2015 Aerospace and Defense Trends
Aircraft makers and military contractors face starkly divergent business landscapes, but both sectors are potentially handicapped by fundamental threats.
Although ostensibly part of the same industry, aerospace and defense are moving in opposite directions. Defense companies face fiscally constrained customers, whereas the commercial aerospace business is expanding because of a rebound in global economies and the rise of emerging regions. Still, there is one critical similarity between the two sectors: They are both continuing to evolve. That means the future of companies in each sector depends on their ability to anticipate what’s next and not just react to what’s now. Here’s an analysis of each industry that could serve as the basis for near-term strategic agendas.
Part 1: Defense industry
The outlook for North American defense contractors is clouded by many uncertainties: constrained military budgets, new and changing requirements, technology advances, and competition from nontraditional rivals. The U.S. Department of Defense is retooling its war-fighting capabilities, with an increasing focus on affordability. Consequently, defense firms need to alter their focus from exquisite systems to innovative equipment that grows out of existing product lines. New, asymmetric competitors are also putting pressure on legacy players to speed up development timelines and reduce costs. Consequently, for defense companies, success will depend on doing many things well simultaneously.
For defense contractors, success depends on doing several things well simultaneously.
Embrace a culture of affordability. Embracing affordability is a big challenge for defense contractors and can be achieved only by adopting a few important tenets. The first is a “must-cost” mind-set, which means delivering products at the contracted price and on schedule. Second, contractors must assess their infrastructure needs and adjust accordingly. Because volumes are declining in certain areas, some companies will need to reduce their labor and manufacturing footprint. The third tenet involves tackling complexity in product requirements and design. Some types of complexity add value for customers and, thus, are necessary costs. Other types just add to the expense of making or selling the item without a concomitant return in price or customer value. The difficulty is knowing which is which and making the right trade-offs.
Adopt commercial capabilities. Defense companies must imitate non-defense outfits in building or expanding capabilities that will enhance efficiency and drive quality and production process gains. Lean manufacturing principles are already widely used in defense plants. However, defense companies would be wise to embed a lean mentality in other areas, including engineering. For example, increasing on-time delivery of products generated by engineers, such as drawings, analyses and specifications, and improving first-pass yields can significantly enhance operations.
Unlike lean manufacturing per se, continuous improvement is an opportunity not fully captured by defense contractors. Where a commercial contractor might seek to achieve productivity gains year after year — possibly by finding ways to do the same tasks in less time — some defense contractors are more apt to be satisfied by simply not exceeding the budgeted amount of time for an activity. In the prevailing environment of cost sensitivity, defense companies must consider aggressive process improvement programs.
Effectively partner with both customers and suppliers. Contractors receive design and feature requirements from customers and then communicate them to suppliers. Inefficiencies often exist at both boundary points. Although most customer requirements are essential, some can be changed or eliminated without impacting the product. And contractors frequently make an equally costly mistake; namely, passing along requirements to suppliers unreservedly without assessing the inherent need for these requirements or considering which suppliers they specifically apply to.
Mitigating these problems requires that defense contractors develop new engagement models with customers and suppliers concerning not only what they buy but how they buy, with the goal of removing transactional inefficiencies, improving affordability, and broadly generating benefits for themselves and their partners. Even seemingly small changes can lead to significantly improved outcomes. For example, when defense contractors reassess and improve their interface with customers and suppliers, focus on eliminating inefficiencies and begin to alter what and how they procure, it’s not unusual to see cost reductions of as much as 30 percent.
Maintain a coherent market approach. Which adjacent markets should companies be looking at? It’s a natural question, especially in a shrinking or flat business landscape. It may also lead to serious harm. Instead of looking outside their areas of expertise for potential growth, defense companies must ensure that they execute coherent strategies, consistent with their core strengths. Doing so allows them to invest in capabilities that will deliver differentiated and sustainable value to their customers. This isn’t to say that a carefully considered organic move into an adjacent market or that a timely acquisition or divestiture is a strategic mistake. Indeed, investing in areas where a defense contractor is already strong can be precisely what is needed to improve profitability. But entering an adjacent market that does not fit a company’s core capabilities should be avoided.
Place smarter bets. Today’s austere environment requires a far more careful approach to allocating scarce investment dollars, whether the investments have to do with strengthening core skills, improving operations, pursuing growth, or repositioning the business. Companies must take pains to allocate investments in ways that are aligned with their long-term strategies and that have clear strategic objectives. This demands a rigorous approach to determining where and how much to invest based on business priorities and justifications.
Attract and retain talent. Many defense contractors confront the dilemma of having to downsize while also needing to add fresh talent. This quandary is heightened by the competition for the most desirable workers from sectors that have come to seem more attractive than defense, including high tech. In addition, the type of talent that defense contractors will need to hire in the future, in some cases, may be far different from those that they typically have recruited — for example, experts in cybersecurity and computer networking. The defense industry must diligently develop a long-term human capital strategy that specifically addresses these labor issue.
Part 2: Commercial aerospace industry
Things have really fallen into place for the commercial aerospace industry. Interest rates are low, financing is readily available, carrier-operating costs have come down (partly because of lower crude oil prices), demand is surging in emerging markets, and the world’s major economies have improved. As a result, airplane orders have never been better. That’s the good news. The difficulty, however, is in successfully managing the surge of orders and the associated production challenge. Already, the manufacturing backlog at Boeing and Airbus — more than 10,000 aircraft — is at an all-time high. Meanwhile, demand is also bolstering regional jet makers Bombardier and Embraer, as well as producers in China and Russia, allowing new players to challenge the single-aisle duopoly .
The difficulty for aircraft makers is managing the surge of orders and the production challenge.
The specific manufacturing issues vary depending on whether a company is an OEM or a parts supplier, and further depending on its size, market share, and performance, but the overall circumstances all aerospace companies face are similar. Indeed, there are six trends that we believe commercial aerospace companies must make a concerted effort to understand — and adjust to — in order to get the most out of this extraordinarily strong mark.
Rapid change in the supply chain. The increase in production rates by major aircraft makers will place intense pressure on every part of the supply chain, testing suppliers that have not previously dealt with such high demand. The problem will be especially acute for subsystem OEMs that have to simultaneously produce high volumes for new product lines and continue serving their installed base. These companies may get overextended, creating troubles like parts shortages, out-of-sequence work, defects, rework, and unplanned overtime. All of this will affect delivery schedules and costs.
OEMs and suppliers will need to conduct supply chain capability and risk assessments to identify and address weak links. Trade-offs will be required for investment in capacity, automation, and utilization to ensure readiness and to maintain flexibility. Often the supply chain has limited time to react. Consequently, now is the time to assess and make improvements to operating models, to minimize supply chain complexity, and to augment tools and systems for improved visibility.
In addition, steps should be taken to limit the fallout from a supply chain disruption. For instance, Tier One and Tier Two suppliers can invest in flexible increments of capacity, perhaps through partnerships with other suppliers. This may be a more prudent approach than ramping up capacity, which would leave suppliers overexposed if demand falls.
Importance of “should-cost” capability. Over the last 15 years, we have observed shifts in oversight and control of intellectual property for subsystems, parts and components from airframers and major subsystem providers to smaller suppliers, taking value and pricing power along with them. To reverse this trend, companies must enhance their purchasing capabilities by building or improving their “should-cost” knowledge, which will enable them to better understand a supplier’s manufacturing economics as the foundation for effectively negotiating improvement options.
The true power of should-cost modeling comes in combination with two other tactics: advanced supplier segmentation, in which suppliers are categorized by their relative economic performance as well as the concentration of similar suppliers in a given market; and improved supplier management, which involves the way should-cost and supplier segmentation analyses as well as other supplier engagement models are used as a basis for supplier interaction. In most cases, a company will have three options:
- Threaten to source from alternative suppliers;
- Collaborate with suppliers to jointly reduce costs; or
- Pursue long-term strategies like vertical integration (that is, start to manufacture parts itself).
The right path will depend on the specific market structure, the product being sourced, category-specific supply market dynamics, relationships within the supply chain, the extent of the suppliers’ excess profits, and the willingness of suppliers to collaborate.
Incremental approach to innovation. Historically, step changes have been the norm in aircraft R&D. But recent development efforts have been so expensive that it is unclear whether the companies will earn the anticipated return on their investments. Furthermore, slips in the program schedule have worsened the economics.
The takeaway from this troubling situation is that airframers must approach innovation in a more disciplined way, diligently determining which feature and manufacturing improvements are worth pursuing because they will pique customer interest and pay off over the life cycle of the product. To be sure, the presence of fresh entrants will keep the innovation dial from being turned down too low and will force incumbents to maintain new product development. But the type and frequency of innovation should definitely change, as aerospace companies seek a new equilibrium in their development programs.
Bifurcated market. Suppliers with positions on high-volume single and dual-aisle planes, or on new regional and business jet models, are well situated to ride the growth wave. However, suppliers not lucky enough to be a part of one or more of these efforts will suffer from a dearth of opportunities in the near to mid-term. Consequently, they should explore inorganic growth options. Given that consolidation has already occurred in most major subsystem markets, the best bet for M&A is component- or assembly-level options. To avoid paying a premium for an acquisition and getting little or nothing from it, aircraft makers must not buy into adjacent markets unless they complement the companies’ experience, knowledge, and skills.
More predictable maintenance cycles. Digital analytics, enabled by the sensors that aircraft now carry, are allowing airlines to better plan when aircraft will be out of service or need repair, and what types of maintenance issues are likely to arise, thus avoiding potential parts shortages and unanticipated downtime. In the future, the amount of unplanned and unscheduled maintenance could be reduced by 20 to 40 percent.
Aftermarket shifts. The production bonanza also presents distinct challenges for aftermarket companies. As airlines seek to reduce their operating costs by upgrading to more efficient fleets, they will replace some current-generation equipment earlier. Indeed, average aircraft retirement age in some segments is expected to drop by as much as 20 percent over the next eight years. In the face of this trend, aftermarket companies may find themselves with lower volume in some traditional areas (for example, replacing tires and seats and repainting) and will have to move beyond these areas and offer a more integrated approach to services and material support. This includes value-added services like kitting, inventory, and supply chain and asset management.
Independent aftermarket companies may struggle in this new environment against established companies with greater scale and may have to consider more aggressive approaches to garnering sales, such as actively tracking the age of parts they sell to airlines and proactively sending replacement equipment as the original part is expected to wear out.
Although the dynamics of the commercial aerospace market are much better than those of the defense market, both industries will face hurdles in 2015. Defense companies need to adjust to a more budget conscious environment and must overcome human capital challenges. Commercial aerospace companies also need to become more methodical, especially in the areas of supplier management and innovation spending — and they need to make the right decisions in a growth cycle that’s offering a lot of options. For the commercial aerospace companies that place their bets wisely, the upside is considerable.
Also contributing to this article were Melanie Roller and Miguel Smart.