Gain Sharing Motivates Vendors to Boost Your Bottom Line

Nov. 1, 2004
Will it catch on with corporations like profit sharing has for employees?

Outsourcing might sound great on the surface, but corporate relationships are like personal ones. They can become stale and even fruitless if both parties don’t work at keeping them fresh. So success at outsourcing requires a good answer to a fundamental question: How does one corporation motivate another to care about its business year after year?

NTN-Bower Corp., based in Macomb, Ill., is one of a small but growing number of progressive companies that just might have found an answer. This manufacturer of precision roller bearings built an incentive, called cost sharing—or more positively, gain sharing—into the deal when it outsourced responsibility for managing its inventory of spare parts and consumables. The inventory is used for servicing NTN-Bower’s production machinery.

Advanced Technology Services Inc. (ATS)—the Peoria, Ill.-based specialist in machine maintenance and support that NTN-Bower hired—gets a share of the gains that it produces. But the maintenance provider suffers if it doesn’t produce to a certain minimum.

Corporations implement the concept in various ways that depend upon the amount of risk that a vendor is willing to assume, and the amount of gain that a buyer is willing to share. In its most aggressive form, the vendor takes half of the gain that it generates for its customer and gets nothing if it produces no gain. A more conservative approach is for the vendor to receive a much smaller percentage of the gain as a kind of bonus over and above its fee, if the gain exceeds an agreed-upon level. Of course, the vendor pays a penalty if the gain fails to reach a minimum.

At NTN-Bower, the parties took the more conservative approach. Because NTN-Bower’s cost of supporting its equipment as a percentage of shipments was growing faster than sales, the team based the gain sharing on that. At the time that ATS took responsibility for the inventory, spare parts and consumables constituted roughly 4.5 percent of sales. The bonus would kick in if ATS reduced that spending below approximately 4.2 percent. “If it goes above the original level, then there is penalty we pay,” says Rick Travis, vice president of operations at ATS. “So we are completely motivated to have the right part on hand to achieve their production levels, but not spend too much doing it.”

For this reason, ATS immediately scrapped the handwritten card catalog that NTN-Bower had used to track the 26,000 items that it held in a 3,000-sq-ft area of the factory. The service vendor not only replaced it with a computerized tracking system, but also put a team of its experts on site to manage the inventory. The experts carry personal digital assistants (PDAs) fitted with bar code readers so they can enter data quickly and feed it into the computer when they return their PDAs into their cradles. “They know where everything is in the cage,” says Travis.

Moreover, the on-site inventory manager knows exactly how much of each item is on hand, and therefore, can keep the least amount of it possible without affecting the uptime of the machinery. Using software that ATS developed for managing such inventories, the manager analyzes consumption rates, determines optimal reorder points, and replenishes supplies when they dwindle to those points. Moreover, he reorders many of these supplies from the network of suppliers that ATS has researched and developed over the last 20 years of purchasing for its clients. Because of the professional staff maintaining these relationships across a number of clients, ATS can get the supplies in a timely and cost-effective manner.

Although ATS orders the supplies, the bill goes to NTN-Bower. Travis explains that the client’s retaining ownership of its spare parts and consumables is just as crucial to the success of the program as the gain-sharing bonus. “If we bought the supplies and supplied them on consignment, then their perspective would be, ‘Let’s have as much of the stuff here on site as we can,’ ” he says. For this reason, “inventory consignment solutions generally don’t give rise to productivity gains.” Both sides must have a financial stake in the program.

The strategy seems to be working. According to Travis, NTN-Bower owns a much smaller inventory of spare parts and consumables today than it did before ATS began managing it about 18 months ago. “And its production has grown,” he notes.

Despite such successes, most vendors offering gain sharing report that few of their clients actually buy it. Of the three or four dozen discrete-parts manufacturers that ATS serves, for example, only three have engaged in some form of gain sharing. Most prefer to pay a reasonable and customary price. “They believe that any gain in their businesses should go to their bottom lines,” says Travis.

Downtime costs

Exceptions exist in a few industries, such as pulp and paper. “The majority of our customers [in this industry] by far request some kind of cost or gain sharing,” reports Cindy Bloodgood, services leader, pulp and paper services, and the gain-sharing guru at Honeywell Process Solutions, in Phoenix. She suspects that the reason for the interest among these manufacturers is their high cost of downtime. In this industry, an hour of downtime can cost $100,000. A small variance of only 1 percent or 2 percent could exceed a million dollars over the course of a year. So, “they like to know we’ve got some skin in the game,” she says.

Nevertheless, industry at large is not embracing the concept. The experience at Invensys mirrors that at ATS. Fewer than 10 of its customers have chosen to engage the company for its services through gain-sharing contracts over the three years that it has been offering them. “In practice, most customers love the fact that you offer gain sharing, but won’t do it,” says Peter Martin, vice president and general manager, performance management, at Invensys, in Foxboro, Mass. “When they get right down to it, they’d just as soon pay you [a fixed amount] without having to worry about making a big payment.”

The sums are quite large in Invensys’ case because the company is one of the progressive ones that structures its gain-sharing deals to take as much as half of any gain over two or three years. Consequently, if it were to save a client a large sum of money, say $6 million, the client would pay as much as $3 million. The problem is that clients often balk at paying that much, especially if they would have paid only $500,000 for the same job structured as a fixed project. Who wouldn’t feel ripped off? “This is a psychological issue that becomes very hard to deal with,” says Martin.

For this reason, Invensys typically offers its clients three options. The first is a fixed price for a specific job, and the second option is a fixed payment plan, which would be similar to a three-year lease. The third is gain sharing, in which the parties split the costs as well as the benefits. Of course, the fixed-price option is the cheapest for the customer. The fixed-payment option is a little more expensive because of the financing and other costs associated with leases. The gain-sharing option is the most expensive because the vendor assumes more risk and typically does more engineering for these projects.

Lack of resouces

Despite the higher cost, some companies do buy it. They perceive that the advantages of hiring vendors committed to their success outweigh whatever the differences in the cost of the payment options might be. “With the globalization that has happened over the last 10 years, many of our clients have reduced their engineering staffs,” notes Martin. “We help show the real financial return.” They no longer have the resources to look around their factories for ways to improve productivity and define problems well enough to request proposals and bids for solving them.

Here is where sharing gains with an expert has the potential to pay huge dividends. A manufacturer can define a problem loosely in terms of a productivity or cost-containment goal and then turn the vendor loose to apply its expertise. “Once we’re not constrained to just responding to requests for proposal, but are actually given the freedom to define the problem and find a solution, then the amount of money that can be generated is huge,” says Martin. In fact, relying on an expert for the up-front engineering for problem identification sometimes can generate gains larger than an internal engineering staff could.

Sticker shock is not the only impediment to wider acceptance of gain sharing. The lack of data often is another. “If you want to set up a gain-sharing program, you need a fair measurement of what the baseline is and what the gain is,” explains Martin. “Part of the problem we encountered early was that most cost-accounting systems do not give you the resolution, either in terms of time or space, to do fair gain sharing in process plants. Most provide, at best resolution, a variance report that’s monthly and plant wide.”

Create a baseline

Consider a project that reduces the energy consumption of a kiln. The cost accounting system might or might not be able to compute the savings, depending on how it tracks energy. If the company measures plant energy consumption at the point of delivery via a meter, for example, then it cannot really be sure how much less energy the kiln consumes. The kiln might indeed use less energy, but the energy load of some other process could fluctuate, making readings at the meter inaccurate measures for individual units and useless for gain sharing.

For this and other reasons, Invensys invested in methods and software for enabling the accounting systems to tap into the computer networks already in most factories and to track the costs and revenue contributions of each process unit in real time. “We did that by using the data that’s already being provided by the thousands of sensors in the automation systems in these plants,” says Martin. “We use that data to build a cost-accounting model for each unit,” which provides information such as productivity, yield, cost margins, contribution margin and in some cases, profit.

Most large facilities, especially those in the process industry, already have the sensors in place to collect the necessary information, and have ready access to it through its local area networks and the process controllers on them. “Our experience is that, if the process is under any regulatory control, then it has enough sensors in place for cost accounting,” says Martin.

The key to success in any gain-sharing program is to choose those sensors which track unambiguous metrics that influence cost in a measurable way. “If the customer has not been diligent in categorizing its expenses and tracking them over time, then it’s very difficult to get an accurate baseline with which to measure results,” says Travis, at ATS. “In that situation, success is difficult because there must be a good before-and-after picture, one that both sides are satisfied with.”

Honeywell’s Bloodgood agrees. “We work closely with the customer up front to set clear metrics that can be interpreted by anyone in the same way,” she says. “When we set the metrics, everyone must understand how they’re being determined and be in agreement that they’re the right measurements.”

Measuring uptime

Because downtime is so expensive in the pulp-and-paper industry, equipment uptime is a common way that these manufacturers track gains in the program—called Results ROI—that Honeywell offers them. The parties to a gain-sharing agreement establish a clear calculation of the time that the system was available when it was scheduled to be in production. If the equipment was available 100 percent of the scheduled time, then Honeywell shares in the gain, earning a bonus in addition to its regular fee. If, however, availability falls below 99.5 percent, it pays the customer a rebate.

Uptime is not the only measure that Honeywell tracks. “System availability is important, but it’s not enough,” says Bloodgood. Because quality also is important, she reports that the industry has shown increasingly greater interest in tying gain-sharing programs to quality measures.

Then users can tie the measures to gains, as NTN-Bower did with its inventory of spare parts and consumables. Management there had maintained good records of these expenses as a percent of shipments before it handed responsibility for the inventory to ATS. “We simply picked up on the process they had and improved it,” says Travis. “Absolutely no trust is involved.” As strange as it might seem, this is the key to making gain sharing work and motivating another corporation to care about your bottom line.