Dell Case Study

Dell Case Study – Harvard Business School Question 1: Dell’s working capital competitive advantage One of the biggest advantages that Dell enjoys is its competitive advantage in not having to spend as much capital in its inventory and storage. As indicated in the case study, Dell built computer systems after the company receives orders from its customers. As a result of this prudent practice, Dell’s work-in-process (WIP) and finished goods inventory as a percent of total inventory in the 1990s was approximately 10% to 20%. Conversely, other leaders in the industry such as IBM, Apple, Compaq, etc., had WIP and finished goods inventory that ranged from 50% to 70% of total inventory, which did not even include the inventory held by their resellers. Dell’s practice is commonly referred to as the “build-toorder” model, and it allowed Dell to deliver a customized order within a very short timeframe, which was something that its competitors could not do. Put simply, because Dell only built computers when ordered and needed (very similar to Toyota’s Just-In-Time, a.k.a. JIT, system), Dell did not have to spend as much capital as a result. The result of this system is evident in the working capital financial ratios as shown in Exhibit 2. As one can see, starting from Q1 1993 until Q4 1996, Dell’s DSI (Days Sales of Inventory) shows a steady decline. What this means is that Dell has been taking increasingly shorter days to sell its inventory, which adds a tremendous amount of advantages to its working capital. Additionally, since Dell’s inventory level is so low, it dramatically reduces the cost of storing the inventory, which is part of the cost of goods sold (COGS) of the product. Last but not least, Dell’s low level inventory has the benefit in allowing Dell to have quicker adoption of new technology. For example, in July 1995, Dell was the first manufacturer to convert its entire major product line to the Pentium technology. Its competitors would have much difficulty in making such conversion in such short amount of time because the competitors have a larger inventory than Dell does. As a result of the large amount of inventory, these competitors had to deplete its existing inventory with the older Pentium technology before it could completely move on to the new Pentium technology. Dell, on the other hand, with its low inventory level, was in a position to offer newer, quicker, and timely introduction of new technology with new systems up and running. This advantage was particularly salient in the 1994 episode when Intel Corporation discovered its chip was flawed. In that incident, Dell was able to quickly manufacture systems with the updated chip while other competitors with their large inventory were still selling products with the flawed chip (another similar incident relating to quicker introduction of Microsoft’s new Windows 95 operating system was also mentioned in the case study). All in all, with its low inventory, it was able to bring new technology to the market at 1/3 the time taken by its counterparts and competitors. Question 2: Determining how Dell funded its fiscal 1996 sales growth In order to determine how Dell funded its fiscal 1996 sales growth, we must first analyze how much fund Dell exactly needed to sustain such 52% growth in 1996. As we know, Operating Assets = Total Assets – Short Term Investment. Plugging in the formula we then have operating assets in year 1995 => $1,594 million - $484 million =

$1,110 million. The operating assets in proportion to sales would be the operating assets divided by total sales, therefore would be $1,110 / $3,475 = 31.9%. Sales increased from $3,475 million in 1995 to $5,296 million in 1996. From our previous calculations, we have found that operating assets are a proportion of sales and would therefore equal 31.9%. In order to figure out the required amount of increase in operating assets as a result of an increase in sales, we should multiply the increase in sales by 31.9%. Therefore, 0.32 * ($5,296 million - $3,475 million) = $582 million, which would be the total operating assets that Dell would need to fund in order to sustain the 52% growth in sales. Liabilities come with assets, so we must figure out the increase in liabilities in proportion to sales from the data given. Similar to previous calculation on assets in proportion to sales, we would calculate the liabilities in proportion to sales in 1995 by dividing liabilities by sales => $942 / $3,475 = 27.1%. After we obtained the figure 27.1%, we then calculate the increase in liabilities by 1996 by multiplying the difference in sales in 1995 and 1996 (sales in 1996 – sales in 1995) with 0.271 => ($5,296 million - $3,475 million) * 0.271 = $494 million. Therefore, as Dell would have the increase of $582 million in operating assets, there would also be a $494 million increase in liabilities. Other factors to consider include the increase in operational profits and short term investments. The short term investments would remain the same, since it is not directly related to operations. In order to figure out the operational profit we should repeat the process and calculate the net profit in proportion to sales of year 1995. As we take net profit/sales => $149 million / $3,475 million = 4.3%, then we calculate by multiplying the total sales in 1996 which is $5,296 million by 4.3% = $227 million. In all, we have calculated that with the sales increase of 52% there will be $582 million operating assets that Dell should fund. The 52% sales increase would also bring additional $494 million in liabilities, while generating $227 million of operating profit yet the short term investment would remain unchanged at $484 million. As a result, any two combination of liabilities, operational profit, or short-term investment will be sufficient to offset the $582 million operating assets needed to sustain the 52% sales growth in 1996. Based on previous calculations, we find that in order for Dell to finance its 52% growth, the firm will require $582 million in terms of increase in operating assets. Nevertheless, this number can be further reduced if the company undergoes internal process improvement, which would result in higher asset efficiency. For 1995, the operating assets in terms of percentage of sales can be calculated once again by subtracting short term investment from total assets, and the number comes out to be around 32% (31.94% to be exact). Likewise in 1996, the operating assets equal ($2,148 million - $591 million) / $5,296 = 29.4% of sales. By subtracting the two percentages from year 1995 and 1996, 31.94% - 29.4% = 2.54%, we find that there is a decrease in operating assets by 2.54% in the year 1996, suggesting that operating efficiency has improved by the same amount. Then, by multiplying total sales in 1996 by the decrease in operating asset in percentage of sales, we will find that there is a decrease in operating asset by $5,296 million * 0.0254 = $134.5 million. This is the amount that can be further reduced from the originally forecasted $582 million required for the 52% growth in 1996. The higher asset efficiency

can be achieved through reducing company’s current asset, which included cash available, account receivables, inventory, or other current assets. Therefore, by subtracting $134.5 million from the estimated operating asset of $582 million, we find the actual additional operating asset needed to fund the 52% increase in sales comes out to be $582 – million $134.5 million = $447.5 million. To put everything in perspective, we need to compare both sides of the balance sheet to determine if additional fund is needed. In other words, the sum of current liabilities, longterm debt, and retained earnings needs to exceed the sum of current assets and fixed assets for Dell to avoid raising public fund such as issuing more stocks. Based on the numbers provided by Exhibit 4 and 5 of the case, we find that the retained earnings (net profit) come out to be $272 million, and there is no difference in long-term debt. The $272 million in net profit is an increase from the forecasted $227 million and can be attributed to improved net margins from 4.3% to 5.1%. Also, we can calculate that the increase in current liabilities = $939 million - $752 million = $187 million. Based on the balance sheet, we find that total liability together with a higher than anticipated net profit is larger than the additional operating asset requirement calculated, $272 million + $187 million = $459 million > $447.5 million. Therefore, without relying on external alternatives, Dell was able to fund its 1996 sales growth through internal resources, i.e. reducing its current assets and increasing its net margin. Question 3: Evaluating Dell’s internal funding options for projected sales growth of 50% in fiscal 1997 To evaluate Dell’s internal funding options for a 50% sales growth in 1997, we will first determine the operating assets and net profit as a percentage of sales for 1996. Operating assets as a percentage of sales for 1996 = Total Assets – Short Term Investments = $2,148 million - $591 million = $1,557 million. Percentage of Net Profit as a percentage of sales for 1996 = Net Profit / Sales = $272 million / $5,296 million = 5.1%. To achieve 50% sales growth, we calculate the percentage increase needed for operating assets. When sales increase by 50% we must also assume that operating assets will also be increased by the same amount. Hence for 1997, Dell requires $1,557 * 1.5 = $2,336 million worth of operating assets. Therefore with an increase in sales of 50%, the increase in operating assets from 1996-1997 would amount to $779 million ($2,336 million - $1,557 million). Here we must also assume that the liabilities and net profit as a percentage of sales will also be increased proportionally by 50% for 1997. Therefore, percentage of Net Profit (1996) * Sales (1996) * 1.5 = 5.1% * $5,296 million * 1.5 = $405 million. Total liabilities as a percentage of sales would equal Liabilities (1996) * 50% = $1,175 * 0.5 = $588 million. Considering that Short Term Investments will be around $591 million in average for 1997, we have a total of $405 million + $588 million + $591 million = $1,584 million which is well above the required increase of sales in operating assets ($779 million). Therefore with the increase in liabilities, projected net profit for 1997, and current short term investment, Dell will have enough money for internal funding. Dell may choose any which way to allocate these funds. For instance, if their short term investments have shown phenomenal growth, they may decide to realize these gains and sell off all of these investments, which would

then cover most of the required operating assets. Furthermore, if the cost of new debt is high, they may choose not to increase their liabilities and instead fund the growth with short term investments and their net profits. Alternatively as an option for internal funding, Dell would sell its fixed assets, or reduce inventory, accounts receivables, and increase payables. The latter brings up the idea of working capital improvements. If we look at Dell’s operations and their use of JIT (as mentioned in Question 1), it is highly plausible for them to achieve a negative Cash Conversion Cycle. If they receive terms from their suppliers of 30-45 days while also using JIT to receive immediate payment from customers, it is possible to improve working capital from the previous year by reducing inventory and receivables. Furthermore, with their size and influence, they can demand increased payment terms and limits, thus increasing accounts payables period. This all combines to the possibility of negative Cash Cycle and the ability to fuel the company’s growth. Looking back at the previous paragraph, we see that Dell has the potential to utilize $1,584 million towards their internal growth. This amount is easily able to cover the required forecasted amount of operating assets of $779 million. It should be emphasized that with the remainder of the funds, it is possible for Dell to utilize it in other matters within the company. For instance, they may use this amount to pay off long term debt or to buy back common stock thus increasing EPS.