Little doubt remains that the Pentagon budget will flatten or contract in coming years. Scaling back on performance and adopting a more austere approach to meeting the country’s evolving defense needs are viewed as a necessary consequence.
It is less understood that defense spending has experienced price inflation that dwarfs other industries and the economy as a whole.
The Defense Department is effectively paying more for less, while at the same time it is being asked to do more with less. This paradox puts defense spending and capability on a collision course.
Inflation in the defense supply chain has proved both excessive and pervasive over the last several decades while also far outpacing overall inflation. This reality isn’t new and has been well documented.
In testimony before the US Senate Armed Services Committee in 2005, Chief of Naval Operations Admiral Vern Clark noted that “among the greatest risks all services face is the spiraling cost of procurement for modern military systems. This tremendous increase in cost runs counter to other capital goods like automobiles, where the inflation adjusted cost has been relatively flat over the same period of time. “
Clark noted alarming price increases since 1967: 401% for submarines, 391% for amphibious ships, and 100% for carriers. More recently, the Congressional Budget Office has tracked shipbuilding inflation since 1981 and found it has consistently outpaced GDP price inflation by two percentage points.
It means that half (half!) of the 2012 shipbuilding budget pays for the escalation premium experienced since 1981. By 2030 the Navy will be able to purchase half the current number of ships if trends continue. Spending on other Pentagon programs faces a similar plight. At the Pentagon, paying more for less is the undeniable trend.
With few exceptions, private industry has proved more successful at containing costs. As defense programs have experienced annual inflation upwards of 5 percent, price increases for automobiles, commercial aircraft, apparel, food and even gasoline have been lower.
Technological and capability advancements in defense programs are often cited as the major driver of price increases, but those are at least partly cop-outs. Several multi-decade product platforms have evolved and innovated quite nicely without suffering the Pentagon’s fate. Despite four major redesigns since 1988, the price of a Ford F-150 truck has risen by only 3.7% annually but the cost of an LPD San Antonio class ship increased by 7.5% annually between 1996 and 2011.
How is it that escalation in defense programs has so consistently and significantly exceeded inflation in other industries? The answer lies in the perpetual program budget and execution cycle, along with a lack of true competition in defense spending.
The expectation and realization of excessive escalation cascades throughout the defense value chain. The Defense Department conservatively accounts for escalation in future programs, as do prime contractors in their negotiations with major equipment suppliers, who do the same with Tier 1 suppliers, and so on. Once budgets are established and funded, the defense acquisition machine is conditioned to consume it. Even those footing the bill have come to accept escalation of this magnitude as the norm.
More competition would remedy this trend. In a competitive environment, increases in manufacturing costs are largely offset by productivity gains. Customer costs often decline.
However, competition is largely limited to early phases of major programs. Once designs are established and initial supplier contracts are selected, the costs of switching often preclude competition and higher prices prevail.
Without competition, excessive inflation can be mitigated – but only through a dramatic shift away from today’s thinking. Three tactics should be applied together:
First, approach inflation with a zero-based mentality. Disallow any notion of entitled escalation. That is, require significant justification to fund any nominal price increase. Moreover, productivity gains experienced elsewhere in the economy should be expected in defense as well. Prices may still increase, but that increase will be much closer to zero than to inflation levels that have become the norm.
Second, highlight equipment cost drivers and their impact on prices. Today, program managers have limited understanding of how swings in raw material and other input costs exactly affect costs. As a result, the price effects of these swings are often overstated. For example, if steel only accounts for 10 percent of the total cost of a component, then a 50 percent increase in steel prices should only increase component cost by 5 percent.
Third, compete on future cost management. Programs wield the most competitive leverage over suppliers at the onset of programs, when the evaluation of potential suppliers should be expanded to include year-over-year cost management. Focus on the maximum price increases that suppliers will guarantee. Suppliers may be reticent but caps should not be viewed as either unreasonable or unachievable.
The Defense Department cannot afford inflation that outpaces the broader economy without suffering a continued decline in the capabilities needed for its core missions. A shift in how inflation is viewed and mitigated is needed to stem this tide. Doing less with less is the alternative.
John Wolff is a partner in A.T. Kearney‘s Public Sector, Aerospace and Defense practice, based in Washington DC. He has over 15 years in consulting experience in major defense programs, including shipbuilding, space and aircraft for both the government and major contractors.
U.S. Navy photo by Mass Communication Specialist 1st Class Lolita Lewis of the transport dock ship USS San Antonio (LPD 17).