Aftermarket pricing for the military market The forgotten profit lever

Aerospace & Defense

Aftermarket pricing for the military market: The forgotten profit lever Many would consider selling aftermarket spare parts to the government to be a fairly straightforward business for aerospace and defense companies, which have few degrees of freedom to drive increased profitability. With cost-based pricing, generally accepted profit factors, and a relatively small list of customers, management has understandably focused on other aspects of the business in greater need of attention. However, despite this non-dynamic nature, the military aftermarket spares business represents a critical source of revenue and margin for aerospace and defense companies. The key to unlocking the potential revenue and margin improvement involves focusing on an often forgotten element in the profit equation: pricing. Our experience suggests that pricing is often overlooked due to a number of widely held myths, yet this can result in losing an opportunity to improve profitability by tens of millions of dollars.

Separating myth from reality Myth #1: All aftermarket sales are profitable. Reality: Strong overall portfolio performance often disguises the fact that, typically, 20%-25% of a companys spares portfolio is sold below target margins or even at a loss (Exhibit 1). Myth #2: Pricing assumptions are always aligned with execution reality. Reality: Cost estimating and pricing organizations often use assumptions that differ from the way actual customer orders will be executed (e.g., supplier charges different prices for spares and production requirements), increasing the risk of margin leakage. Myth #3: The government is only concerned with cost and profit factors. Reality: While cost is absolutely critical in government pricing, contractors can negotiate risk premiums with their customers for high-risk parts (e.g., out-of-production parts, parts not ordered in onetwo years).

Exhibit 1 Exhibit 1: Typical military aftermarket profitability performance and examples (illustrative)
Volume vs Margin vs.
100% 80% 60% 40%

Volume vs. margin

Unique Part Number

The shotgun appearance g g poorly y highlights a p managed pricing strategy and significant value

Gross Marg % gin

20% 0% -20% -40% -60% -80% Expired five-year supplier contract used as basis of estimate, new supplier cost exceeded estimate using escalation factor

Typically, 20% 25% of the portfolio is f th tf li i below target margins

Cost estimated based on supplier contract for production, while pricing for spares requirements was nearly double

-100%

Significant part detail was omitted from component BOM and not included in the cost estimate

Increasing Volume

Myth #4: Spare part catalogs significantly streamline quoting processes and are highly profitable. Reality: External price lists require significant effort to develop and maintain in order to achieve adequate profitability. In some cases, a poor cost estimate can be locked in to a losing price until the next catalog refresh. Myth #5: Spare sales are being replaced by Performance Based Logistics (PBL) contracts, so there is no need to focus on spares pricing anymore. Reality: While some real differences exist between these types of contracts, many of the same lessons learned and capabilities required to profitably price spare parts can be utilized to improve PBL proposal pricing as well. Myth #6: All quotes and customers should be treated with equal importance. Reality: Customer win rates and cost to serve differ dramatically, and companies should monitor win rates to prioritize quote responses across customers. Customers will sometimes ask for quotes without intent to purchase, and these relationships need to be managed to keep resources focused on the right proposal efforts. Myth #7: Historical costs provide a good basis for future cost estimates. Reality: While past costs often provide a good starting point for future costs, many factors, such as supplier changes, time between production, new supplier agreements, nonlinear commodity escalation, and many more, can cause significant changes in actual costs. In many cases, actual cost quotes from suppliers or manufacturing are needed to accurately project future costs.
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Myth #8: Original Equipment Manufacturer (OEM) cost estimating and pricing processes also work fine for the aftermarket business. Reality: Although the basics are similar, OEM processes have been developed to price relatively higher volume, repeatable products, as opposed to the lower volume, intermittent and out-of-production parts often seen in the aftermarket and can lead to inaccurate cost and pricing estimates. When taken together, the end result of these myths is the margin performance shown on Exhibit 1. While many of the parts show a margin consistent with expectations, the shotgun blast nature of the scatter plot shows much less consistency in terms of cost estimating and pricing than desired. Furthermore, with 20%-25% of sales resulting in millions of dollars in lost profits, aftermarket parts sales are actually cutting into the bottom line. Interestingly, we found many of the same myths and profitability issues in commercial aftermarket pricing (see Deloittes Driving Profitability Through Aftermarket Parts Pricing whitepaper).

Aftermarket pricing for the military market: The forgotten profit lever

Finding hidden value While the specific issues and size of improvement opportunity vary by company, our experience suggests that the more a companys military aftermarket business exhibits the following characteristics, the greater the potential to improve margins: Significant number of parts (> 50,000): Parts spanning multiple commodities, part segments, suppliers, and platforms make it impossible to review individual dynamics of each part. High percentage of out-of-production parts: Operating models and processes tend to focus on OEM production, thus, the companys understanding of true costs is lower for these older, out-of-production legacy parts making estimating difficult and time-consuming. Low volumes and infrequent demand: Low, intermittent volume parts have less historical pricing data to serve as a basis of estimate, as well as requiring more effort to obtain supplier quotes given the financial risks for suppliers.

Shifting supply sources between internal production and suppliers: As OEMs continue to focus internal operations on higher volume production components, more out-of-production parts have added costs due to resourcing, such as tooling, Non-Recurring Engineering (NRE), and quality issues, that may be excluded from cost estimates. Pricing for months/years in the future: Applying standard commodity escalation indices to historical supplier contracts does not take into account supplier pricing power and other causes of nonlinear escalation. Customer win rates: Understanding the competitive marketplace (Parts Manufacturing Authority (PMA) sources and source control suppliers) and customer purchase history is necessary to avoid wasting resources on low probability and poor margin pursuits. Commercial development: Companies with significant commercial and military revenues often do not take full advantage of dual-use pricing terms and profit rates.

Exhibit 2: Pricing value stream

Foundational data

Cost estimation and pricing Decision logic to lter and select data for the basis of cost estimate Escalation approach and indices Manufacturing loss of learning Historical cost versus future cost Price-quantity analysis Alignment with execution processes Minimum order quantities Commerciality Cost estimation/pricing Finance Contracts

Execution

Data inputs into the quoting Denition Cost considerations Risk premium considerations Functional groups involved 4 Accurate purchase prices and validity dates Tooling, NRE, and other nonpiece part costs In-sourced or outsourced part Price-quantity analysis BOM accuracy Commodity market volatility Supplier controlled part Supply chain/purchasing Manufacturing operations Engineering

Processes and functions that drive actual margin performance Purchasing contihuous cost reduction Supplier performance Minimum buys Manufacturing cost volatility Negotiation tactics Customer segmentation Sourcing complexity Emergency demand/aircraft on the ground Supply chain/purchasing Manufacturing operations

Taking a holistic view of the pricing value steam Understanding how information flows into pricing and how this is aligned with the execution functions becomes critical to finding the drivers of profitability issues, as exemplified in the scatter plot (Exhibit 1). An effective way to analyze the pricing process is to break up the process into a value stream (Exhibit 2). Laying out the pricing value stream further emphasizes the need to drive alignment across the numerous functional groups involved to improve profit performance in a sustainable way. Foundational data: A simple way to look at the value stream is by starting with the foundational data which estimators use to develop cost estimates. Cost estimating relies heavily on manufacturing work order and purchasing document data in order to respond to customer proposals. Of course, the data most useful to manufacturing and purchasing processes may not be the data that is most useful to pricing. For example, understanding tooling requirements for a part and what tooling is needed is critical to pricing spare parts accurately, but this data is often not available until an order is actually placed. By then, the information is too little and too late to put into a contract. In other cases, data may not be well maintained by those functions because they do not understand the downstream relevance of the information on pricing. For example, purchasing may know that a supplier cost for a part is no longer valid, but since no demand exists, the purchase agreement is not updated. In another example, engineering and manufacturing may not maintain the accuracy of Bill of Materials (BOMs) for out-of-production parts, leading to missing parts when pricing (see illustrative examples in Exhibit 1). Purchasing, manufacturing, and engineering functions need to make sure that the data is maintained in a way that not only supports those functions but also pricing.

Cost estimating and pricing: The foundational data feeds the system tools and processes that are used by estimating and pricing personnel to help set prices for the customer. The estimating system should be configured to pick an initial basis of estimate that best aligns with how manufacturing or purchasing will execute the part if it is ordered; however this is not often the case. The estimator needs to identify the risks associated with the basis of estimate and price the parts accordingly. For parts with a high degree of cost volatility, standard escalation rates may not be sufficient to account for the risk of the underlying part commodities or the leverage of the supplier. Purchase agreements may no longer be executable, or the price may be so old that additional information is required from purchasing before moving forward. Ultimately, a cost estimator needs to evaluate these risks and account for them in the price to the customer. While some costs and risks can be managed before pricing, additional profit factors should be considered in the price where justified. Understanding where additional effort is provided or where additional risk exists can help build a case to the customer for a higher profit rate. For example, out-of-production parts often require much more effort to source and have greater execution risks. Manufacturers often lose knowledge of making parts in-house after a period of time. This loss of learning makes historical information less relevant as a basis of estimate (Exhibit 3). Estimators have a responsibility for accounting for these risks and pricing them into the part. Customer negotiations can then determine the fair value of the risks and the final price the customer will pay.

Aftermarket pricing for the military market: The forgotten profit lever

Exhibit 3: Forgetting curves part example and labor hours escalation by break-in-production length (illustrative) 500

80% loss of learning 400

Labor hours

Labor hour estimate based on projected volumes 350

200 hour difference per part

90% Learning Curve

150 Labor hours estimate using average of historical production orders TX000

T1

Units

150%

125%

100%

75%

50%

25%

0% 3 Months 6 Months 12 Months 18 Months 24 Months 30 Months Break in Production Length

Execution: After pricing and negotiations, a customer sales order or contract generates the final execution step in the value stream. Execution represents the supply chain and manufacturing processes required to meet the requirements of the contract. How well these functions complete the contract requirements will ultimately determine how profitable the parts will be. With a good estimate and price, execution should be relatively easy, but increasing profitability through execution offers an even larger opportunity. For purchased spares, gaining awareness of potential demand through customer proposals or forecasting can provide additional leverage when sourcing from suppliers. Setting up long-term contracts for suppliercontrolled parts can help make you more competitive in the future. Procurement should also be as relentless as their customers in driving continuous improvement in cost reduction. For manufactured parts, continual focus on performance improvement and removing variability can improve the likelihood of achieving higher profitability. In most cases, issues exist across all three aspects of the value stream so focusing on just one area will not likely drive performance improvement. The tight linkage between these three activities, as well as the numerous functions involved in this process, is what makes delivering pricing improvement so difficult. Our experience suggests that a programmatic approach that is cross-functional and focused on early benefit realization is an effective way to drive profitability improvement.

Our experience suggests that a programmatic approach that is cross-functional and focused on early benefit realization is an effective way to drive profitability improvement.

Aftermarket pricing for the military market: The forgotten profit lever

Creating pricing excellence and improving margins 1. Getting started Companies often have difficulty determining how to start a pricing excellence program. There are numerous and diverse opinions as to the causes of below target margin performance that are not always based on reality or data. An effective way to start this effort is to conduct a diagnostic that estimates the margin improvement opportunity, identifies root causes, and develops quick hits improvement opportunities that can fund more comprehensive efforts. The major activities of successful pricing diagnostics at aerospace and defense companies include: Generate a margin scatter plot (similar to Exhibit 1) by building a database for spares sales over the last one to two years, including key financial measures (i.e., price, gross margin, volume, etc.) to identify the volume and impact of parts below target margins. Develop fundamental understanding of current cost estimating/pricing process and system logic. Conduct deep dives on the subset of spare parts below target margins, especially those sold at negative margins, to determine the root causes. Identify major issues and develop an improvement program, which includes quick hit opportunities. By building a fact base and framing the issues, as well as identifying quick margin dollars to capture, obtaining executive support to initiate change is less difficult than one may think. 2. Driving results As described previously, the diagnostic is a great initial step, but in order to truly pursue pricing excellence, companies need to build plans to address the risks and issues in the pricing value stream. The business will need to involve resources across many functions and achieve the right level of executive leadership. While the improvement process will not be easy, the benefits to the bottom line will be well worth it. The key activities of this next stage are building the foundation and infrastructure for pricing excellence and developing the aftermarket pricing strategy.

Pricing strategy The customer is always right mantra seems alive and well in aftermarket pricing. Proposal organizations often take on the challenge of providing the customers with a price for every part quote requested. While the customer experience is important, we find organizations often do not look at what they are getting in return. Customers exercise pricing and proposal groups for information without intent to buy or without funding. Competitive bids can put an OEM in the position of bidding against its supplier. These situations can lead to wins that cost the company money. Pricing and proposal teams need to understand their customers buying behavior and see if the number of contract wins makes sense for the number of proposals that are being created. These win rate customer tiers usually align with the cost to serve and profitability as well (Exhibit A). Reviewing win rate data with military customers is often an eye-opening experience; in many cases, customers are unaware of how much they are exercising their suppliers quoting organizations. We have also found that different types of customer quotes can cause increased amounts of effort to provide a good proposal. Proposal organizations need to understand these cost differences and incorporate them into negotiated prices. Finally, few organizations we have seen have a strong ability to walk away. How much risk is a company willing to take for a sale? Companies should have a wellthought-out walk-away price before entering negotiations so that they can be comfortable saying no because the customers are not always right.

Exhibit A: Differences between military spares customer tiers (illustrative)

65%

% of quotes 20%

15%

Tier 1 Customers Win rates Relative amount of competitive quote requests Time period of supply requested for quote Margins >50% Low

Tier 2 Customers 25% 50% Medium

Tier 3 Customers <25% High

Multi-year requirements At or above targets

Yearly requirements Varied (above and below targets)

Weekly or monthly needs (transactional) Below targets

Catalog strategy Spare part catalogs have become a popular way to improve pricing efficiency in spares businesses. However, these catalogs are often based on the estimating approach used in typical make-to-order pricing. Published pricing demands greater scrutiny because customers can and do take advantage of this if they feel they can get a good deal, resulting in lower margins. Weve found that companies usually have about 2040% of their catalog revenue at risk due to mis-pricing. The biggest catalog companies in the world limit this risk by knowing exactly how much they will make on a particular sale because they have firm supplier contracts or know what it will cost to produce. We recommend including lower value parts, especially those with high demand (e.g., hardware), in order to minimize the estimating workload while not incurring much financial risk (Exhibit B). Costs on these parts should be fixed in order to eliminate the risks associated with published pricing. For higher value parts, any estimating execution efficiencies are outweighed by the financial risk associated with mis-pricing. These prices should be reviewed by experts prior to being proposed to the customer. Collaborating with manufacturing and purchasing on a catalog strategy can help identify potential risks and find the right balance between profitability and efficiency. More proactive pricing organizations will identify potential parts for the catalog and ensure purchasing puts these parts on contracts, guaranteeing profitability and efficiency. Catalogs should also be reviewed quarterly or semiannually to ensure pricing is current with new rates, supplier agreements, or new demand for parts.

Building pricing excellence foundation and infrastructure: This involves forming a team across the pricing, procurement, operations, engineering, information technology (IT), finance, and other relevant functions to refine estimating processes, modify IT systems, and develop new tools to assist estimating personnel in deciphering the volumes of data to drive improved profitability. As we have already discussed, the pricing value stream is tightly integrated, so tackling problems in isolation will usually only result in frustration and minimal progress. Developing pricing strategy: Taking a hard look at your business by evaluating customer win rates, cost-to-serve, catalog strategy, and part segmentation can help identify further opportunities for margin improvement. As discussed in the opening pricing myths and realities, there are actually more degrees of freedom than many perceive, particularly around pricing strategy. Tracking and reporting win rates by customer can be a powerful tool for prioritizing estimating resources efforts, judiciously choosing when to no bid high risk proposals (see Pricing Strategy sidebar), and supporting negotiations. An additional area of opportunity is evaluating the performance and use of catalogs or external price lists. These are often viewed as a way to improve proposal resource efficiency, but often are a drag on profitability due to poor part selection and maintenance (see Catalog Strategy sidebar).

Exhibit B: Catalog assessment framework Example: Catalog assessment framework 1. Minimize inclusion Estimating workload savings are dwarfed by the increased nancial risk of including these parts in the catalog. 1 2 1 2. Minimize nancial risk Since these parts drive signicant revenue, re-estimating and price revision should primarily be focused on these parts. High Part price 3. Minimize workload The primary benet of including these parts in the catalog is avoiding estimation work; the nancial risk is negligible.

Low

3 Low Sales frequency

4 High

4. Maximize inclusion These parts are high estimating workload and low nancial risk prime candidates for inclusion in the catalog.

Aftermarket pricing for the military market: The forgotten profit lever

3. Sustaining the results At this point in the life cycle of the pricing excellence program, efforts should be improving margins with more benefits on the horizon. Another difficult challenge for companies is to maintain the benefits and not let new, competing priorities result in backslide of profitability performance. Ways to help sustain results are cross-functional alignment, metrics, and training. Cross-functional alignment: Collaborating with other functions is critical to sustainable success in pricing. Rarely do estimating and pricing have all of the knowledge required for some decisions. Estimating and pricing usually provide a single face to a customer, but this means the average estimator covers a wide variety of parts. Leveraging knowledge from purchasing, engineering, and operations can help the estimator understand and mitigate potential risks. Developing a process that seeks feedback from experts across the organization can lead to more profitable, less risky proposals. Metrics: When execution is complete, comparing the initial estimate to the actual cost incurred can result in lessons learned and help drive increased accountability for profitability in all functions. System-enabled metrics are crucial to understanding how escapes occur, as well as monitoring overall profitability, proposal process productivity, customer win rate, and supply chain alignment. Rigorous monitoring of metrics can help trace any pricing escapes back to the appropriate function to be resolved going forward and drive continuous improvement. Training: Recurring training for estimating personnel on how to most effectively use the tools available to them, as well as reinforcing their position as the Guardians of Profit for the organization, can help sustain the improvement momentum.

Benefits Taking control of aftermarket parts pricing to improve profitability is something any aerospace manufacturer can do. What often stands in the way is the sheer magnitude of the task tens of thousands of part transactions to analyze and solving chronic crossfunctional issues, such as BOM accuracy, purchase document validity, and changes to the cost estimation IT systems. Transforming your aftermarket parts business through a pricing excellence program can help you to: Improve aftermarket business profitability by 3%6% (we have seen up to 100 basis points of margin improvement within the first six to 12 months). Improve quote accuracy by 15%20%. Improve the quoting cycle time by more than 30%. Strengthen catalog profitability by 2%5% by identifying the right parts with the right prices for the external price lists. Decrease FTEs required to support the proposal process by 5%15% by eliminating time wasted on quotes with a low probability of winning. Understand your most valuable parts and customers to more effectively prioritize resources. Coordinate improved supply chain and manufacturing operations support for the aftermarket business.

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Getting it done This is where Deloitte Consulting LLP professionals can provide real value. We have extensive experience with aerospace and defense OEMs, suppliers, and services companies. We also have a detailed understanding of the landscape surrounding the military aftermarket and spare parts business, including knowledge of customers, government requirements, technical requirements, economic issues, and challenges facing clients. We can help you in your efforts to quickly uncover the issues and root causes, and then prioritize the highest value opportunities to realize bottom-line improvements in the near term. In addition, we can help you as you implement quick hits to capture early value and drive alignment across the organization to make the process changes necessary to sustain margin and revenue improvements over time. We bring client-tested approaches that incorporate effective industry practices and have provided real value all to help you in your efforts to achieve meaningful results.

Contacts To learn more about how we can help your company in its efforts to master the complexities of military aftermarket parts pricing, please contact: Michael Reopel Principal Deloitte Consulting LLP mreopel@deloitte.com +1 617 585 5971 John Coykendall Principal Deloitte Consulting LLP jcoykendall@deloitte.com +1 203 905 2612 Martin Hartigan Principal Deloitte Consulting LLP mhartigan@deloitte.com +1 213 688 5578 Pete Whiting Senior Manager Deloitte Consulting LLP pwhiting@deloitte.com +1 617 585 5909 Steven Shepley Senior Manager Deloitte Consulting LLP sshepley@deloitte.com +1 213 688 4161 Mike Bloss Manager Deloitte Consulting LLP mbloss@deloitte.com +1 212 618 4804

Aftermarket pricing for the military market: The forgotten profit lever

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This publication contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not, by means of this publication, rendering business, financial, investment, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication. Copyright 2010 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu