Pricing of Risk in Product Service Systems

Apr 13, 2019 • FeaturesFuture of FIeld ServicemanufacturingRisk ManagementShaun West

Increasing competition and complexity of product selling put firms under pressure to add value, so many firms are moving towards delivering service solutions and outcomes. Traditional manufacturing companies are often strong with risk-management process on the product side, however they fail to grasp the complexity associated with managing risk on the service side, here Dr. Shaun West and Victoria Paytova of Lucerne University offer their insight into these challenges. 

 When a supplier decides to provide more than just product-related services it has to consider risk over the whole product life-cycle because the risk is no longer just a “warranty”.

Traditional manufacturing companies are often strong with risk-management process on the product side, however they fail to grasp the complexity associated with managing risk on the service side. Based on the interviews with fourteen companies operating globally and domestically in different fields: from power generation to food industry, this paper introduces their insights on risk awareness and evaluation in services.

Some companies produce high capital goods and services constitute the part of the product-service portfolio; others offer purely services; their annual revenues vary from millions to billions. Another aspect is that some of those are pioneers in service provision rather than others already have long experience in the service business. So, we can classify them by the percentage of service sales: three companies with service sales up to 25%, five companies indicate service sales between 25 and 40%, and four firms provide purely services (100%); also, two respondents present opinion on risk from the customer perspective.

Industrial feedback on risk in services revealed that service providers neither recognise risk as a competitive advantage nor actively implement risk management practices into service offer creation. This white paper provides guidance on how to understand and manage risk to create competitive advantage in a product service system environment.

Risks From An Asset Life-Cycle Perspective
Risk should be initially considered on an asset life-cycle perspective. (See Figure 1.)

Fig 1_Typical-risks-over-the-asset-life-cycle

Today a well-documented example is the Rolls-Royce Trent engine, the turbines of which fail to meet the operational performance due to poor design. The deterioration of turbine blades inside Rolls-Royce jet engines has required constant monitoring of the engines, urgent maintenance and repairs through 2022.

The problems have caused serious disruption to airlines — and they are proving costly to the engine-maker. Rolls-Royce reported an accounting charge of $315 million to cover ongoing repairs to two models of its jet engines it has supplied for more than 200 aircraft as well as compensation to airlines for planes taken out of service for the engine retrofits.

Which confirms the fact that issues at early stages cause significant risks and endanger not only product performance but also the reputation and financial stability of the service provider.

Service offering and embedded risks
In order to see what particular services industrial companies offer we analysed 14 firms. The analysis confirmed that in general there was risk transfer from the basic services to the more advanced services. A variety of services can be built-up in product-service portfolios depending on company’s ability and readiness to deliver good service, risk acceptance, as well as the type of relationships service provider wants to establish with a customer.

The analysis also showed that they provided three different levels of service: product services, operations support services, life cycle and asset support services. The typical services in each level are shown in Table 1 (below) and have been categories based on the service level.

Table 1_ From-basic-to-advanced-services

I. Product services – represent services which are closely associated with a product or to help the customer to gain access to it, often mostly associated with the maintenance of the equipment.

II. Operations support services – represent services that support the operation of the equipment provided.

III. Life-cycle/asset support services – support the product over its life; they are designed to ensure good asset performance and to help to improve performance based on new technologies and market requirements. When building a portfolio of products and services, companies should consider risks over the product life no matter whether it is basic or advanced service

The execution risks will continue to repeat unless effective control and improvement measures are put in place. The statistical information on the failure rates will support the understanding of the commercial risks ensuring that they reduce the negative impact.

Finally, if it is not tracked, how do you know where the problem is, the root cause and how to best solve it in future products?

Execution and Commercial risks
This white paper breaks risks into two closely related categories, the first is execution risk and the second is a commercial risk. Execution risk is the additional cost that the firm has due to execution failures and closely associated with service delivery, includes internal and external quality problems, late completion, or post service failures due.

For example, the late delivery of a small consumable item can mean that inspection work on the machine cannot be completed on time. This can then trigger commercial risk to come to play which could be many times larger than the cost of the consumable item.
The commercial risk can be made by the supplier at the contracting stage, such as unsuitable contract decisions, typically firms overpromise performance (delivery, availability etc.), or have unsuitable agreements for services. These are often related to the execution risk (e.g., late delivery) and can be significantly higher in value (e.g., liquidated damages resulting from the late delivery).

This is shown graphically in Figure 2 (below) where the supplier’s liquidated damages never cover the customer’s risk fully, this is because the customer’s business risk is typically orders of magnitude greater than those of the supplier.

Figure 2
Therefore, the customer needs to either self-insure and to buy insurance to cover their full consequential and business interruption costs. The supplier should always consider the full impact it can have on customer’s business because the liquidated damages will likely only cover a part of the customer’s losses.

The use of risk/reward-type performance commitments should incentivise the supplier to achieve the right outcome for their customer, it is not a replacement for insurance.

Understanding Risks
At each stage from the beginning, different risks may unstable internal processes, increase the time to the market and affect future performance of the product. For example, poor reliability of a part decreases the overall reliability of the product, consequently, the supplier under a basic after-market service holds minimum risk and only responsible for the replacement of the first failing part under warranty.

Under an advanced service agreement (performance/output-base) the supplier is responsible for removing and replacing the part as well as paying the liquidated damages for poor performance due to machine downtime because its customer has a revenue loss.
So, the supplier is not only exposed to execution risk but also to significant commercial risk: it has to pay the liquidated damages meaning customer is partly compensated for the loss of performance. Interviews confirmed that risks rise both at the service contracting stage and at the delivery stage, so they refer to commercial risk and operational (execution) risk.

It is common for manufacturing firms to have well defined contracts for new equipment sales whereas service contracts may be less appropriate for the service environment, being more applicable to the sale of basic rather than advanced services.
It is very challenging for contract or project managers identify and measure potential risks and create sort of standardised approach for risk assessment.

Their role is to determine the risks that customers expect them to take with service contracts as well as evaluate the critical risks that they finally accept. The deep understanding of the customer, awareness of your capabilities can decrease the lack of information and associated counterparty risks.

The supplier can actually create competitive advantage by building an active model for risk management. Understanding the risk implies that service provider can identify and measure the risk it transfers from the customer.

Calculating the Value at Risk
Only knowing the possibility of risk appearance does not solve the problem, more important is to know the frequency of events, its execution and commercial impact. Digitalization can help here in the form of data analysis of performance (e.g., lead times, number of failed starts, output), so the firm should create a database that allows the supplier to model and predict risks. By collecting and analysing data on product design or manufacturing issues, failure rates and time (logistics or maintenance completion), the supplier also knows what must be changed or improved as well as understanding the cost of mitigation. Statistical analysis helps service providers to understand better their capabilities and to control risks.

Figure 3
The Value at Risk (VaR) concept is defined as an expected maximum loss of the risk position and it is widely applied in the finance industry. For example, we take the planned maintenance and the issue would be late delivery of parts which was promised at 26 days.

From the past (data analysis), we have to find out what is our actual lead time and deviation from the ‘expected’ lead time. Form this we can calculate the expected execution cost and predict the commercial impact based on the lead time.

The total risk is the position valued at current prices, in our case is the total execution and commercial, from which we can define the expected maximum loss.

The higher the chosen confidence level is, the higher the potential maximum loss. From these principles and calculations results drawn from the concept, the VaR of individual risk position can be derived.

This analysis will help the supplier to decide on what delivery terms, performance commitments or other KPIs they can provide as well as calculate the commercial value of the contract with particular services.

Answers to these questions also will tell what liquidated damages to expect for availability, reliability, efficiency and late delivery if supplier choses terms that do not correspond to statistical analysis.

Pricing the risk
Now that we understand the value at risk, it is important to price the risk. This is because you are taking risk from the customer and you are therefore providing a valuable service for them. How can this additional service be priced? First, the price should be above the cost otherwise you are not getting a reward for taking the risk! Questions to ask yourself when estimating the ‘fairprice’ to charge:

• What are the customers critical performance measures or outcomes?
• How much would it cost the customer to take the risk themselves?
• How much pain are you really taking from the customer?
• Is the gain/pain sharing balanced?
• What do you think is their ‘willingness-to-pay’?

Do not accept to hold a risk where they cannot control or mitigate the risk, taking market risks is not a sure-fire way to go out of business. Finding a balance with the risks so that you are incentivised to improve performance and outcome for the customer is nevertheless difficult but something worth doing.

Learn from past experiences, the RR example with the Trent engine was predictable as were the costs. Recommendations Firms should consider how they assess risk for product service systems, this is practically important for advanced services. It is recommended to measure execution and commercial risks for every project.

Learning to track the events that cause both execution and commercial risks will help you to better understand the risks and the costs associated with them.

By being more proactive in risk management, industrial firms can turn the risk into commercial advantage.