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 / Third Quarter 2001 / Issue 24(originally published by Booz & Company)


Why Cisco Fell: Outsourcing and Its Perils

Cisco. Sony. Palm. Contract manufacturers gave OEMs more supply chain headaches than solutions. What went wrong. What needs to be done.

This article was originally published by Booz & Company

Perhaps no company underscored the limitless potential of the New Economy more than Cisco Systems Inc. Last year, Cisco was poised to become the world’s first trillion-dollar enterprise, wielding a market cap greater than that of General Electric Company in pursuit of annual revenue growth projected at 30 to 40 percent.

Two of the things that gave Cisco its glow were its development of a virtual supply chain with limitless capacity and its ability to provide extraordinarily high reliability to its customers. Another apparent strength was its approach to manufacturing: It didn’t build most of what it sold. John Chambers, president and CEO, once explained, “Our approach is something we call ‘global virtual manufacturing.’ First, we’ve established manufacturing plants all over the world. We’ve also developed close arrangements with major CEMs [contract equipment manufacturers]. So when we work together with our CEMs — and if we do our job right — the customers can’t tell the difference between my own plants and my CEMs’ in Taiwan and elsewhere.”

A specialist in creating network infrastructure hardware for data and telecommunications companies, Cisco prospered as the Internet burgeoned. Between 1998 and 2000, its revenues grew by a compound annual rate of 49 percent; gross profit rose 48 percent; net income increased 42 percent.

By all outside appearances, Cisco was the picture of health and prosperity. But hidden problems were mounting. Early last year, shortages of memory and optical components began paralyzing one path of production. For the first time, Cisco’s supply chain began to experience the kind of growing pains that affected its earnings. When the telecommunications infrastructure experienced a severe downturn, customer orders began to dry up … and Cisco neglected to turn off its supply chain. Orders went out, parts began to pile up. Its raw-parts inventory ballooned more than 300 percent from the third quarter to the fourth quarter of 2000. Cisco’s problems culminated in a $2.25 billion write-down. In short, Cisco simply wasn’t able to scale up or down as quickly as it thought it could.

Cisco is not alone in its sudden confrontation of problems in the supply chain. Witness:

  • The Sony Corporation: A shortage of PlayStation 2 graphic chips in September 2000 meant that it could ship only half the consoles it wanted for its U.S. launch.
  • Apple Computer Inc.: Because supplier Motorola was unable to provide enough G4 chips in late 1999, Apple’s ability to fill orders was sliced in half.
  • Philips (Koninklijke Philips Electronics NV): Suppliers’ inability to produce sufficient flash memory chips threatened to disrupt production of 18 million telephones in 2000.
  • Palm Inc.: Recent revenues might have been 10 to 40 percent higher if Palm had had access to all the liquid crystal displays (LCDs) it needed.
  • The Compaq Computer Corporation: Starting in 1999, an inventory-less strategy led to shortages of LCDs, capacitors, resistors, and flash memory — and unfilled orders for 600,000 to 700,000 handheld devices.

All these companies had one thing in common: They had outsourced their manufacturing of essential components without a full understanding of the changes required in their business models. They didn’t translate the old practices that had made them successful into their new business relationships. They hadn’t adequately codified informal communications practices and channels within their supply chain. They didn’t align incentives through contract terms and agreements, which rendered it almost impossible for the supply chain to scale up in relationship to a hit product, or scale down in response to declining demand.

Outsourcing hasn’t lived up to expectations for many reasons — some foreseeable and others unexpected. In the enthusiastic rush to outsource, many original equipment manufacturers, or OEMs, didn’t understand how the old model worked, and never took time to understand the newer CEM business model. The result: A one–two combination that sent them reeling. Not only were they unable to take advantage of the full benefits of outsourcing, but they also exposed themselves to new and different types of risk. When outsourcing didn’t work, they exacerbated their problem by pulling the wrong levers trying to fix it.

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  1. Scott Buckhout, Edward Frey, and Joseph Nemec Jr., “Making ERP Succeed: Turning Fear into Promise,” s+b, Second Quarter 1999; Click here.
  2. Lawrence M. Fisher, “From Vertical to Virtual: How Nortel’s Supplier Alliances Extend the Enterprise,” s+b, First Quarter 2001; Click here.
  3. Keith Oliver, Anne Chung, and Nick Samanich, “Beyond Utopia: The Realist’s Guide to Internet-Enabled Supply Chain Management,” s+b, Second Quarter 2001; Click here.
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