The Structure of the Defense Industry
Because government and commercial markets are different in terms of regulation, political involvement, unique contracting, specialized cost accounting, and buyer concentration, fi rms that operate in both sectors tend to separate their government and commercial operations into separate divisions and profi t centers. Of interest here is the government sector, particularly the federal portion of it. But in the twenty-fi rst century, there is growing interest in breaking down the legislative and regulatory barriers that have artifi cially forced separated defense and commercial operations and, instead to encourage dual-use industrial operations.
In 2007, federal procurement in the United States was more than $400 billion dollars a year and involved over 169,000 different contractors. 1 However, only a few government contractors hold an overwhelming share of the dollars awarded, and the great majority of the fi rms supplying goods and services to the federal government are small businesses. For example, in the services business (almost 69,000 fi rms in 2005), 2 over 70 percent of the fi rms are small businesses (as defi ned by the U.S. government). 3 In spite of the large number of fi rms involved in the federal marketplace, the concentration of fi rms is high, particularly in the defense sector (which is by far the largest of the federal sectors). In 2005, the share of defense dollars going to the top twenty-fi ve fi rms was 85 percent of research and develop- ment, 70 percent of services, and 74 percent of hardware procurement dollars. 4 As shown in table 4.1 (for fi scal year 2006), the top ten fi rms captured 36 percent of all Department of Defense contracts and approximately 30 percent of all of the federal government contracts. There is a high correlation between the ranking of the fi rms in the total federal marketplace and their position in the DoD market- place — because of the dominance of the DoD in the total federal marketplace. 5
The overall structure of the defense industrial base tends to be separated into product markets, such as aerospace, ships, and armaments (see fi gure 2.2) Although some fi rms function in multiple sectors, their operations tend to be separated due
Table 4.1
Top ten government contractors, fi scal year 2006 (billions U.S. dollars) Government rank Firm Total DoD
Civilian
government DoD rank 1 Lockheed Martin $33.5 $27.3 $6.2 1
2 Boeing $22.8 $20.9 $1.9 2
3 Northrop Grumman $18.6 $16.8 $1.8 3 4 General Dynamics $12.4 $11.5 $.88 4 5 Raytheon $10.9 $10.4 $.51 5
6 KBR $6 $6 $.02 6
7 L-3 $5.7 $5 $.62 7
8 SAIC $5.3 $3.4 $1.9 10
9 United Technologies $5.1 $4.6 $.56 8 10 BAE Systems $4.7 $4.5 $.19 9 Total, top ten $124.8 $110.3 $14.5
Percent of total (top ten)
29% 36% 12%
Source: Government Executive, August 15, 2007.
to major differences in their tasks (building a ship, for example, is very different from building an airplane). As a result, different products have different customers (one branch of the navy buys ships, for example, while another branch of the navy or air force buys aircraft). Thus, corporate executives tend to associate themselves with a specifi c product sector or even subsector of their business. For example, the aircraft carrier business for the navy has an industrial base coalition that represents that industry, and the industry itself consists of over two thousand companies in forty-six states that provide design, material, construction, maintenance, and ser- vices for aircraft carriers. 6 Yet at the prime contractor level, only one shipyard — Northrop Grumman ’ s shipyard in Newport News, Virginia — is capable of building an aircraft carrier. This example illustrates the concentration at the prime contractor level (where there is one fi rm) and the wide diversity of fi rms as business moves down to the lower tiers. A single aircraft carrier costs more than $13 billion 7 (an amount that excludes the costs of the aircraft that go onto it), so there is plenty of money to go around.
In recent decades, the most dramatic structural change in the national security industry occurred during the enormous consolidation that took place in the post – cold war era as the Defense Department ’ s budget plummeted (particularly in the procurement account). This period transformed the U.S. defense industry. When horizontal consolidation fi nally stopped, the handful of remaining large defense
prime contractors shifted (with equal vengeance) to vertical integration (and even these began to attract the interest of antitrust regulators, who imposed a broad range of consent decrees restrictions) (see chapter 2).
After September 11, 2001, the U.S. defense budget grew rapidly, and foreign companies (particularly from Europe) began making signifi cant investments and acquisitions in the U.S. market. The U.S. defense fi rms shifted, with the DoD demands, into supplying services (of a wide variety of types), systems-of-systems integration, and equipment support (as major business areas).
Perhaps the best way to see the overall structure of the current defense industry is to review it layer by layer, beginning at the top.
Prime Contractors
The top fi ve defense fi rms (which were also the same top fi ve for total federal gov- ernment awards) — Lockheed Martin, Boeing, Northrop Grumman, General Dynam- ics, and Raytheon (see table 4.1 ) — had sales to the DoD of approximately $87 billion in 2006 (and an additional $11 billion from other federal agencies), which represented a growth for these fi ve fi rms alone of over 40 percent in the decade from 1996 to 2006. But perhaps even more surprising is that, in that same decade, their volume of services income grew by 180 percent, and their research, develop- ment, testing, and evaluation (RDT & E) income grew by approximately 200 percent (the latter ensuring their future control over DoD dollars). 8 A part of this growth came through acquisitions, but the major share of the growth was stimulated by the signifi cant increases in the Defense Department ’ s budget in the post-9/11 period.
Additionally, a signifi cant cause of the growth among these few fi rms was attribut- able to the fact that there were only a few new major defense programs in develop- ment. Because they were captured by one of these fi ve fi rms, the share of the total DoD business continues to be heavily concentrated.
As shown in table 4.2 , a few large programs (such as the Joint Strike Fighter for the air force, navy, and marines, and the future combat system for the army) cause a great deal of concentration in the industry, especially since the aerospace and defense fi rms tend to outsource 50 percent less of their major assemblies and testing operations than the equivalent commercial-sector fi rms. 9
The challenge for the Department of Defense is to maintain two or three fi rms in each major sector as the number of weapons ’ programs is signifi cantly reduced.
With only one fi rm in each sector, the potential for competition is eliminated. The government needs to address this potential danger continuously, and it has various techniques for doing so. For example, when there is only one fi rm in production in a given product area, a second fi rm can be awarded a next-generation program in that area to maintain the potential for future competition. The market also can be opened to include foreign fi rms. In addition, contracts can be awarded to both of
the two remaining fi rms so that they can continuously compete — rather than going to a sole source after an initial down-select competition (see chapter 7 for a discussion of the benefi ts of continuous competition).
Unfortunately, although maintaining two sources in each critical area has many benefi ts (in terms of innovation, higher performance, and lower cost), the practice is not widely accepted. People continue to hope that “ this time it will be different ” and that the monopoly supplier will continuously strive to improve its performance while lowering its costs (in spite of the overwhelming empirical data to the con- trary). Another way to maintain two or more sources is by using the higher volume of commercial-military integrated operations (in engineering, manufacturing, and support). However, in many product areas (such as missiles, fi ghter aircraft, large navy warships, and tanks), there is little commonality at the fi nal assembly level.
Subcontractors and Parts Suppliers
Subcontractors and parts suppliers are often referred to as the “ critical lower tiers ” of the defense industrial base. When a warship is built, only 12 to 18 percent of the ship ’ s cost goes to the shipbuilder (the prime contractor). 10 The big cost drivers (high-risk, high-technology, state-of-the-art elements) are subsystems, such as the command-and-control systems, the advanced radars, and the propulsion plants.
Similarly, 70 to 80 percent of the costs and the high-risk elements in a missile system are not in the prime contractor ’ s missile fi nal assembly but in the electron- ics, sensors, and propulsion. Even in the production of advanced fi ghter aircraft, only about 20 percent of the cost goes directly to the aircraft producer. The big costs and high-risk items are usually in the subsystems, such as the avionics, sensors, and engines.
Table 4.2
Cost of the Defense Department ’ s top fi ve programs, fi scal years 2001 and 2006 (billions 2006 U.S. dollars)
2001 2006
Program Cost Program Cost
F/A-22 Raptor aircraft $65.0 Joint Strike Fighter $206.3 DDG-51 class destroyer $64.4 Future combat system $127.5 Virginia class submarine $62.1 Virginia class submarine $80.4 C-17 Globemaster airlifter $51.1 DDG-51 class destroyer ship $70.4 F/A-18E/F Super Hornet $48.2 F/A-22 Raptor aircraft $65.4 Total $290.8 Total $550.0 Source: Department of Defense data, 2007; GAO analysis and presentation, 2007.
This lower-tier area also includes the basic parts and material suppliers. A critical issue is often the timely ability to obtain adequate quantities of parts and materials, especially when there is a surge in demand (a demand for a rapid increase in any given area). In the fi rst Persian Gulf War, a large number of rockets were launched against Saudi Arabia and U.S. troops, and the U.S. response was to attempt to build more of the antimissile system Patriot II. Although the prime contractor (Raytheon) had ample production capability at its plant, the company did not have a suffi cient quantity of semiconductor chips on hand to build the missile guidance systems, and there was an eighteen-month lead time for these critical parts. In the Iraq war, roadside bombs were planted by insurgents, which led to a U.S. decision to build armored, mine-resistant, ambush-protected (MRAP) vehicles. The lack of armor material — and not the limitation of the production capacity at the prime contractor level — contributed to years of delay in delivery of the vehicles. 11
Part of the problem at the raw-materials level is that the defense industry often competes with the commercial economy for critical materials. Since the DoD ’ s surges in demand are highly unpredictable, the DoD tends to be a far less predictable and dependable customer than commercial customers. Because of its high strength and light weight, titanium is increasingly being used in the aerospace and defense indus- try and for commercial aircraft. But there are a limited number of sources of the raw material (the principal source is Russia). In the case of nickel (imported from China for use in batteries), prices are rapidly rising, and the dependability of the sources may be a problem (even when the Defense Department has the legal right to exercise a priority (over commercial needs) on the materials if they are needed for national security reasons).
Congress recognized the importance of the nation ’ s strategic dependence on foreign raw materials after World War II when it passed the Strategic and Critical Materials Stockpiling Act of 1946, with the intent of allowing the United States to stockpile critical and strategic materials for use in times of national emergency. By 1975, about $8 billion worth of materials was stockpiled, including chrome, tita- nium, , and castor oil. 12 These stockpiles are intended to be based on specifi c war scenarios. For the “ short war ” (which was the primary basis for U.S. planning in the late twentieth century), there was no need for investments in the critical materi- als stockpiles, but for longer scenarios, these investments have value. However, the dollars for material sales from these stockpiles go to the general (national) treasury, not to the DoD (and therefore sales from the stockpile could easily be used as a budget-balancing technique rather than being held for potential Defense Depart- ment needs). 13 Additionally, DoD requests for increases in the stockpiles require separate congressional action (and are therefore subject to political manipulation — since representatives and senators may participate in stockpile buying to support a fi rm within their district or state by stimulating demand for its products). In more
recent times, Congress has used the strategic stockpile to obtain fuel, and the stock- pile has been used more often for economic reasons than for military considerations.
Finally, because of the great unpredictability of likely wartime scenarios in the twenty-fi rst century (discussed above), it is also diffi cult to determine which materi- als should be stockpiled. This makes it more diffi cult to justify diverting billions of dollars to this insurance policy (at the raw-materials level) versus investing it in completed weapons systems that could be readily available for wartime crisis. The result has been a primary focus on fi nal weapon systems rather than on stockpiling of parts and materials for increased demand or restricted supply in long-war scenarios.
At the government level and even at the prime-contractor level, there is often poor visibility regarding the availability of critical parts and materials. In 1983, the DoD offi cially stopped tracking critical parts that were awarded through various subcontracts and subsubcontracts. This fact was brought to light in 2007, when a proposed amendment to the Federal Acquisition Regulations required contractors to report (on a publicly available Web site) on any subcontracts that were awarded with federally appropriated funds. 14 But even this requirement was only for large subcontracts (over $1 million) and would not provide visibility at the parts and materials levels. As more and more parts and materials are dual-use and are used in both the commercial and military worlds, the DoD gains the advantage of the high volumes for commercial use, which lowers costs and increases reliability (since bugs can be worked out during the high-volume production process). This is par- ticularly true in electronics and software, which are becoming a greater share of weapon systems ’ capability and costs. The DoD ’ s semiconductors and software programs are being produced by the same companies that build microprocessors for personal computers, amplifi ers for cell phones, and high-tech elements for cars and smart appliances. Defense benefi ts signifi cantly from the lower costs and higher performance of such dual-use equipment. Thus, Congress has increasingly mandated greater use of commercial items. For example, sections 2377 and 2501 of title 10 of the United States Code, respectively, call for a “ preference for acquisition of commercial items ” and state that for “ National Security objectives concerning national technology and industrial base: a Civil-Military integration policy (1) relying, to the maximum extent practicable, upon the commercial national tech- nology and industrial base and (2) reducing the reliance of the DoD on technology and industrial base sectors that are economically dependent on DoD business and (3) reducing Federal government barriers to the use of commercial products, proces- sors, and standards are highly desirable. ” Unfortunately, actual DoD practices have not been following this mandate. If they had done so, parts and materials would be readily available for DoD surge requirements, which could be satisfi ed by simply shifting commercial parts and materials from the commercial marketplace to the
military marketplace. (The DoD has legal authority to do this by exercising its priority when parts and materials are required for urgent military needs.) Unfortu- nately, the government has created barriers to this desired commercial-military integration, such as highly specialized cost-accounting requirements. Another barrier is having the defense prime contractors pass on all defense-unique contractual and regulatory requirements to the lower tiers — so that the primes take on no added risk themselves (as they believe they might by allowing their subcontractors and suppliers greater fl exibility). One fi nal benefi t that the DoD can realize through civil-military common use is that as lower-tier industrial dual-use and commercial suppliers make more profi ts, they will invest in more capital equipment and research and development and will not be as dependent as prime contractors and defense- unique lower-tier suppliers on the government to supply equipment and research investments. In 2006, lower-tier fi rms with a balanced DoD and commercial mar- ketplace had a median return on sales of 12.6 percent — which is signifi cantly higher than the profi t for the large defense fi rms, so they could afford the investments. 15
Small-Business Considerations
Innovation is critical for maintaining U.S. technological leadership. Innovation also helps to maintain the economic competitiveness of the nation and stimulates growth in the economy, allowing signifi cant investment in the national security area. Studies have shown the many innovations made by small businesses. 16 These contributions have been signifi cant in recent times, with the increase in consolidations at the large- fi rm level. It has been found that “ in recent decades, 60 – 80% of all newly created jobs have been in small to medium sized companies (with fewer than 500 employees). ” 17
Because far greater innovation, per R & D dollar invested, has been seen coming from small fi rms, Congress established the Small Business Innovative Research (SBIR) program 18 in 1982. Before this date, a large share of the overall federal government ’ s R & D budget had been going to the prime contractors and had not been passed on to the small businesses. The SBIR program mandated that 2.5 percent of all government, externally funded research and development must go to small businesses. Although many in the government community object to this mandate (claiming that it should be a voluntary allocation and even calling it a “ tax ” on their R & D program), the fact that it was mandated made it realizable. A similar program in the United Kingdom is voluntary and largely has not been realized.
The U.S. SBIR program has been extremely successful. It is a highly competitive program that begins when each government agency lists those areas where innova- tion is required to meet mission needs. Large numbers of proposals are received from small businesses, evaluated, and awarded in multiphased efforts — which
increase in dollar value as their feasibility and effectiveness are demonstrated. (The program was described in detail in a series of National Academies Studies in 2007.) 19 Venture-capital fi rms note which small businesses are awarded SBIR contracts, since it demonstrates government interest and a potential market for these fi rms ’ prod- ucts — thus encouraging further private-sector investment in them. All of these actions lead to the early realization of innovations (as commercial and government products), as intended by the legislation. The government also tries to fi nd “ homes for these innovations in future mission equipment ” (such as in weapons systems for the Department of Defense), and similar efforts were made to encourage the success of a mentor and prot é g é program 20 in which the experience of larger fi rms (in man- aging innovation through its development and deployment phases) can assist small fi rms in realizing the commercialization benefi ts of their innovations.
Because most regions of the country have many small businesses, Congress ’ s efforts to stimulate government funding to small businesses are attractive politically (and therefore equally subject to potential political abuses). Congress has mandated a 23 percent goal for small business contracting by the federal government, and by each agency. This is mandated at the direct government-contract level only, so sub- contracts to small businesses do not count in these totals. Typically, the federal government has been meeting this goal. For example, in 2005 it achieved 25.4 percent, 21 in 2006 the total was 22.8 percent, and in 2007 it was 22 percent. The dollars awarded during this period (especially by the DoD) were rising rapidly and going primarily to the big prime contractors for equipment in the Iraq confl ict. The actual dollars allocated to small businesses were rising, but their percentage was slightly declining. (Since the law establishes the percentage as a goal, there is no penalty for not achieving the legislative objective by any given agency or by the federal government.) 22
Because small business set-asides are attractive politically, Congress continu- ously tries to raise the amount of the set-aside. In 2007, the House of Repre- sentatives passed the Small Business Fairness in Contracting Act (H.R. 1873) by a vote of 409 to 13. This attempted to increase the goal from 23 percent to 30 percent. Congress also has established numerous other such goals — a “ small disadvantaged business ” goal of 5 percent, a “ minority-owned business ” goal of 5 percent, a “ woman-owned business ” goal of 5 percent, and a “ businesses located in historically underutilized areas ” goal of 3 percent. These goals amount to very large dollar fi gures since they apply to the entire federal government. For example, in 2005, $79.6 billion was allocated to small businesses. Minority-owned small businesses received $10.5 billion in direct, government-contract awards;
businesses in “ historically underutilized areas ” received $6.1 billion; women-owned small businesses received $10.5 billion; and service-disabled, veteran-owned businesses received $1.9 billion. 23