Panel 5
Dual-Use Supplier Management and Strategic International Sourcing in Aircraft Manufacturing

Todd A. Watkins

Lehigh University

Dr. Watkins presented a case study on how one company deals with supplier management and offsets. The case will be presented as the Generic Aircraft Manufacturing Company (GAMC) because of the sensitivity of the data and issues. Originally, the case was a study of dual-use manufacturing. Data collected on strategic international sourcing and offsets, however, proved to be both very interesting and extremely sensitive. As a result, it took two years for the company to agree to release the case study, even then only in generic form.

An Overview

The purpose of the study was to extend the analysis of lean manufacturing practices to supplier management in the aerospace industry. American aerospace companies began moving to the lean manufacturing model in the 1990s as the industry sought to rationalize the supplier base because of the economic downturn. The complexity of the products in aerospace implies that the industry is managing a supplier base at least as complex as that of the auto industry, where the lean model was developed. Mid-tier companies need to deal with the supplier management practices of the upper-tier manufacturers, as well as manage an equally complex series of relationships with their own suppliers. Unique to the aerospace industry, however, is the need to manage a supplier base in the two separate sectors of defense and commercial products. While supplier management practices at GAMC differed little between the two sectors, the major exception was offsets.



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--> Panel 5 Dual-Use Supplier Management and Strategic International Sourcing in Aircraft Manufacturing Todd A. Watkins Lehigh University Dr. Watkins presented a case study on how one company deals with supplier management and offsets. The case will be presented as the Generic Aircraft Manufacturing Company (GAMC) because of the sensitivity of the data and issues. Originally, the case was a study of dual-use manufacturing. Data collected on strategic international sourcing and offsets, however, proved to be both very interesting and extremely sensitive. As a result, it took two years for the company to agree to release the case study, even then only in generic form. An Overview The purpose of the study was to extend the analysis of lean manufacturing practices to supplier management in the aerospace industry. American aerospace companies began moving to the lean manufacturing model in the 1990s as the industry sought to rationalize the supplier base because of the economic downturn. The complexity of the products in aerospace implies that the industry is managing a supplier base at least as complex as that of the auto industry, where the lean model was developed. Mid-tier companies need to deal with the supplier management practices of the upper-tier manufacturers, as well as manage an equally complex series of relationships with their own suppliers. Unique to the aerospace industry, however, is the need to manage a supplier base in the two separate sectors of defense and commercial products. While supplier management practices at GAMC differed little between the two sectors, the major exception was offsets.

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--> The GAMC Profile GAMC is a producer of major structural subsections, such as wings, for the prime airframe manufacturers. The company supplies subsections for both defense and civil aircraft using a single supplier management system across both sectors. The experience of the company reflects, at a microlevel, many of the issues discussed earlier at a macrolevel—including the mind-set of "if not us, then someone else will get the business" and a lack of data. However, their strategic outsourcing initiatives have come about due to pressure from commercial, not defense, customers. The company also illustrates the turmoil in the industry, having reorganized many times under various new owners. Both employment and the number of suppliers declined between 1991 and 1995 as the company went from a size of $1 billion to $650 million before being absorbed by a larger firm. The company's mix of business has shifted from 60 percent defense to 40 percent defense. Mid-Tier Squeeze The company has undertaken a whole range of supplier management actions normally associated with lean manufacturing, such as collaborating closely with their suppliers, building long-term relationships, and assisting in improving suppliers. Applying these principles while internationalizing the supplier base leads to a situation for a mid-tier company in which the company ends up essentially working to help improve firms that are and will be their competitors. Dr. Watkins labeled this situation "mid-tier squeeze." GAMC has become more attractive to its customers because it is a leader in applying these principles. GAMC is moving away from a loosely organized supplier system to a much more closely controlled structure, with a number of long-term partnerships with both customers and suppliers. Because more than 80 percent of their suppliers service both defense and commercial products, the company uses one single supplier management and quality control system across both sides of the business. A clear goal of their supplier management system was to increase the number of foreign suppliers. All of the pressure for this internationalization of the supplier base was coming from commercial customers. By contract, GAMC was required to increase the number of foreign suppliers to a certain percentage. The reason for this pressure was that the company was supplying subsections to aircraft targeted to Pacific Rim markets. Beginning in the mid-1980s, under severe pressure from their customers, the company went searching for foreign suppliers. Their first strategic outsourcing arrangement was with what Dr. Watkins labels "Nagoya Aerospace," a consortium of five Japanese companies. GAMC transferred to Nagoya the production of a particular substructure that they had been doing in-house for a number of years.

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--> This was a mature, middle-technology part, comprising about 15-20 percent by cost of the total delivered structure that GAMC was sending to the prime contractor for their aircraft, ''Norton Alpha." Nagoya was chosen for three factors: the bid was even lower than in-house production at the time (this is no longer true due to currency fluctuations), the skills of the company for long-term partnering (i.e., will Nagoya be able to do more than build-to-print in the long term), and the interest in the company in taking on a mid-technology product. A year later the product was second sourced to a Korean company. Subsequently, GAMC has made similar arrangements for many other products in many other countries. Improving Foreign Suppliers Under the lean manufacturing model of building collaborative relationships with suppliers, GAMC has the responsibility passed down from the top tiers for managing and improving the quality of the lower tiers. GAMC retains the responsibility for the quality of the product. As a result, GAMC spent a lot of time shifting the production of that part over to its foreign supplier. They provided significant technical and managerial assistance. In essence, GAMC was forced to take on a new role of improving foreign suppliers because of pressure from their customers. Ultimately, Nagoya was given the responsibility for managing the production of that substructure. This means that Nagoya ended up managing the relationship with those U.S. suppliers who had been supplying GAMC for that substructure. Dr. Watkins pointed out that this form of production sharing makes data collection very difficult. The product coming back to GAMC from Nagoya and the Korean manufacturer contains a significant amount of U.S. components and subassemblies. It is unclear how this gets counted as an offset credit when it goes to the prime contractor, "Norton." Because this subsection is a mature product, the U.S. subsuppliers are already in place. The question has to be raised as to whether Nagoya will use the same U.S. suppliers for the next product. As it turned out, in one case Nagoya completely by-passed GAMC and went directly to work for Norton. Over time, the relationship between GAMC and Nagoya has expanded. GAMC outsourced a similar substructure to Nagoya in the 1990s. Significant Payback GAMC has received a significant payback from this process. They spent a significant amount of time, money, and effort over a decade to increase their

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--> ability to work with international suppliers. This international exposure has made them more attractive to other customers and thus boosted their edge in the highly competitive middle-tier supplier market. A new major U.S. customer, Kramden, came to GAMC to work on a new transpacific aircraft. Kramden is attracted to GAMC specifically because Kramden's target market was the Pacific Rim, and GAMC has established relationships with Pacific Rim suppliers such as Nagoya. As a result of the importance of this relationship, Nagoya has moved from essentially a build-to-print shop to being GAMC's development partner on this major substructure. Policy Issues Employment Dr. Watkins then turned to a number of policy issues. In this case, the impact of strategic sourcing on employment was marginal. GAMC went from more than 11,000 employees to about 5,000 employees between 1989 and 1995, which was mostly due to cancellations in defense, not to strategic sourcing. By 1995 the net effect of strategic sourcing was probably positive because of the new deal with Kramden. The longer-run impact on jobs is still unclear. Nagoya may become a viable competitor because GAMC has transitioned its skills to them and essentially introduced them to Norton. This transitioning may have a much greater impact on jobs than the outsourcing, which was probably only about 5 percent of the employment loss. Dr. Wessner asked why, then, was the case so sensitive. Dr. Watkins replied that the problem seemed to be, in part, concern by the company over the reaction of the unions and the public. Although 5 percent may be a small number, it can still be perceived as a example of moving jobs overseas, even if that process may have been responsible for getting new work. In addition, the prime contractors were concerned about revealing contractual information in the report. Technology Transfer A second policy issue raised by Dr. Watkins concerned technology transfer. He stressed that the most important technology transferred in this case of a mid-tier, metal-banging company was tacit manufacturing knowledge. GAMC was not transferring design know-how or proprietary in-house sophisticated manufacturing technologies, as this was a mature, mid-technology product. They transferred manufacturing know-how that allowed the foreign supplier to move more rapidly down the learning curve. It was experiential knowledge, such as engineers noticing that a pneumatic press is turned up too high. They were also training their foreign suppliers in their customers' preferred procedures, such as their total quality management process.

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--> This created a sensitive issue for the company. With Japanese engineers visiting the U.S. production facilities to learn how to make the product, managers needed to acquire the new skill of dealing with workers worried about their jobs being transferred offshore. Dr. Watkins pointed out that this type of technology transfer is a non-market behavior. It is the type of activity that goes on routinely within any company. It is difficult to police this from a policy perspective. Nor can it be distinguished from the classical reasons for strategic alliances, which is to learn from one another and thereby transfer tacit knowledge. Trade Distortion The case study illustrates that trade distortion, while occurring, may be inevitable. The agreements were not necessarily based on price. GAMC transitioned products to the United Kingdom, South Korea, and Australia because these are big markets for their customers, not because of the price differential. Dr. Watkins also noted that the units being supplied to GAMC from foreign sources were going into all their customers' aircraft, not just those for Japan or Korea. There is not a specific offset for a specific customer. The outsourced production goes to all customers. The result is a marginal increase in trade distortion. There is also an economic distortion in the fact that the process has increased the burden on GAMC. Their costs and responsibilities have increased because they now have to manage a process of seeking out and training international sources. Overhead costs, especially the management of procurement, have been rising as the top tier has been pushing this responsibility down the supply chain. Market Access These arrangements are made for market access reasons, where governments have put pressure on foreign aircraft manufacturers. Offsets are not the direct problem. The problem is the trade-restricting policies, which offsets seek to get around. Companies, especially middle-tier companies, can do little about offsets. The target of the U.S. government should be the trade-distorting policies. In trying to apply trade law to offsets, the measurement problems will be enormous. The case has shown that much of the problem will remain hidden because it is so many layers deep in the supply chain. The case also illustrates that the process is unlikely to create new competitors for the top tier with the transfer of tacit manufacturing knowledge. The barriers to entering the top tier are too great. However, this process is expanding the foreign skill base. Nagoya got work directly from Norton, bypassing GAMC in part because of the general "introduction" made by GAMC. GAMC claims they would not have gotten work anyway, but Dr. Watkins believes they had the skills in-house to do the job. The result of the technology transfer is not to turn these

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--> foreign companies into competitors, but to help them get down the learning curve faster then they could on their own. In closing, Dr. Watkins pointed out that companies are facing what he calls "mid-tier squeeze." Top-tier firms are passing responsibilities down to the lower tiers, teaming with the lower tiers, increasing the risk and overhead of the lower tiers, expanding the necessary set of skills in the lower tiers, passing down responsibility for design and risk sharing, and demanding foreign sources. The mid-tier firms follow the same lean manufacturing paradigm of attempting to work with the best suppliers and make them better. The greatest danger to existing mid-tier firms is that of fostering "tier jump," for example, helping a lower-tier firm become a competing mid-tier company. Mid-tier companies are under enormous pressure to take more responsibility and are, at the same time, creating their own competitors. Dr. Wessner asked how there can be "tier-jump." Would not the American prime contractor ask Nagoya to train GAMC in return, perhaps with the encouragement of the U.S. government? Dr. Watkins responded that the reality is that mid-tier firms do not have a lot of bargaining power, nor is there any incentive for the American prime contractor to make such a demand. In response to a question from Joel Yudken of the AFL-CIO as to how typical the situation facing GAMC is, Dr. Watkins stated that his impression is that mid-tier firms are under increased pressure from the upper tier. Discussants John Sandford Rolls-Royce, N.A. Mr. Sandford opened his remarks by commenting that he believed that the case was very representative of what is happening in the industry. The reason the prime contractors push their suppliers is because the prime contractors have market power and access to capital. From the perspective of a CEO, he stressed the importance of moving beyond technology to looking at the extremely crucial role of capital. He has seen numerous cases of prime contractors putting costly pressures on mid-tier firms. But he has also seen cases in which the prime contractor has subsidized lower-tier firms in order to meet their obligations. Although this may be recorded as an offset, the company is getting the capital it needs. He reminded participants that companies need to satisfy the demands of their shareholders. Mr. Sandford was especially pleased that this case study described the real costs. Another example of costs is the process of gaining Federal Aviation Administration (FAA) certification. In the production process described in the case, parts probably have to travel across the Pacific at least twice. All of the steps have to be approved by the FAA because the certification states that the

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--> parts have to be "as designed," "as manufactured," and "as proven." This is an additional cost. Mr. Sandford also stated that, from personal experience as a chief operating officer, the overhead costs of managing the process are very real. However, the companies have no option. In the long term, companies may be training their competition. But, given that the process may take ten years, companies have time to decide where to move. Although the cost of entry is enormous, there is talk of aspirations of companies in China and Japan to become prime contractors. Mr. Sandford stated that in his opinion no sane person would undertake these costs, but some companies and their governments may do it nonetheless. In any event, creating a mid-tier industry creates the ability and the political leverage for a country to move into the prime tier. In summary, Mr. Sandford believes that the analysis presented in the paper was extremely realistic. Although it is unclear whether it was generally right or wrong, GAMC probably made the right decision from the CEOs' and shareholders' perspective. The company has ten years to make their next strategic move, and they did get the current business in the meantime to satisfy short-term shareholder demands. Al Volkman U.S. Department of Defense Mr. Volkman stated that he would focus his remarks on the issues covered in the paper of dual-use management and strategic international sourcing rather than offsets specifically. These two issues are similar to those identified by the Undersecretary of Defense for Technology and Acquisition as key issues facing the U.S. industrial base: commercial-military integration and international armaments cooperation. The Revolution in Military Affairs The security environment facing the United States is one of a changing and unpredictable threat. One of the key factors is the development of new technologies. The new phrase is "the revolution in military affairs." This refers to the increasing importance of communications and information technology and biotechnology in the national security structure and in the way in which wars will be fought in the future. It is important that the United States maintain access to these technologies to maintain a strong defense. In this environment, it is important to bring equipment into place faster and cheaper. The United States, in the future, will be forced to place a greater reliance on coalition warfare. Almost every major war fought by the United States in this century has been fought with allies. These coalition operations will be even more important in the future.

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--> Other factors affecting the security environment include the fact that DoD has a smaller share of the national budget; the increasing globalization of business activity; and the fact that the commercial sector, rather than the defense sector, is increasingly driving the pace of technological change. Less Time and Lower Costs The DoD needs to make sure that suppliers in the twenty-first century are able to design and produce the highly complex weapons systems necessary for national defense. The DoD believes that it takes too long to field weapons systems, and that the cost of the systems needs to come down. In addition, these systems must be designed to support coalition warfare and interoperability. Although commercial technologies are driving the revolution in military affairs, there is also a need for revolution in business affairs. The DoD needs to look at ways to improve its acquisition processes. Important advances in this area have been made. As the paper points out, the defense business operates on military standards and specifications for contracting with companies. In the past, there have been some suppliers, such as Hewlett-Packard, who did not want to do business with the military because of these requirements. Over the past few years, the DoD has tried to rely more on commercial standards. Commercial products are a bigger and bigger part of the procurement system. Given the globalization of the commercial industrial base, there will be more foreign components in our systems as DoD becomes more dependent on the commercial sector. It is therefore important not to impose restrictions, for protectionist reasons, that would limit the military's access to those items. International armaments cooperation between DoD and U.S. allies is fundamental to coalition warfare in the future. Cooperative development and production of major weapons systems have not been all that successful in the past. Such cooperation is not popular and has generally been resisted by Congress, unions, and much of the military. There is an unhealthy trend toward both Fortress Europe and Fortress America. Coalitions Mean Interoperability Nevertheless, globalization of the defense industry and coalition warfare is the direction of the future. Coalition warfare requires interoperability; interoperability is greatly aided by operating the same equipment. Likewise, it is important for U.S. allies to be using the highest quality equipment on the battlefield in support of U.S. battlefield operations. At a time when the defense budget does not match the military's modernization needs, it is important to leverage the investments that Allied governments have to put into weapons systems. European

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--> governments are no longer able to develop highly expensive weapons systems on their own. The costs of U.S. programs, such as the Joint Strike Fighter, have reached the point where financial support from U.S. allies might be welcomed. Mr. Volkman closed by arguing that, to ensure the success of cooperative programs, we must first look at what U.S. warfare needs are. Next, it is important early in the cooperative programs to agree on the business rules and agreements to share technology. Governments will need to make broad agreements on the relative contributions by each government and how much work will go to each country. Companies can then form teams and decide how these rules will be applied. Such an agreement guaranteeing that the United States receives benefits equal to its contribution is crucial in building public support for such cooperative programs. Already, Congress requires that funds for NATO R&D cooperative programs be spent in the United States. That may be trade distorting. It is clearly a fact of life. General Discussion Art Ismay, Defense Industry Offset Association and Rockwell International : Mr. Ismay commented that the case very well described real life in both the aerospace industry and the automotive industry. However, the process is not just dictated by customer demands. The manufacturers themselves undertake strategic outsourcing to improve quality, improve delivery, and reduce costs. Cost saving is achieved by selecting the most competitive supplier available. The lowest-ranked suppliers, who are not good with delivery, are poor in quality, and are not measured well in cost, will be dropped. Companies will work with suppliers to simplify the production process to achieve cost savings. Take for example a product that requires two operations, such as forging and machining. Companies will help upgrade suppliers so that they can do both operations, thereby reducing the number of parts of the process that have to go out for separate bids and thus reducing the overhead. Companies will also send personnel to suppliers to upgrade their processes because the companies need results immediately. Sometimes outsourcing is done for purposes of market access. But companies would not outsource to their disadvantage—they would rather walk away from business. Mr. Ismay emphasized that supply chain management is done to benefit a company, not to benefit a foreign government or for the sake of completing an offsets program. Mr. Ismay disagreed with Dr. Watkins' concern over "tier jump." The work is parceled out in such a way as to minimize this. Companies work to upgrade their suppliers' abilities to satisfy their needs (e.g., better gears). They do not help them produce higher-tier products (e.g., a 16-gear transmission). Deborah Nightingale, Massachusetts Institute of Technology: Dr. Nightingale emphasized her agreement with Mr. Sandford as to the importance of capital.

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--> Decisions are made based on capital requirements. If you do not have the money to develop a new, expensive product, your options are to not do it, or to find partners. Access to capital is essential to grow the business and increase productivity; increasing productivity is easier when business is growing rather than downsizing. Growing the business in aerospace means expanding internationally. That requires partnerships, which are a way of life in many industries other than aerospace, such as automotive and electronics. They require highly skilled people to manage the technology so that you do not give it away. International partnerships may be difficult, but they are a way of life in the globalized economy.