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National Defense > Blog > Posts > Analysis: Pentagon Needs New Ways to Attack Bloated Spending (UPDATED)
Analysis: Pentagon Needs New Ways to Attack Bloated Spending (UPDATED)
By Sandra I. Erwin



There is little appetite at the Pentagon to buy new weapons, officials have told industry CEOs in recent weeks. Sequestration is cited as the reason, but there is more to it.

Weapon buyers are paralyzed by fear, acknowledged the Pentagon’s senior acquisitions executive Frank Kendall. “I have been watching programs get canceled because they weren't affordable. We have done too much of that,” he said. Over the past decade alone, the Defense Department terminated $50 billion worth of programs, and has nothing to show for it.

Even after sequester, there is still plenty of money in the Pentagon’s budget — approximately $100 billion in 2013 — for procurement of new systems. But acquisition officials are gun-shy. They are hesitant to pull the trigger on a new venture that, if history is any guide, will run over budget and result in more embarrassing cancellations. “We are leery to start new programs,” said Lt. Gen. Charles R. Davis, military deputy at the office of the assistant secretary of the Air Force for acquisition.

Countless efforts to reform weapons-buying rules, including major legislation that Congress passed in 2009, have been mostly powerless against cost overruns. The reason is that none of the procurement reforms attack the “true drivers” of cost, says Joseph Martin, vice president of aerospace and defense at the consulting firm Booz & Company Inc.

There is a way out of the so-called acquisitions “death spiral” that has led to the demise of many weapons systems, he says. The key is to reduce crushing overhead expenses — across the entire supply chain — that add no value to programs, he says. These include administration, depreciation, facility expenses, indirect labor, business development and other discretionary expenses that are not directly related to production. The defense sector is loaded with unneeded overhead, says Martin.

Contractors charge the government for direct and overhead costs, and earn a profit margin that is negotiated as a percentage of government-approved costs. Procurement managers are usually aggressive in negotiating direct labor costs and profit margins, but they tend to not challenge the overhead, Martin says. Programs on average could see prices come down by 20 percent by shedding unnecessary indirect costs, he says.

In a typical Pentagon program, the overhead problem is magnified because there are, depending on the size of the project, dozens or hundreds of subcontractors, each of which charges different overhead rates. Defense officials often beat up on the prime contractors, but if they dig deeper, they will find that a lot of the wasteful spending in a program comes from the lower-tier suppliers, Martin says.

Booz & Co.’s research suggests that the frequent carping about excessive industry profits is in fact misdirected and that the outrage should be aimed at overhead rates.

“A lot of the cost in the system is overhead, and yet defense program managers don’t negotiate that,” he says. The government procurement apparatus is geared to enforce compliance with laws and regulations and to police fraud, but not to identify and eliminate inefficiency, says Martin. Auditors will ensure that contractors comply with the Federal Acquisition Regulation, “but the FAR doesn’t say anything about whether you should have an 800 percent overhead rate or a 50 percent overhead rate.

Companies that receive cost-plus contracts — where the government pays for all expenses plus a profit margin — benefit from bloated overhead. The Pentagon in recent years has sought to increase use of fixed-price contracts that incentivize suppliers to lower costs. But a shift to fixed-price contracting is not enough, says Martin. “A cost-plus mentality still exists in the industry even where fixed-price contracts have been written,” he says. “Years of cost-plus work have been embedded in engineers’ minds.” Many companies still see cost as revenue, says Martin. “That culture is hard to break, and creates inefficiency.”

Booz analysts have sifted defense and aerospace industry contracting data that show sub-tier vendors charging eye-popping overhead rates, Martin says. Rates of 300 or 400 percent are not unusual, he says. “I’ve seen as high as 700 percent.”

Martin has seen these high overhead rates charged by subcontractors in a number of defense programs, including military helicopters, satellites and submarines, as well as in commercial aerospace power systems. He declined to name the projects because they are confidential client data. [SEE CLARIFICATION]

In the contracts that Martin probed, the overhead rates were calculated by dividing the indirect costs by the direct labor — engineering, production, some program finance and program management. A 100 percent ratio means that the indirect and direct are equal. Booz explicitly excluded direct materials to ensure comparability.

The inefficiency in Pentagon contracts can be staggering, says Martin, especially when orders are relatively small. The supplier has the same overhead and it’s applied to fewer items, so each item’s price soars. Program managers, in many cases, lack the skills or tools to address this, he says. “They would have to bring tough commercial business practices to get the supplier to even revisit looking at their overhead.” For suppliers, there is no incentive. “Why would I cut overhead that equates to revenue?” he asks.

With a large enough number of billable hours and overhead, companies can get by with small percentage margins. A recent survey by the consulting firm Grant Thornton reveals that 60 percent of the companies that answered the survey received either zero profit or 1 to 5 percent margins. “Our surveys have supported the conclusion that, contrary to conventional wisdom, the profit rate from government contracting is rather modest,” the report says.

Because profit margins are low, companies boost revenue with high overhead rates, Martin says. “You want to make a base so that the multiplier results in a lot of dollars,” says Martin. “This happens all through the supply chain.”

Prime contractors could dramatically lower the cost of a system simply by shaking up their subcontractor base and demanding lower overhead rates, he says. But primes often are reluctant to do that because it can be expensive to switch suppliers. The government must approve any subcontractor change and re-qualify the products. “Engineers develop a favorite supplier list and they don’t want to switch. … It’s extra work that doesn’t add value, in their minds.”

Prime contractors, he says, should demand consolidation within their supplier base.  
He recognizes that these actions would stir political backlash, as slashing overhead across the defense industry would leave thousands of white-collar workers out of a job. The upside, he explains, is that the consolidation of lower-tier suppliers would make the industrial base stronger and healthier. 

Martin’s take on the impact of subcontractor overhead costs on weapons program is a contrarian view, to be sure. Pentagon leaders have sounded alarms about small businesses in the defense sector being financially weak and at risk of perishing.

Some firms, indeed, are fragile, Martin says. “It’s not one size fits all.” But there are many lower-tier companies that are using the Pentagon’s rhetoric as cover to charge aggressively and continue to operate inefficiently, he says. “The government should promote healthy competition in the supply base.” Once subcontractors begin to fear that they might be replaced, the invisible hand of the market will start taking out costs, Martin says.

To be sure, much of the inefficiency in defense contracting is caused by the regulatory burden that government puts on suppliers, industry leaders have argued. Complex procurement processes, as well as reporting and audit compliance requirements fuel overhead expenses, concludes a 2012 industry survey. At least 25 percent of the cost of what the Pentagon buys is attributed to “transaction” expenses such as administrative and legal costs, monitoring purchases, making changes to documents and resolving disputes, says a study titled "Cutting Fat without Cutting Substance,” published by the National Contract Management Association. “Some transaction costs are necessary, but others can be lowered or eliminated,” the report says.

During a House Armed Services Committee hearing last year, EADS North America CEO Sean O’Keefe told lawmakers that doing business with the government can add more than 20 percent to the price of goods. The regulatory load, he said, “stunts competition and increases the cost of doing business.”

Clarification: Martin declined to mention specific programs as it is Booz & Company policy not to discuss specific companies.

Photo Credit: Navy

Comments

Re: Analysis: Pentagon Needs New Ways to Attack Bloated Spending

   Want to really cut cost?  Or should I reword that to ;  Do they really want to cut cost?  An easy way is to cut some of the salaries to these overpaid pencil pushers that do nothing worth their wages. You know a fair wage for a fair days labor.
Richard L. Valimont Jr at 3/18/2013 10:55 AM

Re: Analysis: Pentagon Needs New Ways to Attack Bloated Spending

If they really wanted to cut cost, they'd stop paying defense contractors more to screw us over, and instead they'd pay contractors more to provide good working weapons on time and on budget.  As it is, there is not only no incentive to provide weapons on time and on budget, but there is actually a disincentive, doing that actually causes the contractor to lose money!  How stupid is that?  You don't have to be a rocket scientist to realize that if you pay a company more to drag out development and jack up costs, they will do just that. 

Do you want to know how the company I work for keeps their overhead rates down?  They hire fewer janitors and make more direct employees do janitorial tasks.  Is that what the author is suggesting as a cure for runaway program costs?  Obviously it is cheaper all around to hire janitors to take out the trash than it is to hire engineers to do the same.

Let's look at the big picture for a change.  Instead of focusing on overhead rates, let's stop putting the US taxpayer on the hook for weapons development costs.  Let the defense contractors do development on their own dime.  Let's have the DoD stop buying weapons like buying a "pig in a poke" and start buying real weapons in real competitions developed by the suppliers at the supplier's cost like the real world does in the free market place.  Apple didn't come to me to cover their development cost of the iPhone, why should a defense contractor tap my wallet for the design of the next new gun or fighter jet?  That's a bunch of bull.  These defense contractors should have to sell a good product for a good price and make and make their development costs back in the profit from their sales of real weapons just like real companies do.
Dfens at 3/19/2013 4:28 PM

Re: Analysis: Pentagon Needs New Ways to Attack Bloated Spending (UPDATED)

I agree with last commenter on some things. Why not grade a contractor on producing a part or component on time before awarding them the mother load if a contract is large?. If you cannot fill the first part. Why should you be given the second part to do exactly the same thing again? I have seen this happen repeatedly with some contractors and I am unsure if I should laugh or cry, or send someone to speak to their parents! Honestly!

Additionally, if the government PM changes the spec or requirements, expect delays and cost overruns. You cannot have one without the other. Its the law of equal and opposite reactions. As the PM make your superiors need to understand the consequences of changes in mid stream. From both sides of the equation it is about realistic expectations and accepting responsibility for what each one of us does. If we expect this from our children, we also need to accept it as a standard when we go to work each and every morning. When we treat each other as professionals, and as ladies and gentlemen and define our expectations we have less bad blood flying around and more of a genuine team effort. This is not pie in in the sky, we have executed 6, 7, and 8 figure conrtacts this way and I can only assume we are doing something right? Imagine!

One of my other colleagues who retired from years of military services also made the following comments (we all need to make an editorial contribution if we genuinely expect constructive change and improvement).

Amen.
There are other parties to the madness--besides the PMs and corporate muppets.   There's also the lawyers ("you MUST do it this way and CAN'T tell them this or that") and Congress (no, you can't have a multi-year contract...we want to mess with you EVERY year...even though that raises the costs to the taxpayers!)
christopher Baxter at 4/15/2013 6:16 PM

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