From Cost to Profit: Service Parts Logistics

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Some companies pay little attention to service parts logistics. Others are tapping its potential to increase revenues and reduce operating expenses. Here's how to transform your service parts operations from a cost center to a profit-driven business.

Supporting products in the field can be a matter of life or death for Toshiba America Medical Systems. The Tustin, Calif.-based company manufactures sophisticated diagnostic imaging equipment in five modalities—CT, MRI, X-ray, ultrasound, and nuclear medicine. It's Toshiba America's job to market, sell, and support these products in the United States.

"Our customers—large hospitals, trauma centers, urgent care facilities—use this very expensive capital equipment to treat patients," says Thomas R. Greer Jr., director of services logistics management for Toshiba America. "If these systems go down, patients' lives may be at stake. That creates a unique set of service pressures for us, and we need to respond to them immediately."

For Toshiba America's other customers, non-emergency imaging centers, product support is just as important, albeit for a different reason.

"These centers typically are owned by entrepreneurs who have invested millions of dollars in our equipment," Greer says. "Their return on that investment is based on patient throughput. When a system goes down, they lose money—potentially thousands of dollars per hour."

Toshiba America must meet these two sets of service obligations while managing costs. "With million-dollar machines, many of the parts are expensive and we can't afford to stock everything locally," explains Greer. "We have to be more scientific in our service parts stocking strategy, deciding where to stock high-volume, high- failure-rate items; critical items; and low-demand parts. We have to decide where to take risks with our inventory, and where to play it safe."

Like Toshiba America, Subaru New England (SNE), an independent distributor for Subaru automobiles and service parts, struggled with inventory. Several years ago, the company was carrying $14 million in parts, but providing a same-day fill rate of just 70 percent at its parts distribution center. SNE knew it needed a way to more effectively manage its service parts logistics business.

Both companies' paths to improvement illustrate the profitability potential that best-in-class service parts logistics strategies offer. In the late 1990s, Toshiba America used a customized MRP system to handle service parts demand forecasting and inventory management.

"The system was really designed to address manufacturing," says Greer. "It couldn't look at the entire country and make parts demand forecasts, and it couldn't plan distribution to locate parts near the customer."

Meeting Up-time Levels

In the medical products industry, companies typically contract with customers for a certain level of up-time—95 percent to 98 percent availability outside of scheduled maintenance periods. "If we don't meet the contractual service levels, penalties kick in," says Greer.

"In order to meet our customers' service performance requirements with our old system, we were carrying a lot of extra inventory."

Greer and his team needed a more efficient way to handle service parts logistics. The company decided to invest in a service parts logistics software solution, and in April 2002, chose Atlanta-based software company Servigistics.

Today, Toshiba America uses the software to forecast service parts demand. "We apply different logic depending on the age of the product that a part supports," Greer explains. "If the product is new, or is being sold with a rapidly growing installed base, we apply factors that take growth into account. For products with a more stable profile, we use historical data to forecast demand. And for products in the declining stage of their lifecycle—they are being uninstalled or replaced—we factor a decline projection into the demand equation."

Toshiba America saw immediate improvements in its service parts logistics after implementing the software. First-pass fill rate increased significantly, and improvements in inventory turn rates exceeded expectations. As a result, payback on the solution was much faster than predicted. And the company no longer has to replace service parts planning personnel who leave through attrition.

Thanks to the service parts management system, Toshiba America's inventory planners spend more time being proactive. With a new product launch, for instance, planners can monitor what parts the equipment starts to consume.

"We relay this information to our engineers in Japan, who can institute design changes to correct problems, and help prevent failures on future machines," Greer explains.

Toshiba America's products are now rated best-in-class by industry monitoring groups. The rankings are based on criteria such as equipment reliability and service response. "While I can't say our service parts logistics system is the sole reason for these high scores, I believe it plays an important role," Greer says.

Like Toshiba America, SNE decided to invest in a service parts logistics management system, and selected Servigistics. In an initial 10-week implementation, Servigistics analyzed order data and inventory processes at SNE's warehouse to pinpoint which parts were frequently out of stock and which were oversupplied.

Based on demand analysis, the software vendor adjusted SNE's orders to the Subaru factory and to suppliers in Japan. The change enabled SNE to cut inventory down to $6 million and, at the same time, improve same-day order fill to its 62 dealer customers to 98 percent.

Improving Fill Rates

But SNE wasn't content with those results. "We wanted to cut inventory and improve fill rates with our dealers," says Bryan Klugh, vice president of fixed operations at SNE. "At that time, a typical dealer had anywhere from two to three months of inventory supply, some even higher. But because we ship to dealers daily, in a perfect world, they shouldn't need more than one day's inventory.

"More realistically, though, we thought dealer inventory could be cut to a one-month supply," Klugh says. "We implemented a system for electronically extracting inventory data from our dealers every night. We brought those numbers into the service parts system, then sent dealers suggested parts orders the next morning."

At first, the dealers balked at "having the factory tell us what to do," Klugh says. So, SNE offered an incentive.

"We offered to double dealers' inventory turns, target one month's supply, and save them money on the shelf," Klugh says. "To back this up, we promised dealers if a product didn't sell within six months, we would take it back at the current price. We also offered to monitor the aging of their inventory, and handle returns automatically."

Since launching the dealer inventory management program, more than 99 percent of the parts SNE ships to dealers do not come back.

"Ninety percent of the time, when customers take their cars to a Subaru dealer and need a part, the dealer has the part there. That number used to be closer to 60 percent to 70 percent," says Klugh. "At the same time, dealer inventory has been cut by 50 percent, and the dealers love that."

Not having a repair part at the dealer when a customer needs it has significant repercussions. The dealer or manufacturer may have to provide customers with a rental car if the vehicle is under warranty. Or, if the dealer has to order the part, customers may have to come back again, which could drive them to a competing service shop.

"If the dealer takes care of the problem when the customer is there, the customer doesn't need to return for another 5,000 miles," says Klugh.

The idea that service parts management represents a profit-making opportunity isn't new. Companies have known this for years. What is new, however, is the fact that a growing number of corporations realize that service support profits improve in direct correlation with how well service parts logistics is managed. The Toshiba America and SNE case studies clearly illustrate this fact.

"Durable goods manufacturers are waking up to the fact that they may only achieve 25 percent of revenue from service, but service can be more than 40 percent of their profit," says Eric Hinkle, CEO of Servigistics.

As a result, leading companies have shifted service from a cost center to a profit-driven business. This shift fundamentally changes the service/support business.

"In 1981, when I worked for Xerox, we spent as little as we could to meet customer needs," says Ed Wodarski, vice president of marketing and strategy at Xelus Inc., a service parts logistics software developer in Fairport, N.Y. "Contrast that with Dell today

—Dell has revenue and profit targets for its service business, and invests in marketing and growing the business."

"Traditionally," explains Steve Aschkenase of Deloitte Consulting, "manufacturers assumed that if you sold the initial product to a customer, you would also sell them parts and service for the life of that product. They thought they were entitled to those additional sales and profits. They also believed the service business could basically run itself, so companies didn't put their best people in those positions."

Competition has changed that. Original equipment manufacturers (OEMs) now vie for customers' service support business with a host of competitors. In addition, customers are more empowered today.

"Maintenance contracts traditionally were signed with no performance commitment from the supplier of service, and no penalty for poor performance," Aschkenase says. "Today, customers drive the terms and conditions of their maintenance contracts. They may specify four-hour response time, or demand 99 percent up-time on a piece of equipment."

Complexity and Information

"Service parts logistics management for manufacturers is actually more complex and challenging than traditional supply chain management," says Mary Bell, chairman and president of Caterpillar Logistics Services, a third-party logistics service provider specializing in service parts logistics. "The lifecycle for service parts is significantly longer than for finished products, so more SKUs need to be managed.

"When building a new vehicle, for example, there may be 8,000 new service part items," she says. "When you're supporting 25 years of various models, the number of SKUs increases to several hundred thousand. And demand varies widely from part to part, driven by product failures that are hard to predict and control. You can tie up a lot of working capital on non-moving inventory."

Forecasting spare parts demand is a huge challenge. "Typically, the demand for service parts is very slow," says Krish Srinivasan, strategic services division senior manager, Caterpillar Logistics. "In the auto industry, 40 percent to 50 percent of parts sell less than 12 units per year. As a result, typical forecasting techniques don't work."

To plan and manage the complexities of a service parts business, companies need visibility into end customer demand.

"If the service parts supply chain is all about optimally matching actual customer demand with supply, then the big benefit comes from knowing what the dealer is selling," Aschkenase explains. "If we only know what the dealer orders, we don't have a true picture of end customer demand. We can only make assumptions. We want visibility as close to end demand as we can."

The need for visibility, the sheer number of SKUs, the variability of demand, and the random nature of service parts inventory requirements make service parts logistics very information-intensive. Most companies, however, manage the business with cobbled-together information systems.

"Service parts logistics management solutions are very different from manufacturing or finished goods inventory management solutions," says Mike Landry, founder and chief technology officer of Servigistics. "Inventory management strategies and targets are defined with asset up-time or part availability. To optimally order, move, and position inventory to meet the service goals with minimal cost and capital, the mix of parts, echelons, and locations

—as well as the way they relate to the service strategy—must all be examined.

"Understanding and addressing variability is the key to predicting demand and lead time in an environment that is stochastic, erratic, and often low volume," he adds. "Companies that understand and address these unique requirements will deliver the best service with the best financial results."

Demand and Fulfillment

Forecasting demand and managing inventory are the twin linchpins of service parts logistics. When looking at forecasting in general, two types of demand are considered—dependent and independent. Dependent demand is directly tied to planned repair, Srinivasan explains. If an auto repair shop, for example, plans to replace tires in 1,000 cars, and each car needs five tires, dependent demand is 5,000 tires. Simple.

"Independent demand is harder to predict," Srinivasan says. Independent demand is generated by product/parts failures. Traditionally, most companies viewed service parts demand as independent, which is not necessarily the case.

"A portion of service parts demand is actually dependent," explains Srinivasan. "A major undercarriage overhaul in a Caterpillar tractor, for example, typically requires 70 different parts. The dealer can predict how many tractors it will repair each month, based on its knowledge of customer usage and parts lifecycles. With this information, the dealer can predict the number of tractor undercarriage parts it will require, procure the parts, and keep them out of the independent demand forecast."

In servicing this demand, companies deploy two basic types of order fulfillment strategies—facing fill and search fill. "Facing fill means filling parts orders from inventory on hand at the location nearest the customer," Srinivasan says. "With search fill, manufacturers must search the DC network for the part to fill the order.

"Different companies have different strategies for managing demand. Some companies focus on increasing their facing fill, getting the part quickly for example. They may want 95 percent facing fill from certain key distribution centers, and 90 percent from others. Or, if they know customers are happy with 80 percent facing fill, they can operate with high levels of search fill. In that case, they achieve a better inventory management profile," he adds.

Naturally, companies must balance service levels with inventory cost. The goal usually is achieving the best service level with the best inventory turn rate. But inventory carrying cost has to be balanced against total supply chain cost.

"You may have a high rate of inventory efficiency but spend too much on transportation," Srinivasan says.

Service parts inventory management involves recognizing and juggling all forms of inventory. "You need a system that will permit old parts to be consumed before new, or manage consumption of remanufactured parts versus new, depending on customer requirements," Srinivasan says.

"The underlying theme in service parts logistics management is inventory visibility across your entire network," says Landry. "You need to know how much inventory is sitting on the dock, or in the warehouse, and how much is in transit."

Room for Improvement

Service parts logistics represents a huge opportunity for improvement at most companies. "Service can add substantially to shareholder value," write C. Edwin Starr, David J. Standridge, and Brian M. Sprague of consulting firm Accenture in Service Management: Turning Service into a Growth Engine. In fact, over time, service may actually contribute more to earnings than sales of the product do.

The majority of organizations still manage this part of their business in fire-fighting mode, scrambling to react to service problems as they pop up. Service is viewed primarily as a cost center.

This approach contrasts starkly with that of the service logistics leaders who manage service as a growth engine and profit center.

"These companies leverage service to generate new business and drive revenue," says Servigistics' Hinkle. "They collaborate extensively with dealers, distributors, and other supply chain partners. They conduct proactive market planning, analyze contract and new business profitability, and devote sales and market resources accordingly. They focus on pricing optimization."

Turning service into a growing profit center requires a shift in focus. Everything a company provides after the sale—spare parts replacement, professional services, help desks, warehousing, product recalls, and field technicians, among others—needs to be managed as an integrated whole.

"A company that institutes a first-rate service management capability can increase its service revenues between 10 percent and 20 percent," says the Accenture article. "Moreover, by making its service functions more efficient, a company can reduce operating expenses by 15 percent to 30 percent.

"Finally," the article explains, "the knowledge gained by the service organization, which is in constant contact with the company's customers, can be fed back into the manufacturing organization to help it make better products. And better products translate into a 10 percent to 20 percent reduction in warranty expenses.

"In addition, because fewer faulty products will be sold, the company will not need to field-test as much equipment, which can help reduce capital expenditures by anywhere from 10 percent to 25 percent."

It may be time for your company to discover the hidden opportunities in service parts logistics.

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