22 August 2016

Rethinking Profit Policy In Defense Acquisition


August 12, 2016
“The first responsibility of the acquisition workforce is to think.”

Despite persistent myth, the average profit margin for defense companies is half the margin for S&P 500 companies. Whether that bargain is good for warfighters and citizens depends on DoD acquisition goals and what that policy actually achieves in security, cost effectiveness, and innovation. But defense acquisition has performed poorly for decades and has been under constant reform during all of that time. Lack of progress in acquisition reform suggests underlying assumptions in policy and reform to date are flawed, and that if any progress is expected in the future, then these assumptions and policies must be reexamined. Otherwise, future progress is equally unlikely however comprehensive and well intentioned. 

DoD profit policy continues to operate under the assumption that profit is merely wasted expense, or worse. 
According to a Defense Acquisition University training presentation, “Many in Government see profit as ‘evil’ and unfair to the government vs. a required component of the acquisition process”. DoD leadership consistently denies there is a “war on profit”, but in 2013 HASC testimony, Pierre Chao showed something is clearly wrong with DoD profit policy: “Culturally we have evolved to a point where the system would rather pay $1 billion and 5% profit for a defense good, than $500 million and 20% profit.” The Defense Business Board agrees: “Profit is misunderstood by the government, [It is] seen as something to be minimized” and more comprehensively that “DoD lacks sufficient understanding of business operating models and drivers of innovation.”

The Public View of Defense Industry Profit

Clearly, both the American public and media views of the defense industry and especially defense industry profit are aligned with DoD policy. Neither are generally friendly to the defense industry. A Brookings study noted, “We are accustomed in the American public debate to praising men and women in uniform, and yet we often ignore or even pillory those who equip and support them.” 
Stories of $800 hammers and $1000 toilet seats are not lessons of industry greed. Such prices are instead monuments to a broken acquisition system mired in regulation, process, oversight, and unique and changing requirements – all of which add to the cost of delivering what DoD acquires. They have nothing to say about industry overcharging or profit.
Media and various watch organizations are especially responsible for feeding the public myth of a greedy defense industry. This 2015 Washington Post headlineDefense contractors hunker down, then report blistering earnings is at best misleading. At the close of 2015, defense industry profits were again half of the S&P, and far less than profits for Dow 30 producers of hamburgers, diapers, and Coca-Cola, not to mention the truly prosperous producers of our iPhones and favorite apps. Such stories needlessly inflame the ire of the public and Congress and result in ever more expensive and time-consuming legislation, policy, bureaucracy, and process. Although responsible oversite is necessary for productive, accountable administration, in defense acquisition it has been driven to an extreme “accretion of laws, regulations, reporting requirements, and mandated procedures that are choking the system … Fully a third of our procurement dollars are going to ‘overhead’, much of it dictated by the choking layers of redundant and competitive overseers.” (John Hamre, “An Honest Look at the "Military-Industrial" Complex”)

Examining Defense Industry Profit

“We don’t see why more mature commercial technology firms would need to do business with DoD when margins they could earn might be half of what they see on commercial work”

Numerous sources show the defense industry earns much lower margins than business averages. Media sensationalism aside, no independent, authoritative study known to this author concludes that defense industry margins approach typical business averages. Separate studies by Deloitte, Pricewaterhouse Coopers, and the Institute for Defense Analysis (IDA) all conclude that defense companies earn margins half of typical business averages. The 2013 Grant Thornton study concluded "60% of participants reported either no profit or profit in the 1-5% range”. DoD’s own Defense Business board, in its 2014 report:Innovation - Attracting and Retaining the Best of the Private Sector concluded: “Compared to other markets, the Defense industry has the lowest returns.”

One need not accept these reports and can instead do a basic comparison independently. Simply download the list of top defense companies from federal procurement data here, and a list of the Dow 30 companies from CNNMoneyhere, and retrieve their publically filed profit margins using Google or Yahoo Finance. The July 2016 comparison of 2015 profit margin for Dow 30 companies is 13.9%. For defense companies, profit margin was 5.2%. This basic analysis does not separate the commercial and military business of several companies appearing on both lists, and several top defense companies are private or foreign owned so public financial information is not readily available. But accounting for these factors and more sophisticated analysis drives only to the more rigorous conclusions of the studies referenced.

Predictably, DoD’s study arrives at a different conclusion. Its 2014 reportPerformance of the Defense Acquisition System devoted considerable review of defense industry profit margin. It concluded “Overall, from 2010, the margins earned by defense firms were not systematical [sic] different from the margins of commercial firms shown as a whole.” But mathematically, DoD’s selective analysis showed defense firms earned 9% operating margin and commercial firms earned 11%, still significantly higher than defense firms though not as much as the independent reports. But the DoD analysis is contrived. Defense firms are mostly from the top 10 primes providing the most technologically advanced systems ever produced to typical manufacturers of commercial capital goods, engineering services, and automobiles. Particularly conspicuous from their absence from the list of commercial firms included in the DoD study are high tech companies, many of which DoD is courting with its Defense Innovation Initiative, and many of which earn margins in the commercial sector that likely would land them in front of Congressional committees if earned from defense contracts. The 2015 Performance of the Defense Acquisition System report expanded its study of defense industry margins and this time concluded that first-tier subcontractor margins were higher than for primes reviewed in 2014. This report promised “new work in this area”.

In their detailed examination of defense industry profit, neither report referenced any other public study, including their own IDA and Defense Business Board reports noted earlier here. Nor did either DoD performance report link profit margins to any other defense acquisition goal, including DoD’s great drive today to attract new and innovative suppliers to work with DoD.

Both reports reflect DoD’s public rhetoric of reasonable margins tied to performance. It is an eminently responsible statement. But it is empty without context, and hazardous to taxpayer interests when it drives unproductive process, consumes scarce resources, and frustrates other goals such as the critical need to attract the brilliant minds and performance needed to execute the defense strategy based on technical dominance we depend on.

DoD View of Fair and Reasonable Profit

There is a distrust of the traditional defense-unique industry that translates into

an almost pathological desire to eliminate allegedly excessive profit

No one disputes the legitimate interest of any buyer striking the most favorable bargain it can negotiate, nor denies the sacred trust of the taxpayer’s interests. But like other aspects of acquisition policy, DoD’s approach to fair and reasonable profit is an insular one. It assumes a captured supplier base on which to impose its will. Despite DoD leadership claims to the contrary, DoD policy in practice is that industry profit must be identified and minimized at seemingly any cost. But today’s markets are not only national, but global, and suppliers have a choice about what customers to serve and whose problems to solve.

DoD price analysis is done per the weighted profit guidelines DFARS 215.404-71 and worksheet form DD 1547 which establish the governments negotiating position. The process is supposed to be used in contracts requiring profit analysis but it inevitably works its way into other types of negotiations as well. It is supposed to account for technical, management, performance, and contract type risk suffered by the contractor and capital assets employed by the contractor. But these are all internal government assessments concerning the contractors business, about which government likely knows little, and it fails to account for myriad other business risks. Furthermore, despite the name, the weighted profit guidelines are not about profit at all. They are instead about fee, or the amount the government will pay above estimated costs. Profit is what remains after taxes (nominally 35%), and costs unallowable by government but necessary to run a business (nominally 3%).

In addition to how much DoD will allow in fee, DoD diminishes profit further by also restricting to what fee may be applied. For example, DoD objects to charging fee for subcontracted work. But this has negative side effects for other DoD goals by encouraging vertical integration or bringing work in-house which tends to concentrate the defense industrial base and harms small business.

Perhaps the most important problem with government profit policy is its lack of flexibility regarding unique market conditions and ultimately its understanding of the suppliers choice whether to do business with government at all, or whether to apply its resources and innovation to more favorable commercial markets. With defense industry margins half of market averages, it is easy to understand how current profit policies confound DoD acquisition goals to attract new innovative companies with more attractive commercial options.

Profit and Commercial Items

In a rare period of clarity, leadership in Congress and DoD, as part of the 1994 Federal Acquisition Streamlining Act of 1994 (FASA), reasoned that government could take advantage of available and evolving technological innovations in the commercial sector without incurring the tremendous, needless expense and time required for developing exclusively unique military products.

New streamlined procedures were developed for purchasing commercial products, and products very similar to commercial products adapted slightly for military use (“of a type”). Commercial products were to be purchased at market prices, exempt from the onerous and expensive process of military unique items. In particular, they were made exempt from the requirement for a cumbersome, redundant, and expensive certified government accounting system and the requirement to provide certified cost and pricing data, though in some cases DoD could ask for “other than certified cost and pricing data. The 2001 Commercial Item handbook explained its reasoning:

The more attractive the Government can make itself as a buyer, the more likely it is that world-class sellers will enter into contracts with the Government, that favorable terms and conditions will be negotiated, and that lower prices will be paid.

But DoD soon moved to undermine this reasoning in an effort that has grown in fervor over time. DoD has worked to eliminate from commerciality any item “of a type” adapted in any way for military use. It has fought to define as military unique, commercial items once sold to the public but later superseded by time or technology. More recently, its determination to get commercial profit data, DoD issued a memo to acquisition officers which stated “… the only difference between ‘certified cost and pricing data’ and ‘other than certified cost and pricing data’ can be the fact that the data is certified.” DoD’s unthinking intransigence on commerciality earned it this rare admonishment from the Senate version of the 2017 NDAA: “The committee is concerned about the Department of Defense’s increasingly narrow interpretation of the definition of commercial items . . . If there is a problem with the definition, it appears to be the Department’s repeated attempts to narrow the definition to conform to an oversight strategy that will inadvertently lead to less competition [and] increased costs.”

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DoD pressuring commercial suppliers for cost and pricing data is a direct violation of the spirit of commercial item provisions in FASA which intended toattract talented and innovative companies not previously willing to do business with DoD. It is also a violation of fair play to expect commercial prices while also imposing extensive uncompensated process and demanding proprietary cost and pricing data not required in real commercial transactions. On balance, especially considering DoD’s similarly unfriendly approach to other aspects of commerciality such as intellectual property, it is likely that FASA intent to increase DoD access to new commercial companies with less expensive, innovative products has gone unfulfilled.

The Basis of Sound Profit Policy

Like all policy, sound profit policy must be based on objectives. Criticism of the performance of the current acquisition systems include high cost, slow cycle time, and a deteriorating technological dominance that American strategy has depended upon for decades. Acquisition goals therefore must be more cost effective equipment and services, faster delivery to the warfighter, and restoration of our technological dominance. A comprehensive acquisition reform agenda must understand free enterprise and harmonize all the tools of acquisition effectively including policy on profit, intellectual property, commerciality, competition, partnership and other tools. It must include the proper balance of responsible oversight and trust in both the industrial base and the judgement of experienced acquisition officers.

The excessive bureaucracy that powers the war on profit denies DoD the full power of our enormous industrial capacity and innovation of this great country. Low profit margins is poor policy if it drives away the great problem solvers and innovators into markets outside of defense, reduces competition because potential suppliers are uninterested in a difficult customer and poor returns, or costs actually increase because of monolithic infrastructure fixated on only one component of cost loses perspective on the big picture. 

Fair and Reasonable Profit Policy

“To unite the sinews of commerce and defense is sound policy; for when our strength and our riches play into each other’s hand, we need fear no external enemy.”

-- Thomas Paine, Common Sense, 1776.

Profit as only one component of acquisition cost is not inherently any more interesting than any other component and on its face deserves no more dedicated bureaucracy than any other. But it does have unique properties for both suppliers and buyers. For suppliers, it is critical to basic survival, a measure of success and a yardstick informing investment and market decisions. For buyers, it is an opportunity to shape the market, and to tune supplier behavior. DoD leadership advocates tailoring profit incentives in contracts but overall defense profit levels are so low and incentives so small that it fails to capitalize on the unique property of supplier profit and severely handicaps acquisition objectives.

Fair and reasonable profit is not a number. It is a tool that enables achievement of concrete acquisition objectives more directly relevant to the taxpayer’s defense. DoD profit policy should be to allow contract profit to be what is necessary in order to achieve those objectives. Informing profit policy should be answers to questions like these. What profit policy…
… encourages the best innovators, minds, and companies to solve defense problems. 
… incentivizes key performance such as low cost, rapid development, or extraordinary outcome.
… ensures responsive support when surprises appear that are not on contract.
… attracts sufficient bidders for effective competition.

A logical, objective baseline for reasonable profit would be margins typically earned by a cross-section of businesses, e.g. the S&P 500. Adjustments would be made appropriate to market segment and prevailing conditions. At the same time, much of the bureaucratic machinery choking the system designed to identify and limit supplier profit must be pared back. With one-third of procurement dollars going to oversight, it is irresponsible to spend more on oversight than any potential savings. Google Finance alone is a good benchmark for supplier profit margin, but an efficient, infrequent, and coordinated audit is reasonable. 

Notionally, the profit component of procurement costs would increase but that need not be the case. Competition and innovation will undoubtedly bring new, more powerful and cost-effective solutions to defense. In any case, profit was never as important in the first place as system cost and performance. Using Pierre Chao example, why shouldn’t we be willing to pay 20% margin to a supplier who can cut overall costs in half? That supplier’s success will only invite greater competition, innovation, performance and further cost reduction in the future.

Rethinking Profit Policy in Defense Acquisition

This analysis of DoD profit policy is admittedly critical, but it is no plea for cozy treatment of defense suppliers. Instead, it is a realistic appraisal of the disconnect between DoD profit policy, the unfriendly acquisition environment, and the acquisition goals DoD has set for itself. Acquisition and profit policy based on self-interest is entirely expected, but as in any human interaction, it must be mindful of the interests of those with whom we must partner and depend on lest they make choices reasonable to them that do not support our own interest. It is axiomatic that encouraging particular choices logically involves making that choice easy. It is decidedly not easy to work with today’s defense acquisition system. 

No one protects taxpayer’s interests spending billions to save millions while compromising important elements of a cost effective national security dependent on a vibrant, innovative, diverse industrial base to support it. We know DoD profit policy is problematic for acquisition. Last year, UTC divestedSikorsky helicopters specifically because of poor profitability in defense, and General Dynamics bowed out of the new trainer competition for the same reason. But we will never know the unnumbered occasions when great and innovative potential suppliers simply passed unnoticed on military business because more attractive, less problematic returns were available somewhere else, and we will never know the damage already incurred by the taxpayer in lost cost reduction and a diminished defense.

Defense is a team sport. We must have and respect both soldiers and armorers, and we must engage the full power of the entire economy. New profit policy alone won’t achieve that security. A first principles rethinking is also needed on policy for intellectual property, competition, commerciality and many other issues. In place of the current acquisition system based on lack of trust (Defense Acquisition Performance Assessment Executive Summary), a new foundation is needed based on accountability and partnership.

DoD must be both a better buyer and a better customer. Instead of the problematic customer it is today, imagine if DoD was the preferred customer of businesses across the country. DoD would have economical access to the innovation and power of the entire economy. Imagine what could be achieved then. 

There is nothing more difficult to take in hand, more perilous to conduct, or more uncertain

in its success, than to take the lead in the introduction of a new order of things.

-- Niccolo Machiavelli

Scott Chandler is an Aviation and Acquisition Consultant.

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