Dell’s latest and greatest earnings disappointment pretty much settles it: The company isn’t just struggling to overcome a blip; its traditional strategy is no longer working, at least not the way it used to.
What went wrong? Obviously, there are various factors involved, including too much complexity in its product line and its pricing system and an undistinguished laptop line, not to mention sluggish demand from the corporate buyers in America who account for the lion’s share of Dell’s sales. But let me offer a theory – and it’s just a theory – about what might be the root economic cause of Dell’s declining fortunes. It’s a theory that may have broader ramifications for any manufacturer pursuing a direct-sales model like Dell’s.
The ultimate source of Dell’s great historical success has been its direct sales model. By cutting out the middlemen, Dell benefits in many ways. Since it doesn’t have to fill traditional sales channels, it doesn’t have a lot of PCs sitting in inventory all over the place. Given the breathtakingly rapid price deflation of PCs, that’s been a huge advantage. Also, it can wait for a customer’s order before assembling a machine, which means it can operate with an extraordinarily lean production system. Indeed, since it gets a customer’s payment for a machine before it pays its suppliers for the parts that went into it, it actually enjoys negative working capital – the production system itself becomes a source of profit. It also gets direct and immediate market information on demand trends, which it can use to continuously optimize the set of products it offers.
So on the production/distribution side of the PC business, Dell’s direct model has given it a big cost advantage, which in the past enabled it to make lots of money selling machines at prices that competitors could match only by taking a loss.
But there’s another side to the PC business: the support side. And here, the direct model looks less attractive. If, after all, you’re selling directly to customers, you have to shoulder all the related support costs, from handling information requests before the sale to taking and tracking orders to handling service inquiries after the sale. You can’t offload any of those costs onto resellers or retailers or other distribution partners – because you don’t have any distribution partners.
The direct sales model provides a cost advantage on the production side, in other words, but brings a cost disadvantage on the support side.
Now, as long as most of the costs (for you and your competitors) lie on the production side, you’re golden. If, however, the balance of costs shifts toward the support side, you’re in trouble.
I think that that’s exactly what’s been happening in the PC world. As PC prices have plummeted, thanks to cheaper components and ever more automated manufacturing, support costs have not fallen in tandem. Yes, you can get economies of scale in support and you can automate certain tasks, but in the end there’s a heavy labor component to support that sets a floor for costs: customers need to be able to talk to a human being when they have questions or problems. Dell tested that floor recently, and it got burned by customer-support problems, so now it’s having to reinvest on the support side of its business even as it continues to slash prices to hold onto market share. (In its last quarterly financial staement, Dell noted, “We have increased our headcount not only to accommodate our global growth but to also improve our customer experience.” [italics added]) That’s a painful position to be in – and I think we can see that pain in Dell’s recent financial announcements.
So there, perhaps, is the flaw in the direct sales model, particularly when it’s applied to a commodity product like the PC: You have a cost disadvantage in customer support, which is hidden as long as support represents a fairly small portion of the each product’s overall cost. But as the price of your product falls, due to savings on the production side, support begins to represent an ever larger percentage of its cost. At some point, you cross the line: The direct model’s cost advantage disappears. Dell hasn’t reached that line yet, but it seems to be edging a little bit closer to it every day.