Finance on the Front Line

Defense contractors are benefiting from new controls their CFOs have installed.

In the year since terrorists attacked New York City and Washington, D.C., the United States and its industries have suffered in ways both unexpected and predictable. Between arming the nation for overseas conflicts and bolstering its security at home, though, the defense industry has been thriving.

Not since the Vietnam War has the defense budget risen so sharply in a single year, driven largely by the need to procure high-tech weaponry like that used in the campaign against Afghanistan, and potentially to be used in Iraq. As a result, Lockheed Martin, Boeing, Northrop Grumman, General Dynamics, and Raytheon, until July, at least, had weathered the bear market with hardly a scratch. And the five industry leaders, along with many second-tier contractors, also had better-than-expected earnings in the first half of 2002.

Still, their good fortune can’t all be attributed to the drastic turn in world events. Were we still in the 1980s-style grip of the arms race against the former Soviet Union — when dozens of big arms makers fought to fill the Pentagon’s astronomical appetite for expensive planes, missiles, ships, and tanks — it would be about time now for an industry tailspin.

But that isn’t expected this time. After a rocky decade of decline in the industry following the Soviet Union’s collapse, U.S. defense-industry leaders turned to their finance departments for help, for the most part in the late 1990s. They made major organizational changes and installed new approaches to cost control, while abandoning many old, counterproductive practices.

“There’s been a broad acceptance of financial disciplines and controls that simply were absent in the Cold War environment,” says Robert V. LaPenta, president and CFO of defense-electronics concern L-3 Communications Corp. No longer, he says, is finance “the short leg of the three-legged stool for many defense companies,” deemphasized compared with engineering and marketing.

“It’s a matter of managing the businesses as businesses,” rather than seeing themselves mainly as equipment providers for the military, says Northrop Grumman Corp. vice president and CFO Richard Waugh, who has watched the industry develop over two and a half decades at the company, the last nine years as its finance chief. At Northrop, he says, finance now contributes by carefully planning the integration of its acquisitions, and with “earned-value measurement systems,” which are manufacturing cost-control programs that “go down four or five or six levels to tease apart the cost of various work efforts,” and help the company achieve specific reductions. To a large extent, he credits Northrop’s seven-year-old compensation system, which rewards management efforts that benefit shareholders rather than merely grow the company.

The emphasis on finance is quite a switch from the old days, when the emphasis was on pleasing “the customer,” as the Pentagon has always been known. Indeed, in the bad old days, arms makers played games with their bidding strategies. “Companies asked themselves what it would take to win a program, as opposed to what the program would cost,” explains LaPenta, whose industry finance experience also goes back to the 1970s. “It was a case of bidding to win it, then hoping somewhere down the road to make that money back,” he says.

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