Over the past year, supply volatility and price increases have been extremely high across the market. The 12-month US Producer Price Index, which measures the prices received by domestic businesses for their output, recorded an annual gain of 11.2 percent in March—an all-time high—and it remains elevated across several key segments. The US Federal Reserve and other institutions, such as the European Central Bank, have all signaled that they expect supply chain disruptions and inflationary pressures to continue for the foreseeable future.
As discussed in the first article in our series, many aerospace and defense (A&D) leaders have never worked in an inflationary environment and may be unfamiliar with the unique dynamics that make it difficult for businesses to thrive. But they are quickly becoming aware that they face some constraints when planning a path forward. The US Department of Defense (DOD) instructed contract officers to refrain from offering relief on existing firm-fixed-price (FFP) contracts in June 2022, and it is not accepting requests for equitable adjustments.
Given that long-term FFP contracts are most commonly used in the defense industry, companies typically cannot pass added costs to their customers. And many suppliers have recently increased their prices, further compounding price pressures. In this environment, integrated profit management (IPM), a cross-functional approach to managing inflation, may help defense companies thoroughly evaluate their options, implement best practices for margin protection, and ensure they can continue to serve America’s critical defense needs. If defense companies apply and refine this approach over the long term, it may help improve their current financial position while simultaneously allowing the DOD to fulfill its core security mission.
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Greater cooperation, greater benefits
Traditionally, business development, competitive intelligence, price to win, and other commercial functions have taken a siloed approach to profit management rather than coordinating with other business units, such as procurement and supply chain. For instance, commercial teams might negotiate and confirm the delivery schedule for certain goods without asking supply chain experts about lead times or requesting execution guidance from program management. In such cases, companies must often pay expedited fees to meet the agreed-upon delivery date, reducing overall profitability.
Under IPM, cross-functional teams will have regular huddles to share information, iterate ideas quickly, and conduct analyses. They can then implement innovative strategies to improve efficiency, mitigate cost increases, and ensure that the commercial process is executed according to the most up-to-date information. Major topics to discuss include the following:
- Supply chain: in-bound logistics, lead-time management, holding costs, and location strategy
- Category and product management: design to value, portfolio complexity management, supplier management, and supply hedges
- Pricing: value-based pricing, competitive intelligence, and price to win
- Finance and program management: cost and basis of estimate accuracy, estimate at completion (EAC) analytics, and purchase price variance tracking
- Sales and contracts: terms and conditions management and customer relationship management
As one example, most teams never revisit the costs in the bill of materials (BOM), or they do so only at the time of bids or renewals. With IPM, they will update BOMs at regular intervals to quantify the impact of inflation on key products and programs more easily. Simultaneously, they will highlight potentially overlooked areas of exposure, such as indirect costs. Teams might also recalculate EACs more frequently to increase accuracy.
With a clearer view of current program and product financial performance, teams can make better decisions when managing business health to support the broader national security mission. For instance, they will have an easier time evaluating trade-offs when comparing suppliers or attempting to identify alternative sources for at-risk commodities because all groups share the same understanding of customer value, contract terms, lead times, demand, and other issues.
Critical analyses, data-driven solutions
As cross-functional teams develop strategies to mitigate cost pressures, three activities can help.
Understanding inflationary exposure and margin dilution across the portfolio
Teams can benefit from assembling a real-time analytical fact base for existing commodity spending and risk. To understand available levers, they can segment cost increases based on two factors: the type of contract involved and whether the offering is sold on a commercial basis under Federal Acquisition Regulation Part 12 (FAR-12).
Determining the mix of contract types (for instance, whether most contracts are FFP or cost-plus fixed fee) and the average contract length will help companies understand the level of inflationary exposure. For items not sold on a commercial basis—in other words, those products or services for which companies are required to provide documentation justifying their cost under FAR-151—an understanding of contract types and length will allow companies to understand if current market prices have significantly deviated from the as-bid condition and allow them to determine if they have secured a significant supply. Both higher prices and inadequate supplies would raise the risk of inflationary exposure.
Inflation: How defense companies can support national security
Developing and applying multiple improvement levers
Once A&D teams have developed a solid understanding of costs and associated risks, they can test go-to-market levers that extend across the value chain (exhibit). Teams must work together to understand how these levers may be applied for items sold on a commercial basis under FAR-12 and those sold on a disclosure basis under FAR-15. To ensure cost accuracy with both types of contracts, teams must evaluate deals using replacement costs rather than older data. They should also include commodity-linked material and labor escalators in contracts, especially renewals, since costs in the original bid may be outdated.
Other steps for improving the efficiency of the procurement function might include the following:
- creating a better line of sight on demand
- managing demand, hedging against disruptions, and ensuring that a supply of the highest-risk items is procured up front
- identifying lower-risk alternatives for key inputs when scoping new programs and services
- improving price setting by directly adjusting list prices or tightening discount and margin approval thresholds for items sold on a commercial basis
Other measures focus on commercial policies. Establishing a standard set of terms and conditions for all deals can help protect companies against unforeseen challenges, such as economic price adjustment clauses that share the risk of cost increases with customers. In addition, policies that focus on the aftermarket should reflect the current cost base and the value provided by maintaining key capabilities for the national security mission.
Teams must closely monitor performance by examining competitive intelligence and information on price to win for all new deals. If margin dilution is a problem with existing programs, teams can perform a root-cause analysis to develop a better understanding of risk and apply corrective levers to new deals.
Improving data and analytics
Once the new approach is in place, A&D companies can accelerate progress by improving transparency on data and analytics. First, companies could improve data integrity so they can trace spending from commodities and purchase orders to programs and products (for instance, by tagging purchase price variance at the program level). Next, they could build automated and real-time spending analytics, including value-adding dashboards that compare baseline costs with actual costs in FFP contracts, to analyze inflation exposure.
From an organizational perspective, companies might benefit from increased accountability. They might consider establishing a pricing organization that includes traditional government accounting and rate-setting roles, as well as groups responsible for commercial price setting. To improve performance, they could create sales and program management incentives based on program profitability rather than just focusing on top-line revenue targets.
IPM can feel like a daunting exercise given all the activities required to implement the approach, but A&D organizations can succeed with the right focus and attention. If executed well, the new cross-functional approach can help companies overcome current macroeconomic forces to recover revenue and improve EBITDA by 3 to 7 percent. Simultaneously, they can build long-term capabilities and defend the health of the defense industrial base and its ability to service the national security mission.
In the next article in our series on inflation, we will discuss how leaders can quickly operationalize IPM and apply other procurement levers that produce lasting improvements.
