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Pentagon business

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lems, and in showing government new ways to improve and strengthen the defense business environment. In this article I shall describe the problem areas that seem to me to demand the most urgent and careful attention. The fact that a good deal of thought has already gone into ways to improve DOD procurement efficiency should make it more rewarding for business leaders to help.

For instance, in materiel acquisition I believe that efficiency can be improved by developing contractual incentives that will encourage industry to make productivity-enhancing capital investments; making cost as much a design characteristic as is performance, revising military specifications and procurement practices to make defense business less "unique", motivating industry executives to combine their defense and commercial product lines where possible, and studying the possibilities for strengthening market operations. In particular, the possibilities for effective competition-in parts of the defense industry.

Excess capacity & slim profits

The most striking trend has been the decreasing level of detense expenditures (especially in the procurement account) as contrasted to the other major contributors to the gross national product (GNP). Since reas only detense expenditures have declined steadily procurement alone went from about $44 billion to approximately $17 billion (in constant

By voaw gending for consumer services, con*****INNA Asd and capital goods has increased, * Nax ausdenise buying by government-often gary Namma detense expenditures would be Adeline during the post Vietnam war ***** The mysurant fact is that the trend has vapeol ax we shall sont see some severe problems IN MAHAXs the defense SECİAL

The days in sument dollars has been matched by a comming in rease in the production unit cost of wraport xxtems Over the past 25 years, after correcting for inflation and quantity reductions, the unit cost of US weapon systems (eg ships, planes,

1 Deparment of Dentease Prošle Kynde, Coop Philli në Nummary Report (Washington DC Office DASD (Procurement December 1938 p 30)

tanks) has increased, from one generation to the next, on the average of 5% each year. The net effect of the reduced procurement dollars and the increased cost of systems has drastically reduced the quantities of equipment procured. For example, the U.S. government annually bought over 3,000 fighter aircraft during the mid-1950s, about 1,000 per year in the mid-1960s, and under 300 through the middle 1970s.

In spite of the shrinking market, there has been very little consolidation of the numbers of prime contractors supporting DOD. Instead, with few exceptions, each contractor has been receiving a smaller and smaller absolute amount of defense business, while maintaining its "share" of the total defense market. During the past 15 years, the top 5 companies have consistently been doing about 20% of the business, the top 25 about 50%, and the top 100 about 70%. By contrast, there has been considerable consolidation in the civil sector over the same period, and with an expanding market.

The lack of contraction in the defense area can probably be attributed to the prevention of "free market" forces. Perhaps we can no longer afford such "barriers," and their resulting inefficiencies.

The net effect has been that capacity utilization in the overall aerospace industry has been below 70%; it has been even lower in the aircraft industry, where aircraft production plants are currently less than 55% utilized. This low level of capacity utilization gives rise to three key problems:

1

Since some of the excess capacity is not likely to be needed for mobilization or future production programs, it (and its associated "overhead" structure) may be unnecessarily expensive to carry.

2

The considerable excess capacity creates a possible imbalance between the high level of government "in-house" modification work that goes on in government depots on similar systems, and the decreasing workload in industry.

3

There is a need to modernize the essential parts of government-owned and contractor-owned production capacity in order to improve productivity and thus achieve lower production costs. Current data indicate that defense contractors, or divisions of large companies doing defense business, reinvest about 70% less than their commercial counterparts.1 Yet modernization is required. For example, of the approximately 94,000 government-owned metal-cut

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ting machines, 62% are at least 20 years old and almost 90% are over 10 years old. In contrast, only 28% of the total U.S. inventory of metal cutting machines is more than 20 years old.

Too few subcontractors

Among subcontractors and parts suppliers the problem is just the opposite from that at the prime contractor level-namely, a rapid contraction is taking place. For instance, only two companies produce gun mounts in quantity-and the number may drop to one; only three companies (possibly dropping to two) make aircraft landing gears; and only one company makes tank hull and turret castings.

What accounts for this contraction? The causes range from bankruptcy, absorption by the prime contractors, and very low profit for most small de

fense contractors, to business discouragement over the highly specialized, limited nature of the market. Obviously, the low levels of defense procurement have had a major effect, too. I suspect that "the Defense way of doing business" also contributes to the problem. For example, the government claims to leave all subcontract management up to the prime contractors, yet the primes frequently pass on all of the extensive government requirements (and more requirements of their own) to the smaller subcon. tractors, who do not have the "overhead" to handle this extra burden. Additionally, the increasing complexity of modern weapon systems has introduced high-technology, capital-intensive specialization in the manufacture of parts, and this trend has caused many suppliers to drop out.

As the number of suppliers in many critical areas shrinks to one or two producers, the government and its prime contractors experience rapid increases in the prices of parts, far above the levels of inflation-in some cases 300% to 500% in one year. DOD and the defense industry are paying essentially "monopoly prices" to get the small quantities of

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Why profits aren't motivating

In reviewing DOD profit policies, it is important to emphasize that the government tries to use profit as a means of motivating contractors to perform efficiently. Yet a recent profit study, performed by the independent firm of Coopers & Lybrand and looking at separate profit centers rather than overall corporations for the 1970-1974 period, shows that, in terms of profits realized on sales, which is the method DOD utilizes for negotiations, government business is significantly less profitable than comparable commercial business. The study finds a fiveyear, pretax average of 17.1% for comparable commercial business versus 4.7% realized for defense. (The negotiated profit rate was much higher-8.8% on the average.)

Although profits were negotiated on a uniform basis, they varied considerably by the time they were made. Contractors engaged in the development and production of electronics and missile products were generally the most profitable (5% to 6% profit rate realized) whereas ship producers were the least profitable (under 3% realized). In addition, it was found that, on the average, sales of military hardware to foreign governments were two and one-half times more profitable than sales of the same equipment to DOD.

While profits on sales provide some basis for making generalizations about the health of a business endeavor (particularly on a relative or historical basis), the more critical measure is certainly return on capital investment. The Coopers & Lybrand profit studies show that whereas contractors consistently realize less profit on sales for defense work than on commercial work, the picture is less clear for return on investment. Part of the uncertainty is attributable to the very low levels of investment by defense contractors. The ratio of capital expenditures to sales within defense-oriented profit centers is on the order of 11%; however, it is over 40% for comparable commercial operations.

Again, there are wide differences between sectors in the defense industry. For example, in the missile sector the investment to sales ratio is 8.7%, but it is 22.2% in the shipbuilding industry. The result is that, with return on investment as the measure of profitability, there is a very large spread among defense sectors, the extremes being missiles, showing

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Harvard Business Review

May-June 1977

Exhibit III

Profit before taxes/total assets, 1970-1974

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a pretax return of 20%, and ships, showing a pretax return of less than 6% (see Exhibit III).

The low overall profit level and high investment demands for the shipbuilding industry highlight a broader concern. The number of major private shipyards doing defense business has decreased from 14 in 1960 to basically 3 yards doing the lion's share of the work (approximately 90%) today. Here, unlike the aircraft case, DOD is faced with insufficient overall productive capacity, as well as increasing competition for the existing capacity from government-subsidized domestic shipbuilders. With the projected increase in Navy shipbuilding procurement over the next few years, DOD is finding competition in bidding hard to come by.

In fact, DOD is having difficulty in getting the shipyards to perform on current contracts; some shipyards were even refusing to bid on new Navy business. It appears to me to be a case in which the government procurement activities have emphasized short-term cost benefits on individual programs, without giving sufficient consideration to the possible long-term implications.

Less profit for small companies

Comparing the smaller defense contractors with the larger defense companies, the Coopers & Lybrand study finds the former not only have a significantly lower profit on sales, but also have a much lower profit on investment. In fact, the data for the smaller defense firms reveal a pretax return on capital invested of only around 6% to 8%. In addition, it appears that small defense firms are subject to more risk in profit making-more instability, more chance of loss-than are the large defense contractors. These data help to explain why we are seeing so many of the smaller defense suppliers going bankrupt. In one six-month period on a Navy electronics program, nine subcontractors went bankrupt. Some of these companies were sole-source contractors.

Thus it appears as though the intended "uniform profit policy" of the DOD actually results in the large contractors frequently making very favorable returns on investment, while the smaller defense contractors are frequently not making an adequate return on their investment. Results-the large con

2. An Analysis of Export Control of US Technology-A DOD Perspective, a report of the Defense Science Board Task Group on the export of U.S. technology (Washington DC Office of the Director of Defense Research & Engineering. February 1976

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tractors are plentiful, in some sectors at least, while small producers are in short supply.

This situation is another reason for reassessing "the way DOD does its business.". What changes might be made? One step might be to provide government contracting officers more flexibility in negotiating profits by prescribing different ranges of profit depending on (a) the company size and/or defense sector concerned, and (b) the need for more investment in the industrial defense base. The recently implemented new DOD project policy is a definite move in the latter direction.

Another step might be for DOD to assure that subcontractors do not receive more harsh treatment than government prime contractors do. There may be inequality today. Frequently a subcontract for a development of an advanced device is awarded on a fixed-price basis, while the government contract with the prime contractor is awarded on a cost-reimbursement basis.

Dependence on foreign suppliers

Total world arms exports have more than doubled since 1965. During this period, there has been a significant change in the types of weapons involved in the international arms trade-from exports of follow-on, "prior-generation" equipment, to current-generation equipment that is advanced in technology and may even "push the state-of-the-art."

As Exhibit IV shows, for the United States prior to fiscal 1971, annual foreign military sales orders remained fairly constant at about $1.5 billion. After fiscal 1973, however, annual sales increased to more than $10 billion (with the Middle East getting a major share of these new sales).

On the surface, this trend appears economically desirable, since the sales help our national balance of payments, help maintain our defense production base, and help improve defense industry profits. However, what if these sales were to drop suddenly as a result of some legislative action or changes in buyers' policies? The impact could be serious. For instance, consider the fact that U.S. defense procurement expenditures for fiscal 1976 were only about $17 billion. Last year, the U.S. Army's procurements

for foreign military sales exceeded its own procurements. Similarly, last year the United States built more fighter aircraft for foreign sales than for the Department of Defense.

Perhaps the most significant problem is our growing dependence on the foreign production of critical components. We need not feel concerned about the price competition of foreign sources. In fact, this is considered desirable-it lowers U.S. military hardware unit costs. In areas where there is only one U.S. supplier, foreign sources are essential to maintaining competition and must therefore be encouraged. Rather, the question is whether we can rely solely on foreign production sources if the country must mobilize or for any reason must step defense production up sharply. The unwillingness of certain countries to support us during the 1973 Mid-East war should be ample evidence that we cannot take foreign support for granted.

Related to the issue of increasing use of foreign parts producers are the moves toward greater use of coproduction and offset agreements for major weapon systems. Under such agreements, the U.S. contractors usually supply the prime hardware, and. the foreign sources perform as parts and subsystem suppliers. The net effect of these agreements is to remove a significant share of the defense market from the already troubled U.S. subcontract and supplier-level companies.

Trouble ahead?

U.S. thinking on these problems tends to be geared to the world of the 1960s-selling of old weapon systems-and is not well attuned to the changing multinational environment of the late 1970s-selling of modern weapons, factories, machine tools, management systems, and so forth. According to the General Accounting Office, the various departments involved in overseas sales (DOD, Commerce, and State) have tended to evolve an ad hoc response and to deal with the issues on a case-by-case basis.

A recent study by the Defense Science Board highlights an apparent "structural lag" between changing conditions and the development of U.S. policy. Headed by Fred Bucy of Texas Instruments, the study group concludes that the highest long-term "risk" in foreign military sales comes from the transfer of manufacturing technology. Yet this form of technology transfer appears to be increasing with each new foreign military sale!

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