Key Concerns of OSD Leadership During Meeting with Defense Investment Community

OSD Sr. Leadership held meeting with a group of Defense Investment Community on Friday, 9:00am-10:30am, October 1, 2010, in New York City. Briefing was by “very Sr. OSD Leader”, moderated by Brett Lambert from USD(AT&L). Purpose of meeting was to discuss OSD’s “Efficiency” & “Affordability” Initiatives, and expected impact on Defense Industry. There were 12-15 invited attendees, comprised of both Sell-side & Buy-side analysts. McAleese was fortunate enough to be invited to participate in this group meeting as well.

McAleese cautions that Sr. OSD Official specifically-requested that his comments be treated on non-attribution basis. Additionally, I have attempted to paraphrase key points made by OSD Leadership. However, because of the fluidity & fast-pace of discussion, McAleese may have misunderstood actual intended position. Consequently, please use these notes in a manner that is supportive of ongoing OSD Leadership deliberations.

• Paraphrase: “We are now at the fifth inflection-point/downward-ramp, similar to World War II, Korea, Vietnam, and Cold War.”
• Paraphrase: “The previous 4 Defense drawdowns were handled with little planning, and obviously ended poorly for both DoD and contractors.”
• Paraphrase: “The Secretary wants to manage the growing pressure on Defense Funding, without breaking Force Structure or Modernization.”
• Paraphrase: “The most important thing we can do is make the hard decisions early, because today’s funding is the maximum we could possibly expect to receive; plus any Program decisions will clearly impact that Program’s subsequent cost.”
• Paraphrase: “This is not about cutting Defense funding, but about finding $101B in internal savings to fund future Force Structure and Modernization.”
• Paraphrase: “You cannot get to $101B Savings through pure ‘efficiencies’, so lower-priority functions and organizations must be targeted. Proposed closure of JFCOM, Business Transformation Agency, and NII/J6 are at that level.”
• Paraphrase: “The next most important thing we can do is ensure that the overall Program is balanced. In past cycles, we have targeted funding cuts primarily at Modernization; Operating Forces; or Infrastructure. We have specifically chosen to target the $101B savings during 2012-2016 POM across the entire Defense Budget, to minimize adverse impact.”
• Paraphrase: “Secretary’s 2009-2010 decisions were focused on cancelling platform Programs that were either troubled/broken; or suffered from exquisite/expensive requirements; or delivered Warfighter Capability that was not critical to our evolving priorities. There will still be some Program cuts in 2012, but significantly-fewer.”
• Paraphrase: “Secretary is decisively implementing his Eisenhower Library Speech during the 2012-2016 POM Process.” [Eisenhower Library Speech targets Headquarters (Milper & O&M), excessive O&M Account growth in both “Administrative and Infrastructure” and “Support Service Contractors”; plus “exquisite” Requirements on large-dollar RDT&E Programs.]
• Paraphrase: “Many people have suggested that we cut Force Structure to free up funding. We cannot reduce Force Structure at this time. We should be able to revisit Force Structure within the next few years. Our ability to revise Force Structure downward, will directly be driven by withdrawal of 50K final US Troops from Iraq at the end of 2011, plus eventual speed of drawdown in Afghanistan as circumstances on the ground dictate.”
• Paraphrase: “Many people have misunderstood our need for 2-3% annual funding real-growth, versus the maximum of 1% annual real-growth that Administration has committed.”
• Paraphrase: “We do not need 2-3% of real-growth across every dollar of DoD’s budget. However, we absolutely need that 2-3% real-growth per year, in that 40% of our Budget for Modernization; Training/Operating Forces; and Quality-of-life. That need for 2-3% growth in the core 40% of DoD’s Budget, is exactly how we came up with the $101B internal savings requirement for 2012-2016.”
• Paraphrase: “We are targeting Overhead. We have also given specific direction to the Services to find 1/3 of their savings from ‘one-off’ actions such as F-18 Multi-Year-Program, with the other 2/3 coming from structural changes that will result in recurring outyear savings. F-18 MYP is a good example of meeting the 1/3 ‘one-off’ savings requirement, because it will save $600M through 2015. We will count that $600M as quantifiable savings.”
• Paraphrase: “However, the other 2/3 must come from structural savings that are repeatable year after year.”
• Paraphrase: “Reaction from Services has been positive, because the Services will not only be allowed to keep the savings that they internally generate, but will also receive the additional savings that are generated from OSD’s Defense Agencies.”
• Paraphrase: “We are spending a lot of attention on Dr. Carter’s recent Affordability Guidance, because those will result in significant outyear savings. This is important because it changes both the culture and structure, of how we contract $400B with Industry per year.”
• Paraphrase: “Dr. Carter believes the greatest gain from his Affordability Guidance, will come from generating savings within Services Contracting, rather than hardware/platform Programs.”
• Paraphrase: “For hardware contracts, we are committed to a departure-point of Fixed-Price-Incentive-Fee (FPIF) contracts. Late 1980s-early 1990s use of Firm-Fixed-Price-contracts was disastrous, but we then went entirely to Cost-Plus-Award-Fee contracts [CPAF], which placed all of the emphasis on Technical Capability, to exclusion of Schedule or Cost.”
• Paraphrase: “We will use FPIF contracts for Development Programs, where the Requirements are clear and the Technology risk is low. We will definitely be using FPIF contracts in early LRIP Production, where Cost-reduction is key.”
• Paraphrase: “Industry must understand that both Affordability, and Schedule, will now become as important as Technical Capability. This is a major cultural shift. We are committing ourselves on each Program, to achieve the best-available output by a specific-date. Otherwise, we are constantly extending Development Programs on a ‘marching-army’ basis, in the hope of adding additional cutting-edge technology that is fraught with risk.”
• Paraphrase: “This shift to Production by a specific Schedule, is exactly what happened in Army’s Ground Combat Vehicle Program. It would have been worth waiting, and paying for a longer Development cycle, if we thought we would make major breakthroughs in either Fuel Cells or lightweight Armor Materials within the next several years. However, that will not be the case. Instead, we will have to do the best we can in fielding the Technical Capability that we currently have.”
• Paraphrase: “As you may have observed, some in Congress have taken exception to the Secretary’s proposed closure of JFCOM. The Secretary had to make these types of announcements early, to show everyone that he is serious, and that people cannot simply wait until he leaves the Building. We are convinced that he will never leave the Building.”
• Paraphrase: “We are specifically targeting the 10% annual reduction of ‘Support Service Contracting’ to the specific category of ‘Staff Augmentation’. We are not targeting all Support Service Contractors, ranging from Combat Systems Maintenance, to Base Operations. Instead, these Staff Augmentation contractors are those contractors that support the Pentagon Offices with extra Staff & knowledge, but do not produce a clear stand-alone product. What disturbs us is that these Staff Augmentation contractors have tripled in-size/funding over the past decade.”
• Paraphrase: “We are also freezing all DoD civilian employees to stop the otherwise expected growth of civilian employees, once these Staff Augmentation/Support Service contractors are reduced. This is predictable and we are prepared for it.”
• Paraphrase: “Importantly, we are also scraping off HQ Staff, which again is where JFCOM, BTA, and NII, decisions came from. We are making everyone in Washington uncomfortable, but these actions must be taken now.”
• Paraphrase: “The targeted savings of $101B applies to the 2012-2016 Base Budget, and will not apply to ‘OCO’ funding.”
• Paraphrase: “Of the $200B that we spend each year on Services Contracting, less than 10% of that is for the Staff Augmentation/Support Service Contractors that we are really seeking to cut/reduce.”
• Paraphrase: “There will still be a few Program cancellations expected in the 2012 Budget Request, but these will be significantly fewer than cut in either 2009 or 2010. The focus instead will be on restructuring platform-programs that we have decided to keep, to accelerate Schedule and to make them unit-cost affordable.”
• Paraphrase: “I can tell you from my personal experience in front of both SASC & HASC earlier this week, that Congress loves reform in general, but also hates reform in particular. Congress is critical to the success of our plan. However, Congress is at cross-current pressure. There is growing Congressional concern over the size of DoD’s Topline funding. But any cuts then occur on specific Programs, where there are constituent interests at stake.”
• Paraphrase: “It is not lost upon us that we are facing daily growing pressure targeting Defense funding from the Deficit Commission; mid-term Congressional elections; Tea Party; etc. Even Senator Inouye recently conceded to bi-partisan pressure, to cut an additional $8B from Senate’s 2011 Defense Appropriations Bill.”
• Paraphrase: “Previously, we have also been able to manage our Operations with surplus O&M from OCO Accounts. This is because we now request 100% of OCO funding, one full-year out. However, this will clearly disappear over time.”
• Paraphrase: “Industry needs to understand that we are not seeking to cut their Revenues or their Profits. If you can cut the cost of a DDG-51 order in half, we will immediately buy 2 DDG-51 Ships, instead of only 1. We are absolutely over-programmed, and have a desperate desire for those additional unit quantities. We are not going to cut a contractor’s unit-prices downward, and then not order additional quantities of that same platform with the actual savings. That would be non-sensible.”
• Paraphrase: “We are not generally upset with Industry’s current Profit margins. However, we are concerned in several cases, that contractors are making Profit that is not tied to their actual risk. This is part of the byproduct of CPAF contracts, where the focus is on Technical Capability, with little/if any consideration given to Schedule or actual Cost. If you can demonstrate that you are incurring Cost-risk, or Schedule-risk, then we will be delighted to openly pay premium Profit that is associated with that risk.”
• Paraphrase: “Regarding overall Industry Profit Margins, we do not believe that they are too high. Nor are we hearing concerns of excess contractor-profiteering from Congress.”
• Paraphrase: “You do not need to be afraid that contractors are going to be suddenly absorbing massive risk, because this shift from traditional no-risk/low-risk CPAF, to FPIF, will take place over time as new contracts are negotiated and awarded.
• Paraphrase: “We are also aware of higher-OM Commercial Models, such as Rockwell Collins, Goodrich, etc. We will not disturb that Profit Model, so long as they are outperforming on Schedule and Cost.”
• Paraphrase: “The Affordability Guidance does not represent a wholesale dumping of risk onto Industry by DoD. A perfect example is Army’s Ground Combat Vehicle. The GCV Technology Development RFP was killed because it was clear that actual Development would likely run 10-12 years. The focus had to shift from Technology Development, to managing Integration Risk and accelerating Production/Fielding.”
• Paraphrase: “We need to genuinely-increase competition. I am always troubled when people raise F-35 Alternate Engine as an example of increased competition, because it is not. The F-35 Alternate Engine will cost an additional $2.9B to put two propulsion houses in business, with each expecting to receive a minimum allocation of continuing work each year. The Navy only has room for one F-35 engine on the carriers. Most of the Allies are not buying large-enough Fleets to justify two F-35 Engines. This leaves the Air Force as the only potential buyer, where the savings would then be offset by the greater cost of two separate Logistics tails.”
• Paraphrase: “Some F-35 International Allies have recently voiced support for the F-35 Alternate Engine. This is understandable. When I tell them it will take additional $2.9B to develop that second competitive source, I specifically ask them how much funding they will voluntarily contribute. To date, the response to that question has been radio-silence.”
• Paraphrase: “Expect to see us force more ‘winner-take-all’ and clear ‘winner/loser outcomes’ to drive competition, very similar to Navy Littoral Combat Ship, and also USAF Tanker.”
• Paraphrase: “Many people tell me every day that Defense contractors make significantly less Operating Margin percentage than traditional S&P Commercial Contractors. The inference is that Defense Contractors must make more Profit. In my past life, I ran Program Analysis & Evaluation, so I know how numbers work. We pay for the vast majority of all contractor RDT&E. Our payment is faster. We are much lower-risk from probability of successful transition from Development to Production. We know that Industry is generally making 11-12% Operating Margins now. We will support increased Profit for those contractors that accept commensurate Risk.”
• Paraphrase: “We are taking aggressive steps to get at historic Requirements-appetite. We are using examples such as Configuration Control Boards, to elevate decisions over growth in Contract Scope above the traditional Program Manager. Historically, the PM would ask the contractor to offer options on additional Capability, and contractors did so in good faith, as requested. However, contractors were also paid additional Revenues and Profit for that increased Scope under CPAF contracts. It is important for us to address Requirements-creep with the Services internally, and also to control Contract Scope-growth at higher-levels above the traditional Program Office.”
• Paraphrase: “We are not trying to punish Industry by shifting from CPAF to FPIF contracts. However, it is critical that Industry realize that they will now be bearing part of the Cost-risk. This means that Industry must push-back in response to Program Office requests to add additional Contract Scope or Technical Capability. This Cost-focus is a significant cultural shift from the traditional CPAF focus on Technical Capability alone.”
• Paraphrase: [In response to specific & repeated question from Sell-side Analyst on NOC] “I am obviously aware of examples where companies have chosen not to bid in competitions, such as specific examples you have named of Northrop ‘no-bid’ on USAF Tanker, and potential strategic shift in Shipbuilding. However, your two examples are anecdotal. They are not systemic. We have more companies expressing strong interest in expanding their support of DoD, than I have ever seen before. You keep insisting that these two anecdotes are the norm across our entire business within DoD. That unfortunately, is not so. I have more than enough anecdotes to outmatch your two anecdotes.”
• Paraphrase: “It is too early to speculate on potential changes to Progress Payments, in the recent Affordability Guidance. However, it is very clear that we are openly-encouraging contractors to shift to Performance-paced Payments, tied to specific Deliverables or Schedule, rather than traditional monthly invoicing of total Progress Payments/Costs. I would encourage Industry to focus on negotiating Performance-based-Payments as part of their contracts, where they are already stepping up to either Schedule-risk or Cost-risk, because this supports premium Profit.”
• Paraphrase: “I have directed Dr. Carter, plus Brett Lambert, to review each of the Industrial Base Sectors. This is intended to ensure that we do not inadvertently-collapse a particular market, or drive key contractors out of the business through neglect or ignorance. I do not want to speculate prematurely on specific Industrial Base Sectors that may be at-risk. However, I would encourage you to engage with Dr. Carter & Staff on Industrial Base issues, sooner rather than later.” [Presumably, this Industrial Base review would also identify those specific platform markets where there is either excess Capacity/Overhead to be rationalized; plus those niches where “Design” or “Manufacturing Tradecraft” must be consciously-funded & protected.]

McAleese cautions that Sr. OSD Official specifically-requested that his comments be treated on non-attribution basis. Additionally, I have attempted to paraphrase key points made by OSD Leadership. However, because of the fluidity & fast-pace of discussion, McAleese may have misunderstood actual intended position. Consequently, please use these notes in a manner that is supportive of ongoing OSD Leadership deliberations.