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Shift the Dialogue

Misperceptions Cloud Defense Supply Base Debate

Jun. 20, 2013 - 01:59PM   |  
By ERICH FISCHER and JOSEPH MARTIN   |   Comments
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The debate over cost reduction and the health of the US defense industrial base has been complicated by misconceptions regarding what can and should be done.

Consolidation is viewed with fear by some. Attention-grabbing sound bites have misleadingly cast sole responsibility on prime contractors for high overhead costs. Until recently, public dialogue has focused on the size of overheads as opposed to what is driving these costs. What is needed are fact-based, constructive recommendations to reduce costs while ensuring supply base health.

Many misconceptions can be traced to an outdated customer-contractor model. For example, it is true that accumulated overhead costs are often more than 50 percent of total system costs, and this makes overhead a rich area to mine for reductions for both customer and contractor. But why are these costs so high? Consider the following:

■Today’s government procurement infrastructure was built for the Cold War, and little has been done to address the weight of requirements and redundancies accumulated over time.

■The division of labor administering acquisitions ensures that few among customer or contractor have decision rights to streamline tasks, and that the focus is on direct costs, which are often less than half of total system costs.

■The supply base and customer infrastructure remain, to a large degree, sized for peak demand, and right-sizing is often undermined by legacy incentives. Desires to right-size are complicated on the industry side by the fact that a portion of the value of the benefits from restructuring is retained or recouped by the customer, raising the financial barriers to making changes. On the customer side, right-sizing is complicated by the reduction in real or perceived power often associated with reduced personnel or geographic presence.

Despite these challenges, there are practical actions that can shift the debate and start to enable a healthy, sustainable supply base. These include (non-exhaustively):

Embracing joint customer-contractor efforts to address cost drivers. Overhead begets overhead. While some overhead may be desirable to mitigate risk and maintain critical capability, collaborative efforts to address drivers of overhead (and direct) costs are a good place to start. These joint efforts have proved successful (e.g., for certain Air Force satellite programs) at enabling customers, contractors and supply chains to harmonize program structures and operations, yielding more agile, affordable programs and sometimes higher volumes. Curiously, these joint efforts have been largely missing from public dialogue.

Enabling smart consolidation. Consolidation was one of the most important tools to achieve a sustainable industrial base during the last downturn. Contrary to some beliefs, this generated real benefit for customers; without consolidation, our industrial base would be significantly weaker (see Augustine’s XVIth Law).

The misperception that competition is the only way to improve cost and performance to some extent drives fear of consolidation. But successful joint incentive customer-contractor relationships, as with portions of shipbuilding, show this is not entirely the case. While consolidation isn’t the right approach for all portions of the market, it is inevitable for some and can yield benefits for customers and contractors.

Exploring selective vertical integration. We include this as it has been a topic of much debate. Selective vertical integration may have merit if approached cautiously. But when capabilities and economics are incoherent between acquirer and target, complexity ultimately overwhelms scope and near-term financial benefits. And if critical innovation is derived largely from lower-tier competition, benefits of integration may also be negated.

In these cases, one alternative may be the customer paying “excess cost” in the form of sustaining competition. But vertical integration can be beneficial when done for the right strategic reasons, when it enables long-term financial value and capabilities improvement.

Strategic reinvestment. The ultimate path for thriving in a downturn is to cut costs and grow stronger. That is, to treat costs as discretionary investments, and to redeploy these costs from areas where they may have been valuable in the past to where they will have more value in the future.

By taking a strategic cost-cutting approach, customers and contractors can redeploy significant spending. We have observed companies cut lower-value engineering changes in half, freeing 20 percent of related spending for reinvestment in more valuable capabilities (e.g., human capital).

Of course, there are many other ways to shift the debate, but most importantly, customers and contractors have to work together to break current paradigms. For example, customers should focus on behaviors that drive industry costs and consider shifting incentive schemes to enable more restructuring to happen (as done during the last downturn), and can proliferate joint incentive relationships.

Specific areas for the customer to reduce costs have been articulated elsewhere. For these, too, paradigms will need to be addressed (e.g., timing of vesting to motivate right-sizing). For certain, Congress will have to enable some of this. The benefits will be a customer-contractor ecosystem that costs less and is more nimble, and one that aligns needs, capabilities and incentives with today’s realities, as opposed to those of years ago. ■

Fischer and Martin are partners in Booz & Co.’s Aerospace & Defense practice.

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