Perhaps the most important problem with government profit policy is its lack of flexibility regarding unique market conditions and ultimately its understanding of the suppliers choice whether to do business with government at all, or whether to apply its resources and innovation to more favorable commercial markets.  With defense industry margins half of market averages, it is easy to understand how current profit policies confound DoD acquisition goals to attract new innovative companies with more attractive commercial options.

Profit and Commercial Items

In a rare period of clarity, leadership in Congress and DoD, as part of the 1994 Federal Acquisition Streamlining Act of 1994 (FASA), reasoned that government could take advantage of available and evolving technological innovations in the commercial sector without incurring the tremendous, needless expense and time required for developing exclusively unique military products.

New streamlined procedures were developed for purchasing commercial products, and products very similar to commercial products adapted slightly for military use (“of a type”).  Commercial products were to be purchased at market prices, exempt from the onerous and expensive process of military unique items.  In particular, they were made exempt from the requirement for a cumbersome, redundant, and expensive certified government accounting system and the requirement to provide certified cost and pricing data, though in some cases DoD could ask for “other than certified cost and pricing data.  The 2001 Commercial Item handbook explained its reasoning:

The more attractive the Government can make itself as a buyer, the more likely it is that world-class sellers will enter into contracts with the Government, that favorable terms and conditions will be negotiated, and that lower prices will be paid.

But DoD soon moved to undermine this reasoning in an effort that has grown in fervor over time.  DoD has worked to eliminate from commerciality any item “of a type” adapted in any way for military use.  It has fought to define as military unique, commercial items once sold to the public but later superseded by time or technology.  More recently, its determination to get commercial profit data, DoD issued a memo to acquisition officers which stated “… the only difference between ‘certified cost and pricing data’ and ‘other than certified cost and pricing data’ can be the fact that the data is certified.” DoD’s unthinking intransigence on commerciality earned it this rare admonishment from the Senate version of the 2017 NDAA: “The committee is concerned about the Department of Defense’s increasingly narrow interpretation of the definition of commercial items . . . If there is a problem with the definition, it appears to be the Department’s repeated attempts to narrow the definition to conform to an oversight strategy that will inadvertently lead to less competition [and] increased costs.”

DoD pressuring commercial suppliers for cost and pricing data is a direct violation of the spirit of commercial item provisions in FASA which intended to attract talented and innovative companies not previously willing to do business with DoD.  It is also a violation of fair play to expect commercial prices while also imposing extensive uncompensated process and demanding proprietary cost and pricing data not required in real commercial transactions.  On balance, especially considering DoD’s similarly unfriendly approach to other aspects of commerciality such as intellectual property, it is likely that FASA intent to increase DoD access to new commercial companies with less expensive, innovative products has gone unfulfilled.

The Basis of Sound Profit Policy

Like all policy, sound profit policy must be based on objectives.   Criticism of the performance of the current acquisition systems include high cost, slow cycle time, and a deteriorating technological dominance that American strategy has depended upon for decades.  Acquisition goals therefore must be more cost effective equipment and services, faster delivery to the warfighter, and restoration of our technological dominance.  A comprehensive acquisition reform agenda must understand free enterprise and harmonize all the tools of acquisition effectively including policy on profit, intellectual property, commerciality, competition, partnership and other tools.  It must include the proper balance of responsible oversight and trust in both the industrial base and the judgement of experienced acquisition officers.

The excessive bureaucracy that powers the war on profit denies DoD the full power of our enormous industrial capacity and innovation of this great country.  Low profit margins is poor policy if it drives away the great problem solvers and innovators into markets outside of defense, reduces competition because potential suppliers are uninterested in a difficult customer and poor returns, or costs actually increase because of monolithic infrastructure fixated on only one component of cost loses perspective on the big picture. 

Fair and Reasonable Profit Policy

“To unite the sinews of commerce and defense is sound policy; for when our strength and our riches play into each other’s hand, we need fear no external enemy.”

-- Thomas Paine, Common Sense, 1776.

Profit as only one component of acquisition cost is not inherently any more interesting than any other component and on its face deserves no more dedicated bureaucracy than any other. But it does have unique properties for both suppliers and buyers.  For suppliers, it is critical to basic survival, a measure of success and a yardstick informing investment and market decisions.  For buyers, it is an opportunity to shape the market, and to tune supplier behavior.  DoD leadership advocates tailoring profit incentives in contracts but overall defense profit levels are so low and incentives so small that it fails to capitalize on the unique property of supplier profit and severely handicaps acquisition objectives.

 Fair and reasonable profit is not a number.  It is a tool that enables achievement of concrete acquisition objectives more directly relevant to the taxpayer’s defense.  DoD profit policy should be to allow contract profit to be what is necessary in order to achieve those objectives.  Informing profit policy should be answers to questions like these.  What profit policy…

• … encourages the best innovators, minds, and companies to solve defense problems. 
• … incentivizes key performance such as low cost, rapid development, or extraordinary outcome.
• … ensures responsive support when surprises appear that are not on contract.
• … attracts sufficient bidders for effective competition.

A logical, objective baseline for reasonable profit would be margins typically earned by a cross-section of businesses, e.g. the S&P 500. Adjustments would be made appropriate to market segment and prevailing conditions. At the same time, much of the bureaucratic machinery choking the system designed to identify and limit supplier profit must be pared back.  With one-third of procurement dollars going to oversight, it is irresponsible to spend more on oversight than any potential savings.  Google Finance alone is a good benchmark for supplier profit margin, but an efficient, infrequent, and coordinated audit is reasonable. 

Notionally, the profit component of procurement costs would increase but that need not be the case. Competition and innovation will undoubtedly bring new, more powerful and cost-effective solutions to defense.  In any case, profit was never as important in the first place as system cost and performance.  Using Pierre Chao example, why shouldn’t we be willing to pay 20% margin to a supplier who can cut overall costs in half?  That supplier’s success will only invite greater competition, innovation, performance and further cost reduction in the future.

Rethinking Profit Policy in Defense Acquisition

This analysis of DoD profit policy is admittedly critical, but it is no plea for cozy treatment of defense suppliers.  Instead, it is a realistic appraisal of the disconnect between DoD profit policy, the unfriendly acquisition environment, and the acquisition goals DoD has set for itself.  Acquisition and profit policy based on self-interest is entirely expected, but as in any human interaction, it must be mindful of the interests of those with whom we must partner and depend on lest they make choices reasonable to them that do not support our own interest.  It is axiomatic that encouraging particular choices logically involves making that choice easy.  It is decidedly not easy to work with today’s defense acquisition system. 

No one protects taxpayer’s interests spending billions to save millions while compromising important elements   of a cost effective national security dependent on a vibrant, innovative, diverse industrial base to support it.  We know DoD profit policy is problematic for acquisition.  Last year, UTC divested Sikorsky helicopters specifically because of poor profitability in defense, and General Dynamics bowed out of the new trainer competition for the same reason.  But we will never know the unnumbered occasions when great and innovative potential suppliers simply passed unnoticed on military business because more attractive, less problematic returns were available somewhere else, and we will never know the damage already incurred by the taxpayer in lost cost reduction and a diminished defense.

Defense is a team sport.  We must have and respect both soldiers and armorers, and we must engage the full power of the entire economy.  New profit policy alone won’t achieve that security.  A first principles rethinking is also needed on policy for intellectual property, competition, commerciality and many other issues. In place of the current acquisition system based on lack of trust (Defense Acquisition Performance Assessment Executive Summary), a new foundation is needed based on accountability and partnership.