Kieran Levis.com

21 November 2009

The news that Dell has been pushed from second to third position in the PC market is a reminder of how short are the reigns of most industry leaders – in the first half of this decade it was number one and undisputed heavyweight champion. This industry of course has always been ferociously competitive, but not many companies that create or transform markets hold onto leadership for long. Unless there are serious barriers to entry, it’s inevitable that competitors will eventually develop the capabilities that once gave the pioneer so much competitive advantage.

I’ll say more about the reasons for Dell’s relative decline in my next post, but equally instructive, and even more remarkable, was the way it disrupted the market and achieved its meteoric rise. Dell transformed the PC industry, not by technological innovations, but through its business processes and model.

Michael Dell was an 18 year-old student when he founded his business in 1984 with $1,000 of capital. Buying surplus stock of electronic components at knock-down prices, he reconfigured them into  customised machines for small businesses. The new industry was going through its biggest shake-up since  IBM brought out its PC in 1981. Its remarkable decision a year earlier to make its architecture open had had the unintended consequence of opening the door to hordes of competitors. Components were standardised and easily available, and manufacturing them was becoming basically a question of assembly. Even a tiny business like Michael’s could became a manufacturer in its own right.

He was convinced that most suppliers, and especially most retailers, were providing poor value. His approach was radically different: dealing directly with customers and selling almost entirely over the phone and mail-order, he assembled computers configured to their specific needs and sold them at half IBM’s price. Efficiency, not brilliance was his watchword.

“I’d rather design the winning system to sell and support customers than design an incredibly technically proficient microprocessor that nobody wants to buy. . . There are lots of technologists who will create wonderful things and then go try to find people to buy them. We started with the customer, and then worked our way back”.

Examining every single process he constantly sought ways to reduce costs and improve performance. The extraordinary effectiveness of this approach was not apparent for years – to most  competitors and commentators Dell was just another cheapskate maker of clone PCs. In fact Dell was competing almost as much on quality and service as on price, steadily building a brand based on solid products and service, and focussed on early adopters – knowledgeable, demanding business customers. By 1990, when sales reached $546 million, it was ranked sixth on market share but number one for customer satisfaction. Word of mouth was now generating enormous positive feedback loops: more and more customers meant more repeat orders and even more recommendations. Sales accelerated to $2 billion in 1992, and by the end of the decade an astonishing $25 billion – an average annual growth rate of 65%.

The only companies that have ever grown faster are Cisco, which relied partly on acquisitions, and Google, a virtual and more naturally scalable business. Dell however took a major step towards becoming virtual, long before any of its competitors. In 1994, a year before Amazon’s launch, Dell.com appeared, though it wasn’t until two years later that it started taking orders. In 1997 it took over a billon dollars through the site and by 2000 half of its sales were made online.

The website was just the front-end. Behind the scenes, something really revolutionary was happening. Just as competitors were learning how to imitate parts of Dell’s business model, it reinvented it as what it now called ‘virtual integration’. It automated both its marketing operation and its supply chain, achieving efficiencies very much greater than any vertically integrated company. Most of the work was being done by suppliers, coordinated by Dell electronically. Like  Cisco, it scarcely handled any inventory itself.

The cost of holding inventory in an industry with wafer-thin margins was becoming the difference between profit and loss. The never-ending flow of technological advances meant that all the chips, disk drives and memories most firms had to  hold were constantly falling in value. Dell was the first to master what it turned into a new science of inventory management, concentrating less on the absolute levels of inventory than on how fast it was moving. It also pioneered the delightful concept of ‘negative cash conversion’ – customers payed for their machines long before Dell had to pay its suppliers.

These innovations played an enormous part in making Dell, not just the biggest PC supplier by the turn of the century, but by far the most profitable with net income of over $1.7 billion.  But the relentless pursuit of efficiency came at a price.