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


Why Cisco Fell: Outsourcing and Its Perils

The future looked rosy.

The Fall
Welcome to 2001. The OEM/CEM high-flyers have fallen dramatically.

No one is trumpeting the miracle of outsourcing. An alarmingly long list of tech-related manufacturers have experienced reversals of fortune. Today’s stories are more often about earnings warnings, operational problems, earnings shortfalls, and layoffs. Compaq announced that it would miss first-quarter earnings estimates by as much as one-third. Ericsson SpA posted a first-quarter loss of $485 million. Motorola, reporting its first quarterly operating loss in 15 years, was short by $206 million. Nortel announced a layoff of 10,000 employees in February. Dell announced a layoff of 1,700 in February, and an additional 3,000 to 4,000 in May. And the CEMs haven’t been spared either. In April, Solectron announced that it would close a plant and lay off more than 1,000 employees, and Flextronics announced a layoff of 7,000.

The warning signs had been there for those who wanted to look for them. You can see the problems when you explore both the OEM and the CEM businesses.

Early on, OEMs were wracked with day-to-day execution problems. Whereas OEMs had difficulty forecasting product demand, CEM shortages forced them to miss deliveries; systems implementations took longer than expected; and other problems kept the supply chains from scaling up as fast as promised. When infrastructure development slowed and markets failed to materialize, OEMs cut forecasts. Dramatic revenue shortfalls were compounded by the OEMs’ inability to step back from their commitments to inventory and capacity. As a result, balance sheets became bloated. Profitability forecasts at the unit level took a direct hit. And customers complained as the marketing machines continued to help create unfulfilled demand. The overall message was clear: The OEM/CEM model didn’t scale.

When the OEMs were bruised, CEMs felt the pain as well. Solectron held on to inventories more than two weeks longer in the second quarter of 2000 than in the fourth quarter of 1999 to cover its uncertainty about component availability. As its customers stocked up to ensure their own ability to meet delivery commitments, Solectron incurred inventory-holding penalties and obsolescence costs associated with the inventory bubble. Solectron makes its money by marking up parts. When it’s forced to hold on to extra inventory, it can’t make money. Solectron doesn’t have a lot of margin to give away to its customers; even a bit of incremental cost significantly affects the bottom line. CEM margins are generally thin — often just 3 to 4 percent.

Problems even surfaced around specific components. OEMs’ inability to plan and forecast needs created an error-filled picture for producers, and shortage issues were most acute around highly sought-after parts. Philips’s threatened shortage of 18 million phones showed just how risky the shortage of a single component could be.

The sum of the pieces create a frightening whole: The aggregate market value loss of 12 major OEMs — Cisco, Dell, Compaq, Gateway, Apple, IBM, Lucent, Hewlett-Packard, Motorola, Ericsson, Nokia, and Nortel — over the period from March 2000 to March 2001 exceeded a staggering $1.28 trillion.

The promise of outsourcing seems to be overstated. The OEM/CEM model doesn’t look that much different from the vertical world, except it’s not as efficient. And because experience has exposed weak links in the value chain, the decision to outsource — along with the coordination that must support that choice — has become much harder.

Lessons from Cisco and Compaq
Let’s return to Cisco and see how everything we’ve just told you applies to its precipitous fall.

Certainly, growth in the networking equipment sector slowed and contributed substantially to Cisco’s earnings shortfall. There are some indications, however, that the OEM/CEM model it employed was a contributing factor as well. There’s no question that Cisco was at the forefront of adopting outsourced production solutions. Indeed, the company locked in access to capacity when production lines weren’t running at full capacity, ensuring its ability to scale up better than its competitors.

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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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