Edition 46
Reduce Capital Costs by Performance-Based Contracts
by Jürgen Donders, Managing Consultant, Gordian Logistic Experts B.V.

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Between OEMs and operators of capital assets, there is virulent tension. The perception of huge margins on spare parts is an example for that. By so-called ‘Performance Based contracts’, this can be avoided. Jürgen Donders of Gordian Logistic Experts describes the opportunities that exist for both OEMs and operators.

Capital assets require large investments and therefore depreciation costs during their useful life. In addition, costs of maintenance and spare parts are significant. All these costs over the life cycle are part of the Total Cost of Ownership (TCO).

Between OEMs on the one side and operators on the other side, there is (still) a virulent conflict and therefore operators are confronted with too high costs. The perception of huge margins made on sales of spare parts is an example for that. Because of the apparent trend in which operators increasingly ask for so-called ‘Performance Based contracts’, there is movement in the existing situation. In ‘Performance Based contracts’, spare parts are no longer sold, but are one of the costs in maintaining the capital asset by a service provider (OEM or a third party). OEMs and sometimes even operators, see ‘Performance Based contracts’ often as a threat, while in fact there is a logical win-win situation. This article shows the opportunities that exist for both OEMs and operators.

Conflicting interests

The following figure shows the contradiction between OEM’s on the one side and operators of capital-intensive goods on the other.

OEMs strive for a low initial sales price and possibly for a not very reliable product. After all, there must be many years with a certain amount of after sales support, including spare parts, sold with high margins. Operators however, strive for low TCO. Investing more in the design, a higher initial purchase price as a result, will often lead to lower TCO by a reduced need for after sales support and spare parts.

In recent years, operators are more and more concerned with reducing the TCO of their capital in the operational phase. Although the largest amount of TCO is actually made during the operational phase of a capital asset, the size of this amount is already determined during the design phase. The figure below makes this clear.

When an operator starts projects to reduce the TCO of a capital asset in its operational phase, the potential savings to be found are very minimal. For the TCO to be really low, this must already be taken into account in the design phase.

Here we find a difficult contrast. The design is carried out by the OEM. The question is to what extent the OEM benefits from low TCO. If operators actually base their purchasing decisions on TCO, the OEM may be inclined to pursue this low TCO. In many cases however, there is an operator that is guided by a budget that is available for initial purchase. In these situations, an OEM therefore benefits by keeping initial development costs at a low level (which in fact provides a low initial sales price). An OEM also benefits from a design that is not so perfect, by selling more after sales support and spare parts in the future.

Performance based contract

Since operators are increasingly unwilling to invest in capital-intensive goods and maintain these themselves, there is an increasing need for results-based contracts in which an operator only pays to OEMs in proportion to the actual production delivered. For example, Rolls Royce delivers aircraft engines to airlines, which are only paid in proportion to the number of operating hours of the engine (Power by the hour contracts). In this situation, Rolls Royce itself has become responsible for maintenance, spare parts and asset management of its engines in use by its customers (airlines).

Because airlines now lease an engine based on a low hourly rate (of course given a certain confidence), the OEM is motivated more than before to achieve low TCO. In this way, achieving low TCO and the design are in one hand, where most can be done to influence the TCO. The OEM now benefits from a robust, reliable and low maintenance product with a low demand for spare parts that are as cheap as possible. The initial design costs go up, in favour of lower maintenance costs over many years and (thus) low TCO.

Opportunities and threats

If this is all so obvious and easy, why does Performance Based contracting not yet grow very rapidly in popularity? The following table tries to give more insight:

It is mainly the above-mentioned threats why OEMs and operators in many cases still are reluctant to move to performance based contracting. However, if all this above is taken into consideration, the reliability of capital goods will be greatly improved and TCO significantly reduced. The huge savings can be shared in a win-win structure between the OEM and operators. The OEM gets more business that generates more revenue while at the same time he gets to know its own capital goods better and better. The operator on the other hand can fully concentrate on its core business and is in a position to produce his products or services at much lower costs.
Jürgen Donders is managing consultant at Gordian Logistic Experts B.V. Gordian is a fast growing consultancy firm with a focus on service supply chain management. He has a background as an air force officer. In that role he served as a Logistics Manager and Engineer in several positions. In his last assignment within the air force he was the Squadron Commander of the 921 Logistics Squadron of Airbase Leeuwarden (F-16 Fighter base). Further he was responsible for air force logistics in the United Nations Mission in Ethiopia and Eritrea (UNMEE). He combined these activities with several master studies on procurement, transportation, production and inventory management.

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