THE GREAT INVENTORY CORRECTION

John Chambers likened it to a 100-year flood, although the problem was dearth, not
plenitude. The swift evaporation of technology demand that began in the latter part of 2000
was indeed exceptional, as the CEO of Cisco Systems famously suggested. Chipmakers and
PC companies suddenly found themselves with a glut of inventory and capacity. Networking
and telecom equipment makers were particularly hard hit; Cisco, more irrationally exuberant
than most, was forced to write off a staggering $2.25 billion worth of gear. Throughout the
first half of 2001, a procession of high-tech companies including such bellwethers as Nortel
Networks, Lucent Technologies, Corning, and JDS Uniphase announced huge write-downs of
unsalable inventory.
Today, high-tech companies are still loaded with rapidly depreciating goods. At one
end of the food chain, the cyclical semiconductor industry is suffering through its deepest
trough in demand since 1998, the year of the Asian crisis. In the middle, electronics contract
manufacturers and their suppliers, customers, and distributors are trying to figure out who
owns which surplus components. At the other end of the chain, PC makers are waging price
wars, and the gray market in networking equipment is thriving. Flood of the century or not,
tech companies are taking steps to limit their exposure to the next traumatic event. Some are
revising their inventory models; others are implementing supply chain software and setting
up Web supplier hubs. Everyone wants tighter collaboration with suppliers and timelier
information from customers. Tech companies are trying, in short, to make their supply chains
shorter, transparent, and as flexible as possible.
New Logic
Check out the recent earnings releases of semiconductor makers (not the pro forma kind) and
youll find a litany of inventory write-downs: Agere Systems, $270 million; Micron
Technology, $260 million; Vitesse Semiconductor, $50.6 million; Alliance Semiconductor,
$50 million; Xilinx, $32 million. Worldwide, chip sales in June were down 30.7 percent from
a year ago, according to the Semiconductor Industry Association, and analysts predict a
decline in 2001 revenues of more than 20 percent the steepest ever
Ive been in the chip industry for 20 years, says Nathan Sarkisian, and Ive never
seen anything like it. Sarkisian is senior vice president and CFO of Altera Corp., a San Jose,
California-based chipmaker with 2000 revenues of $1.4 billion. We grew roughly 65 percent

last year with less than four months supply of inventory throughout most of the year, he
recalls. Thats pretty good when you think about semiconductor product cycles.
But in the fatal fourth quarter, units shipped to distributors fell 25 percent short of
expectations. The slide continued into 2001, thanks to declining demand from Alteras major
customers, communications companies. For Q2 2001, revenues were down 25 percent
sequentially and 37 percent from Q2 2000. Altera was eventually forced to write down a
whopping $115 million worth of inventory.
Going forward, Altera wants to ensure that future market dips wont savage the
bottom line, and to that end its revising its inventory model, for starters.
Altera designs programmable logic devices (PLDs). Its a fabless chipmaker,
outsourcing manufacturing to giant foundry Taiwan Semiconductor Manufacturing Corp.
Previously, it would build its mainstream PLDs through to finished goods, stockpiling them
in Asian facilities in anticipation of customer demand. We own the inventory as soon as it
leaves the fab, notes Sarkisian. Also, it would essentially build new products on spec,
producing quantities well beyond what the customer needed for prototyping. The virtues of
this model are highlighted in Alteras annual report: We, our distributors and subcontract
manufacturers not our customers hold stocks of inventory, thereby enhancing the cost
advantage of PLDs for our customers.
Now, Altera will continue to build its mainstream products to stock, but only in die
banks (stores of chips before packaging and testing). By building die, we have taken out the
biggest portion of the manufacturing lead time, but the inventory is in its most flexible form,
with a minimum of value added, says Sarkisian. Only when orders are confirmed will
Alteras subcontractors package, test, and ship the PLDs.
The lead time for these products will be measured in weeks. For Alteras mature
products, we will be strictly build-to-order, says Sarkisian, and the lead time for those will
be measured in months. Finally, new products will no longer be built on spec; a customer
order will be required.
Visible Improvements
Chipmakers are at the mercy of the laws of physics. It takes anywhere from three to
seven weeks to turn a raw silicon disk into a wafer with hundreds of chips, depending on the
complexity of the chip and how much a customer is willing to pay, says Jim Kupec, president
of United Microelectronics Corp. USA, a division of Taiwan-based foundry UMC. Additional
time is required to separate, package, and test the chips. And in the real world, things get

spoiled in the fab, says Arnold Maltz, associate professor of supply chain management at
Arizona State University College of Business. Every now and then, somebody brings the
wrong batch. Capacity isnt always available. Then you have the mismatch of supply and
demand. In a 1999 study of major U.S. chipmakers, Maltz and his fellow researchers found
that the average cycle time for semiconductors, from the fab to the customer, was 117 days
plenty of time for demand to change direction.
To reduce its exposure, a chip company can postpone adding value to die bank
inventory. It can also seek better information from its customers, as Altera is now doing.
Were asking customers to give us more visibility in their inventories and build plans, says
Sarkisian. That may seem like an obvious solution, but it isnt always available, says Maltz,
because theres some concern on the customer side that youre giving away strategic
information. Nevertheless, Altera recently took two big steps toward greater visibility,
announcing joint ventures with Nortel and Motorola to collaborate on product development.
Chipmakers also can shrink cycle times around wafer fabrication using supply chain
management (SCM) software. Alteras i2 Technologies system, which is linked to its fabs,
suppliers, and distributors, has cut weekly planning cycle time from 10 days to 1 day and
reduced long- term planning cycle time from four weeks to one week. About 85 percent of
production is automatically scheduled by the system. i2 runs our foundries, says Tom
Murchie, vice president of operations. It starts wafers by technology process, by fab, and by
the strategic inventory targets weve chosen.
UMCs customers can forecast collaboratively with the foundry via its MyUMC Web
portal, using i2 augmented by an available-to-promise order system. What [MyUMC] does
is automatically take a request for a customers order, then almost instantaneously find the
best manufacturing slot, explains Kupec.
Freak Show
Other kinds of tech companies are using SCM planning tools, from such vendors as
i2, Manugistics Group, and SAP. Cisco, for instance, uses Manugistics to run its Web supplier
hub. At server maker Sun Microsystems, a combination of i2 and Rapt Inc. software enables
short, predictable lead times with the lowest possible costs, says Helen Yang, vice president
of supply management.
But if SCM software is so great, why didnt it prevent the inventory glut? One reason
is that not everyone uses it: Only about 20 percent of companies with more than $500 million
in annual revenues have installed SCM tools, according to AMR Research.

A more compelling reason, however, is that software cant eliminate the problem of
garbage in, garbage out. Supply chain planning tools rely on algorithms to crunch a mix of
historical data, production numbers, and guesswork, says Kevin OMarah, service director
for supply chain strategies at AMR. How good is your guess? Youre speculating on trends
going forward.
This is feasible in mature industries, says OMarah, but high tech, with its volatile
swings in demand, is a very different story. In semiconductors, long cycle times mean that
companies are always making a bet on an uncertain future. And at Cisco, growth changed
from 40 percent to negative 10 percent. Thats a real freak show! exclaims OMarah. Can
you imagine a forecasting system even encompassing this scenario?
We recognize that forecasts will not be accurate, says Yang. The game is how fast
we can respond to changes.
OMarah blames habit, in part, for the inventory overhang. Component shortages have
plagued electronics manufacturing for the past decade, he points out, and the habit of market
leaders is to lock up allocations available for components. Its a reasonable way to think.
When a new technology comes along a faster chip, a new bus there are
constraints in supply, says Karen Peterson, research director at Gartner. A lot of the
[original equipment manufacturers] or contract manufacturers will lie about what they need.
If Im an OEM, I may say I need 200 percent more than I think I need. Its going to put my
priority higher [with the supplier].
Double ordering of chips, capacitors, and resistors from manufacturers and
distributors also contributed to the glut, adds Pamela Gordon, president of Technology
Forecasters, an Alameda, California-based consulting firm for the electronics manufacturing
services (EMS) industries. Those parts were in particularly short supply in 2000, she says. As
for other kinds of high-tech equipment, such as networking and telecom gear, Gordon faults
manufacturers for not doing sufficient due diligence on shaky customers, dot-com or
otherwise.
Dont Know Much about History
The telecom guys thought, We can do no wrong, says Dan Pleshko, vice president of
global procurement and strategic supply-chain management at Flextronics International Corp.
They forgot to look at history, at business cycles. The PC guys had been through a couple of
cycles. They had been through pain.

Flextronics, one of the worlds largest EMS companies, with $12 billion in revenues,
had an unusually good vantage point of the inventory glut. The Singapore-based company
makes everything from printed circuit boards to cell phones for a variety of high-tech clients,
including Cisco, Lucent, Nortel, and Ericsson. In 2000, the companys inventories ballooned
from $470 million at the beginning of the year to $1.7 billion at years end.
As orders poured in, Flextronics and other EMS companies could see the magnitude
of the aggregated supply they were producing. Couldnt they have warned their clients? In
general, I dont think any of [the EMS companies] did that before, says Pleshko. I think
that will happen going forward.
Pleshko says Flextronics wants to obtain a better understanding with customers of
consumer demand and product life cycles. Also, were moving very aggressively to a
supplier-managed inventory environment, he says. The company wants to establish material
hubs, where suppliers facilities are located close to Flextronicss factories. Compaq, Dell,
and IBM have done this already, says Pleshko. The EMS guys are just coming up to
speed.
Meanwhile, there have been some disputes over the ownership of inventory in the
EMS world. Some distributors have complained, for example, that they were being stuck with
surplus parts. But thats a reversal of the situation in 2000, when everyone was looking
under every rock to find parts, says Pleshko. When times were good, distributors were
making a lot of money. They forgot.
The Crystal Ball
Times are bad, and tech companies are still working down inventories. They await an upturn
of the business cycle, a new new thing that will drive computer sales Microsofts Windows
XP operating system, for instance, or an unforeseen killer app and the start in 2002 of an
especially robust three-year PC replacement cycle (companies stocked up because of the year
2000 problem).
Meanwhile, two computer companies are better positioned than most to weather the
downturn, thanks to superior supply chain management. One is Dell Computer. With its
build-to-order business model, Dell is the lowest-cost PC maker; it never has more than a few
days inventory on hand.
The other company is IBM. True, a third of Big Blues revenues come from annuitylike businesses such as services and software. And even with its diversified risk, IBM isnt
immune to the downturn. Sales were relatively flat in the second quarter ($21.6 billion), and

IBM has warned that its chip sales will fall in the second half of the year. But IBMs
inventories have also remained flat. Overall, they are at their lowest level since 1988,
according to Steve Ward, general manager for IBMs Global Industrial Sector. That may owe
something to old- fashioned vertical integration. Still, AMRs OMarah and others regard
IBMs supply chain management as among the best in the business.
Lean inventories are absolutely critical, says Ward. In parts of our business, the
value of components drops about 1.5 percent per month. IBM does build some items to
order, but mostly it builds fast, on a pull or just-in-time basis. Our suppliers have visibility to
how much inventory we have, says Ward.
An SAP system provides crucial automation, but other practices also promote smaller
inventories. For example, IBM has reduced the number of different parts by emphasizing
commonality across platforms and products. Thus, for example, the flat screens used on
ThinkPads and the flat-panel monitors sold for PCs are the same.
The number of suppliers is kept small, too. Purchasing is structured by commodities,
with a market expert assigned full-time to each commodity. IBM buys all of its production
parts electronically, via the Internet and EDI. That means we can have much faster
transactions, moving to much faster collaboration with suppliers, says Ward.
How far into the future does IBM peer? Ward says the company maintains a very
detailed forecast for the next 90 days out, updated weekly and rolled out through all
suppliers; a fairly detailed forecast for 90 days to a year; and a strategic forecast for
longer periods. I cant tell you right now what kind of hard file [disk] were going to put in
our ThinkPads two years from now, says Ward, but I know how many well need.
The principal sources of inputs for those predictions are, of course, IBMs
salespeople. They may not have quite the sobriety of their white-shirt-and-black-tie forebears,
but they know their customers businesses inside out, boasts Ward. Managers meet frequently
to discuss and anticipate demand (is this a conceptual need, or has it been confirmed by the
customer?).
A rationally exuberant sales force. These days, thats about as close to a crystal ball as
a high-tech company can get.

CASE DISCUSSION QUESTIONS

1. How has Altera modified its strategy? Why?
2. Do you think Alteras new strategy will be successful? What are some advantages and
disadvantages of the new strategy?
3. How do you anticipate Alteras customers will react to this new strategy? What are
advantages and disadvantages for Alteras customers?
4. What information does Flextronics have that its clients do not ? Why? How can
Flextronics leverage this information?
5. How does IBM manage its suppliers in order to make its pull strategy more effective?