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1. Residual Value Risk & the Equipment-as-a-Service Model

Opdateret: 30. maj 2023

Introduction

In an evolving business landscape, Original Equipment Manufacturers (OEMs) are shifting from selling physical assets to offering Equipment-as-a-Service (EaaS). This service-oriented model brings forth a new array of challenges and risks, one of which is residual value risk. In this blog post, we delve deeper into the concept of residual value risk, its primary drivers, its potential impact, and strategies for effective management and mitigation.


Definition of Residual Value Risk

At its core, residual value risk refers to the risk that the market value of a piece of equipment at the end of its service term falls below its predicted residual value. In this context, we narrow our focus to the heightened depreciation resulting from more intense or frequent usage than originally projected.


Drivers of Residual Value Risk

The primary driver of residual value risk is the misestimation of the intensity and frequency of equipment usage. These factors are key determinants of an equipment's lifespan and its rate of depreciation. Equipment subjected to more intense or frequent usage than expected can wear out more rapidly, causing a steeper depreciation rate and a lower residual value.


Impact of Residual Value Risk

The implications of residual value risk are predominantly financial but also extend to operational aspects. If the actual residual value of the equipment significantly falls short of the projected value, the OEM might have to acknowledge the difference as a loss. For instance, if an OEM estimated the residual value of an asset to be €5.000 at the end of its service term, but due to excessive usage, its market value drops to €2.000, the OEM would then need to write off the $3.000 difference. This directly impacts the OEM's profitability and can disrupt financial planning and forecasting.


From an operational perspective, higher-than-expected depreciation might lead to early equipment failure. This can strain resources as the OEM may need to replace the equipment sooner than expected. The associated costs – procurement, installation, and customer service – are additional burdens that further escalate the impact of this risk.


Finally, the marketability of the equipment post-service can also be a concern. If the equipment has depreciated significantly more than expected, it might be harder to offer it again or sell it in the secondary market, leading to further financial losses.


So, while the direct impact of residual value risk is financial, it has operational implications that can affect the overall functioning of an OEM's business. Effective management of this risk is therefore crucial in maintaining a successful and sustainable EaaS model.


Negative Residual Value

One of the severe consequences of excessive depreciation is the emergence of a negative residual value. This occurs when the residual value of the equipment becomes less than the cost to repossess. In such cases, the OEM not only fails to recoup the residual value of the asset but also incurs additional costs, leading to a significant financial burden.


Negative residual value may force the OEM to keep the equipment in service longer than planned to avoid the immediate costs of repossession and preparation for resale, even if the equipment is not in optimal condition. This can further exacerbate service and reputational issues.


Additionally, the prospect of a negative residual value complicates the decision-making process for the OEM. The choice between incurring the cost of repossession now or the potential for even greater costs in the future due to further depreciation or equipment failure becomes a challenging decision to navigate.


Therefore, managing and mitigating residual value risk, and avoiding a situation where negative residual value arises, is of paramount importance in an EaaS model.


Risk Management Strategies

There are several comprehensive strategies that OEMs can employ to manage and mitigate the residual value risk (mitigation potential in parentheses):


Technology-based strategies - High

Exploit the capabilities of predictive analytics and machine learning to accurately estimate equipment usage. By doing so, depreciation rates can be adjusted accordingly, providing a more accurate forecast of the equipment's residual value. Regular usage monitoring through IoT devices can also help in real-time risk assessment and proactive decision-making.


Contractual strategies - Mid

Implement clauses in EaaS contracts that put a cap on equipment usage or adopt usage-based pricing. This approach allows better control over wear and tear, thus preserving the equipment's value over the service term. Moreover, contractual penalties for excessive usage can serve as a deterrent, further mitigating the risk.


Operational strategies - Low

Regular maintenance schedules are crucial in maintaining the equipment's value and extending its lifespan. By ensuring the equipment's optimal functioning through periodic inspections and preventive maintenance, the rate of depreciation can be significantly reduced. However, these strategies may not fully eliminate the risk if equipment usage far exceeds expectations.


Financial strategies - Mid

A financial strategy to mitigate residual value risk in the EaaS model is off-balance sheet financing. This approach involves working with specialised financial institutions that assume equipment ownership and financing responsibilities while the OEM retains service and maintenance duties. Off-balance sheet financing offers advantages such as financial flexibility, improved cash flow predictability, and access to expertise in managing residual value risk. Careful consideration of terms and selection of reputable financial partners are crucial when implementing off-balance sheet financing as a risk mitigation strategy in the EaaS model.


Remember, the mitigation potential depends on a variety of factors including the specific circumstances of the OEM, the nature of the equipment and its use, and the broader market conditions. Therefore, these rankings are not absolute and could vary based on these factors.


Case Example

An excellent example of an OEM tackling residual value risk is a global construction equipment manufacturer that implemented a comprehensive risk management strategy.



Faced with the challenge of excessive equipment usage leading to higher-than-expected depreciation, the company turned to technology for a solution. They integrated IoT devices into their equipment to track usage data in real-time. This allowed them to accurately assess the wear and tear on the equipment and adjust their residual value estimates accordingly.


In addition, they modified their EaaS contracts to include usage-based pricing. This incentivized customers to use the equipment responsibly and helped control excessive wear and tear.


The company also implemented a rigorous maintenance schedule for the serviced equipment. Regular inspections and preventive maintenance helped to maintain the equipment's value and extend its lifespan, reducing the rate of depreciation.


This comprehensive approach to managing residual value risk allowed the company to continue offering their EaaS solution profitably, while also preserving the value of their equipment over the course of its service life.


Conclusion

Residual value risk, particularly the heightened depreciation due to increased or harder usage, poses a significant challenge for OEMs in the EaaS model. Understanding the drivers of this risk and implementing comprehensive risk management strategies can safeguard OEMs' financial health and ensure the long-term viability of their EaaS offerings.


With advanced technology, carefully crafted contractual agreements, regular maintenance, and appropriate financial tools, OEMs can effectively mitigate residual value risk. This, in turn, allows them to fully capitalise on the opportunities presented by the EaaS model, thereby driving business growth and boosting profitability.


In our next post, we'll explore another crucial risk in the EaaS model: asset utilisation risk. This will include a deep dive into its drivers, impact, and management strategies, including a real-world case study. Stay tuned!

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