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

Topics: Business Trends, Doing Business with the Government, Defense Contracting, Defense Contracting, Government Policy, Procurement