Last year was a record one for commercial aircraft sales orders, production and backlog, with an astonishing 1,274 aircraft delivered—about twice the volume produced just nine years ago. The forecast continues to be rosy, with more than 30,000 commercial jets expected to be produced over the next 20 years to address new demand, particularly in Asia and the Middle East, and replace older, less fuel-efficient models. New aircraft are in design phases. Factories are planning rate increases. OEMs and suppliers are busy. What's not to like about this picture? Deloitte's recent informal feedback from suppliers is reason for pause, and there may be plenty to be concerned about.

The commercial air transport value chain is putting enormous pressure on suppliers, which could have a detrimental effect. Low airfares drive airlines to buy new aircraft at lower prices. OEMs are reducing their costs by investing heavily in lean manufacturing, digital product development and supplier rationalization. Finally, OEMs are demanding suppliers—whose products now make up the majority of aircraft manufacturing costs—to respond in kind to these pressures with significant price concessions.

As shown in the accompanying chart, OEMs have borne the brunt of financial investments and risk recently, evidenced in their lower operating profit margins compared to their suppliers'. With supplier margins being about twice the average for OEMs, it is no wonder that prime contractors are driving hard bargains and advocating for a change in the cost structure and business model for aircraft production.

The supplier business model has changed in the last 10 years from “build to print,” to 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 have to hire skilled engineers and designers. They also in turn need to manage a larger supply base themselves and require the same kind of skilled supply chain management personnel as the OEMs.

This is a big change for the subs. In essence, they need to put their balance sheets at risk, invest much more of their own working capital, substantially increase their skilled workforce in engineering and supply chain talent—and meet the new expectations of cost reductions. This is occurring in an environment that requires the highest levels of quality and reliability, meticulous adherence to the promised dates of delivery and year-on-year cost reductions.

What are the implications of this change? The financial, talent and operational challenges of becoming a “super-supplier” may not be addressable by some companies, because they do not have scale, possess a strong balance sheet or have access to the required talent. Some might simply drop out of business. 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 fewer competitors being available, especially when some are maxed out and don't have capacity. This could lead to bottlenecks and manufacturing capacity-related delays, OEM margin pressure and/or supplier price increases.

The aerospace industry (and defense, for that matter) has encountered certain cost and schedule reliability issues in the past, with frequent aircraft program delays. Execution difficulties, plus the new supply chain model challenge, spell potential trouble on the horizon for the industry—additional risks of schedule delays and constrained ability to meet production volume demands. OEMs may potentially have to bail out certain suppliers, or worse, deal with ones that fail financially. Although it is a worst-case scenario, we saw this happen in the last decade as suppliers started to make the transition to the new business model.

However, we have seen some progress already, with OEMs taking some design authority back in-house, recalling some of the manufacturing work packages, executing of supplier development and surveillance programs to de-risk the supply base, and financial support to help certain suppliers. However for OEMs, driving hard bargains may result in supplier consolidation that could have an adverse impact. For suppliers, the new reality is upon us. Continuous cost reductions and pricing pressure are here to stay.

Captain is vice chairman of Deloitte LLP and is based in Seattle.

A&D Industry Operating Margins
2011 2012 2013
OEM 6.3% 6.4% 7.5%
Tier 1 13.2 12.8 12.7
Tier 2 15.8 16.2 17.1
Tier 3 11.0 9.6 2.1
Aerostructures 5.0 4.9 5.5
Electronics 11.4 11.9 12.1
Propulsion 11.6 12.2 13.7
Services 5.5 6.5 6.1
TOTAL A&D 8.4% 8.6% 9.4%
Source: Deloitte LLP