If Washington doesn't find a way to reduce the federal deficit by next year, it will mean leaner times for American defense contractors.

Without action by Congress and the White House, $1.2 trillion in federal spending cuts over the next nine years will automatically go into effect on January 2, 2013, under a legislative provision known as sequestration. While sequestration would mandate a nearly across-the-board budget cut, some of those who will be hit hardest are government contractors--particularly those working with the Defense Department. According to a study released recently from the Aerospace Industries Association, the cuts would lead to nearly 1 million job losses for small businesses.

Until now, sequestration, which was first defined in the Gramm-Rudman-Hollings Deficit Reduction Act of 1985, has rarely come close to being triggered. In fact, the measure was inserted into last year's Budget Control Act in order to encourage a speedy compromise on the budget. But so far, it hasn't had its intended effect.

Last week, the Office of Management and Budget released a 394-page report detailing the extent of the budget reductions. Most items on the budget would be subject to 10% in budget cuts. However, some programs, such as Social Security, military payroll, and certain programs for veterans and low-income citizens, would be exempt.

Department of Defense Braces for a Shock

Because some programs are exempt from sequestration, certain portions of the budget would be hit harder than others. The cuts would have a notable effect on the Department of Defense, which faces a 9.4% cut across most of its programs. By contrast, discretionary non-defense spending would be cut by 8.2%, and mandatory non-defense spending would be cut by 7.6%. In all, annual defense spending would be slashed by $54.7 billion through the 2021 fiscal year.

The reduced funding would primarily affect defense contractors and civilian employees within the department. Combined with previous cutbacks in defense spending initiated last year, defense contractors now face an 18% reduction in available contract awards as compared to 2011 levels, according to the Center for Security Policy.

Under sequestration, all defense programs would receive budget cuts indiscriminately, without any consideration to their level of importance for national security. That aspect has proved especially worrisome to observers across the political spectrum. Indeed, the OMB's own report states: "Sequestration is a blunt, indiscriminate instrument and not a responsible way to make policy."

The indiscriminate aspect of the cuts also hampers small contractors' abilities to forecast appropriately, says Adelle Pierce, the president of AM Pierce & Associates, an engineering services firm based in Lexington Park, Maryland, that works extensively with the Navy. Defense contractors that have made investments to meet recent government demand will be especially hurt, she adds.

"For small businesses, especially fast-growing companies that have done well, the ability to absorb the loss in revenue will be real challenging," she says.

Small Businesses Already Preparing for the Worst

Several contractors say they have already felt the impact of the government's belt-tightening. As U.S. military involvement in conflicts in Iraq and Afghanistan has wound down, so has defense spending, leading to the cancellation of certain contracts. As a result, some contractors have had to downsize.

"We've already gone through probably a 20% reduction in revenue," says Forrest Burke, the CEO of Connected Logistics, a Huntsville, Alabama, company that provides IT services to the Army and the Defense Logistics Agency. To account for that decline, Burke's company has had to lay off about 10 of its employees since the beginning of the year.

Tony Jimenez, the CEO of MicroTech, an IT consulting company based in Vienna, Virginia, whose customers include the U.S. Army, says he has gone out of his way to retain his employees. But doing so has required significant reorganization of his company--in particular, eliminating middle management and only hiring salespeople with thorough technical expertise. Senior managers' roles have been changed so that they interact directly with customers and partners.

Jimenez has also decided to put off attaining an additional ISO certification, an internationally recognized standard for quality management, in order to save his company's resources. "I don't want to spend money on something we may never get a return on," he says.

Plan Well to Prosper?

Amidst the worry and belt-tightening, there is one piece of good news. Sequestration would not affect contracts that have already been rewarded. As a result, according to a report by the Center for Strategic and Budgetary Assessments, contractors would not feel the brunt of its impact until several years after the initial cuts.

CEOs of companies in certain fields, such as the engineering of weapons systems, may have even less reason to worry, though--at least initially. That's because there is typically a greater delay between the initial award and payment for those contracts, according to the CSBA. If sequestration were to occur, the effective cuts for those contracts for the 2013 fiscal year would be between 3.5% and 5.9%, depending on the funding source. By contrast, contractors that provide maintenance, logistics, and other support services to the Department of Defense, would see an effective 6.9% cut. 

Manan Patel, the CEO of Special Operations Solutions, is among the entrepreneurs who remain optimistic.

His company, which is based in Silver Spring, Maryland, develops intelligence, surveillance, and reconnaissance systems for U.S. military aircraft. Although certain programs in that field have been discontinued in recent year, Patel says, his company's contracts have remained intact. He is also planning to extend his company's services to defense forces in other countries, including the U.K. and Japan.

"We have read multiple articles on the future of the business, and all signs indicate that spending in this field will increase worldwide," he says. "The difference between us and other companies is that we have been associated with projects who have demonstrated success."

There may also be a silver lining for companies that plan especially well, regardless of their area of expertise. In some cases, says Burke, agencies cut costs by reducing the number of companies on a particular contract, rather than eliminating the program entirely. As a result, the remaining companies may ultimately end up with more opportunity to work.

"If you're a victor, it can actually mean growth," he says.