The January 4, 2010 edition of Aviation Week & Space Technology carried an interesting story called “Tactical Retreat,” that discussed the Boeing 787 supply chain.  We’ve discussed this issue before—notably here—and linked to an article that described Boeing’s supply chain as a “nightmare” in which “individual suppliers [ ] maximize their own self interest at the expense of the program’s objectives. In the 787 supply chain, ‘a complicated array of companies share the risk and the profits of the new airliner. That means financial burdens will inevitably shift up and down the line as each company protects its own interest.’”  In other words, rather than forge true partnerships with its suppliers, Boeing created an environment where risks were pushed downwards in the supply chain, and each supplier was on its own with respect to performance. 

It was a Darwinian environment.  Instead of reinforcing its supply chain to ensure performance, Boeing created a situation where each individual link in the chain was stressed.  Inevitably, some of the links were bound to fail.  We noted in this article that companies connected to Boeing supply chains underperformed their peers.  Finally, the 787 supply chain snapped.  Vought was the first to go—as we reported here—but perhaps not the last.  Boeing reportedly paid out somewhere between $400 million and $1 billion in order to buy out Vought’s South Carolina manufacturing plant, and then paid an undisclosed sum for the Alenia North America portion of Global Aeronautica’s subassembly facility at the same plant.  (In 2008 Boeing bought out Vought’s share of Global Aeronautica in a separate transaction.) 

Although there is likely strategic value in the purchase, the bottom line is that Boeing has paid out hundreds of millions of dollars in order to internalize its external supply chain.  As the AW&ST article states, “Boeing’s [South Carolina] acquisition … gives the company control of a crucial link in the troubled 787 supply chain as it moves to ramp up production….”  The article recounts that Global Aeronautica was “a cornerstone in Boeing’s strategy to outsource major pieces of the 787,” but was “ultimately an example of how that strategy was too far of a reach.”

If there is one axiom of modern aerospace & defense supply chain management, it is this:  execution risk cannot be transferred from one part of the supply chain to another.  Regardless of which entity performed the work, Boeing ultimately was responsible for its aircraft.

The AW&ST article quotes one union member as saying that Boeing’s “attempt to spread the 787’s development risks and costs across the supply chain actually made the company more vulnerable” to performance problems.  We agree with that assessment.  By treating each supplier as an individual entity without properly acknowledging the interdependence of the supply chain—and its ultimate dependence on each supplier at whatever tier—Boeing put its program at risk.  In the final accounting, the 27-month delay in the 787’s first flight is not the fault of any individual supplier; instead, it is the result of Boeing’s mismanagement of its program and its program supply chain.

As the article notes, Boeing paid the price for its mismanagement.  The union member is quoted as saying, “Rather than saving money, Boeing has become the reinsurer of its supply chain and has in fact had to buy outright or loan money to different suppliers to keep its outsourcing model from failing.”  The article reports that part of the Alenia deal “addresses Alenia’s demand to be compensated for costs related to the 787’s schedule slips,” among other things.  Alenia is not alone.  The article states (without providing specifics) that other 787 suppliers have submitted financial claims for the repeated program delays.  An industry analyst is quoted as describing the situation as a “logjam” of supplier claims.

Such claims take time away from program execution, of course, exacerbating an already delicate balance of cost, schedule, and execution.  Time spent reviewing and negotiating claims is time that is not being spent managing program performance.

We’ve heard time and again that implementing long-term fixed-price supplier agreements, even before design finalization, reduces the risk of cost overruns.  This is a nonsensical statement that ignores the fact that supplier change orders and claims are the inevitable result of design changes, schedule slips, and other normal changes to the pricing assumptions initially used.  The Boeing 787 program is evidence that fixed-price supplier agreements mean nothing, if program performance is imperiled.

Although things have reportedly improved—and, really, how could they not?—Boeing’s initial approach to program supply chain management should stand as the poster child of how not to do it.

We’ve discussed the potentially misplaced emphasis on contractor fraud and corruption before, and asserted that the majority of contractor fraud also involves corruption on the part of Government officials.  On January 7, 2010, the Department of Justice reported that a former Army and Air Force Exchange Service (AAFES) official “was sentenced to three years in prison “for his role in a bribery conspiracy involving a multi-million dollar telecommunications contract” and for income tax evasion.  “In addition to the prison term … Henry Lee Holloway [was ordered] to pay a $5,000 fine and to forfeit $70,000 as the proceeds of [his] involvement in the conspiracy.”

The DOJ press release notes that the AAFES provides billions of dollars of goods and services each year to service men and women by operating base and post exchanges.  Holloway was a general store manager at the Central Exchange in the Republic of Korea (RoK) from 2003 through 2007.  During his tenure, he accepted “at least $70,000 worth of stock, entertainment, travel expenses, cash and other things of value” from the CEO of Samsung Rental Company (SSRT) in return for maintaining “SSRT’s $206 million contract with AAFES to provide telecommunications services to U.S. Armed Forces installations” in the RoK, “despite Holloway’s knowledge and belief that SSRT was underperforming and violating the terms of its contract with AAFES.”  (The SSRT CEO was sentenced to five years in prison and a $50,000 fine.)

But fraud and corruption are not confined to the aerospace/defense industry.  On December 24, 2009 reports emerged that Koss Corporation fired its long-time VP of Finance and Corporate Secretary, for allegedly embezzling millions from the company.  The individual in question (Ms. Sujata “Sue” Sachdeva), was “suspended” on December 21^st, “for financial improprieties,” and was fired on December 24^th for embezzling as much as $31 million over the past 18 years.  Two members of the Koss accounting staff who reported to Ms. Sachdeva were also put on unpaid administrative leave.  According to the Wall Street Journal, “The government alleges she embezzled company funds to pay off her personal American Express credit-card charges for the purchases of furs, jewelry, apparel and home decor.”

Importantly, Ms. Sachdeva, as VP of Finance, was responsible for many “management representations” provided to its external auditors, Grant Thornton.  Because those representations can no longer be relied upon, Koss’ financial statements must be reaudited, and will likely need to be restated.  Koss is a publicly traded company, so the SEC and PCAOB will also be involved in the resolution.  But Grant Thornton won’t be involved in that resolution, because that audit entity was dismissed after the fraud was uncovered.

It’s not clear why Grant Thornton was dismissed (and replaced by a smaller audit firm).  News reports indicate that the dismissal was based on a “recommendation” from Koss’ audit committee.  One might think that Grant Thornton was being blamed for failing to uncover the multi-million dollar embezzlement scheme during its audits.  (One article notes that it was American Express who brought the fraud to the company’s attention--and not the external auditors, nor the internal auditors.)  However, Grant Thornton states that “The fraud was apparently conducted by a longtime, trusted senior financial executive who was hired and supervised by senior management.  The company (Koss) did not engage Grant Thornton LLP to conduct an audit or evaluation of internal controls over financial reporting. Establishing and maintaining effective internal control is management’s and the board’s responsibility.”

Those in Government contracting hear a lot about internal control systems and contractor “business systems”.  As far as we can tell, current DCAA audit guidance tells auditors to expect perfection from DOD contractors, with the slightest mistake potentially imperiling the adequacy determination of an entire internal control system.  Based on DCAA testimony before the Commission on Wartime Contracting, more than two-thirds of the largest contractors have at least one inadequate control system.  But as this story shows, very few systems of internal controls can prevent 100% of fraud and corruption, especially when it is a trusted member of the senior leadership team who is engaging in it.