On January 18, 2010, Defense-Aerospace.com carried an interesting story, which was really a lead into an analysis of Defense spending over the past decade by the organization, Project on Defense Alternatives (PDA), which is policy think-tank associated with The Commonwealth Institute.  The PDA report, entitled “An Undisciplined Defense Understanding the $2 Trillion Surge in US Defense Spending,” is a copyrighted report.  Because it’s copyrighted, we’ll avoid too much cut-and-pasting, and stay within “fair use” limits—even though the entire report can be downloaded from here.

Why consider an analysis from some policy wonk that may well have a political axe to grind?  Well, for starters, every forecast of near-term defense spending seems to point to a flat—or even declining—budget, which has obvious implications for Defense contractors.  We’ve posted a number of articles on the tightening budgetary environment (for example, here), but this report struck us as exceedingly (almost painfully) detailed.  Detail is good.  Detail creates credibility.  So even if the author is biased—and we have no reason to suspect he is—the detail in the report is worth examining.

The Defense-Aerospace.com story notes that, in 1998, DOD’s budget was $361.5 billion.  (Note:  all values in this article are 2010 equivalent US Dollars—i.e., adjusted for inflation.  We’ll omit references to 2010 equivalency in our quotes.)  As the article reports, “If we treat the 1998 budget level as a “baseline” and project it forward to 2010 (adjusting for inflation), we find that the total amount of funds that have been given to DoD above this level during the years 1999-2010 is $2.15 trillion.”  The article continues—

The rebound in annual defense spending reached its recent peak in 2008: $696.5 billion – which is 92.7% above the 1998 level. The portion unrelated to contingency operations (the so-called ‘base’ budget) was $503 billion that year – which is 41% higher in real terms than in 1998. Total DoD budget authority receded slightly in 2009 and 2010. But it now seems likely that 2011 will set a new high – somewhat over $700 billion in DoD’s authority to spend.

In other words, current Defense budget levels are nearly double what they were a decade ago, even after adjusting for inflation.  Ignore the reasons why that is for a moment, and dwell on the fact that the Pentagon is currently spending at twice the rate it was ten years ago.  And for giggles, remember that it is spending at these levels while having cut back significantly on DCMA contracting officers, Contracting Officer Technical Representatives, Quality Assurance Specialists, and DCAA auditors.  It is any wonder DOD program execution is under fire?

The article (and the PDA report) uses that historical perspective to assess the near term Defense budget horizon.  As the article reports—

Looking forward, the Obama administration’s 2010 budget plan allocates an average of $545 billion per year to the DoD base budget for 2011-2017. In addition, it set aside a “place keeper” sum of $50 billion per year for military operations, recognizing that actual war costs will vary. (And, indeed, the Pentagon already is expected to request at least $163 billion for contingency operations in 2011.) … All told, the Obama administration plans to spend at least $5 trillion (2010 USD) on defense during 2010-2017, which is 5% more in real terms than the Bush administration authorized for 2002-2009.

If Obama Defense spending is reaching a plateau, that plateau is at least 5 percent higher than recent history in inflation-adjusted dollars.  So where is the budget squeeze coming from?  The PDA report suggests that one source is the sheer expense of the current war.  As Aerospace-Defense.com reports, “Measured in 2010 dollars, the Korean conflict cost $393,000 per person/year invested; the Vietnam conflict cost $256,000; and the Iraq and Afghanistan commitments, $792,000 so far.”

Another metric reported in the PDA analysis is DOD spending per uniformed service member.  According to the analysis, “For 2007-2010, [DOD budget authority] averaged $459,000 per full-time person in uniform. This is 78% higher than the Reagan peak, 95% higher than in 1989, and nearly three times the inflation-adjusted peak during the Vietnam era.”  In addition, “During the 20-year period 1981-2000, budget authority for personnel varied by only a few percent around an average of $73,200 (2010 USD) per person. It then rose by 46% between 2000 and 2010. The increase was enough to bring total personnel expenditures back up to Cold War levels – for a military only 69% as large.”

The report discusses a number of other factors that drive Defense budgetary spending, from the all-volunteer force to the increasing reliance on contractors to support operations.  As the report notes, “between 1989 and 2005, the pool of DoD contract labor has grown more than the pool of uniform and civilian employees has declined.”

To conclude, this seems to us to be a worthwhile analysis that provides good insight into how the Defense budget got to where it is today, and also provides some clues regarding where it may be going in the future.  We encourage interested readers to read it in detail.

The January 2010 edition of National Defense magazine carried an interesting article discussing the Pentagon’s Industrial Policy Directorate, and its new emphasis on anticipating financial failures by critical suppliers in its supply base.  According to the article, which related an interview with Director of Industrial Policy (IP) Brett Lambert, the IP team “does not plan to be an advocate for industry but rather to engage in a closer dialogue with the private sector so the Pentagon is better informed about the financial health of critical suppliers.”  The article reported that Lambert said the new emphasis “will help the Defense Department anticipate ‘points of failure’ in the supplier base and save taxpayer dollars by avoiding costly rescues of failing companies.”

The article reports that, unlike the prior focus on the health of the largest prime contractors, today the Pentagon is concerned about the financial standing of “smaller companies in the lower echelon of the supply chain.”  According to Lambert, “What we are seeing increasingly is that all primes rely on a single source, or point of failure, that is down in the second, third or fourth tier … I believe we don’t have adequate insight into those critical subcomponents.”  The article notes that “The Pentagon’s own contracting databases only capture information about the top-tier industrial base….”

Welcome to the club Mr. Lambert.  At Apogee Consulting, Inc., we have been preaching this philosophy for quite some time.  Let’s restate the issue and our point of view for clarity:

1. In today’s aerospace/defense environment, where up to 80 or 90 percent of program execution has been outsourced to external suppliers, program execution risk is found in the supply chain and managing that risk is inextricably tied to managing supplier performance.  In other words, 21^st century program management is not significantly different from supply chain management.

2. Most primes delegate supply chain management, and supply chain risk management, to a separate silo—the same silo that sources, evaluates, and awards subcontracts.  That’s a recipe for failure.  The skill set in acquisition management is not the same as that necessary for program management.  At a minimum, the priorities are different and the technical emphasis is different.

3. Most primes hold their 1^st tier subcontractors responsible for lower tier supplier execution.  Most 1^st tier contractors hold their 2^nd tier suppliers responsible for lower tier supplier execution.  And so on ad infinitum.  This is again a recipe for failure, because execution risk cannot be transferred and always resides, ultimately, with the prime contractor—who is responsible for program execution regardless of what some lawyer thinks.

4. Despite the foregoing, most companies engaged in program management fail to devote sufficient resources and budgets and management attention towards supply chain management.  Most companies don’t know their program supply chain and, if challenged, cannot produce any written or graphic description of a single program supply chain—let alone map multiple program supply chains to identify where a common supplier exists between programs.  Those common suppliers are both opportunities (in terms of establishing long-term alliances) and risks (in terms of single points of failure for multiple programs), yet companies almost invariably have made no effort to identify them.

5. Those critical few suppliers that support multiple programs must be identified, because they represent risk to multiple (and now interdependent) programs.  Once identified, they must be evaluated for financial health, and contingency plans must be created so that, if one of those suppliers ends defense production or enters bankruptcy, impacts on the multiple programs will be minimized or mitigated completely.  We know of no single company that is making this effort in a rigorous manner that befits the true risk to program execution.

The National Defense article also notes that the Defense IP Directorate is concerned about loss of critical skills during the upcoming defense spending downturn.  (About which we’ve also written about many times.)  Lambert is quoted as saying, “we are focused on preserving skills necessary to support our war fighters in the near term and long term.”  However, he cautions that skills are not jobs, and (according to the article) suggests that “debates about critical skills are biased toward white-collar positions.” 

As if in evidence of the Defense Department’s awareness of the need to preserve critical skills, we noted that on January 15, 2010 a $93.4 million contract was awarded by the Defense Logistics Agency to AM General LLC.  The contract was a fixed-price, sole-source award made without competition, and it was awarded to AM General “in support of HMMWV industrial base requirements.”  In other words, the award was made so that AM General’s suppliers would be able to keep their Humvee production lines open and to delay layoffs associated with the declining need for new vehicles. 

As the National Defense article reports, “When military orders go down and it becomes unprofitable to make defense-unique components … firms may decide to end production of those items.  Other subcontractors may go out of business altogether because of declining orders.”  Lambert is quoted as saying, “When we terminate programs, the cascading effects on the lower tiers can be catastrophic.”  And, we would add, because certain lower-tier suppliers supply multiple programs, ending one program may create unintended consequences for many others. 

The DOD finally appears to be recognizing some of the risks embedded in its industrial base, and the article reports that “Lambert’s office will be reaching out to CFOs of prime contractors to gain access to their subcontractor data.”  Little does he know that the primes will have little, if any, data to provide his office.

And that fact should frighten many people in the Defense Industrial Policy Directorate.