DoD Cannot Solve Its Budget Woes By Squeezing The Defense Industry

The Holy Grail of defense acquisition reform is a methodology, system, approach — something — that will enable the Department of Defense to procure equipment, platforms and services of quality relatively cheaply and quickly. Over the recent decades, DoD has careened from one fashion to another in acquisition reform. Sometimes diametrically opposed solutions are advertised as somehow saving the exact same percentage of defense costs.

Right now, the strategy is one of achieving better buying power largely by squeezing the private sector companies on whom the department relies. This is being pursued in a number of ways. DoD is increasing competition among private sector companies for contracts. Where only one qualified bidder exists, program managers are sometimes attempting to create a competitor or cancelling desperately needed procurements for fear of having to award a sole source contract. The Pentagon is making the winning companies assume a much greater degree of risk by requiring fixed price bids even for programs that require lots of developmental work. There is also an increased use of criteria for contract award such as the lowest cost, technically acceptable bid. This particular approach is all but guaranteed to result in the dumbing down of the industry since there are no points scored for innovation, superior quality or even a better workforce.

The cost structure in the defense and aerospace sector is heavily burdened by the weight of regulations, technical specifications, oversight and reporting requirements, material standards, testing requirements and even export sales limitations. As a consequence, it is very difficult for the aerospace and defense sector to lower their prices except when they have contracts of sufficient duration and size to allow for the companies to exploit the effects of moving down the performance learning curve. But since DoD is championing more and more frequent competitions, the opportunities to exploit the learning curve phenomenon are becoming fewer and fewer.

That leaves those companies that stay in the defense business with few options other than reducing their profit margins. Squeezing the private companies might work for DoD if the defense industry was a high profit enterprise and could afford to give up some of those profits in the interest of winning a contract or retaining the government’s business. However, that is not the case. According to a newly-released study by Deloitte, the average profit margin in the defense and aerospace industry (which includes both defense and commercial activities) is 10.3 percent while that of all U.S. industry is 42 percent higher at 18.3 percent. Even worse, given the trend towards the use of the lowest cost, technically acceptable standard for awards, the average profit per employee in the aerospace and defense sector was $14,863 — 37 percent lower than that for all industry and 63 percent less than the IT industry.

Moreover, even the 10.3 percent profit level is high by historical standards. Until the upsurge in demand caused by the wars in Iraq and Afghanistan, the average profit rate for the aerospace and defense sector was about 8 percent. It would be logical to expect profit margins in this sector to return to the historic average over the next few years.

Defense department leaders insist that they are not out to cut the profit margins of defense companies. Yes, they are not pursuing this as their explicit strategy. But recent acquisition reform initiatives will have the same effect as a cap on profits.

DoD risks forcing companies to disinvest in defense. Even if companies stay in the sector, given the pricing pressures they face, they are going to spend less and less of their own capital to develop new defense products or to improve existing processes and products. The advantage the United States has held for more than sixty years in advanced military technology will erode more rapidly.