DEFENSE CONTRACTING

BREAKING: Report Finds U.S. Defense Industrial Base in Decline

2/5/2020
By Yasmin Tadjdeh

Image: Defense Dept.

The defense industrial base is on a negative trajectory as companies grapple with deteriorating conditions for industrial security and the availability and cost of skilled labor and materials, according to a new report released Feb. 5.

In the report, “Vital Signs 2020: The Health and Readiness of the Defense Industrial Base,” researchers dug into three years’ worth of data, ultimately bestowing the defense industrial base with a worrying low “C” grade. (Read the report here.)

“2020’s mediocre ‘C’ grade reflects a business environment characterized by highly contrasting areas of concern and confidence,” said the report which was compiled by the National Defense Industrial Association — the publisher of National Defense — and its partner Govini. Vital Signs is intended to be an annual report.

The report examined eight different dimensions including: market competition; cost and availability of skilled labor and critical materials; demand for defense goods and services; investment and productivity in the U.S. national innovation system; threats to industrial security; supply chain performance; political and regulatory activity; and industrial surge capacity. Researchers analyzed 40 longitudinal statistical indicators and converted each into an index score on a scale of 0, which is bad, to 100, which is excellent.

Hawk Carlisle, NDIA's president and CEO, said a key reason the association created the Vital Signs report is because there is a need to have a broad national conversation about the health of the industrial base.

"A lot of that's in the classified area and we really believe this is a discussion that has to be with the American people, with Congress, with everybody," he said during a telephone call with reporters.

While the United States still has the greatest military and defense equipment in the world, "we won't stay that way if we don't address this problem now," he noted. He pointed to China as an advanced adversary that is bolstering its military capability. The 2018 National Defense Strategy listed China, along with Russia, as peer competitors. 

"Our ability to counter that is our own industrial base and our ability to provide our warfighters with the greatest capability — the training and the resources they need to continue to win the fights we put them in," Carlisle said.

Carlisle noted that NDIA worked closely with the Defense Department and industry as it compiled the report. 

Wesley Hallman, NDIA's senior vice president of strategy and policy, said since the Budget Control Act of 2011 and sequestration in 2013, the Pentagon has had a concerted effort to explain what readiness is, how it measures readiness and what the impacts are of those policy decisions on readiness over time.

"Unfortunately, there's no similar way to discuss or talk about the health and readiness of the defense industrial base at an unclass level that brings all the viewpoints into the discussion," he said. "Vital Signs seeks to fill that gap as we embark on a long-term strategic path laid out in the National Defense Strategy."

NDIA's goal was to build an open source, data-driven model from which stakeholders could assess the health and readiness of the industrial base on an annual basis, he said. However, the association made no specific recommendations in the report, which was the culmination of an 18-month process.

"We do this because we want the broader community to see this as a baseline for the discussion that we have on an annual basis of what is that health and what do we need to do about it to ensure it over time," Hallman said. "Given that we've moved from the post-Cold War era where we had overwhelming U.S. preeminence to now great power competition where we're talking about peer and near-peer competitors, that discussion should revolve around whether a 'C' grade for this year is good enough to compete."

As decision makers see that grade, they should consider doubling down on efforts to pass authorization and appropriation bills on time, he added.

"Every day that we spend with budget uncertainty in a CR, in a continuing resolution, can be measured in wasted time and wasted dollars that we will not only never get back ourselves, but our competitors will take advantage of," Hallman said.

In the report, the industrial security dimension received the lowest score with 63 in 2019. To assess that category, NDIA and Govini analyzed indicators of threats to information security and intellectual property rights.

“The indicators of global information security threats were already failing in 2017 and scored even lower in 2019 given the rising annual average number of new cyber vulnerabilities ... which almost doubled between 2016 and 2018 when compared to the period between 2014 and 2016,” the report said.

Threats to information security are a major risk for industrial supply chains. Companies rely on the production, manipulation, transaction and distribution of information, meaning that vulnerabilities can threaten production capabilities, service deliveries and the integrity of intellectual property rights, the report said.

“The proliferation of information security vulnerabilities forces industrial supply chain managers to continuously adapt to a dynamic threat,” the report said. “Accordingly, information security threats constitute an enduring source of costs as companies invest in measures to prevent or recover from information system breaches and disasters.”

Defense industry production inputs also received a poor score of 68 in 2019. Industry production inputs include skilled labor, intermediate goods and services and raw materials used to manufacture or develop end-products for the Pentagon. Included in this section is the defense industry workforce size, which contributed to the dimension’s low score, according to the report. The workforce is currently estimated at 1.1 million, which is far lower than its mid-1980s peak of 3.2 million.

That dimension was also affected by the security clearance process as backlogs shrink but persist, the report said. “Onboarding new personnel in the defense industry often requires navigating the security clearance process,” the report said. “Defense contractors face a security clearance management process that became more complicated from 2017 to 2019.”

Despite some concerns, the report also pointed out areas of confidence, including the state of defense contracting competition, which received a score of 96.

“Several high-scoring indicators drove the strength of market competition conditions, including the availability of cash assets, the low level of market concentration of total contract award dollars, the relatively low share of total contract award dollars received by foreign contractors, and the high level of capital expenditures,” the report said.

Poor performing areas included return on assets and contract offers per contract action.

Another positive area included the state of demand for defense goods and services, which received a score of 94. That was an increase of 16 points since 2017.

“This result comes from an increasing financial volume of contract obligations issued by DoD,” the report said. Total contract obligations issued by the Defense Department grew from $306.7 billion in 2016 to $368.7 billion in 2018, the document said. Further, acquisition expenditures grew in all categories, rising by 11 percent for aircraft, ships and land vehicles; by 33 percent for electronic and communication equipment; by 35 percent for weapons and ammunition; by 39 percent for sustainment; and 23 percent for knowledge-based services.

Conditions in other dimensions of the report conform to the pattern of moderate but declining health and readiness, the document said.

For example, in the innovation conditions section, the industrial base received a score of 74 for 2019 — a drop of 2 points since 2018. Feeding into that was a decline of international patent applications which are seen as a measure of innovation. Additionally, the share of global research and development comprised by U.S. expenditures saw its score fall between 2018 and 2019 from 75 to 74.

The report noted that there were no well-performing factors in this section.

“The steady erosion of investment in the government-universities-industry ‘innovation triangle’ pioneered during World War II has contributed most to America’s recent innovation decline,” the report said.

Additionally, U.S. investment in basic research at university and federal labs has declined for a generation while China has made substantial investments, the report added.

“In 2017, federal R&D spending as a share of the gross domestic product fell to its lowest level since 1955,” the report said. “Comparatively, China’s public sector investment in R&D increased by 50 percent between 2011 and 2016. Unsurprisingly, Chinese entities now file nearly 50 percent of all patent applications submitted worldwide.”

However, the United States’ innovation system still remains highly competitive, it added.

Political and regulatory conditions had a steep drop between 2017 and 2019, decreasing from 92 to an index score of 79, the report said.

“Congressional defense budgeting process indicators contributed to this decline since their composite index score decreased from 90 for 2017 to 77 for 2019,” said the document.

Additionally, congressional interest in major defense acquisition programs, or MDAPs, also plunged. “Mentions of MDAPs in congressional hearings decreased from 86 in fiscal year 2016 to 18 in FY 2018, which is echoed in an index score drop from 97 in 2017 to 54 in 2019,” the report said.

Meanwhile, regulatory conditions also deteriorated between 2018 and 2019, the report said.

“The index score for our ‘red tape ratio’ of nonrestrictive rules to new restrictive rules decreased by 18 points from 100 to 82,” according to the document.

Another key area examined by the report included productive capacity and surge readiness, which received a score of 77 — a 9-point increase since 2017. That can be attributed to gains in output efficiency and stability in capacity utilization, the document said.

“An assessment of the surge capacity of the defense industrial base using industrial input-output analysis uncovers fewer shortages in critical defense supplier industries than estimated for the defense industrial base of the early 1980s, which constitute the last era of great power competition,” the report said.

During that time, the defense industrial base experienced a significant build up in defense spending and force posture as well as a 31 percent surge in Defense Department expenditures through the Jimmy Carter and Ronald Reagan presidencies, the report said.

“We estimate that the defense industrial base circa 1980 experienced shortages in the productive capacity of 54.5 percent (6 of 11) of critical defense supplier industries,” the report said. “Presently, 27.3 percent (3 of 11) of critical defense supplier industries would likely experience shortages in the event of a surge in demand for combat-essential defense programs equivalent to the Carter-Reagan buildup of the late 1970s through the mid-1980s.”

The final dimension examined by the report is supply chain, which earned a score of 68 — a decline of 15 points from 2017.

“Industry supply chains today experience lengthening cash conversion cycles and a declining average rate of inventory turnover as they invest in new inventory to fulfill the rising demand for defense goods and services,” the report said.

Additionally, schedule-based cost changes to MDAPs and Nunn-McCurdy cost breaches continue to fall below baseline values, it said.

Well performing factors in this dimension include schedule management and cost management, but poor factors include contract failure, financial performance and inventory management, the report said.

This story has been updated with quotes from the press conference.

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Topics: Defense Contracting, Defense Department

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