*NEWS* PROFITING FROM SPARE PARTS
*NEWS* PROFITING FROM SPARE PARTS
2005-03-27 at 10:21:00 am #11116
Profiting from Spare Parts
Some aftermarket parts businesses lack
the resources they need to raise their profitability and fend off low-priced
competitors. Others have these resources without knowing it.
supply of aftermarket parts is a $400 billion business that covers everything
from replacement toner cartridges to cruise ship engines . Sales of such items
are an important source of profit for companies that sell durable equipment.
Indeed, many of those in the Fortune 100 rely on the aftermarket for up to 40
percent of their profits. But these profits are under attack.
Competitors—particularly the low-cost Asian companies known as will-fitters—copy
and sell aftermarket parts at prices that original-equipment manufacturers often
can’t match. Meanwhile, customers are reducing the amount of inventory they
hold, buying non-OEM and used parts, refurbishing instead of replacing parts,
and, in some cases, creating their own. These developments are undermining the
traditional OEM formula for success: discounting the price of original equipment
and recovering lost profits by selling parts and services at higher margins in
Many OEM executives underestimate the size of the prize
available to well-run aftermarket businesses. Moreover, they don’t grasp that
their companies might already be in an excellent position to compete with
lower-cost producers. Compared with such rivals, OEMs often have much stronger
relationships with customers, better distribution systems, deeper engineering
resources, more advanced technical support, and superior quality assurance.
Despite the attractions of the aftermarket, many senior executives
underinvest in these businesses, thereby denying them the talent and management
time they need. In our experience, the problem is a bias that ties the identity
and financial priorities of many companies, as well as the morale of their
employees, to shiny new products rolling off the assembly line. This tendency
manifests itself in poor communication between the people who produce the
original equipment and their colleagues in the aftermarket. Although intense
competition and more sophisticated customers are here to stay, OEMs have tools
to defend aftermarket businesses and to improve their overall profitability.
Spare parts can be a great business in good times and bad.
Greater investment in an OEM’s aftermarket business can go a
long way to redress the balance. Consider an industrial-machinery manufacturer
that earns a 15 percent margin on sales of new products and 25 percent on
aftermarket parts. The machinery, which might have a useful life of 30 years,
consumes spare parts amounting to 2.5 percent of the purchase price annually. On
this basis, the product itself and sales of aftermarket parts represent the same
net present value to the company. Depending on the profit margin of the parts,
they could contribute even more. But with better management of the aftermarket
business, the company could increase its profits in this category by up to 25
percent—equivalent to raising the operating margin on new-product sales by 19
percent, something most OEMs would be hard-pressed to accomplish by other means.
Yet for many companies, the performance of after-market businesses is a
mere afterthought. Executives tend to have only a limited understanding of how
aftermarket sales contribute to profits and, as a result, miss opportunities to
link spare parts to the development or sale of original equipment. Moreover, the
executives who manage the aftermarket business are frequently left out of sales
and product discussions that reach decisions directly affecting its
profitability and its capacity for serving customers. The issue can be broadly
characterized as a communication gap. OEMs with healthy aftermarket businesses
know that communication between the units dealing with original equipment and
aftermarket sales is vital. Many companies, however, don’t understand the
relationship between the value of original equipment and of aftermarket parts.
The result is value-destroying behavior, such as the use of arbitrary
aftermarket discounts to sweeten deals for new products.
case of the sales force at a leading North American manufacturer of industrial
equipment. Under pressure to meet sales targets in a sluggish market, the
company offered too many spare parts as incentives to close sales involving
long-term contracts. Most of these deals were brokered in 11th-hour negotiations
that excluded managers from the businesses dealing with aftermarket parts.
Although the contracts included price escalation clauses, they were detrimental
to the spare-parts business in three important ways.
First, the terms of
the contract, which allowed the OEM to raise aftermarket prices by a certain
amount every year, prevented the company from pricing its parts against
competitors. To make matters worse, the price escalator was based on a
raw-materials index that corresponded poorly with the actual costs and risks the
aftermarket business was likely to face. Third, the aftermarket business had to
offer the prices set by these long-term agreements to a wider group of customers
that had already received lowest-price guarantees. Unsurprisingly, such lapses
cost the company millions of dollars in potential profits.
sales representatives can avoid this kind of problem by opening lines of
communication with their counterparts who sell original equipment and with
product-development teams. All sides should work together to consider the total
revenue stream that can be generated from the time original equipment is sold
until it is retired from the field. Older machines that consume large quantities
of high-margin spare parts and services, for example, could be more profitable
than the new ones with which the OEM sales force is seeking to replace them.
To preserve both income streams, OEMs can try to place their used
equipment with customers (such as companies in developing countries or,
sometimes, the customers of competitors) that aren’t likely to buy their new
equipment. Some OEMs upgrade or modify equipment even at the expense of new
sales: granting passenger airliners a new lease on life by converting them to
freighters, for example, can add decades of spare-parts revenues that otherwise
would be lost.
Often, technical resources flow freely to new products at
the expense of improvements to spare parts, regardless of their profit
potential. An aftermarket business might have only a small engineering staff
lacking the authority to alter specifications without the approval of the OEM
product-engineering group. In many cases, requests to redesign older spare parts
receive a low priority because companies regard the benefits as insignificant or
because implementing the changes seems too difficult given the installed base.
Competitors can exploit this kind of sluggishness to design and market
lower-cost alternatives that take advantage of new production technologies and
purchase new equipment only once every few years, but they buy parts all the
time. Thus the aftermarket business is one of the few constant connections that
customers have with a brand, and every interaction shapes their perception of
its value. The better the quality of (and the service for) aftermarket parts,
the better the brand image. OEMs that have good relationships with their
customers also benefit from the ability to gather valuable information that
helps them develop better products for both the original and the aftermarket
businesses. Most companies can improve their performance by being smarter about
how they segment aftermarket customers, by keeping parts up-to-date, and by
learning to price products or services more adroitly (see sidebar, “An
opportunity in aftermarket services”).
Many managers of OEM aftermarket businesses complain that it is hard to
compete with low-cost competitors that cherry-pick the highest-margin parts and
customers, as will-fitters do. OEMs frequently feel obliged to supply parts for
even their oldest models to protect their reputation, if nothing else. But there
are other ways for them to win, even given the constraints.
consumers of aftermarket parts don’t always rank price among the most important
considerations when deciding what to buy. In a recent survey1 of managers
responsible for purchasing industrial commodities, 64 percent of the respondents
identified factors other than price as the key influence on their decision. The
supplier’s reputation, the consistency of a product’s quality, the speed of
delivery, and technical support were most important to more than 40 percent of
the respondents. Once an OEM understands this truth, it can offer several
packages of parts and services, perhaps under different brand or package names,
at various price points and through a number of distribution channels. The key
to executing such a strategy is segmentation.
segment customers of their OEM businesses but tend not to apply the same rigor
to the aftermarket. Even when they do, they sometimes apply the same methods to
both groups. Yet the criteria for grouping customers when a company markets new
equipment might not be relevant when it groups the same customers in the
aftermarket. A customer highly focused on the acquisition cost when buying a new
piece of machinery, for example, could be less sensitive about the price of
parts and components in the aftermarket; other considerations, such as
reliability or the level of technical support, might hold sway.
aftermarket businesses don’t try to segment at all. One commercial vehicle
company in North America delivered the same level of aftermarket service—from
the time it took to develop a price quote to delivery times for parts—to all of
its thousands of customers, whether they were buying all of their parts from the
OEM or merely shopping around. The company decided to learn more about the needs
and buying patterns of its customers to ensure that only the best ones received
the highest level of service. Segmenting them enabled managers to create
tailored packages that provided clear service levels. Surprisingly, most
customer segments thought that service had improved, even where the level had
Keeping parts up-to-date
consistently update aftermarket parts prevent would-be competitors from
introducing their own higher-performing or lower-cost versions. True,
redesigning some parts might not make financial sense and could disrupt the
maintenance practices of customers. But there are often good opportunities to
improve the performance of a part in ways that benefit both them and the
manufacturer and to standardize replacement parts across models.
Consequently, an important element in updating parts is communication
with customers: However valuable a design change might be, unless the
manufacturer markets the improvement properly, they will see only the disruption
in coping with a different-looking part or a new part number. As a result, they
might continue to order the old part even after an updated version became
available, thereby saddling the manufacturer with the cost of building and
selling two parts instead of one.
Taking advantage of opportunities to
redesign parts and streamline catalogs can be particularly tricky for OEMs
making durable goods such as aircraft and power generation equipment, whose
designs might be decades old. Original drawings and engineering specifications
may be difficult or impossible to locate. By contrast, low-cost competitors are
likely to focus on a handful of parts they understand intimately—an approach
that enables them to offer compelling value. Customers might even view them as
having superior products and insight.
Getting the price right
Pricing aftermarket parts is another problem for OEMs. For one thing,
prices often reflect initial product design, testing, and other costs that
will-fitters don’t incur. Historically, OEM parts have set the upper price limit
in the marketplace, or a price umbrella. If the OEM tries to compete purely on
price, competitors follow suit, initiating a downward, value-destroying price
spiral. Many OEMs manage thousands of spare parts, which vary widely in price,
cost, and the frequency of orders. Some companies try to duck the task of
pricing individual parts by using a cost-plus model to set general expectations
for gross margins. This approach results in prices with no real relevance to the
parts’ potential value. At first, the time required to set prices might fall,
but OEMs that don’t understand the real value of their parts end up giving away
the store. Even in aftermarket businesses that manage thousands of parts, some
simple approaches to differentiated pricing can capture much of the value
available. One North American transportation manufacturer divided its parts into
three categories: those facing no, some, or heavy competition. The company then
tried to understand why its individual customers bought parts. Were they needed
for emergency repairs, in which case the customers were unlikely to shop around,
or were they purchased frequently, so that, as with milk, everyone had an idea
of what they should cost? The subsequent adjustments, which raised prices on
some parts and lowered those on others, improved the company’s gross margin on
aftermarket parts by no less than 30 percent.
Such an approach, however
simple, can require aftermarket businesses to bolster the data they gather about
their parts: they will need to know how components are used in the field, for
instance, and where competitors are making inroads. Often this information
already resides in the company’s field-engineering or customer support groups,
though a process for using the data to set aftermarket prices might be lacking.
Companies can add value not only by introducing differentiated pricing but also
by carefully reviewing and updating their supply chain and manufacturing costs,
particularly for older, infrequently ordered parts. One industrial company found
that it sold 5 percent of its parts at a loss because it had based its cost
estimates for them on out-of-date batch-manufacturing and inventory costs.
Raising only the prices of parts with negative margins increased the
profitability of the OEM’s aftermarket business by almost 10 percent.
EVEN top-performing aftermarket parts businesses usually have room to
improve, particularly in the way they link up with the OEM side of the company,
in how aggressively they pursue opportunities, and in their pricing strategies.
Such improvements can increase the profitability of aftermarket businesses, help
their customer relationships, and—given the time horizons of many such
businesses—contribute significantly to shareholder value.