The current approach to managing the U.S. defense budget creates a lose-lose proposition for the military and its contractors. Funders and buyers are making meat-cleaver cuts across the board, stretching out programs, slashing R&D investments and launching, then canceling, costly programs. That causes a ripple effect across the contractor base: Companies shelve innovation investments because of no clear returns, they suffer from program budget overruns and excess capacity, and they delay strategic acquisitions.

In addition to placing national readiness and security at risk, the continued uncertainty and mismanagement of the budget process jeopardizes the long-term health of the contractor community. Ominously, these impacts are evident in the very early stages of what could be an extended cyclical downturn in the industry as mandated cuts kick in and wars wind down in Iraq and Afghanistan. How much more damage will occur if we follow this path for several more years?

In our extensive research across multiple industries on managing through downturns, we've found that the most successful organizations follow two norms:

•Cut costs in advance of the downturn, aggressively but surgically. While every part of the organization may feel some impact, strategic cuts are more effective than across-the-board reductions.

•Strengthen your core. You can't shrink your way to success. Cost-cutting may sustain short-term profits, but if there is no reinvestment in the strongest parts of the organization, the core withers and becomes obsolete, and competitors jump in.

If government leaders, both funders and buyers, adhere to these business norms, then contractors have the clarity needed to follow suit. There is an opportunity to create a long-term win-win from the current losing scenario. How can the government accomplish this? Start by making tough surgical decisions about where to cut the budget. If that means killing programs, so be it, but don't undermine all programs to avoid killing a few. For example, today we are funding upgrades for older weapons systems and next-generation replacement systems but not at a level to advance either group to the field in a timely manner. These decisions to “cover all bases” are no longer affordable or productive. They leave warfighters without current systems and contractors unsure about how to prioritize investments.

Next, be decisive on the missions that matter and where it is critical to be the best. Then, fund these missions accordingly and take the money away from lower-priority areas. For instance, consider the politically charged issue of military installations. Bases serve a variety of missions. Some are strategically critical while others are legacies and exist more as a source of local employment. By clarifying government priorities and where they need to be served, the military can pare back costly base infrastructures and operations, thereby saving money for essential programs elsewhere.

But the government cannot do it alone. To make these actions successful, contractors need to be encouraged to develop the very programs that will help the government get itself into shape. Without the promise of adequate returns, few contractors will make the necessary investments. To turn this around, the government should reward innovative investments that bolster the military's core defense and security missions—and save money. These investments could be for advanced technologies that improve our military edge, new business models that deliver outcomes more affordably or acquisitions that enable a leaner supplier base.

For example, several contractors have considered offering products as a managed service. That would allow the government to avoid costly up-front procurement costs and simply pay for using the product as needed. Unmanned-aircraft-system providers have offered such managed services and seem willing to do so in the future. But most contractors are understandably skittish without a way to reliably forecast demand. Contractors also are poised to make acquisitions that could strengthen their core businesses and improve the efficiency of the supplier base, especially where there is still excess capacity or unnecessary fragmentation. Technical Services and Tactical Weapons are two market segments where companies are ready to buy but lack sufficient market clarity to accurately assess the valuations of their targets.

A defense downturn does not have to weaken national security and contractors. By honoring the business norms followed by leaders worldwide, and clarifying priorities for budgets and missions, contractors can again invest in their core strengths. The payoff: a more nimble, leaner military buoyed by strides in technology, business model breakthroughs, acquisitions of key assets and reduced costs—all vital to national security.

Michael Goldberg leads Bain & Co.'s global aerospace and defense practice. He is based in Los Angeles.