How the Pentagon’s Acquisition System Disincentivizes Business

Private companies are in business to make money. That is their basic incentive. If they make money they can pay their workers, buy materials, continue to manufacture and sell products, invest in R&D on new or improved processes and products, pay back investors, provide dividends to shareholders and even pay taxes. It is just that simple.

Figuring out how to make money, however, can be anything but simple. The decision to enter a line of business, expand or contract current activities and even exit the market are the function of a complex set of factors that either incentivize or disincentivize a company’s decisions.  One of the most obvious of these is the potential profit margin, the ratio of profits to total sales or revenues, for a given period of time. The higher the profit margin, the better the return to the company relative to its investments and the greater the incentive for a company to be in that particular line of business. Revenues and profit margins are extremely important to private companies that must rely on the commercial marketplace for investment funds and respond to shareholders.

Many incentives and disincentives are functions of the character of the market: how open and competitive it is, the costs of entry, the degree of competition from other companies, the behavior of the customers. Others are a function of government policies and regulations in everything from health and safety, labor, taxation, contracting and standards.

One of the most important incentives/disincentives is predictability. The more orderly or stable the market, the better able a company is to predict its sales and profit margin over time thereby enabling it to make informed decisions regarding the deployment of human and financial resources, the wisdom of investments in infrastructure and the likelihood of realizing adequate returns for taking the risk to develop proprietary intellectual property.

It is generally agreed that the defense sector is, shall we say, one of the most challenging for private companies. The incentives are modest, at best, and the disincentives are high, particularly for new entrants from the commercial marketplace.  According to U.S. government data, the average rate of return in this sector is substantially lower than for any other that involves high-end product development and manufacturing. Doing business with the Pentagon requires accepting a plethora of unique regulations, standards and specifications, and instituting a separate and unique set of accounting and reporting practices. The sanctity of privately generated intellectual property can be at risk, particularly for products that transition over time from primarily commercial sales to largely military sales.

The cycle times between the commercial and defense markets are also entirely different. That for commercial products is often measured in terms of months or, at most, a few years; those of defense items can extend for a decade or more. The commercial developer of an ultra-light combat vehicle now under consideration for acquisition by the U.S. Army put the difference this way: “We change models every year. Imagine the headache you’d have with that in a program of record; you’d just be buried by the change orders.”

Even worse, the defense market can be extremely unpredictable. Contracts can be cancelled in mid-stream at the convenience of the government. Budget trials and tribulations can result in previously well-funded programs losing funding or even being terminated. Requirements can change not only before a competition is initiated but even after a contract is awarded. Contract periods can be arbitrarily changed, often shortened in order to allow program managers to demonstrate that they are increasing the number of competitive contract awards. Unfortunately, a shorter contract period can be a disincentive in itself if a company believes it will not have sufficient time to recoup its upfront investments.

One of the clearest statements of a long time defense-oriented company regarding the fundamental incentives that drive business decisions in this sector was by the well-respected CEO of General Dynamics, Phebe Novakovic. Clarifying her company’s decision to withdraw from the competition for a new Pentagon jet trainer, she explained that changing Air Force requirements (called “creep” in the business) had increased the upfront costs of competing while reducing the magnitude of potential returns.

“We are not going to compete for programs where we do not believe we can get a fair and sufficient return. Chasing revenues that don’t have good earnings doesn’t help us or shareholders one lick. This really has more to do with discipline of how we run our company, rather than response to any particular program. We’re just not going to compete in programs where we don’t think we can make a fair and good return.”

What Ms. Novakovic didn’t say was the requirements creep that was driving the competitors away from existing aircraft (called non-developmental items) and towards a clear sheet design also would likely raise the cost of and increase the time it would take to deploy the new trainer.

As budgets shrink, the number of new programs decreases and the burden of oversight and regulation actually increases, the balance between incentives and disincentives in the defense sector are tilting substantially towards the latter. No wonder companies are increasingly choosing not to play, particularly if they are up against incumbents. The disincentives are becoming too high.