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B6701A Strategy Formulation
Professor Lihua Wang
MIDTERM EXAM – Matching Dell
CLUSTER Y GROUP 3
Angela Butler
Deirdre Eng
Alessandro Santo
Rei Shinozuka
Agam Singh
Angela Butler, Deirdre Eng, Alessandro Santo, Rei Shinozuka, Agam Singh
February 7, 2005
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Angela Butler, Deirdre Eng, Alessandro Santo, Rei Shinozuka, Agam Singh
MIDTERM EXAM – Matching Dell
1. How and why did the personal computer industry come to have such low average profitability?
The personal computer was designed from the outset as a commodity product, and the
market was deliberately engineered to prevent market dominance. IBM laid out the framework
of the PC marketplace in such a way that no one, especially itself, would be able to establish a
leadership positions by erecting barriers to entry to other vendors. In 1981, IBM a virtual
monopolist in the computer industry had vaguely sensed the growing importance of
microcomputers. IBM believed that this new segment would represent limited opportunities, but
nevertheless did not wish to be cut out of it, and so IBM’s strategy was to create a market for a
simple low-margin product in which it could participate.
HISTORY
IBM believed that success of the new PC would depend on building a
critical mass of compatible software and hardware from the microcomputer industry. Phil
Estridge, the IBM Vice President credited as the father of the PC, said in 1982: "We believed
that a very wide array of software would be one of the key factors in the widespread use of the
Personal Computer. There is no way that a single company could produce that much software;
even if it were possible, it would take too long. So we needed to have the participation of other
software authors and companies." 1 Bill Sydnes, IBM Engineering Manager, echoed: "The
definition of a personal computer is third-party hardware and software." 2
COMPLEMENTORS
Ironically, while IBM's presence would legitimize the microcomputer market to its customers,
IBM's reputation would also threaten the very players in the nascent microcomputer industry
IBM needed as partners. Fearing IBM’s dominance in computers, no one wanted IBM as a
potential competitor. It was critical that IBM convince these players that they could invest in
and profit from this new platform free from fear of IBM's dominance. Estridge's strategy was to
define the hardware ISA (Industry Standard Architecture) in which IBM had no proprietary
interest. Furthermore, Estridge emphasized that IBM would not change the microcomputer
market: "We wanted to fit into what we believed was the existing infrastructure of software
houses, authors, hardware vendors, and retail distribution channels that had arisen. We were very
anxious to get people to understand that we really did want to fit in and that we weren't trying to
set rules for others to live by." 3 Finally, IBM’s PC marketing consciously avoided the strong
IBM brand. The PC did not have the traditional IBM product number, and IBM licensed the
Charlie Chaplin character to communicate its “kinder and gentler” image..
Nothing within the PC itself was leading edge. The PC was conceived not in IBM's
Thomas J. Watson Research Laboratories, but in Boca Raton by a 12-man team headed by
Estridge. Their selection of two particular components in the PC would have resounding effects
over the next quarter-century, yet were made almost by happenstance. The Intel 8088 CPU was
uninspired; in comparison, the Motorola 68000 was a true next-generation design. However, the
Intel 8088 was inexpensive, and importantly IBM already possessed a manufacturing agreement
to use the 8088 in another product. Similarly, Microsoft's MS-DOS was offered on the strength
of that company's well-regarded BASIC language interpreter; Microsoft had never created an
operating system.
SUPPLIERS
http://www.pcmag.com/article2/0,1759,1176262,00.asp
http://www.pcmag.com/article2/0,1759,1163291,00.asp
3
http://www.pcmag.com/article2/0,1759,1176262,00.asp
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Angela Butler, Deirdre Eng, Alessandro Santo, Rei Shinozuka, Agam Singh
By virtue of IBM’s selection, Intel and Microsoft became single-source suppliers to PC
manufacturers, and both companies exploited this position to become extremely powerful forces.
By this selection, IBM used its market influence to establish a secure market position not for
itself, but on behalf of two then-minor and unthreatening players in the computer world.
Vendor support for the new PC was enormous, and soon clone PCs appeared in
competition with the IBM PC. Because of the PC's low-tech components, cost of entry was very
low. Michael Dell started his business part-time assembling computers while a college
freshman. A relatively sophisticated mass production line could be constructed for a $1 million
capital equipment. The success and cost-efficiency of the PC market would gradually diminish
the role of substitutes in the market, which included Apple computer, but also such diverse
players as DEC and Sun and part of IBM and HP’s business.
COMPETITION
By the time that IBM management recognized the importance of the PC market, the die had been
cast, and even IBM was powerless to change the course of PC development. In 1985, Estridge
was killed in an airplane crash and IBM management began to reevaluate its PC strategy.
In 1987, IBM attempted to strengthen its role in the PC market. IBM introduced MicroChannel
as a proprietary and licensed replacement for ISA. On the software front, IBM released OS/2 as
an advanced operating system to replace MS-DOS.
In response to IBM's moves, in 1988 nine clone-makers led by Compaq formed a consortium to
promote an open alternative to MicroChannel. Intel won this skirmish with its PCI standard, still
in use today. OS/2 never found an audience, and Microsoft increased its dominance with its
Windows OS. The control was rapidly shifting from the PC manufacturers to the "Wintel" Axis.
The failure of IBM to assert its control over the PC market in 1987 vindicated Estridge's strategy
of the open platform. So long as vendors perceived IBM's control over the industry, they would
not play. Ironically Estridge's vision would prove more enduring than IBM's marketing. During
the period between 1985 and 1989, IBM saw its market share slide 20 percentage points from
37% to 16.9%, and IBM forever relinquished its influence over the PC industry.
Compatibility is the most important characteristic of every PC; it is critical that all PCs run all
software precisely the same and interoperate with the same hardware peripherals as the industry
standard. So seriously has the compatibility issue been addressed that it is hardly a concern
today. Given that compatibility is the prime objective, it is impossible for PC manufacturers to
differentiate themselves by way of features. Differentiation by computer performance is also not
possible because all manufacturers have access to the same microprocessors, disk drives and
other components used to improve performance.
The only significant differentiator between the vendors is cost, and customers are
very sensitive to price. Customers are in a powerful position since there are virtually no
switching costs between PC brands. Given that the cost of supplies is similar for all
manufacturers, only the most efficient manufacturer is able to keep internal costs low and either
pass on lower costs to the consumer, preserve margins, or a combination of the two.
CUSTOMERS
2. Why has Dell been so successful despite the low average profitability in the PC industry? Discuss Dell’s core
positioning, strategy and the activities underlying Dell's position and the manner in which they fit together.
Dell recognizes itself as a service provider rather than a product manufacturer. In many ways,
Dell has more in common with Federal Express than with IBM. Much of Dell's business model
hinges upon routing information, components and product quickly and efficiently between
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Angela Butler, Deirdre Eng, Alessandro Santo, Rei Shinozuka, Agam Singh
suppliers and customers. In an environment where computer components decline in value by 2530% per year, or as in 1998 decline 1% per day, Dell's zero-inventory model is not a luxury but a
survival factor. The build-to-order model exemplifies the service perspective. In a market where
both the finished product and components used in its manufacture are commoditized, Dell
differentiates itself from the competition by the manner in which it interacts with the customer
through the Dell Direct, and then in the efficiency by which it coordinates convergent delivery of
all parts and services needed to land the PC at the customer’s door.
Michael Dell explains: "Dell is a company that--from the ground up... started with a very
distinctive and different way of doing business." The company is principally an extraordinarily
efficient extension of the 18-year old freshman assembling PCs for clients. Much of Dell's
success derives simply from what it chooses not to do, and conversely its competitor's failings
are a largely a result of a lack of focus as PC manufacturers.
The strength of Dell’s direct distribution and zero-inventory model is what it
does not have: it does not have resellers or middlemen to squeeze margins, and it does not have
costly and wasteful inventory. Dell's competitors distribute product to businesses through valueadded resellers and to home consumers through retail outlets. The inventory and support
provided by these channels are prohibitively costly in the low-margin PC marketplace. Rapid
obsolescence makes inventory management a large problem, and buy-backs and price protection
cost PC makers 2.5% of revenue. Distribution markups and channel advertising cost 5-7% of
gross revenue.
COMPLEMENTORS
By eschewing the middleman, Dell can retain that markup for itself, and replace channel support
by contracting this support directly from Xerox, Wang and Unisys. Physical distribution is
contracted to UPS and Airborne Express. Dell reduces expensive services typically provided by
distribution channels into commoditized services which can be multiply sourced and switched
with little cost.
In the late 1990's HP and Compaq both attempted to emulate Dell's direct marketing program,
but neither would commit to duplicating Dell’s entire business model. They fashioned awkward
compromises to create direct marketing portals while pacifying their partners. Rather than
recognizing Dell's direct distribution as the face of its service model, HP and Compaq sought to
duplicate Dell’s distribution in isolation and graft it onto their existing models. Similarly when
attempting to duplicate Dell's zero-inventory model, rivals cut inventory so blindly that they
were unable to deliver product. These half-hearted measures not only doomed the new
initiatives to failure, but succeeded in alienating resellers into partnerships with generic "whitebox" PC makers or setting up manufacturing operations of their own.
Companies with wide product portfolios like HP or IBM depend on the reseller
relationship to support their wider product line and cannot afford to alienate resellers. Their
wider market scope, often touted as a synergy, is actually a disadvantage versus Dell.
COMPETITORS
HP and IBM lack Dell’s PC focus. As long-time traditional (non-PC) computer manufacturers
they attempted to transplant that business model to PC manufacturing. In traditional computer
manufacturing, companies design their own proprietary hardware, operating systems and
software. These systems compete primarily on performance and features. The price position is
protected because from the customer’s vantage, these systems almost always involve high
switching costs. Furthermore, the traditional computer market has a high barrier to entry, since
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Angela Butler, Deirdre Eng, Alessandro Santo, Rei Shinozuka, Agam Singh
new entries must pay high costs for R & D to design proprietary software and hardware, as well
as branding and marketing the product.
HP and IBM both run expensive R & D programs; HP filed 1,400 patents in 2003. R&D is of
limited value in a commoditized industry, and R&D costs have been long dropping in the PC
market. As a percent of sales, Dell spends a quarter of what IBM or HP spends on R&D. Dell
is more efficient overall, with SG&A and Advertising expenses about half what they are for its
rivals, but the difference is striking in R&D. Unlike HP or IBM, Dell has no illusion of itself as
a "high-tech company" with its expensive trappings. In the "Wintel" universe, R&D is the
province of Microsoft and Intel, and Dell again wins by what it does not do.
3. What, if any, competitive advantages do they have because of the choices they have made?
Dell succeeds because the company has self-awareness its
rivals lack. Because of this, Dell can concentrate on PC
manufacturing.
In late 90's, Compaq was busy emulating IBM as a fullservice computer company, and embarking on reckless
multi-billion-dollar mergers with Tandem and Digital
Equipment while CEO Eckhard Pfeiffer declared: "We
want to do it all and we want to do it now." Gateway 2000
was similarly engaged in distracting mergers while losing
track of its growing inventory. The trend toward
consolidation culminated in 2001 when HP merged with
Compaq, resulting in large product overlap which even
today remains unresolved.
Figure 1 shows the effects of increased expenses and
reseller markups in a scenario of Dell versus Compaq
and Reseller selling a $1000 PC. Because of the
commoditized nature of the products, both cost of
components and cost to customer are fixed at $800
and $1000 respectively. Dell is able to extract a 7.6%
margin from the transaction, whereas Compaq loses
7.4%. Dell saves $14 by over Compaq by
maintaining a smaller inventory, $90 via expenses,
and some $60 in reseller markup. By only holding 7
days of inventory, which depreciates at a rate of 25%
per year, Dell saves $14 for each PC versus Compaq.
Figure 2 shows how Dell and Compaq’s expenses
have dramatic effects on profit margins and how close
total costs are to revenue (grey bars in front).
Expenses and markup tip Dell’s positive margin into
Compaq’s negative margin. Compaq is under
pressure to increase its prices, or to renegotiate terms
with its resellers to reduce their markup.
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Dell
Sale
Hardware Components
Advertising
R&D
SG&A
Reseller Markup @ 60%
Net Income
Net Profit Margin
Day of Inventory
Holding Loss/Year
Cost per $1000 sales
Compaq &
Reseller
1000
800
11
15
98
0
76
7.60%
1000
800
11
43
160
60
-74
-7.40%
7
25%
$3.84
34
25%
$18.63
Table 1Costs for $1000 PC
$1,200
$1,000
$800
$600
$400
$200
Reseller Markup
R&D
Advertising
SG&A
Hardware
Selling Price
$Dell
Compaq + Reseller
Figure 2 Profit Margin for a $1000 PC