Is Dell hitting the efficiency wall?

Dell Computer has developed an enviable reputation as a lean and mean PC manufacturer, but a debate is emerging over whether the company's efficiency engine can rev much higher.

Dell's penchant for making and selling products easily and inexpensively has allowed it to weather periodic slumps in information technology spending for years, enjoy higher profit margins during boom times and ultimately gain share at the expense of rivals such as Gateway and Hewlett-Packard.

Some investors and analysts, however, believe that Dell, which announces earnings next month, can't cut much more fat from its operation. Manufacturing improvements at HP also will likely erode the Dell's comparative cost advantage.

"Dell can be more efficient, but the gains are likely to be marginal," said IDC analyst Roger Kay, who compares Dell's PC business to an oil well that's still producing but is bound to run dry. "Dell is probably getting about as much efficiency as it can out of the PC business."

That may explain why the company is looking to expand--or is at least rumored to be expanding--into new markets such as services and printers, Kay said.

But Dell says it isn't satisfied with its efficiency rate, and improvements still can be made in dozens of areas from shipping components to manufacturing and servicing customers.

"I believe we still have lots of room to improve," said Rosendo Parra, senior vice president of the Americas for Dell. "And it's more than just tweaks."

One possible frontier for Dell is tracking shipments to garner more services revenue. Daily, 5 percent to 10 percent of the products Dell ships are for orders placed the same day. The problem? Dell doesn't know which orders are getting same-day shipping--it's largely luck for customers and a missed opportunity for Dell.

"If we can track that 10 percent that ships the same day and sell that ability to just half of the customers that want it, it adds up," Parra said.

Other ideas--focused on cutting shipping costs and boosting efficiency--percolate almost daily, he said.

Measuring efficiency Dell uses a series of benchmarks to measure efficiency. These are a few key statistics: • 80 percent of annual spending on materials is spread among its top 25 suppliers • Current inventory levels are 4 days • About 90 percent of components are purchased online • Each factory is receives new components every two hours • Component inventory in factories is measured in hours versus days • The number of touches--or worker steps--in the manufacturing process has been cut in half in recent years. Source: Dell Computer

In Dell's Nashville factory, employees figured out a way to put together a notebook by flipping it over two times compared with the customary six times. "That helps our throughput and improves units per man-hour," Parra said. "If you move that needle, you save money."

It's that sort of penny-pinching where the difference among manufacturers really shows. According to UBS Warburg, Dell has an expense ratio--a company's operating expenses divided by its revenue--of 9.9 percent, well below that of its competitors. Gateway's expense ratio hovers above 27 percent, and prior to their merger, HP and Compaq Computer had expense ratios at least in the high teens.

And Dell isn't done. Executives at the company boast that "proprietary" efficiency gains will lower costs even more than will falling component prices, and some analysts agree. UBS Warburg estimates that Dell's expense ratio will fall to 9.6 percent.

"Dell's low-expense ratio should result in continued share gains as the company leverages its expense structure to drive a lower pricing model," UBS Warburg analyst Don Young wrote in a research note.

But competition looms from HP. For years, Compaq tried to develop a build-to-order system that would rank with Dell's. After several false starts, the company bought configuration centers from Inacom in 2000. Subsequently, Compaq saw direct sales increase and costs decline, according to the company. Analysts also note that Compaq enjoyed higher margins on the system.

In the new HP, the build-to-order systems will be used to satisfy large corporate customers. HP will also consolidate its component suppliers, which will streamline operations and allow the company to get larger volume discounts, President Michael Capellas has said.

Low-hanging fruit all gone?
Morris Cohen, a professor at University of Pennsylvania's Wharton School, said that Dell may be able to become more efficient, but added that most of the low-hanging fruit has been plucked.

According to Cohen, supply-chain efficiency runs in three steps. In the first step, which generally has a low return on investment, companies need to integrate internal processes and data using enterprise resource planning (ERP), customer relationship management (CRM), Web services and other tech tools. The second step is to design the data and use it to predict supply and demand.

Dell has the first two mastered. The third part--integrating suppliers and helping them become more efficient--is trickier.

If all three of those stages are humming, it's supply-chain euphoria. "That's the dream," said Cohen. "It's the potential of, every time a consumer squeezes a bottle of Heinz, Heinz knows it should order more tomatoes."

Warren Hausman, professor of Management Science and Engineering at Stanford University, said integrating suppliers is largely uncharted waters.

"When it comes to dealing with suppliers, the theory hasn't been developed in academia," said Hausman, who founded Supply Chain Online, an Internet-based training site.

New products, less efficiency?
Though analysts give Dell high marks for manufacturing efficiency, some note that the risks will increase as the company tackles new products.

"It remains to be seen how Dell would do with other products," Cohen said. "Right now, Dell has only made one thing. As they expand it will become more difficult."

The question, though, is somewhat academic. Dell has enlisted contract manufacturers to make low-margin or low-volume products in the past. Contractors make the cheap SmartStep PCs and several of Dell's ultrathin notebooks, for example. Nearly every analyst has said Dell will use contractors in printers and handhelds. Dell has disbanded an internal handheld group.

Contract manufacturing can be just as efficient, said Adeel Najmi, director of supply-chain management solutions for i2 Technologies. Hiring contractors, though, typically results in split--and hence lower--profit margins.

Parra said Dell evaluates each new market to see if it's worth making in-house. And if Dell enters a new market such as blade servers, it will customize processes to make manufacturing more efficient.

Dell will contract out manufacturing if doing so makes sense, but Parra notes that the company considers its manufacturing and its supply chain to be its "crown jewels."

"We see our supply chain as our core competency," he said. "Whenever a company outsources anything, it concedes it can't do it better, and the outsourcers make a profit. We say, 'Why can't we do that and keep the profit?'"

It's that drive to be efficient that underlies Dell's success, Najmi said. Dell uses i2 software to run factory reports every two hours and to monitor component supply and demand.

"Efficiency largely depends on the mind-set," Najmi said. "Dell's success isn't technology--it's how it uses the technology."