Summary of Development and Manufacture Contracts in the Aerospace and Defense Industries
Our third contract research paper is by James Wilkinson, focusing on aerospace contracts which typically entail a great deal of risk (as illustrated by the Boeing 737 MAX incident…)
The type of contract of interest in this report is for Development and Manufacture contracts in the Aerospace and Defense industries. These contracts include the overall aircraft contract from the governments for military and subcontracts for commercial (civil) aircraft systems originating from public/private companies. The subcontract efforts feature the majority of military and part of commercial aviation, systems are outsourced by the overall airframe manufacturer, known as “primes” (Boeing, Airbus, Sikorski, etc.) to subcontracting companies, known as “tier 1”. Subcontracting activities can continue down to “tier 2 and so on.
Risk in Aerospace and Defense Industries
The major sources of risk in Development and Manufacture contracts in the Aerospace and Defense industries start at the top, where the contracts are awarded, and flow downwards to the subcontracting suppliers. Any risk the prime carries, the sub-tiers must also carry. In 2017, Ernst & Young (EY) published a list of the top ten (10) risks for the Aerospace & Defense industries per [7]:
General Risks in Development and Manufacture Contracts
In the Aerospace and Defense contracts, typical risks of uncertainty, variability, and ambiguity [1] exist due to the duration and depth of the contracts. Each contract is custom, and risks should be dealt with in a cooperative basis [3] to address each requirement’s [6] objectives, changeability, causes, and impact. General topics which may be susceptible to rick include: Pricing of raw materials; Service levels; Order complexity; Quantities; Resource utilization; Liability exposure; Subcontracting rights; Work scope; Delivery locations and schedules; Contract duration; and Intellectual property ownership.
Specific Risks in Development and Manufacture Contracts in the Aerospace and Defense Industries
The major risks in Development and Manufacture Contracts in the Aerospace and Defense Industries includes risks identified by Ernst & Young [7] and additional risks considered in industry:
- Volatility in geopolitical and economic environment [7]
- Managing the supply chain [7]
- Competition in domestic and international markets [7]
- Managing and retaining talent [7]
- Ability to perform on key contracts [7]
- Compliance to a wide range of regulation and restrictions [7]
- Capacity to innovate [7]
- Failure to realize the benefits of M&As and partnerships [7]
- Exposure to cybersecurity events [7]
- Foreign currency and commodity price fluctuations [7]
- Confidentiality of Intellectual Property
- Unreasonable Terms
Figure 1: Risk Classifications [7]
Risk: Volatility in geopolitical and economic environment [7]
Description
Aerospace and Defense is noted separately as typically the commercial and military industries, while similar, have significant differences. The military and commercial industries are cyclical and originate from political and economic volatility. When the US is at war, often the economy is down and therefore commercial aviation is down, but military spending is up. And vice versa occurs. Resultingly, the demand for goods and associated spending is highly dependent on macro forces.
While the overall aircraft program spans decades, the contracts typically are not for extended periods of time due to huge costs (hundreds of millions to trillions of dollars, and poor forecasting for 20 to 30 in the future).
Mitigation
On a corporate level, this risk is mitigated by being intentionally diversified about commercial and military projects. With the inverse relationship between the two sides of the industry, this allows a company to offset any changes in contract expectations.
The typical contract life is therefore three to ten years, and the focus is on making this near term contract balance, with accommodations for long term distribution of costs if possible. For example, a near term contract may need to amortize some costs over a larger amount of units that the current near term 3 year contract, so long term accommodations are made to impact the pricing on future units as well, before settling to the long term price.
Risk: Managing the supply chain [7]
Description
Due to the complexity and quality of the components, the lead times and costs are high. With inventory desired to be at a minimum. Placing aircraft orders can be a large hurdle at the top level, and the order typically comes with a desired expedite due to ordering delays. Orders inside lead time, completing product designs, successful fabrication of the components, and conforming product manufacture all become key items to maintain schedule.
Mitigation
The customer and suppliers utilize operating structures that provide for program and contract management functions to oversee the obligation fulfillment.
The contract calls out the technical specifications, deliverable lists, statement of work, and quality requirements in order to align the expectations. The contract may also include metrics and resulting consequences (late fees, etc.)
Risk: Competition in domestic and international markets [7]
Description
Competition is simultaneously becoming increasing fierce and scarce.
Firstly, for companies at the top all the way to the bottom, aerospace contracts are large, lengthy, rigid programs. The programs are scarce, a new plane project is not created every day. And due to the flight certifications, once a supplier selection is made, changing suppliers is a major challenge. Resultingly, the contracts are big, and as a company, failing to obtain a contract will mean the company will significantly shrink instead of significantly grow. So competition is fierce.
Secondly, many companies from overseas are now becoming players as the overall industry matures and technology becomes developed. Therefore, new international competitors are entering the market.
Thirdly, consolidation of companies has reduced the quantity of competitors domestically.
Mitigation
Buyers will receive a number of bids from a variety of potential suppliers. Due to the long term, extensive relationship that will commence, the buyer must be extremely diligent with supplier selection. Therefore, extensive audits including quality and capability are utilized before contracts are made to ensure the vendor is viable long term.
Risk: Managing and retaining talent [7]
Description
In Aerospace, like many other industries, the company composition, including a few key players, can have an impact on the project success. The most impactful players are few. Retaining the workforce for manufacturing is also key, but is not dependent on a few individual but manageable on a larger scale.
Mitigation
Part of the pre-contract assessments is an understanding of the team whom will be working on the project. Items such as unionized workforce will be reviewed. When applicable, the actual team members will be broadcast and reviewed. Suppliers are often contractually required to submit the resumes of the workers on the project to the buyer. This workforce review can inform and help mitigate risk of workforce issues that may impact project outputs.
Risk: Ability to perform on key contracts [7]
Description
The majority of aerospace projects are custom designed. Typically, it is not a smooth evolution such as a refresh of an automotive design for a new model year. These designs are from a clean sheet of paper and must adhere to a lengthy list of requirements. The project teams are typically new. Many items are in process to achieve the contract. Reasons for unsuccessful performance on key contracts may include: failure of product in development stages, technical failures, quality issues with the product, and/or problem with the design [7].
Mitigation
Formal processes and reviews are heavily utilized to ensure checkpoints on the designs and operations. The contracts will include requirements for specific processes to be followed (example: ISO) as well as dictate milestone reviews. Each program will typically have a kick off meeting, requirements review, preliminary review, detailed review, test readiness review, and qualification test complete review, etc., which ensures formal review of the product design and manufacture.
Risk: Compliance to a wide range of regulation and restrictions [7]
Description
The requirements within a program contract span across numerous functions (finance, quality, engineering, etc.), but more significantly, the specifications can compound, with specifications requiring other specifications.
At each subcontracted level, the subcontractor must pass along the applicable regulations and restrictions. In many cases, these regulations must be tailored for the next subsupplier. There is a risk to regulation and restriction specification and compliance.
Mitigation
The contracts will require a compliance matrix in the statement of work, which is a line-by-line assessment of compliance to ensure that each line item is conforming to the requirement. And at the end of development and qualification (airworthiness), a complete compliance package is assembled, based on the compliance matrix, but details the documentation where the supporting analysis/test results/etc. are located.
Risk: Capacity to innovate [7]
Description
The capacity to innovation translates to the financial ability to resource for innovation. In aerospace, technology development is expensive and time consuming as it must be a robust solution, often requiring extensive testing to become qualified as airworthy. And often it is difficult to forecast if unforeseen challenges exist and/or iterations are required for a solution.
Given the typical demands of a maturing market, the aerospace companies are required to be cheaper and faster in order to stay competitive. This increase pressure drives innovation, but expenditures in research and development (R&D) often become charged to overhead.
Mitigation
Innovation is avoided in most aerospace contracts. If a product is needed, developing a new technology will be too significant of a risk. While the units are typically customer and therefore a new design, which may have various new applications and tweaks of existing technology, no brand new technology content is often agreed upon.
R&D contracts are often separate contracts that allow more flexibility for schedule and resourcing. Often these contacts may be Cost Plus type contracts.
Risk: Failure to realize the benefits of M&As and partnerships [7]
Description
Though historically this may not be a significant risk in contracts, in the early 2010’s many mergers and acquisitions (M&A) occurred. In light of the acquisitions, many previously subcontracted tasks and/or subcomponents may be made “in-house”, which will reduce cost and improve performance.
But there have been many experiences where the integration did not provide the expected benefits, and therefore caused significant risk to the project budget and schedule.
The company may be acquired, but not well integrated, continuing to act as a stand alone division. Without corporate efforts, the two co-companies may still financial operate separately but as an additional downside, as an “internal” customer, they are lower priority than external customers. Therefore, there is no cost savings and a delayed schedule.
Mitigation
Contract proposals must have a thorough review for an adequate partnership process. At a corporate level, agreements between sites must be made to ensure easy accounting processes are in place that allow the development team to function seamlessly and with ample support.
Risk: Exposure to cybersecurity events [7]
Description
Security is key for many parties engaged in aerospace development including Export Administration Regulations (EAR), International Traffic in Arms Regulations (ITAR), and company proprietary IP concerns.
Mitigation
The contracts within aerospace typically reside under the domain of one of the two governments standards, EAR or ITAR. Each standard has published processes and methods that must be followed to ensure security. The required domain is specified clearly on every released document within the program, including reports, drawing, etc.
The company IP concerns may require a more stringent security process to be in place. These required polies are dictated, verified, and audited by the specifying customer.
Risk: Foreign currency and commodity price fluctuations [7]
Description
The aerospace industry and supply chain operations are both worldwide and long in duration, two characteristics that make these contracts susceptible to foreign currency and commodity price fluctuations. Fluctuations in foreign currency may impact the value paid for a good, for example, if a contract is based in euros and the US dollar weakens, a US buyer would need to pay more due to the conversion rate. For fluctuations in commodity price, the Aerospace and Defense products are heavily reliant on high quality aluminums, steels, and other costly materials. In a fixed price contract, an increase of material cost will diminish the profit margins of the supplier.
Mitigation
The contracts may implement hedges to neutralize the effects of foreign currency and commodity price fluctuations. For exchange rates, contracts may use forward contracts, futures contracts, and options contracts 98]. Forward contracts specify a particular amount at a particular exchange rate; Futures contracts use the rate at the time a specified time, and; Options allows for call option for a sale or purchase at a specified exchange rate within expiration date. For commodity price hedging, pass through contracts can be used, which links the pricing to an applicable, agreed upon commodity index
Risk: Confidentiality of Intellectual Property
Description
In aerospace, the product design must be correct on the first design and test attempt. Any failures will significantly increase cost and schedule of the final product, which neither the customer nor supplier wants. Therefore many design reviews and submittals are specified in the contract.
The design reviews and analyses are all founded on the product design details, typically coming down to the components drawings and design practices (may also include copyrights, patents, trademarks, registered designs, trade secrets). At this level, the supplier intellectual property may begin to be uncovered if not properly handled.
Concerns of intellectual property transfer could allow the buyer to transfer IP to other vendors, reducing your competitive advantage.
Mitigation
The prevent undesired IP transfer and clarify the acceptable procedures, the related IP elements are stated in the contract, for example, if drawings are shared with the buyer or not.
Additionally, it is the contract manager’s task to take the following approaches [5]:
- Preventative and proactive
- Creates awareness
- Builds on management systems that are already in place; and
- Leverages the expertise among existing employees
Each given company should also implement and build company-wide processes to ensure robust IP protection [5]:
- Policies, procedures, and records
- IP compliance team
- Scope and quality of risk assessment
- Supply chain management
- Security and confidentiality management
- Training and capacity building
- Monitoring and measuring
- Corrective actions and improvements
Risk: Unreasonable Terms
Description
At times, sellers agree to terms that are unobtainable. Two items contribute: long term contract that the seller feels they can find a solution, and; the competition is fierce such that a seller may over-extend themselves in order to get the work.
“[Unreasonable terms] results in incompetent and sometimes dishonest suppliers winning business that they have no chance of performing, or the burden of risk promotes an adversarial relationship.
Selections based on the lowest price are an obvious culprit here, but it goes further. The tendency for buyers to burden suppliers with unmanageable or unquantifiable risk is another major issue.” “Innovation depends on dissatisfaction with the status quo, a belief that things could be improved. If buyers never set aspirational targets, the incentive for suppliers to raise their game would reduce.” [2]
Mitigation
Diligent contract review must take place with ample checks in the proposal and agreement. For example, without any particular plan in place, no orders will be accepted within the product’s lead time. If no expedite plan exists, anything less than the normal lead time will not be robustly achieved.
Sources
- Cummins, “Risk – What Risk?” Contract Management, IACCM, 6 Mar. 2014, www.iaccm.com/resources/?id=7428.
- “Do Unreasonable Terms Drive Innovation?” Commitment Matters, 17 2018, commitmentmatters.com/2018/10/17/do-unreasonable-terms-drive-innovation/.
- ENDRES, ROBERT “Cooperative Risk Management: Creating Opportunities out of Uncertainties.”
Contract Management, IACCM, 15 June 2008, www.iaccm.com/resources/?id=7978&cb=1552185616.
- “IACCM – The Global Contract Management ” Managing Contract Risk, IACCM, 19 May 2011, www.iaccm.com/resources/?id=6513&cb=1552184740.
- Moss, “Closing in on Intellectual Property Theft.” CONTRACTING EXCELLENCE JOURNAL, 15 Jan. 2014, www.iaccm.com/resources/?id=7395.
- Stepanyan, THE ANATOMY OF RISK. IACCM, 30 May 2017, www.iaccm.com/resources/?id=9729&cb=1552185354.
- Top 10 Risks in Aerospace & Defense (A&D). Ernst & Young, 2017, Top 10 Risks in Aerospace & Defense (A&D).
- Madera, (n.d.). Coping with Exchange Rate. Business Credit, Oct(1993), 22.
