TransDigm uses a value based pricing technique. What I mean by that is that the price of the product or service is based on the economic value it offers to the customer, and not necessarily the cost of that product or service. When DOD only has one source for the part, and that part is necessary for the weapons platform, the value of that part to DOD then is very high, even if the cost to manufacture the part may be very low.
So I thought it would be helpful to provide an example in our audit. There was a very small part that DLA purchased for an airplane. This part only cost about a few hundred dollars to make, and DLA ended up paying almost a 2,000 percent profit on the part.
That was the assistant inspector general for acquisition Theresa Hull speaking with Jared Serbu. Here is the IG report on the audit of TransDigm.
The usual view is that if the government receives certified cost and pricing data from the contractor, and can analyze exactly how many dollars went into the production of an item, then it could negotiate a “fair and reasonable” price which allows for perhaps 10-15 percent profit. In such cases, sole source (monopoly) doesn’t seem to be a problem. You only have to support the operations of a single, most efficient supplier. No wasted money on redundant competition, and no wasted money on excessive profits.
It is interesting to note that the inspector general study of TransDigm used uncertified cost and pricing data. Even then, knowing the vagueries of cost accounting, the data are not exactly objective enough to come up with precise profit figures. The spread of indirect costs, for example, is arbitrary, and often can be gamed. When companies are multifunctional, it becomes increasingly difficult to assign costs to objectives.
In most market activity, a 2,000 percent profit rate would be a glowing signal for other firms to enter, which would drive down that profit. Advertising these profits TransDigm is making should be the best way for the DOD to eliminate them. But for many reasons (including cost accounting requirements), companies are not chomping at the bit to get into the defense business.
One reason is that average profits made by firms in the commercial world have been, on average, going up, from 18 percent in 1980 to 61 percent in 2016. Making 61 percent profit, of course, is considered scandalous by defense officials. That means the opportunity cost of entering the defense market has gone up. The grass is definitely “greener” on the commercial side. (Note: TransDigm’s operating profit was 43 percent in 2018, and about 1/3 of total sales were to the government.)
Of course, the reason for the rise of commercial firm profits could be traced to increasing market concentration, much like in the defense industry. But, we have a very real sense that the commercial world is delivering more value — better products at lower costs — than defense contractors have been. So commercial firms are earning higher profits at the same time consumers are clearly better off. That is not the normal story for market monopolies, which earn those profits at the expense of consumers.
A better explanation for the increase in profit rates in the economy is the rise of intangible assets like software, databases, R&D, training, and company culture. The output of intangible assets has low or zero marginal cost of reproduction. There literally is no cost to another unit of output, even if the output provides a great deal of value. But of course the firm has to be paid for its investments, and must be rewarded for its risk-taking and innovation.
This poses major problems for the DOD assumption that a good or service’s price — its value — should equal the marginal cost of its production. Everything there is basically indirect cost. There is little or no touch labor or raw materials to track, then burden with indirect costs. We no longer live in an industrial age. Even for major hardware items like aircraft, touch labor has whittled down to a small fraction of total labor employed.
It is true that a lot of these pricing scandals happen on spare parts and repairables. These are tangible goods. They are a physical object, of a known specification, using known production methods. They should represent the best use-case for cost accounting methods to arrive at a “fair and reasonable” price.
Just because the good itself is tangible doesn’t mean that intangibles will not dominate. Metal from the Earth has no inherent value. It has only become valuable because of the processing and design that goes into it. And as the manufacturing process itself becomes more ingenious, cost fall even further. Profits are a reward for that ingenuity. Even with a defined output specification, we should not stamp out better processes to get there.
Consider the future of additive manufacturing. Why would any DOD supplier of spare parts ever switch to such a low marginal cost method, and thus receive low profits? Let’s say the new methods reduce costs by 50 percent, should not the innovator receive high profits as a reward? Aren’t these profits justified until another entrant beats them on it?
Cost and pricing data are great for a static world where all economic decisions are “known”. But what is needed are ways of reducing cost, increasing quality, and generating more value. If cost and pricing data were all that the government had to go on, then we become stuck until the government directs new methods and injects capital itself. Then we’re at a system no different than nationalization.
One final thought is that it seems crazy how the defense procurement officer had no idea they were paying 2,000 percent profit. It shows a lack of technical understanding of what the thing really is, which is particularly damning for spare and repair parts. And this is what happens when you fill procurement offices with business and administrative folks (like myself), who have no other relevant benchmarks for comparison.
When I was reviewing defense costs, I pondered to myself, “how could I know whether this valve should cost $300 or $30,000?” Usually, that’s too detailed a question, we would look at entire components and subsystems, which abstracted the problem even further. But a technical understanding is not all that is necessary.
I only know that I’m willing to pay, say, an extra $10 for the nicer whiskey because there are tons of other buyers — as well as sellers — whose aggregate decisions have been reflected in that $10 differential. I may personally value the nicer whiskey at $20 or maybe even $50, but I would be a sucker to pay anything more than $10.
The competitive pressure between various sellers and buyers keeps the price in check. And it isn’t that there are many interchangable whiskey makers doing the exact same thing. But they are unique and overlap, and any distortions to one area of the whiskey market will be noticed and closed by some entrepreneurial firm. So I am able to buy whiskey without getting certified cost and pricing data from the distillery.
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