Lucrative but "Risky" Aftermarket Business—Service and Replacement Parts SCM

The Business Challenge

Growing pressure to improve customer responsiveness and profits has lately changed the traditional role of service management for spare and replacement parts. As competitive pressures push more products to a commodity-like business model, many manufacturing companies are increasingly relying on customer service to retain or establish a competitive advantage. Many manufacturers and distributors are also beginning to recognize that there are significant revenue stream and ways to increase customer satisfaction in the aftermarket once their product has been sold.

The aftermarket has traditionally been a lower priority, a sort of "necessary evil" for many, particularly manufacturers, who historically view themselves purely as product companies where their brand new or well established products are "cash cows" consistently generating revenue for the company. However, the singular focus of developing and selling products ignores the fact that maintenance costs can easily be several times greater than the purchasing cost of the product. As a result, this additional revenue has often been left to various third party companies, such as third party parts, service, and repair providers.

Lately, the aftermarket is becoming a major driving force for many original equipment manufacturers (OEM) as opportunities are created when original parts include additional and often heavy customizations designed to ameliorate the operation and care of products and services. The value of the aftermarket is highly dependent on the type of product and the industry. In industries that sell capital equipment such as medical devices, telecommunications, instrumentation, information technology (IT) hardware and other complex equipment, companies are starting to significantly increase their focus on services revenue. For some companies this is a strategic move to increase the top line, while others are looking to replace revenue from slower new product sales in the current economic conditions.

Immaculate service has also been directly correlated to improved customer satisfaction and loyalty. Many manufacturers are discovering that maintaining account control of their customers and differentiating themselves from intense, global competition, means offering enticing and creative service, maintenance, repair, and warranty programs. Managing spare parts is a critical part of accomplishing this. Some firms like third party service providers even offer to manage the spare parts inventories of their customers, often with a consignment payment or vendor managed inventory (VMI) arrangement. In such arrangements the customer does not own nor is invoiced for the part until it is used.

General Electric (GE) is an excellent example of a company that has focused on aftermarket opportunities, going so far as to call itself a "services" company as opposed to a "products" company. GE has proved the value of serving the product aftermarket. It has been widely reported that the company has significantly increased both its total revenue and profitability by focusing on service opportunities in addition to developing world-class products,

APICS Dictionary (the 11th Edition) defines service parts (synonymous with repair parts and spare parts) as those modules, components, and elements that are planned to be used, without modification, to replace an original part. They differ from replacement parts, which are parts that can be used in place of original parts, after some physical modification (e.g., boring, cutting, grinding, or drilling). Likewise, replacement parts differ from interchangeable service parts. In any case, both service and replacement parts are delivered to end users by a diverse network of partners including OEMs, distributors, retailers, third party logistics providers (3PL), and other third party service providers. Also, for asset-intensive industries, asset owners might deliver these parts to various locations.

Associated with these are service parts demand, which is the need or requirement for a component to be sold by itself, as opposed to being used in production to make higher level products or finished goods. To that end, service part planning requires dealing with a sparse and certainly uneven, volatile demand. For example, two units per year, may be requested. It also requires dealing with supply chains that are much more complex than those in new product manufacturing, wholesale distribution, and retail, because knowing in advance when, where, or what kind of equipment breakdown (or any other reason for a service part requirement) will take place, is difficult for anyone (other than clairvoyant fortunetellers). Estimating typically low, yet highly stochastic demand; exploiting multinode opportunities to determine optimal safety stocks within the supply chain; incorporating parts substitution (e.g., interchangeable and rotable parts) and assembly options; and integrating repair streams with replenishment require quite different supply chain management (SCM) methods.

The challenge is having the right number of spare parts to meet demand. This is a precise process, because having too many parts will unnecessarily increase and tie-up investment, overhead, and other inventory carrying costs; however, having too few parts will impede swift replacement and contractual service level agreements (SLA). Inventory carrying cost (synonymous with holding cost) is the cost of holding inventory, usually defined as a percentage of the dollar value of inventory, per unit of time (generally one year). Currently, the technology component within parts, such as programmable logic memory chips, has increased and has changed the parts cost structure. Namely, stock items with embedded expensive technology can each cost a thousand dollars or more. Consequently, associated inventory carrying costs have increased to the point where intelligently planning parts inventory has become a financial necessity for many enterprises.

Carrying cost depends mainly on the cost of the capital invested and of maintaining inventory. These include taxes, insurance, obsolescence, spoilage, and space occupied, and cost between 10 percent to 35 percent annually, depending on type of industry. Carrying cost is ultimately a policy variable reflecting the opportunity cost of alternative uses for funds invested in inventory. Storage costs is a subset of inventory carrying costs, including the cost of warehouse utilities, material handling personnel, equipment maintenance, building maintenance, and security personnel.

This is Part One of a four-part note.

Part Two will discuss the changes in service and replacement parts.

Part Three will continue analyzing service parts planning.

Part Four will cover players and benefits and make user recommendations.

More Complications

Further, holistic service and replacement parts supply chains should provide support to end users of serviceable products via several channels, including

• call centers (with necessary information on hand and call-in assistance for self-service);
  
• available service and replacement parts, where and when required;
  
• field service or after-sale service (the functions of installing and maintaining a product for a customer after the sale or during the lease, which may also include training and implementation assistance); and
  
• provided carry-in service support (service centers/repair depots).

Therefore, service or spare parts have lately become both a blessing and a curse for many manufacturers of complex finished products. On one hand, contract manufacturing, maintenance repair and overhaul (MRO), depot repair activities, and aftermarket service parts and sales can generate additional revenue streams with higher margins (even at multiple levels of original product sales). They can also contribute significantly to corporate profits and thus offset typically lackluster growth in other mainstream operations. Yet, on the other hand, these companies must maintain large inventories of highly expensive, often slow-moving parts. At the same time, they are dangerously susceptible to obsolescence, as they satisfy customer demands for immediate delivery and action. Shrinking margins are placing greater pressure on all manufacturers to operate with leaner inventories (including spare parts) throughout their complex supply chain networks. At the same time, many enterprises are realizing that a good way to increase margins is to offer MRO services. In fact, a number of high tech and electronics companies make the most of their profits from repairs and upgrade kits. Industrial equipment manufacturers often earn more than half of their gross margins on complex spare parts, without incurring much sales costs (given that most equipment users are captive audiences for spare parts anyway).

Additionally, the need for better service parts management is finally gaining top-level management attention in many aerospace and defense (A&D) companies, and in similar complex manufacturing or asset intensive industries, including automotive, high tech/electronics, medical equipment, office equipment, specialty equipment, telecommunications, utilities, etc. The basis for this new found interest is that excessive inventory carrying costs and obsolescence losses are now being recognized as an unexploited opportunity for savings and a means to better bottom-line performance. Companies with extensive spare parts needs include manufacturers that service products (e.g., IBM, Philips Medical, Nortel Networks or Cisco Systems), provide parts for dealers or others to service products (e.g., Ford, Nissan, or Boeing), or own a large number of assets which they maintain themselves (e.g., United Airlines, US Airways, DHL, Delta Air Lines, or FedEx).

With increased customer demand for a quick response, often within hours, manufacturers, and service organizations must plan inventory to proactively respond to changes in customer requirements or material availability. Many manufacturers and service organizations have service contracts with their customers to provide service in a fixed amount of time, often in as little as two to six hours with guaranteed parts, and service technician availability across the globe.

To further complicate things, product lifecycles are becoming shorter to better accommodate ever-changing customer demands, which has further muddled the challenge of weeding out obsolete parts. In many cases, it becomes necessary to know, for example, which and how much equipment have extended warranties in a particular region in order to allocate the appropriate number of discontinued parts in regional and satellite warehouses, or to determine if substitute parts can be used. Also, increased equipment uptime and guaranteed parts availability are directly correlated to higher customer satisfaction, as customers increasingly demand reliability and responsiveness.

The move to just-in-time (JIT) and demand-driven manufacturing styles makes equipment uptime even more critical, as many enterprises can no longer afford large and costly inventory safety stock buffers and risk complete production line shutdowns if repair parts are not available when needed. Moreover, customers expect equipment, appliances and so on, to be restored on the first visit instead of having to wait for replacement parts to be ordered. Thus computer and appliance service firms have long introduced "swap and replace" programs rather than asking customers to wait (seemingly endlessly) for their equipment to come back from the repair shop.

Ultimately, the quintessential business challenge is to minimize downtime on assets while minimizing the cost of spare and replacement parts inventory. To meet these challenges, heavy investments have been made in extensive spare and replacement parts networks. Here, inventory is staged at central or regional supply centers, local maintenance shops, or field service centers and even in the trunk of service technicians' cars and vans. Multilevel and multi-echelon inventory locations are critical to the balance between rapid part availability and curbed inventory cost. For instance, it makes more sense to deliver some parts from a second or higher tier rather than from the central warehouse, whereas expensive items or slow-moving non-critical ones should often be better held at central locations to reduce the overall safety stock carrying costs.

This concludes Part One of a four-part note.

Part Two will discuss the changes in service and replacement parts.

Part Three will continue analyzing service parts planning.

Part Four will cover players and benefits and make user recommendations.

About the Authors

Olin Thompson is a principal of Process ERP Partners. He has over twenty-five years experience as an executive in the software industry. Thomspon has been called "the Father of Process ERP." He is a frequent author and an award-winning speaker on topics of gaining value from ERP, SCP, e-commerce and the impact of technology on industry.

He can be reached at Olin@ProcessERP.com.

Predrag Jakovljevic is a principal analyst with TechnologyEvaluation.com (TEC), with a focus on the enterprise applications market. He has nearly twenty years of manufacturing industry experience, including several years as a power user of IT/ERP, as well as being a consultant/implementer and market analyst. He holds a bachelor's degree in mechanical engineering from the University of Belgrade, in the former Yugoslavia, and he has also been certified in production and inventory management (CPIM) and in integrated resources management (CIRM) by APICS.