In the 1990s, Tim Cook shifted Apple (NASDAQ:AAPL) to an incredibly efficient, contract-based manufacturing model.
In this segment from the Industry Focus: Tech podcast, Dylan Lewis and Evan Niu talk about why -- outside of the obvious reason of reduced labor costs -- the company made that move. Find out just how efficient Apple's supply chain is compared to its competitors', how much flexibility this model allows the company, and how long it takes for the company to clear inventory of each model.
Dylan and Evan also talk about some of the very real risks associated with the contract model -- from quality control to concerns about working conditions, and the risks associated with putting that much of your intellectual property in another companies' hands.
A full transcript follows the video.
This podcast was recorded on May 27, 2016.
Dylan Lewis: Evan, any thoughts on why they do this, beyond just the very conventional cost, because it's cheaper to outsource production to some of these countries where labor's a little bit cheaper?
Evan Niu: I think part of it is that -- in addition to the engineering talent thing I was talking about earlier -- Tim Cook absolutely hates inventory. Setting up this model and supply chain, I've read reports where other industry executives look at Apple supply chain and they're just blown away. They're like, "Well, we can't compete with this." You can order a custom-built Apple device like, a Mac, or an iPhone or something. You'll get the tracking information, and it literally ships from the factory to your doorstep in a matter of days. They build it and they ship it directly to you. That's the kind of scenario when the purchase transaction goes like that. I mean, Apple does very little hands on. Apple's not physically handling the product too much if you're ordering like that, and that's kind of a testament, because they still get to book all the revenue and all the sales.
It goes from a contract manufacturer, to a third-party shipping company, directly to a customer. With that happening all so quickly, their inventory turnover times are so insanely high, that it's comparable to fast-food restaurants and stuff like that, instead of $600 dollar smartphones. I think that's been a huge boon to Apple, because that just makes the whole operation a lot more efficient.
It's this huge strength, because again, other companies have seen this and they're like, "We can't do that. We can't set it up this seamlessly and streamline to this point where is incredibly efficient and direct." Of course, they have to have a lot of inventory for retail stores and things like that. They're very good in inventory management, they keep it really lean. Otherwise, having a lot of inventory is not really a good thing, because it just sits there and risks getting written down, if you can't sell it, and if you have too much, it's just kind of a big pain. That's why Tim Cook has really pursued this path so aggressively.
Lewis: To your point, while I was researching this show, I came across this stat that the flip to contract manufacturing took the amount of time that inventory sat on Apple's balance sheet from months to days. You talk about that inventory turnover -- and actually, this is something that Vincent Shen alluded to when he did the consumer goods episode of Industry Focus, talking about industry turnover -- Apple's got the best in the business. It's because inventory sits on their balance sheet for such a short amount of time.
Niu: Mm-hmm, yep.
Lewis: I think beyond that, there's also a little bit more manufacturing flexibility abroad. I think some of these contract manufacturers are ready to go, and they can get things set up very quickly. They have the talent in place to within two weeks really be up and running.
Niu: That's another thing. If you had these really big demands, and you need to be able to scale up and down depending on seasonality and these other factors. That's another big benefit of this contract-manufacturing model, because you can just say, "I need X number of units, go build them." Whereas if you're doing the manufacturing yourself, you also have to worry about things like excess capacity, capacity utilization. Let's say you need to ramp down for whatever reason, which makes a lot of sense now with the iPhone just finally declining for the first time. Just in general, to have that ability to, this lever of being able to increase production as needed, without really worrying to much about the logistics of personnel. Like hiring, laying off, which is something companies that have a lot of manufacturing footprint have to constantly worry about -- how they're going to manage increasing and decreasing production. Particularly, when it comes to hiring and laying off workers, which is a tough thing to do, and they're kind of outsourcing that responsibility in a way too.
Lewis: Yeah. Of course, this approach is not without its own risks, right? For as much as we praise Apple's operational smarts here, there are some issues with the model. One of them namely, I think is control, right? We haven't seen a ton of this, but there is the possibility of quality control being a problem. I think more when you think about Foxconn and some of the contract manufacturers in Asia, there's always this worry about working conditions, and this is something that has gotten a lot of press in the last couple years. There's always this concern of working conditions being substandard, of being overly demanding, of overtime being required, things like that. That's definitely one of the risks here.
Niu: Yeah, I definitely agree there.
Lewis: One of the other ones that immediately comes to mind for me is just intellectual property risk, too. I think you can't go more than a couple weeks without seeing online, leaked photos of some rumored iPhone design or configuration. I think that's a byproduct of these contract manufacturing systems. When you have all these intermediaries within the design and fulfillment, it's just bound to happen somewhere.
Niu: With as global as Apple's business has become, the supply chain is just too massive. You can't keep it secret. There's just too many moving parts, there's too many third parties involved. Everyone wants a piece of it and wants to know. You can easily sell a picture of a leaked iPhone, and get paid a ton of money if you can smuggle it out. You'll risk losing your job, but I mean, for some of these workers, there's actually a lot of upside to sneaking these things out. They know how much appetite the media has for it.
Lewis: I wonder how much the company really minds that that happens.
Niu: Well I know that they've punished workers that have been caught doing this. It's pretty severe punishment, I don't remember exactly what it was. Obviously, Apple is such a huge contract for them, and they have all these confidentiality agreements, and all these things like that. I do think that Foxconn does care, they do try to do their best to stop it. Again when you're talking at this scale, all it takes is one person to get a picture, prototype, or molding or something out, and you have a headline.
Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.