Strategy Dynamics Briefing 28: Quality of physical assets

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It’s not just customers and staff whose qualities affect performance – many organizations rely heavily on physical assets for their operations — the production equipment of manufacturing companies, the distribution equipment for utilities firms, furniture and fittings in restaurants, hotels and hospitals, and so on. One important feature of physical assets is their state of repair. Nearly all such items wear out, with a range of undesirable consequences. In restaurants and hotels, worn out furniture damages customers’ perceptions of quality, and in many industries, aging equipment becomes unreliable.This causes a tricky issue – on the one hand, equipment needs to be kept sufficiently young and well-maintained to perform well. On the other hand, we need to minimize the cash spent on maintaining equipment and on replacing especially poor items.

In the following figure, a utility company has increasingly unreliable units of equipment (e.g. pumps for a water supplier, power switches in an electricity distribution firm). There are 5 000 of these units, which are initially quite reliable with only 5 % failing in any year. To contain costs, spending on both maintenance and replacement is limited – $5m/year on replacing the worst of its units, sufficient to upgrade 100 units per year, and $5m/year on maintenance, enough to maintain each unit once every three years. Units deteriorate evermore quickly as the time between each maintenance event increases.

A strategy for improving equipment reliability

The attribute of concern here is the failure frequency per unit—strictly its “unreliability.” New units bring with them a low number of failures per year. Unreliable units that are replaced take with them their high failure rate. Since it is the worst units that are replaced, they take with them five times the average failure rate of the entire population of units. (This constant multiple is a big simplification!).

Current policy will lead to an ever escalating failure rate (dashed lines and light text for values at year 10). Costs of maintenance and replacement remain low, but costs are rising on fixing the growing number of failures. The problem only slows in its growth because the few units that are replaced are so unreliable that removing them nearly balances the high rate of new failures.

Until next time…

 

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Strategic implications of asset-decline

This situation focuses on the cost side of the firm’s P&L, rather than revenues — a big challenge in capital-intensive industries, where time-scales are long. Here, it is 5 years before higher maintenance spend is outweighed by lower cost of failures.

This makes it tempting to cut current costs to hit short-term targets and “investor expectations”, though investors will not be happy later with a business in bad shape and getting worse.

Strategic Management Dynamics book coverCustomers may counter this temptation. You can tell when a hotel or restaurant chain is in trouble from the poor state of its outlets and go elsewhere, but such punishment is not always possible — we cannot usually choose another power grid or water network. So such industries are often regulated, with targets for prices and reliability. But regulators too can get it wrong—in one market, regulators approved investment rates sufficient only to replace water network assets every 250 years! .. and the US has seen the problems of power outages and bridge collapses caused by long-run underinvestment.

This briefing summarises material from chapter 5 of Strategic Management Dynamics, pages 264-267.

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