DoD's reduction in total ownership cost effort: R-TOC--a viable solution to DoD's funding predicament.

Recapitalization at no additional costs--possible or preposterous? Will the Department of Defense (DoD) be able to redirect sufficient funding, under a relatively flat budget topline, to meet its identified needs?

The Department faces a crucial challenge in making sufficient funds available to meet the force structure requirements of today and setting the stage for those of the future. The austere DoD budget must support an aging equipment inventory, while attempting to recapitalize, or modernize, current systems and to procure the next generation's platforms.

One initiative to reallocate funding is the Department's Reduction in Total Ownership Cost (R-TOC) effort, which attempts to identify potential operation and maintenance (O&M) cost reductions and to move those savings into the acquisition accounts for recapitalizing weapon systems through modernization.

Although the Department is placing a lot of emphasis on its R-TOC initiative, the effort cannot succeed, given its current approach and funding. The ability to reduce costs implies an understanding of the factors that compose them in the aggregate. But before program cost changes are made, the difficulties impacting on and inherent within R-TOC merit examination.

R-TOC Background

Integral to understanding the difficulties of R-TOC are an appreciation of its origin, the nature of recent defense budgets vis-a-vis planned force structure, planned out-year budgets in the context of national strategy, and why R-TOC provides little relief for O&M cost growth, given the increased use of progressively aging equipment.

To understand this effort to reduce operating costs, one must first have a solid definition of what composes total ownership costs (TOC):

"DoD TOC is the sum of all financial resources necessary to organize, equip, sustain, and operate military forces sufficient to meet national goals in compliance with all laws, all policies applicable to DoD, all standards in effect for readiness, safety, and quality of life; and all other official measures of performance for DoD TOC [comprise] costs to research, develop, acquire, own, operate, and dispose of weapon and support systems, other equipment, and real property; the costs to recruit, retain, separate, and otherwise support military and civilian personnel; and all other costs of business operations of the DOD." (1)

Proceeding from this definition, the impetuses for reducing ownership or operating costs must also be understood. The age of military equipment is increasing, stretching far beyond the dates initially planned for replacement or system retirement. Today's inventory of aging systems unfortunately coincides with an austere funding environment that doesn't readily provide additional funds, in excess of those needed to operate existing equipment, for upgrade and/or replacement of legacy systems.

This absence of additional funds necessitates an attempt to reallocate O&M (also known as Operation and Sustainment, or O&S) funds to aid in the modernization of military equipment and weapons platforms. Figure 1 depicts the growth in O&S costs as well as the desired transfer of funds from the operational accounts to modernization that helps fund recapitalization efforts. R-TOC is one effort meant to facilitate this transfer by identifying operational cost savings initiatives and redirecting those savings into modernization accounts. Creating such venture capital in the face of increasing operating costs is quite a challenge.

Increasing Operating Costs Strip Funds from Modernization Efforts

At the core of this challenge is the runaway increase in operating costs over the past few years. As previously mentioned, many systems are beyond their planned phase-out dates. Consequently, component parts are in wear-out failure, driving often unpredictable repair costs. Although Sun Tzu's adage that support costs amount to 60 percent of total ownership cost (2) is widely quoted in program cost contexts, Army studies have shown that as much as "... 81 percent of the total ownership cost of a system is incurred after the item has been delivered to the user." (3) As systems get older, demanding more dollars to maintain, and as the overall defense budget remains static, removing funds from O&M for modernization becomes increasingly difficult. This difficulty creates the necessity for a delicate balancing act between the research and development (R&D) and the operation and maintenance accounts.

Such a balance is necessary because of the relatively flat, at best, nature of defense budgets over the past 15 years. The real purchasing power of the DoD's budget over the past decade and a half has declined steadily, save for a small 1.7 percent upturn due to Operation Desert Storm in 1991. Figure 2 illustrates the percentage change in defense dollars since 1981, adjusted for inflation and shown in fiscal year (FY) 1999 dollars. In absolute, base-year FY 1999 dollar terms, the DoD budget decreased by more than 28 percent between 1986 and 1999, with continued reductions slated to total more than 34 percent for the time period 1986 through 2003. (4)

Given the flat DoD budget topline and the need to perform today's mission, R&D funds are feeling the squeeze.

The percentage of the DoD budget dedicated to R&D has historically amounted to approximately one-third of the defense budget, but currently stands at one-fifth. (5)

This situation is largely due to the movement of funds out of R&D appropriations to cover the increasing bills being incurred by O&M activities. (Note: While the defense budget has shrunk by almost one-third, O&M costs continue to rise steadily as aging equipment is deployed at unprecedented rates.) Migration of funds from R&D to O &M accounts is in direct opposition to the fundamental requirement to recapitalize the nation's military equipment through modernization and new procurement.

In the absence of an infusion of additional funding to modernize, daily operations will continue to consume a growing share of the defense budget. This share is driven by the Quadrennial Defense Review (DQR). The QDR plan was designed with the knowledge that defense budgets were unlikely to exceed $260 billion in the near future.

Unfortunately, the force structure therein defined appears to have a cost in excess of $270 billion just to sustain current low levels of R&D and high operations tempo. (6) A $10-billion gap in nominal (not inflation-adjusted) terms makes the real purchasing power of the arguably inadequate $260 billion even less. Any attempt to modernize under the current total DoD budget comes at the expense of O&M funds. Indeed, "... procurement accounts remain insufficient to sustain the QDR force over the medium to long term." (7)

Under this funding scenario, operational pace must decrease drastically and the old equipment must break less often to fund any further systems modernization efforts. Simply stated: Without an infusion of new, additional funding, the force structure supported by the QDR is most likely too small to maintain current operational commitments to the stability of the post-Cold War world.

Having clarified the definition and impetus for R-TOC and reviewed the budget versus force structure condition, attention now shifts to why R-TOC is unable to solve DoD's funding predicament.

R-TOC Not a Viable Solution

Based on the current austere funding and relentless deployment conditions, insufficient venture capital is available to modernize American military forces. Given the expense and difficulty of modernization, R-TOC is not currently a viable solution to this problem. Thirty initial R-TOC pilot programs--10 from each military service--were chosen and directed by the Under Secretary of Defense (Acquisition and Technology) (USD (A&T)) to identify initiatives that would reduce operating costs. Funding for these R-TOC initiatives was non-existent within these programs, and the acquisition community implied that funds specifically earmarked for R-TOC would be distributed. A total annual R-TOC investment of $600 million was originally touted, with the Army, Navy, and Air Force each receiving some portion based on implementation plans and goals. (8)

Unfortunately, only $140 million per annum was later programmed for DoD as a whole. (9) This $140 million is an extremely small amount when considered in the context of the upfront investment often required to garner a significant return on investment in the arena of modernization for the purpose of recapitalizing the value of physical assets. In fact, virtually no funding came to fruition as a result of the program objective memorandum process.

Some other reasons why R-TOC currently can't succeed can be found by looking at the shortfalls between projected budgets in contrast to future force structure requirements and the lack of buy-in from operational commands. First, modernization costs take a relegated position when competing with current procurement priorities and meeting immediate operational mission requirements.

Additionally, R-TOC exists as an outgrowth of an acquisition community plan to aid in reprogramming O&M funds. As such, buy-in from operational commands is insufficient for success. While the commands support the concept, they are quick to emphasize the need for additional O&M funding, not methods for reducing their fiscal flexibility. After all, the operational commands already are struggling to fit all O&M requirements into their appropriated funding levels. The absence of operational command buy-in limits the scope of potential savings that R-TOC could realize.

Potential savings could be pursued through concept of operation (CONOP) changes; however, those changes aren't likely to receive approval. Changing a platform's CONOPs due to fiscal influences is a difficult sell in the face of perceived mission degradation precisely attributable to O&M funding shortfalls. However, failure to change now will ultimately engender greater degradation in the future.

If concentration isn't focused on finding efficiencies, no incremental reductions will be available to offset the continued growth in operational costs as deployment and age continue to ravage defense systems. Even with the critical need to find efficiencies, efforts to reduce total ownership costs probably won't yield a lot of net savings. (10)

Most of the "easy" savings have been identified and taken, as commands have operated at a higher than historical pace over 15 years of real-term budget reductions. Any potential savings due to successful R-TOC initiatives, while substantial in terms of incremental benefits to operational accounts, does not create enough lumpsum funding to adequately recapitalize on the scale necessary to modernize the military forces. Any O&M efficiencies are severely needed for O&M-funded infrastructure reinvestment.

Conclusion

The challenge of how to come up with the funds necessary to modernize military systems and equipment is a complex one, inextricably linked to rising O&M requirements and a flat overall defense budget. R-TOC is one such approach to fund this recapitalization, one that involves identifying a platform's total ownership costs and determining ways to reduce those costs. The foregoing has provided an understanding of R-TOC's origin, the nature of recent DoD budgets versus force structure, and why R-TOC fails to provide relief from the funding dilemma driven by O&M cost growth.

While the reasons for R-TOC are laudable, the insufficiency of near-term budgets to sustain the QDR force is evident. Clear analysis and sound reasoning show' that although the Department is placing a lot of emphasis on R-TOC initiatives, the effort cannot succeed given its current approach and lack of funding. The challenge of redirecting funding to source modernization is a crucial issue facing DoD leaders, but their ability to recapitalize at no additional costs to the federal government, above the projected Defense budget, doesn't appear possible.

FIGURE 2 OMITTED

References

(1) "USD (A&T) Sets Goals for Total Ownership Cost." Program Manager. March-April 1999, Volume XXVIII, Number 2, DSMC 149, pages 72-73. Also, USD A&T Memo, 8 October 1997.

(2) Griffith, Samuel B. Sun Tzu: The Art of War. Oxford University Press: New York, 1963, page 74.

(3) Mathews, Randy T. "Total Ownership Cost Reduction--A Secretary of Defense Imperative." Army Logistician. January-February 1999, PB 700-99-1, Volume 31, Issue 1, pages 138-9.

(4) "National Defense Budget Estimate for FY99." Office of the Under Secretary of Defense (Comptroller). March 1998.

(5) O'Hanlon, Michael. How to Be a Cheap Hawk: The 1999 and 2000 Defense Budgets. Brookings Institution Press; Washington, D.C., 1998.

(6) Ibid.

(7) Ibid.

(8) USD (A&T) letter dated 10 May 1999; subject: Future Readiness.

(9) Air Force FY02-FY07 Program Objective Memorandum Preparation Instructions: Attachment 1; and Defense Planning Guidance for Cost Savings Modernization Initiatives (CSMI): Attachment 3.

(10) Hale, Robert F. "Strategy for Achieving an Effective and Affordable Air Force." Briefing to CORONA TOP, May 1999.

David Peeler is chief, Cost Accounting and Pricing, for Arnold Air Force Base, Tennessee. Previously he served at operational and acquisition locations performing finance, cost, program management, and budget functions. A member of ASMC and SCEA, Mr. Peeler is a Certified Cost Estimator/Analyst and a Certified Acquisition Professional. He has worked as adjunct professor of accounting at Campbell University, North Carolina.