Scenario: The owner and manager of a small family-owned precision machining company (we will call it "Little Guy"), an expert at making quality aircraft parts, just died. His two sons, also skilled craftsmen, are continuing the business. Neither has any business experience. Little Guy is losing money, and debt is increasing. Seventy-five percent of Little Guy sales are to one large prime contractor (we will call it "Big Guy"). There is one year left on a three-year contract to Big Guy. This contract imposes price reductions of 6% per year on Little Guy plus penalties for non-performance. Realizing that this imposition is trending badly and that more business expertise is needed, the sons called on consultant Gene Siciliano of Ironwood Advisory LLC for assistance.

Gene presented this case history in transition management at the November 14, 2006 gathering of the Enterprise Chapter of the Los Angeles Section of AIAA under the title of Building Airplanes Can Be Hazardous to Your Balance Sheet.

To a trained financial professional like Gene, it was apparent that corrective action in the cost accounting system was needed fast! Labor hours were being recorded without reference to the parts being made. The total cost of all parts was known, but the costs of individual parts were not, so that it was not known which parts were profitable and which were losing money. A job cost system was installed under Gene’s guidance, along with an inventory control system. The Job Boss software system was used to track costs and inventories of raw materials and work-in-process.

Banks and finance companies are wary about lending money to a company that cannot demonstrate an understanding of financial management or a good knowledge of its cost structure, so Gene made sure that the sons who were now managing the business learned more about finance and cost accounting. To deal with financial issues, Gene held periodic meetings with them at least monthly, to review the balance sheet and income statements so as to familiarize them with financial terminology and the analysis of working capital, other assets and liabilities, and cash flow.

In the cost accounting area, Gene drilled them in the methods of contribution margin analysis, so that they would understand how to track costs and margins by part. It was found that about 1/3 of the parts were making money, about 1/3 were breaking even, and 1/3 were being built at a loss. Little Guy was then able to determine the amount which each part contributed to covering to covering fixed costs of administration, occupancy, utilities, etc. With such knowledge, shop rates could be determined more intelligently, and jobs could be bid at prices providing a positive margin for all parts.

Gene also schooled Little Guy in marketing strategy, especially with respect to competitor analysis, and in relationship marketing, where multiple levels of managers help sell products through their good customer relations rather than confining contacts to vice president levels only. Business from customers other than Big Guy grew by 15%.

With demonstrable management knowledge of finance and cost structures gained under Gene’s guidance, Little Guy was able to increase its line of credit from banks by 300% to cover payroll costs and to carry raw material and work-in-process.

When the Big Guy contract came up for renewal, Little Guy stood fast and refused to concede any price cuts. Typically a prime contractor like Big Guy will press for cost reductions on the theory that the least cost is not really knowable until the subcontractor is squeezed sufficiently. But Little Guy now knew his costs quite accurately and knew that his price to Big Guy must be increased to earn a reasonable return. Big Guy could shove his weight around only so much, because his customer is Bigger Guy (U. S. Government) who had established certain product specifications that only Little Guy could meet. After some bluster, Big Guy quickly substituted individual purchase orders for the long term contract. Little guy did not lose any business; dollar sales to Big Guy actually grew 20%.

Little Guy losses turned to profits equal to 12% of sales. The company has hired a marketing firm to develop a broader market presence, and should survive even without sales to Big Guy. As Gene pointed out, there are three keys to success: produce a quality product to fill a need, develop the ability to sell the product, and develop effective financial management.

For aerospace entrepreneurs (especially when dealing with government contracts): COST ACCOUNTING IS NOT AN OPTION. IT IS A REQUIREMENT!

Guido Frassinelli 03/07/07