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The personal computer industry was populated with multiple manufacturers that produced astoundingly similar products; some were practically clones of one another. Because of IBM’s original policy to use Microsoft’s Windows operating system in combination with Intel’s microprocessors, this dual company arrangement practically monopolized (85%-90% of computers sold) the inner workings of almost all brands of personal computers for the better part of 20 years. The low average profitability came from multiple factors ranging from:
Rapid advances in technology combined with the lower costs of internal hardware (microprocessors, etc.).
Later (1998), Intel would ration and distribute high demand/high price processors to PC makers in proportion to their past orders. Typically, the newer the microprocessor – the more expensive the PC (higher profit margin). The price would fall as the “generation” of the product (the processor) got older.
Competitors’ sales, distribution/channels, and shipping methods.
Retailers – operate on thin net margins, e.g. -“0.6% in 1998 for CompUSA” and had limited space to display PC inventory. Display setups and the influence of sales associates accounted for majority of customer selection.
Large Distributors and Resellers – The average customer in the beginning was not as familiar with PC configuration as were the retailers. It was stated that “93% of end-users accepted reseller recommendations for computer purchases.” Mark up was added for services and for profit margins.
Integrated Resellers – Large enough to work with manufacturers directly. Still had thin net margins of approximately 1.3%
Direct Method – Manufacturer would sell directly to the end-user. Delivered through third-party.
Buybacks and price protection, advertising, manufacturing costs, and availability of hardware.
Buybacks and price protection – Companies often spent approximately 2.5 cents on every dollar for buybacks of PCs that weren’t sold and covered falling prices of computers while in the “distribution channel.”
Advertising/Market development & returns- additional 2.5 cents per dollar. Dell’s advertising targeting Compaq was highly effective.
Manufacturing: on average a computer selling for $1000.00 cost $800-$900 to produce.
Prices on hardware declined on average 25-30% per year.
Availability of hardware – it is stated that Intel dominated the marketplace with 80-90% of the market share of PCs with Microsoft’s OS. Only AMD and Cyrix competed with Intel, and even then they only made progress in the <$1000.00 PC category.
With this data, we can see that the main reasons how and why the personal computer industry came to have such low average profitability. The barriers to entry may have been high, but increased competitors in the market would not have had as drastic an effect to pricing. The price war that existed was mainly fought between the high volume, made to order, direct model company – Dell and the philosophy of multiple methods of distribution and sales – Compaq. Compaq continuously sought to keep relations good with their retailers at the expense of providing a more affordable product to the consumers. Dell’s superior method of offering products directly to the consumer was ahead of its time and proved to be the more successful method as eventually every other major producer of PCs integrated some sort of direct method in their distribution strategy. This mitigated the traditional suppliers’ and retailers’ power, as the direct method flourished, traditional outlets were rendered less competitive to price conscious consumers. In addition to this, the importance of the PC industry to the suppliers was absolute; they had no alternative methods of revenue generation. Dell knew when coming into the PC production market that they couldn’t compete with Compaq by following the same strategy, so they created a different system of marketing and distribution.
The product offered by all the manufacturers was practically identical with few differences in outside appearance, pre-loaded software specific to the manufacturer, and performance specifications desired by the end-user. However, since the use of Wintel was practically universal, PC users tended to have less brand loyalty than Apple users that were vehemently loyal to their respective Operating Systems and hardware. This universal use of similar hardware and software kept prices low because of consumers’ beliefs that there was no clearly discernible major difference in PC performance. Reliability and quality were taken into consideration with price and were factors that drove purchasing priority.
As PCs became more popular buyers’ volume and increase in educated consumers kept prices and profit margins low due to the ease at which the World Wide Web allowed customers to do value comparisons.
The proliferation of both the internet and e-mail created a larger population of interested buyers. The almost non-existent cost of switching PC makers, low product differentiation, and the sheer number of buyers using the direct method compared to sellers also kept the retail prices incredibly close to the cost of the goods sold and thus the segment highly competitive.
It can be debated that the single largest driving factor behind the low margins of the PC was the fact that the industry growth rate was something that has never been seen before. There were a multiple large companies that with similar fixed costs and similar products, using highly demanded hardware to ideally produce the highest quality product in the fastest manner, and maintain a low days in inventory because of the rapid risk of technological advancement. The only way to overtake or to maintain market share was to ascertain your relevance, efficiency, and price-competiveness. Staying up to date with technological performance, making sure you were able to deliver your product as fast and reliably as possible, and keeping your prices as low as you can while still achieving a positive net margin were the minimum requirements to stay competitive. The later introduction of suitable substitutes, such as personal data assistants and palm devices increased competition yet again. Advances in microprocessors created a scarcity issue for hardware and the greatest price increases came at the time of an introduction of a new generation. The assured manner to net the highest margin was to grow as fast as possible and reap the benefits of economies of scale. Dell had at that time perfected their increase in volume equaling increase in returns.
Like it was stated in the response to question 1, Dell revolutionized a inefficient system of distribution by performing an elementary and proven step: removing the “middle man.” To remove the broker barrier between the producer and the consumer in a reliable manner (with effective advertising and competitive pricing models) naturally lowers price and increases demand. Through meticulous, yet common-sense shipping and distribution practices, Dell was able to take an order for a competitively priced PC and have it processed, assembled, tested, and shipped according to end-user specifications within a day and a half. The data in the article stated that although large firms, who purchased more than a $1 million in PCs each year, provided 70% of the firm’s revenue, no single customer represented more than 2% of Dell’s sales. Dell was diversified with enough large accounts spanning the business sectors to the public venues (such as government institutions), educational facilities, and small offices and home users to maintain a broad spectrum of customers. Dell had the foresight to split his customers into two groups to identify the method in which the accounts would be serviced. These two groups were Relationship buyers and Transaction buyers; separated to keep customer satisfaction maximized, increase expertise about individual accounts, and to calculate potential PC purchases for future. Dell typically saw the highest gross margins with Relationship buyers.
Once Dell had a grasp on the market, he wanted to penetrate the PC market more deeply to capture more share. The company identified a potential customer that they were sacrificing by solely implementing the direct model – the customer that wants to “test drive” the machine they’re planning to purchase. In order to generate new business, Dell distributed to retail providers. The resulting sales figures were promising, but the company lost money in the retail realm. In combination with a product recall, the losses equated to meager fiscal outcomes. The following year Dell no longer offered retail services. However, it can be argued that the market penetration was still accomplished and indirectly increased revenues for home and small office users’.
Another method that streamlined the direct order method was the launch of the dell website. This allowed potential customers to browse the online service catalog, build their own system, order their configuration, and then track the shipment. The website was customized for the Relationship customers as well with customized web pages.
Not only was Dell manufacturing PCs that were specifically tailored to the end-users’ specifications, they mastered the system of efficiencies that escaped other companies. The company found that if they treated the computer building process as an assembly line with the necessary parts and hardware in separate “cells” as the PC was being assembled, they experienced less flaws in manufacturing and higher efficiency re-ordering inventory of necessary components. All these improvements to streamline efficiency and improve effectiveness and performance added to the profitability to the bottom line.
Dell’s aggressive marketing plans did the same as well. After targeting Compaq, the pricing war had set the stage for a battle that the Dell manufacturing plants were strategically organized to exceed in. Minimizing the number of days in inventory, minimizing R&D expenditures, locating warehouses and shipping points close to production facilities, and cooperatively shipping subcontractor parts to the same destination as the computer it partners (such as Sony monitors) were all methods to increase profitability in a market segment that was highly competitive with harsh margins.
On the financial side of the spectrum Dell closely monitored everything by the numbers. For example, it made certain that accounts receivables were collected 5 days prior to having to pay suppliers. The company also focused on return on invested capital, which was 186% for 1998’s returns. In comparison, IBM lost a total of $992 million from its PC division, an increase from the two previous years’ losses of $39 million and $161 million. Compaq’s profitability has been strong since its inception, however, its loyalty to its retailers at the expense of the lower prices for consumers delayed its eventual transition to a direct order method. Dell’s competitive advantage over its competition has always been rooted in their judging of performance by the numbers and offering the most efficient delivery of goods/services. When the other companies eventually switched to mimic Dell’s method, the playing field evened out a bit. Even Compaq in 1998 reported that it would “break even in the first quarter rather than post a profit of $500 million.” HP suffered similar symptoms as other companies refusing to acknowledge the superiority of Dell’s marketing and distribution model, even rejoicing when Compaq decided to transform – believing it was a grievous mistake. Just like IBM, HP still required a middle man when business ordered from their website. However, HP’s CEO (Lew Platt) later stated that, “you can’t ignore what Dell has doneâ€¦” He was continued in saying that certain suppliers refused to deal with brokers anymore; they demanded to buy direct. The consumers at that point in time had spoken.
It can be said that the best form of flattery is imitation, and Dell firmly believed that the transition of their competitors towards their model is reaffirmation of a superior business plan of an industry-leader. Dell does what it does to the best degree, it is believed by the CEO (Michael Dell), that the time and opportunity cost of its competitors to refine their method in the same manner will only play towards the PC giant’s favor.
Dell’s comparative advantage of servicing its Relationship customers through the methods of saving customer purchasing data, having dedicated operators and support systems in place, and dedicated web pages specifically designed to minimize ordering problems yielded an advantage over Compaq’s retailed method. Specifically, Dell held continuous pricing competitive advantage for year 1996, Q1-Q4 of $522, $407, $612, and $647 – respectively (see exhibit) for PC prices configured for the business market. Nonetheless, if it isn’t price that makes Dell superior, it can easily be customization of a PC to fit corporate users’ needs. Dell’s PC for corporate accounts were built to order and processed almost instantly. Compaq had an improved system where they were now building PCs for business use that were no longer constructed based on company speculation of needed features and functions, but rather the channels’ suggestions of what configuration of computers to produce. Compaq’s days in inventory was reduced from 60 to 30 days. But, because necessary retailers and distributors held an additional 35 days in inventory, the total time before getting to end user was 65 days. Compaq then offered a more direct method, while still remaining attached to retailers the following year – mid 1997.
Competitors’ effectiveness in responding to the challenge posed by Dell’s advantage has been sub-standard due to the difficulty in mimicking not only Dell’s logistics, but their efficiency as well. For example, IBM had a policy where no matter where the PC was being shipped all the components must be shipped with the unit. This led to situations where components could be leaving one part of the country, arriving at the production facility to match with the appropriate unit, and then be sent off to the exact location from whence it came. These types of inefficiencies along with the choice to not completely break away from retailer loyalty held other companies back from fully achieving the market share that Dell possessed. In addition to these inherent drawbacks, Dell had been fine-tuning their process to work out their own set of interruptions. These constant improvements increased the competitive learning curve for other PC makers and isolated Dell’s advantage. The data in the exhibits for 1998 show Dell’s stock appreciation is on average 5,271.5% more than its competitors. Dell’s only competitor that attributed most of their revenues to the direct channel was Gateway, whose corporate revenue was $7.6 billion compared to Dell’s $18.2 billion. IBM, Compaq, and HP all held higher corporate revenues ($81.7bn, $31.2bn, and $47.1bn) than Dell, however, their methods of marketing and distribution were held no comparative advantage. As of today, IBM is no longer in the PC market after selling to Lenovo in 2005 (for $1.75bn).
For FY1999, the best thing for Dell’s competitors to do is maintain the market share they have in non PC fields, such as IBM’s role in Data Storage and Information Technology consulting and Compaq’s position as a worldwide PC market share holder. Secondly, Dell’s competitors should re-examine their marketing and distribution methods to streamline efficiency, examine performance and reliability issues with production, and reorganize their R&D budgets to strengthen their relevance for future sales. Eventually, the PC market will pass and there will be some competitors that will move on to the next wave of profitable strategies, while others continue to rely on the PC for the majority of their corporate revenue.
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