OEMs’ pressure on suppliers: signs of upcoming crisis?

Last year was a record one for commercial aircraft sales orders, production and backlog, with an astonishing 1 274 aircraft delivered. However, as low airfares drive airlines to buy new aircraft at lower prices, the OEMs have been also demanding suppliers to respond in kind to these pressures with significant price concessions. But the combination of pressure to trim unit costs and boost production could prove to be more disruptive than transformative.

With a combined backlog of more than 10 000 commercial aircraft worth close to $1 trillion, both Boeing and Airbus have never been in a stronger position, particularly when it comes to negotiating with their suppliers. The manufacturers can promise suppliers 10 years of recurring orders in exchange for cost reductions, improved quality and close to 100% on-time delivery. However, only the largest ones have the ability to manage their businesses on these terms.

“Lately, the supplier business model has evolved into the “risk-sharing partner” approach, where suppliers get paid when the OEM gets paid, and the supplier pays for and is responsible for design authority. That means the subcontractors are expected to manage a larger supply base themselves and require the same kind of skilled supply chain management personnel as the OEMs,” shares Zilvinas Sadauskas, the CEO of Locatory.com. “This is a big change, as they need to put their balance sheets at risk, invest much more of their own working capital, increase their skilled workforce and meet the new expectations of cost reductions. However, the financial, talent and operational challenges of becoming a “super-supplier” may not be addressable by some companies.”

One example is Boeing, which has been encouraging its vendors to optimize their supply chains and lower costs in exchange for more business. The manufacturer is using 777X participation for as much leverage as it can on the supply chain for further cost reductions. Many suppliers have indicated that a 15-20% reduction is what is expected for involvement on the 777X. Moreover, a push for reduction in supply chains cost is likely not to ease up even as the economy improves, as found by a survey by Canaccord Genuity. As a result, more and more suppliers have been indicating that they may be prepared to walk away from some business. Boeing’s switch from United Technologies Aerospace Systems to Heroux-Devtek in landing gear supply solutions, when the price concessions became too extreme for the former, is one of the proofs of the trend.

On the one hand, as loosing such giants as Airbus and Boeing is simply not rational, they currently enjoy a dominating position when it comes to negotiating such deals. The downside of such change, however, is that the manufacturers will inevitably have no choice but to take responsibility for every one of its suppliers, however small.

“Large airframe manufacturers are relying on very small companies as single sources for some key parts and sub-assemblies. When such small players are asked at the same time to invest in new capabilities and share the risks for new programs, they become overstretched both financially and operationally. Such companies can spin out of control quickly—and run out of cash—forcing the OEMs to intervene, even if it is only a relatively small business producing one part for a single program. One of such examples is Latecoere, which became so undercapitalized that it almost went bankrupt in 2010. Even today, its debt-to-capital ratio is over 170%,” comments the CEO of Locatory.com.

The other side of the coin is that many of the smaller suppliers may be acquired to enable the surviving bigger companies to gain better economies of scale. With fewer suppliers to work with, OEMs may find that vendors will be able to control prices for components and systems better, due to less competition. This could lead to manufacturing capacity-related delays, OEM margin pressure or supplier price increases.

“Of course, some progress has been noticeable, as OEMs have started taking some design authority back in-house and providing financial support to help certain suppliers. However, the fact is that beyond the unprecedented backlogs, the business reality down the supply chain actually displays a very different picture: too many weaknesses embedded in the system are not being addressed properly. While the manufacturers are trying to make the most of favorable environment, it’s important that the industry focuses of not allowing the system to overheat,” concludes Zilvinas Sadauskas.