Defense Chief Gates Seeks to Tie U.S. Contractors' Profit to Cost Controls

Defense contractors can increase profits if they reduce costs on major weapons programs such as the Lockheed Martin Corp. F-35 fighter under an initiative unveiled today by Defense Secretary Robert Gates.

The program calls for the Pentagon to potentially raise payments for meeting contractual targets, increase the use of fixed-priced contracts that award more profit if programs come in under budget and reward contractors for reducing supplier costs.

“Higher performance should naturally lead to higher reward,” Gates said at Pentagon news briefing.

Gates is determined to reduce the growth in U.S. defense spending. His stated goal is to save as much as $100 billion through 2015 by wringing out inefficiencies and overhead in the defense industry and the Pentagon itself.

These savings would be spent on weapons and personnel accounts with the intent to increase them annually by as much as three percent above inflation even as the overall defense budget is projected to grow only 1 percent annually.

“Given the fiscal challenges facing the nation the Department of Defense must make every dollar count,” Gates said.

“We have not seen the productivity growth in the defense economy that we have seen and expect from the rest of the economy,” he said. “When it comes to the defense sector, the taxpayer has had to spend significantly more in order to get more.”

‘More Without More’

Ashton Carter, the Pentagon’s top weapons buyer, discussed the new initiative in an interview with Bloomberg Television ahead of today’s briefing.

“With the right incentives, profitability and productivity can go together,” he said. “If you squeeze unnecessary costs, we get a better price, they get a better profit.”

Gates in April 2009 cut or truncated at least 20 programs, including the Lockheed F-22 fighter and Boeing Co.’s Future Combat Systems.

“There will undoubtedly be more program terminations, but the focus here is on the things that we need and what I call ‘do more without more,’” Carter said.

The budget is “not going to be increasing” at the rates of the last 10 years, he said. “So that’s a different climate. We need to learn to live within our means.”

The Pentagon also is targeting savings from the $200 billion it spends annually buying services, Carter said at today’s news conference.

The way the U.S. military buys services is “even worse” than how it buys weapons, he said.

Cutting Budget Growth

The proposed budget for fiscal 2011 is $549 billion. That’s an increase of about 1.8 percent over fiscal 2010, which was 2.1 percent higher than fiscal 2009.

In the previous eight years -- starting after the Sept. 11 attacks -- the defense budget grew an average of 4 percent annually, not counting spending on the wars in Afghanistan and Iraq.

“We are coming off an era of rapid budget growth which would suggest that ‘fat’ has been allowed to creep in that we should be able to find,” Carter said.

Carter said Pentagon officials will review guidelines used to set profit on fixed-price “incentive” contracts that allow contractors to share in savings for programs that come in below budget.

“We are going to review the guidelines -- not with the objective of reducing profit but aligning profitability to our objectives,” he said. “If the program overruns, they have pain. If the program under-runs, they have gain,” Carter said.

Negotiating on F-35

Carter said the Pentagon is negotiating with Lockheed on monetary incentives that would persuade the company to keep the average cost of a F-35 fighter closer to its original estimate in fiscal 2002 of $50 million apiece. The current estimate is $92 million, an increase of 84 percent.

Gates has included money in future budgets for the higher price, but “he doesn’t want to pay” it, Carter said.

Gates wants Lockheed to meet its original projection, and “I am working with Lockheed to identify ways” to do that, he said. “Those negotiations are going on.”

Carter said the Pentagon, in approving and monitoring weapons programs, also is putting new emphasis on affordability.

He cited as an example the Navy’s new nuclear-missile submarine, which is still being designed and already looms as one of the most costly weapons programs. The cost per ship isn’t set but it ranges as high as $8.2 billion, according to the non- partisan Congressional Budget Office.

Pentagon and Navy officials have reviewed the design and think they can cut the program’s cost by at least 16 percent; they’ve set a goal of 27 percent, he said.

“It’s not a case of let’s design the submarine and pay whatever it costs. We are starting the other way around,” Carter said.

To contact the reporters on this story: Tony Capaccio in Washington at acapaccio@bloomberg.net Peter Cook in Washington at pcook6@bloomberg.net.

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