. He said, for example, that
for many models, there were as many as 500,000 configuration options, though
of course nowhere near that many were actually ordered.

Why do that? “Because we could,” Cannon said. “We had a very flexible supply
chain that allowed us to offer that level of configuration choice.”

That approach, contrary to popular belief, in turn actually led to higher product
costs in many cases. Here’s how. Base/entry models had to be built in a way that
permitted all these add-ons to much higher end models. So, if/when customers
configured their way up to a high-end unit, Dell made good money. But if a
customer stayed with a basic offering, the company lost margin because the
base unit versus the competition had extra costs to support the potential of high-
end add-ons. And it certainly added to overall supply chain complexity.

One could say that the essence of Cannon’s comments and strategy is that now,
in the computer world, cost trumps speed and flexibility. He said Dell is
committed to leading the industry in delivering equipment “at the lowest total
landed cost” anywhere on the globe. “That’s what drives our supply chain
decisions,” Cannon stated.

That clearly means, in part, production in low-cost countries, not Austin. And the
company believes there are a large segment of customers who just don’t need
Dell’s traditional supply chain model.

“They are very happy with fixed configurations and extended cycle and delivery
times,” Cannon said.
Dell has said it believes it can save $3 billion annually from various measures,
and Cannon said most of that will come out of these changes to the supply chain
over the next 2-3 years. It had sales of $61 billion last year, so that’s about a 5%
reduction in total costs.

Like a growing parade of other companies, it also sees its future growth tied
heavily to developing markets – where the price/cost structure must be radically
different (See End of a Supply Chain Era).

When asked what his biggest insight was upon joining Dell about a year ago,
Cannon said after a moment’s reflection that “I think we underestimated the
capabilities of our supply chain partners.”

He said the company, understandably, in recent years kept trying to

incrementally improve its existing model that had led it to market leadership. In
reality, the model needed to be substantially transformed – or one might say
blown up.

I have a number of other thoughts here, but am out of space. In next Tuesday’s
SCDigest On-Target edition, we’ll run a transcript of Cannon’s full comments
under our Manufacturing section. I’d love now or then to get your thoughts on
this.

It’s another end of an era, though one we’ve seen coming for some time. It’s
Back to the Future indeed. Dell is now like the rest of us.

The News: In a very interesting quarterly conference call last week, Dell executives cited in
part challenges in balancing supply and demand and other supply chain issues in results that
disappointed investors.
The Impact: Dell’s challenges show just how hard it is to get demand-supply management
right, even for a company almost universally cited for supply chain excellence. It also
highlights how difficult it is to remove sales optimism and pressure to meet financial goals
from the forecasting process.
The Story: In an extremely interesting quarterly earnings conference call last week, Dell
executives, notably CEO Kevin Rollins, cited a number of supply chain related issues as
leading to financial results that disappointed Wall Street. (See Dell 2nd quarter earnings call
2006 to listen for yourself. The open question session is where all the interesting discussion
takes place.)
It needs to be remember that Dell is still growing nicely and highly profitable. The
conference call included some debate about whether or not Dell is losing market share, and if
so how much of it is by choice (the statement was made in the call that Dell may be
intentionally losing some U.S. consumer market share).
Also true is that Dell’s profit levels have deceased, and the stock has taken a pounding, which
always puts tremendous pressure on company execs. Some of this is probably due to a
general reduction in the growth of the computer market, but as Rollins stated, “[Dell] can do
better. We know that.”
Dell’s CEO then stated that there were problems both on the demand management and
supplier/procurement sides.
Specifically, it appears Dell overestimated either market growth or market “elasticity,”
leading it to setting lower prices in the quarter to a level that was not made up by a balancing
increase in unit growth. Margins took a hit as a result.
We’ve heard Dell executive Dick Hunter several times state that “Sales and Operations
Planning [S&OP] is like a religion at Dell.” Undoubtedly true, but the second quarter shows
that even the best S&OP process are subject to challenges. It wasn’t explicitly stated, but the
implication was that Dell was over optimistic about unit volume forecasts.
“We don’t think we did a good job on this,” said Rollins. “We were overly aggressive on our
pricing in a period of decelerating demand.”
Perhaps more surprisingly, Rollins said Dell has work to do on the procurement side, and has
been paying more for key components that it needed to.
Dell is “Not doing a good enough job” in managing component procurement, Rollins said.
Specifically cited were opportunities flat panel displays, storage, and memory, as well as
challenges in visibility of future component pricing.
He added that the company was undertaking a full review of all Supply Chain and
Procurement processes. While he said these processes have historically been very good at
Dell, the company may “have reached a point of share and critical mass” that can lead to cost
improvements from re-looking at those functions.
In total, Dell executives said they will soon implement changes that will reduce costs be $3
billion annually.
Michael Dell's reassumption of the CEO's post at Dell is a shell game that can do little more
than temporarily assuage Wall Street. Let's be honest. As chairman of the company, Michael
Dell had whatever opportunity and access he needed (to the now-ex CEO Kevin Rollins as
well as other Dell execs) to implement a course correction. When Michael Dell spoke,
everyone listened and listened closely. A more honest assessment of Dell's current situation is
that Michael Dell knew that the business model on which his namesake company was built
and made fortunes would eventually run out of gas. Now, that time has finally come and the
big question is, what to do next.
A lot of people think Dell is a computer company. They're mistaken. It's a bank. One that's
been trying to diversify, but a bank nonetheless.
A while back, I did a whiteboard video that explains why Dell is a bank (see The Bank of
Dell). It works like this: Dell assembles PCs. It doesn't "make" them. It takes off the shelf
parts from household name suppliers for processors, hard drives, memory, etc. and assembles
them into the PC that someone is going to order tomorrow. The suppliers of these parts have
inventory depots across the street from where all this assembling takes place and, since Dell
has been in business so long, it has a very good idea of how many of each part it will need at
3pm tomorrow. And that's when the race starts (or perhaps I should call it the financial
clock).
Just because Dell takes delivery of a hard drive at 3pm tomorrow doesn't mean it has to pay
for it at 3pm tomorrow. Using common deferred payment terms (eg: "Net 15", "Net 30",
etc.), Dell usually doesn't pay for that hard drive until well after it's not just assembled into a
computer, but also after that computer has been shipped to its customer who has already paid
for it. In other words, there's a window of time where Dell has collected money for a hard
drive that it hasn't yet paid for. Now picture the volume of business that Dell does on these
terms and you can begin to see why I see Dell more as a bank than a computer company.
Making massive amounts of money on this sort of financial manipulation, often called "the
float," is usually the domain of financial institutions.
This financial efficiency didn't happen overnight. Inventory-laden companies are often
measured on a metric called Day Sales of Inventory (DSI). DSI essentially measures how
many days it takes a company to turn the raw materials in its possession into sales. The key?
Don't possess the raw materials for very long. Or the final product for very long. Back in the
day when the company was called PCs Limited and Michael Dell first pioneered the direct
model (selling directly to customers instead of going through the retail channel), his DSI was
not even remotely close to a day or two (as the aforementioned "3pm scenario" implies). It
was probably more like a month.
But even so, a one month DSI was significantly better than the DSIs of the rest of the PC
makers who operated through the retail channel. For them, the time it took for a raw material
like a hard drive to finally end up in a computer on someone's desk was probably three to six
months, if ever. Computers had to be manufactured, shipped in bulk to a wholesaler, and then
from there, to the stores, and stocked on shelves (where inventory burns holes in financial
pockets), and then someone had to walk into the store and buy it. And, unlike with other
stocked merchandise (eg: a blender), Moore's Law was constantly conspiring against this
model. Before too long, the inventory that was on the shelves was obsolete, costing the entire
channel even more money.
Out of the gate, Dell's direct model already put the company at a significant supply-chain
advantage since the entire channel inventory problem was a non-issue (or at least less of an
issue). Then, for a while, Dell's competitors, with their legacy channel businesses, watched
like deer in headlights as Dell whittled its DSI down by squeezing more and more efficiency
and cost out of the supply-chain side of the business; everything from doing a better job
predicting inventory needs to having suppliers across the street simply converted into a lower
DSI which in turn meant more float time.
But now, two decades later, Dell is no longer alone when it comes to supply-chain efficiency.
Sure, Dell's competitors went through some painful conversions as they straddled the
traditional sales channel and direct-to-customer businesses. But today, Dell's supply-chain
story is no longer the competitive advantage that it once was. But that's not really what haunts
Dell. Stripped of its huge supply-chain advantage, what now haunts Dell is that it has never
been able to break away from the Fabrication, Assembly and Test (FAT) model. Dell is and
always has been primarily an integrator of off-the-shelf parts. Dell claims it does Research
and Development (R&D). But it's not the sort of R&D that Dell's suppliers do; the kind that
yields really profitable intellectual property. Like other system integrators, Dell's real R&D
departments are at Intel, AMD, ATI, NVIDIA and its other suppliers. Unfortunately for Dell,
it's the same "commodity R&D" that the company's competitors have access to.
So, if the R&D playing field is level and the supply-chain field is level (or the gap is
significantly closed), is there anywhere for a FAT-specialist like Dell to hide?
In meeting with executives over the years, Dell has clearly tried to diversify. It has gone the
TV and printer route (and maybe the consumables market will eventually pay-off for Dell the
way it has for HP). But in terms of hardware, the area of servers and networking
infrastructure is where the gold is if only you can close the business. Dell may have made
some good inroads there. But, if desktops and notebooks are difficult markets to be in if all
you have in terms of competitive advantage is an efficient supply chain, then servers and
network infrastructure are an even worse place to be. For starters, while it's always an issue,
supply chain efficiency doesn't matter nearly as much with servers and network infrastructure
since the sales lead times tend to be longer, the deliverables are far more customized to the
end-users' requirements, and buyers generally don't need the products within a day of
ordering them.
But to make matters worse for Dell, relying on commodity R&D really puts a server and
network infrastructure player at a significant disadvantage since it's in this segment that R&D
can make or break a sale.
I've always been suspect of Dell's server strategy, calling it for what I think it has always
been: a strategy that's tied to Intel's R&D. Dell has shown us what it believes to be its own
innovations on top of the R&D of others. But the phrase "blue blinking lights on the front"
comes to mind. I remember a server briefing where some Dell server product manager was
explaining how the company had, based on customer feedback, put the blinking lights on its
rack mounted networking infrastructure on the front rather than on the back. Who am I to
poo-poo what the customer is saying? But is this the R&D on which fortunes are made? Not
quite.
Dell has forever said the way to scale your computing infrastructure is to scale-out.
Coincidentally (not), Dell's ability to scale up was completely tied to whatever Intel had to
offer it in the way of off the shelf parts, none of which were scale-up parts. To do a two, four,
or eight way system, Dell had to wait for Intel (or some other supplier) to offer two, four, or
eight-way parts. Dell was incapable of doing what IBM and HP were doing: R&D that
yielded multiprocessor server chip-sets (EXA and ZX1) that could scale Intel's processors to
16- and 32-way systems where some real margins live. Even so, there was a period of time
where, for customers, the penalties for scaling out versus scaling-up were few. The hardware
was cheap. Energy was cheap. And the Internet wasn't yet a viable medium over which to
distribute computing off premises. So, a commodities player in a scale-out market (validated
by Google's approach) with an efficient supply chain like Dell's has a good shot as long as
market conditions remained unchanged.
But then, everything changed when it came to that one potential sanctuary of margin (servers
and infrastructure). Between managed hosting services or something like Amazon's EC2 and
S3, buying your own servers and storage makes far less sense than it ever did. Not only that,
if you must stay on premises, then with technologies like VMWare and XenSource on the
loose, why buy five servers when you can get away with better utilization of one (one that
looks like five). And then, with both Software as a Service (SaaS) and services oriented
architectures (SOAs) finally proving themselves to be viable, components of a business
process (or the whole enchilada) are far more easily outsourced than they have ever been.
Think about it. For every customer that Marc Benioff signs up to use salesforce.com, that's
probably one to twenty less servers that get purchased by some business.
But it gets worse (for Dell). The energy situation is a mess. Talking scale-out smack (even
though that's all Dell could do because of how it relied on Intel's R&D) may have worked
when there wasn't a war in Iraq and there wasn't a giant question mark hanging over the
energy sector. But now, scale out isn't looking quite as smart as it once did. Generally
speaking, scale out means more machines: Machines that need their own electricity;
Machines that need to be cooled off. Suddenly, having lots of machines driving up your
energy costs isn't looking so good. Even worse, with no real R&D of its own to correct the
problem, what's a commodities player like Dell to do? Answer? Hold a press conference to
talk about how energy can be saved by scaling out. I laughed. I cried "Say what!!!???". I
recorded the press conference for podcast and wrote about it.
Now, energy is on everyone's mind and Dell's reliance on its suppliers to give the company a
compelling energy story is out in the open. The emperor's clothes are off. Whatever Dell's
suppliers come up with to address the energy situation will be the same, at the very least, as
what Dell's competitors (those suppliers' other customers) will come up with. Meanwhile,
companies with real R&D — companies like Sun — are showing up in the market with scale
up solutions (Niagara) that save enough energy to motivate utility companies like PG&E to
issue rebates for buying them. I personally can't validate that Sun's current or forthcoming
scale-up offerings perform better at a reduced energy cost. Others including fellow ZDNet
blogger George Ou have questioned the claims and no standard benchmark involving energy
consumed, overall cost, and units of compute power currently exists.
But I do believe two things. First, scaled-up systems (especially when virtualized) will
eventually prove to be so much more energy efficient than scaling out that even Google will
have no choice but to reconsider the approach given its potential impact on the bottom line
(Google is clearly keeping an eye on the situation). Second, whether it's energy or some other
important end-user reflection of market conditions, Dell, with its heavy reliance on
commodity R&D, is incapable of coming up with any potential big game changers on its
own. Not for its customers. Not for itself. Now, with Dell's supply-chain advantage having
been whittled away, it's going to take a lot more than a shell game in the management ranks
to regain its competitive edge.
Finally, if I had to point to one other problem at Dell which may be a source of its woes, that
would be agility. Yesterday, as I was putting the finishing touches on ZDNet's coverage and
42-slide image gallery of four Windows Vista-based notebooks from Toshiba, I came across
a notebook from Asus (shown here in the image gallery) that had actually done a better job
than Toshiba at implementing a Microsoft technology found in Windows Vista called
SideShow. Both Asus and Toshiba were at CES showing off their Vista "innovations." Other
than recommending Windows Vista for its existing systems, Dell, which in the past has been
known for some innovation in the area of mobile computing, has been relatively silent.
Michael Dell needs to be asking someone at the company why a Dell-branded PC wasn't on
stage at CES with Bill Gates instead of the Toshiba Portege. He also needs be asking why
Asus (a company that hardly anyone has ever heard of) upstaged every household name in
mobile computing, especially Dell, with an innovative Vista-based notebook. Finally, he
needs to ask himself why his company's own home page for Windows Vista buries the path
to buying a Dell computer with Vista installed on it (on the lower left-hand side). Not that I
have any vested interest in fixing Dell's problem. But having once run a computer shopping
site (computershopper.com), I know that if the objective is to sell something (and what other
objective should most pages on Dell's site have), then the ability to buy something should be
top, dead, center.