Managing Director & Senior Partner
On the surface, the defense industry may not look or act like the commercial aerospace industry, but it can actually learn a lot from the latter’s microeconomics.
Commercial aerospace is all about longevity and continuity. By keeping successful programs alive for decades, unit costs for production shrink and companies reap huge economies of scale. They also tie customers to their products by providing ongoing support and a steady stream of improvements over many years. The deep aftermarket they provide—not just in modifications but also in parts, maintenance, and performance improvements—is a source of tremendous profitability. It’s also a buffer against the volatility of demand cycles.
Defense contractors have long followed a different model: their single customer sets requirements, and the companies earn their keep primarily on a cost-plus basis. Companies pursue the next big program, hoping geopolitics and the political winds work in their favor. If a program doesn’t sell, they settle for the dwindling revenues generated by older programs. Even the most skilled leadership can’t stop the vicious cycle of attrition that begins once the second round of orders fizzles out: production invariably gets cut, which in turn drives up unit costs and eventually pushes programs to extinction. In following this model, defense OEMs unnecessarily shorten the lifespan of otherwise worthy programs, and they lose out on ancillary, but significant, sources of income as a result.
Yet there’s no real reason for this model. The defense business need not—and should not—settle for limited returns.
In reality, defense and commercial aerospace have more commonalities than differences. Both invest enormous sums and many years to develop their major programs. Both have dialed-in production lines, deep supply chains, products whose spare parts are high-value, and similar operations. Traditional weapons systems are, like commercial aircraft, industrial equipment. The process and engineering solutions to the challenges posed by these highly engineered products are the same as those in commercial aviation. So by applying the winning strategies of commercial aerospace, defense contractors could unlock significant economic gains and compete on a higher level.
Given their staggering development costs, it almost defies logic to think that airplanes could ever be profitable. Designing the Boeing 787 and its components (engines, control systems, subsystems), building and testing prototypes, and constructing the manufacturing facilities came to well over $20 billion. Such investments often take a decade or more to reach the break-even point. However, the programs and their aftermarkets last for four, five, or even six decades. For more than 80% of their lives, these programs are solidly profitable.
In commercial aerospace, longevity is central to the business model. Not only does production last for decades, individual planes fly for decades. The built-in demand for parts and modifications ensures that manufacturers’ investment is recouped many times over. Even when discounted for time, the profit flowing from the aftermarket is sufficient to make commercial aviation very attractive. On a net present value basis, the returns far outweigh the cost of capital.
Consider these other long-running success stories:
Defense has had its success stories, to be sure: the B-52, the F-16, the C-130, the US Navy destroyers of the Arleigh Burke class. Yet these programs are the exceptions; most defense programs have nowhere near the longevity of the commercial successes.
In the commercial sector, longevity is based on derivatives, and the economics of the aftermarket create the profit basis for derivative aircraft. Modifications change some key systems and components, but not all. The aftermarket continues to grow as the derivatives add volume to the installed base. The most successful commercial aviation participants think strategically about which parts to change, and about who will therefore access the aftermarket. The customer support system reinforces program longevity and the customer’s incentive to maintain a consistent fleet. Parts availability, maintenance programs, and performance improvement investments are managed by the OEMs to deliver flight hours economically. That, in turn, completes the cycle that keeps the enormous installed base of planes flying, which is what drives the aftermarket.
Certainly, economics is not the primary concern of defense departments. Military equipment must be capable of overpowering an adversary. The requirements for that capability must ultimately outweigh the powerful industrial economics of incumbency, installed production lines, and supply chains.
Still, as the requirement setters, defense departments need to consider three key questions:
The answers to these questions help answer an even bigger question: How much investment can be reallocated away from uneconomic program development to focus instead on the most critical capability areas?
What lessons can the defense industry glean from its commercial counterpart? We’ve identified six.
For example, if flight control is modularized, the OEM can later add autonomy simply by swapping out the box. For a ship, if containerized gas turbine units are modularized, the customer can effectively install a higher-power module later on.
Thus, a sacrifice in efficiency is offset by the ability to update faster—no minor issue when you consider that, often, by the time a project finally gets to market, an adversary has made it obsolete.
Attention to the long-term economics of the platform is deeply ingrained in the commercial aerospace mindset. All of the lessons we point to here reinforce that perspective. And, when applied together, they create a virtuous circle effect. For defense contractors, this way of thinking is foreign; it will take conscious, deliberate recognition and alignment to drive the needed emphasis and focus.
Defense departments around the world are actively looking to develop more capability at lower expense. One hundred years of intense competition in commercial aerospace—and the resulting survival-of-the-fittest operating environment—provide clues for how to accomplish that goal. By stretching the performance and life of their existing platforms, defense departments can steer more of their investment toward the game-changing applications that existing weapon systems cannot hope to address.