What profits are made by defense contractors?

It has been reported that one study showed that pretax profits on some $4.3 billion in defense contracts averaged 56.1 percent on investment. In your opinion are the profits made by defense contractors generally excessive, or not sufficient, or about right?

Will you address yourself to this business of profits? Some people take one view and some another.

Mr. PACKARD. Mr. Chairman, I would be pleased to do that.

Let me say in doing so that I believe this GAO report which was submitted yesterday is a fair analysis of the profit picture. Whether the profits before taxes expressed on equity capital are 56 percent or some other number is an issue which I think must be addressed with

care.

What we are talking about here is the ratio of profits to invested capital and whether it is equity capital or whether it is total capital is a detail. This is a ratio. This ratio can be high if profits are high, but it can also be high if investment is low. So this issue is not one in which you can determine whether these profits are too high or not. It has to be looked at on a broader basis.

Now, the report brings out-and I think all of the other studies bring this out-that there is a large segment of the defense industry without adequate capital, whether it be equity capital or whether it be total capital.

The lack of capital has required the Defense Department to provide Government-furnished facilities and Government-furnished equipment in a great many cases. It has required the Defense Department to provide working capital in the form of progress payments in a good many cases and these contractors then are able to operate on rather small amounts of capital. Because they have inadequate capital the Defense Department has had to provide some of this capital.

There are several things that are unfortunate about that, and I say to you very clearly that it is my view that we would be better if we could find some way around this problem. It is expensive for us to supply Government-furnished equipment.

Mr. ADDABBO. What type corporation are we talking of?

Mr. PACKARD. We are talking about the major weapons system contractors-it is the prime contractor supplying weapons systems. In general we are talking about those companies which have a major part of their business as defense business; not companies like General Electric or General Motors which have adequate capital.

We are talking about companies like General Dynamics, Lockheed, LTV, and so forth.

There is no question that this ratio of profits to capital employed is high and it is not a satisfactory situation for a healthy industry. Now, we have to go back, I think, and remind ourselves that a major source of capital for any business is profits. It doesn't make any difference whether that capital comes by way of reinvesting profits in the company as capital-and if you examine the balance sheets of most companies, a substantial part of their equity capital is reinvested profits or whether the profits are used to pay dividends and thereby attract outside equity investment in return for dividends being paid.

The final source of capital for any business eventually has to go back to that firm's profitability.

Let's go over on the other side and talk for a minute about profit on sales. We also have to remember that the profit that is available to go to equity, whether through dividends or whether through the reinvestment process, is capital after taxes, not capital before taxes. The only money that a company has to increase its capital is that which remains after it has paid its taxes.

If we examine the record of profits on sales after taxes, we find that over the last 5 or 6 years these have amounted to about 2 to 3 percent, depending on which sample you take. For the last year given in the GAO report, the profits on cost after taxes were 1.7 percent. Not everybody, but a great many people, say we have got to reduce the cost of our defense programs by getting rid of these high profits. I just want to remind you that we are talking about roughly 1.7 percent of the cost. If you want to reduce the cost of our defense programs we can't do so by focusing on profits; we have to focus on controlling the costs, the things we have been talking about here today.

Now, I have been quoted as saying that I thought profits ought to be a little bit higher, and I do think they should be a little bit higher. I think arrangements should be made so that these profits are converted into more equity capital so that this industry can have a better base to operate from in the future. This comes about because the only way in which you are going to get increased capital is to have a higher profit after taxes on which to generate this.

At the present time the Department has about $10 billion tied up in progress payments. This has increased from a level of about $4 billion in 1964. This means that this Government has advanced these companies about $6 billion since 1964. If that financing had come from private sources, or some other way, the $6 billion, or a substantial part would have been available for other defense products, for nondefense products or expenditures of the Government. In a sense we have an inequity here where we are taking a substantial chunk of Government resources to finance a small number of contractors and, in doing that, we have taken these funds away from a useful purpose.

The excuse used for this is that it is cheaper for the Government to borrow money than it is for the contractors to borrow money. Therefore, why shouldn't the Government borrow money and advance it to the contractors? This is a perfectly good argument. It is a very difficult argument to rebut. It overlooks the fact that there are administrative costs and other costs in doing this.

I am not making these comments today with the idea that I have a solution for this problem. You wanted to get my views on the matter. We have a difficult problem here. I am not prepared to make a recommendation, but in general I think we need to do what the report says: Give more attention to this ratio of profit to capital. Exactly how we can focus attention on that in our ASPR regulations, or programs in order to attract more capital to the industry, is something we are going to address. We think it should be done.

I just want to remind you, however, that we have a very difficult problem here, because what we are saying is that there is not enough

capital in these industries. It is going to be very difficult to get much more capital in them without, as I said, increasing the after tax profit in these industries to some extent. I don't know how far we can or should go, but this is an issue that I think we need to address.

Mr. ADDABBO. On progress payments, is any part of the progress payments procedure due to the fact that our regulations do not let you carry over some of the money to a new fiscal year so if you want to use the money, you must get it out of the account?

Mr. Moor. No, sir; the buildup in the progress payments took place, as Secretary Packard said, during the war escalation period, and the regulations were somewhat relaxed simply because of the pressure to get moving on the production of war material and our weapons system, so that it is a question of how frequently we pay and at what rate we make progress payments on inventory work in progress, and we are now averaging about 86 percent of the work in progress which is Government-financed. In other words, each week and sometimes more often than that, twice a week, the contractor will submit a bill for his costs incurred for work moving through production and we will make a progress payment.

The increased rate at which we are making these payments, and the increased frequency has resulted in the growth from the $4 billion figure to approximately the $10 billion figure, which is much higher than the contract growth during that period.

What Mr. Packard is trying to do now is to bring that down in order that we might not have so much money out, and quite frankly in certain cases it is money out at risk, if the contractor does go into receivership and we can't get our completed products, then we have lost Government money.

Mr. SIKES. Have there been significant losses in Government money? Mr. Mooт. Not to any great extent. There have been one or two minor bankruptcies.

Mr. SIKES. Do you agree with the GAO observation that the present system of linking profits to costs encourages higher costs and that by considering also a contractor's investment in a program the contractor would be encouraged to reduce costs by introducing modern, more efficient equipment

Mr. PACKARD. I think there is some justice in that observation. That is why we have to focus on this cost business. The way we are going to reduce the cost to the Government is to get the cost part of this equation down on the part of the contractor. You can vary the profit one way or the other or take it all out. You are only going to correct it by a couple of percentage points.

Mr. SHILLITO. We are testing, by the way, an approach by which we are trying to relate profits to capital as the GAO suggests in the report. We are not in a position to talk about the results of these tests, but we are proceeding with studies in this area.

Mr. PACKARD. We would like to encourage these contractors to make investments in more modern machinery and equipment and to undertake other steps which will indeed reduce our costs. What we ought to do is to find a way-if they can demonstrate to us they have done this that they can get some credit for doing it.

Mr. SIKES. Include some details on these tests in the record.

60-295 0-71-pt. 2- 4

(The information follows:)

The Department of Defense has for some time been studying the merits of modifying its profit policy for negotiated contracts in order to give greater recognition to capital employed by a contractor in the performance of his contract. The recent release of the General Accounting Office defense industry profit study has renewed congressional and industry attention on the subject. Several months ago the Department of Defense created a special Armed Services Procurement Regulation Subcommittee to gather and analyze data on the amount of capital contractors employ in the performance of contracts for which profits have been negotiated using the weighted guidelines method now required by the ASPR. Various approaches for recognizing capital allocated to Government contracts have been considered. Limited testing has been done and the Department is now ready to move forward with a new method to be tested at this time. The Office of Management and Budget has approved a plan to collect the necessary data from contractors. The tests currently underway will involve a representative sample of contracts recently awarded by the Department. The test has been designed to permit collection of data needed to test the "capital employed" method over a wide spectrum of negotiated procurement actions awarded during the last fiscal year. Upon receipt of the data from this test, it will be analyzed to determine how best to relate profit in part to the amount of operating and facilities capital a contractor may employ in performing a contract. The end results will be used to develop procedures for contracting officers to follow in developing prenegotiation profit objectives which recognize capital employed. It is possible that this can be accomplished by adjusting the present weighted guidelines computational procedure.

This effort will constitute the first formal testing procedure of the new method. The preliminary results of this test are expected to be available by the end of this fiscal year.

Mr. SIKES. In your earlier remarks, Mr. Shillito, you mentioned a comparison of defense contractors' profits with those of commercial enterprises. As we have just discussed, in defense work we frequently provide Government-owned facilities. We purchase industrial equipment. In some few cases we provide advance payments and, in most cases, progress payments. Commercial firms, on the other hand, own their own facilities, and their own equipment. A firm obtains its money on the open market and sells its product for a profit. So is there really a fair comparison of these two situations?

Mr. SHILLITO. There indeed is, insofar as the GAO report is concerned. The numbers in the report and the numbers we have talked about before the committee deal with taking these differences into account. In other words, you see the capital turnover rate reflect a larger profit than the ratio of profits to sales.

When you weigh and compare these statistics you still end up with an average profit that is still less, on the defense side, when you use profit to equity or profit to total capital investment. You can readily see this, as Mr. Packard has said in examining the last renegotiation board report. Comparing pretax profits to sales reveals a rate of 3.16 percent which is about 1.6 percent profit to sales on an after-tax basis. Of course, the profit to capital, consequently, becomes much greater once you consider the kinds of things you mentioned. A higher turnover of capital leads you to a higher percentage of profit to capital.

The turnover rates are much higher, in other words, in the defense business than in the commercial business, but the relationship of one to the other is such that they are relatable and these are taken into account.

Mr. PACKARD. I think we should say that when the factors that you have mentioned here are involved, then defense profits should be lower than commercial profits.

Mr. SIKES. With respect to what we are discussing here, we are in a situation where Defense contractors are often provided facilities, industrial equipment, progress payments or advance payments, and we are discussing a higher degree of management by the Department of Defense. Are we approaching or almost to an arsenal or depot system for providing our war materiel by this approach?

Mr. PACKARD. Well, you can say that there are many similarities between what we are talking about and, say, going to a completely government-owned and government-operated situation. I do think there are some significant differences, however.

One of the problems I think we would have, if we went to a completely government-owned facility, would be the loss of all the flexibility we have in terms of our personnel programs.

With the civil service and so on, it would be awfully hard to have the flexibility needed. I think the direction the Post Office is going, for example, indicates that maybe that way isn't so good either.

My own view is that we should not go all the way to bring these under the government. I think we can achieve what we would like to achieve, keep it a private enterprise business, keep some of those incentives, keep the flexibility, but I think it will require more management. In other words, we can't go the way of giving them a contract and forgetting it until they come in and get paid for it.

We do that on a lot of things where it is appropriate such as small easily handled items-but I am talking about these big, complex weapons. I think the approach we are recommending here is one that will be viable. I do not see that there would be any likelihood you would want to go all the way.

CONTRACTOR OVERSIGHT

Mr. WYMAN. Where you have a situation in which you have something like $10 billion going out to these companies in progress payments, do you have any management or advisory role in these situations so that if the contractor starts in a direction which appears to be patently ill-advised, you have something to say about it? Mr. PACKARD. There are various controls. We have audits

Mr. WYMAN. I understand, but do you have somebody in there keeping an eye on how the company is running when you fund them this deeply?

Mr. PACKARD. It depends upon the contract and I am frank to say that, in my judgment, we have not had controls in some of these matters as good as we probably should have had.

Let's look at the C-5A contract. Here the theory was that if you gave the fellow a job on a competitive bid basis and he had to meet specifications you should not have to get in and tell him how to run his program. The idea was to turn it over to the good old American free enterprise system, and they would take care of it. So the contracts were such that you couldn't get in and have as much to say about the management as you should have.