One of the long-standing problems has been the fact that the government tends to pay profit as a percentage of cost. If a contractor is able to reduce costs through efficiencies by 50%, then they will only earn half the profits. And if the contractor is able to negotiate a cost twice as high, then they will earn twice the profits.
We often hear pious statements from defense officials that they want to reward contractors for saving costs, not punish them. This has yet to be seen.
In the market, if the firm can reduce costs by 50% and reduce price by only 25%, then they earn a handsome profit at the same time that they are better serving the customer. Without the innovative cost reduction effort, the customer would not have seen a 25% price reduction.
Profits act as a signal for entrepreneurs. If the firm is earning handsome profits, then it alerts other entrepreneurs to imitate and innovate along the same lines, attempting to pull away the profit opportunity. Eventually, competition will drive prices down closer to costs, so that consumers will experience the full benefits of the innovation. The only way for the firm to earn new profits is to innovate further.
Unfortunately in the DOD, profits are something to be held down to 10-15% on cost. Profits are just fair returns on capital as a matter of course, often without regard for performance. (It seems that contract performance data is not indicative of profit rates on major DOD contracts, particularly at the prime level.) The profit allure is precisely what helps drive competition and innovation.
I’d like to perform a simple thought experiment from this idea. Let’s presume that real quality-adjusted prices of DOD outputs, such as aircraft, ships, and satellites, have been flat. Meaning, that weapon system “cost escalation” has been in line with inflation for the economy at-large. What profits would we be willing to pay contractors in that world, and still be indifferent between that fantasy world and the one we actually live in?
Now, as I’ve written earlier, nominal defense prices are growing on the order of 7-11% per year, and quality-adjusted prices seem to be growing about twice the rate of inflation. Let’s just say for simplicity that defense output prices have actually been growing at 2% per year over and above inflation.
In the 50 year period between 1969 and 2019, compounding growth of 2% per year would have created quality-adjusted price escalation of 169%. In other words, if a military system cost $1 million in 1969, the same quality-adjusted system would cost $2.69 million in 2019.
So in our thought experiment, let’s say that if the DOD was willing to pay large profits to firms to identify areas of innovation and excite competition, and this strategy results in 2019 prices no different than 1969 (i.e., zero real price growth). This shouldn’t be too hard to believe, since many manufacturing and tech sectors have seen downward — deflationary — prices.
With these assumptions, the taxpayer should be indifferent between paying 10% profit on the actual costs contractors incur today, where there is little competition to keep prices down, and paying 196% profit on cost had costs seen zero real price growth.
Now, of course, this is simply a thought experiment. If we could somehow stimulate effectiveness such that contractor costs were flat for a quality-adjusted item, then we could pay handsome profits and still be far better off than in today’s world. Over 50 years, we could have grown profit-on-cost from 10% to 196%, and been indifferent to the world we live in today. But quality-adjusted contractor costs have been growing much faster than economy-wide inflation, meaning the DOD is losing a tremendous amount of buying power to inefficiency.
Perhaps a willingness to see big profits, advertise them, and draw in innovation and competition is the only way to keep costs from going up. After all, 196% profit rate would be attractive to any investor.
One unintuitive outcome here is that if real prices were growing 2%, then we should be willing to see profits growing at 6% per year if that managed to keep production costs flat. The taxpayer would be indifferent between “cost disease” of 2% a year and “profiteering” of 6% a year. They both lead to the same overall price level after 50 years. Yet clearly, the latter would be viewed as a national scandal while the former is business as usual.
One (of many) major issues is that when we are building new technologies and one-offs, we don’t have an objective measure of what the price should be, and therefore a gauge for deciding fair profits. Ultimately that “willingness to pay” that matters most. And that willingness depends on competition on the buying side so that relative valuations can emerge from the various purchasing offices.
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