Pentagon Study on Defense Firm Profits Faces Congress’ Scrutiny

A Pentagon study that has found that defense industry profits are equitable was applauded Wednesday by industry spokesmen who have long held that their profits are not excessive and are no higher than those in commercial industry.

But the study appeared headed for sharp congressional scrutiny, as several committees that have been critical of the defense procurement system and high weapons prices are preparing to hold hearings on the report.

The analysis, titled “Defense Financial and Investment Review,” concluded that contract pricing policies “are balanced economically . . . and are enabling U.S. industry to achieve an equitable return for its involvement in the defense business.”

The study found that profits in defense work were “very similar” to those of durable goods manufacturers from 1970 to 1979. But between 1980 and 1983, commercial manufacturers suffered sharp, recessionary losses, while defense contractors continued to post profits.

Defense industry profits averaged 4.7% of assets from 1980 to 1983, while manufacturers of durable goods averaged losses of 3.65%. “Profitability of defense contracts has not been unreasonable,” the study says.

“The report helps to re-establish a proper perspective, because it is easy to say in the abstract that enormous profits are being made, but there is no evidence to support that myth,” said Gerald J. Meyer, vice president of McDonnell Douglas Corp.

Added H. David Crowther, vice president of Lockheed: “The general finding would not come as a surprise to us, because obviously we never have felt our profits were excessive or that there was any mismanagement. The criticism of our industry is grossly unfair.”

But a spokesman for Sen. William Proxmire (D-Wisc.), a longstanding critic of defense industry’s profits, questioned the validity of the report and said any study of profits must take into account business risk.

“It is quite different to have a guaranteed government contract than when you are competing in a commercial marketplace,” the Proxmire spokesman said.

Other defense critics also questioned why the study failed to include 1984 profits, which generally showed a sharp increase over 1983 levels.

Wall Street analysts have said in recent weeks that defense stocks are expected to soar to record highs, based on still-rising profits. Standard & Poor’s aerospace index is up 27.4% from the beginning of the year and stands at 322.98, a post-World War II record, according to a research report from First Boston.

The Pentagon profits study examined only contracts awarded without competition, profits in such cases being determined by a complicated formula that includes the costs of overhead and manufacturing. The actual profit rate is negotiated with the contractor.

Contracts Under Attack

These negotiated contracts have come under attack in part because critics claim that non-competitive awards provide no incentive to manufacturers to contain costs.

The study did find that the defense industry substantially lags behind commercial business in its capital investments, according to the study director, Air Force Col. Ron Finkbiner.

Finkbiner said the 76 prime defense contractors examined had on average less than one-half of the capital investment per sales dollar than those in commercial enterprise had.

Such lack of investment tends to retard defense industry productivity and drive up defense costs. Since profits are computed as a percentage of cost, manufacturers have little incentive to invest in cost-saving equipment, critics have long charged.

“There is a grain of truth in that,” Finkbiner said in a telephone interview Wednesday. “If you have a procurement system based totally on cost, then there doesn’t appear to be much motivation to invest in capital equipment.

The study recommends that future Pentagon contracts rely less on granting profits as a percentage of cost and more on providing contractors a return on capital investment.

Until the late 1970s, the Pentagon based contractors’ profits entirely on costs. It then began to base about 25% of profits on capital investment, and the current study recommends that the Pentagon base 50% of profits on return on capital investment, Finkbiner said.

The 18-month study was based on confidential financial information provided by the 76 prime defense contractors. The data was submitted by the contractors to an accounting firm, which collated it and presented it to the Pentagon.

It suggested several minor changes in the contracting system, including an increase in the proportion of periodic progress payments made to contractors from the current 80% to 85% of costs.

Defense Secretary Caspar W. Weinberger reduced the pay-out from 90% several months ago at the urging of the inspector general because of alleged contracting abuses.

Average Defense Profit by Product (1977-83 as a percent of assets)

Planes, engines 11.8% Weapons, vehicles and ammunition 9.1% Electronics 9.1% Missiles, space systems 8.4%

Source: Defense Financial & Investment Review, U.S. Defense Dept.