DoD study finds big vendors flush with cash, but concerns in the supply chain

After a three year study, the Pentagon has concluded the large contractors who receive most of its prime contracting dollars are in extremely good shape, with financial advantages that purely-commercial companies can only dream of. But few of those advantages are available to vendors at lower levels of the supply chain.

Large prime contractors, for instance, have the benefit of legal provisions like the Prompt Payment Act, which requires the government to pay invoices within 30 days, and progress payments, which allow early payment of up 90% of a contract’s value before work has been completed. But in lower tiers of the Defense supply chain, where, by some estimates, 70% of the work is actually done, companies are much less likely to see the cash flow benefits that come from those policies.

DoD’s office of Defense Pricing and Contracting published the nearly 900-page study on Monday in response to a 2019 Government Accountability Office recommendation that the Pentagon examine how its contract financing mechanisms affect the Defense industrial base. It’s the first time such an exercise has been undertaken since 1985.

The Pentagon hired three universities and a federally-funded research and development corporation to conduct the research that informed its conclusions. Among them: Companies that get most of their business from defense contracts are, as a whole, very financially healthy with plenty of cash flow. And for those firms, the picture has only improved over the past 20 years.

Researchers at the University of Virginia’s Darden School of Business, for instance, found defense companies increased their operating margins from between 7% and 9% in the 2000-2009 timeframe to between 11% and 13% in the decade that followed.

“They are profitable. They generate substantial amounts of cash beyond their needs for operations or capital investment; the bulk is returned to shareholders so they can invest it elsewhere,” UVA’s Darden researchers wrote. “While it is difficult to find direct commercial peers to defense companies, the defense companies in our database in recent years outperformed commercial companies with similar operational profiles. While operating margins in defense are lower, that gap is more than offset by lower asset and investment requirements, so that returns on assets in defense exceed those of the commercial analogs.”

Monday’s report found one key advantage big defense companies hold — compared to firms that sell mainly to private sector customers — is the financing the government provides its biggest vendors via “pre-delivery” progress payments.

Those arrangements are rare in commercial industry, the authors found, but customarily, in the DoD setting, they’ve been allowed to reach as high as 80% of a contract’s agreed-upon value before a final product is delivered. During the COVID pandemic, DoD increased the progress payment ceilings to 90% for large firms.

Monday’s report recommends returning those progress payments to the 80% level for large companies, while also finding new ways to provide financing and speedier payments to companies at lower levels of the supply chain.

“The federal government generally, and DoD specifically, have taken numerous steps to ensure the cash flow of our prime contractors, and these measures go far to make DoD a good customer,” Defense officials wrote. “However, our attempts to push these cash flow benefits to the subcontractor and supplier level appear, for the most part (with the possible exception of construction contracts) neither robust nor effective. The department believes there is more to be done to contribute to the financial health of the subcontractor/supplier component of the Defense Industrial Base.”

But assisting that “supplier component” is a thorny problem, since, by definition, the formal defense acquisition system doesn’t interact directly with companies at lower tiers of the supply chain.

DoD acquisition regulations already include some protections for those subcontractors: in theory, they can complain directly to the government if a prime contractor is late on paying their invoices. But the definition of a “late” payment from prime vendors to subcontractors is 90 days, well beyond the 30 days the government demands of itself to pay those prime contractors.

And even then, subcontractors may not necessarily know they’re working on a government contract — let alone which specific government official to complain to if the prime vendor is late on payments.

“Tracking down the prime contract number and cognizant contracting officer in order to elevate payment concerns would require a level of investigative know-how that many DoD subcontractors may not possess. As a result, the avenue of elevating subcontract non-payment concerns to the prime’s contracting officer should not be considered to be routinely available to subcontractors,” Defense officials wrote.

Even when lower-tier vendors do know that the government is the ultimate customer, their relationships with the prime vendor often dictate that they should never make direct contact with the government contracting officer, according to the report.

The Pentagon did not announce any immediate intent to alter its policies in conjunction with the release of the long-awaited study.

“As the first time the department has comprehensively assessed contract financing in over 35 years, I look forward to acting upon the study’s recommendations to attract new entrants to the defense marketplace at all levels of the supply chain while maintaining the financial health of our existing partners,” Bill LaPlante, the undersecretary of Defense for acquisition and sustainment, said in a statement.

The DoD report recommends that DoD itself continue to “explore” changes, like giving subcontractors more meaningful payment protections and new ways to raise issues to government contracting officers when they’re not paid on time.

Other changes, like extending the Prompt Payment Act’s 30-day terms to subcontractors, would require Congressional action, according to DoD.

In a separate section of the report that attempted to address whether government-unique accounting and business rules were keeping potential vendors out of the defense marketplace, officials concluded it’s mostly an urban legend.

Another sub-study DoD commissioned as part of the report, conducted by George Mason University, found that only 2.2% of the contracts the department awarded over the past two years actually required contractors to use systems that adopt and use the government’s own formal cost accounting standards (CAS).

A larger group of contracts demanded only that vendors systems “comply” with DoD’s accounting guidelines, but even then, the number of contractors affected was just 12% of the companies the department did business with over the past three years.

“The department, however, recognizes that perception can become reality, and lack of knowledge regarding accounting systems could serve as a barrier,” officials wrote. “Accordingly, the department believes the best way to combat this perception is to educate potential new entrants … government-unique requirements may be perceived as a barrier to entry, even if the requirements do not actually apply. Where the requirements do apply, the department acknowledges some companies may find such requirements challenging to implement if the predominance of their accounting systems and procedures are based on commercial applications and business to business transactions.”

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