Report Summary

This report is part of “Defense Outlook: A CSIS Series on Strategy, Budget, Forces, and Acquisition,” a new International Security Program initiative examining the dynamics and interlinkages of strategy, budget, forces, and acquisition on the current and future state of the U.S. Armed Forces.

 
This report, Defense Acquisition Trends 2015: Acquisition in an Era of Budgetary Uncertainty, is the first in an annual series of reports titled “Defense Outlook, a CSIS Series on Strategy, Budgets, Forces, and Acquisition.” It builds upon previous CSIS reports on defense contract trends by identifying and discussing broader policy trends in acquisition and providing close analysis to these trends using information derived from contract data. This year’s report looks in great depth at issues in research and development and the pipeline for major weapon systems, access to innovation, acquisition reform, the use of contract incentives, competition, shifts in industry and industry consolidation, and major trends apparent in the activities of the major defense components.[1] By combining detailed policy and data analysis, this report provides a comprehensive overview of the current and future outlook for defense acquisition.For the past few years, the overriding factors influencing trends in DoD acquisition have been the postwar budget drawdown, defense budget caps, and sequestration and its aftermath. These factors have combined to result in a substantial decline in contracts to industry and a significant decline in contract spending’s share of DoD funding. Figure I shows the impact that the recent budget reductions have had on DoD contracting, comparing total DoD contract obligations to total net DoD obligations[2] for each fiscal year.

Figure 1

Source: Federal Procurement Data System (FPDS); DoD Comptroller Financial Summary Tables; CSIS analysis.

While DoD contract obligations have declined steadily since their peak in 2009, total net DoD obligations were largely steady between 2009 and 2012, before declining precipitously in 2013. As shown by the green line, the share of total net DoD obligations going to contracts has declined notably over that same period, from 53 percent in 2009 to 46 percent in 2014. The exemption of the Personnel accounts from sequestration cuts, as well as rising health care and retirement costs, are major factors in the relative stability of total net DoD obligations, even as contract obligations continued to decline. There is no question that the declining pace of overseas operations, as well as budgetary pressures, have pushed DoD to reduce its contract spend.

The accelerating downward direction of this trend along with the contentious budgetary maneuvering between the Department of Defense and Congress in the period from 2012–2016 has created what we characterize as an era of budget constraints for acquisition that has created significant uncertainty for acquisition. This situation is particularly problematic because major acquisition programs require multi-decade investment decisions and the ability to make long-range budget estimates and projections with at least reasonable fidelity. With the passage of the Bipartisan Budget Agreement of 2015, an inflection point appears to have been reached, and defense acquisition is poised to begin to emerge from this era of budget constraints. Fiscal Year 2015 is likely to be either the bottom of the trough for contract spending or very close to the bottom depending on how quickly funding from the FY2016 budget translates into contract spending. However, it is almost certain that the recovery of acquisition from the defense draw down and sequestration and its aftermath will be slower and lower than the recovery of the defense budget overall. This is because the increased share of defense budgets going to cover personnel, readiness, and other internal DoD costs is unlikely to be significantly reversed in the foreseeable future absent unprecedented efforts by the Department of Defense and Congress to embrace heretofore unpopular reforms.

Our findings on the key issues in defense acquisition in 2015 are organized in four main sections:

What Is DoD Buying?

Birth of the Defense Innovation Initiative—Third Offset Strategy

Concrete details of the previously amorphous Defense Innovation Initiative, first launched in the fall of 2014 and more commonly referred to as the Third Offset Strategy, emerged in the latter part of 2015. Deputy Secretary of Defense Bob Work revealed the first set of insights about where the initiative is heading at the 2015 Reagan Defense Forum. He said that human-machine collaboration and combat teaming were the big ideas emerging from DoD’s three simultaneous efforts over the past year to assess the capabilities required for potential conflicts in the next 5, 10, and 20–30 years. This suggests that the unique military advantage the United States must gain to counter adversaries who increasingly have access to many of the same high-end technologies will come from the integration of this technology with the capabilities of the highly trained personnel of the U.S. military.

The success of the third offset, just as with previous offset strategies, will not be measured simply by the development of new technologies, but by how those technologies solve operational problems. To measure this impact, the following three guideposts bear watching: funding, force structure and doctrinal changes, and responsive investment priorities. If the technologies identified as potential game-changers are to reach the force, they must first be funded. Second, new technologies entering the force must be accompanied by changes to force structures and doctrines that maximize the value of those technologies. Finally, investment priorities should be continuously updated to reflect the changing security and technological environment and the emergence of new operational problems. The success of previous offset strategies was not the result of a singular investment decision, but because of the investment decisions continuously updated to reflect the emergence of new operational challenges.

Access to innovative technology suppliers is critical to the Third Offset Strategy. Early in 2015, Secretary of Defense Ashton Carter announced that DoD would be establishing a new organization located in Silicon Valley, Defense Innovation Unit Experimental (DIU(X)), to help forge new and strengthen existing relationships between the Department and innovative companies such as those in Silicon Valley. DIU(X) is now in operation. Its success will be determined by its ability to establish effective partnerships, similar to the FlexTech Alliance established with several Silicon Valley firms this year, whether DoD succeeds in significantly enhancing its ability to recruit tech-savvy personnel, and ultimately in the ability of the DIU(X) model to replicate in other innovation hubs, domestically and internationally. Also notable will be the extent to which innovation available from traditional defense suppliers is encouraged and leveraged.

DoD’s Seed Corn Has Been Relatively Preserved under Sequestration

Numerous statements by policymakers inside DoD and Congress, as well as outside experts, have expressed concern that under sequestration, DoD would be forced to “eat its seed corn”—that is, DoD would be forced to sacrifice the early stages of research and development (R&D) that lead to major technological advances—in order to preserve R&D contracts related to current, high-priority, later-stage efforts. Figure II shows that early-stage R&D has fallen, but has done well relative to R&D generally.

Figure 2

Source: FPDS; CSIS analysis.

The data show that the share of R&D contract obligations going to basic and applied research (6.1 and 6.2) has risen from 27 percent in 2009 to 38 percent in 2014. This is the result of contracts for those two stages of R&D being relatively preserved—compared to overall DoD R&D contract obligations, which declined by 43 percent between 2009 and 2014, contract obligations for 6.1 and 6.2 combined declined by only 22 percent. While early-stage R&D has fallen back to 2003 levels in constant dollar terms, R&D generally has fallen to 2001 levels.

A Five-Year Trough Has Developed in the Weapon Systems Pipeline

The enormous decline in System Development & Demonstration (6.5) reveals a significant trend: over the last several years, as many R&D programs related to Major Defense Acquisition Programs (MDAPs) have either been canceled or matured into production, DoD has been largely unable to start and sustain new development programs, either due to budgetary pressures or to programmatic difficulties. To a degree, the overall decline in R&D contract does not represent broadly distributed cuts, but instead represents a five-year trough in the pipeline of new major weapons systems.

This problem particularly affects the Army, which, in the wake of the failure of the Future Combat Systems program, has been largely unable to start and sustain new major development programs. By contrast, the Air Force is preparing to begin large-scale development efforts, including for the Long Range Strike Bomber (LRS-B). The Navy, meanwhile, has major development programs in the pipeline, such as the Ohio-class ballistic missile submarine replacement. However, to preserve funding for current priorities, the Navy has been forced to push back the timelines for some of its efforts due to budgetary constraints.

This interruption of the developmental pipeline for new major weapons systems presents an unusual opportunity for DoD, and particularly for the Army. As spending on war materiel continues to be replaced by funding for next-generation priorities, the Army has little to no developmental money already committed to projects. The Army thus has an opportunity to take a step back, draw lessons from the wars in Iraq and Afghanistan, evaluate potential future threats and missions, and direct their requirements and developmental priorities accordingly.

Services Contracts Surprisingly Resilient

A careful analysis of DoD contract obligations by budget account, with detailed examinations of trends in contract obligations funded out of the Procurement, Operations & Maintenance (O&M), and Research, Development, Test, & Evaluation (RDT&E) accounts, reveals that spending on services has been surprisingly resilient as the budget has fallen. In both the Procurement and O&M budget accounts, services declined less than obligations for products and R&D. Contrary to the expectations, and perhaps the intention of both Congress and DoD, spending on research and materiel has proven less compelling than services.

How Is DoD Buying?

Major Acquisition Reform Efforts in 2015 Will Take Time to Deliver Results

In 2015, both DoD and Capitol Hill simultaneously made substantial efforts to reform the defense acquisition system. DoD’s internal effort, Better Buying Power 3.0 (BBP), represented the latest iteration of the Better Buying Power series originally launched in 2010 to improve the efficiency of the defense acquisition system. While largely continuing the initiatives of previous iterations, BBP 3.0’s primary focus was not to find additional efficiencies in the system, but to preserve U.S. technological superiority into the future. As such, new initiatives under the BBP 3.0 guidance largely sought to maintain U.S. technological superiority by leveraging existing R&D investments made by both DoD and in the commercial firms, increasing the use of modular open-system approaches, or improving communication between industry and DoD.

On Capitol Hill, the 2016 National Defense Authorization Act (NDAA) made the most significant changes to the defense acquisition system since those made in the Federal Acquisition Streamlining Act of 1994. In fact, the provisions adopted in 2015 are simply the beginning of Congress’s efforts to improve efficiency within DoD as both Armed Services Committee chairmen have indicated their intention to continue the effort in 2016. Key in the 2016 NDAA was the effort to consolidate authority, and therefore accountability, for acquisition in the military services. Along with this significant change, the 2016 NDAA also creates or expands several mechanisms intended to accelerate acquisition programs in the hopes of replicating acquisition successes such as the fielding of Mine-Resistant Ambush Protected vehicles (MRAPs) and developing and fielding rapidly emerging capabilities. Also notable were a range of provisions adopted to streamline documentation and approvals, increase access to commercial and non-developmental technologies, and improve the acquisition workforce.

CSIS research, especially a recent report for the Naval Postgraduate School titled “Measuring the Outcomes of Acquisition Reform by Major DoD Components,” suggests that significant patience will be required to assess the success of the efforts. Changes in acquisition policy take years to begin to show effects, the complexity of the acquisition system makes it challenging to identify and implement policy changes that deliver clear outcomes, and it is even harder to identify policy changes that significantly alter the performance of the acquisition system. This evidence lends real credibility to the argument that there are no simple answers or silver bullets in the effort to improve performance of the acquisition system.

DoD Starting to Focus on Contract Incentives, Rather Than Contract Type

Recent research has led the Department of Defense to place more emphasis on contract incentive structures rather than solely on contract type. Throughout the drawdown there has been a notable rise in fixed-price incentive contracts while other types of fixed-price contracts declined. The same is not true, however, for cost-plus incentive fee contracts. In fact, cost-plus fixed fee contracts grew during the drawdown while other cost-based contracts declined. Disfavored incentive types such as award fee, however, have declined significantly. In September 2014, Better Buying Power 3.0 emphasized the use of contracts with objective incentive structures. FY2015 may see further increase in both types of incentive contracts and a reversal of the growth in cost-plus fixed fee contracts.

Effective Competition Rates Are Steady, Despite Desire to Promote Competition

Despite intense policy focus within DoD and from Congress on increasing competition for defense contracts, the rate of effective competition (that is, competed contracts receiving at least two offers) has been largely unchanged in recent years, with similar stability in the rates of competition for products, services, and R&D DoD-wide. It thus appears that, at a macro level, DoD’s policy initiatives have been unable to move the needle on competition. Within the contracting portfolios of the major DoD components, however, there have been some notable shifts, but not all of them have been positive. As CSIS discussed in a report released in October, there has been a notable decline in the rate of effective competition within the Air Force’s services contracting portfolio.[3] See the Air Force section in Chapter 5 for a brief summary of the scope of that decline.

Competition rates within particular states and at the Major Contracting Commands can be used to assess the health of the industrial base as demonstrated in CSIS’s recent report for the Naval Postgraduate School, titled “Competition and Bidding Data as an Indicator of the Health of the U.S. Defense Industrial Base.”

Contract Outcomes Can Be Examined Using Contract Data

Recent CSIS work—see our report for the Naval Postgraduate School entitled “Avoiding Terminations, Single-Offer Competition, and Costly Changes with Fixed-Price Contracts”—demonstrates that that there is increased risk of termination and cost ceiling increases in fixed-price contracts. The study team has overcome a notable limitation of FPDS, namely the difficulty of deriving any data on contract outcomes. By measuring the frequency and magnitude of contract cost ceiling breaches and terminations, this research demonstrates that risk in the acquisition system is asymmetric. Although the vast majority of contracts are relatively small and short, the vast majority of ceiling breaches and terminations occur on contracts that are either large, long, or both. These factors serve as indicators for complexity. The data demonstrate that the system handles non-complex acquisition contracts with relative ease, and that the problems of concern to policymakers are in fact almost exclusively a feature of more complex acquisitions. That said, there is still greater risk inherent in fixed-price contracts when they experience trouble, as the rate of termination for those contract types is consistently twice that of cost-based contracts. Based on these findings, any attempts to rebuild the system from the ground up may be misdirected, as problems are focused where challenges are greatest, rather than endemic throughout the system. The current policy of offering greater flexibility below certain dollar thresholds and focusing management attention instead on larger contracts are justified not just because, as Willie Sutton said, “that’s where the money is,” but also because this is where the actual problems lie.

Whom Is DoD Buying From?

Small Vendors Accounted for Their Largest-Ever Share of Defense Contracts in 2014

Figure 3

Source: FPDS; CSIS analysis.

While the composition of the defense industrial base, measured by size of vendor, has been remarkably stable in recent years, there was a notable shift in 2014. The share of defense contract obligations to small vendors rose from 16 percent in 2013 to 19 percent in 2014, the highest share in the period observed. This rise is not simply the result of obligations to small vendors declining more slowly than for other size categories—as overall defense contract obligations declined by 9 percent in 2014, obligations to small businesses rose by 11 percent. Within the Army, the share of contract obligations to small vendors increased from 21 percent to 26 percent, the highest share for any of the three military services between 2000 and 2014, while the Navy and Air Force saw smaller increases.

This increase in share was primarily concentrated in services and electronics & communications (E&C) products; for the latter, small vendors now account for the largest share of contract obligations. This is particularly notable, because the small vendors within the E&C industrial base likely include many of the sorts of small, high-tech, potentially innovative firms that DoD has made a concerted effort to bring into, and keep in, the defense market. While, in real dollar terms, obligations have not increased for small vendors in the defense E&C market in recent years, the fact that small vendors have managed to maintain their level of obligations in an extremely tough market can be seen as a success.

The Big 5 Defense Vendors Are Winning a Declining Share of R&D Contract Obligations

The Big 5 defense vendors (Lockheed Martin, Boeing, Northrop Grumman, Raytheon, and General Dynamics) have consistently accounted for the largest share of defense R&D contract obligations. However, that share has declined significantly in recent years, from 63 percent in 2006 to 41 percent in 2014, the lowest share in the 2000–2014 period. As discussed in the analysis of R&D contracting trends, this decline is largely attributable to many large development programs either being canceled or maturing into production in recent years, as well as the dearth of new major development programs being started and sustained over that same period. Since the Big 5 disproportionately performs development for major weapons systems, this interruption of the development pipeline in recent years has impacted them the hardest.

With the Air Force recently issuing, or about to issue, large development contracts for major weapons systems such as the LRS-B, this trend within the Air Force should reverse in the next few years. The Navy will likely see a similar reversal once development work ramps up on programs like the Ohio-class replacement, but on a longer timeline due to many of those programs being pushed back during the current budget drawdown. For the Army, however, it is uncertain when this trend will begin to reverse, as the service does not currently have nearly as many large development programs for major weapons systems ready to begin over the next several years.

The Present and Future of Defense Industry Consolidation

Over the last year, there have been significant mergers and acquisitions (M&As) among the notable prime defense vendors. The purchase of Excelis by Harris Corporation, the merger of ATK and Orbital Sciences Corporation, the merger of CSCGov and SRA International, and the sale of United Technologies’ Sikorsky business unit to Lockheed Martin all reduce the number of potential competitors in major sectors of the defense contracting portfolio. Though the current budget drawdown has not seen a wave of consolidation at the prime contractor level comparable to the post–Cold War “Last Supper,” this M&A activity (particularly the Lockheed Martin acquisition of Sikorsky) has prompted statements of concern from Under Secretary of Defense for Acquisition, Technology, and Logistics (USD (AT&L)) Frank Kendall.

This is in contrast to the preceding several years, where the trend had been one of spinoffs and divestitures, as major defense vendors attempted to refocus on their core business areas or get out of less promising/profitable business areas. The spinoff of Northrop Grumman’s shipbuilding business into Huntington Ingalls Industries, the spinoff of ITT’s defense business as Excelis, the spinoff of Computer Sciences Corporation’s government services business, and the spinoff of Engility as L3 Communications have all changed the structure of the defense industrial base, particularly for services, but have not acted to lower the number of competitors in their respective markets. Media reports have noted that other major defense vendors, including Lockheed Martin and BAE Systems, either intend to sell or spin off major business units, or are seriously exploring the possibility of doing so. Notably, most of these major spinoffs have been in the government services sector, particularly for information technology services, which could indicate significant pessimism within the defense industry for the future growth and profitability of that sector of the defense contracting market.

DoD Starts with a Narrow But Sustained Base for Outreach to Silicon Valley

DoD generally and each of its major acquisition components already do a relatively small, but by no means insignificant, amount of contracting in Silicon Valley. The current base of activity is characterized by a solid base of a few firms such as Hewlett Packard and Lockheed Martin that consistently work with DoD joined from year to year by a frequently changing mix of smaller companies. The relative stability at the top of this list and the relative churn below the top suggest that smaller suppliers in Silicon Valley are stymied not just by barriers to entry, but by barriers to remaining involved in defense acquisition. To the extent that DoD’s policy initiatives can help sustain the participation of smaller Silicon Valley firms in defense, real progress appears possible. Secretary Carter’s plan for more cooperation between the big and smaller firms focuses on three steps. The first step, focusing on reforming the hiring process to make DoD more competitive, is crucial to any effort of incorporating Silicon Valley experts into the Department. Additionally, DoD must continue to make significant improvements to intellectual property efforts, as this is one of, if not the, main concern for persons considering working with the government. Lastly, similar to how it is in Washington, Silicon Valley highly values interpersonal relationships and networking with peers. Secretary Carter has made significant efforts to meet with the heads of many Valley companies in order to strengthen interpersonal relationships. Maintaining and building on these current efforts to strengthen relationships between DoD and Silicon Valley should be considered for the baseline during the new administration.

What Are the Defense Components Buying?

Service Acquisition Portfolios Are Shifting In Distinct Ways

Because most contracting decisions are made within contracting elements of the major DoD components, it is important to examine trends within the major DoD components engaged in acquisition: Army, Navy, Air Force, Defense Logistics Agency (DLA), Missile Defense Agency (MDA), and “Other DoD,” which aggregates all other DoD contracting entities. Figure IV shows DoD contract obligations, broken down by the components responsible for the contract.

Figure 4

Source: FPDS; CSIS analysis.

The decline in Army contract obligations since 2009 (-52 percent) has significantly outpaced the decline in overall DoD contract obligations, reflecting the ramping down from the wartime buildup. The Navy (-19 percent), Air Force (-24 percent), and DLA (-22 percent) all declined more slowly than overall DoD. Meanwhile, contract obligations within MDA (-1 percent) and “Other DoD” (1 percent) were nearly steady, though MDA saw significant volatility within the 2009–2014 period.

Army

Army contract obligations in 2014 were at their lowest level since 2002, the result of several factors, including: the ramping down of overseas combat operations; the overall budget drawdown and fiscal uncertainty facing DoD; and the Army’s recent inability to start and sustain major development and procurement programs meant to replace aging and worn-down platforms. Army obligations for products and R&D have declined significantly more steeply than Army contract obligations for services since 2009; and particularly in 2013, the first year in which the impact of sequestration could be observed. In 2014, however, products and services declined at roughly the same rate, while Army R&D contract obligations declined at half the rate of overall Army. Nonetheless, Army R&D contract obligations in 2014 were at their lowest level in the 2000–2014 period.

Navy

Navy contract obligations have fluctuated up and down in recent years, largely based on the timing of contracts for large programs such as the Joint Strike Fighter (JSF) and the DDG-51 destroyer. By 2014, overall Navy contract obligations were 19 percent below 2008 levels, at $84 billion, the lowest level since 2005. Navy contract obligations were virtually steady in 2013, despite the impact of sequestration, but in 2014 obligations declined roughly in parallel with the overall decline in DoD contract obligations. Navy R&D contract obligations have declined by nearly half since 2007, largely as the result of major developmental programs like the JSF maturing into production, but also due to a 77 percent decline in Navy contract obligations for basic research.

Air Force

Air Force contract obligations fluctuated near $70 billion from 2008–2012, before declining significantly in 2013 to $56 billion. In 2014, however, Air Force contract obligations were virtually stable. Air Force contract obligations have been exceeded by the combined total of DLA, MDA, and “Other DoD” in every year since 2008. The declining pace of overseas combat operations has not altered that trend—contract obligations from outside the three military services exceeded Air Force levels by over $15 billion in 2013 (the largest difference was in the 2008–2014 period) and the gap in 2014 was only slightly lower.[4] Air Force contract obligations for products and R&D have declined sharply since 2009, while obligations for services were relatively preserved.

Andrew Hunter is a senior fellow in the International Security Program and director of the Defense-Industrial Initiatives Group at CSIS.

Download the full report


FOOTNOTES

[1] See Appendix A, Methodology, for a detailed description of how this analysis is performed.[2] Total Net DoD Obligations is a new category, created by CSIS for this analysis, that attempts to provide an apples-to-apples comparison of contract obligations to overall obligations. See Appendix A.2.1 for a detailed description of how CSIS generated this categorization.

[3] Jesse Ellman, “Air Force Faces Puzzling Decline in Competition for Services,” Center for Strategic and International Studies, October 2015, http://csis.org/files/publication/150925_Ellman_AirForceFacesPuzzlingDecline.pdf.

[4] Classified contracts, which are disproportionately administered by the Air Force, are not required to be reported into FPDS, which CSIS takes to mean that most are not. This artificially deflates Air Force contracting totals, though that is consistent across the 2000–2014 period, so trend analysis is still possible.