Strategy Dynamics Briefing 38: When Resources Deteriorate

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Not all resources develop in a positive direction. Equipment and other fixed assets deteriorate, often through recognizable stages. Management of physical assets is a neglected issue in strategy, even in operations management. Yet for many companies the value involved is considerable — a typical utility company, could have tangible assets worth more than five times the company’s annual turnover. For such organizations, the renewal and maintenance of physical assets is a dominant component of its business strategy. This is not simply due to the sheer scale of financial value and expenditure involved; the consequences of success or failure on the issue reaches out into the market, through the impact on customers’ experience and hence on the company’s reputation.

Briefing 28 discussed how physical assets deteriorate, often by becoming increasingly unreliable. It treated any particular type of asset as a single population, and averaged out its reliability across all units. We also pointed out that the distribution of asset quality has important implications for asset management strategy, whether quality is rather uniform across all units, or heavily skewed by a few particularly poor units.

Strategic management of an asset base includes a number of policy options— how often to do routine maintenance, when to replace a unit completely, and when to refurbish a unit. Refurbishment involves taking the unit out of service, replacing worn-out parts and effectively restoring it to an as-new state. Depending on the asset involved, this may be possible only with units that are not too seriously dilapidated, and may only restore the unit to a partial state of as-new health. Similar stages can be seen with buildings and assets in other industries, such as refrigeration equipment in data centers, vehicles in logistics firms, food preparation equipment in catering and the quality of fittings in restaurants, hotels and leisure outlets. To use the framework in other cases, you need only define the appropriate life stages, identify how many units reside in each stage, and why and how fast they move between them.

The figure below shows a population of units in a regulated power-supply firm, distributed amongst four states, and the corresponding failure rate. The company receives a fee for each unit of power it supplies to customers in its region, but a penalty charge is deducted from this fee for any failures in its system that inconvenience its customers. (This reflects a particular regulatory regime, which may differ in other countries.)

Diagram: illustrative population of units in a regulated power - supply firm.

The business starts with a poor asset base that continues to deteriorate for the first five years:

  • maintenance on reliable assets is not sufficient to keep this number at its initial level.
  • maintenance and refurbishment of degenerating units are not enough to prevent a rapid flow of units into the unreliable state.
  • spend on new equipment is insufficient to prevent the number of unreliable units growing quickly.
  • the total rate of failures is growing, driven especially by the rising number of unreliable units, and price penalties are reducing the company’s revenue.
  • falling revenue and rising operating costs are causing a rapid decline in the company’s net cash flow.

The strategic question here is where to intervene with changed spending rates, and how those spending rates should change as time passes, so as to both reestablish and sustain an acceptably low failure rate whilst at the same time producing acceptable and sustainable cash flow. The strategy depicted is as follows: From years 5 – 10, the company undertakes a major investment program to replace many of its unreliable units.

  • Over the same period, most of the degenerating units are refurbished. This not only reduces their contribution to the overall failure rate, but also cuts drastically the pool of degenerating units that subsequently become unreliable. The number of unreliable units therefore continues to decline even after the replacement program is cut back from year 10.
  • To prevent the number of degenerating units rising too quickly once again, maintenance of reliable units is progressively increased—a switch of spending away from the declining number of degenerating units. The rate of reliable units starting to degenerate does rise, simply because of the greater number of reliable units in existence, but not sufficiently to allow much increase in the population of degenerating units.
  • Over the later years, the continuing fall in unreliable units allows a slight reduction in overall failure rates, though this is partly countered by a small increase in degenerating units.

Until next time…

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Strategic Management Dynamics book cover
It’s not just equipment that degrades

Certain intangible “assets” also degrade over time. Information technology systems (as distinct from the hardware on which they run) effectively become less useful, even though the code of which they consist remains the same or even improves, because the business needs that the systems serve are moving forward. Similar decline applies to business processes and technologies.

‘Content’ in many media sectors also degrades – we see feature films released first in cinemas, before moving to rental channels and cable or satellite TV, before reaching broadcast channels and eventually the bottom of the pile – off-peak multiple repeats.

This briefing summarises material from chapter 6 of Strategic Management Dynamics, pages 336-340.

Read more about the book on the Strategy Dynamics website

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