Paying More for Less:
Price Escalation at the
Department of Defense
Today, the U.S. Defense Department is not only being
asked to do more with less but also pay more for the
privilege. This paradox is putting defense spending
and capabilities on a collision course.
Paying More for Less: Price Escalation at the DoD
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Little doubt remains that the budget for the U.S. Department of Defense (DoD) will flatten or
even contract in coming years, and the impact of this trend across the defense value chain
will be far-reaching. Most observers seem to agree that a more austere approach to meeting
the country’s evolving defense needs is a necessary consequence.
A corollary issue that goes less frequently addressed, however, is that defense spending inflation
dwarfs that of the economy as a whole. While simultaneously being called to do more with less,
the DoD (and by extension, taxpayers) is paying more for less. To ensure its long-term viability,
the DoD must address this troubling paradox and get the most out of its precious dollars.
Pervasive Inflation
It is well documented that inflation—or escalation, to use the defense acquisition term—
throughout the defense supply chain has proved both excessive and pervasive for several
decades, far outpacing the general inflation rate. In his testimony before the U.S. Senate
Armed Services Committee in 2005, Admiral Vern Clark, chief of naval operations, said,
“Among the greatest risks all services face is the spiraling cost of procurement for modern
military systems …. This tremendous increase in cost runs counter to other capital goods,
such as automobiles, where the inflation-adjusted cost has been relatively flat over the same
period of time.” The testimony cited alarming price increases between 1967 and 2005: 401
percent for submarines, 391 percent for amphibious ships, and 100 percent for carriers.
Blaming new technology for rising
prices doesn’t fly when cars and
commercial aircraft innovate quite
nicely without the same level of inflation.
More recently, An Analysis of the Navy’s Fiscal Year 2012 Shipbuilding Plan, a study by the
Congressional Budget Office, tracked shipbuilding inflation since 1981, noting that it has
consistently outpaced gross domestic product (GDP) price inflation and currently sits at
a 2 percent premium. This difference may not sound like a great deal in the context of one
annual budget, but it means that half of the 2012 shipbuilding budget is paying for the
escalation premium experienced since 1981. Looking forward, it means that if trends
continue, the Navy will be able to purchase only half of the current number of ships by 2030,
a reality that does not reconcile with current shipbuilding plans. Other Pentagon programs
face a similar plight. Across the DoD, paying more for less is the undeniable trend.
With few exceptions, private industry has been more successful at containing costs.
While defense has seen escalation of close to 5 percent annually, price increases for
automobiles, commercial aircraft, apparel, food, and even gasoline have been much lower.
Technological and capability advancements in defense programs are often cited as the major
force behind price increases, but that argument doesn’t fly when you consider how many
other multi-decade product platforms, such as automobiles and commercial aircraft, have
evolved and innovated quite nicely without the same level of inflation.
Paying More for Less: Price Escalation at the DoD
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For example, despite four major redesigns since 1988, the price of a Ford F-150 pickup truck
has risen an average of 3.7 percent per year over the past 25 years. Since 2004, the price of
the Boeing 737-800 twin-engine jet airliner has increased by 3.2 percent annually, while the
Beech Bonanza single-engine airplane has experienced a 4.1 percent annual price increase
in that same period. The Gulfstream G550 business jet has seen a 2.1 percent annual price
increase over the past nine years.1
Meanwhile, escalation for several major defense projects has been much higher. The cost
for a landing platform and dock (LPD) amphibious warship increased 7.5 percent annually
between 1996 and 2011. From 1987 through 2011, the cost of a DDG-51 destroyer increased
6 percent per year (see figure).2 Note that these cost increases came despite the typical labor
reductions that come from learning-curve benefits. According to one report by the RAND
Corporation, other programs during the second half of the 1900s, such as CVN, LHA, and LHD,
saw similar levels of escalation.3
Isolating the effects of escalation in recent years is difficult because of changes in ship
classes, which have only exacerbated cost increases. Yet, a closer look at even the seemingly
successful programs shows room for improvement. For example, costs for the SSN-774
Virginia-class submarine have increased only 2.2 percent per year since 2000. However,
the impact of escalation is clouded by volume-driven cost benefits from multi-ship purchases.
Moreover, this increase, while seemingly minor, comes despite the learning-curve impact that
Figure
Warships’ rising costs exceed private industry counterparts
Price by year (%)
320
300
LPD
280
DDG
260
Ford F-150
240
Beach Bonanza
220
200
180
160
140
120
100
80
60
40
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Notes: LPD is landing or platform dock; DDG is the U.S. Navy’s classification for a guided missile destroyer.
Source: A.T. Kearney analysis
Prices for the Ford F-150 and Beechcraft Bonanza are the manufacturer’s suggested retail price (MSRP) for the base models;
the price for the Gulfstream G550 is the average marketplace retail price provided by Vref.
1
Ship costs reflect award values construction, long lead time material, and engineering as noted by the DoD contract announcements.
2
CVN is a nuclear-powered aircraft carrier. LHA and LHD are amphibious assault ships.
3
Paying More for Less: Price Escalation at the DoD
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likely reduces the required labor hours. In other words, the underlying price inflation
is likely much higher than it appears.
Why has price inflation been so consistently and significantly higher for defense than
other industries? The answer is twofold: a perpetual accounting for excessive escalation
in the program budget and execution cycle, and the lack of true competition to prevent
this self-fulfilling prophecy.
A Deep-Rooted Problem
The expectation and realization of excessive escalation permeates the entire defense value
chain. The DoD’s estimating and budgeting cycles account for escalation in future programs
by more or less aligning it with past rates. Prime contractors budget and plan for escalation
with their major equipment suppliers, which plan for escalation with their tier 1 suppliers.
Once budgets are established and funded, the defense acquisition machine is conditioned
to consume the extra costs. As price inflation projections become reality, they become the
justification for future cost estimates and budgets. And the cycle continues.
As a result, price inflation in the mid-single digits has become both the expectation and
the goal of the supply base. Some suppliers explicitly reward managers based on their
ability to increase prices over time, and they view cost management, quality, and customer
satisfaction as secondary performance measures. Meanwhile, those that foot the bill for
excessive escalation—prime contractors and the DoD—have come to accept escalation
of this magnitude as the norm.
Price inflation has become both
the expectation and the goal of the
defense supply base.
Frequent and legitimate competition would quickly remedy this trend. In a competitive
environment, increases in manufacturing costs (for example, raw materials or market-driven
labor rates) are largely offset by productivity gains. Prices for customers do not increase at the
same rate as cost inflation, and often they decline. Further, even seemingly unavoidable cost
inflation can be mitigated through hedging strategies. For example, automakers typically
expect up to 3 percent unit cost reductions from their suppliers year over year through
various continuous improvement and productivity measures. There must be evidence of raw
material price increases or unavoidable labor rate agreements to avoid this annual reduction.
Mitigating Escalation
The kind of true competition that would otherwise impede escalation is largely limited to the
early phases of major programs. Once designs are established and initial supplier contracts
are selected, the cost of switching usually precludes any real competitive leverage. Excessive
escalation typically follows.
Paying More for Less: Price Escalation at the DoD
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Despite the absence of ongoing competition, it is possible to reduce excessive price
escalation. But it requires a dramatic shift away from today’s thinking. Three tactics can
be applied simultaneously:
Approach escalation with a zero-based mentality. Instead of merely accepting price
escalation as it stands, program leaders must dismiss any notion of entitled escalation. That
is, any nominal year-over-year price increases require significant justification. Yes, raw material
price volatility and labor wage increases over time will inevitably lead to cost increases, all
things being equal. But productivity gains experienced widely across the economy should
also be expected in defense. The net impact could very well result in a price increase, but that
increase will be much closer to zero than to the levels that have become the norm.
Gain visibility of equipment cost drivers and their impact on end prices. Today, program
managers and prime contractors have only a limited understanding of how price swings for
raw materials and other inputs impact total cost, so they are often overstated. For example,
if steel only accounts for 10 percent of the total cost of a component, then a 50 percent
increase in steel prices should only increase component cost by 5 percent. Or if wage rates
are flat (as they have been the last several years in most industries), suppliers cannot make
a case for increases in any labor-dependent cost elements.
Compete on future cost management. Programs wield the most competitive leverage over
suppliers at their onset, before designs and supplier relationships are locked in. During this
early period, programs and prime contractors must expand their evaluation of potential
suppliers to include year-over-year (or hull-over-hull) cost management. Allow for truly
unavoidable cost increases (such as the steel example above), but beyond that, focus on the
maximum price increases that suppliers will be willing to guarantee. As we noted earlier,
automakers agree to annual price decreases when multi-year contracts are awarded, with
provisions to allow for truly unavoidable cost increases. True, suppliers may be reluctant
to sign up for a cap on price increases in the low single digits. But considering that in some
industries, year-over-year cost decreases are the norm, a request like this would be neither
unreasonable nor unachievable.
Rising Above the Status Quo
The Department of Defense simply cannot afford to perpetuate the status quo. Accepting
this rate of escalation will undoubtedly lead to a gradual decline in what the department can
purchase for its warfighters. To stem the tide, the DoD must change how it views escalation
and what it does to mitigate it at all levels. Before doing more with less, defense programs
need to make sure they are getting more out of their budgets.
Author
John Wolff, partner, Washington, D.C.
[email protected]
Paying More for Less: Price Escalation at the DoD
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