large gas turbine

Seven days to form a company

The business of providing civil aero engines is desperately complicated. Not just the technical issues like having engine parts operate in an environment where the gasses are 200°C above the material’s melting point, or where the centrifugal force caused by spinning at full speed stresses each turbine blade as if you were hanging a London bus on it; the business model itself is scarcely any less complex.

Nozzle guide vane

Those tiny holes? They ensure that the part is protected by a jacket of cold air, so the engine doesn’t melt. Have a nice flight.

Aero engines are typically sold at less than cost, with the loss being made up in the provision of spares and services. Manufacturers compete to get their brand of engine into service with airlines, offering services and support through a lifespan that could exceed a quarter of a century.

Although the engine is sold at a loss, it more-or-less locks the customer into giving the vendor a continuing revenue stream. Some researchers refer to this as a ‘bait and hook’ business model, although this is a little unfair because airline executives are smart enough to know what they’re getting into. Kotler et al [2005] are more polite, calling it captive-product pricing. Lots of other businesses operate a similar model, as you may have found out the first time you tried to buy a replacement cartridge for a ‘free’ printer that came with your computer…

Now, one obvious challenge when developing and selling a batch of ten million pound products at a loss, in the hope of recouping that loss over the next decade or so, is that you need everybody to stay profitable in the meantime. On the upstream side, that means you’re dependent upon the supply network not only when producing original equipment, but for all the spares and other enablers that will be needed for years to come… and on the demand side you need the airlines to stay profitable, since if they fail to utilise their engines fully it reduces their consumption of spares and services, and delays the day when you break even. Cash flow is always going to be a major issue: just how great a deficit can you run up before ‘successfully’ selling all those captive products actually puts you out of business?

To cope with these challenges, the solution of choice is the risk and revenue sharing partnership, or RRSP. Cox et al [1999] describe an RRSP as normally involving a foreign supplier seeking to enter the industry (since this is a neat way to address currency fluctuation risks). Entrants commit to a project in several ways: paying an ‘entry fee’, performing development work, investing in plant, and supplying products or components for free. In return, they receive a percentage of the revenues that the project yields. If that isn’t complicated enough, our own investigation [Farr et al, 2006] reported one case where a manufacturer had bought into an RRSP despite making no parts on the engine concerned. To compensate, the parts they made for a different engine were counted against their contribution.

Are you confused yet?

Well here’s the kicker: you need to respond to a request for proposal quickly, or the airline might go elsewhere for their engines. This led to the requirement for the seven day lead time virtual company – one of the goals of the VIVACE integrated project, an EU-funded effort to make the aerospace industry more competitive in a number of key areas.

That’s how I found myself trying to understand how a group of companies could respond quickly to an expression of interest, through the formation of a virtual enterprise. Rapid supply network configuration is difficult enough when all you’re doing is delivering a product. When it’s a “functional product” – a bundle that includes services as well – things get complicated. You’re not just putting together a team that has to hold together long enough for a production run to be completed; you’re committing to provide product support for decades – perhaps delivering services in a country where you haven’t done business before.

In a week.

Michelangelo: the Creation of Adam (detail)

The Book of Genesis teaches us that you can achieve a lot in a week. Still…

“Trolla med knäna”, our friends at Volvo Aero (now GKN Aerospace Engine Systems) might say. It means “do the impossible”, although Swedish is a language rich in idiom, and if translated literally the phrase means “make magic with your knees”. It’s probably best if we don’t look into that too closely.

Even assuming that you can identify a winning team in just a week, and assuming that your ideal supplier agrees that you are an ideal customer… how do you go about setting up a virtual enterprise? Obviously you need to ensure the contracts that are drawn up (in a hurry) are acceptable to all parties… but contract law doesn’t actually help much: it assumes an adversarial relationship, which may run contrary to the spirit of what you are trying to achieve.

To address the difficulties of forming a virtual enterprise in a hurry, we adopted a Concurrent Engineering paradigm – an approach that we were sure would be familiar to the companies involved. Concurrent Engineering is all about lead time reduction, too. The table below shows how the two philosophies map quite nicely together:

Concurrent engineering mapping with the virtual enterprise

There are two other things that are necessary if the formation of the virtual enterprise is to proceed smoothly. The first requirement is an established, secure means of data-sharing (the Collaboration Hub was being developed in a different VIVACE work package), and the second… is trust. This is an awfully difficult thing to pin down, as there is no SI unit for reputation. Trust is difficult to obtain, easy to squander and hard to express in those adversarial contracts.

If, during the virtual enterprise formation stage, you go from feeling that all is well (“Det är ingen ko på isen” in Swedish; literally “there are no cows on the ice”) to finding that you smell a rat (“Han har inte rent mjöl i påsen”, whereby you’re actually saying “he doesn’t have clean flour in the bag”)… what next?

We used simulation tools to model cash flows within the virtual enterprise, permitting potential partners to engage in well-informed discussions about the risks they would share. We couldn’t guarantee a benign business environment (the industry was still smarting from 9/11, and as we finished this work the ‘credit crunch’ was just around the corner…) but at least we could help businesses involved in these astonishingly complicated deals to see just how deep their pockets would need to be, before payback is achieved.

Aero engine revenue graph

Total revenue for a virtual enterprise supplying aero engines under a variety of scenarios. Click to enlarge.

 

Want more? You can see the slides from the ICE2006 conference paper here.

 

References:

Cox, A., Harris, L. and Parker, D. (1999) Privatization and Supply Chain Management: On the Effective Alignment of Purchasing and Supply after Privatization, Oxford: Routledge

Farr R, Buxton D, Bovik C and MacCarthy B (2006) “Streamlining the Formation of Virtual Enterprises in the Aerospace Industry”, Proceedings of the 12th International Conference on Concurren Enterprising (ICE 2006), 26–28 June 2006, Milan, Italy (available online: http://eprints.nottingham.ac.uk/3312/)

Kotler, P., Wong, V., Saunders, J. and Armstrong, G. (2005) Principles of Marketing, 4th European Edition, Harlow: Prentice Hall

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