The Lean Recession

The WSJ just posted (1/20/10) a small article about the semiconductor industry. Here is a line from the article:

 

Distributors controlled 36.9 days of inventory at the end of the third quarter, down 15% from a year earlier,according to iSuppli. In dollar terms, distributors held $4.8 billion worth of semiconductor inventory at the end of the third quarter, down 22%.

 

I couldn’t help but pull out Little’s Law to calculate the sales rate this year and last year. This year’s sales rate is R = I / T = 4.8 / (36.9 / 365) = 47.5$b.

This year’s days-of-supply is down 15% from last year, so last year’s days-of-supply was 36.9 / 0.85 = 43.41.  This year’s inventory is down 22% from last year, so last year’s inventory was 4.8 / 0.78 = 6.15.  Hence, last year’s sale rate was R = 6.15 / (43.41 / 365) = 51.7$b.  We can conclude that sales are down only 1- 47.5/51.7 = 8%

The bad news is that sales are down. The good news is that firms were able to reduce their days-of-supply even though their sales rate was declining. This is remarkable.

Imagine firms were producing at a certain rate and then demand softens. A natural reaction is to think this is a temporarily blip and to keep producing. Before you know it, inventories have ballooned and your days-of-supply has skyrocketed. That is not what happened in this industry and I suspect in many others. Firms “hit the brakes” very quickly and consequently, we are not in as big of a mess as we could otherwise be.

I suspect this happened because firms had very good information/production systems – they knew what was going on throughout the supply chain and so they could determine that they needed to slow down production rapidly. Second, they had the ability to slow down production – flexible workers, flexible suppliers.

When we go back and dissect this recession, I believe we will discover that it was quite different than earlier ones. The economy indeed operates differently now.

Will Intel keep rolling?

Intel is on a roll. They just reported 2009 Q4 revenue of $10.6 billion with net income of $2.3 billion – not bad indeed! (See NY Times, 1/14/20).  The success is attributed to their recent investment in new plants ($7 billion), a resurgence in PC demand,  and their move to make chips for netbook and smartphones (their Atom chip targeted to those markets brought in $1.4 billion in revenue). Kudos to Intel, but will the fun last? How long can Intel succeed with its strategy to heavily invest in new manufacturing technology so that it can stay ahead of rivals?

There are reasons to believe that this strategy will work for at least another 5 years. This is based on the premise that the need for new, smaller, more energy efficient chips will continue. And in particular, the premise that the latest investment is necessary to make improvements in performance that generate real value for which people are willing to pay for.  As we continue to push towards the “Dick Tracy” era (everything can be done on something the size of a wristwatch), there is reason to believe that this will be the case.

The economics of chip manufacturing is well known. Invest a huge sum of money to build a clean plant with very advanced equipment. Then you start to make chips and most don’t work, so continuous refinements of the production process are necessary to increase the yield of good chips.  The faster the yield curve increases, the better the return on investment.  The more sophisticated the chip, the lower you start on the yield curve and the hard it is to increase your yield. 

There are plenty of companies that can make chips in the world. But these chips are not as complex as the ones Intel makes. Hence, they are satisfied to let Intel take the lead. Intel bears the risks and earns the reward. And it is important to recognize that the risk is significant. At some point Intel will follow this strategy and it will fall flat – the new chips they will make won’t be sufficiently better than existing, simpler chips, meaning that they won’t be able to charge a premium price and recover their investment.

It is interesting to compare Intel’s situation to two other companies, Microsoft and Dell.  Microsoft earned a huge amount because it had its hands around everybody’s neck (the operating system), not because they were particularly good at making software. (Or, maybe they were particularly efficient at writing code, but the technology has changed and they no longer appear to have that advantage. Plus, the fixed cost to write code is much lower than the cost to build a chip plant.) Dell’s advantage came from declining component prices. As long as they were dropping really fast (40% a year), Dell had a commanding lead over its rivals becuase it carried less inventory. Once the cost of components stopped declining at a torrid pace, Dell lost is advantage – having very little inventory buys you little if prices are not dropping.  Plus, its product design was not sufficient to command a premium price.

So Dell and Microsoft were victims of changing technology. At some point Intel will be too… just probably not in the immediate future.

Facebook and Google – Part II

Two follow ups to our previous post about customer service at Google and Facebook. The NY Times quoted Andy Rubin, Google vice president for engineering in charge of Android technology, from an on-stage interview Mr. Rubin conducted at the Consumer Electronics Show in Las Vegas:  “We have to get better at customer service,”.  I think I found video of that interview in the WSJ: click here.  You would think that his response would be “We have a fantastic product and we need to have equally fantastic support wrapped around it. We haven’t been where we want to be, but we are going to be there very soon.” But instead, his response is more like “There are a bunch of complaints out there, but have you ever tried to launch a new tech product? I think we have done really well.” This response is almost a case study in customer service on its own.

Next, Facebook. Last week the imposter Gerard P. Cachon was on facebook. I had tried for six months to remove it and/or to contact the company. Mike Trick, couldn’t find the account this morning … and neither could I! Go figure! I am glad the account has been removed. I would love to know why and how (given that I was never able to contact anyone at Facebook). Nevertheless, it is still an interesting customer service approach – provide a bunch of help pages and nary a phone number or an email address. Like I wrote, it may be the ”optimal” approach.

Death to Facebook – a self service nightmare

 Before getting to Facebook, let’s start off with Google. The NY Times today reported on Google’s troubles with their customer service for their new phone, the Nexus One (see NY Times 1/12/10).  Apparently, if you have a problem with the phone, there is no one to call – no customer service representative to help you figure out why you can’t use your phone … nobody! This should not come as a surprise to those of us (all of us?) who use Google’s search page – nobody to call if you have problems with that either. But the big difference is that who needs to call about the search page? – it just works and is simple. A phone is entirely a different product.  A wonderful example of how a company can get into trouble when it becomes dogmatic about business practices – “we don’t do X for service A, so why should we do it for product B?”. 

Of course, Google doesn’t offer live help for their phone because (a) they think everyone has at least 1/2 the IQ of their engineers (we don’t) and (b) it costs too much.  They do offer email support – with a lightning fast 3 day turnaround (they hope to get it to 3 hours at some point soon)…. “we are thrilled that you chose to purchase a Nexus One, and in about three days we will respond to your e-mail so that you can be thrilled to use it”.

Before I start to rant and rave too much, let me get to a company that infuriates me more than any other – Facebook. I know, everyone loves Facebook. But I don’t. And here is why – there exists a Gerard P. Cachon on facebook and it isn’t me. The problem is not that there is another person out there with my name. The problem is that that account is using my old Wharton picture.  So if somebody wants to “friend” me, they search for me, see my picture so they think they have “found me”, offer to be my friend and then never hear from me… because it isn’t me!

No problem you say… report the account as fraudulent. I can’t. Although it is found in Facebook, the hacker is using an id that Facebook doesn’t recognize, so Facebook’s self-service “report a fraudulent account” service doesn’t work. OK, just contact somebody at Facebook to resolve the issue … you can’t! Not a phone number, not even an email – they won’t even let you send them an email… I’d even wait 3 weeks for a response.  They provide plenty of help files that keep pointing to the webpage that doesn’t work precisely because the account is fraudulent. (BTW, my anger boiled to a froth when the account started listing my relationship as “complicated” and I am “seeking a relationship with a woman”… neither of which are true.)

I understand that a growing company needs to avoid burning cash and customer service can look like a frivolous expense. But a complete lack of even basic customer support can burn good will. Still, maybe it actually is the optimal solution – sacrificing 1% of your customers so that you don’t have to incur costs to support 99% of them may actually make sense. Plus, it provides a self-inflicted motivation to design the product/service so that it doesn’t need customer support – no engineer can say in a meeting ”if they don’t get it they can call customer service”.

My main advice – if you want to take the “Customer service is for wimps” approach, make sure your product is actually simple enough to not need any support.

Ford to build one Focus

Ford is trying to do it again. Do you remember the Escort? It was suppose to be the “world car”, but apparently there was only about one part that was common between the U.S. and the European versions.  But that was then and this is now. Ford is (and they are serious this time) committed to developing *one* Focus for the world (see NY Times, 1/9/2010)

The strategy is based on the premise that preferences are converging around the world and so the one world car strategy is feasible. Not only is this probably correct, it probably has been correct for quite some time – customers have always wanted a safe, inexpensive, fun to drive, fuel-efficient, stylish, reliable vehicle.  Car manufacturers like Toyota and Honda understood this (though Toyota has waivered from this strategy in recent years).  Mind you, the Focus is probably too much vehicle for the newly not-so-poor of India and China. But for the market that wants this size of a vehicle, it may indeed be possible to provide them with one vehicle around the world.

If the market will accept this approach, then there is a lot to be gained through operational efficiency. Ford could amortize the development and tooling costs over more vehicles. Multiple factories could produce the vehicle, thereby sharing production know how.  Procurement should be simpler and scale should give bargaining power. Finally, it may even be possible to share capacity across markets, assuming the car will be built in multiple markets as well.

And it is worth noting that they will not insist on “any color, as long as it is black”. The plan is to allow some market localization of interiors in such a way that it would not significantly alter the production process. Furthermore, there will not be a single marketing campaign, but more like 5-6 themes that are designed to the particular needs of the target market.

If this strategy will work, then it probably is due to a commitment by senior management, in particular, the CEO, Alan Mulally.  He came from Boeing and noted that Boeing used one door on all of their planes sold throughout the world. Why should Ford need to design doors, steering wheels, etc, for each market? Very good point. Let’s hope the strategy works for them this time.

China passes US in auto sales

I remember when Nixon resigned, where I was when I learned of the first Space Shuffle disaster, and my shock and disbelief when I saw the pictures of the Twin Tower burning (I turned on the TV only after the 1st one had already fallen) and now we have China passing the US in auto sales (NY Times 1/08/10).  OK, maybe this is not as important as some other events, but in the operations management world, it is a biggie…. or is it?

China sold 13.5 million vehicles (including 650,000 heavy trucks) whereas the US sold 10.4 million, the lowest level in 27 years. I suspect the US will be able to regain that title in the next year or two as our market rebounds to the old/normal levels, but that will only be a temporary “victory”. However, we probably will “own” the “number of autos per capita” stat for a long time, and I am sure that the total carbon emmission of our 10.4 vehicles swamps the carbon output of China’s 13.5 million. So there is hope for those who need to feel good via stats.

In the end, the most important part of this news item is that if you want to be a world player in the auto industry, then you better be a player in China.

Upper Mismanagement – and Who Should Be Blamed for the Economic Crisis

No matter which top business school you talk to, the number of students who enter b-school with the aim to make a career in operations is small, relative to the future investors, CFOs, and traders. At the same time, many schools are updating their core curriculum to make it more relevant to the needs of future managers. More often than not, this means cutting ops and expanding on leadership, communication, and ethics. Now, nothing wrong with these topics… But, if the US wants to recover from the ongoing economic crisis, it sooner or later might want to start producing things again (with things being something like computers or cars, not mortgage backed securities…). 

The link shown below makes an interesting link between the US inability to be competitive in many manufacturing sectors and what we teach at b-school. You might agree or not agree, but this is a timely topic.

http://www.tnr.com/article/economy/wagoner-henderson

Managing Sewage Demand and Holiday Demand

When it rains it pours – that is, sewage overflows into streams, rivers and lakes and then into our beaches and drinking water (yuck!).   (NY Times 11/22/09)  For example, cases of serious diarrhea at one Milwaukee hospital increase when local sewers overflowed.

The problem with our old sewage systems is that they are capable of handling normal “loads”, but when it rains, the demand on the system exceeds capacity. With no place to inventory the excess water, it is spilled into local waterways.

So what is the solution when peak demand exceeds capacity? The knee jerk reaction is to increase capacity. But this can be foolish – it can be very costly to increase capacity when it will be used only at peak demand times. A better strategy is to smooth out the demand peak.  Of course, we can’t control rain, so that won’t work. But we can slow down the flow of rain into the sewage system by how we design our cities. In particular, planting trees helps to absorb the flow of water (maybe we can interpret this as an increase in capacity). Planting organic roofs can also slow down the flow of water – instead of rushing off the roof, it drips from the roof.  Or, if we could design sewage systems so that rain water was processed in a different system than toilet water, then the peak demand problem is solved - peak rain water can be safely spilled into the river and it would be unlikely to have a coordinated demand peak of toilet water, i.e., separate smooth demand from the variable demand. (I never did believe the stories about the problems induced when too many people flush during a Super Bowl commercial.)   

So what is the connection between sewage and holiday demand? Retailers face the peak demand problem in spades. The following graph plots sales of general merchandizers from 1992 to 2008 and clearly illustrates the annual holiday spike in demand

An interesting feature of this paper, contrary to what you hear in the press, is that the end-of-year spike is actually getting smoother. To illustrate, the following graph shows the % of annual demand that occurs in November and December:

From a peak of 25%, the fraction of annual sales occurring in November and December has been steadily declining, and now is about 21%.  Why is this? It could be that consumers want to smooth their consumption (they can’t wait for that holiday present) or it could be that retailers are encouraging this demand smoothing (via pricing). 

Another change in the data is the “back to school effect” - August’s sales relative to September’s sales has been showing a steady increase. Back-to-school is now the mini-Christmas of the year.

Buy now! Limited supplies!

Related to my post yesterday, the NY Times today has an article on retailers intentionally keeping stocking quantities low (NY Times, 11/19/09, Luxury Stores Trim Inventory and Discounts).  If the Brioni leather bomber jacket is what you need for that special someone this season, you better get to Saks fast because they have only 1 left – at a mere $5295! (And then you need to see a therapist to explore why you feel compelled to spend $5295 + taxes on an article of clothing which is not suitable for climbing Mt Everest or walking on the moon.)

The idea is simple – intentionally stock less than a “normal” amount so that you will not have too much inventory left over which needs to be discounted. Because if you have too much inventory left over, then customers may anticipate this and not plop down $5K to buy at the regular price, thereby certainly ensuring that you will have to discount.  Or, you are doing this to generate a sense of scarcity, and therefore desirability:

“What’s luxury retailing all about?” Mr Sadove said. “It’s about a scarcity of supply.”

Given that we are talking about ultra luxury products, I wonder if the scarcity argument holds water. If you are spending $5K on a jacket, then you better be sure that you will never see another person walking down 5th Avenue with that jacket on. But only people walking down 5th Avenue would be willing to spend that kind of money on a jacket (i.e., not everyone has the same probability of encountering another person with this jacket on). So unless that jacket is *unique*, it is not scarce enough.

Next, the standard approach to avoid markdowns with luxury goods is to not markdown! A $5K jacket probably has a very healthy margin (say $4,750), so if you have a few left over, then ship them back to the producer, take more time to sell them, or burn them. But whatever you do, don’t markdown the price! Having a few left over jackets that need to be sold in some other country with the label ripped out may be cheaper than stocking out when somebody wants to pay you an obscene amount (ok, I’ll stop harping about the ridiculousness of the price).

The article recognizes that the best approach is to start with a limited supply and then replenish only if necessary. This is feasible in some categories (contemporary apparel and women’s shoes) but not in others (European designers). Of course, this reminds us of Zara:

The graph above nicely illustrates the Zara strategy – start with a more reasonable price and a limited quantity, replenish if necessary, and don’t mark down all that much.  The net effect is that your total profit (light blue) can be higher.

And there is one key lesson from Zara that is missing in the discussion of Saks.  If Zara runs out of one item, they generally have another item available that is a close substitute. If you like a particular black bomber jacket at Zara, then you should buy it because (a) it will not be marked down and (b) if you wait then you will have to buy a different black jacket.  Either way, Zara gets the sale. In the NY Times article, they are suggesting that it can be better to simply stock out.  If you don’t have an adequate substitute, then that is really a costly strategy.  Being smart doesn’t mean you are willing to incur costs. Being smart is avoiding costs while maximizing revenue.

4Q is time for what’s hot and unavailable

Every 4th quarter there are stories about what is hot and hard to find. This year, it is the e-reader category, specifically Sony’s Daily Edition Reader ($399) and Barnes & Noble’s Nook ($259). (See WSJ 11/18/09 – Sony Says Some E-Reader Orders May Miss Christmas).  Sony is telling customers that they are now shipping orders on Dec 18th – a little tight to ensure being included as a stocking stuffer.

My favorite quote from the article is:

“The possibility that Sony, a huge electronics manufacturer, would be caught off guard by supply-chain issues is surprising, said Mike Serbinis, president of Shortcovers“

The presumption is that an experienced and large manufacturer should not have any trouble matching supply with demand. This simply ignores the fact that size and experience are no match for the uncertainties of the market.

Next, it is interesting that Sony is capable of quoting shipping dates:

“In October, the company told its first wave of customers that the Nook would ship Nov. 30. A second wave of customers was told it would ship Dec. 7; shipping dates of Dec. 11 and Dec. 18 were later given.”

This does demonstrate a sophisticated level of supply chain management, assuming their quotes are reasonably accurate: to be able to do this requires a significant amount of real-time information sharing across the supply chain and the skill to process that information quickly.

Finally, I can’t help but speculate on whether they intentionally kept supplies short. Suppose you think you could sell 100,000 units. If you make 75,000, they you are likely to run short. If demand turns out to be 120,000, you are really short and you get lots of free press about how hot your product is. But to make that strategy work, loosing thousands in sales has to cost you less than the free advertising. Hard to say if it is worth it.  Then again, it is entirely possible that if your new techno gadget isn’t “hot”, then it becomes “stone cold”. For example, if “natural” demand is 100,000 but you make 75,000, then actual demand turns out to be 125,000.  If “natural” demand is 100,000 but you make 100,000, then actual demand turns out to be 60,000 because who wants to buy a product that isn’t popular.