A Dell For Every Industry With powerful software that lets neophytes challenge stalwarts in everything from retailing to banking, information technology has created a new species of business.
By J. William Gurley Reporter Associate Jane Hodges

(FORTUNE Magazine) – Every once in a while trends converge and technology helps us move to a whole new way of doing business. This is one of those times. The change isn't obvious, and only becomes clear after a detailed analysis of such financial issues as how companies can improve their return on invested capital. But the convergence of three things--sophisticated enterprise software that streamlines processes like customer orders and the movement of products from suppliers to manufacturers, Net technology, and entrepreneurs who understand the new tech landscape--has resulted in the emergence of a new species of enterprise. Call it information-based businesses. With the right software and a smart business plan, these upstarts can threaten the survival of established companies in virtually any industry.

Understanding why isn't easy. Even economists who follow the technology trade fail to understand technology as an evolutionary force. They spend most of their time debating something known as the productivity paradox. The optimists claim the U.S. is in the midst of a long boom cycle resulting from the fact that productivity rises as technology replaces human labor. Therefore, they say, companies win higher profits, a higher return on equity, and higher stock prices--and the economy soars.

The skeptics insist there is a hole in this argument. They point out that ROE, margins, and profits have not improved markedly since the advent of high tech. Chief skeptic Paul Strassmann has argued that computer technology may often reduce productivity. He urges companies to rein in tech spending that doesn't directly boost the bottom line.

Both optimists and skeptics are having the wrong argument. Tech spending needs to be considered in light of the evolution of American, and global, business--which is remarkably similar to evolution in the natural world. Companies are competing beings in a capitalist ecosystem, and technology lets them extend their capabilities in ways that may help them survive. Having a good accounting system is like being able to walk erect; adding a Website that's ready for E-commerce is like developing an opposable thumb.

From an evolutionary perspective, arguing about productivity is pointless. The optimists are wrong because while new technology is nice, it can't guarantee better returns. Evolve only as much as your natural enemy, and you've done nothing to improve your chances of survival.

As for the pessimists, well, choosing not to adopt technology is like deciding not to evolve. Consider the effect the oversized racket had on tennis. Old-timers scorned the innovation as somehow improper. Now every pro uses one. Does this mean tennis players are more productive? No. They hit more aces--but so do their competitors. The game has absorbed the technology advantage, so the only person with a demonstrable disadvantage is any fool who insists on using the small wooden racket of yesteryear.

Those mired in the productivity debate need to face facts. No one starts a bank today with paper accounting ledgers. You wouldn't dare build an insurance company, utility, manufacturer, or large retailer without infotech infrastructure. Imagine a global company trying to manage its back office without technology--the odds are enormous that big errors would occur, while the chance that this company would effectively manage its balance sheet is next to zero.

In evolution-speak, the term fitness is often used to describe a species' capacity for survival. From a corporate perspective, the best measure of fitness is return on invested capital (ROIC). This measure matters most because over the long haul, capital flows toward investment opportunities with a high ROIC. Inefficient companies, on the other hand, are eventually starved of the cash they need to survive.

To understand just how indispensable technology has become, you have to follow the basic math of return on invested capital. To get ROIC, you divide EBIT, or earnings before interest and taxes, by invested capital. Now let's divide the numerator and the denominator by annual sales. This restates ROIC as operating margin multiplied by asset turnover. In other words, the two components that define a company's fitness are the ability to charge a high spread between price and actual cost, and the ability to generate sales from a small base of invested capital.

Now let's take a look at how these two components are affected by technology. A business can charge more if consumers think its product is differentiated from others. Obviously, the most differentiated product is something designed specifically for one customer. Technology is now helping companies do this efficiently. The concept, known broadly as mass customization ("The Customized, Digitized, Have-It-Your-Way Economy," FORTUNE, Sept. 28, see fortune.com archive), is best exemplified by Dell Computer, which builds millions of PCs a year, each to the buyer's specifications. Dell's the perfect example of the convergence of an entrepreneur, Net technology, and enterprise software.

Look at what the company does for one big customer, Ford Motor. Dell created a bunch of different configurations designed for Ford employees in different departments. When Dell receives an order via the Ford intranet, it knows immediately what type of worker is ordering and what kind of computer he needs. The company assembles the proper hardware and even installs the right software, some of which consists of Ford-specific code that's stored at Dell. Since Dell's logistics software is so sophisticated, it can do the customization relatively inexpensively.

Ford pays a premium for this individualized service. Is the price worth it? Consider the alternative. Ford could purchase its PCs from a local distributor. The distributor would send over some boxes that need to be opened and configured by an IT worker. That process typically requires four to six hours of a professional's time, and often results in configuration errors.

Customization like Dell's is worth a premium. The same is true of other custom products. Levi's can charge more when it customizes a pair of jeans, and Mattel can be sure that little girls will pay a higher price for personalized dolls. The technology keeps costs low and allows customizers to charge more: Clearly, technology can push corporate margins higher.

What about the other half of the ROIC equation: Can technology improve asset utilization? Historically, most companies have thought of costs simply in terms of the physical labor and raw materials that went into a product. However, many leading-edge companies today are using technology to focus more on another cost, the cost of capital. This focus serves two purposes. First, a company that implements build-to-order manufacturing or just-in-time inventory ends up with a much tighter supply chain and much less capital tied up in inventory. Second, as these companies are no longer building to potentially inaccurate forecasts, they significantly reduce the risk of inventory waste. They can use their cash in more efficient ways.

Companies with information infrastructures that allow them to custom-build products are beginning to enjoy higher margins and improved asset utilization. In the quintessential reference book on business strategy, Competitive Strategy, Michael Porter argued that companies must choose between a strategy of differentiation and one of low cost. But now we know about the real costs of extended supply chains, and we know that consumers will pay to have lots of choices, and we know that technology can help solve these problems. Porter was wrong: You can have your cake and eat it too.

There is, of course, a catch. In order to attain mass-customization Nirvana, you must have perfect information about every customer order (both new and old) and about every asset in your business (both permanent physical assets and various inventory components). And guess what? The only way to secure, maintain, and harvest this information is through the aggressive use of information technology. And guess who understands all this? The new competitive species emerging in the corporate marketplace. These companies are built around delivering a valuable personalized experience at a lower cost than that of their competitors. Their key competitive weapon is mastery of information.

Over the next ten years, companies that lack competitive information technology will be in serious trouble. They will resemble a 40-year-old trying to win Wimbledon with a small wooden racquet. Their business models may no longer be economically sustainable. Companies like Dell have reached an interesting new stage in the evolution of business--negative working capital. They collect money from customers before they have to acquire components or spend money. This phenomenon allows these companies to grow without raising capital, even if day-to-day profitability is zero. This is similar to a swimmer who can hold his breath for a really long time. These young companies are highly evolved creatures.

Of course, technology investments don't guarantee success. To prove valuable, technology must either increase customer satisfaction or increase asset utilization. This is much more important than using technology to replace workers. What good is a robotic manufacturing facility if postproduction inventory sits in the channel for 120 days? Tomorrow's marginal competitive advantage will be obtained by tightening the supply chain through perfect information about customers, distribution partners, and suppliers. Information is what is powerful, not technology alone.

The venture capital community wants to press this opportunity. Rather than back businesses that sell technology to companies already established in a market, investors are instead funding technology-enabled startups that attack these stalwarts. Silicon Valley VCs are investing in information-technology-based grocery stores, toy stores, insurers, and more, in the hopes that entrenched competitors continue to fail to understand the powerful new forces at work. Dell and Amazon.com have shown that this strategy can work. Now eToys looks to challenge Toys "R" Us; E*Trade scares established brokers; SportSite.com wants to be the biggest sports retailer in the world; and a number of Net banks aim to become the next Citibank or Chase.

Let me use a company my firm has invested in, HomeGrocer.com in Seattle, to show how efficient these new businesses can be. This Net-based grocery store has just 55 employees, but has already deployed six major infotech systems: a call-center application, an accounting package, a purchasing system, a warehouse-management system, a logistics-routing system, and a package that produces personalized Websites for customers. In the warehouse, grocery clerks have on their wrists computers that download individual orders so they can pack as quickly as possible. The technology helps increase margins by allowing the company to save customers' shopping lists (which lowers the cost and time of each order), target promotions, and charge premiums for fresh fruit (orders are placed nightly with the wholesaler). And the technology helps lower costs by allowing the company to maintain an inventory level dramatically lower than that of a bricks-and-mortar grocer.

Business managers in traditional industries who think of technology as more of a nuisance than a benefit should be concerned. For years, they've run the risk that a competitor might wake up and take advantage of this emerging business model. Now they also run the risk that a startup will invade their business. Still, many executives continue to believe that they are not in the technology business and that they might just as well outsource their information-technology needs. This is like an athlete saying that he is not in the strength business or the coordination business. As the marketplace continues to evolve, these naysayers might as well say that they are not in the business of being in business.

J. WILLIAM GURLEY is a partner with Hummer Winblad, a venture capital firm. Except as noted, neither he nor his firm has investments in the companies mentioned. To receive an expanded version of Above the Crowd, visit www.news.com; to subscribe to the E-mail distribution list, send E-mail to listserv@dispatch.cnet.com with the following in the message body: subscribe atc-dispatch. If you have feedback, please send it to atc@humwin.com

REPORTER ASSOCIATE Jane Hodges

INSIDE: Microsoft v. Sun in court, page 168...The year 2000 threat, page 172...The Dreyfuss Report: great printers, page 183...Alsop gets all his data straight, page 187