Private Sector Drivers for Value-Based Sourcing and the Implications for Government Procurement

1. Value Based Sourcing Private Sector Drivers for Value-Based Sourcing and the Implications for Government Procurement Albert Sun, Principal, A.T. Kearney Session 1002 April 25, 2005 1:30pm – 2:30pm NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

2. Agenda • Private Sector Trends – moving to Value-Based Sourcing • Implications for Government Procurement and Contracting Professionals • Questions NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

3. Importance of Procurement inCompany Efforts(Average Responses from 2004 CEO Survey) Observations Between the 1999 and 2004 studies, the percentage of procurement organizations with goals in value creation increased from 28% to 66% CEO’s see value capture from the supply market as the largest challenge their company faces in procurement Past Current Future CEOs expect more and more in terms of Value Creation contribution from their procurement professionals 4 = High CEO’s priorities for procurement “Leveraging the creative talents of our suppliers” “Integrating and making our value chain more effective” “Create value through effective innovation with key suppliers” 1 = Low Sources: A.T. Kearney 2004 AEP study; A.T. Kearney 1999 AEP study NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

4. Significant factors are driving changes in the way private sector sources – especially in highly-engineered industries like Aerospace and Defense Macro-environmental Factors Globalization Natural Resources Political Integration/Disintegration Macro Factors Value Chain Implications Regulation and Activism Demographics Industry Factors Factors Affecting A&D Value Chain Direction Changing Industry Structure Industry- Specific Factors • Areas impacted • Employees • Organization • Processes • Technology Demand Volatility Aftermarket Growth Opportunities Value Chain Complexity NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

5. Scenarios 2016 Scenarios for the world in 2016 focus on hot spot convergence Legend Key political hotspots Israel/Palestine; Taiwan Straights; Indonesia; Korea Central Asia, Iraq, India/Pakistan Key water hotspots Jordan River Basin, Turkey, Egypt, Aral Basin, Middle East scarcity Key oil hotspots Middle East, North Africa, Caucus/Caspian States, Indonesia Key transit chokepoints Turkish Straits/Pipeline, Russia Pipeline, Panama and Suez Canals, Straights of Hormuz and Malacca Key demographic hotspots Middle East, North Africa, South Asia “Arc of Instability” • Key Notes • Significance of the Eurasian Landmass as “where the action is” • Emergence of “Arc of Instability” that stretches from North Africa to Indonesia NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

6. Key macro-environmental implications dictate that value chains will need to be responsive to uncertainties and risks • Private sector value chains must consider: • A combination of Circle-the-Wagons and Patchwork World in the near term (up to 2008) • Prepare to take advantage of any opportunities associated with the Open Society scenario (by 2016) NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

7. Industry Factor 1: Traditional OEMs are assuming system integration responsibilities and value-added roles are increasingly being assumed by a few key partners Next Step Past Common Today Platform Assembly OEM’s System Integrators System Integrators Large-scale Integration Sub System Integrators Value-added Parts and Assemblies Make-to-print Parts and Assemblies Raw Materials • Primarily direct supply • Many direct partners • No real role for “integrators” • Many “supply paths” • Fewer, but still many direct partners • Limited role for “integrators” • Larger role for value-adding partners • Fewer “supply paths” • Far fewer direct partners • Extensive role for “integrators” • Still larger role for value-adding parts partners These models are being further complicated as offsets and regional agreements require multiple partners for the same value-added parts and assemblies NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

8. Industry Factor 2: Customers are seeking more value which requires a fundamental shift from traditional design-and-build to full solution provider Aftermarket Value Chain Improvement Opportunities • Supplier responsible for front line availability of equipment including: • Inventory availability • Preventative maintenance • Product development • Front line repair including hot swaps Contracting for Capability Supplier • Supplier delivers to front line • Supplier consolidates and manages all inventory • Supplier responsible for some aspects of product development • Supplier has responsibility for regional repair/storage facilities Contracting for Availability Supplier Front Line Increasing Business Opportunity • Supplier delivers to 2nd line (staging/support area) • Supplier consolidate and manage all spares • High frequency service to 2nd line(depot and maintenance facility) • Supplier are inventory management and logistics managers • Short lead time (<1 week) Contracting for Spares Supplier 2nd Line Front Line Traditional • Spares for partner equipment to 3rd line • Armed Forces hold inventory • Lead time in months • Armed Forces manage facilities, people and infrastructure • Armed Forces have maintenance responsibility Supplier/ 4th Line 3rd Line 2nd Line Front Line Degree of Transformation Sources: A.T. Kearney analysis NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

9. Industry Factor 3: Continuing transfer of traditional customer responsibilities is increasing the complexity of the value chain • Prime contractor • Boeing • Contributing contractors US • Lockheed Martin • Allied Signal • Honeywell • United Technologies • Space Systems/Loral • Titan • Contributing contractors EU • Aerospatiale  • Alenia Aerospazio • Bradford Engineering • EADS • Aerospace  Fokker • Space  HTS • MAN Technologie • Matra Marconi • Space Verhaert Design and Development KIBO JEM • Prime contractors • Lockheed Martin • Northrop Grumman • BAE Systems • Contributing contractors • Rolls-Royce • Pratt & Whitney • Honeywell • Other contributors • 24 other partners • Global network of preferred partners NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

10. Observations Industry Factor 4: Demand volatility such as those experienced by A&D industry requires more flexibility in the value chain Forecast Commercial Satellite Launches(1) • Forecasted launches down by 40% from forecast just 5 years ago during 2004 – 2010 • Highest single year variation is 60% (2006) • No recovery in sight for the commercial market Department of Homeland Security Annual Budgets(2) • Fragmented, low level spending and organization prior to September 11, 2001 • 27% CAGR over 2001 – 2004 timeframe • Significant forecasted growth – 15% CAGR – through 2008 Ramp-up to support Operation Enduring Freedom(3) • Rapid ramp-up of A&D supply chains is required in response to unforeseen events • Companies must be profitable in both states – high and low production Sources: (1) FAA – 2003 Commercial Space Transportation Forecast. May 2003 (2) Center for Strategic and Budgetary Assessments; (3) CD Military Pentagram, 4/2003 NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

11. To respond to the uncertainty introduced by macro and industry-specific drivers, value chains will need to develop the capabilities below Required Capabilities Definition Collaborative Working with upstream/downstream global ecosystem partners to achieve common goals, e.g., effective product design, production planning, forecasting, etc., that optimize value chain performance. Virtual Extending a firm’s control of resources through partnering and outsourcing. The firm is virtual in that it effectively controls an asset without owning it Synchronous Coordinating value chain activity and data flow with global business partners to reduce costs and cycle times while increasing velocity throughout the value chain Adaptive Dynamic reconfiguration of the value chain to meet new customer needs and to leverage relative competitive advantage among value chain participants Agile Rapid expansion or contraction of the value chain in response to changing customer requirements with existing products, programs and services NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

12. To build these capabilities, industry must do business in a radically different approach – Ecosystem thinking Client X Partner E Partner A Customer Ecosystem Partner D Partner B Partner C Innovate Product Development Market/ Sell Manufacture/Deliver TechnicalOperations Customer Support Value Chain Program Management Partner Relationship Management Ecosystems are designed to benefit all partners and optimize value for the customer across a program’s entire lifecycle NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

13. Current Responsibilities Additional Future Responsibilities Concept Design Test Produce Maintain Improve/ Upgrade Retire A company’s role responsibilities within an ecosystem may shift across the program lifecycle Illustrative Typical Program Lifecycle – Highly Engineered Products Company Company EcosystemPartners Ecosystem Partners Influence/ Direction • Implications for the value chain • Longer support program timelines • New capabilities required that are not currently widespread • Increased complexity NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

14. There are four competencies that must be in place to be effective at managing an ecosystem Competencies Description Category Management is a consolidation of responsibilities for the management of a group of external purchases. Management responsibilities range from defining purchasing specification to contract negotiation with selected ecosystem partners Category Management Partner Relationship Management is the effective management of partner relationships through out the ecosystem to deliver value on three dimensions – cost leadership, innovation, and marketing differentiation PartnerRelationship Management Demand Management is the process to assure accurate forecasts are created and shared for products designed with maximum flexibility and the most efficient and effective manufacturing processes DemandManagement Value Chain Reconfiguration is the systematic analysis of capabilities delivered throughout the ecosystem for realignment opportunities to improve ecosystem performance and to identify new business opportunities for ecosystem participants Value ChainReconfiguration NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

15. As a result, traditional sourcing techniques will evolve and expand to focus on Value-Based Sourcing… Example – High Tech Focus of Sourcing – Approaches Targeted scope for VBS to build and manage intense value chain collaboration Production Material High Cordless Devices Time-to-Market Spec-Right-Sizing, Design-to Cost/to-manufacture/to-serviceability for required technical or other (e.g. branding) capabilities • Chip sets/ASICS • Battery • Display • Plastics/Resins/ Cradles • . . . • Strategic relevance • Value creation potential along whole value chain • Differentiation sensitivity • ... Indirect Material EMS Low High Low • Relative capability performance to best practice • Critical Mass • Capacity • Experience • ... ODM/OEM NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

16. . . . Requiring a new approach to the supplier market Process Landscape Value Based Sourcing Result Full Capitalization Of Suppliers‘ Capabilities To Maximize Value Value Definition Value Delivery (Idea Pipeline Management) Select Capabilities to be Leveraged Define Supply Market Scope Structure the Relation-Ship Define Value Drivers Map Capabilit-ies Imple-ment Generate Value Decide More than just Innovation conferences and design-to-cost Process interface to strategic product planning and further cross functional partners mandatory Optimal Supplier Portfolio At Best Total Cost Of Ownership Strategic Procurement Supplier VBS capabilities Increased Supplier Performance Supplier Management NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

17. Achieving full Value-Based Sourcing competence requires developing a broader set of skills Value Chain Leverage Strategies Networks / ecosystems Value Based Sourcing Extended Enterprise Closed Loop Spend Management Scope TotalEnterprise Advanced Sourcing Traditional Sourcing Procurement New Business opportunities Discrete Capabilities / Value Creation Function /Performance Components,products, and Services Impact Focus NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

18. Advanced Sourcing Techniques More Complex Categories Advanced sourcing techniques are being pursued by many leading companies Target Pricing Collabor-ative Cost Reduction Tiered Sourcing Mega-Supplier Strategy Design -to- Cost Level of Supplier Collaboration Low Cost Country Traditional Strategic Sourcing Global Sourcing Best Price Evaluation Volume Consolidation Level of Internal Coordination and Collaboration NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

19. Closed Loop Spend Management is a key mechanism to support Value-Based Sourcing by systematically capturing value creation and preventing leakage... Full Leverage Of Supplier Capabilities Sourcing Levers Applied Supply Chain Inefficiencies Demand Rightsizing & Optimal Specs Maverick Buying/ Compliance Full Spend Transparency Suboptimal -Payables Management Dynamic Performance Monitoring And Management Value To The Bottom Line NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

20. . . . And will require the implementation of enabling IT infrastructure Client Example – Redesigned Infrastructure For Value-Based Sourcing Starting point Result Scope of Functionalities • Transparency of sourcing volume • Volume per company • Volume per sourcing group • … Business Warehouse • Supplier analysis • Supplier profile • Qualified/non-qualified supplier per sourcing group • … • Frame contract management • Available frame contracts per sourcing group • Available frame contracts per supplier • … • > 10 different material classification schemes • > 120 legal units with dedicated ERP systems • ca. 220,000 supplier records • Lack of spend data transparency • About 50 SAP and legacy systems automatically linked (80% of relevant spend) • Consistent corporate wide classification system • Normalization to 38,000 suppliers • Compliance management • Use of frame contracts per company/sourcing group • Volume procured via frame contract • ... • Savings tracking • Indirect measurement of savings • Direct measurement of savings • Payables management • Transparent payment terms • Use of discount • ... NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

21. Agenda • Private Sector Trends – moving to Value-Based Sourcing • Implications for Government Procurement and Contracting Professionals • Questions NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

22. Government procurement and contracting officials can help jump-start value-based sourcing thinking in both new and mature programs • Understand the supplier base and their overall procurement strategy • Recognize that as customers of these suppliers, government can drive the value creation through the solicitation process • Encourage value-based sourcing techniques that apply within each step of a product/systems product life cycle • Promote value-creating opportunities by building on partnership and preference practices such as MWBE, Small Business, etc. NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

23. Value creation approaches Innovation and Growth Value Chain Optimization Advanced Cost Management Risk Management/Supply Continuity Organizational key Center-led for Coordination Capabilities required Appropriate IT Tools Formal, Systematic Processes Broad Human Resource Skills Category 2 Category 2 Risk Management / Supply Continuity (4) Risk Management / Supply Continuity (1) Innovationand Growth Innovationand Growth Value Creation Advanced Cost Management (3) Advanced Cost Management Value Chain Optimization (2) Value Chain Optimization IT Systems & Tools Processes & Measurement Human Resources Organization Alignment Development of government competencies is critical to lead and promote value-based sourcing Category 1 Sources: A.T. Kearney 2004 AEP study; A.T. Kearney 1999 AEP study NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

24. Academia has recognized the need for supply and value chain management skills Example Curriculum With Concentrations In Supply Chain Management Undergraduate and graduate concentrations in supply chain management are offered at many leading universities including University of Michigan, University of Arizona, University of Penn-Wharton and MIT Sloan with more to taking notice NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

25. ProcurementAnalyst Program Management Ecosystem Managers Demand Management Category Management Although universities will prepare students with the basics, advanced value chain management expertise will be learned through rotational job assignments Illustrative NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

26. Risk Management / Supply Continuity (4) Risk Management / Supply Continuity (1) Innovationand Growth Innovationand Growth Value Creation Advanced Cost Management (3) Advanced Cost Management Value Chain Optimization (2) Value Chain Optimization IT Systems & Tools Processes & Measurement Human Resources Organization Alignment It’s not rocket science, but it will most certainly “rocket” value-creation for customers and suppliers NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”

27. Agenda • Private Sector Trends – moving to Value-Based Sourcing • Implications for Government Procurement and Contracting Professionals • Questions NCMA World Congress 2005 “Prime Time: Contract Management at the Core of the Enterprise”