Once again, the semiconductor industry is plumbing the depths of one of its untamed business cycles.
Typically in this sector, erratic supply and demand cycles cause order backlogs to swell beyond six months, forcing suppliers to increase their capacity excessively. Measurements of real consumption are lost as customers and distributors rush to place orders just to get in line for shipments. Then, on the downswing, those phantom orders collapse, shipment projections are missed and a good deal of manufacturing capacity becomes idle. The figure below demonstrates the increasing volatility of orders as they move up the supply chain from the consumer to the vendor who supplies a manufacturer.
From the OEM with retail channels to the semiconductor supplier with distribution channels, the increasing variability of orders up and down the supply chain causes companies to make investments that they may later regret. Our industry's challenge is how to communicate real demand from the end consumer through the retail OEM, the electronic manufacturing services industry, distribution and component supplier.
In 1999, Agilent Technologies' semiconductor unit implemented two simple operational processes that enabled us to navigate the business cycle of 1999-2002 without a swollen backlog or cancellations from our channel.
Consumption as the Compass
Agilent uses a three-month moving average of resales--that is, our distributors' sales to their end customers by commodity--to work with our channel partners to ensure they have three to four months of inventory and Agilent has three to four months of backlog. The result is intended to be a product pipeline that is six to eight months long.
The discipline is to keep a balance of backlog and inventory as demand rises or falls by taking the backlog up or down to maintain equilibrium. So, as the consumption rises, inventories fall and backlog increases to replenish the depleted stock. Inventory may shrink to one month and the backlog may grow to above three months until the market stabilizes and inventories can rise to their targeted levels. On the downswing, inventories go up beyond three months, causing us to cancel some of the backlog until both inventory and backlog are again in balance with consumption.
The close relationship authorized distribution has developed with the component industry over a 30-year period allows this sharing of end-user demand for the benefit of both parties.
For consumption to be an accurate compass, a supplier must allocate products based on historical usage instead of a first-come, first-served backlog.
Agilent allocates components based on historical usage. When lead times stretch beyond 12 weeks, we allocate to our entire customer base by historic run rates. So, for example, a large direct customer historically using 50 percent of our capacity will get 50 percent of what is available. A channel partner that historically uses 10 percent of our capacity will continue to get 10 percent of what is available. The process is fair, has integrity and is easy to explain to customers.
What if there is no history, such as in an emerging market? During the recent digital radio boom-bust cycle, Agilent avoided $85 million in cancellations by calculating that radio towers could not be built fast enough to accommodate our customers' component forecast. We used consumption further down the supply chain as our compass.
There is no substitute for an accurate market analysis of a company's end customers. Simply stated, in a market where 20 players are each going to get a 10 percent share, the forecasts of those 20 players need to be tempered.
The reality is that visibility beyond 12 weeks is sketchy at best. An allocation based on backlog tends to encourage end users to place orders from two or more channel partners based on the same consumption. This sets our industry up for the typical train wrecks on the downslide.
It takes discipline for a supplier to ask a distributor not to place orders when inventories rise. It also requires discipline to avoid spot sales of large bulk orders, speculating on an upturn, or to lock in a low cost on a downturn. The discipline for customers to place one order vs. double orders for the same requirement will be reinforced as more manufacturers use consumption instead of competing backlogs to allocate product in short supply.
The figure above shows how Agilent's channel inventories climbed in an orderly fashion in 1999 through 2001 and declined in an orderly fashion in 2001 through 2002. Agilent was one of the few component suppliers in the distribution channel with little to no write-offs during this period.
Frank Robertazzi can be reached at email@example.com.