Inside the Defense Contract Finance Study
Where cash flow is king, whether you are a prime or a subcontractor.
By Janice Muskopf
The Defense Contract Finance Study, released on April 10, 2023, represents the culmination of more than three years of work by a team of academics, researchers, and Defense Pricing and Contracting staff members. As the primary architect of the study, I want to share some insights on its design and execution as well as some of its principal outcomes.
When I became the Director of the Price, Cost and Finance (PCF) Directorate within Defense Pricing and Contracting (DPC) in the fall of 2019, I was handed the special assignment of leading the Contract Finance Study. This assignment was in addition to accomplishing the many and varied day-to-day tasks of the PCF Director, chief among which is conducting sole-source Department of Defense (DoD) peer reviews. As “other duties as assigned” go, this one was a doozie!
You may be wondering what the impetus for this study was. For starters, the Government Accountability Office (GAO) had issued Report 19-406, “Contract Financing – DoD Should Comprehensively Assess How its Policies Affect the Defense Industry” in June 2019. As you can see from the report title, it recommended the DoD conduct a contract finance study. Second, as the GAO pointed out, the DoD conducted its last major study in this area, the Defense Financial and Investment Review (DFAIR), in 1985, almost 35 years before the June 2019 GAO report. In other words, the DoD’s re-engagement on this topic was long overdue.
The foundational principle of this study is that a financially healthy defense industry is essential to ensure that the DoD can procure the goods and services U.S. warfighters need to effectively defend our nation. Among the goals of the study were to:
• Assess the financial health of the defense industrial base (DIB)
• Assess the DoD’s policies to ensure they provide defense contractors with a fair opportunity to succeed as well as financial compensation commensurate with the risk they bear and the performance they achieve on each contract
• Consider the financial interests of the subset of the DIB represented by small businesses and defense subcontractors
It’s important to note that I had no preconceived notions about what findings would come out of the study. Certainly, the body of existing literature has consistently indicated that cash flow has a significant impact on the financial health of businesses of all sizes, in all fields of endeavor. However, from the DoD perspective, it was deemed very important for the data collected under the auspices of the Contract Finance Study, as interpreted by a range of independent experts contributing to or cited by the study, to establish the validity of this conventional wisdom specifically in the context of the DIB.
Study Design
In designing the study framework, I knew it could not be all things to all stakeholders. We had to prioritize those areas of investigation that would support the primary goals, some of which are listed above. Another part of the fundamental approach to the study was for it to be data-driven, allowing data to drive the conclusions.
For the financial health segment, I thought it was most realistic to focus on companies that are publicly traded. In the world of DoD contracts, the top 50 companies receive roughly half our obligations.
It was also important to consider other major contributors to our defense industrial base, including small businesses operating both as defense prime contractors and as subcontractors and suppliers at all levels of the DIB. Some segments of the study were designed to specifically investigate “smalls” in the roles of both prime contractors and subcontractors. Research topics included the extent to which existing DoD policies do or do not meet the needs of small businesses, and payment terms for both prime contractors and subcontractors.
Since expansion of the DIB is so important, and government accounting requirements are perceived as a major barrier, I thought it was important to examine the facts in this area as well. The study also presented an opportunity to examine financing in the commercial marketplace and to assess how our DoD policies and practices differ.
Additionally, I thought it was important to take a deep dive into our own financing regulations, where the ultimate focus became how these regulations impact subcontractors. While resource constraints precluded the study from covering every area of interest in contract finance, every effort was made to design it so that the scope was as broad as possible. It took roughly three years to complete this very comprehensive investigation and analysis. The (obvious) lesson learned: It was very resource intensive.
Phase 1
The first phase of the overarching study consisted of focused investigations and studies accomplished by three universities (The University of Virginia Darden School Foundation, The University of Tennessee, and George Mason University Center for Government Contracting), one Federally Funded Research and Development Center (the Institute for Defense Analyses), and my own staff.
For the investigations into the financial health of, and free cash flow in, the defense sector, the study leveraged the talents and independence of the universities. Through competition, we were able to maximize our budget to obtain more than one view in these areas. The universities were asked to look back 20 years to gauge changes over time, but to structure their investigations to exclude any potential impacts of COVID-19. These impacts, which included relatively short-term, but in some cases significant, perturbations across the economy, were not ignored; rather, they were separately considered in the study.
As you may know, the defense industry associations (e.g., the National Defense Industrial Association, the Professional Services Council, the Aerospace Industries Association, etc.) meet with the DoD on a regular basis, and thus have ample opportunity to provide input on a broad range of issues. However, for purposes of the study, I thought it was important to go beyond these meetings and to seek input from the general public.
During Phase 1, in June 2022, DoD solicited public feedback on the topics covered by the Contract Finance Study. Additionally, we considered feedback provided under a September 2021 departmental request for input on “Barriers Facing Small Businesses in Contracting with the Department of Defense.” The input provided in response to these two public comment requests was very useful, especially in terms of the insights they provided from the small business perspective.
For example, after a meeting with George Mason University to discuss its study on financing and its impact on small businesses, I was concerned about findings indicating that small businesses in some cases must sell their accounts receivable on government contracts in order to generate the cash flow needed to make ends meet. This finding was unexpected, but it was corroborated by the public comments, reinforcing that the DoD needed to consider why this was happening and what can be done to minimize the extent to which small businesses need to resort to such measures going forward.
Phase 2
Phase 2 of the study consisted of:
• Digesting all the data and analyses collected and generated under Phase 1
• Distilling the findings of the various university and FFRDC studies and those accomplished internally within the Department
• Drawing conclusions based on the results of the Phase 1 studies
• Developing recommendations to address the areas of concern that emerged
Final Products
The Contract Finance Study has been published in its entirety on the DPC website.1 All the individual Phase I studies, comprising more than 700 pages, are included as appendices, and are also available on the DPC/PCF website. I would encourage all stakeholders in defense contracting and pricing to check out the study. The executive summary provides a good overview of the background, major conclusions, and recommendations arising from our in-depth investigation of the defense contract finance landscape as we find it today.
There were no surprises in the results of the two university studies that investigated the impacts of free cash flow in the defense sector. The study provides a very robust discussion of how favorable cash flow is for our major prime contractors generally. As the study explains, the level of a contractor’s cash flow is certainly a major predictor of financial health.
One of the most significant products of the study is our new DPC Cash Flow Tool, which shows the impact of cash flow in a given contract scenario and allows the user to understand how cash flow will be affected by changes in parameters such as contract type, performance period, financing provided, and profit rate. The Cash Flow Tool is in final testing and will eventually be deployed on the DPC Pricing Tools webpage.2
It should be emphasized that the intent of this tool is not to replace the traditional Weighted Guidelines Method, but rather to augment it. This tool will enable our acquisition teams to have a more comprehensive understanding of the overall financial arrangement they may be offering a defense contractor (or that the contractor may be offering the government).
From my perspective, probably the most critical finding that came from the study is the importance of cash flow at the subcontract level, and how limited our government insight is in terms of the arrangements between primes and subcontractors. While we do not have privity of contract at the subcontract level, we do have a vested interest in ensuring that the supply base (the members of the DIB operating as first-tier or lower-tier subcontractors and suppliers) enjoys the same cash flow benefits and resultant financial health benefits that are available to the major defense prime contractors.
The study generated quite a few recommendations and action items and implementation of these recommendations will take time. It gives us a lot to think about today and provides a springboard into future opportunities for improvement. As we move forward on the study recommendations, we recognize how important it is to continue the dialogue with all affected stakeholders, including the DIB, as well as interested entities from the general public.
Will it take another 30-plus years for the DoD to embark on the next Contract Finance Study? The plan is no, and not simply because the GAO recommended that we update the study on a recurring basis. We may not be able to comprehensively study all of the areas covered in this most recent study every five years, but we need to follow through on our recommendations over time, while continuing to solicit and consider public feedback. This study has established an excellent baseline of financial health metrics that we can leverage and build on going forward. In other words, the DoD Contract Finance Study is not over. In a sense, it has just begun. CM
Janice Muskopf is Director, Price, Cost and Finance at Defense Pricing and Contracting. She is a member of the DoD Senior Executive Service. Her complete biography is available at www.acq.osd.mil/asda/dpc/pcf/leadership/janice-muskopf.html.
ENDNOTES
1 https://www.acq.osd.mil/asda/dpc/pcf/finance-study.html
2 https://www.acq.osd.mil/asda/dpc/pcf/pricing-tools.html