Mutually beneficial? Replacement parts supply: opportunities for vehicle manufacturers and customers

by Karsten Platz, TEQPORT Services GmbH

Reverse Logistics Magazine, Jan/Feb 2008

In Part One of this article (RL Magazine November/December 2007), we explained that European manufacturers of railway vehicles cannot count on their new vehicle business to sustain long term growth in the future. We showed that establishing Vendor Managed Inventory agreements with their customers in the field of spare-parts sourcing may be a feasible strategy to ensure that manufacturers receive a substantial share of the spare-parts business. In this second of a 2-part series we will outline the ways in which vehicle operators can benefit from such a scheme.

VMI cooperation reduces the vehicle operator's capital tie-up costs

To answer this question it should be noted the material prices represent only one component in the overall cost of supplying replacement parts. As another cost pool, there are first of all the capital tie-up costs for the replacement parts held. To calculate these costs, the value of the average stockholding of replacement parts to ensure the operability of the vehicles in question must first be determined. The capital tied up in these replacement parts is no longer available for other investments. Therefore, the value of the replacement parts held must be evaluated using an imputed rate of interest geared to the minimum return on investment required within the company. It should be noted that these imputed costs are incurred over the entire service life of the vehicles in question. If the vehicle manufacturer takes over the stockage of the replacement parts, the operator no longer needs to finance the required pool of replacement parts. The capital required for this purpose is freed up for other uses. This effect can be felt as soon as a VMI project comes into force if it is agreed that the vehicle manufacturer buys back from the customer the replacement parts which the latter has procured prior to the VMI.

The vehicle manufacturer takes on the material demand planning risk

If he is obliged to stock replacement parts, the vehicle operator faces the attendant risk of material demand planning whereby he attempts to ensure a certain material availability. Whether this is successful depends on the quality of the operator's material planning. If this is less than optimum, the operator faces the problem of material bottlenecks and their consequential costs even if replacement part stocks are high.

In the best case scenario, in the event of bottlenecks at one storage location the operator will be able to circumvent the problem by transferring stock from other locations. However, this entails costs for transportation and materials handling, as well as for the accounting processes involved.

If material transfer is not possible, the bottleneck must be overcome by express orders which are more expensive than regular orders. Further costs accrue in this case due to the disruption of vehicle maintenance associated with the bottleneck. Here it is necessary to consider in particular the reduced workload of the employees who cannot continue working on the vehicle as planned and must be deployed elsewhere. If an express order cannot be fulfilled quickly enough, in some cases the vehicle affected by the bottleneck must be taken down and removed from the maintenance shop because the assembly stand blocked by it is needed for other vehicles. The VMI concept, on the other hand, guarantees the vehicle operator a contractually defined material availability. Within these availability requirements, material bottlenecks remain the manufacturer's responsibility and are subject to the agreed contractual penalties. In turn, the vehicle operator must provide the manufacturer with details of his medium-term planning for vehicle maintenance and overhaul and notify him promptly of any changes. With the aid of the known parts list structure and the operator's medium-term planning, the manufacturer can take a combined planning approach based on past consumption and planned estimates.

Figure 1
Cooperative materials management reduces the complexity of the supply network

Guaranteed availability allows the vehicle operator to predict vehicle maintenance delays caused by supply bottlenecks more precisely, which means that vehicle availability also can be more accurately planned. Under a VMI arrangement, the vehicle operator can therefore reduce his fleet of standby vehicles by the number of vehicles currently required to compensate for variations in the downtimes due to supply bottlenecks. If a level of availability greater than that already existing is agreed, a further reduction in the standby fleet is possible. This means that vehicles can perhaps be decommissioned or not even ordered at all. For this reason it is advisable to take the material supply concept into account even when ordering new vehicles.

Vehicle operator saves obsolescence costs

As the vehicle operator does not need to manage the replacement parts covered by the cooperation agreement, he is also exempt from the risk of these parts becoming unusable. Conventional shelf life problems are naturally somewhat rare in the case of railroad spares (with the possible exception of rubber seals). Nevertheless, it is possible that parts which, because of the requirements planning difficulties, have been purchased and stored in large quantities, may not be used within the service life of the relevant vehicle. In the best case scenario, the vehicle operator is able to sell these obsolete stocks at a slight loss or otherwise dispose of them. However, if problem materials are involved, additional costs may even be incurred for their disposal. This cost saving must likewise be taken into account when assessing a VMI project.

In response, industry is adopting Cradle-to-cradle or C2C approaches, aiming for optimal customer service, low cost and environmental friendliness (read carbon footprint) simultaneously. Now if waste = food then it might as well be raw material. In fact this is what Baumgart and McDonough are claiming.

Vendor Managed Inventory defers the start of the warranty period and simplifies warranty management

A possible saving that is perhaps less obvious at first sight is the deferred commencement of the warranty period for the replacement parts supplied. The warranty period normally begins with the delivery of a part to the vehicle operator. However, the part now often remains in storage until it is required. When it finally comes to be used, part or all of the warranty period will have pointlessly elapsed. If the part is then found to be defective when installed, the supplier of the part can no longer be held responsible. The operator of the vehicle is therefore faced with additional costs of procuring a new part and also for disposing of the defective part.

With the VMI concept, the replacement parts remain the property of the vehicle manufacturer until they are used, i.e. the warranty period does not commence until they are actually installed.

In many cases it is only through a VMI model that warranty claims can be exercised, as the storage date of a particular replacement part (identified by its serial number) is only rarely documented. If under these circumstances a replacement part is found to be defective when being installed or fails shortly after installation, it is difficult to know whether a warranty claim in respect of the replacement part is possible or whether the warranty has already run out. With the VMI concept, the storage date of the replacement part is immaterial to the exercise of warranty claims: if a part removed from storage is defective, it is automatically covered by warranty.

The extra charges for the cooperation must be financed by savings

From the rail operator's point of view, the difference between the additional costs arising from the service premium payable to the vehicle manufacturer and the abovementioned savings is critical for the profitability of a VMI project. The premium charged by the manufacturer is therefore the most important point of discussion when negotiating a VMI.

The size of the premium depends on the guaranteed material availability and on the agreed contractual penalties for noncompliance. Also critically important is the question of which materials must in the customer's opinion be kept continuously available, and in what quantity, at the place of consumption. This factor affects in large measure the vehicle manufacturer's scope for reducing the costs he incurs in providing the material: in the optimum case, the manufacturer is able to store most of the material destined for the customer at a central location, together with the materials for the production of new vehicles and for maintaining the leasing machines. Only the function-critical materials are then stored at the place of consumption, and in a quantity commensurate with one day's requirement including a small safety margin. This approach, also known as "geographic postponement" enables the manufacturer to combine the material requirements of the place of consumption with his own requirements. In the case of correspondingly low demand correlation, combining the individual demands results in a smoothing of the overall demand, as the variations in the individual demands cancel each other out (see graphic). Consequently, the safety margin maintained to ensure the desired material availability can be selected lower than the sum of the safety margins necessary for individually safeguarding the demand functions.

Figure 2
Combining demand from the customer's workshops and the manufacturing plant can result in a smoothing of the total demand curve

A large part of the possible savings relates to the guaranteed material availability. To calculate these savings, it is therefore necessary to calculate simulatively the inventories with which the rail operator would have to work in order to achieve, with his own resources, the material availability guaranteed by the manufacturer. In this context the material availability indicators to be used must also be agreed.

The evaluation of the replacement part inventories to be taken over by the manufacturer at the start of the VMI project generally constitutes another contentious issue.

In addition to the financial topics mentioned, there is also a need for clarification in organizational areas. For example, a physical separation between the materials managed by the manufacturer and the customer's other replacement parts must be organized. It is necessary to clarify which employees are responsible locally for issuing materials and for booking out materials removed and in which form such consignment stocks are to be shown in the vehicle operator's ERP system (Enterprise Resource Planning). The question of preventing procurement elsewhere of the materials managed by the manufacturer must also be addressed.

It is on resolving the above questions that the success of a cooperation project depends. In the interest of all parties, the VMI premium must be pitched in such a way that the vehicle operator can make reasonable savings, while the vehicle manufacturer generates substantial additional business. Lastly, in concluding a VMI agreement the vehicle operator enters into a certain dependence on the vehicle manufacturer. Due to a lack of own stocks for important replacement parts, the supplier could massively disrupt the railroad transportation company's operations if he should fail to meet his supply obligations. If the forecast savings on the part of the customer do not allow an adequate margin to be generated for the manufacturer, the project should not be entered into.

Karsten Platz is employed as Manager Business Development at TEQPORT Services GmbH, a Munich based ICT business solution provider. TEQPORT specializes in developing concepts for marketing pre-owned equipment.

Karsten studied business administration at Mannheim and Swansea University and served various internships, predominantly within the rail industry. Prior to joining TEQPORT, Karsten worked as a consultant on various railway-related projects at Barkawi Management Consultants. You can contact Karsten at Karsten.Platz@teqport.com.

Reverse Logistics Magazine, Jan/Feb 2008