Restructuring government/defense contractors to compete in the commercial market


Concerns of Project Managers

Stephen E. Krug, AEP Engineering, Ellicott City, Maryland

Many companies that profited and grew within the traditional government/defense industries are now attempting to compete within the commercial arena. As the defense industry shrinks, it is only natural for these huge companies to convert their products and services over to the commercial marketplace, A concept, High-Efficiency Operating Systems (HEOS), was developed to enable these companies to make this transition successfully through a lean organization. The lean company may then be able to compete on equal financial footing with existing commercial organizations. Many government contract companies are attempting to submit proposals within the commercial marketplace without restructuring.

One frustrated company was submitting proposals with little or no profit margin in an attempt to gain work and still could not win significant commercial contracts. The upper management within this company could not understand why they could not compete. Their weakness was that they did not have the experience or understanding of any type of business structure other than what they had worked within for their entire careers. The sad fact is that many defense contractors have viable products and services but do not understand how to make them commercially competitive. This article examines the components within the lean organization—the labor cost accounting system, program management, and the management structure—to demonstrate why reengineering is necessary.

Editor's Note: The author presents on analysis of problems found in many organizations that do business with certain segments of the government. Some readers may find the recommended “lean organization” to be too extreme. Those who do are invited to direct their comments to Letters to the Editor (see page 5 for address).


Companies that are financially structured for government/defense contracts use a cost account system designed to utilize charge numbers for individual tasks and programs. This system may be required for government contracts but introduces unnecessary costs into commercial projects. For example, one company studied had a manager supervising a group of 15 employees that used the traditional government charge number system. On each biweekly timesheet day, the manager would spend four hours locating, verifying and substituting charge numbers for the department. Each employee would require about one hour to verify existing numbers and fill in any missing or closed numbers.

To evaluate how the above process ultimately affects a proposal, consider a product development organization. This new product effort involves the following ten groups: Mechanical Engineering; IF/RF Engineering; Data Management; Program Management; Quality Assurance; Technical Writing; Production; Hardware Engineering; Firmware Engineering; and Software Engineering.

If each group requires a similar effort to deal with charge numbers, then the total organization requires 190 hours every two weeks, or 4940 hours a year. Translated into dollars, the one-year expense, at an average employee cost of $25 per hour, is $123,500. In preparing a proposal, this base labor number requires the addition of overhead (130 percent), upper management (3 percent), G&A (1 percent), and profit (15 percent).

Base labor $123,500
Overhead   160,550
Upper management     8,521
G&A    29,257
Profit    48,274
Total $370,102

This means that, during the course of one year, $370,102 of costs are embedded within product development proposals for the implementation and maintenance of the charge number system. The actual cost impact is much greater than this if the efforts of administration and accounting are included in these figures. The additional labor for administration and accounting contributes to inflating the overhead rate (130 percent). In summary, 1.6 percent of the base labor and an unknown percentage of the overhead are embedded within every proposal for the maintenance of the charge number system.

In comparison, a lean typical commercial product development organization is treated as a cost center, responsible for its own profit and loss. This, by nature, does not require charge numbers. Sometimes charge numbers are used, but with a different purpose than what is normally associated with defense contractors. The time required to fill out timecards within this commercial environment is negligible. The most difficult feature to deal with is recording vacation and sick leave.


Companies structured for government/defense contracts often possess an excessive management structure when compared to commercial organizations. The lean organizational approach provides methods to reduce management and integrate group functions to enable defense contractors to restructure into commercially competitive organizations, The major problem with military-oriented organizations is the existence of two management structures: program and functional. One Fortune 500 company charges about 12 percent of the base labor to program management. By comparison, many commercial organizations use fewer program managers than is typical of defense contractors. There also exist many hidden costs associated with the co-existence of the program management/functional management structure. Often, these two management teams may work against one another, especially when program management has excessive control. One struggle that frequently occurs is that program management is constantly trying to remove people from their program to reduce costs and define their own unique standards and requirements. In contrast, the functional manager is attempting to keep people on the program to complete the tasks, adhere to standards, and maintain billability and continuity of their staff. The different goals between management groups can cause friction and ultimately a lack of teamwork.

The following interesting situation actually occurred at a Fortune 500 company. The company had recently upgraded the capability of their printed circuit design CAD system with the purchase of $200,000 in hardware and software. Some of the program managers did not like to use in-house services. One of these program managers chose, despite functional management opposition, to send his printed circuit designs to an outside vendor. The end result of this action was that the program manager received his PC board for $12,000 from the vendor, and the in-house PC designer charged $12,000 to overhead since he had nothing to work on during this time. The company actually spent $24,000 for the development of the PC board; however, the program manager was satisfied since only $12,000 was charged to his program. The program manager by definition was concerned with only budgets and schedules that are related to his program. This focus may have prevented him from making decisions that are in the company's best interest.

Other situations occurred when program managers attempted to cut costs for various reasons. The reasons could range from the program being in financial trouble to the program manager attempting to increase program profit margin/bonus. The action often taken by the program manager was to close the charge numbers for tasks considered insignificant. The tasks considered insignificant were usually documentation in the form of manuals, and site and manufacturing documentation. The customer, as well as upper management, was usually unaware that these tasks were never completed. An interesting situation could develop if the customer ever had a system or product failure that required troubleshooting or parts replacement.

The premature closing of the charge numbers also had a negative impact on the technical staff. The staff felt their jobs were threatened and believed their expertise was not respected by program management or the company.

The inherent nature of this organizational structure can allow each program manager to become a small company within a company. The team concept can be lost and decisions concerning what is in the company's best interest are compromised. An important component of the lean organization is to maintain the employee's dignity and team spirit.

In comparison, many commercial organizations use considerably fewer program managers than defense contractors and are sometimes structured without program management. Within a commercial company a program manager could be assigned to a dozen or more simultaneous projects. In the lean organization the specific projects are assigned to the functional managers instead of program managers. The program managers provide services for, but do not necessarily report to, functional management. The program manager provides a valuable service to the functional manager by tracking all schedules and budgets associated with each project. A functional manager's weakest link is usually his or her ability to track budgets and schedules. This is due to the fact that the functional manager's focus is on staff and technical issues. The functional managers are responsible for making decisions that are in the best interest of the project, as well as the company.

The focus within the lean organization environment is always in the best interest of the company, not the best interest of a program or the individual preferences of the program managers. As mentioned previously, it is not uncommon for program management to reach or exceed 12 percent of the base corporate labor; in the lean organization program management is limited to 2 percent of the base labor.


Government/defense contract companies frequently possess an excess of functional management. These companies often organize individual departments with department managers instead of integrating functions within existing departments. The lean organization defines a much more streamlined structure with fewer functional managers by examining commercial structures. For example, the responsibilities of Data Management, Configuration Management and Quality Assurance departments can be effectively integrated into Mechanical Engineering, Technical Writing and Production departments. Since commercial companies do not use charge number accounting and require fewer functional and program managers, their overhead rate is approximately half that of defense contractors.

Table 1. Defense Contract Organization Versus Lean Commercial Organization

Defense Contract Organization Lean Commercial Organization
Base Labor 40,000 L-H Base Labor 40,000 L-H
Charge Number Labor (1.6%) 640 L-H Charge Number Labor N/R
Program Management Labor 4,877 L-H Program Management Labor 800 L-H
Total Labor 45;517 L-H Total Labor 40,800 L-H
Labor Cost @ $25/hr $1,137,925 Labor Cost @ $25/hr $1,020,000
Overhead (130Yo) 1,479,302 Overhead (65%) 663,000
Subtotal 2,617,227 Subtotal 1,683,000
Upper Management (3%) 78,516 Upper Management (3%) 50,490
Subtotal 2,695,743 Subtotal 1,733,490
G&A (10%) 269,574 G&A (10%) 173,349
Subtotal 2,965,317 Subtotal 2,906,839
Profit (I 5%) 444,797 Profit (I 5%) 286,025
Total Bid to Customer $3,410,115 Total Bid to Customer $2,192,864

In Table 1 we examine how a company structured for government/defense projects compares with a lean commercial organization when bidding on a project requiring 40,000 labor-hours (L-H). Since this is intended to be a comparison of corporate structure as it affects labor, we will assume that there are no material costs associated with the bid.

It is interesting to note that, in the Table 1 scenario, the defense contractor could remove the entire profit margin and the bid would still be $772,453 higher than the commercial competitor. This comparison only scratches the surface, since we have only examined the charge number system, program management, and portions of functional management. Much more detailed analysis would be required to determine the advantages that a lean management organization enjoys with regard to overhead, administration, accounting, financial decisions, team spirit and morale. Many military/government-oriented companies will go through a period where they provide both commercial and military products/services. The lean organization has been devised to allow government contracts to co-exist within the same company as commercial contracts with minimal compromise to profitability.

How can a military/government-oriented company make the transition to become competitive with commercial companies? The lean organization is one answer; however, many companies will not find an answer. This is a situation where companies have to bite the bullet, especially before they consume assets that can make the transition easily possible. Only the board of directors, CEO or president is capable of executing lean organization concepts; it is not something that will be driven from the bottom up. Many companies will resist change until they lose significant proposals and financial pressures force some type of reorganization. The successful and dynamic CEOs will make these adjustments before sagging profits force the board of directors to reorganize at the executive level.


Stephen E. Krug is currently an independent technical and business services consultant to a group of diverse customers. The technical services include mechanical design/electronic packaging for the computer and telecommunications industry. He also provides management, restructuring and product development services. Though majoring in architectural engineering, he entered into industry as a mechanical engineer and rapidy progressed to senior mechanical engineer with Data General. He then entered into management as department manager of mechanical engineering with COMSAT. Mr. Krug has developed new technologies in the fields of electronic connectors and diesel engines and has published articles featuring these designs in Connection Technologies, Machine Design, Design News and The Fleck Report.

PMNETwork • May 1994



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