CEO pay for defense contractors skyrocketed after 9-11 but before the invasion of Iraq.
Lockheed Martin: $5.8M in 2000 increased to $25.3M in 2002
General Dynamics: $5.7M in 2001 to $15.2M the next year
Honeywell: $12.9M in 2000 up to $45M in 2002.
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| CEO pay raises (compounded annual growth rate). Note that the actual level of CEO compensation in 2002 is inversely related to the annualized growth. Honeywell had the highest pay but lowest growth rate. The reverse is true for General Dynamics. |
I see two plausible explanations.
(1) When defense budgets were turned back on, contractors may have been flush with cash that they didn’t want to book as profits (fearing charges of war-profiteering). Much of the additional dollars went to higher expenses, like executive pay or modern facilities.
(2) Shareholders saw a huge potential for defense budgets to increase, not just in 2001 or 2002, but for the long term. With the market opening up, they may have wanted to incentivize the CEOs to capture as much growing market as possible. Higher CEO pay doesn’t just incentivize the CEO, but creates a tournament at all levels of management to win that position.
I think both of these were going on. But having worked closely with contractor rate structures, (1) has some very plausible features. Let’s explain how they might be “flush with cash.” After all, shouldn’t the higher budgets be buying more stuff, not more profits?
Sources of contractor reimbursement (quick and dirty).
Large contractors negotiate rates with the Government that they will use in contract proposals. When they say they need 100K hours of manufacturing labor, there are negotiated rates to dollarize direct labor, fringe, overhead, G&A, etc.
The negotiated rates depend on how much business there is. When revenue is low, there are less people “turning wrenches,” but relatively fixed overhead costs still must be paid (like employee benefits, facilities and capital cost, management and business administration). When revenue is high, you can spread the fixed overhead across more variable work, bringing rates lower.
These rates then become the basis of pricing contracts. If business was better than expected, then the negotiated rates were too high. Outcomes depend on contract type.
Fixed Price contracts are just that, fixed price. If the rates were too high, then the contractor will keep the excess profit. A deal was a deal. Government doesn’t monitor the business systems of fixed price contracts.
Cost-Plus contracts have the Government reimburse contractors for expenses paid. Here, Government auditors will check to see what the actual expenses were contributing to labor and overhead rates. They will reimburse only the actual expenses, so no higher profits.
Plausible explanation of the CEO pay jump:
The Government initially thought the war on terror would be short, so they would expect overhead rates to come down some, but not much.
Let’s say the contractors expected the war of terror to last many years and consume large budgets. This means that the rate the Government expects will be too high.
Now, contractors want to avoid a couple things: (a) They don’t want to earn too much fixed-price profits, which will be reported to the public; and (b) they don’t want to be reimbursed at a lower rate than negotiated; they want to keep current and future overhead rates stable or high.
So what happens? You jack up your expenses to eat into what would otherwise count as profits. One common way is to book revenue against the home office (G&A), which can go toward higher CEO pay, or more Bid & Proposals, or Internal R&D, or nicer facilities.
One final note.
Government may not aggressively negotiate rates. Flat overhead rates seem fine. Government wants to stop them from increasing. But when business is growing, a flat overhead rate means overhead expenses are growing at the same rate or faster than direct labor/materials costs. (This is because of compounding; fringe is paid as a percent of total direct labor, then overhead is built on top of that, and then G&A, FCCOM, etc.) So in reality, overhead is going crazy even if the percentage rate isn’t.
There is downward stickiness to contractor overhead rates. Upward adjustments are a lot less sticky. I think of it like the ratchet effect.
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