Defense manufacturers reported upbeat financial results in the first half of 2023, attributable in large part to the surge in demand associated with the war in Ukraine and the rebuilding of stockpiles. Looming over the entire industry, however, is continuing pressure on operating margins - particularly due to unexpected negative Estimate-at-Completion (EAC) adjustments that continue to hammer at the bottom lines of OEMs and suppliers alike.

The Earned Value Management System (EVMS) is widely accepted as a defense industry program management leading practice. And the EAC metric – the current projection of the total costs of a program once completed – is critical to understanding program performance and profitability. Negative EAC adjustments signify cost overruns that diminish profits. 

A&D management can avoid negative EAC surprises and strengthen their core program management fundamentals, but it takes strategic planning to achieve this.

Solving the underlying problem

As a business leader, it might be reasonable to ask, “if I’m winning large contracts and my revenue is going up, why should I care about negative EAC adjustments? Isn’t it just a financial detail?” No – in fact, the ability to hold to EACs projected at the outset of a program is the core skillset of effective program management. Deviations from the EAC flow through directly to the bottom line and impact profit, shareholder value, and even the compensation of senior leaders.

Poor EAC performance often stems from inaccurate initial program cost estimates. Subsequently, program managers who place insufficient attention on managing variances from that baseline land in situations where program costs grow so much relative to the baseline that reserves are expended. This causes negative EAC adjustments, a need to re-baseline, a failure to meet contractual milestones, and more. In some cases, negative EAC adjustments on a single program can be sufficiently large that they can lead to material write downs – even for a large public company.   

Negative EAC adjustments are often blamed on real issues like supply chain disruption, COVID-19, inflation, or other secular factors. While these are real challenges, the root causes almost invariably lie in weakness in program management fundamentals, such as poor cost projections; ineffective risk management; program managers chasing technical details rather than managing cost and schedule variances; and insufficient coordination between business development, finance, engineering, and other functions.

The consequences are not insignificant, as indicated in Figure 1 below.

The impacts of negative EAC adjustments are not easily passed off to customers (particularly with the industry’s growing trend of fixed price contracts), nor easily offset by using positive EAC adjustments to wash out negative ones – these practices are unreliable and fail to address root causes. On some occasions, there is a perception that risk reserve or management reserve is a bucket of “free money” available to offset EAC growth; however, eating into reserves reduces profit at the end of a program. Additionally, negative EAC adjustments are sometimes waved away using the rationale that a program is cost-plus and therefore the cost doesn’t matter. This may be true to a limited extent within a single program, but contractors who don’t believe that poor cost performance will reflect negatively on them when it comes to winning future business are not being realistic about today’s environment.

So, what’s the fix? Companies must develop a robust program management capability, particularly in an era when customers are pushing back much harder on blanket cost-plus contracts, requests for equitable adjustments, and price changes. In other words, companies need to know how to control their own destiny rather than play a high-stakes game of roulette.

Unlocking the power of robust program management 

Program management, and the skillset needed to master it, is unlike any other discipline. A person who is good at one area of expertise isn’t necessarily fit for a totally different assignment. Imagine asking an accountant or lawyer to design a thermal control system or build a rocket. That isn’t all that dissimilar from asking an engineer who may be good with complex systems and specialized details for instance, to be an expert program manager, especially when a company may lack a robust ecosystem for program manager training beyond archived PowerPoint presentations and the occasional lunch and learn.

Program managers (PMs) are not “super chief engineers.” Effective PMs possess a well-rounded understanding of operations, supply chain, finance, business management and administration, and engineering.

Development of new program managers needs to be tackled via a well structured and thorough roadmap. Companies should consider creating a PM academy or other training program that mirrors continuing education options many companies create in-house for engineering skills. For engineering-heavy firms, a purpose-built program for those who want to become PMs should include multi-year rotational programs that teach employees how the job is done well.

Investments in technology are also needed, with a heavy emphasis on data. Information availability and flow are essential to effective risk management, cross-functional communication, and cost forecasting – to support accurate and rapid decision making.

The pyramid approach

Weak cost estimation is often the starting point of a poor baseline and leads to EAC overruns later in a program’s lifecycle. Costing at the outset of a program is often driven by either price pressures and the desire to win a bid, or the incentives for engineers to use the last program they did as a template, add on an adjustment factor, and declare the cost estimate complete. Starting a program with a poorly estimated, unexecutable baseline means that the program manager will be trying to dig out of a deep hole from day one.

Consider instead approaching cost estimation from a “pyramid” framework. The base of the pyramid is formed by engineering, operations, supply chain, and sustainment teams all working collaboratively to develop initial data based on past or comparable experience, with documented, detailed Basis of Estimates (BOEs). Those inputs are fed to finance experts who use parametric and historical cost data to inform an actual estimate they are accountable for. Finally, top the pyramid with a call to business leadership for approvals. This approach has the advantages of forcing the technical teams to document the rationale behind their assumptions, and for finance to sanity-check estimates with actual historical data. At that point, if management wishes to override the cost estimates to win a capture, they have that option, but this will be a late adjustment to the bid price rather than its foundation, and it will be well understood that such a decision vastly increases execution risk.

To make the shared-responsibility design of the pyramid work, there needs to be a well-defined stage gate process that links costs to specific profitability targets. This ensures the program will lead to profitable growth and cash flow. Growth for the sake of growth is not the goal: profitable growth is.

Of course, in the instances where a company chooses to “invest” by proceeding with low or even negative margin programs in their initial stages, there must be clear rationale and a well understood pathway toward eventual program profitability. Simply hoping that customer-funded changes will eventually drive profitability is not a sustainable strategy and has caused large losses in the industry over the past decade as the customers have moved more aggressively to fixed-price development contracts.

At every step, work with the customer. Changing, vague, or unrealistic requirements can sometimes be the largest challenge to creating an accurate estimate, so lock down agreed-upon parameters as early as possible.

Managing risk

Too often, risk registers are backward-looking documents where program management records all the bad things that happened on a program. Ideally, risk and opportunity management (opportunities are very rarely accorded the same level of focus as risks, but should be) is a proactive, anticipatory activity entailing the expenditure of resources prior to risk realization. If you ask your program managers what adjustments to the “no-risk” baseline have been made to consider and mitigate risks, and the answer is “we are doing the exact same thing we would do anyway,” then you haven’t spent enough time planning to mitigate program risks.

To be better prepared, a rapid response capability – including the right cross-functional teams, tools, and processes – needs to be in place from the start and ready to be quickly deployed. This will ensure that when needed, the response team is ready to be brought into action.

Another leading practice in managing program risk is to periodically perform “stress tests” across each phase of the product lifecycle. As referenced in Figure 2 below, there are several areas that companies can investigate to assess the likelihood of negative program performance. Performing these “stress tests” can help expose potential risks and give teams a better chance of recovering.

A key behavior to avoid is a “green culture” where the team is afraid to surface issues for fear of punishment, blame, or ostracization. Bad news never improves with age – the earlier a problem surfaces the more options there are for mitigating it. Deviating from risk reporting guidelines, or simply not reporting problems, are never acceptable behaviors if the goal is to avoid getting blowback from management. Unfortunately, however, these are common industry behaviors.

Earlier we mentioned a management reserve (MR). MR should be diligently planned and retained for the inevitable “unknown unknowns” that arise throughout the program’s lifecycle. Program managers should carefully consider, for example, “remaining points of invention” – if the company, its suppliers, or its customers have never done something before, PMs should be extremely cautious with estimates for development time and cost – especially on fixed-price development programs. A sufficient MR can be a make-or-break provision – and it must be sized based on documented rationale linked to the size and risk of the program. It cannot be “the amount of money left over that we can afford to put into MR.” 

Coordinating between functions, aligning incentives

The various functions involved in cost estimation and managing to that cost – BD, finance, program management, engineering, supply chain, operations and business leadership – often have different incentives causing communication breakdowns, lack of coordination, and mixed messaging to customers.

No matter the reason, problems can be solved by aligning incentives across programs. For example, tie BD compensation to whether the cost and price that were bid were met if the program is won. Consider holding engineering to design-to-cost targets rather than just technical specifications alone.

As demand for defense products is rapidly growing and publicly traded companies are experiencing strong upticks in revenues, firms should be reaping profits that reflect this strength. However, there are continued reports and announcements about program cost overruns, negative EAC adjustments, and programmatic challenges that are preventing this from occurring.

Unexpected negative shocks due to poor execution unnecessarily burn cash that could otherwise be returned to shareholders, creating downward pressure on valuations relative to where the firm could or should be. A practical approach to turn this around is multi-focused on talent and skillsets, cost estimating capabilities, effective risk management, and stronger collaboration across the enterprise.

For a deeper discussion about this topic, contact:  

Eric Bernardini 
Global Lead, Aerospace, Defense, and Airlines
[email protected]

David Wireman 
Partner & Managing Director
[email protected]