Risk Sharing in Aftermarket Service

How Performance-Based contracting creates a win-win for OEMs and their customers

Introduction: Opportunity & Risk in Aftermarket Service

Across a number of capital equipment industries, successful companies have recognized that the aftermarket is critical to the long-term success of their core business. These original equipment manufacturers (OEMs) understand that the aftermarket represents an important revenue opportunity that can serve as an offset to the cyclical nature of their equipment business. And yet a myriad of studies have shown that, in general, the aftermarket remains a largely untapped resource for many capital equipment manufacturers.

At the same time, total cost of ownership (TCO) is emerging as a priority for capital equipment end-users as the technology gap between OEMs narrows -- making aftermarket service performance a major competitive differentiator in a number of industries. Complex capital equipment consumers demand world-class equipment performance along with consistent and efficient service delivery and these have become key factors in the vendor selection process.

There are significant risks for OEMs in their effort to satisfy demanding aftermarket service requirements. The aftermarket supply chain is incredibly complex and differs significantly from the traditional manufacturing supply chain. These differences include extended global service supply networks and complex reverse logistics, demand patterns that are intermittent and highly unpredictable and dynamic support requirements at all stages of the product lifecycle across a wide range of service parts. Investing in service assets (people, parts, repair, warehouses, etc.) can have a significant impact on the bottom line and lacking the necessary solutions for optimal resource deployment can lead to over-investment in service parts and the inability to meet customer commitments.

Performance-Based Contracting: Managing Shifting Ownership of Service Assets

In traditional customer-supplier relationships, customers want to lower their total cost of ownership by increasing product performance, ultimately putting more demand on the support infrastructure necessary to deliver that performance and driving higher costs for the OEM. OEMs, similarly, want to lower their costs and increase profits, but this puts pressure on the resources necessary to deliver superior aftermarket service -- creating a misalignment of incentives between customers and suppliers.

But the capital equipment industry is changing. Customers are demanding that they own less of the risk involved in equipment ownership, while paying even lower prices. And some OEMs are even willing to accept responsibility for servicing products that they don't manufacture in order to increase their revenue.

In a number of industries, most notably aerospace and defense, traditional relationships between manufacturers and customers are being replaced by risk-sharing relationships commonly referred to as Performance-Based Contracting. In Performance-Based Contracting, the customer pays for the performance of the product -- nothing more. This means that it is up to the OEM to manage the maintenance and repair of the product throughout its lifecycle and ensure that the equipment meets availability targets.

One of the most critical elements of Performance-Based Contracting is the clear separation between the customer's expectation of service and how the supplier meets that expectation. Customer driven efforts often multiply overall supply chain cost without any tangible improvement in overall product performance. The OEM is always in the best position to determine how to achieve a performance improvement goal, but there aren't always sufficient incentives to drive a change in OEM behavior.

With Performance-Based Contracting, OEMs and their customers can effectively align incentives by directly tying supplier compensation to product performance and customer value. The OEM has an incentive to achieve performance objectives at the lowest possible cost and to take actions that would cost-effectively improve the performance of the system -- which is also a significant benefit to the customer. This gives the OEM the incentive they need to meet contractual performance levels by separating the performance metric from the tactical methodology behind achieving it.

For example, a high-tech manufacturer was traditionally required to provide consigned on-site service parts for several of its key customers. These customers defined the parts and stock levels in an effort to minimize the risk of equipment downtime. With the application of service parts planning technology, the manufacturer was able to recommend an optimized mix of parts for on-site support that resulted in higher fill rates and lower overall inventory levels -- a win-win for both parties.

Challenges & Risk in Performance-Based Contracting:

It's this alignment of incentives across the value chain that results in significant benefits for both OEMs and their customers including reduced total cost of ownership, increased profitability, and increased service supply chain efficiency.

While the implications of Performance-Based Contracting can be enormous for both OEMs and their customers, there are significant challenges to any organization trying to implement a Performance-Based Contracting system. These challenges include:

  • Pricing the contract correctly
  • Determining an accurate forecast of the customer requirements
  • Analyzing the financial risk of a performance-based contract
  • Managing suppliers
  • Tracking and managing performance against contractual metrics
  • Bad service data

In order to gain the efficiencies necessary to meet increasing customer requirements while boosting profitability, OEMs need technology to help them track, manage and execute competitive service contracts.

Summary: Service Pricing Must Incorporate the 'Risk Premium'

Pricing of Performance-Based Contracting and other service products remains the most significant challenge given the risks inherent in providing aftermarket services over the life-cycle of the equipment. The pricing problem is characterized by the presence of a high level of customer differentiation in both service requirements and the willingness to pay for those requirements. In order to mitigate the risks and effectively meet the needs of a highly segmented market, suppliers of aftermarket services typically define pricing that is contingent on the level of performance either promised or delivered, i.e. payment for system restoration response time or parts availability. Suppliers of aftermarket services also demand a risk premium from their customers. The quantification of that risk premium and the determination of mutually acceptable, service-differentiated prices for support remain a contentious issue.

Dr. Morris Cohen is Panasonic Professor of Manufacturing and Logistics at the University of Pennsylvania's Wharton School. He's also co-founder and chairman of MCA Solutions Inc., a company that specializes in aftermarket service parts planning.

John Nunes is the vice president of strategic consulting for MCA Solutions Inc. He heads the company's Strategic Consulting business to help clients develop and implement aftermarket and service supply chain strategies. www.mcasolutions.com

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