Next-generation affordability in aerospace and defense: Transforming capabilities and costs
The steady decrease in U.S. Department of Defense (DoD) investment spending will continue for the foreseeable future. To better compete in this new environment, traditional companies should look beyond simple cost-cutting measures to a more comprehensive “next-generation affordability” approach that transforms cost structures and refocuses capabilities on the new market requirements.
Next-generation affordability in aerospace and defense Transforming capabilities and costs
Chicago Eric Dustman Partner +1-312-578-4740 eric.dustman @strategyand.pwc.com DC Marty Bollinger Senior Executive Advisor +1-703-682-5750 martin.bollinger @strategyand.pwc.com
Dubai Alessandro Borgogna Partner +971-4-390-0260 alessandro.borgogna @strategyand.pwc.com Florham Park Randy R. 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 Steven Beckey Partner +1-424-294-3739 steven.beckey @strategyand.pwc.com Joseph Martin Partner +1-424-294-3745 joseph.martin @strategyand.pwc.com Jono Anderson Principal +1-424-294-3736 jono.anderson @strategyand.pwc.com
About the authors
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. Jim Adams is a partner with Strategy& based in Los Angeles. He specializes in the aerospace and defense industry with a focus on largescale cost transformation, product competitiveness/design for affordability, and operations improvement in a low-rate manufacturing environment. Steven Beckey is a partner with Strategy& based in Los Angeles. He focuses on the aerospace and defense industry and specializes in strategic sourcing, engineering efficiency, and cost transformation. Ryan Brukardt was formerly a principal with Strategy&.
This report was originally published by Booz & Company in 2011.
Pressured by declining investment budgets and urgent wartime needs, the U.S. Department of Defense (DoD) has adopted a new acquisition philosophy that favors “affordable” weapons systems that can be deployed quickly to meet near-term warfighting requirements. The steady decrease in investment spending will continue for the foreseeable future, as will the Pentagon’s increasing desire for affordable systems and solutions. Nontraditional defense companies are already making inroads with low-cost alternatives that are supplanting the exquisite systems produced by traditional defense firms. To better compete in this new environment, traditional companies should look beyond simple cost-cutting measures to a more comprehensive “next-generation affordability” approach that transforms cost structures and refocuses capabilities on the new market requirements. The basic components of this approach are the following: • Market requirements analysis: Offer products and solutions aimed at the specific affordability requirements of each market segment. • Capabilities-driven strategy: Focus on aligning operational and organizational resources to build market differentiating capabilities. • Industry cost comparisons: Leverage industry best practices to identify and target specific cost categories. Next-generation affordability helps companies strengthen capabilities as well as address structural costs. Implementation requires careful planning, persistence, and strong leadership to stay the course, but adopting this approach will enable traditional defense companies to reduce costs intelligently, hone capabilities valued by customers, and reassert their right to win in an evolving defense market.
• As defense budgets tighten, traditional defense companies face increasing pressure to reduce costs significantly under the Pentagon’s new “affordability” approach. • Nontraditional defense companies that provide affordable, 75 percent solutions have already made inroads into markets for ships, aircraft, and land vehicles. • Traditional companies can transform cost structures by adopting a next-generation affordability approach that focuses their capabilities on market requirements. • Next-generation affordability goes beyond simple, across-the-board cuts to help companies intelligently restructure operations and apply scarce resources to sharpen their competitive advantage. • Several traditional defense companies have already applied these principles to reduce costs while meeting clients’ requirements, enabling them to fend off challengers and win new business. • A strong governance model is critical to successfully implementing next-generation affordability.
The affordability mandate
Two significant and interrelated changes are driving the Pentagon’s preference for affordable weapons systems. First, military investment budgets began a steep decline in fiscal 2008 that will likely result in a 30 to 40 percent drop in investment spending by fiscal 2015. As a result, Pentagon officials are pushing for significant reductions in procurement costs, most recently introducing a “should cost” approach to managing 14 major acquisitions, including the F-35 Joint Strike Fighter, the Army’s ground combat vehicle, and the Navy’s littoral combat ship. The goal of the should-cost management initiative is to generate deep savings and productivity improvements through tougher negotiations and rigorous analysis of each program’s costs. Second, the need to meet ongoing wartime needs in Iraq, Afghanistan, and other locations has spurred a push for a more versatile acquisition approach that can get systems developed and fielded more quickly, particularly products and solutions that address the asymmetric threats encountered today by U.S. forces. Consequently, the Pentagon is showing a growing preference for “affordable” weapons systems — that is, low-priced solutions that meet 75 percent of the requirements or, in essence, are good enough. Under this approach, military leaders have cut back and even terminated major weapons programs experiencing cost overruns and delays and shifted spending to less costly or elaborate solutions that get the job done more quickly and efficiently. “Given the variety and complexity of threats America faces, we need a portfolio of affordable, versatile military capabilities that can be produced on a reasonable schedule and in sufficient quantities,” Defense Secretary Robert Gates said in January 2011 regarding what he called the department’s “reform agenda.” Our analysis shows that new entrants employing practical, affordable solutions have already secured a major foothold in a number of defense markets (see Exhibit 1, next page). These nontraditional providers of defense products and services have captured 30 percent of current and planned procurement spending for fiscal years 2010–2012, including 75 percent of spending for military land vehicles (see Exhibit 2, page 8).
Exhibit 1 Aerospace and defense industry ways to play
Traditional ways to play Exquisite systems providers Program-driven Legacy DoD suppliers • Low-rate production • Very complex systems
• • • •
Nontraditional ways to play Agile smart customizers Product-line-focused DoD is a minor customer • Leverage global scale • Exploit commercial scope
• • • •
Scale-driven standard suppliers Process-oriented Legacy DoD suppliers • High-rate production • Sophisticated products
Disruptive specialists Problem-centric “Silicon Valley” culture • Small and nimble • Risk-taking/innovative
Source: Strategy& analysis
Exhibit 2 DoD procurement by type of supplier
DoD procurement by type of supplier, FY2010–12
Procurement total (US$ billion)
$118 8% 11%
Nontraditional Disruptive specialists Agile smart customizers
Traditional Scale-driven standard suppliers Exquisite systems providers
Source: DoD 2012 P1 budget; Strategy& analysis
The successful challengers include the following: • Commercial truck manufacturer Oshkosh Corporation has won the contracts for the last two major Army tactical vehicle programs because the company could rapidly produce low-cost, lightweight armored vehicles that were urgently needed by U.S. troops. • Eurocopter has leveraged its scale by tailoring its commercial platforms for military and government customers, winning nearly all helicopter purchases by the U.S. Department of Homeland Security. • Harris and Thales provide military ground forces with commercialbased tactical radios in place of more expensive purpose-built systems as originally envisioned. • General Atomics’s Predator unmanned aerial vehicle (UAV) is increasingly used for surveillance and strike missions once performed by manned aircraft and ground troops. These programs found success because the new market environment rewards affordable solutions that can be quickly developed and fielded. In contrast, the programs that have struggled and suffered cutbacks are often longer-lead exquisite systems, such as the Expeditionary Fighting Vehicle, F-35 aircraft, and Transformational Satellite Communications System developed and built by traditional defense companies. Defense companies ignore the changing market at their peril. Some industry leaders, skeptical that “affordability” is a long-lasting trend, have delayed action, hoping that investment budgets will be restored when the economy turns around or that a new defense leadership will revert to traditional acquisition approaches. But we don’t expect a reversal in policy anytime soon. Many of the cuts in investment spending are already incorporated in Pentagon budget plans through fiscal 2012. Even after the economy begins to recover, the federal government’s ballooning deficit will constrain defense spending. In addition, nearly a decade of wartime operations has stressed warfighters and weapons, creating a need for increased spending on operations and maintenance, personnel, and healthcare that will further crowd out investment spending. And finally, the continued need to counter terrorists and other asymmetrical enemies will require the military services to remain focused on solutions and products that can be developed and fielded rapidly in response to present-day threats.
Defense companies ignore the changing market at their peril.
When confronted with the need to reduce costs, many companies simply make across-the-board percentage cuts that spread the pain evenly among all business units or departments. The problem with this approach is that cuts are not strategically aligned with the company’s requirements, capabilities, or market strategy. For example, a company may need to bolster its supply chain capability and its internal manufacturing capability to produce a more affordable product or solution, so equally apportioned cuts do little to improve — and may even harm — its competitive position. Similarly, such reductions may cut too deeply into a department or activity already operating at peak efficiency while cutting too little from an inefficient department or one whose activities are less critical. The next-generation affordability approach provides a much wider lens for viewing and addressing affordability. Achieving genuine affordability requires a deep understanding of market requirements, an organization’s cost structures, and the differentiating capabilities that help the company operate at the highest levels of efficiency to deliver products and solutions targeting its defense customers’ specific mission and budget requirements. Thus, next-generation affordability goes beyond cutting costs to restructure and refocus the organization on what is required to deliver value to its customers. The next-generation affordability approach integrates three reinforcing sub-strategies: Market requirements analysis Affordability drives demand. If a program’s costs rise too high, a customer may scale back or terminate the program and seek more cost-effective alternatives, as we have seen recently with the cancellation of the EFV, the planned changes in the F-35 program, the success of Oshkosh in producing armored vehicles, and the increasing use of UAVs as more affordable alternatives for surveillance and ground support. We also see this in military aircraft markets, where programs
experiencing cost growth have been punished with cuts in planned purchases, while affordable programs have been rewarded with increased demand (see Exhibit 3). It is also important to note that affordability may be defined in different ways in different markets. For example, one customer might require per-unit cost reductions on an existing platform, while another customer might want overall life-cycle costs reduced for its program. Thus, companies must understand the affordability requirements for
Exhibit 3 Cost impact vs. procurement levels: Aircraft example
Change in program costs per unit 240% 200% 160% 120%
VH-71 F-22 V-22 H-1 upgrades
Higher costs/ fewer orders
F-35 (A/C only) F-35 RAH-60 C-17 F/A-18E/F EA-18G Apache Block III E-2D AHE CH-53K Global Hawk
Lower costs/ more orders
0% -40% -100% -50% 0%
Bold = Nunn-McCurdy violation
Change in procured units (Original plan to most recent plan)
Source: GAO assessments of major weapons programs; Strategy& analysis
each market or customer, particularly how trade-offs between capability and cost will affect unit demand. How might companies apply their knowledge about a customer’s market requirements? General Dynamics Electric Boat and Northrop Grumman Shipbuilding (now Huntington Ingalls Industries) developed a costcutting approach — called “design for affordability” — to meet the Navy’s very specific affordability target of US$2 billion per submarine in the Virginia-class nuclear attack submarine program. As a result, the Navy increased its demand from one to two boats. Similarly, the Airbus A400M military transport aircraft is having trouble attracting international customers because it delivers less lift capacity at a higher cost than either the C-17 or C-130 platform (see Exhibit 4, next page). In fact, the C-17 and C-130 lie on the same cost-capacity curve: A C-17 can carry four times the payload of the C-130 at four times the cost. In contrast, the A400M currently lies above these aircraft on the curve, offering less market utility. This understanding of the current market curve could help any of these companies develop an affordability target to shift demand in its favor. In an era of should-cost management and prudent spending, a firm knowledge of market requirements can help contractors determine the right “price to win” strategy and make the appropriate trade-offs between cost and capability. Capabilities-driven strategy (CDS) A company seeking to achieve affordability cannot afford to expend time or resources on activities that fall outside its core markets and core competencies. It is therefore essential to understand which capabilities are critical to enable a right to win, or achieve a competitive advantage, and which capabilities only need to be “good enough.” Affordability requires a coherent focus of all organizational resources, energies, and capabilities on delivering the company’s unique value to the customer. A capabilities-driven strategy enables companies to achieve this coherence by aligning three basic elements: 1. Way to play: This is how a company approaches the market and delivers value to its customers. Each of the four major ways to play in the defense market — exquisite systems provider, scale-driven standard supplier, agile smart customizer, and disruptive specialist — is characterized by a different set of capabilities, and each set is geared for creating the different types of weapons systems, equipment, and services valued by military customers. Because each way to play requires a different operating model and capabilities to be successful, companies need to have a clear understanding of how they will play in the market.
Exhibit 4 Mobility: Payload vs. cost
Cost per unit (US$ million) 300 C-17
200 A400M price range 150
Market utility curve
100 C-130 50
0 0 20 40 60 80 100 120 140 160 180 Maximum payload (million pounds) Source: Defense News; Defense Industry Daily; AIAA; Strategy& analysis
2. Capabilities system: This is a company’s engine of value creation. Typically, a company has three to six differentiating capabilities that are not only essential to delivering value to its customers but also give the company a competitive advantage over competitors. An exquisite systems provider’s differentiating capabilities might include superior control processes or deep systems engineering and mission expertise. An agile smart customizer might bring large commercial scale (to bring down costs) or an ability to effectively manage product lines and reuse existing designs. A disruptive specialist might excel in innovative research or have access to investors willing to fund and develop solutions whose payoff is far in the future. However a company chooses to approach the market, it will be required to build differentiating capabilities into a tightly knit capabilities system to establish its right to win in that market. 3. Product and service portfolio: A coherent company builds a product and service portfolio that is aligned with its capabilities system and the way it plays in the market. The company can eliminate or divest itself of products and services that do not fit either its capabilities system or its way to play and, at the same time, search the market for new opportunities that will reward its capabilities system. Industry cost comparisons The third element of a next-generation affordability approach leverages industry best practices and benchmarks in conjunction with market requirements and capabilities to achieve affordability objectives. Market requirements will establish an overall affordability objective for a company, while CDS defines areas to strengthen or de-emphasize. On the basis of these insights, industry cost comparisons can help set specific cost targets and establish the “art of the possible” in achieving those reductions. This process can take a number of forms. For example, a company may examine indirect cost categories — such as IT service costs, compensation/benefits, or facility footprint costs — and then use industry benchmarks to identify opportunities for delivering these services more efficiently (see Exhibit 5, next page). A company can also examine functions such as human resources or finance to ensure that an appropriate and affordable service is being provided to the business, again using industry benchmarks and best practices to guide these efforts. And it can look at direct labor to ascertain whether a competitive infrastructure is in place — for example, assessing the engineering skill mix to ensure that the company has the right mix of capabilities at an affordable level. Several factors are key for successfully bringing costs in line with industry benchmarks. After identifying the benchmarking goals, a
Exhibit 5 Aerospace and defense industry best practice comparisons
Indirect cost benchmarks (Strategy& A&D industry benchmarks)
Indirect cost driver
Direct labor skill mix assessment (Engineering by labor grade, L1-L6)1
Market affordable (Average = 2.8) Current state (Average = 3.7)
Best in class 50% Worst in class
Indirect labor dollars Discretionary spend New business funds Footprint costs IT spend Beneﬁt costs
% rate reduction 11% -1,400
Current rate $40/hr. +1,400
Target rate $35/hr. L4-L6
L1 is entry level and L6 is the most senior level.
Source: Strategy& analysis
company should create a plan for achieving these goals, including the best practices that will be implemented. The company also should put in place mechanisms for measuring progress and managing the process to completion. In addition, a robust baseline that encapsulates all cost categories will enable the company to understand all of the cost drivers within a product or solution and how individual requirements contribute to its overall cost and value. Such knowledge enables companies to build affordable solutions — often in collaboration with customers — by identifying low-value/high-cost specifications that can be eliminated. A strong governance model is critical to bringing these elements into alignment and successfully implementing a next-generation affordability strategy. Companies should involve the entire organization in developing the transformation plan, establishing milestones and metrics for measuring progress, making the difficult decisions regarding what capabilities and programs to eliminate, and institutionalizing the required change. When implemented in this manner, next-generation affordability not only focuses a company on what it does best but also helps it understand what not to do, making it easier for corporate leaders to cut activities and investments that are likely to produce suboptimal returns. This yields what we call a “coherence premium,” with all elements of the operating model and capabilities system working together to create value as efficiently as possible and positioning the coherent company to excel in a defense market that demands affordable solutions.
Next-generation affordability not only focuses a company on what it does best but also helps it understand what not to do.
Value that exceeds the sum of its parts
Each one of the components of the next-generation affordability approach informs and reinforces the others. For example, a company that applies industry cost comparisons and best practices can streamline operations and create more efficient processes. However, a market requirements analysis and CDS will ensure that the company does not shortchange the unique capabilities that give it a competitive advantage and that are strongly valued in its specific markets, regardless of industry averages. Two companies that have started to employ a next-generation affordability approach are traditional military satellite providers Boeing Space and Intelligence Systems (S&IS) and Lockheed Martin Space Systems Company (SSC). In order to offer competitive satellite systems, both companies used their understanding of commercial and military satellite markets — particularly the demand curve for satellites in each of those markets — to reduce costs while still meeting their customers’ performance requirements. To compete more effectively in the commercial market, Boeing’s S&IS conducted a top-to-bottom renewal focused on reducing and controlling overhead costs, reducing the size of the organization, and introducing a more affordable, and more modular, 702MP satellite product line. S&IS also exploited its position in both commercial and government markets to offer hosted payloads and create a competitive advantage in the commercial satellite market. As a result of these affordability efforts, S&IS has almost doubled the size of its commercial satellite business in the past two years with contract awards that include a three-satellite system for the Mexican government, three Ka-band units for Inmarsat, and a four-satellite deal with Intelsat. To increase price certainty on military satellite programs, Lockheed Martin’s SSC has initiated a holistic approach to managing cost. SSC has begun by focusing on both scaling organization size based on demand and targeting “sticky” overhead costs that tend to be variable when businesses grow but often stick around when businesses contract. For example, it has targeted cost reductions by reducing the staff associated
with programs that are winding down (such as the space shuttle external tank) and oversized middle management. Sizing the organization appropriately has helped bolster SSC’s right to win in a military market that requires large, exquisite, technologically sophisticated satellites to meet unique customer demands. SSC is parlaying its activities into increased follow-on sales for its flagship programs. Affordability thus highlights the need for companies to understand which capabilities are critical to achieving a competitive advantage and which can just be “good enough.” Some capabilities should not be targeted for reduction and, in fact, may require additional investment, especially if competitive capability gaps are present. At the same time, less critical capabilities can be de-emphasized and structured to deliver acceptable quality support at minimal cost. This is why companies should resist the urge to make across-the-board cuts to share the pain. The next-generation affordability approach forces companies to make difficult decisions about investment and allocation of resources. Done right, it helps build an organization that is more focused, nimble, and affordable — giving it an enhanced right to win in the market.
The U.S. military services will always have a need for exquisite systems, but the Department of Defense’s new affordability approach requires traditional defense companies to find ways to cut costs and speed the development of advanced weapons systems. Some traditional companies are already losing market share to smart agile customizers and disruptive specialists, whose unique capabilities are well-suited to the new acquisition philosophy. If traditional defense companies do not adapt to the new affordability environment, they risk falling into the classic “death spiral” in which falling demand causes overhead rates and per-unit costs to increase, which leads to further cutbacks, additional cost increases, and, potentially, program terminations. The nextgeneration affordability approach provides a path for traditional companies to not only survive but excel in this new environment. When implemented with an effective governance model that ensures organization-wide participation in the transformation effort, nextgeneration affordability will halt the downward spiral and reverse its direction by lowering costs and, equally important, spurring increased demand by aligning the unique and highly sophisticated capabilities of the traditional defense firm with its customers’ affordability requirements.
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This report was originally published by Booz & Company in 2011.
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