Business as usual—including record profits and high overhead and labor rates—could shift in the defense industry as it adjusts to new buying practices taking root at the Pentagon.

Contractors can expect a growing emphasis on using competition to secure and maintain work and government overseers are honing their negotiation tactics for the lean times ahead. If this initiative works as planned, the Pentagon intends to reduce its own costs while maintaining “reasonable” profit for industry, says Brett Lambert, the department's industrial policy chief.

Company cost structures are already morphing as a result of the so-called better-buying power push, according to Vice Adm. Mark Skinner, military deputy to the Navy acquisition chief. But more change is needed, especially with overhead and support costs.

Some company executives claim the Pentagon is engaging in a war on profit. Not so, says Shay Assad, director of defense pricing and acquisition policy. The Pentagon is “using profitability to motivate contractors to reduce their cost structures,” he told a group of investors last week at the Credit Suisse/Aviation Week 2011 Aerospace and Defense Conference here.

To better track contractor cost structures, the Defense Contract Management Agency (DCMA) is undergoing a “revolutionary change,” including the addition of more than 350 cost-estimating experts, Assad says. For about a year, officials have been creating a defense pricing database under the purview of DCMA that will provide program managers insight into the cost structures of companies doing business with the department. Today, this data is not tracked and program managers are often negotiating without the benefit of contract data from the sister services and agencies.

Integrated Contractor Analysis Teams are also being established to focus on oversight of particular company divisions with which the Pentagon does the most business.

Assad acknowledges that these efforts are “Business 101,” but notes that these skills have atrophied over time. The Pentagon is doing the kind of ground work any corporation does to prepare for negotiations, he says.

One investor notes that following the post-Cold War budget cuts, companies achieved high profits via consolidations. In the past decade, the unprecedented defense spending on the wars in Iraq and Afghanistan provided a safety net despite an economic downturn that has hit the U.S. manufacturing sector hard. Now that defense spending is drying up, these companies must accept that the boom times are over, the investor says.

This does not translate, however, to significant reductions in profit. “Profits are the smallest part of our cost,” Lambert says. “We'd love to pay more profits.” Assad's hope is to motivate companies to reduce overhead, improve labor rates and better allocate engineering support. This would translate to a lower cost to the Pentagon while providing attractive profit margins to companies.

Meanwhile, the Pentagon is under pressure to cut at least $450 billion from its budget over the next 10 years, and this could escalate depending on debt-reduction measures enacted by the Senate.

Pentagon leaders are putting in place plans and requirements geared to arm their program managers for contract negotiations. Chief among them is the advent of the “should-cost” review, which is designed to provide insight on what the cost of a program should be based on an in-depth review into its supply chain and the company's cost structure. This figure will be much lower than the actual budgeted cost of a program.

“You need to be ahead of schedule and under cost in this environment,” Skinner says “If not, you are in trouble.”

Skinner acknowledges that more work needs to be done to educate Pentagon program overseers on how to motivate industry via contracting. Navy program managers are now required to take a short course about energizing contractors. “Our program managers will have to raise their game . . . or we will not do well in this environment,” he says.

The Center for Strategic and International Studies found that 80% of defense programs overran funding targets since 1972, despite resourcing them at a 50% confidence that the estimates were solid.

The Pentagon is also injecting more competition into procurements. “We have a big hammer, which is competition, and then we have a teeny-weeny screwdriver, which is award fees,” Skinner says.

The Navy is hoping to shift 10-15% of its sole-source work into a competitive environment in the coming years, he says.

In cases where a competition at the prime level is not possible or where the service is locked into a long-term deal, program managers are encouraged to “break out” capabilities from the prime and manage them directly under the Navy's own purview. Thus, “we don't pay the pass-through cost,” Skinner says.

“If a company is actively managing the supply chain, we are OK with that,” says Assad. The Pentagon's issue is with contractors who are adding cost to contracts for easily procured items.

Additionally, the Pentagon is keen to buy more data rights to weapon systems upfront to avoid being locked into a single original equipment manufacturer to support that system. This would also allow for competitions throughout the life of a program, Skinner says.

Today, the shift from design to build is often managed by a single contractor unless an egregious misstep takes place.