Defense Industrial Base faces short and long term challenges

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The defense industrial base faces a lot of long-term challenges, many of which have been well documented in studies generated both inside and outside the government. But here and now concerns like inflation and the war in Ukraine have introduced a lot of new ones, ones that need to be dealt with this fiscal year. David Berteau is president of the Professional Services Council. He testified before the Senate Armed Services Committee last week on the health of the industrial base, and he joined Jared Serbu on the Federal Drive with Tom Temin to share some of those insights.

Interview transcript:

Jared Serbu: And, David, there’s a lot to talk about this week. But let’s start with some industrial base health issues since you were just on Capitol Hill last week to testify about exactly that. It was a really wide-ranging hearing, it’s worth watching, I would tell our listeners if they’ve got the time to do it. But I was struck at how much of it was focused on the here and now and the myriad issues that contractors are dealing with in this fiscal year, as opposed to just long-term health issues. What’s kind of on your radar in terms of the near term?

David Berteau: Well, thanks, Jared, and you’re right. Typically the Armed Services Committee, when they’re having their hearings at this time of year is thinking about the FY ’23 National Defense Authorization Act and the FY ’23 spending for the Pentagon. That’s six months away, five months away, really, and maybe eight months away, or 10 months away, depending how many [continuing resolutions] we have. But the reality is that in a whole host of areas, the issue is today, not next year. Two obvious examples in a quarter sort of benchmark, the whole thing is number one, lots of drawdown of US stocks of both munitions and materiel for Ukraine, not only for Ukraine, but also to send to other countries who have sent their stuff to Ukraine, typically Russian-based materiel, and we’re replacing it with U.S.-based materiel. There’s no plan for replenishing that, and really no funds for that replenishment in the FY ’22 supplemental or in the appropriations. Then at the other end of the spectrum, there’s the contractors across the board, who are seeing dramatic increases in their cost, both for material and supplies, supply chain issues and that sort of thing. But even more importantly, in wages, where we’ve seen wage growth, 8% year over year, and for a company that’s operating on a 5% margin on a contract, it’s pretty hard to absorb 8% growth in wages and still stay in business.

Jared Serbu: The munition stocks issue is kind of an interesting one, because it does point to industrial base health and the long term and the short term a little bit, I think because, and you certainly know more about this than me. But I’ve heard of a couple instances in which these particular munitions just have not been produced in so long the production lines don’t exist at the moment. So you would have to kind of restart that do some retooling. So it’s not as easy as just plugging money into the system.

David Berteau: That’s absolutely the case and even where there is an existing production line. In many cases, that production line is now for foreign military sales, which is a lesser capability, and it has some constraints on it in terms of what you can include in the system. But more importantly, it’s not the kind of system you need going forward. So one of the comments I made in before the Senate Armed Service Committee last week is that, to the best of my knowledge, there is yet to be a contract for replenishing any of these supplies. There have been contracts issued for delivering stuff directly to Ukraine, but that doesn’t rebuild the U.S. stock. Keep in mind, these stocks are sometimes not assigned to a particular theater. But in many cases, we’re drawing down European stocks set up for NATO for scenarios that haven’t disappeared yet. So timeliness, I think in one example, it’s the javelins, the anti-tank missiles. Public reports have indicated we’ve already gone down and given away 1/3 of our stock in barely two months of combat. It doesn’t take long to see that you’re gonna get to zero before the war is over. You could get to zero before the war’s over.

Jared Serbu: Well, let’s talk a bit specifically about the effects of wage inflation and how that’s affecting contractors again in the current year. Because at some point, those costs are going to get theoretically passed on to the government through some sort of request for equitable adjustment. Do we have any idea what that process looks like or what the magnitude of the of the dollar hit might be?

David Berteau: Well, let’s first talk about the magnitude and how you size the magnitude, right? So there’s really two aspects to this. Number one is for the employees you currently have and the employees you’re hiring, wages are going up. They’re going up to the employees you hire because they have plenty of options. There are 11 million jobs opening in America today and 6 million people looking for work. That says the odds favor the person looking for work, not the not the person trying to hire. But secondly, there’s the cost of retaining the people you have. We had 4% of the workforce, over 4% of the workforce each month is leaving their job and going to the Great Resignation, right? And so you add that up, 4% per month, that’s 50% over the course of a year are people leaving. And so you’ve got to retain people you have. Oftentimes companies just say it’s cheaper for me to pay the guy I have more now than it is for me to pay somebody else more and have a vacancy. Then the second piece is, all those vacant jobs that are out there are actually work not being done that’s already contracted for. And you have to ask yourself what work’s not getting done? Well, there’s no central location for that. So that problem has two aspects to it: How do you resolve this? Well, it depends. If you’ve got a fixed price contract, there’s very little opportunity for you to say, well, now I have more costs, and I need to pass those costs on to the government. As you and I were discussing earlier, many contracts used to have a clause called the economic price adjustment clause, the EPA clause, which gave the contracting officers program the flexibility to consider changes in costs. But inflation has been so stable for so long, so low and stable for so long, that many contracts now, no one has idea how many but a lot, no longer have that clause in them, which makes the case even harder to make up front. And then the third piece is, even if you file a request for an adjustment based on increased costs, if the government doesn’t have the money, they can’t pay that anyway. And all that request really is an opening round of negotiations over how much you’re gonna get and when you’re gonna get it. There’s a tight time limit at the front end for filing the request shortly after you’ve incurred the costs, but a no real time limit on that back end for how quickly the government gets it to you. These are putting companies at real risk, both in the contract arena, and in the bidding and future on future contracts. So it’s a whole host of problems. And you can’t wait ’til next year to address this.

Jared Serbu: But it is likely to still be a problem next year, which it strikes me means it’s important for the government to get its arms around how big the magnitude of this problem might be, so that they can start programming it for FY ’23. If we’re still in CR mode for the first five months of fiscal year ’23, the problem is exponentially worse isn’t it?

David Berteau: It is very much worse and as you know, for 12 of the last 13 years and likely to be 13 in the last 14 years, we start the year with a continuing resolution and it lasts at least two or three months. Now, there’s an additional problem here, which is if you do it one contract at a time, these adjustments for the wage inflation and the inflation growth in general, you do it one contract at a time, it’s almost an insurmountable challenge. But what we would like to have, what PSC has been arguing for is agencies should issue general guidance to their programs and contracting officers that would say something along the lines of it’s important to let companies recover their costs to do the work you’re contracted to do. And you need to do put the flexibility in place to both speed up the process. In the case of one agency, the General Services Administration, they remove the cap on the number of times you can make a request for an equitable adjustment, thereby freeing up a little bit of one of the constraints here, but it doesn’t make more money available. And it doesn’t say if you’ve got the money, this is what you should do with it. We think that kind of general guidance needs to go out. Contracting officers need to realize that they have both an affirmative responsibility on the individual contract, but also a responsibility to maintain the long term viability of the business base that’s supporting the government across the board.

Jared Serbu: What would agencies actually need to do mechanically to enable that flexibility? Does it require a mass contract mod or a class deviation or just simple guidance?

David Berteau: I would think it’s simple guidance. We saw, for example, back at the beginning of the pandemic, guidance from OMB, under the auspices of the Office of Federal Procurement Policy that just instructed contracting officers across the federal government to maximize teleworking for contractors, even if there was no clause in the contract that permitted such teleworking. We didn’t need to mod the contracts. All that guidance did was freed up the contracting officers to make a judicious and correct decision on their benefits that clearly benefits the government. You could do the same thing with recovering costs from inflation.

Jared Serbu: One last thing, we’ve been mostly focused on wage inflation here, because I think that probably is one of the biggest drivers for your members. But what are you hearing about other inputs whose prices are being driven up and how much of an effect that’s currently having in the current year?

David Berteau: This started actually, obviously, before the invasion of Ukraine, because under COVID, we had both supply problems from generating material, raw materials and components, but also from delivering them, right, the backlog in the transportation system. Nothing that’s happened in the global economy in the last few years has sped that up. Everybody keeps thinking, well, maybe the end is in sight here, but it hasn’t been. We hear reports across the board from our member companies of delays in in raw materials, delays in components, substitutions for components that may or may not meet the requirements of the contract. Whenever you can get them they’re going to cost more, both for providing them and for delivering them.

Jared Serbu: David Berteau, president of the Professional Services Council, thanks as always for sharing your insights, David.

David Berteau: Appreciate it very much, you’re welcome.

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