Industrial economics and operations: installed base, OEE and make or buy
Why services can earn most of the profit, how to measure a factory with OEE, how to decide whether to make or buy a part, and how the tiered supply chain works.
Industry brief, with a one-minute summary: Industrial manufacturing and aerospaceKey takeaways
- In industrial companies, a small share of revenue from services can earn a large share of profit, and a factory usually loses output in three places: stops, slow running and defects.
- Tiered supply base: a final assembler depends on tier 1 suppliers of systems, which depend on tier 2 and 3 suppliers of components, castings, forgings and raw materials.
- Long lead times: some parts take a year or more to make and must be certified, so switching suppliers is slow.
- Production systems: most plants use lean methods (remove waste, level the flow, fix problems at the source) and track OEE, lead time and on-time delivery.
Key idea
In industrial companies, a small share of revenue from services can earn a large share of profit, and a factory usually loses output in three places: stops, slow running and defects. Measure them before you fix them.
Worked case
How much of the profit comes from the installed base?
The prompt
Ironfield Machines (a fictional company) sells 1,000 mining trucks a year at USD 250,000 each, with a 10 percent operating margin. It has 10,000 of its trucks working at customers. Each truck needs about USD 20,000 a year of parts and service, and Ironfield wins 60 percent of that spending at a 35 percent margin. How much profit comes from new trucks and from the aftermarket?
The structure
- Profit = new equipment profit + aftermarket profit
- New equipment profit = units x price x margin
- Aftermarket revenue = installed base x spend per unit x capture rate
- Aftermarket profit = aftermarket revenue x margin
Working it through
1. New truck revenue
1,000 trucks at USD 250,000.
New equipment revenue (USD million):1,000 × 250,000 ÷ 1,000,000 = 2502. New truck profit
10 percent margin.
New equipment profit (USD million):250 × 0.1 = 253. Aftermarket revenue
10,000 trucks, USD 20,000 each, 60 percent captured.
Aftermarket revenue (USD million):10,000 × 20,000 × 0.6 ÷ 1,000,000 = 1204. Aftermarket profit
35 percent margin.
Aftermarket profit (USD million):120 × 0.35 = 425. Share of profit from the aftermarket
42 out of a total of 67.
Aftermarket share of profit (fraction):42 ÷ (25 + 42) = 0.6269
The recommendation
Ironfield should invest in its aftermarket, because it is about a third of revenue but about 63 percent of profit. First, the aftermarket earns USD 42 million on USD 120 million of revenue, against USD 25 million from new trucks. Second, raising the capture rate from 60 to 70 percent would add USD 20 million of revenue and USD 7 million of profit. The risk is that customers switch to cheaper independent parts suppliers. As a next step, sell service contracts with each new truck and track the capture rate by region.
Overall equipment effectiveness (OEE)
OEE measures how much good output a machine or line produces compared with what it could produce if it ran all the planned time, at full speed, with no defects. It multiplies three rates. Availability: the share of planned time the machine actually runs (lost to breakdowns and changeovers). Performance: how fast it runs compared with its ideal speed (lost to slow cycles and small stops). Quality: the share of output that is good (lost to scrap and rework). OEE of 85 percent is often cited as world class for discrete manufacturing; many plants are far lower.
Worked case
OEE of a machining line in India
The prompt
A machining line in Pune is planned to run 480 minutes a shift. It stops for 48 minutes of breakdowns and changeovers. The ideal cycle time is 0.8 minutes per part. It makes 459 parts, of which 450 are good. What is its OEE, and which loss is biggest?
The structure
- OEE = availability x performance x quality
- Availability = run time divided by planned time
- Performance = (parts made x ideal cycle time) divided by run time
- Quality = good parts divided by parts made
Working it through
1. Availability
Run time is 480 minus 48, which is 432 minutes.
Availability (fraction):(480 - 48) ÷ 480 = 0.92. Performance
459 parts at 0.8 minutes ideal is 367.2 minutes of ideal work in 432 minutes of running.
Performance (fraction):459 × 0.8 ÷ 432 = 0.853. Quality
450 good out of 459.
Quality (fraction):450 ÷ 459 = 0.98044. OEE
Multiply the three rates.
OEE (fraction):0.9 × 0.85 × (450 ÷ 459) = 0.75
The recommendation
OEE is 75 percent. The biggest loss is performance (85 percent: the line runs slower than it should), then availability (90 percent). Quality is already high. So the first actions are to find the causes of slow cycles and small stops, then to shorten changeovers, before spending money on a new line.
Risks: A wrong ideal cycle time makes performance look better or worse than it is.
Make or buy
A make-or-buy decision asks whether to produce a part in-house or buy it from a supplier. The trap is to compare the supplier's price with the full cost of making the part, including allocated overheads. If those overheads stay even when the part is bought, they are not saved, so they should not count. Compare the supplier price with the costs that would actually disappear (the relevant costs), then add strategic points: control of key technology, quality, supply risk, and what else the freed capacity could make.
Worked case
Should we buy a valve body from a supplier?
The prompt
A pump maker in Germany makes 100,000 valve bodies a year. Its variable cost is EUR 40 per part (materials, direct labor, energy). The accounting system also allocates EUR 25 per part of factory overhead, which would not go away if production stopped. A supplier in Poland offers EUR 55 per part. Should it buy?
The structure
- Compare the supplier price with the costs that would really be saved
- Relevant cost of making = variable cost only (overhead stays)
- Yearly difference = (supplier price minus relevant cost) x volume
- Then: strategy, quality, risk, other uses of the capacity
Working it through
1. Full cost on paper
Variable 40 plus allocated overhead 25.
Full cost per part (EUR):40 + 25 = 652. Extra cost of buying
The supplier charges 55, but only 40 of cost disappears.
Extra cost of buying per year (EUR):(55 - 40) × 100,000 = 1,500,000
The recommendation
The pump maker should keep making the valve body, because buying would cost EUR 1.5 million more a year. First, the EUR 25 of overhead per part stays whether or not production stops, so the real comparison is EUR 55 against the EUR 40 variable cost. Second, this means the EUR 65 full cost makes buying look cheaper than it is. The risk is ignoring other uses of the capacity. As a next step, check whether the freed capacity could earn more than EUR 1.5 million a year, or whether the overhead could truly be removed.
Supply chain and operations
- Tiered supply base: a final assembler depends on tier 1 suppliers of systems, which depend on tier 2 and 3 suppliers of components, castings, forgings and raw materials. In aerospace, a few specialist suppliers of engines, castings and forgings can limit the whole industry.
- Long lead times: some parts take a year or more to make and must be certified, so switching suppliers is slow.
- Production systems: most plants use lean methods (remove waste, level the flow, fix problems at the source) and track OEE, lead time and on-time delivery.
- Ramp-up: raising the production rate, for example from 40 to 50 aircraft a month, needs every supplier to rise at the same time. The slowest one sets the pace.
- Aftermarket logistics: spare parts must be available fast anywhere in the world, so companies hold parts stock in regional warehouses and plan it by predicting failures.
- Footprint: where to build (near customers, in low-cost countries, or close to suppliers) is a common case, covered in the Capacity, supply chain, and footprint module.
Sources for this lesson (1)
- Recognized public explanations of case-interview concepts and frameworks
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