In July of 2017, the consulting firm McKinsey & Company concluded a study of Original Equipment Manufacturers (OEMs) across 30 industries. The study found that these OEMs achieved an average earnings-before-interest-and-taxes (EBIT) margin of 25 percent on sales of aftermarket parts and services. That compared to a margin of just 10 percent for new equipment sales. The 15 percentage-point gap between aftermarket and new equipment spotlights a market opportunity. Manufacturers can build much stronger recurring revenue models based around robust parts and services contracts, more lucrative in many cases than a primary reliance on new equipment sales.
As many industries endure falling prices and uncertain growth trajectories for new equipment sales to emerging markets, executives at many of the industrial giants are taking a harder look at the auspiciousness of core aftermarket parts and services, which are generally comprised of:
Spare parts planning
McKinsey & Company advises that to gain a clearer understanding of total revenue and profit potential, manufacturers need to complete a detailed analysis of the lifetime value of aftermarket services contracts. This includes an accounting of total potential revenue from long-term contracts with the installed base, existing and projected. This calculation, which is often figured per product line, is a more accurate proxy for aftermarket value potential than other commonly used metrics, such as existing services revenue per customer.
Buyers: Measure your spare parts categories
For equipment buyers, two of the most popular methods for determining optimum spare parts inventory levels are related to the Pareto Principle, also known as the 80/20 rule; 80 percent of results stem from 20 percent of inputs (or vice versa).
The first method is the ABC method, which involves a review of your parts inventory, and a categorization as follows:
- A parts make up about 80 percent of all parts used, but account for 20 percent or less of inventory stock.
- B parts make up about 25 percent of usage, but account for about 30 percent of inventory stock.
- C parts make up about 5 percent of usage, but account for about half of the inventory stock.
The other main method for measuring inventory is the XYZ method. This looks at costs rather than inventory composition. Once again, following review of the inventory, items are categorized as follows:
- X parts make up about 80 percent of inventory value, but account for 20 percent or less of inventory stock.
- Y parts make up about 25 percent of inventory value, but account for about 30 percent of inventory stock.
- Z parts make up about 5 percent of inventory value, but account for about half of the inventory stock.
OEMs: Identify your key spare parts buyers
When looking to increase profits through aftermarket parts and services, you must first identify your top quintile parts and services buyers. Using the results of ABC and XYZ methodologies, and finding your key buyers, allows you to plan your strategy effectively. For example:
- Which parts and services are used most often?
- What is their profit margin?
- How can you most cost effectively structure your long-term services contracts around them?
How Vanguard Software can help
Vanguard Software makes applications that automate forecasting, inventory optimization, sales and operations planning (S&OP), and Integrated Business Planning (IBP) with full financial integration.
Vanguard IBP for MRO is a cloud inventory platform that automates forecasting while applying advanced analytics to derive trends, patterns, and probabilities from even the most intermittent of demand sets. Vanguard’s advanced analytic tool set includes Croston’s intermittent demand model, as well as more advanced Monte Carlo simulations for probability modeling. All of this helps users improve margins and service levels while reducing stocks-outs and net carrying costs.