The U.S. national security industrial base has reached an inflection point. The decade-long growth cycle that began in 2001 is over, and even if sequestration is undone, the U.S. Department of Defense will still need to significantly reduce spending.
Over the next few years, we expect a 40 percent drop in investment spending (procurement and RDT&E) from the 2008 peak. This decline will hurt all players in the defense industrial base, perhaps most notably the lower-tier suppliers. Because the supply base accounts for 40 to 70 percent of a typical program’s value, any risk to suppliers poses an alarming threat to defense contractors. Unfortunately, the defense sector is ill-prepared to face this threat.
Many suppliers are already struggling. Some rely heavily on eroding defense contracts; others have defense-related operations that are not essential to their core business. Most worrisome are small lower-tier firms residing deep in the supply chain that provide a crucial product, technology or service and suffer from structural weaknesses, such as lack of access to capital.
We estimate that half of a typical large defense contractor’s lower-tier supply base could be at moderate to high risk of becoming economically unviable or exiting the defense market during this downturn. A risk of this magnitude should most certainly be on the radar screen of senior executives.
Too often, sources of supply base risk are not identified until effects are felt. For example, reduced volume could force a supplier to pass overhead costs to the integrator, causing the unit price of the system to unexpectedly balloon. The loss of a critical technology with no suitable replacement could create severe delays in a program. These effects are already being felt, and companies will need to act now — or watch their operations and financials suffer.
Specifically, senior executives will want to ensure that their company improves its ability to detect the greatest risks to the supply base, know their mitigation options and mobilize the right parts of the organization to address these risks. Given the magnitude and complexity of the task, this is not something that typically can be delegated to lower layers of organizational authority.
The first task is to understand the sources of risk related to supply markets as a whole, as well as those associated with individual suppliers. In general, supply markets can suffer from three types of risk.
Limited-source markets feature a small number of suppliers, creating a dependency that can threaten an integrator’s ability to deliver.
Capacity-constrained markets exist when goods or services are in high demand relative to available supply, leading to potential market unresponsiveness.
Technical erosion can occur when the supply base atrophies for lack of demand or the market migrates offshore, making it difficult to source required technology.
Examples of individual supplier risks include an over-concentration in programs exposed to budget cuts, threatening financial viability; underlying structural problems, such as lack of access to capital, that damage a supplier’s performance; and a parent company that neglects its defense-focused business to invest elsewhere.
For example, semiconductor suppliers facing low margins and regulatory hurdles for defense sales may choose to exit the defense industry and focus only on commercial sales, which are characterized by growth and better long-term returns. A semiconductor supplier’s exit may result in the loss of critical intellectual property (IP), forcing integrators to purchase expensive IP or redesign the system.
Next, companies must assess the degree of exposure they face and whether the solution lies at the enterprise or program level. Companies often underestimate the impact of a single supplier (or supply market) on the enterprise as a whole. In today’s world of consolidated supply bases, a single supplier may serve multiple programs across multiple business units of a major integrator.
Therefore, the risk at a single supplier may be an enterprise-wide risk, and decisions made at a single program may have unintended consequences for other business units. This makes it imperative to determine the level of supply base risk, and to determine the nature of the solution and who should lead it.
For example, corporate supply management may lead a “buy” strategy to shift enterprise-wide suppliers in a supply market with many options; corporate strategy and engineering may lead “make” or “hybrid” strategies when there are few external options for an enterprise-critical technology; business unit program management may lead the solution when the risk is highly localized.
Despite its urgency, there is a silver lining to this challenge. First, the risk to a supply chain is eminently addressable with a structured approach led from the top. Second, companies that take a proactive approach will not only get out in front of affordability and operational challenges, but can also increase competitive leverage by securing supply “choke points.”
Companies that lead the way in reducing supply base risk will have a higher likelihood of keeping their programs sold through the downturn, and will position themselves well for future growth.
The authors are part of the Aerospace & Defense practice at Booz & Company.