New Pentagon Cost-Cutting Proposals Could Impact Contractor Margins

The Department of Defense today will propose a series of cost-cutting initiatives intended to reduce the budgetary burden of contracting for military goods and services. In meetings with industry executives, acquisition workers and the media, Under Secretary of Defense for Acquisition, Technology & Logistics Ashton Carter will explain how his part of the defense establishment intends to implement guidance from Secretary of Defense Robert Gates to avoid $100 billion in overhead costs during the 2012-2016 period. Gates expects the efforts at greater economy to ramp up gradually, but eventually he aims for the defense department to save more money each year than most countries spend on their entire military posture.

The Carter initiatives being proposed today are not about cutting weapons systems. However, from the perspective of industry and the investment community they might as well be, because the areas being targeted for savings largely determine how profitable military contracts can be. For example, one item that will be discussed is when it is appropriate to use various contract types. So-called “time and material” contracts typically generate bigger margins than cost-plus contracts, which in turn are usually more profitable than fixed-price contracts. There is longstanding concern among Pentagon policymakers that the acquisition system wastes billions of dollars each year by using inappropriate contract types, permitting excessive overhead charges, requiring unnecessary performance features, and generally failing to get the best deal.

Under Secretary Carter proposes to change all that — gradually at first, but fundamentally and permanently over the long run. Carter is operating on the assumption that weapons budgets are unlikely to grow significantly above the rate of inflation in the years ahead, and therefore that keeping technology investment plans on track will require shifting money from non-value-added activities to activities that produce real value for warfighters and taxpayers. Such changes are long overdue, and may help to shield contractors from more draconian cuts imposed by Congress or the White House as pressure to reduce deficits mounts.

However, defense companies are not likely to welcome the Carter initiatives, because they will fear that targeting overhead costs endangers industry profits. Those profits are already at risk due to $330 billion in weapons cuts recommended by Secretary Gates last year and insourcing initiatives aimed at pulling contracted services back into the government. When combined with the more demanding acquisition procedures imposed by recently-enacted reform legislation and the prospect of reduced funding for overhead functions, the emerging pattern is far from encouraging for key sector players. Carter’s initiatives undoubtedly will accelerate the plans of some of those players to exit the business before valuations begin to erode in response to softening demand.

The good news is that Under Secretary Carter is a smart, open policymaker who will not rush into implementing poorly-constructed initiatives. He will consult with his workforce and contractors before making decisions on where to seek savings, and he understands that profits are essential to preserving a healthy defense industrial base. The industry could not ask for a more intelligent, reasonable partner. The bad news, though, is that industry will need all the help it can get from Carter and his government colleagues, because Wall Street has gotten the message that the long-anticipated defense downturn is upon us.