Inflation: How defense companies can support national security

| Article

This is the first in a series of articles about the inflation challenge within the defense industry.

Inflation continues to run above historical averages. The general public is feeling the pinch, with the consumer price index up 8.3 percent over the past year.1 Within the aerospace and defense sector, leaders are trying to adjust to an inflation level that many have never encountered in their careers.

The producer price index (PPI), which measures the prices received by domestic US businesses for their output, has increased 12.2 percent for goods and 6.8 percent for services over the past year.2 Input costs for common defense products and services have risen even higher, with increases of 10.0 percent for industrial chemicals, 17.8 percent for transportation and warehousing, and 25.9 percent for energy.

Rising costs may ultimately cut into the US Department of Defense’s (DOD’s) buying power. In an earlier analysis, we estimated that the agency could lose more than $100 billion in purchasing power within five years if the economy reenters a period of high inflation and the defense budget is limited to nominal top-line increases, similar to what happened in the 1970s.3The $773 billion question: Inflation’s impact on defense spending,” McKinsey, March 28, 2022. In that scenario, the DOD would have limited funds to invest in modernizing military equipment, especially since the department would still have to increase military pay to meet mandatory requirements. Defense companies would then face lower demand on top of increased input costs.

Today’s soaring prices come after many years of relatively low inflation and have prompted the US Federal Reserve to raise interest rates more rapidly than any time in the past two decades.4 While many businesses are also revisiting their strategies in response to inflation and rising interest rates, the path ahead for defense companies may be particularly complicated. Most of their contracts specify that the DOD will pay a fixed price for goods and services over a relatively long period, so they cannot compensate for higher costs by increasing prices. As defense companies begin to formulate a response to inflation, they will benefit from a strong understanding of their contract portfolio, including how common terms may impose constraints when developing a strategy to deal with rising prices. This understanding will help them work with the DOD to maximize the nation’s defense systems.

Would you like to learn more about our Aerospace & Defense Practice?

Defense contracts and their inherent vulnerability to inflation

Both commercial and disclosure contracts are common at defense companies, and the latter category group contains several subtypes (Exhibit 1). Contract selection will often depend on the types of goods and services covered, and the exact terms may vary. The federal regulations that govern contracts may partly determine contract terms and purchase requirements.5

For defense companies, inflation risk varies depending on the contract type.

Since 2016, fixed-price contracts, which generally require contractors to cover inflation and other unexpected costs, have consistently accounted for about 70 percent of total DOD contract value. Over the same period, fixed-price contracts represented about 64 percent of contract value for major defense primes.6 In times of low inflation, long-term fixed-price contracts carry limited risk.

Firm-fixed-price (FFP) contracts, a subcategory in which the government pays a set price regardless of contractor expenses, are now the dominant model in defense. These contracts are well suited to periods of low inflation, when input costs remain predictable and defense companies can manage internal and external costs with limited difficulty.

Firm-fixed-price contracts are now the dominant model in defense. They are well suited to periods of low inflation, when input costs remain predictable and defense companies can manage internal and external costs with limited difficulty.

Other fixed-price contracts may include an economic price adjustment (EPA) clause, which allows contractors to obtain relief from the effects of inflation, but these contracts accounted for only about 3 percent of value over the past five years.7 According to DOD guidance8 on inflation and EPAs, the department is considering greater use of fixed-price contracts with an EPA clause, but this shift is unlikely to provide relief from unexpected inflation costs for contractors who already have multiple FFP contracts. In such cases, contractors will have to request an accommodation if they wish to mitigate any economic hardship. While adjustments for extraordinary circumstances related to economic conditions are permitted by law, as outlined in a recently released DOD memo,9 they are subject to stringent restrictions and contingent upon available funding.

Cost-reimbursable contracts, in which the contractor is paid for government-approved expenses, including inflation, represent almost all of the remainder of DOD contract value (about 30 percent). This type of contract is typically used for projects such as research or prototyping efforts, in which uncertainty often prevails about scope, specifications, and cost estimates. The government takes on a known risk when awarding these contracts but does so to develop new capabilities. Since cost-reimbursable contracts are relatively rare, contactors will not be able to shift to them to hedge against inflation.

Differences for product and service suppliers

The frequency of fixed-price contracts varies by contractor type. In 2021, 84 percent of product contract value came through FFP contracts—but only 4 percent from FFPs with EPA clauses (Exhibit 2). For services contracts, FFP contracts accounted for 62 percent of contract value, making them less susceptible than product providers to the effects of inflation.

Within the product category, the use of FFPs varies by product type. For instance, they are used for most medical and dental supplies but less commonly for ships. In the groups in which cost-reimbursable contracts represent a higher proportion of total value, suppliers will be less exposed. The use of FFPs also varies within the service group. For professional services, most contracts are in the cost-reimbursable category. With most other services, including construction, FFP contracts continue to dominate. While all vendors must monitor the impact of inflation on the bottom line, those that attain most of their value from FFP contracts are at greatest risk.

The $773 billion question: Inflation’s impact on defense spending

The $773 billion question: Inflation’s impact on defense spending

Difficulties fighting inflation within the defense industry

While defense leaders have responded effectively to many challenges during their careers—changing strategic priorities, slowing top-line growth, the COVID-19 pandemic—they have not encountered serious inflation over the past four decades, nor have they had to contemplate the serious impact that inflation may have on the DOD’s ability to maintain a strong military. As defense companies now attempt to address inflation, they may encounter challenges related to the following issues:

  • The processes for creating and awarding defense contracts. Defense companies initially set a “price to win” when attempting to capture a contract. When setting this price, companies must estimate costs for production labor, program management and support, and, most critically, purchased materials. Given the extensive number of subcontractors required to deliver a major program, defense companies often rely on supplier quotes in their basis of estimate, and these will likely be outdated and inaccurate by the time a program is under way.
  • Performance management processes. During production, contractors manage their financial performance using an estimate at completion (EAC) forecast—the current expectation of total cost at the end of a project. While the EAC is fairly accurate when inflation is low and predictable, increased input costs can make this measure unreliable if a product will not be delivered for a year or more. Even projects that remain on track could miss their initial EAC and jeopardize the incentive fee paid to contractors based on performance. While companies could build higher inflation costs into their financial estimates, resulting in higher EACs, their US government customers would have to agree with the amount. It may be difficult to reach this consensus because inflationary trends are difficult to predict.
  • Common contract terms. With FFP contracts, which are preferred for long-term projects, payment is tied to performance measures. This mechanism helps keep projects on track, but it leaves companies in a difficult position when economic conditions rapidly change. What’s more, contractors must sometimes increase costs to meet high performance standards for certain sustainment and repair tasks to comply with contract requirements. In such cases, inflation will exacerbate the cost burden.

Although inflation is an ongoing challenge, defense leaders have a host of tools to understand and respond to the risks it poses to their businesses. By addressing these issues now, they can help the DOD maintain a strong defense system to protect the nation. In the next article in our series, we will discuss how companies can diagnose cost challenges using an approach to integrated profit management.

Explore a career with us