By Vice President & Senior Associate, Tom Wells, SES (DAF) (Ret.)
Financing and payment policies are viewed as a critical aspect to preserving the overall health of the defense industrial base and ensuring global competitiveness, but are the current policies effective in achieving these goals?
In 2019, the General Accountability Office issued a report that noted the DOD last performed a comprehensive assessment of its contract financial policies in 1985.i ii In response, the Office of the Undersecretary of Defense for Acquisition & Sustainment (OUSD/A&S) Defense Pricing and Contracting (DPC) team conducted a study and issued a final report titled, “Contract Finance Study Report.” My summary of the report is below. If you’d like to read the report in full, it can be downloaded from the Dayton Aerospace’s Defense Acquisition Library here.
DOD provides contractors with billions of dollars in financing payments on contracts for weapon systems and other products that may take years to produce. Without these payments, contractors would have to borrow funds from commercial sources or internally fund the costs of producing these systems. Financing and payment policies are viewed as a critical aspect to preserving the overall health of the defense industrial base and ensuring global competitiveness, but are the current policies effective in achieving these goals?
There were two major findings from this study:
For major prime contractors, operating in the DOD environment has real advantages, especially with respect to cash flow through DOD’s contract financing policies. As a result, traditional major defense contractors are out-performing commercial counterparts in many key financial metrics. DPC concluded that there was no evidence of any need to change the weighted guidelines method used to establish contract profit objectives.
Defense subcontractors and suppliers generally do not receive the same favorable cash flow benefits to the extent enjoyed by defense prime contractors. This is significant, because estimates suggest that 60 – 70% of defense contract work is being performed by subcontractors.
FINDING 1: Operating in the DOD environment has real advantages for major prime contractors.
Regarding the first conclusion, the study used financial data from publicly traded companies and compared firms primarily engaged in defense contracting with those engaged predominantly in commercial products and services.
Over the last 20-years, defense firms experienced improved:
Operating margins
Return on equity
Return on sales
Cash flow from operations
At the same time, these firms made continuing reductions to corporate investments in:
Capital expenditures
Independent research and development
The remaining cash was used primarily to pay shareholder dividends and stock buybacks that served to drive up share prices. As a result, the defense industry’s annual return to shareholders was significantly better than in commercial industry or any other, broader market metric, such as the S&P 500.
Using prime contractor corporate financial reports for this study makes sense, but this also has the unintended effect of including significant sales that result from non-competitive major weapon system “franchise” follow-on contracts. These contracts are priced using complicated cost analyses and negotiation procedures and, in my experience, tend to be more profitable than contracts awarded based on full and open competition.iii These sole source contracts may significantly contribute to strong overall financial performance reported for the major defense prime contractors.
FINDING 2: Defense subcontractors and suppliers generally do not receive the same favorable cash flow benefits as defense prime contractors.
The second study finding is of greater interest to every subcontractor and privately held small business seeking to do business with DOD.
The study correctly noted, “Small businesses have challenges with obtaining cash flow to pay operating costs and do not have the same opportunities to obtain working capital as their larger counterparts.”
Small business prime contractors were most likely under-represented in the study analysis. They are not among the largest prime contractors, and many are privately held companies. For those small business contractors who seek to win prime contracts—the path to secure a financially lucrative contract is very challenging.
Small business prime contractors rarely win weapon system “franchise” contracts.
Small businesses often compete in a low-price technically acceptable environment, where margins must be razor thin to win.
Even in a best value trade-off source selection, price is often significantly important to the award decision so the pressure to propose a low price is intense.
Most small business contracts are priced on a firm fixed price basis, which means the contractor bears the full risk of any cost overrun.
The good news is that a contractor does not need a government accounting system to compete for and win a firm fixed price contract, but lacking such a system creates other challenges.
Small businesses make significant investments to prepare and support proposals through DOD’s source selection process. It is less expensive to seek work as a subcontractor.
It is difficult, if not impossible, to recover any bid and proposal costs without a government-compliant cost accounting system.
With no government accounting system, cost-based progress payments are not an option.
The study claimed that creating a government accounting system is not difficult.
That may be true, but such a system is incompatible with the simple mark-up pricing method most commercial and small business firms use–government unique requirements create impediments to entering the defense market.
Performance based payments (PBPs) are the only option without an approved accounting system—PBPs are difficult to establish in a competitive environment.
Establishing milestones to provide for a payment every 30 days is time consuming and challenging; every 14 days is nearly impossible.
Well-established small businesses often secure a bank line of credit to pay expenses until payment or financing is received.
Some use invoice factoring or other methods, which can be expensive.
Many of the large U.S. banks do not consider a government contract to be an asset, since the government can terminate the contract at any time.
Commercial small business loans are commonly based on the credit worthiness of the owner(s).
Many firms end up paying significant interest expense to maintain cash flow.
The most promising action item recommended in the DPC report to address the above concerns is Action 4, which proposes to develop a new, simple form of time-phased contract financing that will not require a government cost accounting system or the complexity of negotiating PBPs.
For subcontractors, the financing and cash flow challenge is even greater.
Many primes do not offer any form of financing to their subcontractors.
Payment is typically invoiced monthly or upon delivery for work completed during the period.
Some primes set payment terms stating they will pay the subcontractor when the prime is paid by the government. This can delay payment to the subcontractor for 60-90 days.
Subcontractors are unlikely to complain to the government about late payments, because they do not want to jeopardize their good relationship, which can be key to follow-on work.
For this problem, the most promising action items are to make prompt payment terms, including interest, applicable to subcontractors (Action 2a) together with improving oversight of subcontract invoice payment timeliness (Action 2c).
Kudos to the DPC team for conducting and completing such an in-depth study and report! I look forward to seeing progress occurring on the recommended action items.
Click here to download the DOD Defense Contract Finance Study Report.
i US General Accountability Office, “Contract Financing: DoD Should Comprehensively Assess How Its Policies Affect the Defense Industry,” GAO 19-406, 27 June 2019. ii Department of Defense, Defense Financial and Investment Review, Washington, D.C., June 1985. iii Consider that nearly every major weapon system development contract awarded on a fixed price competitive basis over the last decade resulted in a significant loss to the contractor. This may be due to a deliberate effort to buy-in (propose below the actual expected cost) or simply not adequately pricing potential risk due to the pressure to offer the lowest possible price.
About the Author
Tom Wells has over 35 years of government acquisition-related experience, including executive leadership of major and complex organizations, as well as direction of procurement operations supporting weapon systems life cycle management from research and development to production, test, and sustainment. Prior to retirement from government service, Tom was the Director of Contracting, Headquarters Air Force Materiel Command (AFMC) and Director, 7llth Human Performance Wing, Air Force Research Laboratory (AFRL). He is a recognized contracting subject matter expert who is frequently published in the National Contract Management Association’s (NCMA) CM Magazine. Learn more about Tom here.