Can the Pentagon Be Run Like a Business?

The U.S. defense industry is hardly a bastion of free market competition. The industry has a socialist component: government laboratories, shipyards, depots, and arsenals that, in many cases, compete with private companies. Even the part of the industry that is in private hands is subjected to the Department of Defense’s (DOD’s) industrial policy and excessive regulation. Congress, to win votes in states and districts that are home to defense firms, keeps unneeded government and private facilities open through phony competitions, creating much excess capacity in an industry that was insufficiently downsized after the Cold War.

The result is weapons that have ballooning costs, are years behind schedule, and contain technology that is out of date when the systems are finally fielded. Costs per unit accelerate because of the military’s excessive emphasis on performance and frequent changes in design, the dwindling numbers of units purchased, and contractors’ deliberate initial underestimation of costs.

DOD has no incentive to reform the system when the president and Congress continue to reward such inefficient practices by slathering the department with ever-increasing budgets, long after the demise of its only superpower rival. (Its national defense budget gives the United States overkill in the fight against the pauper states that harbor or sponsor terrorists.) In fact, if the Pentagon’s budget were reduced, it would be under increased pressure to make the process of weapons buying more efficient.

Although DOD officials have talked a great deal about using commercial practices in military procurement, only limited progress has been made. The Pentagon should not only step up these efforts, it should also eliminate excessively detailed military specifications and buy commercial products for its weapons systems. In all of its purchases, DOD should focus on obtaining the best value for each dollar spent instead of focusing so much on performance. In addition, Congress should allow the Pentagon to buy weapons systems from friendly nations, thus opening the market to greater competition.

“D” for business efficiency

According to Jacques Gansler, undersecretary of Defense for Acquisition during the Clinton administration, during the post­Cold War period the U.S. defense sector was the only major part of the world’s economy to become more socialist. In remarks made at the Pentagon on September 10, 2001, Defense Secretary Donald Rumsfeld compared the way DOD does business to Soviet central planning. David Walker, Congress’s chief evaluator of government programs, in May 2001 gave the Pentagon a grade of “D” for business efficiency.

The defense bureaucracies–that is, the military services and the Office of the Secretary of Defense–are willing collaborators with Congress and the defense companies in condoning escalating costs, retaining excess industrial capacity (both public and private), and imposing industrial policy (government interference to achieve outcomes that are different from those deriving from the operation of a free market).

Although much post-Cold War consolidation has taken place, actual industrial production capacity has decreased much less than would have been expected in an era in which the United States has no major rival. Many companies that acquired or merged with other companies merely changed the nameplates on the factories instead of reducing or eliminating capacity. In addition, the Navy still retains four publicly owned shipyards that compete with private shipyards for maintenance, repair, and overhaul business. Similarly, the Army uses a government depot to perform maintenance, overhaul, and upgrades to tanks instead of relying on General Dynamics’ tank-building plant. The Air Force uses public facilities that do the same for aircraft and engines.

The inefficient retention of excess capacity relative to the existing demand for weapons is rooted in a larger problem: Politics plays a much larger role in the defense industry than it does in the commercial market. The military bureaucracies are spending taxpayers’ money to keep production facilities open across the country to retain grassroots political support for a larger military by providing jobs. They are also keeping the facilities open to pressure Congress to use them to build more weapons.

The military argues that excess capacity is needed to produce a surge in production in case a major threat emerges. Yet most defense analysts do not foresee such a threat for 15 to 30 years. Thus, most national emergencies will probably be similar to the war against terrorism. The conventional military equipment used to fight such low- to medium-level conflicts could easily be produced without retaining such excess industrial capacity.

The military services use competition as an excuse to retain excess capacity. However, despite the existence of more than one supplier (in most instances), most defense contracts are not competitive in the commercial sense of the term. Some contracts are awarded without competition, and others are let as administrative exceptions to procedures for open competition. The military services often believe that it is simpler to avoid competition by working with known companies than to incur the costs of searching for additional suppliers.

A case in point is the F-18E/F aircraft program, which the Navy chose as the successor to the F-18C/D. Despite the name, which would seem to indicate that the aircraft is an incremental improvement on the F-18 series, the E/F version is a significantly different aircraft. Yet, a new designation other than F-18 would have required a competition between military aircraft manufacturers. DOD, with the help of Congress, designated the aircraft the F-18E/F so that McDonnell Douglas could obtain the contract without competition.

Even when there is true competition, price hikes stemming from changes in the military’s original specifications and requirements (which are numerous and costly) are negotiated on sole-source terms. Further, DOD takes steps to ensure that the losing company remains in business. In the competition between Boeing and Lockheed Martin to develop and produce the tri-service Joint Strike Fighter, DOD officials made it clear that the loser would be given enough maintenance and repair work and foreign military sales to remain in the military aircraft sector.

True competition means more than just retaining two or more producers. It requires sufficient demand for at least two suppliers to produce articles efficiently. In many cases, the quantity of defense articles demanded does not meet this standard. For example, the Navy has two facilities producing DDG-51 destroyers and two facilities producing submarines, but no competition exists for the production of either type of ship. Members of Congress kept demanding competition in submarine production, but the Navy astutely realized that Congress really wanted both fully capable submarine producers to have work. So the Navy decided to let Newport News in Virginia and Electric Boat in Connecticut form a “team”–an absurd and costly arrangement by which one producer builds one part of each boat, the other producer builds the other part, and they alternate integrating the parts to assemble the submarine.

Considerations of overhead, economies of scale, and learning curves all argue for conducting winner-take-all competitions for major weapons systems. A sole producer can be kept in check by the government, because of its powerful leverage as sole buyer and market regulator. In addition, a sole producer’s pricing can be restrained by the potential entry into the market by large firms in other sectors (in this case, by other defense subsectors).

Because of the small quantities of expensive defense-unique weapons, such as submarines, ships, tanks, and military aircraft, that are currently demanded and the existing barriers to entering the U.S. defense industry, genuine competition between two or more producers is not possible in most cases. But there are ways to introduce more true competition into the defense industry.

The case for foreign competition

Traditionally, national security has been the rationale used to close the U.S. defense sector to foreign competition. In a war, the argument goes, the United States would not want to depend on foreign sources for its weaponry. Also, national security considerations have been used to severely limit direct investment in the U.S. defense sector, even by NATO allies. Only a few token cooperative weapons development programs have been undertaken with Western European nations.

With the end of the Cold War, the national security rationale for limiting foreign imports and investment needs to be reexamined and the walls around the domestic defense market lowered. The demise of the potent Soviet threat and the lack of a credible replacement in the foreseeable future have reduced the dangers of purchasing weapons produced by companies from friendly foreign countries. In the march toward a global economy, U.S. prime contractors already purchase a growing proportion of critical parts and technologies for weapons from foreign subcontractors. Those subcontractors are exempt from the Buy American Act, which requires that weapons be built in the United States. That restriction should be lifted for foreign prime contractors as well.

The U.S. government is usually given plenty of advance warning of adverse political changes in friendly countries. As insurance against a friendly country’s disagreeing with U.S. military action and withholding components or spare parts, a stockpile of critical items could be maintained. Of course, if foreign suppliers withheld such items, they could develop a reputation for unreliability and lose substantial amounts of long-term business.

The universe of firms from friendly countries that are given access to the U.S. market should not be limited to those from NATO nations. Arms imports from nations such as Israel, South Africa, South Korea, Japan, Sweden, Switzerland, Singapore, Australia, and Brazil should not be ruled out.

U.S. defense firms naturally have an interest in restrictions on foreign competition. By keeping the barriers to foreign suppliers high, DOD is really defending the domestic industry, not the nation’s security. Yet because the U.S. defense budget is so huge relative to the budgets of other countries (accounting for 40 percent of worldwide military expenditures), U.S. defense companies have grown large compared with their foreign competitors. Thus, a single large U.S. company in a defense subsector could compete with large companies from other countries. The U.S. government would obtain better and more innovative weapons systems for lower prices, weapons from the United States and friendly countries would be more compatible for battlefield operations, and U.S. defense companies would become stronger and more efficient.

Even if friendly countries refused to reciprocate by lowering the entry barriers to their own markets, it would still be in the U.S. interest to open its defense market to foreign competition. As with unilateral free trade in other goods, U.S. taxpayers would benefit from cheaper and better weapons regardless of what other friendly countries did with their defense markets. In fact, if friendly countries failed to open their markets, it would be their own loss. Different countries specialize in different weapons and produce them more efficiently than other countries, rendering self-sufficiency for all weapons costly.

Opening the U.S. defense industry to foreign investment will, however, require some caution. To prevent a foreign parent company from acquiring advanced technologies from a U.S. prime contractor, the government should stipulate that the U.S.-based subsidiary of the foreign company erect firewalls in its management structure. This could be done by requiring the U.S. subsidiary to operate autonomously from its foreign parent. Foreign direct investment would not cause a problem in a time of national emergency because weapons production would remain on U.S. soil.

Barriers to entry

DOD officials and members of Congress routinely complain that the average rate of return is lower for the defense industry than for the market as a whole. But they neglect to mention that the risks are also lower because of the protected nature of the industry. Pete Aldridge, the undersecretary of Defense for Acquisition, wants to lower the risk for defense contractors even further. In June 2001, he sent a memo to DOD acquisition offices announcing the end of private financing for future defense R&D programs. He argued that requiring defense contractors to risk losing their R&D investment could hurt the industry. But government funding for R&D is a subsidy that most commercial firms do not enjoy.

Another way of reducing risk to the industry has been proposed by Philip Coyle, who directed DOD’s Weapons Testing and Evaluation Office during the Clinton administration. He advocates making defense R&D contracts more profitable by increasing the amounts paid by the government at completion. Doing so, he argues, would help industry lure and retain more technology specialists and would attenuate political pressure to rush weapons programs into the more profitable production phase.

Admiral Mike Boorda had a better idea when he was chief of naval operations. He advocated an approach that was the opposite of Aldridge’s: requiring the defense industry to fund a greater percentage of R&D contracts. Defense companies could make more money on production contracts, but they would need to put more of their own funds into R&D. Boorda’s proposal, however, would create an even bigger incentive than already exists for suppliers to rush weapons into production. If defense contractors were required to fund more of their own R&D but could make more profit in production, DOD would need to make sure that it tested weapons thoroughly before they were allowed to go into production. During the past decade, however, the services have cut testing personnel by 30 percent and testing installations by 32 percent. Such cuts have to be reversed, and more emphasis should be placed on ensuring that taxpayers get their money’s worth when weapons are purchased.

Defense contractors also have lower risks because of barriers that dissuade commercial firms from competing for defense business. Major entry barriers for many commercial firms are the Pentagon’s very demanding and unique noncommercial specifications for weapons. Although controlling cost is now a requirement in weapons development, the commercial sector is much more cost-conscious than is the defense sector, which remains focused on weapons performance. A better balance must be achieved between performance and cost.

The Pentagon has constructed a labyrinth of bureaucratic processes to regulate and oversee defense contractors, largely to prevent fraud. Yet, as various defense analysts have shown, much more public money is squandered on the inefficiencies and expenses of complying with the audits than is lost through the small amount of fraud in the system. Furthermore, excessive regulation in the defense industry causes programs to be inefficient and sometimes fail, spurring demands for even more regulation.

Few commercial firms want to incur either the actual or the opportunity costs of navigating the exacting, highly bureaucratic, regulated, and inefficient defense market. “Our processes and regulations have become so burdensome that many businesses have simply chosen not to do business with us,” Secretary Rumsfeld said in his remarks at the Pentagon on September 10, 2001. Even firms that do decide to undertake defense work are often forced to conduct defense and commercial business in separate facilities. In contrast, Japan has encouraged its defense sector to buy commercial products and has encouraged Japanese companies that build aircraft and jet engines to build both advanced military fighters and major components of civilian transport aircraft with the same machinery in the same plants.

Buying commercial

There will probably always be a few large defense firms that are heavily or totally dependent on DOD as a customer. Military weapons systems such as tanks and aircraft carriers that are made by prime contractors may not have counterparts in the commercial sector but more than likely they have parts and components that do. At the component level, the technology of both the product and the manufacturing process for defense and commercial applications is most similar. Instead of generating excessive specifications for military-unique items, the Pentagon should direct prime contractors to use commercial off-the-shelf products unless a special military item is the only alternative. In 1994, Secretary of Defense William Perry did just that, but progress in implementing the directive has been slow.

The U.S. military has traditionally obtained its technological edge from the brute force of applying large amounts of government R&D funds to the task rather than from spending money efficiently. But the technology developed by fierce competition in the commercial marketplace is rapidly outrunning the technology developed by sluggish defense bureaucracies. Although the U.S. Airborne Warning and Control System aircraft is the most technologically advanced military airborne early-warning system in the world, its technology is now primitive by commercial standards. Future adversaries might obtain the more advanced technology readily available worldwide in the commercial sector, use it in weapons, and leapfrog U.S. military-unique technology in important areas.

The military must either buy commercial technologies or face the obsolescence of its hardware. For example, commercial semiconductors now meet the environmental standards of the military and are more reliable, much more advanced technologically, and cheaper than military semiconductors. Yet excessive military specifications and procurement regulations have led many of the top commercial semiconductor firms to refuse business from DOD, which means that the military pays exorbitant prices for obsolete, specially designed circuits. Electronics is the defense industry subsector that will have the most effect on future combat and in which buying commercial components is most feasible and most urgent.

Frequently, requirements and specifications for weapons are modified during development to reflect government-mandated design changes containing new military-unique technologies. The weapon that finally rolls off the production line rarely looks like the one originally planned. As weapons systems have become more complex, the time required to develop, produce, and field them has grown. In the early 1990s, the average time from a U.S. weapon’s start to production was 16.5 years, compared with a 6- to 18-month cycle of obsolescence in the commercial information technology sector.

The problem of obsolescent technology could be ameliorated by incrementally improving weapons every so often rather than waiting a long time for quantum leaps in capability offered by a new development program. In a significant reform of the current acquisition process, Aldridge has instituted regulations requiring such a “spiral” or “evolutionary” acquisition approach. That approach aims at achieving more modest improvements in a shorter period of time and then incorporating feedback from military users in the field when upgrading the weapon. The concept was not invented by the Bush administration, but making it mandatory was. Unless program managers can show that the technology exists up front for the entire program or that a critical need exists for all technology to be incorporated at once, they must use the evolutionary approach.

The advantages of spiral development are twofold: less risk to the government because less money is spent before a weapon is tested and fielded, and quicker incremental technology insertion for the benefit of the users so that the technology is not outdated by the time it gets to the field. Evolutionary acquisition also results in fewer gaps in production. Fewer gaps reduce costs and approximate the efficient and timely way in which commercial items are produced.

In the commercial sector, with each new generation of products, quality usually goes up, costs normally come down, and the time needed to field the item usually decreases. In the past, the same has not been true for the defense sector; performance gets better with each generation but costs escalate and development timelines become longer. But the new evolutionary process has promise: The Air Force’s new remotely piloted vehicle program took only five years from its start to the fielding of the system. The Joint Strike Fighter is using the same approach.

But there is underground resistance to the incremental approach from the defense acquisition bureaucracy, and that resistance is likely to continue. According to Katherine Schinasi of the U.S. General Accounting Office, “We find [program managers] are not willing to accept evolutionary acquisition, because they know they are not going to get another project for 20 years, so everything has to be in it now.” They fear they may never get the money for future project improvements and believe it is easier to obtain funding for all of the technology when the weapon is new.

Although evolutionary weapons acquisition is a positive development, the problems of high costs and outdated technology will not be solved until the defense sector not only adopts commercial practices but also buys components commercially. Some progress, however, has been made by the military services. The Navy made adjustments to the designs for new submarines to incorporate commercial computers and software. Similarly, the Navy and Marine Corps, instead of attempting to purchase, operate, and maintain their own hardware and software for the services’ intranet, saved funds and obtained new technology by outsourcing the intranet’s operation. The Air Force claims savings as large as 50 percent in the C-17 military cargo plane program and the Joint Primary Aircraft Training System (a training aircraft) by reducing military-unique requirements.

Joint production

Until World War II and the Cold War, the United States had no permanent arms industry. When the nation went to war, civilian industries were converted to weapons production and then reconverted after the conflicts ended. With modern technology, the United States may be able to move at least partially back to that way of doing things. Now, instead of converting entire factories after a war starts, we can produce defense and commercial items on the same assembly line during peacetime.

Common production lines for defense and commercial items have been made possible by several technological developments: the growing similarity of defense and commercial technologies; the development of reliable, durable, and advanced commercial components; and the advent of flexible manufacturing techniques. The lists of critical military-related technologies issued by DOD and the Department of Commerce have an 80 percent overlap, and commercial technologies (such as supercomputers, special materials, and advanced electronics and communications) now meet and exceed DOD’s requirements for ruggedness on the battlefield. Modern flexible production lines can change robotic tools quickly and manufacture small quantities of items efficiently. In the short term, the U.S. military may have to relax some of its requirements to allow the adaptation of commercial technology for use in weapons, but in the long term that policy will solve the problem of outdated technology. If the prime contractors bought commercial components–or versions modified for military use and built on commercial assembly lines–from commercial subcontractors, the time required to develop weapons would be dramatically reduced, and potential adversaries would have less of an opportunity to leapfrog U.S. technology. Moreover, competition at the subcontractor level would increase greatly, thereby lowering the costs and improving the quality of weapons.

Efforts made by the Clinton administration to reform the acquisition process have been continued by the Bush administration. Yet until top DOD officials demand the purchase of commercial components and greater integration of military and civilian production, the military services will continue to insist on militarily unique products and waste billions of dollars in the process. According to the Defense Science Board, the executive branch could scrap 60 to 75 percent of the barriers between the defense and commercial sectors. In the remaining cases, legislation would be needed. In short, the executive branch could do much to introduce true market forces into the defense industry–if only it would.