Defence & Aerospace · Defence Primes
Cost-Plus vs Fixed-Price Contracts
How cost-plus and fixed-price contracts split margin and risk in defence, the filed portfolio mix, and why contract type drives segment-margin dispersion.
Selborne Research · Defence Primes coverage: 9 guides, 6 company profiles, a primer and Excel model
Educational analysis. This guide is not investment advice or a recommendation to buy or sell any security, and it is not personalised.
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Contract Type Sets the Margin-Risk Trade-Off
Defence primes do not earn a single margin on a single risk profile. Cost-type (cost-plus) contracts reimburse allowable costs plus a fee. Firm fixed-price (FFP) contracts lock in a price upfront. The contractor takes more margin opportunity on FFP when costs stay inside plan, and more downside when they do not.
Northrop Grumman’s FY2025 10-K states the trade-off directly: cost-type carries lower margin and lower cost-growth risk; firm fixed-price carries higher margin opportunity and higher unanticipated-cost risk. That language is the filing anchor for every segment-margin comparison in the peer set.
Cost-Type vs Firm Fixed-Price
| Feature | Cost-type (cost-plus) | Firm fixed-price |
|---|---|---|
| Price basis | Allowable costs + fee | Predetermined price |
| Margin opportunity | Lower, fee-based | Higher if costs controlled |
| Cost overrun risk | Lower (reimbursed) | Higher (contractor absorbs) |
| Typical phase | Development, R&D-heavy | Production, mature lots |
| Billing | Tracks allowable costs | Milestone or delivery based |
Time-and-materials sits between the two on risk: GD reports 5% of US government revenue on T&M alongside 51% fixed-price and 44% cost-reimbursement.
Neither type is “better.” Development programmes skew cost-type because the government shares technical risk. Serial production (F-35 lots, missile rounds, submarine blocks) shifts toward fixed-price as costs stabilise.
Filed Portfolio Mix
Four filers publish a contract-type split, each on its own basis:
| Filer | Fixed-price | Cost-type / cost-reimb | Basis |
|---|---|---|---|
| Northrop Grumman | ~50% of FY2025 sales | Balance cost-type | Company sales, rounded filing language |
| General Dynamics | 51% | 44% cost-reimbursement (5% T&M) | US government revenue only |
| L3Harris | 75% of FY2025 revenue | Balance | Company revenue |
| Lockheed Martin | Not stated as its own figure | ~40% of 2025 sales | Company sales; fixed-price share is the balance, not stated |
NOC’s “approximately half” is rounded filing language. GD’s split is precise on US government revenue only; Gulfstream commercial work sits outside that breakdown. Lockheed Martin states only the cost-reimbursable share, so its fixed-price share is an inference. RTX and BAE do not publish a consolidated fixed-price percentage; for those two, segment margin tables are the practical mix proxy.
Segment Margin Dispersion
Contract type and programme lifecycle show up in segment operating margins, which a company-wide ratio averages away:
| Company | Segment | FY2025 segment operating margin |
|---|---|---|
| L3Harris | Communication Systems | 25.2% |
| RTX | Collins Aerospace | 16.3% |
| NOC | Mission Systems | 14.6% |
| GD | Combat Systems | 14.4% |
| LMT | Missiles & Fire Control | 13.8% |
| RTX | Raytheon | 11.5% |
| BAE | Electronic Systems | 15.4% (return on sales) |
| LMT | Aeronautics | 6.9% |
| NOC | Aeronautics Systems | 6.3% |
| GD | Marine Systems | 7.0% |
| RTX | Pratt & Whitney | 7.9% |
BAE reports return on sales; like operating margin, it measures profit as a share of revenue. The full ranking of all 24 segments, with each filer’s margin basis, is in Defence Prime Segment Margin Benchmarks.
The spread from 6.3% (NOC Aeronautics) to 25.2% (LHX Communication Systems) is not noise. Platform production at volume, F-35 in LMT Aeronautics at 6.9%, with F-35 at 27% of consolidated sales, runs thinner than tactical comms or missiles at mature production rates. The comms archetype at the top of the range, L3Harris, links to C4ISR (command, control and sensor systems) and tactical communications revenue (75% US Government). Northrop Grumman’s Mission Systems segment sits in the middle of the table: electronics and sensors on a mix of contract types.
Platform vs Subsystem Economics
Platform primes (LMT, NOC Aeronautics, GD Marine) carry programme lifecycle risk on a few large contracts. F-35 makes up 27% of Lockheed Martin’s consolidated sales and keeps Aeronautics revenue high while margin sits near 7%. General Dynamics’ nuclear-powered submarine work runs a similar shape: $12.6B of revenue, 24% of the consolidated total, at a 7.0% Marine Systems margin.
Systems and electronics names (LHX comms, NOC Mission Systems, RTX Raytheon) earn higher margins on subsystem content but lack that single-programme anchor. RTX does not disclose programme-level revenue percentages; GTF (Pratt & Whitney’s geared turbofan engine) and Patriot are key programmes without a filed share.
The house screen flags single-programme concentration above 25% of consolidated sales. F-35 at LMT and the submarine programme at GD sit either side of that line. A platform prime’s earnings quality depends more on the health of one contract than a subsystem supplier’s does.
How Mix Feeds FCF Conversion
Fixed-price production with smooth billing converts cash predictably. Fixed-price development with milestone revenue recognition can bunch earnings and cash in different years. Cost-type work bills against allowable costs, which tends to align OCF with segment profit more closely.
General Dynamics ran 94% FCF conversion in FY2025 with a 51% fixed-price US government mix. Northrop Grumman ran 79% conversion with ~50% fixed-price. Contract type explains only part of the conversion gap (NOC’s 1.10x book-to-bill ties up working capital too), but FFP-heavy development phases are the first place to look when conversion drops. The FCF conversion guide walks the full FY2025 ladder.
Reading Contract Mix in Filings
- Pull the contract-type paragraph from the 10-K risk factors (NOC’s wording is the clearest example to work from).
- Match segment margins to the programmes named in the segment discussion (Aeronautics vs Mission Systems at NOC; Combat vs Marine at GD).
- Flag development-to-production transitions: a programme moving from cost-type to FFP often compresses or expands margin over 2-3 years.
- Do not infer company-wide fixed-price % from segment margins alone without a filed split.
- Cross-check backlog momentum: a cost-type development award builds backlog without the FFP margin pop until production lots begin.
Northrop Grumman is the contract-language teaching case. General Dynamics supplies the filed 51/44/5 split. L3Harris shows where subsystem mix pushes margins to the top of the peer range.
Funded backlog and FCF conversion are the inputs. This primer takes them to a ten-year cash-flow value and an FCF yield you can screen.
- 15 sections, backlog roll-forward to a discounted cash-flow value
- 44 pages
- platform prime (Meridian) and diversified systems (Vectra)
- 2 worked archetypes
- book-to-bill, FCF conversion, programme concentration, segment margin
- 6-company screen
The Excel model is the primer's two archetype builds live across 11 sheets: a ten-year, backlog-driven free-cash-flow DCF with a Gordon terminal. Change the book-to-bill, the FCF conversion ratio or the WACC and the value per share moves; the backlog, conversion-bridge and concentration sheets update alongside it.
See what's in the Defence Primes Sector Primer →£25 PDF · £59 with the Excel model · £159 for all three Defence & Aerospace industries
Frequently Asked Questions
- What is the difference between cost-plus and fixed-price defence contracts?
- Cost-type (cost-plus) contracts reimburse allowable costs plus a fee: lower margin opportunity, lower cost-growth risk to the contractor. Firm fixed-price contracts set a predetermined price: higher margin opportunity if costs are controlled, higher unanticipated-cost risk if they are not. Northrop Grumman's FY2025 10-K uses this margin/risk framing explicitly.
- What share of defence prime revenue is fixed-price?
- Approximately half of Northrop Grumman's FY2025 sales came from firm fixed-price contracts ("approximately half" per the 10-K). General Dynamics' US government revenue was 51% fixed-price, 44% cost-reimbursement and 5% time-and-materials. Portfolio mix varies by prime; there is no single industry average in filings.
- How does contract type affect segment operating margins?
- Contract mix and lifecycle phase drive segment margin dispersion. L3Harris Communication Systems ran 25.2% segment operating margin in FY2025; Northrop Grumman Mission Systems 14.6%; GD Combat Systems 14.4%; LMT Missiles & Fire Control 13.8%; NOC Aeronautics Systems 6.3%; LMT Aeronautics 6.9%. High-volume platform production (F-35 at LMT) tends to run thinner margins than subsystem or comms work at scale.
- Why do analysts care about fixed-price exposure?
- Fixed-price share sets the earnings risk profile on cost overruns, supply-chain inflation and schedule delays. A prime with heavy fixed-price mix can post strong margins in stable production but face charges when development programmes slip. Cost-type work protects margin percentage but caps upside. Segment margin tables reveal the mix effect faster than a company-wide average.
Read next
Free Cash Flow Conversion for Primes
Why primes screen on FCF ÷ net income: GD incentive weight 25%, OCF 122% vs FCF 94%, and the FY2025 ladder from LHX 170% to NOC 79%.
Backlog and Book-to-Bill in Defence
Funded vs unfunded backlog, book-to-bill arithmetic and FY2025 peer ratios: RTX 1.56x, GD 1.6x defence, LHX 1.3x, BAE 1.2x, NOC 1.10x, plus the LMT filing gap.
Defence Prime Book-to-Bill Benchmarks
FY2025 book-to-bill ranked across RTX, GD, LHX, LMT, BAE and NOC, each with backlog and the filer's own orders-to-revenue definition beside it.
FAS vs CAS Pension Accounting
Why a defence prime books its pension cost twice, where the reconciling line sits between segment and consolidated profit, and how each filer defines it.
Defence Prime Segment Margin Benchmarks
A ranked table of FY2025 segment margins across six primes, showing why what a segment builds sets its margin and how four reporting bases change the ranking.
See it applied
These company profiles apply the concepts from this guide to real public companies.
Also in Defence Primes
- Backlog and Book-to-Bill in Defence
- Defence Prime Book-to-Bill Benchmarks
- Defence Prime Segment Margin Benchmarks
- Funded vs Unfunded Backlog in Defence
- Free Cash Flow Conversion for Primes
- FAS vs CAS Pension Accounting for Defence Primes
- Cost-Plus vs Fixed-Price Contracts
- Defence Budgets and the Demand Cycle
- Valuing Defence Primes (FCF Yield)