Stochastics and Statistics
A model for maintenance service contract design, negotiation and optimization

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Abstract

A model is presented in this paper for maintenance service contract design, negotiation and optimization. The model was developed under the assumption that there are one customer and one unique service provider who is the Original Equipment Manufacturer (OEM) and is called the agent in this paper. This is typically applied to the situation where the OEM is the only possible service supplier such as in the case of major military equipment in the defense sector. Three contract options were considered, depending on the extent of outsourced maintenance activities. From an agent point of view, they are, (1), the agent carries out all repairs and inspections; (2), the agent carries out failure based repairs, and (3), the agent does inspections and repairs to the defects identified at inspections. For options two and three, the customer does the rest of maintenance. The relationship between inspections and failures was modeled using the delay time concept and a numerical example was illustrated. The cases of perfect information to both parties and information asymmetry were also discussed in the example. The model developed can be used for contract design, negotiation and optimization.

Introduction

Repair and necessary maintenance are part of our life for most goods we have bought. For simple products, often the owner is responsible for all the maintenance and repairs and maintenance outsourcing is not an issue affecting the purchase decision. For consumer durable products, manufacturers have used and continued to use warranty to provide failure based maintenance with the manufacturer or dealer repairing all failures that occur within the warranty period and often at no additional cost to the buyer, Murthy and Djamaludin (2002). The warranty is tied to the sale and is factored into the sale price. Over the last decade, manufacturers have started offering extended warranty which provides the customer with coverage beyond the normal warranty period. The extended warranty is provided for an additional cost. The popularity of extended warranty has resulted in third parties (such as, financial institutions, insurance companies and independent operators) providing these services. They have been found to be highly profitable in many product markets (e.g. consumer electronics). As a result manufacturers have scaled back considerably the basic warranty to force customers to choose extended warranties.

For most complex and expensive commercial and industrial products, and particularly for defense related products, neither the owner can carry out all the maintenance, nor the manufacturer uses a simple warranty scheme like the case in consumer durable products. This is because of a number of reasons;

  • Small maintenance departments within the owner’s organization cannot operate economically, i.e. the scale of operation is too small.

  • Technological advancements, increased safety and environmental legislation in production processes necessitate an ever increasing need to train the maintenance workforce. Thus, maintenance is getting more costly and requires more management attention.

  • An increase in operational flexibility may be achieved via contracting out. The speed at which markets change is growing, creating a necessity for companies to change their modes of operation accordingly. More specialized contractors are able to change more quickly than large internal departments. The basic idea behind this assumption is that the complexity of changing an organisation is much smaller if more professional and talented contractors can operate more or less independently on a narrower scope. Instead of managing a process of change for all company activities in detail, a client can now concentrate on updating the contract with a contractor. The contractor is responsible for the management of his own processes.

  • Depending on the type of contract, financial flexibility of a client company can be increased. A contractor can offer a wide range of options all of which are based on financial constructs such as taking over client technical systems, exchanging shares of ownership, payment of contractor services depending on the client’s primary output, etc.

  • Finally, but most importantly, the manufacturers usually have the expertise and equipment for the maintenance intended where the customer may not be fully qualified to do so. Because of technological advances, periodically upgrading is often a necessity over the life cycle of the equipment and the manufacturer may be the best to provide such a service as part of the maintenance service contract.

The above demonstrate the need for a maintenance service contract between the buyer of the equipment (the recipient of maintenance service, we call them the customer) and the service supplier, (usually the manufacturer or an independent specialized third party, we call them the agent) providing the maintenance. The terms and conditions of the contract together with the feasible options available will guide the buyer to decide whether or not to purchase the equipment and associated maintenance. Then based on the buyer’s decision and chosen option, the agent should schedule and adopt an optimal maintenance strategy.

It goes without saying that a contractor is motivated to offer maintenance services because it may be an important source of income. But new opportunities may arise if he is able to sell added value by taking over parts of clients’ business risks and other (financial) burdens. In this way a contractor can diversify his “product” range and may be able to achieve a higher profit.

However, there are two disadvantages associated with outsourcing of maintenance and they are as follow:

  • Reduced in-house maintenance knowledge.

  • Getting locked in with a single agent.

For much specialised products, such as military equipment, the knowledge to carry out maintenance, and spares needed for replacement, can only be provided by the Original Equipment Manufacturer (OEM). In this case the customer is forced into a maintenance contract with the OEM. As a result it is very important for the customer to carry out a proper evaluation of the implications of outsourcing the maintenance. It is reported that the cost of spares and maintenance over the life cycle of the item bought can be far more than the original purchase cost, Jenning (2007).

There are several forms of cooperation in maintenance outsourcing practice; these include warranties and service contracts, which on a global scale are agreements between the customer (service recipient) and the agent (service provider). Under these agreements, parties agreed to be bound by terms and conditions in relation to the maintenance service to be provided and the service price to be paid. In the case of a warranty, the agreement often stems from a bundle sale. In the case of a typical service contract the situation can be different: the agreement can stem from a bundle sale or from a real necessity from an organisation to outsource its maintenance activities.

In this paper, we consider a particular maintenance service contract case which can be often found in large and expensive equipment maintenance outsourcing, such as aircraft, major power plant and marine ships. In this case, because of the special nature of the product, the numbers of the agents and customers are limited. It is usually that the OEM is the only possible agent. For simplicity, we study a designed maintenance service contract involving a single agent and a single customer under reliability and availability constraints. However, the model developed can be applied to multiagent and multicustomer cases, though certain modifications need to be done. We aim at developing a model to obtain the optimal strategies for the customer, but will make sure, at the same time, that the agent is not disadvantaged under information symmetry. In other words, we aim to optimise the contract parameter under each option for the customer with a required availability and reliability level and fixed budget, and therefore optimise the chosen contract by the customer to maximise the expected profit of the agent with perfect information available to both parties. The information asymmetry case was discussed in detail in the numerical example. This paper is subdivided into 5 sections, the next one gives an overview in maintenance service contracts. The two subsequent sections focus on service contract modelling and the numerical analysis. We finish by a conclusion with some proposals of topics for an extended research.

Section snippets

Maintenance service contracts

This section gives a brief literature overview on maintenance service contracts. It does not intend to provide a complete and detailed review of outsourcing models since many books and several journals have dedicated to the subject, see Espino-Rodriguez and Padron-Robaina (2006) for a recent review in outsourcing. Outsourcing Maintenance activities as a way of outsourcing, if optimised, can be used as a key factor to improve organisation’s efficiency and effectiveness. It can enhance the

General introduction

Within the framework of this paper, we focus our attention on the profits, availability and reliability of the equipment as they are expected from today’s systems in that the equipment should be available and operational whenever they are required in a cost-effective manner. Many options can be derived depending on the type and characteristics of the equipment under the contract. However, there are two basic possible scenarios: either there is a service contract or not. We are not interested in

Numerical example

In this numerical example we examine the model developed earlier and assess the validity of the development. From model notation there are a large number of cost and downtime parameters which need to be carefully considered. In particular the relationships between some of the cost and down time parameters must be reasonably specified. We start with some basic model parameters.

The cost and downtime parameters need careful consideration, here we assume

  • Average spare part cost is £500.

  • Man-hour-cost

Conclusions

This paper discussed and developed a novel model for maintenance service contract design, negotiation, and optimization. The new contribution is the use of the delay time for the formulation of the inspection models which can then be used to evaluate the impact of various contract options. Three contracts were considered in this paper, namely a full contract covering both inspections, repairs at inspections and failure repairs, a partial contract covering failure repairs only and another

Acknowledgement

The research reported here is partially supported by EPSRC under Grant numbers EP/C54658X/1 and EP/F038526/1.

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Also at School of Management, Harbin Institute of Tech., China.

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