Turning the business around involved more than segmenting and pulling out of retail. It also meant maximizing every strength we had in order to boost our profit margins. In re-examining the direct model, we realized that inventory management was not just a core strength; it could be and incredible opportunity for us, and one that had not yet been discovered by any of competitors.
In Version 1.0 of the direct model, we eliminated the reseller, thereby eliminating the mark-up and the cost of maintaining a store. In Version 1.1, we went one step further to reduce inventory inefficiencies. Traditionally, a long chain of partners was involved in getting a product to the customer. Let’s say you have a factory building a PC we’ll call model #4000. The system is then sent to the distributor, which sends it to the warehouse, which sends it to the dealer, who eventually pushes it on to the consumer by advertising, "I’ve got model #4000. Come and buy it." If the consumer says, "But I want model #8000," the dealer replies, "Sorry, I only have model #4000." Meanwhile, the factory keeps building model #4000s and pushing the inventory into the channel.
The result is a glut of model #4000s that nobody wants. Inevitably, someone ends up with too much inventory, and you see big price corrections. The retailer can’t sell it at the suggested retail price, so the manufacturer loses money on price protection (a practice common in our industry of compensating dealers for reductions in suggested selling price). Companies with long, multi-step distribution systems will often fill their distribution channels with products in an attempt to clear out older technologies or meet their financial targets. This dangerous and inefficient practice is called "channel stuffing". Worst of all, the customer ends up paying for it by purchasing systems that are already out of date.
Because we were building directly to fill our customers’ orders, we didn’t have finished goods inventory devaluing on a daily basis. Because we aligned our suppliers to deliver components as we used them, we were able to minimize raw material inventory. Reductions in component costs could be passed on tour customers quickly, which made them happier and improved our competitive advantage. It also allowed us to deliver the latest technology to our customers faster than our competitors.
The direct model turns conventional manufacturing inside out. Conventional manufacturing dictates that you should always have a stockpile of raw materials, because if you run out, your plant can’t keep going. But if you don’t know what you need to build because of dramatic changes in demand, you run the risk of ending up with terrific amount of excess and obsolete inventory. That is not the goal. The concept behind the direct model has nothing to do with stockpiling and everything to do with information. The quality of your information is inversely proportional to the amount of assets required, in this case excess inventory. With less information about customer needs, you need massive amounts of inventory. So, if you have great information – that is, you know exactly what people want and how much – you need that much less inventory. Less inventory, of course, corresponds to less inventory depreciation. In the computer industry, component prices are always falling as suppliers introduce faster chips, bigger disk drives, and modems with ever-greater bandwidth. Let’s say that Dell has six days of inventory. Compare that to an indirect competitor who has twenty-five days of inventory with another thirty in their distribution channel. That’s a difference of forty-nine days, and in forty-nine days, the cost of materials will decline about 6 percent.
Then there’s the threat of getting stuck with obsolete inventory if you’re caught in a transition to a next generation product, as we were with those memory chips in 1989. As the product approaches the end of its life, the manufacturer has to worry about whether it has too much in the channel and whether a competitor will dump products, destroying profit margins for everyone. This is a perpetual problem in the computer industry, but with the direct model, we have virtually eliminated it. We know when our customers are ready to move on technologically, and we can get out of the market before its most precarious time. We don’t have to subsidize our losses by charging higher prices for other products.
And ultimately, our customer wins. Optimal inventory management really starts with the design process. You want to design the product so that the entire product supply chain, as well as the manufacturing process, is oriented not just for speed but for what we call velocity. Speed means being fast in the first place. Velocity means squeezing time out of every step in the process.
Inventory velocity has become a passion for us. To achieve maximum velocity, you have to design your products in a way that covers the largest part of the market with the fewest number of parts. For example, you don’t need nine different Disk drives when you can serve 98 percent of the market with only four. We also learned to take into account the variability of low-cost and high-cost components. Systems were reconfigured to allow for a greater variety of low-cost parts and a limited variety of expensive parts. The goal was to decrease the number of components to manage, which increased the velocity, which decreased the risk of inventory depreciation, which increased the overall health of our business system.