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


Why Cisco Fell: Outsourcing and Its Perils

The unwritten values and objectives didn’t easily translate to the new relationship, either. The supply contract was harder to define than the old relationship between divisions in a vertical company, in which knowledge of the needs of the company (and how to fulfill them) was shared as a matter of course. Formal contracts simply couldn’t capture that attitudinal energy — the kind of corporate-wide entrepreneurial spirit that had made so many OEMs successful. Although CEMs did have the same level of commitment, their problem-solving methodology and their seeming inflexibility were foreign to the OEMs. On a very basic level, many CEMs had no idea what their OEM partners were talking about.

Misalignment of Agendas. OEMs and CEMs run their businesses with different sets of goals and different methods for achieving them. OEMs, with more comfortable margins, focus on early penetration and rapid market share growth to generate profits. CEMs, operating with razor-thin profit margins, need to maintain an aggressive focus on cost. Although the CEMs and the OEMs were able to create a balance of cost and capacity at the outset of their relationship, their plan was destroyed by market and supply variability. OEMs, to achieve their goals, need flexibility — the kind of agility that allows them to divert resources to a given product as it becomes a hit. CEMs, on the other hand, need predictability — they want to make commitments in advance to reap benefits like big-lot purchases and decreased overtime. The OEMs’ tactics, therefore, keep them from making the firm commitments the CEMs need to keep their costs down. Indeed, when OEMs begin to engage in the sort of longer-term commitments that CEMs need, their flexibility is reduced almost immediately. When times go bad, their different techniques for fixing problems are incompatible.

Several conflicts emerged from such misalignments of agendas. The OEMs and CEMs had different inventory targets — OEMs wanted the pipeline full, whereas CEMs doggedly adhered to the terms of their contract. They had different appetites for surge capacity — OEMs were willing to pay for lower utilizations and just-in-case capacity, whereas CEMs were committed to consolidating the industry for better unit-cost production. OEMs were connected to the customer and would change the production mix to maximize production of the hits. CEMs generated margin on parts markups and were enormously sensitive to buying incremental, high-cost inventory on the spot market that accompanied mix change.

CEMs have even punished OEMs for not building to the original forecast. As an example, a producer of specialty handheld computing devices sourced its production with a major contract manufacturer. The OEM committed to a build schedule with a frozen production window. Inside that window, the OEM couldn’t change anything about the quantity or product mix it was buying from the CEM, which manufactured a range of products for the OEM. But when the market moved, the OEM wanted to change the mix. The CEM agreed to take some production out of the line (“we’ll let you net down on the stuff you don’t need”), but wouldn’t allow the OEM to add new items. The OEM was punished for trying to do the right thing. Ultimately, this behavior led to further system-induced variability, as marketing at the OEM inflated forecasts to create shadow capacity, and the CEM lost its purchasing advantages.

Outsourcing and the New Supply Chain
We look at the rubble of what was outsourcing and now hear a new set of proclamations: “Stop the old vertical thinking!” they say. “Align expectations!” — once again, great slogans. But, this time, what do they mean? The answer lies in the design (and operation) of the new supply chain.

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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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