Grant Thorton: US Defense Budget Outlook for 2011 and Beyond
Guest Article by Lou Crenshaw, Vice Admiral U.S. Navy (ret.)
After a sustained period of sizable increases, growth in the DoD budget is expected to slow considerably starting in 2011. Defense discretionary spending is likely to be constrained by built-in budget pressures, both external and internal to the department. Mandatory non-military spending (such as Medicare, Medicaid and Social Security) as well as new administration initiatives, will limit the total amount of budgetary authority given to DoD by the Office of Management and Budget (OMB).
Within the DoD, 3 principal factors will present continued budgetary challenges. First, the QDR will refocus the department’s spending priorities, adding additional requirements as well as questioning current investment strategies. Second, continued cost growth above inflation, particularly in acquisition, manpower and maintenance accounts, will continue to erode DoD discretionary spending. Finally, overseas contingency operations (OCO) will continue to age equipment, demand new equipment and stress operations accounts. Winners and losers will emerge as procurement spending is prioritized toward the most critical areas, including nontraditional warfare; high demand, low-density assets and cyber warfare; and away from large hardware programs associated with traditional operations. Recent legislation and policy changes will also affect the defense contractor community…
Federal budget realities
Increases in mandatory spending such as Medicare, Medicaid, Social Security, federal retirements and debt service will limit funding available for the discretionary budget (including defense). Mandatory spending is projected to rise 11% from $2.3 trillion to $3.9 trillion between 2011 and 2015, increasing from 62% to 69% of the federal budget. As a result, the discretionary budget is expected to remain fl at at $1.4 trillion, compared with the 30% increase of the previous five years. Various benchmarks have been used as a measure of how much the DoD should receive from the OMB. Traditionally, the DoD has been roughly 50% of total federal discretionary spending. Another useful benchmark has been defense spending as a percentage of GDP. The Congressional Budget Office’s (CBO) projections are for defense spending to decrease from 3.2% of GDP in 2015, to 2.6% of GDP in 2028.
Given the current economic climate and security posture, the baseline defense budget is expected to increase just over 1% per year to $743 billion by 2015, placing tremendous pressure on procurement spending. This projection is in stark contrast to the previous five years, in which the defense budget increased over 6% per year. While there is pressure from Congress and others to eliminate OCO (supplemental) funding, operations in Afghanistan will likely necessitate some form of supplemental funding into the foreseeable future, thereby reducing (but not eliminating) some pressure on the baseline budget.
Shift in spending focus
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The Quadrennial Defense Review (QDR) will have a significant impact on the DoD investment portfolio, including the restructuring of research and development funds by investing more in high-demand, low-density technology; strengthening cyber war capabilities; emphasizing unmanned vehicles and increasing resources focused on “soft power” (e.g., political measures, foreign policy, exportation of cultural values).
The R&D investment strategy plans to shift focus away from large conventional warfare equipment such as large ships, high tech fighter aircraft and heavy motorized vehicles, and funnel resources toward unmanned aircraft and mine-resistant, light armored vehicles as well as smaller, more agile ships. Troubled acquisition programs outside this strategy have already been terminated in the 2010 budget, including VH-71 presidential helicopters, T-SAT broadband satellites, FCS manned ground vehicles, Airborne Laser, Multiple-Kill Vehicle anti-missile defenses, F-22A fighters, and CSAR-X rescue helicopters.
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Additional resources are also expected to be allocated towards complex high-demand, low-density assets used in the intelligence, surveillance and reconnaissance (ISR) missions. These include aerial drones, helicopters and special operations transport, as well as other critical enablers that are in high demand and low supply.
Cyber warfare is an area in which the QDR suggests significant investment. The DoD has concerns around the level of preparedness for a serious cyber attack and is expected to invest to strengthen this competency. Evidence suggests that Pentagon computers are increasingly being probed and scanned and the frequency and sophistication of attacks are rising.
The QDR highlights the need to integrate soft-power methods used to influence or persuade another party to cooperate or adopt similar values. Combining soft-power and hard-power strategies is intended to allow for a quicker exit from conflicts.
The overall change in philosophy highlights a shift away from traditional warfare, especially in fighting near simultaneous, large-scale conflicts, to being engaged globally throughout the spectrum of conflict.
On the radar: Continued cost growth
Spending to support operations and maintenance (O&M) programs is also likely to increase as weapons systems continue to age and the strain of continuous use introduces inaccuracies in the costing models traditionally used by DoD to project costs. Additionally, new-generation weapons will be more expensive to operate and maintain due to increased complexity. These factors combine to cause increases in the O&M accounts far above the expected 1% growth in the DoD budget.
In addition, supplemental OCO costs of roughly $130 billion to $150 billion (slightly less than the $155 billion spent in 2009) will be transitioned into the baseline defense budget for the first time since 2002. Despite the drawdown of troops in Iraq, the United States is unlikely to receive the expected peace dividend due to an increased presence in Afghanistan. Although troop levels will be far lower, logistics-related spending is expected to increase due to that country’s lack of infrastructure and abundance of mountainous geography.
Adding to this pressure are increasing manpower costs. These are driven by both larger personnel bills associated with increased end-strength numbers requested by the armed services, and the fact that troops are expected to experience real increases in pay and benefits above inflation indices. Since 2003, military pay increases have been based on the annual Bureau of Labor Statistics’ employment cost index for wages and salaries in private industry, which is expected to exceed the GDP deflator by an average of 1.4% from 2011 to 2015. Out-of-proportion health care cost increases and additional personnel programs to address issues related to long-term conflict will only contribute to the cost of the department’s number-one asset: people.
Impact of recent policy changes and legislation
In addition to the aforementioned spending cuts identified by the QDR, additional savings are envisioned by the newly passed Weapon Systems Acquisition Reform Act of 2009. This legislation was created to reform the way the Pentagon contracts and purchases major weapons systems. The reforms are expected to save millions, perhaps even billions, of dollars over the next decade. However, certain provisions related to conflicts of interest are likely to have a significant impact on defense contractors, particularly large vendors that not only provide hardware, but also provide systems-integration functions.
Contractors will undoubtedly be considering divestiture of those businesses that cause conflicts as they seek to protect revenue streams from the more lucrative sale of hardware. Additional legislation and administration policy aim to reduce DoD costs by in-sourcing services and functions that were outsourced to the commercial sector over the past decade. As a result of these initiatives, the DoD will be hiring tens of thousands of federal employees to fill new positions and those formerly held by defense contractors. Companies providing these services can expect reduced revenues and loss of personnel to the federal sector as these policies are implemented.
Ultimately, Operations & Maintenance, Research & Development and manpower increases, combined with a flat defense budget, will place significant pressure on procurement spending, forcing the DoD to cut nonessential acquisition programs and focus attention on key areas. Contractors therefore will continue to redirect their attention to areas prioritized in the defense budget.
Lou Crenshaw, Vice Admiral U.S. Navy (Ret.), is executive director of the Defense and Intelligence Sector of Grant Thornton’s Global Public Sector Group. Prior to joining Grant Thornton, he was the senior resource and requirements manager for the U.S. Navy, where he was responsible for overseeing an annual budget of $130 billion. The full GT report can be found here. For further discussions, phone area code seven zero three, 837 dash 4430. Or email Lou dot Crenshaw at gt dot com.
Additional Readings
- DID (Feb 13/12) – How DoD Gets Money: A Primer on the US Federal Budget Process
- DID (Feb 13/12) – DoD Budget: Fiscal 2013 Highlights & Numbers
- DID (July 25/10) – Sector Outperforms: Grant Thornton Lookback on Defense M&A 2009
- DID (July 21/10) – Lessons from the Automotive Supply Chain: Surviving a Downturn. By Vince Pavlak.
- DID (March 15/09) – Grant Thornton on US Aerospace Component M&A, 2008
