Why Would You Outsource Your Capabilities?
Or, the dangers of not knowing what really gives you an edge
đ Hey there! My name is Abhishek. Welcome to a new edition of The Sunday Wisdom! This is the best way to learn new things with the least amount of effort.
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Q: What is the one thing we all must know about ourselves?
It may not look so anymore, but there was a time when Dell was the worldâs most successful and unchallengeable PC manufacturer. But few people know that this was possible because of a Taiwanese component supplier by the name of Asus. And even fewer know that the reason behind the downfall of Dell has less to do with the smarts of someone else and more to do with the stupidity of Dell itself.
Dell hit its stride in the early 1990s. Mainly due to three reasons. First, its business model was disruptive: it started making simple entry-level computers at very low costs, because they sold largely by mail or over the Web. It then moved up-market, making a sequence of higher- and higher-performing computers.
Second, its products were modular â allowing buyers to customise their own computers by choosing what components they wanted in their machines. Dell would then assemble and ship them within forty-eight hoursâan impressive achievement.
And third, Dell tried to use its capital more and more efficiently, wringing more and more sales and profits per dollar of its assets â something Wall Street applauded.
These three strategic initiatives helped Dell succeed in quite an extraordinary way.
Interestingly, Asus played a big role is enabling Dell to pull this off. Like Dell, Asus started at the low end providing simple, reliable circuits for Dell â at a lower price than what Dell could do itself.
Then Asus came to Dell with an interesting proposition: âWeâve done a good job making these little circuits for you. Let us supply the motherboards for your computers, too. Making motherboards isnât your competence â itâs ours. And we can make them for a 20 percent lower cost.â
The Dell analysts realised that not only could Asus do it cheaper but it would also allow Dell to erase all the motherboard-related manufacturing assets from its balance sheet.
Wall Street analysts hawkishly monitor financial metrics and ratios that track the âefficiencyâ of capital used in a business. One particularly common one is RONA, or Return on Net Assets. In manufacturing businesses, this is calculated by dividing a companyâs income by its net assets.
A company can be judged as being more profitable either by adding income to the numerator, or by reducing the assets in the denominator. Driving the numerator up is harder, because it entails selling more products. Driving the denominator down is often easier â because you can just opt to outsource.
The higher the ratio, the more efficient a business is judged to be in using its capital. Asusâs proposal made sense. If Dell could outsource some of its assets but still be able to sell its customers the same products, then it would improve its RONA, making Wall Street happy.
âGosh, that would be a great idea,â Dell said to Asus. âYou can produce our motherboards.â Funny enough, the agreement made Asus look better to investors, too. It was increasing its sales with the use of its existing assets. Both companies seemed better off â a perfect win-win! What more could you ask?
After it had reorganised to accommodate this arrangement, Asus came to Dell and said, âWeâve done a good job fabricating these motherboards for you. Why donât you let us assemble the whole computer for you, too? Assembling those products is not whatâs made you successful. We can take all the remaining manufacturing assets off your balance sheet, and we can do it all for 20 percent less.â
The Dell analysts realised that this, too, was a win-win. As Asus took on the additional activity, Asusâs RONA increased as the numerator of the ratio â profits â got bigger.
Shedding manufacturing processes also increased Dellâs RONA. It didnât change the revenue line, but driving out those assets from its balance sheet improved the denominator of the ratio.
That process continued as Dell outsourced the management of its supply chain, and then the design of its computers themselves.
Dell essentially outsourced everything inside its personal-computer business â everything except its brand â to Asus. Dellâs RONA became very high, as it had very few assets left in the consumer part of its business. Wall Street was very happy!
Then, something interesting happened. In 2005, Asus announced the creation of its own brand of computers. In this Greek-tragedy tale, Asus had taken everything it had learned from Dell and applied it for itself.
It started at the simplest of activities in the value chain, then, decision by decision, every time Dell outsourced the next lowest-value-adding of the remaining activities in its business, Asus added a higher value-adding activity to its own business.
All along, the numbers had looked good to Dell. But what the numbers had not shown was the impact these decisions would have on Dellâs future.
Dell started out as one of the most exciting computer companies around, but over the years, it slowly outsourced its way to mediocrity in the consumer business.
Dell doesnât build those computers. It doesnât ship those computers. It doesnât service those computers. It simply allows companies in Taiwan to put the name âDellâ on the machines. Why not buy directly for Asus then, that too, for for 20 percent less!
Today, letâs talk about capabilities. More precisely, letâs talk about what capabilities really are, their importance, and how to know which ones are critical and which ones matter less.
You can tell from this story that Dell didnât know what its core capabilities were. Clearly, if Dellâs leadership had known what the outcome would be from taking the approach they did, they would have been much more hesitant to accept Asusâs offers.
But how could they have known?
In simple words, capabilities define what a person or a business can or cannot do well. Capabilities fall into one of three buckets: resources, processes, and priorities.
Resources are usually people or things that can be used. For example, employees, equipments, technology, cash, brands are all resources. At a personal level, it boils down to the resources you have, which are usually time and information (i.e. what you know).
Processes are the ways that products and services are developed. It also includes how things get done, for example the methods by which research, budgeting, employee development, compensation, are accomplished. Unlike resources, which are often easily seen and measured, processes canât be seen on a balance sheet. At a personal level, itâs about productivity â how you balance your time between thinking and doing so that you can get more done in less time.
The third â and perhaps most significant â capability is an organisationâs priorities. The set of factors that define how a company makes decisions. Priorities give clear guidance about what a company is likely to invest in, and also what it will not. This is the same at a personal level â knowing what is the goal and why is it the most important goal.
These offer an accurate snapshot of how things are going at any given time, because they are mutually exclusive â a part of a business cannot fit into more than one of the categories â and are collectively exhaustive â together, the three categories account for everything inside of a business.
These offer an accurate snapshot of a company or a person can and, perhaps more important, cannot accomplish. Knowing our capabilities gives us insight. Itâs a good framework to not only anticipate othersâ behaviours but also our own future success.
One company that understood this well, and bet on its own capabilities â resources, processes, and priorities â to become a market leader is Nvidia.
Itâs the 1990s and there was a strong demand for 3D graphics chips among teenage boys, owing to the success of games like Doom and Quake. The first company to tap into this demand, and thereby cash in on PC-based 3-D graphics, was 1994 start-up 3dfx Interactive which sold a successful add-on graphics board called Voodoo. Nvidia was formed in 1993, but itâs 3D graphics card NV1 was a commercial flop.
Faced with the failure of the companyâs first product and the sudden rise of 3dfx, Nvidiaâs CEO Jen-Hsun Huang reformulated the companyâs strategy. A key aspect of his strategy was to construct an advantage by breaking out of the industryâs eighteen-month cycle.
He reasoned that since it looked possible to advance graphics power three times faster than CPU power, Nvidia could deliver a substantial upgrade in graphics power every six months instead of every eighteen months.
The first step in executing the guiding policy was the establishment of three separate development teams. Each would work to an eighteen-month start-to-market cycle. With overlapping schedules, the three teams would deliver a new product every six months.
But there were several friction points not in Nvidiaâs control that could delay release. One of that was dependency on external board makers.
Traditionally, drivers were written by the board makers, who could start driver development only after receiving working chips from the chip maker. In addition to the problem of delay, the new 3D graphics methods demanded much more sophisticated drivers.
Plus, board makers had mixed incentives about communicating driver problems back to the chip maker. For example, if Nvidia were selling chips to two board makers, each would tend to keep its learning and bug fixes to itself, so as not to benefit the other board maker. Finally, the current practice generated different drivers for identical chips on different boards, greatly complicating the tasks of keeping drivers current and of helping users update older drivers.
To address these problems, Nvidia took control of the creation and management of drivers for its chips, developing a unified driver architecture (UDA). All Nvidia chips would use the same driver software, easily downloaded over the Internet. The driver software would adapt itself to each chip by querying the chip about the actions it supported, and then the driver would tailor its commands to that chip.
This approach would greatly simplify things for users because they would not have to be concerned with matching drivers to chips. It also meant that driver construction and distribution would be proprietary to Nvidia and taken out of the hands of the board makers.
To speed up driver development, the company made a significant investment in emulation facilities. These were complex hardware âmockupsâ of new chips that allowed driver development to begin four to six months before the first true chips appeared.
The benefit of a faster cycle is that the product will be best in class more often. Compared to a competitor working on an eighteen-month cycle, Nvidiaâs six-month cycle would mean that its chip would be the better product about 83 percent of the time.
Plus, there is the constant buzz surrounding new product introductions, a substitute for expensive advertising. As a further plus, the faster companyâs engineers will get more experience and, perhaps, learn more about the tricks of turning the technology into product.
In 1998, Nvidia released the RIVA TNT, followed by TNT2. Both were successes. Seven months after the TNT2, Nvidia released the GeForce 256, moving the 3D graphics industry into new territory with Nvidia at the helm. There was no looking back after that.
When you look at the Dell story from the point of view of Asus, their whole strategy from the get-go has been to attain strong capabilities (similar to Nvidia) instead of giving them up.
Although Asus started out by assembling only the simplest of products, they didnât want to stay there. They had no capability. It was low-cost work, and almost anyone could do it. They knew that they would be vulnerable to losing that work to an even lower-cost assembler. So they strove to keep moving up-market, fabricating and assembling ever more sophisticated products.
On the other side, Nvidiaâs Rival 3dfx followed spurious advice from Wall Street and the marketing instincts of a new CEO, setting out after the mass market. Instead of capitalising on its leadership with enthusiasts (precisely where it had strong capability), it allocated engineers away from the cutting edge to work on lower-tech boards, and ramped up advertising in imitation of the âIntel Insideâ campaign.
Spreading its resources too thin, it attempted to compensate by stretching the goals for its next high-performance chip beyond the competencies of its development process.
In the last months of 2000, 3dfx closed its doors, selling its patents, brands, and inventory to Nvidia, where many of its talented engineers wound up working.
Several companies and individuals make the stupid mistake of downscaling their capabilities without assessing the future. They are encouraged to do this by financiers, consultants, and academics â none of who have skin in the game.
Even though they see how quickly and easily they can reap the benefits of outsourcing, they donât see the cost of losing the capabilities that they forgo in doing so.
They risk creating their own version of Asus.
Timeless Insight
Instead of asking what you should achieve, ask what you should really avoid.
Spend less time trying to be brilliant. Instead, try to avoid obvious stupidity. The good news is that avoiding stupidity is easier than seeking brilliance.
Inverting a problem like this wonât solve it, but it will help you see it in a different light. Sometimes thatâs what you need to solve it.
Spending time thinking about the opposite of what you want doesnât come naturally. However, this is the work you have to do to improve your thinking.
And this goes for everything you wish to achieve. Rather than trying to be famous, or successful, or wealthy, try inverting the problem instead. Turn it upon its head, and think of it backwards.
What Iâm Reading
This is where I think the idea of âdoing nothingâ can be of the most help. For me, doing nothing means disengaging from one framework (the attention economy) not only to give myself time to think, but to do something else in another framework.
â Jenny Odell, How to Do Nothing
Tiny Thought
A learner is someone who displays less than he knows. A expert, the opposite.
Before You GoâŚ
Thanks so much for reading! Send me ideas, questions, reading recs. You can write to abhishek@coffeeandjunk.com, reply to this email, or use the comments.
Until next Sunday,
Abhishek đ