BCBT: Buy Cheap, Buy Twice

The impact of Early Equipment (Reliability) Management on ROI

I was talking to a colleague and peer the other day, who is working for a large multinational in the world of capital development. He had recently attended an international tender review with a global E.P.C.M. company bidding on a significant new build project and was a bit dismayed to find that the key topic of conversation and selection criteria was upfront cost.

All capital investment is made with the ambition of recovering that outlay over a required period and continuing to gain a Return On Investment (ROI) for the life of the asset and equipment. Sure, we sometimes need to invest for risk management or compliance reasons however, even in these situations we should be able to associate a risk cost or a potential non-compliance cost that allows us to project the return on investment from a financial or business perspective.

Yet, it is very rare that I come across a business where two, five or ten years down the track after a capital investment, they analyse the actual return achieved and compare it to the predicted return and the justification for the project in the first place. There is little in the way of Learning From Experience applied in this domain from what I can determine.

It is also just as rare that a business will stipulate the ongoing performance requirements of the new assets and associated equipment at project initiation or front-end engineering design. The technical & functional specifications will rarely contain any reliability criteria.

The capital application will be based on the assumption the assets & equipment will deliver the required performance to achieve the projected ROI, optioneering & tender review criteria will frequently not consider the probability of achieving this performance and ultimately tender selection will be based, mostly, on upfront costs with little consideration to asset life cycle costs and the risk to ROI/ROCE through asset under performance.

To demonstrate, let’s work through a couple of examples.

Here we have a capital investment justification based on a projected Return On Investment (See Diagram 1). While this is a simplistic version of the calculation considered (we’ve included Weighted Average Cost of Capital, but no depreciation or other discounts applied), it does give us enough data to see that this project is viable. We have a £5 mil capital outlay with another £1mil in additional non-capital costs such as recruitment, training and so forth.

The return from this new asset and its associated equipment is £2.5 mil/annum in additional revenue or EBITA (Earnings Before Income Tax, Depreciation and Amortisation) and the ongoing operational costs are £500k/annum. It will provide an internal rate of return of 31.1% for the 10 years considered.

Not bad in anybody’s book I suspect.

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Diagram 1: Scenario 1 Baseline Capex ROI Calculation

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Diagram 2 shows the forecast annual EBITA and NPV over the asset 10-year lifecycle period.

Diagram 2: Scenario 1 Baseline EBITA & NPV

Ok, so let’s break it down a bit further. Let’s assume that the projected return on investment was based on a Performance Target. This could be any number of outputs such as O.E.E., security of supply, reduced outages, improved regulatory compliance, improved product quality, reduced customer complaints and so forth. It doesn’t matter what this target is, it matters whether we achieve the target or not. So, in our project, the £2.5 mil/year revenue required is 100% of our target. This is the ideal scenario where our asset & associated equipment has met the performance requirements assumed at the proposal stage of this investment.

Great stuff, everybody is happy!

But is this what really happens with capital projects and new equipment????

My experience and knowledge tell me otherwise.

Firstly, let’s consider what happens at tender/procurement selection step. Quotations or tenders are reviewed against a set of criteria, of which one will be the total cost to deliver a functioning asset or equipment items to the required specifications (this is usually the most heavily weighted criteria).

Other criteria may be equipment offered (brand or model), financial security of the vendor, delivery time and so forth.

With any luck there will be a performance criterion in there along the lines of XYZ product or output at a speed or throughput of x units/hr/day etc. More broader thinking organisations may request energy usage diagrams and possibly mandatory or minimum annual downtime for maintenance & compliance inspections, although I believe this is still rare.

There may be an obligation to stipulate maintenance requirements although the result of this will usually consist of a concatenation of all the sub vendors standard OEM Maintenance Manuals with no consideration to inter dependencies, operating environment, or efficiencies. Spares requirements and sourcing may also have been quantified but often this is based on the vendor “cashing in” with no real consideration to failure rates, shelf lives, condition monitoring and failure warning periods. A training program for operators and maintainers may be established and sometimes a documentation specification with a schedule and deadlines delivery of drawings manuals etc will be set (although how often do we find we are still waiting for as built drawings, equipment manuals and so forth months if not years down the track…)

As part of the project, there will be a commissioning & handover/takeover test phase which may last anywhere from a week to maybe six months.

At the end of all this, the Project Manager gets his final sign off for having met the triple constraint (on time, on spec, on budget) and all monies will be approved for payment.

That is the end of the story for the Project Manager. (Lucky him/her!)

Once the asset and associated equipment has been handed over it is now required to start paying for itself by delivering the targeted output that justified the investment in the first place. And of course, we are now in the warranty phase.

So, we start ramping up our start up curve toward our target performance

But let’s say we do not achieve the start-up target performance and that we sit 15% behind the target line for the first 12 months. It may be that we took longer to get our Operations Team up to speed using the new equipment or that we had a few equipment early life failures that took the plant down for the repairs and associated re-start up periods (these do happen but hey, no problem, under warranty, right?). This also added another 20% to our forecast operations costs for this plant.

In year 2 we manged to get the operational costs back on target, but we suffered some more early life failures post warranty which added 10% to our maintenance expenditure and 5% downtime.

We are now in to our first annual 2 week shut down (which has been allowed for in all our target calculations, by the way). The Planner is planning all the work to be done. They discover that due to there being no consideration of maintenance inter-dependencies at design, certain tasks that were assumed to be able to be done coincidentally, cannot and will have to be done sequentially. This lengthens the shut by 2 days.

They also discovers that access for maintenance of certain equipment has not been built in so temporary access is now having to be built adding 5% cost to the annual budget and another 1-day delay between shut down and maintenance work starting. A critical spare was not delivered on time adding another 1 day and it was discovered that specialist tools were not supplied as part of the project so another 2.5% on the annual maintenance budget to resolve this. 

During the shut, due to inadequate training and no maintainability demonstrations at capital project stage, the planned times for some jobs are proven to be short and this adds another 3 days to the total downtime and 2.5% to the expenditure. So, the shut has overrun by 1 week and cost another 10%

So, adding in the 10% for early life failures, our maintenance costs were up 20%. Our new asset performance has improved a little but due to the early life values and extended shut, we are still only at 90% of target.

In year 3 we have all costs at our projected targets and the plant is now running at 95% of the ROI target performance. It remains at this level for the remaining 7 years under consideration.

Believe it or not, this scenario happens. I have supported quite a few companies where plant has not performed well on start-up and, for many years, has never achieved target performance.

Now let’s look at the impact on our investment (see Diagram 3, 4 & 5):

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Diagram 3: Scenario 1 Actual ROI/ROCE Calculation

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Diagram 4: Scenario 1 Actual EBITDA

Looking at the EBITDA graph (Diagram 4) we can see that there is a distinct gap between the Baseline scenario and this one. The area between the two lines represents the lost opportunity to the company financially due to asset non performance against targets.

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Diagram 5 shows that the total Net Present Value has also decreased from £8.4 mil to close to £7 mil.

Diagram 5: Scenario 1 Actual NPV

Our much-cherished Internal Rate of Return that the project was approved on (Diagram 3) is under 27% compared to the projected target of 31%! We are now nearly 4% shy of our promised return. Our shareholders & stakeholders may be OK with this and take it as normal volatility and risk.

Or they may not.

This is the impact that no consideration of Reliability, Availability and Maintainability at Capital Project stage can have on the life-cycle cost and performance of an asset & it’s associated equipment. This is the all too common consequence of not applying Early Equipment (Reliability) Management during the Capital Project.

To clarify, Early Equipment (Reliability) Management is a programme of activities rolled out at an early stage of the asset life-cycle to optimise its total cost of ownership by ensuring the project delivers reliable and safe equipment, a complete and integrated manual and aligned training of operation & maintenance teams.

Once we pass that line of handover and sign off and enter the operational phase, asset redesign and equipment modifications are extremely costly, usually 10 to 100-fold the original cost. Equipment information and strategies become increasingly difficult to put in place as the focus moves elsewhere and less than ideal behaviours start to set in (See Diagram 6 below)

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Diagram 6: Cost and ease of change vs Asset Life-Cycle

Now, let’s try a different scenario. Scenario 2.

In this scenario where Early Equipment (Reliability) Management is applied as per the definition above, it was determined through analysis that to assure reliability and reduce risk from asset non-performance, an extra £200k would be invested over the original £5 mil.

This would be spent on higher reliability components and/or redundancy, maintainability aspects such as access for repair, lifting provision and appropriate spares. Also included are predictive technologies and real time asset condition monitoring. Maybe even some reliability analysis as part of the optioneering design stage. The CMMS will be populated before start-up with all assets and associated maintenance plans and Maintainers and Operators will be properly trained.

And here we have our new baseline calculations:

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Diagram 7: Scenario 2 Baseline Capex ROI Calculation

This has cost us 1% in our projected Internal Rate of Return (See Diagram 7) as opposed to our first scenario and of course NPV has decreased by the £200k. 

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Diagram 8: Scenario 2 Baseline EBITA & NPV

Diagram 8 shows the baseline EBITDA as being the same as Scenario 1 and the slightly lower NPV line.

In this scenario, due to the extra care and attention in the early phases of this project (design, specification, procurement, commissioning etc) we achieved 98% of target performance in year 1 and kept all costs within target budgets.

Years 2 to 4 we are on target both from a performance and costs perspective. In years 5 to 10, due to our ongoing predictive data collection, asset condition analysis and asset management plans, optimised maintenance planning & scheduling and maintenance carried out by trained competent maintainers, we are able to potentially optimise our maintenance and operations costs below target. 

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Diagram 9: Scenario 2 Actual ROI/ROCE Calculation

Our ROI calculations now show that despite the extra expenditure we have achieved our target IRR. The NPV and Benefit Cost Ratio (BCR) are both slightly above target. (See Diagrams 9, 10, 11)

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Diagram 10: Scenario 1 Actual EBITDA

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Diagram 11: Scenario 2 Actual NPV

By understanding what our capital investment (and the associated assets and equipment) target performance requirement is, how the capital investment (and the associated assets and equipment) will achieve the required target performance, assessing whether our project will actually deliver what is required and by being prepared to invest more upfront in Early Equipment (Reliability) Management to ensure target performance is met over the asset life-cycle, we gain assured reliability, healthy assets and reduced risks.

So, which would our shareholders and stakeholders prefer?

Comes back to the old adage: BCBT, Buy Cheap, Buy Twice………