Why the Pentagon Pays More, and Buys Less
By Sandra I. Erwin
Over 25 years, the price of a Ford F-150 pickup truck has risen an average of 3.7 percent annually. Buying a Boeing 737-800 has cost 3.2 percent more per year since 2004. The price tag of a Gulfstream G550 business jets has inched up by 2.1 percent annually over the past nine years.
In the world of military hardware, inflation rates are in a whole different league.
Between 1967 and 2005, the cost of Navy submarines is up by 401 percent, 391 percent for amphibious ships, and 100 percent for aircraft carriers.
“Across the Department of Defense, paying more for less is the undeniable trend,” says John Wolff, partner at the consulting firm A.T. Kearney, in Washington, D.C.
The Congressional Budget Office concluded in a recent study that, if the trend lines stay the same, the Navy will be able to purchase only half the current number of ships by 2030. “Other Pentagon programs face a similar plight,”Wolff says in a recent white paper. “The Defense Department is paying more for less.”
Complex technologies in defense programs are often blamed for cost overruns, says Wolff. He believes that argument is weak, considering how civilian products such as automobiles and commercial aircraft have evolved and innovated without the same level of inflation.
The Pentagon’s own cost estimating and budget processes continue to fuel the vicious cycle of inflation and cost escalation, he says. Programs build in inflations rates often between 4 to 6 percent into their budgets, which creates a self-fulfilling prophecy, Wolff says. “Prime contractors budget and plan for escalation with their major equipment suppliers, which plan for escalation with their tier one suppliers, and so forth.”
Once budgets are approved, the defense acquisition machine is conditioned to consume the extra costs, he says. “As price inflation projections becomes reality, they become the justification for future cost estimates and budgets. The cycle continues.”
Inflation in the mid-single-digits has become both the expectation and the goal of the supply base, says Wolff. “Some suppliers explicitly reward managers based on their ability to increase prices over time, and they view cost management, quality, and customer satisfaction as secondary performance measures.”
Free-market competition in the supplier base could quickly reverse this trend, he suggests. In a competitive environment, increases in manufacturing costs, such as raw materials or labor rates, tend to be offset by productivity gains. “Prices for customers don't increase at the same rate as cost inflation, and oftentimes they decline. … Automakers typically expect up to 3 percent unit cost reductions from their suppliers year-over-year.” The defense industry is mostly made up of monopolies so the Pentagon must find other ways to motivate suppliers, Wolff says. “That requires a dramatic shift away from today’s thinking.”
Program managers have to banish the concept of “entitled escalation,” he says. Raw material price volatility and labor wage increases over time will drive up costs. “But productivity gains experienced widely across the economy should also be expected in defense,” he says.
Weapon programs need greater visibility of what propels their cost growth, he says. “Today, program managers and prime contractors have only a limited understanding of how price swings for raw materials and other inputs impact total cost, so they are often overstated.”
Wolff says these trends are seen across Defense Department programs. In an interview, he says the primary force that keeps the Pentagon from tackling these cost escalations is “complacency.”
Every program receives an allowance for higher that average inflation, he says. “It’s a foregone conclusion and inevitable fact of life” that cost will go up. Over time, even a couple of inflation points adds up to real money. Half of the acquisition budget today is paying for the weapons inflation of the past 30 years.
There are ways to incentivize suppliers to charge less, but the Pentagon chooses not to do so, Wolff says. Even if there is only one prime contractor that can build a particular system, sub-tier suppliers can be motivated to drop prices over time, as it’s done in the automotive industry, says Wolff. “Suppliers of automakers are allowed to bid on their ability to decrease cost year over year,” he says. “That might be a bridge too far in the near term for this industry … but you could move in that direction fairly easily. You could challenge suppliers when bidding on new programs to commit to managing cost and holding inflation to low single digits.”
Critics of defense spending often have blamed “cost-plus” contracts — where the government reimburses suppliers for their expenses — for the rising price tag of weapon systems.
But even if all contractors were switched to “fixed price,” that still would not fix the underlying problem, which is the culture that accepts rising costs as the norm, Wolff says.
Pentagon contractors often dismiss the comparisons between their industry and the commercial sector as irrelevant because the Defense Department buys equipment in small quantities, which does not allow for economies of scale. Wolff recognizes that small orders are inefficient, but that the reason the Pentagon cuts back on quantities is because it is the only way it knows how to cut costs. If inflation rates came down, maybe the government would purchase larger orders, he says.
Military buyers also need to become more aware of the impact that their decisions have on the ultimate price tag of a weapon, he says.
One of Congress’ most vocal critics of wasteful Pentagon spending, Sen. Tom Coburn, R-Okla., says there is too much “fat” in the defense budget because there is no discipline in weapons programs. “We spend way too much money, and there are no grown ups in the room when it comes to major weapon systems,” Coburn says in an Aug. 2 interview on MSNBC “Morning Joe.”
Coburn unveiled aplan last year that would cut a trillion dollars from the defense budgetover a decade.
“There's no grown up in the room saying the bells and whistles have to stop,” says Coburn. “We suck the dollars out of the Pentagon, and no adult is watching. … In major programs, nobody balances the technology against what we can afford.”
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Topics: Business Trends, Doing Business with the Government, Defense Department, DOD Budget, Procurement, Defense Department