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<td width="75%" valign="top"><font SIZE="4"><b><p ALIGN="left"></b></font><strong><big><big>INVENTORY
MANAGEMENT FOR</big></big><br>
<big><big>THE DEREGULATED</big> <big>ELECTRIC POWER INDUSTRY</big></big></strong></p>
<p ALIGN="left">By Daphne Weaver, AGES Group, <a href="mailto:[email protected]">[email protected]</a><br>
<font face="Arial" size="2">(<em>originally published by PMA OnLine Magazine: 03/98</em>)</font></p>
<p>Right now, efficient inventory management has limited significance in the electric
power marketplace because there is no reason for a utility to focus on inventory cost.
They are simply added to the rate base. As deregulation progresses, inventory costs will
became critical.</p>
<p>This article describes methods employed for controlling inventory costs, including
sale-leaseback agreements, consignments and sales, pre-positioning agreements, pooling
arrangements and exchange agreements.</p>
<p><strong>THE COMMERCIAL AVIATION INDUSTRY MODEL</strong></p>
<p>In a competitive market, power generating utilities ("PGUs") must learn to
manage their inventories in a competitive manner. Fortunately for utility management,
there is another similar industry which has blazed the path of deregulation-- the
commercial aviation industry.</p>
<p>The commercial aviation industry and electric power industry have similar requirements
for inventory purchasing and management. In fact, many of the largest commercial jet
engine original equipment manufacturers ("OEMs") are the same OEMs who supply
combustion turbine engines to the electric power industry (GE, Pratt, and Rolls Royce).
OEMs which have a large market share for equipment such as steam turbines and pulverizers
are very similar operations to aircraft manufacturers. </p>
<p>As was true of aircraft manufacturers, as deregulation progresses, we can expect to see
less competition among the OEMs of the electric power industry as more mergers and
acquisitions between these OEMs occur. Until recently there were three major commercial
aircraft manufacturers. Now there are two. Recently, one of the most hallowed names in
electric power equipment, Westinghouse, simply ceased to exist.</p>
<p>Of course, as market share grows for an OEM, so does its ability to increase prices. </p>
<p>The aircraft industry has been able to mitigate this tendency toward consolidation in
the OEMs by turning to a new secondary market in parts and materials-- the
"after-market parts company."</p>
<p>The after-market parts company</p>
<p>One of the great successes of deregulation in the aviation industry relating to
inventory management was the rise of the after-market parts company. The after-market
parts company is in the business of acquiring surplus inventory in all conditions at
wholesale prices and then reselling the inventory to users. </p>
<p>The purchase of after-market material is one of the easiest ways to save on inventory
needed for use on older equipment. The after-market parts company buys inventory at cost
well below the list price offered by the manufacturer. The after-market parts company will
generally offer manufacturer new inventory at 95% of its list price, new inventory at
85-95% of list price, overhauled inventory at 70-80% of list price, serviceable inventory
at 60-70% of list price, and repairable inventory at 50% of list price. These prices for
parts used frequently can amount to substantial savings. After-market equipment includes
many categories ranging from manufacturer new to unserviceable. A brief description of the
categories is as follows:<ol>
<ol>
<li>Manufacturer New -- The part is traced directly to the manufacturer but is currently
owned by someone other than the manufacturer.</li>
<li>New -- The part was purchased new from a company other than the manufacturer.</li>
<li>Overhauled -- The part has been repaired and overhauled and is certified as such by the
repair facility.</li>
<li>Serviceable -- The part works but its remaining hours before overhaul are limited.</li>
<li>Repairable -- The part needs to be repaired to be put into a serviceable or overhauled
condition.</li>
<li>Unserviceable -- The part must be overhauled or scrapped.</li>
</ol>
</ol>
<p>After-market equipment is not synonymous with an inferior product. The stigma of
after-market parts has been created in part by the OEM. An OEM is in the business of
selling new equipment. The after-market Parts Company is the only competition an OEM has
with respect to aging inventories. For example, if you operate a piece of equipment which
is five years old, an OEM can still sell you new parts for that piece of equipment. The
OEM will, however, charge you list price. An after-market parts company can sell the same
part in new condition at a price below list. If the part is in an overhauled, serviceable
or repairable condition the price will be even further below the list price of a part in
new condition. This is because the after-market parts company is in the business of
acquiring surplus equipment from operators and OEMs at a wholesale rate. These price
reductions are then passed on to the customer. </p>
<p>The after-market parts company will offer an alternative to purchasing costly new
equipment for the electric power industry as it becomes increasingly cost-conscious.</p>
<p>However, the role of the after-market parts company is not limited to that of a
competitive source of material supply-- it is also the solution to an increasingly
pressing problem for today's electric power companies-- massive surpluses in inventories.</p>
<p><strong>REDUCING INVENTORIES WITHOUT LARGE WRITE-OFFS</strong></p>
<p>There are four primary causes of non-productive inventories:<ol>
<ol>
<li>Materials are too costly to maintain and overhaul;</li>
<li>They are not required for current levels of operation;</li>
<li>Technical obsolesence; and</li>
<li>Book value grossly exceeds market value. </li>
</ol>
</ol>
<p>One of the first issues being encountered by PGUs as deregulation is taking hold is how
to reduce these nonproductive inventories. Options available to the PGU include (A) the
sale/leaseback transaction, (B) consignments and (C) outright sales.</p>
<p><strong>A. The Sale/Leaseback</strong></p>
<p>In a sale/leaseback transaction, the inventory is sold at the cost on the PGU’s
books and leased back for a term of years. The PGU is essentially paying the new
owner/lessor the cost of the inventory plus a finance charge over time. The lease term on
this type of transaction is generally 5 years but can go up to 15 years depending upon the
equipment. </p>
<p>The inventory may belong to the lessor outright upon the expiration of the lease term
or the PGU can retain the right to repurchase the inventory at market value.</p>
<p>The benefit for the PGU is fairly simple, the PGU will not have to write down its
inventory and essential working capital is available to spend on other areas such as
R&D, advertising and developing the PGU’s retail market. </p>
<p>To the extent that the lessor has lower capital costs than the PGU, either due to
credit or capital structure differences, significant savings can result.</p>
<p><strong>B. Consignment Agreement</strong></p>
<p>Under a consignment agreement, the PGU designates the after-market parts company as an
agent to sell its excess materials. The PGU can either keep its surplus inventory on site
or ship it to a third party. At either location, the consigned inventory is designated as
such by the use of simple gates and placards which identify it as "Consigned
Inventory -Property of PGU". The after-market parts company tries to sell the
inventory for the PGU. The sale price of the inventory will be determined by the market,
but the PGU can keep the right of first refusal if the offer price is too low. The PGU
will generally keep 75% of the sale price The PGU eliminates costs associated with
international marketing, advertising, and sealed bid procedures. In addition, the PGU will
generally avoid credit risk, as well as other transaction-related risks by consigning to
the after-market parts company.</p>
<p>Consignment agreements should be entered into at least two to three years prior to a
scheduled write down of inventory.</p>
<p><strong>C. Sales of Excess Materials</strong></p>
<p>Sales of excess materials can be attractive for the PGU seeking a quick resolution to
the problem of excess inventories. This can be an expensive approach, as materials may go
for ten cents on the dollar, or even for scrap prices. However, it may be acceptable in
circumstances in which writeoffs are being covered by transition fees or securitization of
stranded investments.</p>
<p><strong>RUNNING A TIGHT SHIP: KEEPING INVENTORY STORES LOW WHILE MAINTAINING EFFECTIVE
SERVICE</strong></p>
<p>Once the PGU has eliminated non-productive stores of inventory it will need to run
operations economically and provide for maintenance requirements and for recovery from
unscheduled outages. This can be accomplished without massive stores of inventory if the
PGU uses some or all of the following:<ol>
<ol>
<li>Pre-positioning Agreements</li>
<li>Pooling Arrangements between product user groups administered by an independent third
party</li>
<li>Equipment leasing - Short and long term leases</li>
<li>Exchange Agreements ("Exchanges")</li>
<li>after-market equipment </li>
</ol>
</ol>
<p><strong>The Pre-positioning Agreement</strong></p>
<p>The Pre-positioning Agreement is a hybrid consignment arrangement in which a third
party supplies a surplus parts "pool" of inventory at the PGU’s designated
facility. When the PGU uses the inventory it is paid for. Plant engineers and managers can
see and touch the inventory which will eliminate hoarding. The PGU also pays a fee for the
ability to use the inventory at will. This fee is really a form of a finance charge.</p>
<p><strong>The Pooling Arrangement</strong></p>
<p>The Pooling Arrangement between product user groups has been tried for years without
much success between utilities. The key to the Pooling Arrangement is the management by an
independent third party which has no affiliation with any particular utility.</p>
<p>A proper Pooling Arrangement would be structured as follows:</p>
<p>PGUs wishing to participate in the product user group would designate inventory to be
managed by an independent third party for use in the pool. The inventory would be stored
on either the PGU’s premises or the third party’s premises. Participating PGUs
would have access to the inventory under the management of the third party. Minimum
quantities of critical or hard to find inventory would be maintained to insure that each
participating PGU had access to such inventory. The inventory would be actively marketed
to members outside the pool with the participating PGUs retaining the right of first
refusal before sale to a member outside the pool. Surplus inventory would be marketed on a
first-in, first-out basis. The key to success of the Pooling Arrangement is the neutrality
of the third party which eliminates "jockeying among competing PGUs which are
participants in the pool. Neutrality of the third party would be assured by strict rules
governing pool participation and inventory management. </p>
<p><strong>Equipment Leasing</strong></p>
<p>A PGU should always consider leasing equipment as a less costly alternative to
purchasing. The most cost-effective practice is to arrange long term leases for equipment
which is in continuous operation and short term leases for equipment used during peak
periods.</p>
<p>Another variation on the theme which reduces costs even further is the Standby Lease
Agreement. A standby lease works as follows. The PGU leases a spare for 30 day periods. A
standby lease fee is paid. If there is a need to use the spare an additional "Reserve
Fee" is charged. If the spare is never used the additional fee is never paid. The
Short Term Lease Agreement is the same except that the PGU anticipates usage and pays the
Reserve Fee in advance.</p>
<p><strong>The Exchange Agreement</strong></p>
<p>The Exchange Agreement ("Exchanges") applies only to parts which have a
repeat market. The old part is exchanged for a new or overhauled part. The PGU pays a
reduced price by getting credit for the used core and does not need to worry about the
repair. The title to the old part is given up and title to the new or overhauled part is
taken in exchange by the PGU.</p>
<p><strong>CONCLUSION</strong></p>
<p>In addition to selling new and used parts, engines, and completely assembled equipment,
the after-market parts company has developed specific services in response to industry
needs. The specific services developed for the aviation industry range from engine and
inventory management to consignment, repair and exchange services. Increasingly, those
companies which choose to generate power in the competitive electric power industry will
find it cost effective to contract for similar support services.</p>
<hr width="98%" color="#FFFF00" size="1">
<blockquote>
<p><strong>About the Author: </strong></p>
<p>Daphne Weaver is Director of New Market Development for the AGES Group. AGES (Air
Ground Equipment Sales) has provided after-market parts services to the aircraft industry
since 1979. Its aircraft services company is majority owned by Volvo Aero Corp.</p>
<p>Ms. Weaver may be contacted directly at (561) 833-0609 or through AGES at (561)
998-9330. <br>
Email: <a href="mailto:[email protected]">[email protected]</a></p>
</blockquote>
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