Cut costs and get agile: U.S. defense industry faces low-rate, low-cost production
Traditional defense manufacturers are facing a period of change that, if poorly navigated, could severely cripple their competitiveness and even threaten their very existence. Success in today’s defense market will require (1) understanding and investing in new capabilities; (2) attacking structural costs; and (3) advancing systemic processes.
Cut costs and get agile U.S. defense industry faces low-rate, low-cost production
Chicago Eric Dustman Partner +1-312-578-4740 eric.dustman @strategyand.pwc.com
Florham Park, NJ Albert Kent Partner +1-973-4107660 albert.kent @strategyand.pwc.com Randy Starr Partner +1-973-410-7604 randy.starr @strategyand.pwc.com
Los Angeles Jim Adams Partner +1-424-294-3735 jim.adams @strategyand.pwc.com Joseph Martin Partner +1-917-293-8679 joseph.martin @strategyand.pwc.com Jono Anderson Principal +1-424-294-3736 jono.anderson @strategyand.pwc.com Steven Beckey Principal +1-424-294-3739 steven.beckey @strategyand.pwc.com
About the authors
Eric Dustman is a Strategy& partner based in Chicago. He focuses on operations transformation, including strategic sourcing, manufacturing, and supply chain. Joseph Martin is a partner with Strategy& based in Los Angeles. He heads up the firm’s West Coast aerospace and defense practice and specializes in driving operational improvement. Thornton Hughes was formerly a principal with Strategy&. David VanHorn was formerly a principal with Strategy&.
This report was originally published by Booz & Company in 2011.
Traditional defense manufacturers are facing a period of change that, if poorly navigated, could severely cripple their competitiveness and even threaten their very existence. With cuts in the defense budget already under way and likely to continue for many years, some companies may find themselves woefully unprepared for the dramatically different market they face — a landscape where lower, perhaps less predictable production volume and demand for more affordable products will become the norm. Traditional responses to troughs in the business cycle such as “hunkering down” or “chasing base” are counterproductive in this situation. Moreover, well-tuned efforts to drive lean processes, reduce discretionary spending, or trim overhead by thinning management ranks are necessary and helpful but insufficient. The capabilities that led to success in the past are no longer adequate, and ongoing investment in legacy assets may not only drive an uncompetitive cost position but also distract from a needed focus on new strategic approaches that will drive profitability. Success in today’s defense market will require (1) understanding and investing in new capabilities such as improving workforce flexibility or speeding up processes for developing and prototyping products; (2) attacking structural costs by consolidating facilities, segmenting production, or rethinking collaboration with suppliers; and (3) advancing systemic processes, including driving decision making closer to the shop floor to improve agility and lower costs.
• The U.S. defense industry is changing dramatically into a business marked by lower production volume and renewed demands for affordable products. • Many defense contractors are likely to find themselves unprepared for these challenges and tend to fall back on old techniques that are unsuitable for resolving their new problems. • The difference between success and failure in the defense industry comes down to doing three things well: (1) attacking structural costs; (2) advancing systemic processes to be more agile and less costly; and (3) investing in core capabilities for low-cost production.
The new world of defense
The cyclical nature of the defense industry has been long acknowledged and widely understood. Every 20 years or so, the market pauses, defense budgets contract, volume slows, government spending comes under attack, Pentagon overreaching or gold plating draws concern — any or all of these factors can severely curtail growth. But the current situation is anything but typical, and certainly not temporary: A low-volume, low-cost environment is taking hold in the defense industry and will control its direction for many years to come. To navigate this, defense manufacturers will have to cast aside conventional tactics and make difficult trade-offs to ensure that they are investing in the right capabilities, sizing factories for real business demands, reconfiguring organizations and supply chains, and rethinking how to apply lean tools. The distinctiveness of this period has both macroeconomic and environmental dimensions. On the heels of the worst recession since the 1930s, the path to economic recovery remains highly uncertain. Moreover, because of historically large U.S. budget deficits, government spending will be tightly scrutinized during the next decade and sharply reduced where possible. Concurrently, the nature of overseas threats has changed; asynchronous warfare has produced a generation of adversaries with atypical innovation cycle times and ever more novel ways to attack the U.S. and its allies. The landscape is faster-moving and more daunting than perhaps any that the U.S. Department of Defense (DOD) has ever faced. These factors are, in part, driving a series of fundamental and structural shifts in the defense industry. For one, demand is falling, especially in traditionally manufacturing-intensive segments. As overall government spending shrinks, the defense industry is experiencing a 40 percent drop in total spending from its peak in the mid-2000s, with a return to pre-recession levels not expected before about 2030. The Air Force’s F-22 fighter, the Navy’s DDG-1000 destroyer, and the Army’s Future Combat Systems have already been shelved, while programs like Lockheed Martin’s F-35 fighter plane have been slowed or switched to new fixed-price contracts. More projects are likely to be abandoned in the next few years as DOD spending on research, development, testing,
and engineering is projected to fall by 19 percent between 2010 and 2015 with no future growth in sight. Heightening the instability in the defense market, a raft of nontraditional defense equipment manufacturers are gaining a foothold against established firms. Some of these companies are leveraging existing platforms and technologies to provide less costly tailored solutions — these could be called “agile customizers.” A good example is Eurocopter, which is owned by EADS (the parent of Airbus) and supplies nearly all of the helicopters used by the U.S. Department of Homeland Security (DHS). To meet DHS requirements at the lowest possible cost and without constantly reinventing the wheel, Eurocopter builds all of its helicopters on a single basic design and then customizes them with features demanded by the Pentagon. This enables the company to leverage commercial scale in the defense sector. Other companies could be termed “disruptive product/service specialists” because they provide innovation often at a cost that is orders of magnitude below legacy company prices. SpaceX and iRobot fit into this category. For example, SpaceX, the maker of the Falcon 9 medium lift launch vehicle, has been able to deliver an industry-best cost per kilogram of payload to geosynchronous transfer orbit. This performance has opened the door for the company to win several government and commercial contracts for launch services. SpaceX has achieved its high level of efficiency and agility in part by imposing a flat hierarchy while eliminating traditional layers of management, developing small engineering teams with a high ratio of engineering to management, and cross-training technicians across multiple jobs.
Old answers may be wrong now
These dramatic industry changes clearly place many defense manufacturers at a distinct disadvantage. Excessive structural costs and processes, partnered with a cost-plus mind-set, are simply anathema to the lower-cost, lower-production-rate realities that these defense companies now face. Furthermore, the new fundamental challenges will not be resolved by the defense manufacturers’ default options for managing slowdowns: • Hunker down by cutting costs marginally through efficiency improvements without addressing inherent, structural, and systemic cost elements — all in hopes that higher volumes will soon return. For legacy players, the landscape has changed too dramatically for this approach to work this time. Moreover, short-term tactics such as across-the-board workforce reductions destroy value and are inconsistent with an overarching and sustainable manufacturing strategy. By arbitrarily firing people, companies lose critical production capabilities, and by focusing solely on efficiency improvements, they fail to achieve the level of transformation necessary to successfully compete in their new industry environment. • Merge to scale by acquiring competitors. This strategy was effective in counteracting the last down cycle, during the 1990s, but current conditions argue against it in most cases. Many parts of the defense industry are already so thoroughly consolidated that little additional M&A is even possible. Also, national barriers limit cross-border partnerships, and vertical integration always raises regulatory concerns about conflicts of interest. Moreover, these days the Pentagon prefers competition as a tool to drive prices down, a point loudly made recently by an undersecretary of defense who said in a speech to a Wall Street investor group that “the department is not likely to support further consolidation of our principal weapons systems prime contractors.” Indeed, in this environment, the only M&A activity that could pay off for legacy players would involve acquiring smaller, nimbler competitors like the agile customizers
The new challenges will not be resolved by the defense manufacturers’ default options for managing slowdowns.
and disruptive product/service specialists or buying a company to protect a vital part of the supply base. • Chase base by in-sourcing and bidding for as much work as possible regardless of the strategic fit. In our experience, when companies chase after non-strategically relevant programs, even when there is a high probability of winning the contract, the benefits and returns are minimal. And not surprisingly, going after these programs when the chances of winning them are slim is a costly, losing proposition. In short, this is a knee-jerk approach with little tactical or strategic value. In today’s uniquely uncompromising defense environment, choosing any of these strategies largely serves to distract companies from taking the actions necessary to address the real challenges. These “old” strategies may offer a false sense of accomplishment while failing to stop a rapid, self-reinforcing downward spiral (see Exhibit 1, next page). Production volumes drop; some, but not enough, costs are eliminated; capabilities erode, yet high cost structures remain; factories are taken offline without a clear idea of current or future production needs; no new business is won, while program terminations accelerate; and production rates decline further. Perhaps worst of all, many defense manufacturers, burdened by systemically optimistic long-range business planning processes, have not yet conceded the existence of this vicious cycle — a myopic conclusion that emboldens the inertia of executives who are in a state of denial about the tough choices they need to make for their companies to prosper again.
Exhibit 1 The changing face of the defense industry
Business is lost
– Increased global competition – Rise of agile customizers – Rise of disruptive product/service specialists Volume drops
– Declining defense spending – Increased uncertainty
– Structural costs sized for high rates – Denial of new low-rate reality – Processes and systems not effective Not enough costs are taken out … … and/or wrong costs are taken out
Traditional options Customers
– Seeking less costly systems that can be ﬁelded quickly through shorter schedules and rapid development – Willingness to consider nontraditional solutions – Desire to transition from cost-plus to ﬁxed-price contracts – Aggressive cost and weight reduction expectations Hunker down Merge to scale Chase base
Source: Strategy& analysis
The right solution
To stop the downward spiral, improve margins, and stabilize the business — and in general prepare for a prolonged low-productionrate world — legacy “big program” defense manufacturers need a transformation strategy that adjusts structural costs for slower sales and provides the ability to seamlessly ramp production up or down as necessary ( for an example of this strategy, see “A Sharp Turnaround with Big Results,” page 18). This strategy must be based on a realistic assessment of demand for the next five to seven years, one that dispassionately takes into account decidedly less rosy market forecasts. In the current environment, overly optimistic planning represents a lost opportunity to determine where to make critical investments and an excuse for not jettisoning sufficient costs. Moreover, included in this strategy should be a road map for developing the appropriate capabilities — skills, tools, and processes — that the company will need to win new business, provide differentiated value to customers, and maintain an operational advantage over competitors. Implementing this approach is no easy feat; it’s a difficult balancing act that involves taking costs out while investing in distinctive manufacturing capabilities and at the same time changing the organization’s operational culture. But it is an essential step for any legacy defense company. Specifically, this low-rate transformation strategy should focus on three fronts (see Exhibit 2, next page): • Attack structural costs • Advance systemic processes • Invest in core capabilities
A transformation strategy must dispassionately take into account decidedly less rosy market forecasts.
Exhibit 2 Road map to transform manufacturing for low-rate production
Transform manufacturing for low-rate production
– Resize your factory footprint and use capacity more efﬁciently – Revisit sourcing – Segment production – Align your production control architecture for low rates (e.g., lean approach) – Apply lean strategies to non-shop-ﬂoor processes – Use lean approach to create faster and more repeatable processes – Invest in technology, people, knowledge, systems, tools, and processes that provide a competitive advantage at low rates
Develop a strategy that ﬁts
Be realistic about demand – Understand the evolving market and customer requirements – Create realistic demand projections with high/low scenarios Know what capabilities matter – Determine what capabilities are important to customers now and in the future – Know what your core capabilities are – Evaluate your capabilities relative to market requirements and competitors
Attack structural costs
Advance systemic processes
Invest in core capabilities
Source: Strategy& analysis
Attack structural costs Attacking structural costs means resizing the factory footprint to match projected volumes by consolidating or shutting down facilities or areas within facilities, and creating smaller but more efficient and effective plants. In each factory, labor and infrastructure costs must be rationalized by matching staff size to new workloads, decreasing management layers, and eliminating redundant roles. Also, during this period of reassessment, manufacturers should consider options to reduce current wage and benefit levels (including unionized compensation) as well as to relocate workers and facilities to lowcost regions — as long as intellectual property can be managed. Similarly, other generally fruitful cost reduction measures should be undertaken. These may include creating shared-services centers; co-locating functions like design and engineering to increase collaboration and problem solving; realigning reporting relationships to match corporate objectives; and de-layering the organization to create a flatter and more accountable structure. But even more important, defense companies must reconfigure their supply chains because supply base cost structures are typically a key driver of manufacturers’ costs and competitiveness. This includes in-sourcing strategically critical elements of the value stream and outsourcing production to increase overall adaptability to volume changes or to exit poorly performing operations. Low-rate production often reduces a manufacturer’s influence on cost and delivery requirements with suppliers; therefore, standardization should be used to increase leverage with suppliers so that traditional strategic sourcing cost reduction tactics such as supplier rationalization, competitive sourcing, and supplier development can be used more effectively. However, it’s important to recognize that widespread standardization can be difficult to achieve within legacy infrastructures, which is why the concept of platform-based solutions is so powerful. With this approach, maximum standardization is implemented for certain core and stable items (or platforms) in the production mix, while “tailored” approaches can be maintained for items that require more flexibility or customization. Furthermore, different cost reduction approaches are needed for different segments of the supply base. For instance, in dealing with strategically important suppliers, defense companies should build strong relationships and forge contracts that make it worthwhile for these suppliers to reduce costs over the long run. In addition, lower demand could affect the financial health of valuable suppliers; thus, investments in joint cost reduction efforts may be warranted to sustain critical sources of supply in the short term. Vertical integration by
acquiring strategically important suppliers should also be considered as a way to protect supply and pricing or to eliminate higher-cost facilities. But it is essential that in-sourcing, outsourcing, and vertical integration flow from an overarching manufacturing strategy derived from market fundamentals and core capabilities. Finally, production segmentation is important, particularly by legacy manufacturers of highly advanced and complex systems that want to compete effectively against agile customizers. Manufacturers frequently employ a “one size fits all” approach to production, in which government cost-plus programs are housed under the same overhead structure as commercial fixed-price programs, or in which new, unproven complex products are mixed in with mature and simple products. As a result, the latter is often burdened with the generally unavoidable costs of the former — high support-to-touch ratios, complex processes and production flows, standing armies of engineers, slow decision making, and more. In turn, manufacturers may be less competitive across all markets, a situation made worse by declining volumes. To mitigate this, production processes, systems, and cost structures should be sized to provide the lowest cost for each segment. For example, the simplest and most predictable products can flow through the most efficient and least expensive production segments, while more complex, less predictable products can be siphoned off to a more robust and expensive infrastructure. The production streams can be distinct to prevent contamination; easy operations don’t require the expensive management and operational systems that more complicated activities need. Each segment can also be fine-tuned as market conditions and costs change over time. Advance systemic processes Facing a low-rate production environment also demands transforming manufacturing operating processes and systems to be more agile and efficient so they can be scaled up in a timely manner to capture new, strategically relevant work or scaled down if volume recedes. Today’s challenging defense marketplace is unforgiving about bureaucratic logjams, slow-moving processes, and cumbersome systems that aren’t prepared to perform well in a dynamic environment. Lean principles are a bedrock of agility and efficiency and should be used to drive simpler, faster, more repeatable processes with fewer management layers and less bureaucracy. Concepts such as standardized processes, building quality through zero defects, minimizing waste and complexity, and kaizen can make a huge
Production processes, systems, and cost structures should be sized to provide the lowest cost for each segment.
difference in a low-rate production environment, as long as they are applied in a fit-for-purpose way. All too often, standard work is developed for a vast array of procedures that lead to complex processes and overly bureaucratic workflow procedures. Although it is widely recognized that many defense manufacturers have had marked success with their lean programs, the new low-rate production environment will require adjustments to traditional approaches and principles. For instance, the transition to a low-rate production environment can create a mixture of “job shop” production flows (in which a variety of products in relatively low numbers are produced) and regular “at rate” production flows (which mirror output at full plant capacity), each with unique characteristics. Thus, the application of lean principles may need to be realigned to optimize its effectiveness across this operational mixture. For example, a hybrid push/pull scheduling approach (in which, when necessary, customization triggered by customer orders can be applied late in the manufacturing process) may be warranted to segment predictable and unpredictable production. Similarly, in a low-rate environment, the workforce will need to be more flexible and have the ability to perform multiple tasks. As such, documenting and codifying processes and procedures, along with capturing tribal knowledge of experienced individuals in the organization, are essential. Another critical element of improving performance and applying lean principles in a low-rate environment is greater empowerment of workers — especially frontline supervisors, whose role should be expanded to include more rapid problem-solving responsibilities and oversight of continuous improvement initiatives. Equally important, all employees should have the appropriate tools, skills, and access to management; hence, training and capability building as well as group meetings that allow ideas to percolate up the organization from the workforce should be a major element of the lean transformation. Finally, the application of lean principles shouldn’t be limited to shop floor and organizational processes. It should also be an integral aspect of joint manufacturer/supplier cost reduction and operations development efforts. Ineffective upstream support can produce significant downstream waste on the factory floor. Driving lean principles into the engineering/manufacturing interface between manufacturers and suppliers leads to fewer (or less costly and more disciplined) configuration changes and the necessary integration of product design and engineering from one side of the development process to the other.
Invest in core capabilities The third front required to create long-term competitiveness involves investing in the capabilities — people, technology, knowledge, systems, tools, and processes — that can drive world-class manufacturing programs. Although these investments provide differentiated value to customers and an operational advantage over rivals in a low-rate production environment, they are often overlooked. Put simply, most companies do not put sufficient internal R&D funding into manufacturing. But if defense manufacturers hope to transform their operations for low-rate production, investments in manufacturing capabilities must be elevated. For example, in a low-rate environment, lot sizes are typically smaller and changeovers more frequent; therefore, acquiring new process technologies that allow for rapid factory setups and assembly activities is imperative to reduce costs and lead times relative to competitors. A case in point: Low-volume composite manufacturing was traditionally done by hand using old-fashioned tools like tape measures. But today some manufacturers are taking advantage of laser projection systems and other production technologies to automatically outline the proper placement of composite plies, cutting the time it takes to align composite materials by more than 25 percent and improving the quality of the finished items. Also, implementing new prototyping technologies and equipment would allow legacy manufacturers to better keep up with agile customizers by getting products to market quicker. Moreover, at low production rates, scrapping an entire part is a costly proposition; therefore, developing quality systems that can detect manufacturing flaws sufficiently early in the process is important. And new investments in improving low-cost-country manufacturing are justified as well — specifically, to perfect ways to make labor-intensive parts (those that don’t justify automation) at minimal cost and high quality. In manufacturing, the most critical resources are often not machines but people. Therefore, as operations are transformed for low-rate production, it is essential to identify and actively work to maintain critical skills in the organization. This means collaborating with unions to design a labor strategy that includes investing in a workforce that is trained across multiple jobs (cross-trained) to increase flexibility; reducing the amount of labor required in manufacturing; and minimizing the time spent waiting for work by allowing movement from one process to the other depending on production demands. Eliminating “tribal knowledge” — reliance on individuals for information and expertise that the organization at large should have access to — is a critical step toward cultivating low-volume capabilities.
Having only one person who knows how to produce a quality part on a specific machine is a risky proposition for a company. Finally, investing in manufacturing capabilities should extend to procurement and the broader supply chain. Developing the procurement organization’s skills and knowledge to become a better strategic partner with more suppliers, allowing them to jointly reduce costs and drive innovation, is a capability that legacy manufacturers can use to better compete against disruptive product/service specialists. Also, at low volumes, improving the ability to manage product and design variations in the supply chain can go a long way toward ensuring that the costs for changes in the production line are minimized and paid for by the entity responsible for them, whether manufacturer or supplier.
A sharp turnaround with big results
A US$2 billion military aircraft manufacturer had experienced a steady decline in production volume, which exposed the weaknesses in its business structure. For example, costs were 30 percent higher than the industry average and were projected to continue to increase annually. Initially, the company responded by falling back on one of its traditional strategies: Do anything to bolster production — that is, chase new contracts with little concern about whether the production jobs fit with the strategic direction of the company or create additional inefficiencies and higher costs. Not surprisingly, this approach fell far short in mitigating the company’s problems. In fact, things got worse. Roles overlapped as internally everyone was fighting for business from the same customers; management confusion over who supervised which programs was rife; indirect and direct costs rose as no one was focused on operational efficiency in factories or at suppliers; and product quality worsened. Everything seemed to be a chaotic emergency. Realizing that this approach was untenable, top executives decided that the company could be saved only by a radical overhaul, one that transformed the business into a low-rate production outfit with sufficient flexibility to respond to market conditions and customer needs. In other words, bold changes were needed to dramatically reduce structural costs, transform manufacturing into a lean and agile operation, and create a set of capabilities that could win future programs. The company reduced structural costs by streamlining and consolidating manufacturing facilities. Some factories were embedded with local support functions for more efficiency, and high-cost, labor-intensive work was shifted to low-labor-cost areas; overhead functions were combined to cover wider operational regions; and assembly line layouts were redesigned to maximize colocation of similar production processes. To increase operational performance, lean and agile processes were embedded on the factory floor that streamlined processes while maintaining flexibility for production that had to be tailored for customer needs. And capabilities were upgraded, particularly in configuration management, production planning, materials management, and procurement. The positive results from this dramatic overhaul were immediate and remarkable: Labor costs fell by 32 percent, and the company’s factory footprint was reduced by 40 percent. Problem resolution, not paperwork linked to endless analysis and reporting, became the primary role of engineers, and operational coordination improved significantly. But most important, the culture in the manufacturer’s factory changed. Production targets were met for the first time in a long time, and employees on all levels earned bonuses. People in support functions felt like they were actually doing something useful and were not merely a bureaucratic layer. And winning new business seemed again like a desirable outcome of strong sales and production efforts, not desperation.
A cost-plus mind-set, excessive structural costs and processes, and capabilities tuned for a much different business landscape are threatening the very existence of some A&D manufacturers. Current production systems are simply too costly, inflexible, and complex for today’s market. Simply put, defense manufacturers are at a crossroads. Unfortunately for legacy defense companies, typical time-tested answers are insufficient to address the challenges of the new climate. To survive, these companies must instead embrace a fresh manufacturing strategy that better fits a new low-rate reality. They should start by being realistic about demand and developing greater insight into which capabilities really matter in this shifting market. Guided by this clearer vision of the challenges they face, defense contractors can more confidently attack structural costs to match demand, transform and leverage lean programs to drive more process agility, and invest in capabilities to profitably and consistently win new work.
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This report was originally published by Booz & Company in 2011.
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