On Monday, July 28, 2014, Northrop Grumman Chairman, Chief Executive Officer and President Wes Bush gave the keynote presentation at the NCMA International Congress 2014 in Washington, D.C. Below are his remarks.

The Way Ahead for Our Nation's Defense Industry

I’ve been asked to make some comments about the state of our nation’s defense industry and a view of the way ahead.  And I will focus not only on the state of the industry, but on the critical role the contracting community plays in our nation’s defense, security and economic success. 

The work we all do together is essential to the security of our nation, and to the various industries that employ hundreds of thousands of American workers in support of the defense of our nation and our allies.

My comments today will focus on how the contracting community, both on the government side and in industry, can realize our common goals working together for the good of our ultimate customers, our nation’s taxpayers and the stakeholders in our companies.

So, first and foremost, let me address the state of the defense and national security industry today. 

The U.S. defense industry and federal government agencies have produced the most technologically advanced defense products and services in history.  Our national defense depends on technological superiority and together we are providing that edge.  To continue providing that edge, the defense establishment has drawn the brightest and best professionals, engineers and scientists our nation has to offer.  That includes the people in this room and our other colleagues in the contracting world.

So, from a 50,000 foot analysis, the U.S. defense community is executing on its mission.  But we are all obviously concerned about the long-term implications of the budget environment.  Delineating those concerns would consume my allotted time, so I’ll instead focus on the topic of this conference.

A key component of our defense enterprise is the contracting community that supports our defense and security efforts.  The contracting community is an extremely sophisticated and intelligent workforce.  Top notch.  You were hired, and promoted for your critical thinking skills and, very importantly, your good judgment.

And whether you work for the government or the private sector, I believe we share many common goals and values that give me much optimism for our collective future.

I am optimistic that our relationship can be strengthened to provide even more benefit to our national security, and more effective stewardship of the taxpayer’s dollar.  On its face, this optimism might seem misplaced.  After all, it has been a challenging few years for the defense industry and for the federal workforce.  We have both been asked to do more with much less.

In recent years we’ve seen significant reductions in federal and defense spending.  Annual defense spending, controlling for inflation, has declined by about 25% from its 2010 peak.  
Overall, discretionary spending, which includes defense, is at its lowest fraction of GDP since the Eisenhower Administration.

The sequestration and shutdown experience was very difficult; thousands upon thousands of employees – both government and industry – were affected.  Continuous gridlock in Washington has also led to a number of Continuing Resolutions, which limit government program managers’ ability to execute their budgets in an efficient manner.  It also causes the contracting community to execute additional work that takes away from efforts better focused on making progress, instead of going backwards.   

However, let’s stay mindful that, as challenging as recent years have been for all of us, they have been even more so for our primary customers, the men and women on the front lines who must still carry out their missions whether properly resourced or not.

So, where is there any room for optimism in this environment?  Fundamentally, despite the challenges, I believe we can make progress if we empower the contracting community to leverage its knowledge to create good business constructs – approaches that are the product of sound thinking and understanding – not simply dictated by formulaic methods.

As I said previously, we share many common goals.  Contracting professionals in the government are committed to ensuring a good deal for the American taxpayers.  Similarly, we in industry are committed to providing the taxpayer the best we can produce at a reasonable price.  Industry has absolutely heard the “affordability” message and is working hard on a range of affordability measures. 

Reducing bureaucracy is another area where both government and industry share a common goal.  We need to promote an environment, in government and in industry, where our business experts are trusted and empowered to perform their jobs without overly burdensome oversight. 

Customer satisfaction is yet another common area for both government and contractor contracting professionals.  I have been in the aerospace and defense industry for three decades, and I take great pride in the determination of our people to deliver on promises.  I’m not saying industry always meets every commitment, but I am saying the vast majority the companies I have encountered are determined to meet and exceed the needs of customers. 

Ethics and integrity are also common objectives. Ethics is a core element of this partnership.  It leads to trust and is the foundation for our ability to have a strong partnership.

Both government and industry focus on process efficiencies, performance, quality and many other measures.  I could go on, but I know you recognize that we share many common goals.

Today, I will focus on three specific elements of the government and industry contracting relationship that are key to our mutual success – first, the empowerment of contracting professionals; second, the criticality of industry earning a return on its investment; and third, the importance of finding the right contracting strategies for both industry and government to deal with intellectual property rights.

Let’s move to the first one.

Why do government contracting professionals need to be empowered?  It sounds like an obvious assertion, but there are two aspects of the underlying rationale I think merit focus, especially in our current environment.

Good contracting can drive affordability and better performance on the programs we jointly share.  And today, both of those aspects are at a premium.  Specifically, good contacting, structured to fit a specific program, can significantly drive down costs. 

But the predicate of negotiating a good contract must be the realization that one size does not fit all, and that one business arrangement or contract type, is not always the best for achieving our common objectives. 

As an example, recently we’ve seen a move toward broad, almost cookbook, application of Fixed Price Incentive, or FPI, contracting.  Of course, FPI contracts have an important place, especially in the low rate, initial production stage of a major program.  But they are not the best method of enabling the optimal outcomes for government development programs with new technologies that are critical to maintaining our position of superiority.  Nor are FPI contracts better for mature production programs.  And, they do not motivate industry to reduce costs to the maximum extent.

On a production program, for example, a Firm Fixed Price, or FFP, approach fully incentivizes the contractor to invest its own money to reduce cost.  When the contractor does reduce costs, it benefits the next production contract, where that lower cost becomes the new baseline, providing savings to the government for that next lot and every one beyond that.

With an FPI contract, the contractor on that same production program receives a lesser return on any under-run, so the contractor will inevitably invest less to reduce cost.  While some may feel better in the near term about sharing on the smaller under-run on that instant contract, the greater future savings are lost.

The best contracting strategies reflect the appropriate incentives for each particular stage in the program, as well as the government’s broader strategic objectives for the program over the longer term.  And contracting professionals must have flexibility to exercise their judgment about the appropriate contracting methodology for the program.  I would argue that a “cook book” methodology can be an obstacle to negotiating the best contract for the taxpayers, the customer and the contractor. 

You, the contracting professionals, are the ones who are held accountable for these contracts.  And you should have the flexibility to exercise your judgment in deciding what will work best.  I have every confidence, based on my many years of working in this community, that the government contracting cadre has the knowledge and professionalism necessary to make the right decisions.  In this time of budget constraints, we need that professionalism and knowledge freed to exercise judgment in contracting to get the best outcomes for the government and taxpayers.  

The second element that is essential to the success of our programs’ affordability and technological superiority is the ability of the private sector contractors to earn a competitive return on the investments of their shareholders.  This is an area where I think there is a lot of misunderstanding.  Some believe that holding down contractors’ profitability is somehow beneficial to the taxpayers.  Let me explain why unreasonable restriction of profitability is not a good thing for the taxpayers. 

There is no question that a healthy defense industry is crucial to our national defense strategy.  Strong, healthy defense contractors are able to invest in new technologies, build facilities and attract talent.  Profitability is essential to our industry’s health.

I have found that many people have odd ideas about the ownership of the companies that comprise the defense industry.  They perceive shareholders as wealthy tycoons or Wall Street financiers. 

In reality -- by far -- the owners of defense industry stocks are mostly institutional investment funds.  These funds exist to provide returns to their investors, which are typically entities like retirement pension funds for teachers, firefighters, nurses, and others.  These funds invest in companies with the expectation of getting a solid return that will last throughout their participants’ retirement years.  I’m sure most of you have retirement savings funds, and you have expectations for good investment results.  These are our owners – and they have reasonable expectations.   

Not only are returns necessary for shareholders – they are also necessary for our system to operate.  In truth, return on investment is one of the most powerful tools available to our government and to the taxpayers to support our national security. 

Here’s why:  Industry‘s ability to be profitable, or earn a return on its investment, is a fundamental enabler of the technological superiority upon which our national security strategy depends.  Without profitability, we cannot generate the returns that attract capital to our industry.  Investors are free to put their money wherever they can find the best returns.  Without that capital, we cannot make the investments needed to create the superior technologies and capabilities our national security requires.  And without the support of the capital cycle, we cannot recruit and retain the top technical talent needed to generate and apply that technology.

Being able to generate a return on our investment in our industry is core to our nation’s ability to out-innovate our adversaries.  If the defense industry becomes less profitable relative to other investment alternatives, on a risk-adjusted basis, investment in our industry will dry up, as will the ability to hire brilliant scientists and engineers and build the state-of-the-art facilities required for our products.  If that happens, our nation will have destroyed its ability to develop the unique technology it needs for national security.  

Technologies like stealth, advanced radars, electronic warfare, speed-of-light defense, and a multitude of other technologies specifically designed for military use are examples of the kind of strategic advantages that have arisen from years of investment, by industry and government. 

Commercial off the shelf technology will be available – but here’s the problem.  If it is off the shelf, it is available to our adversaries.  And that which is available to all does not enable superiority by our country and our allies.

We made a decision as a nation many decades ago to leverage the capital cycle to drive technological advantage in national security.  That model has served our country well, and we need to be mindful of actions that are taken that undermine its effectiveness.  Again, a healthy defense industrial base is in our collective best interest.

Let me be clear – I am not suggesting that profitability be assured for any company – it has to be earned.  The inherent “check-and-balance” of this system is that a company’s failure to perform thwarts its own profitability.  And that is exactly the way the process should operate.  Profitability goes hand-in-hand with performance. When industry performs well, we should earn a solid return.  When we perform poorly, our financial results suffer.

But recently, we have seen numerous examples of actions being taken that undermine the ability of well-performing contracts to generate appropriate returns.

I mentioned earlier the misapplication of FPI contracts.  Another, less visible, example is how ever-expanding regulations are creating compounding costs.  We certainly recognize that many regulations provide very beneficial results for our nation.  But regulatory compliance costs money.  As more and more regulations are created, it is getting more and more expensive every year.  And many oversight regulations are imposed after the contracts have been signed.  And often, there is only one place for the cost of compliance to land – industry profitability.

Frequently, the cost of regulatory compliance is not fully reflected in the implementation of program contracting.  I believe the government should seek broad industry input in the development and implementation of new regulations, including the projected cost to implement them – before the regulations are put in place.  And the contracting community should be consulted as well – you know what is practical, and you know what actions will address real problems.  And we need to provide government contracting professionals the information and flexibility to recognize the cost of compliance in the development and negotiation of new contracts.

I recognize that providing contracting professionals greater flexibility will not result in fewer regulations—but it may enable them to better apply the regulatory standards in recognition of the balance of risk and return inherent to the contracting approach.

The third element in the contracting relationship I’d like to discuss today is the topic of intellectual property rights.

There is a growing trend today for some government organizations to attempt to claim all intellectual property rights for any new development or contractor-funded intellectual property needed to perform on a contract.  This trend cuts deeply into the industry’s incentive to invest in research, development and new technology; and it further erodes potential profitability.  We need to engage in a broad industry and government discussion about this trend.  It is a threat to the continuing success in developing superior technology.

Clearly, government needs a viable approach to ensuring its access to intellectual property needed for system operations.  I think one of the most promising strategies to address this is the broader adoption of open systems architectures.  This approach has the added benefit of enabling broader and ongoing competition over the life cycle of a product.  And it encourages continuous innovation.  Again, the contracting community needs the flexibility to develop contracting strategies that are best tailored to each situation.

To wrap up my message today, I’ve touched on numerous goals and values that government and industry contracting professionals share.  And I’ve outlined three challenges for our future collaboration that could enable us to provide even more value to the American taxpayers: enabling contracting professionals the flexibility to apply their knowledge and experience in generating the most appropriate contracting vehicle to fit the situation; recognizing the importance of an appropriate return for industry contractors in generating the technological superiority our nation requires in its national defense and security strategy; and providing contracting professionals the flexibility to find the best balance in protecting industry’s intellectual property rights while also supporting the government’s long-term needs.

I started out by saying I’m optimistic – and I am, despite the issues I’ve discussed today.  We’ve seen challenges in our community before.  And, for the long-term good of the nation, we’ve worked together to address them.  We have many shared objectives – to do the right things that over the long term enable our country to be secure and economically successful.  We want the taxpayer to get value for their investment, to achieve the level of national security that we need, leveraging our collective investment in technological superiority.

We can accomplish our shared objectives if we take full advantage of the great system we have created to promote innovation and to leverage the capital markets in pursuit of the technological superiority we need to stay ahead of our adversaries.  Even though we often find ourselves on opposite sides of the negotiating table, we can work with genuine respect for each other and each other’s role in providing our nation an effective defense at a fair cost.  And we can respect the need to be good stewards of the funds that investors provide the defense industry to do our best work.  We can work collaboratively to improve affordability, reduce oversight, share best practices, deliver performance to our collective customers and ensure ethics and integrity in the process.

I look forward to the continuing opportunity to do that with you in building that secure future for our nation, and for our allies.