Parts Management Service©

Published in the AFSMI Sbusiness Journal, March/April 2002

Executive Summary:

While today’s products are designed for high reliability, nothing lasts forever. Therefore, prudent customers demand a “local” stock of critical spares on-site to minimize the risk of equipment downtime and production upsets. Reasons for stocking spares are as varied as competition and the customer base. Some keep spare parts on hand for maintaining their own equipment. Others keep critical spare parts on hand as a preventive measure against excessive downtime waiting for needed spares to arrive. This is particularly important where geographical distance, transportation problems, or political boundaries with their bureaucratic regulations impede speedy or timely parts delivery.

Strategically oriented Service organizations can create special parts management offerings for all these conditions designed to provide value to customers while contributing greatly to their own financial, marketing, and strategic objectives.

Customer Perspective:

Customers must balance the cost and overhead associated with local spares against the cost of downtime. Downtime even for a small enterprise can add up to a lot of money; negatively impact product sales, revenue, profit and delivery performance; create customer dissatisfaction as well as become a threat to new and repeat business.

Third-party service providers can be viewed as customers as they have similar problems. They need to stock spares for their customers but usually do not have the volumes to justify investing in repair facilities. Additionally, many vendors view them as annoying threats to their own business and place as many obstacles in their path as legally possible.

Stocking critical spares is always a problem; balancing the opposing requirements of having sufficient spares on hand, minimizing capital tied up in inventory, managing the inventory to ensure it is up-to-date, and ensuring physical availability and integrity. For example, Even if the right an in-stock critical spare is in stock, it may not work when installed because it is below acceptable revision levels, its has exceeded its shelf life, or been damaged while used for trouble shooting. Even if it is presumed to be in stock, it may have been lost, misplaced, used and not reordered or, worse stolen.

Indeed, it is quite common to find that customers only have 30 percent of the initial critical spares purchased in stock or serviceable within two to three years after purchase. While the customer’s ineffective management of critical spares can be a source of incremental service provider revenue and profit, it is also a major source of customer frustration and dissatisfaction.

While, in the past, customers felt they had to own and manage their own spares, many have come to realize that owning and managing their own spares is too expensive. Most now feel it is an expensive luxury that diverts time and management attention away for what they do best. Consequently, many customers are looking for alternatives to owning and managing spares. Some demand their product suppliers take responsibility for local spares management as they have found that this approach assures that critical spares are available, functional, at the current revision, offers significant savings and an attractive solution to their needs.

Parts Management Service --Design and Features:

A “Parts Management Service” should provide some combination of the following features, depending on who retains title (owns) the spares.

For Service Provider owned spares:

• On-Site spares: Critical spares located on the user’s site owned and managed by the service provider. The service provider ensures that the recommended and agreed upon spare types and quantities are on-site, functional and at the correct revision level.
  
  The customer is responsible for ensuring the safety and integrity of the spares.
• Locally available or Back-up Stock: Spares located in a central location (depot) owned and managed by the service provider and available only to Parts Management Service users 24 hours a day, seven days a week with shipment and on-site delivery within the agreed time frame of for pickup or receipt by authorized customer representatives.

Since the Service Provider retains parts ownership, the customer may select from these options:

• Be billed at list price for each spare part drawn from stock and receive a refund or rebate for parts returned for repair.
• Pay a fixed “Maintenance Charge” depending on the quantity and type of equipment being covered. Normal parts usage is included in this charge, but abnormal parts usage is billed at list price.

For Customer owned spares:

• On-Site Stock Audit: Routine audits of customer-owned spares. The Service Provider ensures all parts are at or above the current “minimum shipping levels.” The Service Provider also recommends stocking level adjustments as the customer adds or retires equipment.
• Used or missing parts. Charges for used part replacement are covered by the “Maintenance charge” but the customer is responsible for replacing missing spares. The Service Provider retains the used part in exchange for the replacement.

Managing for Success:

The following criteria are essential to ensure financial success and meet contractual requirements. Each criterion has a number of implications. Parts must be:

1. Immediately available when required.
   This means the Service Provider must carefully determine stocking levels for each part. The optimal stocking level (OSL) for a given part is a function of the:

   Number of parts to be covered under the agreement

   Failure rate

   Time for replenishing shelf stock to replace parts issued

   Desired safety margin

   OSL= function (Qty Covered, MTBF, Replenish Time, Safety Margin)

   The ratio of OSL to Qty Covered diminishes as the Quantity Covered increases

2. At or above minimum shipping revision levels
   

   This inventory control program must track not only the part number and quantity on hand but also the revision level of each part. A periodic comparison of shelf stock data against minimum shipping levels should identify below-revision stock, which should then be recycled through the repair loop for upgrades. This might drop stock on hand below contractual minima. An emergency replenishment may be indicated.

   Parts and logistics management play a key role. Many of the functions can be automated.

Inventory Management and Access Rights:

Depending on the location and number of spares involved, the Service Provider may elect one or more of the following options:

Have a Logistics person manage the stock, handle disbursements and returns, and order replacements as needed, and re-stock the shelves. Required parts may be delivered to the customer site or handed over to a customer representative to transport to the site. If the customer elects to have stock located on site, the Logistics person may need to schedule regular site visits for stock management with special trips to handle emergencies.

Use one of the newer automated parts dispensing system where an authorized customer employee uses an identification method and password to draw needed spares from an automated dispenser. This method is particularly appropriate where the Service Provider has a number of customers tightly localized in a small area such as a business campus. It is also very cost effective when dispensing large numbers of small consumable parts or supplies.

Customer Value Proposition:

Determining the “Customer Value Proposition” is relatively straightforward. Let us use the following assumptions and demonstrate the process.

1. The customer’s equipment includes a large amount of common products or sub-systems.
2. The site installation includes $1M in equipment requiring critical “on-site” spares.
3. Common practice suggests the customer purchases spares equivalent to 10 percent of the equipment list price if the customer-owned option is adopted.
4. The customer’s inventory carrying costs (ICC) are 35 percent per year of the initial spares inventory investment.
5. The service provider’s annual fee is 3% of the installation list price for a minimum 5-year agreement.

	Spares Owned by
	Customer	Service Provider
Initial Investment	$100,000	$0
Inventory Carrying Costs
Year 1 Year 2 Year 3 Year 4 Year 5	$35,000 $35,000 $35,000 $35,000 $35,000	$30,000 $30,000 $30,000 $30,000 $30,000
Total Cost	$275,000	$150,000

Table 1: Annual Costs as perceived by Customer

This arrangement saves the customer $125,000 over a five-year period. Additional benefits result from cost avoidance; as has been noted earlier, after two to three years, less tha n 30 percent of the customer’s initial spares inventory investment is either in stock or useable. So, from a customer’s perspective, it is a “real” bargain and very sellable.

Service Provider Value:

Let us examine why the Service Provider also finds this arrangement quite profitable. The value to the Service Provider comes from a number of sources.

The optimal stocking level for any given part rises much more slowly than the number of parts being supported. In other words, the ratio of parts in stock to the parts being supported diminishes as the number of parts supported increases. Since the Service Provider generally has contracts of various sorts covering many different customers, fewer incremental parts are needed to support an additional customer. This means that the cost per customer decreases while the revenue per customer holds steady. This in turns results in each incremental customer yielding improved margins.

Typical Service Provider Perceived Revenues and Expenses for varying numbers of Parts Management Contracts
Number of Contracts	Revenues	Costs	Margins
1 2 3 4 5	$35,000 $70,000 $105,000 $140,000 $175,000	$24,500 $40,000 $50,000 $55,000 $58,000	30% 43% 52% 61% 67%

Table 2: Service Provider perspective of Revenues,Costs, and Margins

Some important caveats to note while managing agreements:

1. The “on-site” spares stocked on the user’s site, cannot be shared with any other user.
2. Establishing a fixed bundled annual price for all Parts Management Service deliverables.
   “Cherry picking” – where the customer places only certain parts or units under this contract - cannot be allowed. This is because of a yet undetermined law of physics that concentrates all failures at the site on the covered parts.

As Table 2 shows, while the initial return for Parts Management Service may not be very high due to the initial investment in OSL spares, margins continue to rise as more Parts Management Service agreements are sold. Indeed, margins ranging from 60 to 70 percent or more are not uncommon. This is because, if optimum spares levels are maintained, inventory rises at a lower rate than the number of parts covered.

However, “on-site” spares, inventory audits, on-site inventory upgrades, support infrastructure and supply chain costs, which are volume responsive, will increase at a rate proportional to Parts Management Service revenue unless other actions which we will cover later are taken to contain these costs.

Experienced contract service providers should not be surprised by the revenue growth, as they know that annual contract service revenues are accumulative providing of course existing contracts are renewed.

One obstacle the service provider may encounter is the initial “on-site” and “back-up” spare investment and its impact on working capital. This is not as daunting as it may appear:

• First, much of the initially required “back-up” spare inventory should already exist for warranty support and demand parts sales. It is just a matter of gradually shifting more and more of this inventory to support the Parts Management Service business. It is highly recommended that this inventory be cordoned off, and locked in a separate area to eliminate any risk that it is used for warranty support and demand parts sales.
• Second, since the inventory used to support the Parts Management Service business generates revenue, it can be classified as a revenue-generating asset, which does not have an impact on working capital.
• Third, the service provider can for a small financing fee built into the cost model, sell “on-site” and “back-up” inventory to any number of financing concerns which provide these services.

Outsourcing:

Outsourcing distribution to freight forwarders many, which now offer total distribution and supply chain services, provides an opportunity to reduce delivery costs as well as improve delivery performance. Certain freight forwarders provide added value services which include, order taking, parts stocking, inventory management, custom clearance, duty-free in-country distribution hubs, even small central configuration and repair services, in addition to their primary shipping role.

The service provider must determine if this is a cost-effective approach for their Parts Management Service distribution model. If they have a global business, they may want contract with two or three freight forwarders based on their regional distribution resources and performance. This is a very cost-effective approach to distribution, and indeed, many manufacturers have switched to using full-service freight forwarders for product and parts distribution.

We do not recommend outsourcing distribution until internal processes are functioning flawlessly. Nor that the service provider advocates its responsibility for determining the amount of “back-up” spares to be held in the freight forwarder’s central depots and hubs.

Inventory Buy-Back

Service providers will find that existing customers, those who have already invested in “on-site” inventory may want to convert to Parts Management Service. The service providers may themselves want to convert their existing installed base to Parts Management Service to accelerate revenue growth and profit.

While on the surface this might appear to be an expensive move, it isn’t. As previously mentioned, it is not uncommon to find that customers only have 30 percent of the initial critical spares purchased in stock or serviceable within two to three years after purchase. The service provider may opt to purchase just those spares that are serviceable and at the current revision level at or below cost. Or, they may opt to make a one-time buy-out offer for all say like 10 cents on the dollar. Serviceable parts can then be used to fulfill critical “on-site” stock requirements and the remainder put into the ‘back-up” spare inventory.

Some customers may balk at getting so little return for their on-site inventory. An on-site inventory audit can provide an objective assessment of the current serviceability of the customer’s spares inventory and will often serve to reinforce why the customer should outsource their spare parts management rather than do it themselves. Furthermore, if the customer has written-off their spare parts investment, anything they can get for them will go right to the bottom line.

Automated Local Parts Disbursement:

New automated parts distribution centers have recently made their appearance. These units are usually placed centrally in secure, high-customer-density areas so that customer personnel can reach them easily.

Access to the parts is via an “ATM-type” card and an individual password to these transactions can be tracked and audited, and usage monitored. A customer needing a part goes to the machine, uses the “ATM” card and password for identification, and gets parts as authorized by the agreement.

The unit monitors usage in virtual real time and transmits all pertinent data to a central “back end” system that generates usage and billing statements, and requests for parts replenishments.

Summary: A Win-Win Proposition for All

Parts Management Service provides the customer significant savings and a very attractive alternative to owning and managing their own spare parts. It provides the service provider a continuous, predictable, high margin revenue stream, significantly improves customer satisfaction and eliminates threats to new and repeat product sales due to unsatisfactory parts support.

About the Authors:

Ted Gibbon has held numerous senior management positions with Honeywell including Vice President Global Service Honeywell-Measurex, General Manager Products and Industrial China area. Ted led thedevelopment of several professional contract service initiatives, established customer response centers in North America, Europe and Asia-Pacific, formed,trained and managed two separate consultative service sales organizations and has over 20-years service marketing, sales and operations management experience. He can be reached at 619-427-2811 or tgibbon@msn.com

Roy Sequeira, President of Sequeira Consulting LLC, creates the right combination of analysis, tools and process to improve the effectiveness and profitability of service organizations worldwide. Roy’s first-hand experience includes multi-national giants and focused companies in a dozen countries. He helped service organizations worldwide improve service delivery performance, revenue growth and profit. Youcan reach him at 508-481-1190 or www.SequeiraConsulting.com