Contract Financing: DOD Should Comprehensively Assess How Its Policies Affect the Defense Industry

Each year, DOD provides contractors with billions of dollars in contract financing on fixed-price contracts for major weapons systems and other long-term efforts. Contract financing helps contractors manage expenses until they begin delivering the contracted items to DOD. Contract financing can take several forms, including

progress payments based on the cost incurred by the contractor, and

performance-based payments, in which the government pays the contractor an agreed-to amount for achieving certain milestones.

DOD last performed a comprehensive assessment of its contract financing polices in 1985.

The Conference Report accompanying the Fiscal Year 2019 National Defense and Auhorization Act included a provision for GAO to analyze the level of financing currently provided to contractors, among other things. This report (1) describes changes in DOD contract financing policy since 1985 and (2) assesses the extent to which DOD has analyzed the effect of its contract financing policies on the defense industry. GAO assessed relevant legislation and DOD regulations; obtained data on DOD's use of progress and performance-based payments from fiscal years 2010 through 2018; and interviewed cognizant DOD and industry officials.

Congress and the Department of Defense (DOD) have changed the contract financing legislative and regulatory framework since DOD last performed a comprehensive assessment, including eliminating a requirement that contracting officers justify a need for contract financing and establishing a preference for performance-based payments. However, Defense Contract Management Agency data indicates that the amount of performance-based payments it administered fell from 2010 to 2016 (see figure).

DOD officials acknowledged that DOD has not comprehensively analyzed how its policies affect the defense industry since 1985. Industry and economic conditions, however, have since changed, including lower interest rates and the emergence of contractors who do not typically work with DOD. In August 2018, DOD proposed introducing performance-based elements into its process for setting progress payment rates. DOD officials stated that since the proposed rule focused on incentivizing contractors' performance, they did not assess how it would affect defense contractor profitability or whether other financing or profit policies changes would be needed. DOD withdrew the proposed rule in October 2018. GAO's Standards for Internal Control in the Federal Government call for organizations to monitor the effectiveness of their policies on a recurring basis. In December 2018, DOD officials acknowledged the need to do so. Until DOD conducts a comprehensive assessment and ensures they are done on a recurring basis, it will not be in a position to understand whether current or future contract financing policies are achieving their intended objectives.

GAO recommends that DOD ensure it conducts a comprehensive assessment of the effect that its contract financing and profit policies have on the defense industry and update that assessment on a recurring basis. DOD concurred with the recommendation.

Contract financing provides contractors with billions of dollars in financing  payments on contracts for major weapon systems and other products that  may take years to produce. In the absence of such payments, contractors  would need to borrow funds from commercial sources or use their own  funds to pay for the costs to produce these systems. As early as the  1950s, the Department of Defense (DOD) recognized benefits in  providing contract financing. Contract financing can take several forms,  including progress payments based on the cost incurred by the contractor and performance-based payments, in which the government pays the  contractor an agreed-to amount for achieving certain contractual  milestones.

DOD last performed a comprehensive assessment of its contract  financing polices in 1985. This study, called the Defense Financial and  Investment Review (DFAIR), assessed DOD’s contract pricing, financing,  and profit policies in effect at that time. The review assessed the impact  of contract financing on the cost of weapon systems and the health and  profitability of the defense industry, among other things. More recently,  several defense industry associations expressed concerns about DOD’s  current contract financing policies including the impact these policies had  on the defense industry. DOD has stated that a healthy defense industrial  base supports economic prosperity and global competitiveness, and arms  the military with capabilities to defend the nation.

The Conference Report accompanying the John S. McCain National  Defense Authorization Act for Fiscal Year 2019 contained a provision for  GAO to analyze the level of financing currently provided to contractors  among other things. This report (1) describes the changes in DOD  contract financing policy since 1985 and (2) assesses the extent to which  DOD has analyzed the effect of current contract financing policies on the  defense industry.

To describe the changes in DOD contract financing policy since 1985, we  reviewed relevant changes to legislation, the Federal Acquisition  Regulation (FAR), the Defense Federal Acquisition Regulations  Supplement (DFARS), and DOD guidance governing contract financing.  We assessed DOD contract financing policies to determine the rationale  behind these changes. We also interviewed officials from the Defense  Contract Management Agency (DCMA), Under Secretary of Defense  (Comptroller), and Defense Finance and Accounting Service (DFAS). We  analyzed progress and performance-based payment data provided by  DCMA from DOD’s Mechanization of Contract Administration Services  (MOCAS), the system of record for processing contract financing  payments for DCMA administered contracts. We used these data to  determine how much DOD made in contract financing payments between  fiscal years 2010 and 2018, the types of contractors that received these  payments, and how the mix of performance-based and progress  payments changed as policies changed. We adjusted the numbers for  inflation, using the fiscal year 2018 Gross Domestic Product Price Index.  We determined these data to be reliable for purposes of our objectives by  interviewing DCMA officials who maintain the MOCAS system and  reviewing documentation provided by DCMA.

To assess the extent to which DOD has analyzed the effect of its contract  financing policies on the defense industry, we assessed prior and current  DOD studies on contract financing. Specifically, we assessed DOD’s  1985 DFAIR study, studies prepared by the Institute for Defense  Analyses and RAND, and DOD regulations and supplementary  information related to DOD contract financing policies. We also  interviewed representatives within the Office of Defense Pricing and  Contracting (DPC) about the department’s approach to assessing the  effect of contract financing policy on contractor profitability and  operations. We also obtained views on DOD’s current contract financing  policy from industry groups including associations that publicly  commented on DOD’s August 2018 proposed rule on contract financing.  These groups included the Aerospace Industries Association, National  Defense Industrial Association, and the Professional Services Council.  We also met with Financial Executives International. We also reviewed  our prior work on contract financing, profit, and profitability. Specifically,  we assessed DOD’s studies and policies against our Standards for  Internal Controls in the Federal Government to determine the extent to  which DOD was conducting ongoing monitoring and assessments of its  contract financing policies.

We conducted this performance audit from August 2018 to June 2019 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

DOD has long recognized that the contracts for items like weapon  systems are capital intensive in nature and take a long time to produce.  Contract financing assists the defense contractor in managing expenses,  such as material, labor, and overhead. In such cases, DOD can agree to  help finance these expenses as the work progresses through various  types of contract financing payments, including progress payments and  performance-based payments.

Progress payments based on cost are determined as a percentage  of the costs incurred by the contractor as work progresses. Currently,  DOD pays 80 percent of incurred costs of large business concerns  and 90 percent of incurred costs of small business concerns. To  receive progress payments on the basis of cost, contractors are  required to have an accounting system and controls that are adequate  for proper administration of progress payments. The cognizant  contract administration office is to maintain surveillance of the  contractor’s accounting system as appropriate, and the Defense  Contract Audit Agency is to audit the accounting system. DOD  provides contract financing on fixed-price type contracts for non- commercial items.

Performance-based payments enable the contractor to be paid for  achieving certain contractual milestones, such as delivery of a major  subcontracted component. DOD can pay up to 90 percent of either  the contract’s price or the price of a deliverable item using  performance-based payments. DOD’s performance-based payments  guide states that these payments should not be structured such that  they amount to advance payments, which in general terms are  payments made before work is complete on a contract regardless of  what performance milestones are met. Unlike progress payments,  however, performance-based payments do not require that the  contractor have an adequate accounting system.

Lastly, contract financing can also be used when the terms and conditions  of a contract are not yet “definitized,” a term that generally means  finalized. These actions, which are termed undefinitized contract actions  (UCAs) at DOD, are to be used only when the negotiation of a definitive  contract action is not possible in sufficient time to meet DOD’s  requirements and the department’s interest demands that the contractor  be given a binding commitment so that contract performance can begin  immediately. The government may incur unnecessary costs if  requirements change before the contract is definitized. Defense  acquisition regulations generally require UCAs to be definitized within 180  days of the UCA date or before more than 50 percent of the estimated  contract price is obligated, whichever occurs first. During this period,  progress payments are limited to 80 percent of work accomplished.  DOD’s 2014 performance-based payments guide recommends that a  UCA be awarded using progress payments first; performance-based  payments should then be considered during the definitization process.

Table 1 summarizes the conditions and rates applicable to progress  payments based on costs and performance-based payments.

Several offices and agencies within DOD have a role in managing  contract financing.

The office of DPC, within DOD’s Office of the Under Secretary of  Defense for Acquisition and Sustainment, is responsible for all pricing,  contracting, and procurement policy matters. This office formulates  and oversees DOD-wide pricing policies and strategies supporting the  procurement of major defense programs, including programs that use  progress and performance-based payments.

DCMA and other contract administration offices monitor contractors’  performance and management systems to ensure that cost, product,  and performance are in compliance with the contract terms. DCMA  generally maintains contract financing payment data for DOD  progress and performance-based payments for contracts DCMA  administers. Within DCMA, the Cost and Pricing Center supports  DOD-wide analysis of contract data to support DOD-wide decision  making, among other things.

Relationship of Contract Financing to Contract Profit and Contractor Profitability

Contract financing has an impact on the price of negotiated contracts and,  more generally, on the health and profitability of the defense contractor.  On negotiated contracts, DOD requires contracting officers to use  weighted guidelines, a structured approach used to develop profit  objectives for individual defense contracts. DOD implements its profit  policy through the weighted guidelines. As part of their efforts to  determine the government’s negotiating position, including how much  profit the contractor should receive under the contract, contracting officers  are to consider various factors, including the degree to which the  government is providing contract financing. Assuming other factors are  held constant, the weighted guidelines suggest that the negotiated profit  rate of a fixed-price defense contract might be 1 to 2 percentage points  lower when the government provides contract financing. The contracting  officer may vary the amount to consider other risk elements when  establishing the government’s negotiating position.

DOD-provided contract financing can also provide contractors higher  rates of return on the amount of corporate funds contractors invest on that  same contract. One measure of this benefit is “internal rate of return”  (IRR), a tool that can be used to assess the impact of contract financing  on overall contractor profitability. DOD’s 2001 Incentives Guidebook  notes that IRR is one of the basic tools used by industry to determine  where to invest its funds and assess the risks and potential rewards  involved in contracting with the government or commercial entities. IRR  is a measure that integrates both the contractor’s investment to produce  the product and the profit earned on that product. In contrast to contracts  in which the contractors must either self-finance or borrow from  commercial lenders, when contractors receive financing on a contract  from the government the contractor’s IRR can be significantly higher.  Figure 1 provides a hypothetical example of how changes in the progress  payment rate on a 40-month, fixed-priced contract affects the expected  contract profit rate and the contractor’s IRR.

As illustrated above, providing contract financing (in this case, progress  payments) has a significant impact on the contractor’s IRR and a lesser  impact on the actual profit that DOD expects the contractor to make. For  example, if DOD provided no contract financing, the weighted guidelines  would suggest a profit rate on this hypothetical contract of 13.8 percent,  which would provide an internal rate of return to the contractor of 7.5  percent. If DOD provided progress payments at the customary rate of 80  percent, the weighted guidelines would suggest a profit rate on this  hypothetical contract of 10.4 percent, or 3.4 percentage points lower than  if no financing was provided. However, even though the contractor’s  expected profit is lower, the IRR for the contract would increase to 30.9  percent, or a little more than four times what would be realized if the  contractor had to finance the effort on its own.

Prior Studies of Contract Financing and Contract Profitability

Several studies conducted by DOD, nonprofit organizations and GAO  have assessed the impact of contract financing on contract profit or  contractor profitability. These studies have generally found that,  depending on the measure used, the defense industry generates high  returns on investment. For example,  In 1976, DOD’s Profit ‘76 study examined earnings’ relationship to  capital investment and increased productivity. The Profit ‘76 study  group concluded that government contractors were able to maintain  higher profits by keeping investment low partly because DOD did not  have profit policies in place to encourage investment in items such as  facilities. As a result of the Profit ‘76 study, DOD made a number of  changes to its profit policy to encourage corporate investment in  facilities, among other things.

In 1991, GAO suggested that using return on assets to measure  profitability of defense contractors is beneficial because it recognizes  how government financing can affect contractors’ levels of  profitability.

In 2008, the Institute for Defense Analyses reported that defense  contractors generated high returns with low operating margins, in part  because government-provided contract financing helped fund the  contractors’ long, asset-intensive product cycles.

According to DPC officials, however, the most comprehensive study of  contract financing and profit policies was conducted by the DFAIR  commission in 1985. We discuss this study in more detail below.

Changes to the Legislative and Regulatory Framework Governing Contract Financing since 1985

Since the DFAIR commission issued its report in 1985, Congress and  DOD have made a number of changes to the statutory and regulatory  framework intended to (1) reduce the administrative burden associated  with contract financing and (2) encourage the use of performance-based  payments (see figure 2). Our review found that DOD paid less in  performance-based payments after making some changes to contract  financing policies, but started increasing these payments again in 2016.

DFAIR Commission’s 1985 Study Considered to Be the Last Comprehensive Study of DOD’s Contract Financing and Profit Policies

According to DPC officials, the most comprehensive study of contract  financing and profit policies was conducted by the DFAIR commission in  1985. The DFAIR commission assessed, among other issues, whether DOD contract financing policies were equitable in maintaining  the defense industrial base and cost-effective for DOD,  the effectiveness of DOD contract financing policies as a means of  encouraging contractor cost efficiencies,  the profitability of defense work and its reasonableness in comparison  with the profitability of the non-defense sector, and  the interrelationship of DOD’s contract finance and profit policies.

In evaluating contractor financing costs, DFAIR developed a model of a  typical contract to use in calculating contractors’ contract financing costs,  the amount of interest a contractor would have to pay if it were required to  bear all those costs, and the effect of payment delays on contractor  financing costs.

The DFAIR commission reached a number of conclusions about DOD’s  contract financing and profit policy in effect at that time. The study  concluded that:

The progress payment rate was appropriate for the time period  studied but should be revised based on changes in short-term interest  rates.

DOD’s profit policy as reflected in the weighted guidelines at the time  of the study did not explicitly take into account the cost of working  capital (the difference between a contractor’s assets and liabilities).

The profitability of individual defense contracts the commission  reviewed had been consistently lower than the profit levels reported to  have been negotiated by government contracting officers.

DOD’s profit policy needed to be simplified and better integrated with  contract financing policy.

The study also concluded that there was a need to make DOD contract  financing more responsive to economic conditions and that profit policy,  contract financing, and contractor investment are related. We agreed with  the conclusion that profit policy, contract financing, and contractor  investment are related. We also highlighted the need for recurring DOD  contract profitability studies using a generally accepted methodology in  our 1986 report.

DOD Efforts to Reduce the Administrative Costs

Our work found that since the DFAIR study was issued, DOD made  several changes to reduce the administrative burden associated with  contract financing requirements. These changes included

Elimination of flexible progress payments (1999) – DOD  introduced flexible progress payments in 1981 as a new approach to  contract financing. Under flexible progress payments, DOD  contracting officers were to use the DOD Cash Flow Computer Model  to develop an applicable progress payment rate for that contract.  Under this approach, DOD specified the minimum percentage the  contractor was required to invest and DOD would provide the  remainder. The amount of contractor investment required by DOD  varied from 5 to 25 percent, depending upon the year. Flexible  progress payments were not allowed on contracts issued after  November 11, 1993; the references were eliminated completely from  the DFARS in 1999.

Elimination of “paid cost rule” (2000) – The paid cost rule required  large businesses to pay subcontractors before billing the government  for payment. After DOD eliminated this rule in March 2000, large  businesses were generally able to include subcontract costs incurred  but not yet actually paid on progress payment requests to the  government.

Elimination of “financial need requirement” (2016) – Since 2000,  one of the ways contractors could receive progress or performance- based payments under the FAR was on the basis of financial need or  the unavailability of private financing. In that regard, an April 2013  DOD Inspector General report found that contracting personnel did  not properly negotiate and verify contractors’ need for contract  financing before authorizing performance-based payments. The  Inspector General recommended that contracting personnel  determine whether private financing is available to a contractor before  authorizing performance-based payments. While DOD concurred with  the recommendation, it subsequently amended the DFARS in 2016 to  eliminate the requirement for DOD personnel to justify the use of  contract financing for certain fixed-price contracts. In doing so, DOD  stated it was in DOD’s best interests.

Efforts to Encourage the Use of Performance- Based Payments

Congress enacted the Federal Acquisition Streamlining Act (FASA) in  1994 to provide the executive branch with requirements to improve the  process for acquiring goods and services. FASA, among other things,  established performance-based payments “wherever practicable” as a  form of contract financing. In 1995, the FAR Council amended the FAR  to enable the use of performance-based payments up to a maximum  amount of 90 percent of the contract’s price. In 2000, DOD issued a rule  amending the DFARS to emphasize that performance-based payments  were the preferred method of financing. The rule required contracting  officers to consider and deem performance-based payments  impracticable before deciding to provide progress payments. This rule  was part of a larger effort by DOD to make contract financing procedures  easier to understand and to simplify related provisions. DOD  subsequently issued a user’s guide in 2001 to help its contracting  personnel and contractors in using performance-based payments.

Despite the provisions to encourage the use of performance-based  payments when appropriate, DOD subsequently initiated department- specific actions that, according to industry officials, decreased the  frequency with which they received performance-based payments on  defense contracts. For example, the Under Secretary of Defense for  Acquisition, Technology and Logistics’ September 2010 Better Buying  Power memorandum instructed contracting officers to use progress  payments as the basis for price negotiations. After the contractor and  DOD contracting officer agreed on price using progress payments,  contractors could propose using an alternate financing arrangement,  including performance-based payments. The memorandum indicated  that the rationale for this change was to provide increased incentives for  contractor performance. In April 2011, the Director of Defense  Procurement and Acquisition Policy (now known as DPC) issued a  memorandum that focused on the “practicality” of performance-based  payments, stating they “are not practical for use on all fixed-price  contracts and require considerable effort between the contractor and  Government.” The memorandum noted that if contractors wanted to use  performance-based payments, then the contractor should submit a  proposed schedule to include all performance-based payment events,  completion criteria, and event values, along with the contractor’s  expected expenditure profile.

To implement its April 2011 performance-based payment policy, DOD  issued a proposed rule to amend the DFARS in January 2012. This rule  was finalized in March 2014. The 2014 version of the DOD  performance-based payments user’s guide noted that performance-based  payments are the preferred method only when they are deemed practical  by the contracting officer. However, industry officials told us that they  frequently cannot reach agreement with DOD regarding performance  milestones, and therefore agree to the use of progress payments instead.

The impact of DOD’s changes on the relative use of progress versus  performance-based payments is uncertain. Between fiscal years 2010  and 2018, DCMA data indicates that DOD provided between $36 billion  and $49 billion a year in contract financing on contracts DCMA  administered. We found that nearly 98 percent of those contract financing  payments were paid to medium and large defense contractors. We also  found that the amount DOD paid out in performance-based payments on  those contracts fell between 2010 and 2016 before increasing in 2017. In  December 2016, Congress enacted Section 831 of the Fiscal Year 2017  NDAA to establish performance-based payments as the preferred type of  contract financing for DOD in statute. Section 831 also directed the  Secretary of Defense to ensure that nontraditional defense contractors  and other private sector companies are eligible for performance-based payments, in line with best commercial practices. Figure 3 shows the  differences in DOD’s progress and performance-based payments  between fiscal years 2010 and 2018 for contracts administered by DCMA.

In August 2018, DOD introduced a proposed rule that was intended to  use contract financing rates to help incentivize contractor performance  and to implement Section 831. The proposed rule would have set a base  progress payment rate for large businesses (specifically, for other than  small businesses) at 50 percent and small businesses at 90 percent. At  the same time, however, the proposed rule provided opportunities to  increase the rate if the contractor achieved certain enterprise-wide  priorities such as meeting contract delivery dates. The proposed rule also  eliminated some of the administrative requirements associated with  performance-based payments to encourage their use. According to DPC  officials, the rates would be subject to an annual adjustment based on the  performance criteria provided in the rule. Table 2 summarizes key  aspects of the proposed rule.

DOD officials acknowledged that if implemented, contractors would  initially receive a lower level of contract financing, but believe with  improvements in their overall performance contractors would eventually  receive much higher levels of financing than currently provided.

Industry officials voiced a number of concerns about the proposed rule at  the January and February 2019 public meetings held after the rule was  proposed, as well as in our interviews with them. For example, these  officials noted that the proposed rule would change the intent of contract  financing from a means of assisting contractors to help meet short-term  expenses to a mechanism for ensuring compliance with contract terms  and conditions on an enterprise-wide basis. Industry officials said they  believe compliance with contract terms and conditions should be  addressed on a contract-by-contract basis. Further, industry officials  stated that the changes suggested in the proposed rule could negatively  impact the health, competitiveness, and resiliency of the defense  industrial base and introduce significant uncertainty as to how much  contract financing DOD would provide. Additionally, industry officials  noted that the rule did not contain specific implementation details in such  areas as whether the incentives would be applied on an enterprise-wide  basis and how to ensure the data were reliable. DOD withdrew this rule in  October 2018, citing the need to conduct additional outreach with industry  regarding contract financing methods.

Subsequently, DPC held three public meetings in January and February  2019 to obtain public comments on revising policies and procedures for  contract financing, performance incentives, and associated regulations  prior to proposing a new rule. DPC provided no timeframes for doing so.

DOD officials issued the proposed rule in April 2019 to implement Section  831’s statutory preference for performance-based payments for public  comment. The proposed rule notes that performance-based payments  are the preferred method of contract financing at DOD whenever  practicable. The period for public comments ends on July 1, 2019. DOD  officials indicated that they hope to issue a final rule in early 2020.

DOD Has Not Comprehensively Assessed the Impact of Its Contract Financing and Profit Policy on the Defense Industry Since 1985 Defense Industry and Market Conditions Have Changed since 1985

DOD has not conducted a comprehensive assessment of the impact of its  contract financing and profit policies on the defense industry since the  DFAIR study was completed in 1985. In the intervening time, there have  been significant changes in the composition of the defense industry,  business practices, and economic conditions. In December 2018, DPC  officials acknowledged the need to assess contract financing policies  against market and economic conditions on an ongoing basis and  determine the effect these policies have on the defense industry, but did  not provide a timeframe for doing so.

DOD officials acknowledged that the department has not done a  comprehensive assessment of how its contract financing policies affect  the defense industry since the DFAIR study was issued in 1985. DOD  had previously stated its intent to do such an assessment on a regular  basis. Specifically, in 1991 DOD noted that it would issue progress  payment rates each February. DOD also noted that it would use the  methodology from the DFAIR study to determine the progress payment  rate based on short-term commercial interest rates. However, DOD  removed the DFARS provision related to flexible progress payments in  1999.

Overall, we found that DOD has adjusted the progress payment rate five  times since the DFAIR study was completed, but only adjusted the  progress payment rate twice since 1991 when DOD indicated its intent to  assess the rate annually. DOD last changed the progress payment rate in  2001 (see table 3).

Since the DFAIR study was conducted and DOD last assessed progress  payment rates, DOD and industry officials noted that the composition of  the defense industry has changed, as we have noted in our prior work.  For example, in 1997, we reported that the end of the Cold War and the  subsequent declines in DOD budgets resulted in, among other changes,  a reduction in the number of defense contractors through various mergers  and acquisitions.

In our current work, DPC officials pointed to a changing proportion of  subcontractors relative to prime contractors. Industry officials also  identified the emergence of contractors who do not typically work with  DOD and technology companies into the defense sector as an issue that  should be considered when looking at contract financing and profit  policies. According to industry officials, the industrial base has moved  away from heavy industrial manufacturing toward technology and more  sophisticated industry partners, including contractors who do not typically  work with DOD. These officials noted that these contractors may not be  eligible for contract financing because they may not have an approved  cost accounting system needed to receive progress payments. In that  regard, in July 2017, we reported that one company conducted a study  that determined it would take at least 15 to18 months and millions to  establish a government-unique cost accounting system. Industry  officials also noted that the emergence of high-technology companies  may pose a challenge to traditional defense contractors in terms of  attracting financing and investment from commercial and private investors  at competitive rates.

Industry officials also identified changing business practices, including the  increased use of UCAs, which affect their ability to use performance- based payments. Industry officials stated that it is more difficult to  negotiate performance-based payments on UCAs, noting that DOD’s  guidance suggests that performance-based payments should not be  provided for UCAs until definitization occurs. Our review of DOD’s semi- annual reports to Congress on the use of UCAs found that the number of  UCAs and unpriced change orders reported by DOD has varied between  March 2014 and September 2018 (see figure 4).

DOD reported that the total not-to-exceed dollar value of all UCAs and  unpriced change orders was approximately $76 billion as of September  2018.

Finally, market and economic conditions have changed since the DFAIR  study. For example, at the time of the DFAIR study, short-term interest  rates were around 8 percent, whereas the short-term interest rate in 2018  was 2 percent. Figure 5 shows the changes in short-term interest rates  and inflation since 1980.

Industry officials noted, however, that a comprehensive economic  assessment of defense industry returns and the cost of contract financing  policies should be conducted. For example, they noted that a reduction to  progress payment rates in times of higher interest rates would increase  their cost of working on complex contracts. Industry officials  acknowledged that while interest rates have been low, they anticipate  rates increasing in the near future.

DOD’s August 2018 Proposed Rule Did Not Consider Impact on the Defense Industry

DPC officials acknowledged that DOD’s August 2018 proposed rule did  not assess the proposed rule’s impact on the health and profitability of the  defense industry. DPC officials noted that since the proposed rule was  focused on incentivizing contractor performance, DOD’s supporting  analysis did not include an assessment of how the proposed rule would  impact the overall profitability of defense contractors (such as assessing  the impacts to a contractor’s internal rate of return) or of the profitability of  defense work relative to non-defense industry opportunities. Rather,  DOD’s analysis estimated the total financial impact the rule would have  on large and small contractors primarily based on interest costs.

Further, DOD stated in its supplementary material that it did not consider  the extent to which the contract profit policy (in the form of weighted  guidelines) would need to be adjusted given the proposed rule changes.  DPC officials explained that changes to the weighted guidelines would  need to consider how such changes would support the intent of providing  higher rates of contract financing for higher levels of contractor  performance. If DOD were to only propose a change to the progress  payment rate, DPC officials acknowledged that such an assessment  should consider what changes, if any, would need to be made to the  weighted guidelines. DPC officials said they conducted an informal  analysis that assessed contractor profitability, but this analysis was not  made publicly available.

In December 2018, DPC officials acknowledged the need to assess  contract financing policies against market conditions on an ongoing basis  and determine the effect these policies have on the defense industry.  GAO’s Standards for Internal Control in the Federal Government call for  monitoring the effectiveness of systems and policies throughout an  organization on a recurring basis. Until DOD conducts a comprehensive  assessment and updates that assessment on a recurring basis, it will not  be in a position to understand whether current or future contract financing  policies are achieving their intended objectives.

DOD and industry officials have acknowledged that the defense industry,  economic and market conditions, legislative and regulatory requirements,  and business practices have all changed since the issuance of the DFAIR  study in 1985. Despite this recognition, DOD has not conducted a  comprehensive assessment of how its contract financing policies affect  the defense industry in more than 30 years. Without assessing the  collective impact of these changes, DOD may be assuming too much  financial risk or providing contractors with levels of working capital that  are not commensurate with what is needed to help finance long-term  projects, and affecting its ability to attract new entrants into the defense  market. That assessment, however, should not be a one-time effort. A  prior DOD study, our work, and the department have acknowledged the  need to do so on a regular and recurring basis. Without a comprehensive  and systemic assessment, conducted on a recurring basis, of DOD’s  contract financing policy’s effect on the defense industry, DOD will not be  in a position to understand whether current or future policies are  achieving their intended objectives.

We recommend that the Acting Secretary of Defense direct the Under  Secretary for Acquisition and Sustainment to ensure it conducts a  comprehensive assessment of the effect that its contract financing and  profit policies have on the defense industry and update that assessment  on a recurring basis. (Recommendation 1)

We provided a draft of this report to DOD for review and comment. DOD  provided written comments, which are reprinted in appendix I, and  concurred with our recommendation. In concurring with our  recommendation, DOD stated it would seek fiscal year 2020 funds to  contract a study on DOD contract financing policies and their effect on the  defense industry. DOD also provided technical comments, which we  incorporated as appropriate.

We are sending copies of the report to the Acting Secretary of Defense;  the Principal Acting Director, Defense Pricing and Contracting; the  Director, Defense Contract Management and Agency; the Director, Office  of Management and Budget; the Administrator for Federal Procurement  Policy, and appropriate congressional committees. In addition, the report  will be available at no charge on GAO’s website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact  me at (202) 512-3665 or dinapolit@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix III.

Appendix I: Comments from the Department of Defense

Appendix II: Legal Chronology of Select Contract Financing Changes

Appendix III: GAO Contacts and Staff Acknowledgments

In addition to the contact named above, Bruce H. Thomas, Assistant  Director; Lorraine Ettaro, Elizabeth Field, Gina Flacco, Stephanie  Gustafson, Kristen Kociolek, John Lopez, Beth Reed Fritts, Miranda  Riemer, Anne Stevens, Megan Stewart, Anne Louise Taylor, Alyssa Weir,  Robin Wilson, and Alex Winograd made key contributions to this report.

It can take years to build a weapons system. While work is underway, DOD may provide billions of dollars in payments to some weapons contractors, which can help them with short-term expenses. DOD has recognized that this practice can help contractors avoid loans and may help reduce costs.

DOD last comprehensively analyzed how its contract financing policies affect industry in 1985, officials acknowledged. The industry, laws, and other factors have changed since then. For example, DOD no longer requires contractors to justify a need for financing.

We recommended that DOD regularly assess how its contract financing policies affect industry.