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On the defensive.

STRICTLY SPEAKING, there is no specific defense industry in the U.S. Many companies in a variety of sectors serve the Pentagon as prime contractors on weapons systems and other types of military equipment or supply components or services to these firms. However, a majority of these organizations devote most of their resources to meeting nondefense needs in civilian markets. Very few of them truly are government-oriented enterprises. The leading examples are Lockheed Martin, Boeing, General Dynamics, Northrop Grumman, and Raytheon. In most other cases, only specific divisions of otherwise civilian-oriented companies identify primarily--or at least heavily--with military work. Examples are United Technologies and General Electric, the major U.S. suppliers of jet engines for large aircraft.

Prior to World War II, defense industries as such virtually were nonexistent. When the nation found itself at war, civilian businesses converted to producing the tools of war. When war ended, they quickly reconverted to producing traditional civilian products. Specialized defense industries grew out of the increasing gap between civilian and military technology as well as the growing specialization of the tools of war.

The current defense-oriented companies and divisions operate in a business environment fundamentally different than the commercial economy. Unlike civilian government agencies, the military customer often enjoys a monopsonistic (one buyer) position in dealing with contractors. Thus, the government's procurement actions determine the success or failure, and the growth or decline, of the firms providing military equipment. To complicate matters, the weapons acquisition process is characterized by a unique set of uncertainties that differentiate it from other economic activity. Some of those uncertainties arose from a constantly changing external environment in terms of technology, actions, and plans by other nations, as well as our own defense policies.

The major defense companies (including the militarily-oriented divisions of civilian-oriented firms) are unusual business organizations. They are very good at what they are set up to do--design and produce state-of-the-art weapons systems or assist companies that are engaged in that activity. However, to do so, they differ in fundamental ways from commercially-oriented companies in basic characteristics. Defense firms have relatively low capitalization, little, if any, commercial marketing ability, and limited experience in producing at high volume and low unit cost. However, they thrive in a high-technology environment. Then again, their administrative structures are geared to the unique control and reporting requirements of the government.

Much of their work requires making products that do not exist when contracts are awarded. The government lacks knowledge of relevant prices and the offering company lacks production experience for the specific products on which it is bidding. Moreover, the powers of business and government in the military market are uneven: companies can lobby, drawing on their financial resources and on the support of unions and civic groups concerned primarily about the impact on the employees and their families. In contrast, government possesses awesome powers of taxation and regulation. Every defense contract can be terminated "at the convenience of the government."

On the surface, defense is not a regulated industry. There is no regulatory agency operating in the military market comparable to those facing utilities. Yet, defense contractors are subject to far more intrusive regulation than any civilian business. The government's control over defense contractors results from the detailed provisions in the contracts awarded, many of which give the government substantial power to monitor and review the performance on those contracts. The standard defense contract gives the governmental customer power to review and veto decisions as to which activities to perform in-house and which to subcontract; which firms to use as subcontractors; which products to buy domestically rather than to import; what internal financial reporting systems to establish; what type of industrial engineering and planning systems to utilize; what minimum as well as average wage rates to pay; and how much overtime work to authorize.

There are substantial reasons for this unique governmental role. Both the buyer and seller lack the basic data on which procurement negotiations normally are based. The cost and price estimates used are so fragile that often very limited weight is given to them. As a result, the customer provides most of the funding of the very risky--but necessary--research and development and much of the working capital. The latter is in the form of "progress payments." These typically are far more generous than for comparable commercial products. In the military market, firm fixed prices for a given product usually are limited to commodities that already are available in the civilian marketplace. The typical weapons system contract has a complicated cost plus a profit-sharing provision. The important step of determining which costs are "allowable" and thus can be charged to the contract is made in an extremely bureaucratic process.

However, there is a basic risk borne by the firms competing for defense work that cannot be shifted to government. The key resources of a major military supplier are the scientists and engineers who are hired to design and develop new or improved products for the military market. In any given time period, the teams of engineers and scientists are assigned to projects that may be cancelled prior to production--or during the long production phase. The history of the defense sector is filled with examples of important prime contractors that no longer produce major weapons systems--Curtiss-Wright, North American Aviation, and Republic Aviation.

Fundamental changes continue to occur in the demand for, and supply of, military goods and services in the U.S. These trends are propelled by the shifting nature of threats to national security and the government's response.

In recent years, the focus has shifted from a world dominated by competition between two superpowers to an unstable landscape of dangerous governmental and private groups whose responses often involve unconventional actions that depart from traditional military functions. What does seem clear is that, in the future, the U.S. will continue to need a substantial military establishment and, in a world of advancing technology, a viable and dedicated defense industry.

The nature of the contemporary defense industry also is affected strongly by a variety of civilian-oriented trends that have permeated the American business system in general. These common factors include

the continuing merger movement, the emphasis on a farm's core competence, the contracting out of ancillary functions, and the increasingly high-tech nature of U.S. manufacturing.

At the top of the chain of military production, there is relative stability in the composition of the prime contractors. In fiscal year 1992, four traditional aerospace companies led the pack--McDonnell Douglas, Northrop, Lockheed, and General Dynamics. They received 26% of the contracts going to the top 100 defense contractors. The top 10 suppliers accounted for 50% of this market. By 2010, four firms--Lockheed Martin, Boeing, Northrop Grumman, and General Dynamics (in the interim, each of these companies acquired one or more substantial defense contractors)--accounted for 34% of the market. During the same period, the top 10 obtained 54% of the total.

The cumbersome process through which the armed forces buy goods and services constitutes a barrier to entry into the military market. A staggering array of detailed requirements faces any firm that attempts to participate in the design and production of aircraft, missiles, space vehicles, naval ships, and tanks. For instance, one producer of both military and commercial aircraft had to prepare 550 documents in the development of a new military aircraft, yet 10 documents were sufficient to meet the combined requirements of the airline customers and the Federal Aviation Administration.

The contrast with normal civilian activities is striking. In June 201 l, it was headline news that the major Federal banking regulators were "imbedding" some of their personnel in the offices of the largest banks. For defense contractors, it has been standard procedure for decades to provide a suite of offices to representatives of the Department of Defense who are assigned full time to review many of the operating decisions of those ostensibly private companies.

The specialized defense contractors are "locked in" to government markets. The idea of converting their specialized resources to peacetime uses is tantalizing. It would create jobs for unemployed defense workers, but the reality is much less comforting. Time and time again, defense contractors have tried, but failed, to achieve success in civilian markets. Failures literally have included attempts to produce bathtubs, coffins, and kitchen sinks.

The defense industry has attempted to learn from its negative experiences in the commercial marketplace. It responded to the large cutbacks in military expenditures after the end of the Cold War with an unprecedented wave of consolidations. More than 50 defense firms or units that existed in 1980 have been folded into the top four defense companies.

Tangled up in bureaucracy

Clearly, the bureaucratization of the military procurement process has affected the competitive ability of specialized defense contractors negatively. Thus, much of the technology now used by the armed forces has its origin in commercial, rather than military, initiatives. Many new high-tech developments, such as fiber optic-laced clothing, head-mounted computer displays, global satellite phones, and impromptu wireless networks, have descended largely from ideas originally conceived in Silicon Valley and other centers of new commercial product development.

This is a shift from the traditional procedure whereby the U.S. military developed--or rather sponsored the development of--the technology used to produce the equipment purchased by the armed forces. Civilian-oriented firms often subsequently utilized this technology in serving commercial markets. Two or three decades ago, military technology frequently generated civilian applications as by-products of their basic function, instead of the other way around. For example, Global Positioning Systems grew out of a project originally conceived in the 1970s by the Department of Defense to help receivers pick up location signals from orbiting satellites. In contrast, the military more recently adopted the Iridium global phone network, which originated as a civilian satellite-based wireless communication system.

The increasing complexity of the defense acquisition process and the resultant burgeoning of overhead costs are in stark contrast to the downsizing and streamlining occurring in the civilian economy. Spurred on by growing foreign competition, companies in commercially oriented industries have eliminated layers of overhead, reduced internal reporting requirements, and given more discretion to operating managers. By doing so, they have lowered their costs and raised their productivity. There is a cogent lesson there for defense policymakers.

That "lesson" applies not only to decisionmakers in the Department of Defense. Many of the bureaucratic requirements have been imposed by Congress because some of its members were dissatisfied with one or another aspect of defense procurement activities. Examples of such legislative micromanagement include setting rank and grade for competition advocates, making roles for allocating overhead to spare parts, and establishing regulations governing contract costs for special tooling.

As a result, does the nation lose the benefits of risk taking, initiative, and innovation--the key reasons for using private business in the first place? These concerns were illustrated when Russian government officials approached the CEO of a major U.S. defense contractor. They sought advice on how to convert a tank-producing facility into a refrigerator factory. His response: tear down the tank plant and build a new refrigerator factory.

What is the outlook for the defense sector of the American economy? That sector always has been subject to sharp fluctuations because the U.S. lives in a dangerous and fundamentally unpredictable world. Military procurements of goods and services most likely will continue on a large scale, although their size and composition will continue to shift. New equipment cycles follow old ones as the nature of threats to the national security change, as well as the nation's ability to respond. Thus, a key task for national security decisionmakers is to maintain the capacity to design and produce the changing array of systems and forces needed to deal with future threats.

The concern with the defense industrial base requires far more than dealing with contract forms, cost controls, and business procedures. The fundamental challenge facing planners in the second decade of the 21st century is how, at a time of severe budgetary pressures, does the nation maintain the defense industry's innovative, managerial, and technological strength so vital to national security? The concern over deficit financing of military budgets has a long history reflecting the difficulties involved in responding to that key challenge.

Murray Weidenbaum, Economics Editor of USA Today, is Mallinckrodt Distinguished University Professor at Washington University, St. Louis, Mo., where he is Honorary Chairman of the Weidenbaum Center on the Economy, Government, and Public Policy.. He served as Chairman of the Council of Economic Advisers (1981-82) for the Reagan Administration; Assistant Secretary of the Treasury for Economic Policy (1969-71)for the Nixon Administration; and fiscal economist for the Bureau of the Budget (1949-57)for the Truman and Eisenhower administrations. He is the author of The Competition of Ideas: World of the Washington Think Tanks.


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Title Annotation:National Affairs
Author:Weidenbaum, Murray
Publication:USA Today (Magazine)
Article Type:Company overview
Date:Jul 1, 2012
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