The Defense Industrial Base of the Future

The Bottom Line

• America’s advantage in technology continues to decline; maintaining its military overmatch will require a commitment to modernizing the defense industrial base.
• Future military operating environments will require technology from more diverse sources and business models that enable faster innovation cycles. If DoD wants industry to change what it produces and how it delivers capability, then the department needs to change its incentives.
• Seeking commercial suppliers is not a panacea for future military superiority, and the role of policy for the defense industrial base will be to incentivize cooperation and investment from commercial and defense firms alike.
• Next-generation weapon systems superiority will be derived from progress in science, and the next NDS needs to help the nation prioritize basic research as a source of competitive advantage.

Introduction

In 1916, the Industrial Preparedness Committee accurately predicted that war in the 20th century would need to mix five drops of sweat from the factory for each drop of blood on the battlefield.¹The next National Defense Strategy (NDS) will need to define a new ratio for the 21st century. The balance may shift on both sides of the ledger; future industrial capacity may be measured in more code and less sweat, and conflict may be more robotic and less manned. This will profoundly affect how the U.S. military fights and how it engages with industry. The NDS will need to proactively prioritize the country’s technological superiority as a national security imperative.

Looming Challenges

America’s future leadership in the world and on the battlefield will be dependent on its ingenuity. Yet, while America remains the world’s leader in technology, its relative advantage wanes.² For instance, every year since 2007, China has awarded more doctoral degrees in technical disciplines than the United States. Since 9/11—while the United States focused on countering terrorism, Afghanistan, and Iraq—the U.S. share of global research and development (R&D), government and commercial investments combined, fell from 40 percent to less than 25 percent.³ A year before COVID-19 emerged, 60 percent of Americans believed the United States would be less important in the world due to its debt, inequality, and skills gap.⁴ Even before the current crisis, global perceptions about U.S. leadership had decreased, while those about China’s had increased.⁵ Even though the U.S. share of global defense spending remains high at 38 percent, it has declined by 10 percent since 2001; China and Russia combined have nearly tripled their share.⁶

The 2018 NDS is a rare document that provides long overdue strategic clarity. Its pillars of lethality, partnership, and reform established the department’s priorities to modernize the force. From an industrial base policy perspective, however, that NDS is reactionary; it stresses the military’s dependence on commercial market innovation. As the Department of Defense (DoD) increases its reliance on commercial technologies, its industrial base policy, perhaps paradoxically, needs to be more proactive about fostering America’s prosperity and less reliant on its commercial technology leadership being widely available. A modern defense industry will need to deliver differentiated capabilities faster, incorporate innovation from across sectors, and continue to use and apply advancements in science from across disciplines to military-relevant technology.

Technological Battlefields

Today’s defense industry is focused on developing highly complex systems that take, on average, 7–10 years to reach initial capability, and are expected to provide overmatch against adversaries for decades.⁷ This has made U.S. systems and capabilities more predictable. Since Operation Desert Storm in 1991, U.S. rivals learned that they will need new strategies to offset American advantage, and they have spent decades observing U.S. vulnerabilities and investing in new approaches to be competitive.⁸ As adversaries negate the U.S. advantage, they also reduce the value of current U.S. military systems.

An ever-increasing share of military capability will rely on commercially sourced technology.⁹ This is not a new phenomenon. As electronic content on defense platforms increased starting in the 1960s and supply chains became more global, many subsystems and components (e.g., sensors, displays, processors) were sourced commercially, as were a growing share of raw materials. While a specialized defense industry emerged due to divestments and consolidation after the end of the Cold War, its supply chain remained relatively diverse.¹⁰

The next iteration of defense technologies, however, will require much more overlap with commercial industry. Proposed new space architectures need higher volumes of highly networked and dynamic satellites. More air-based capabilities are expected to be unmanned and disaggregated. The next generation of ground vehicles is likely to be increasingly optionally manned and robotic. At sea, unmanned surface and underwater vessels are expected to offset manned ships that are more expensive and vulnerable. In cyberspace, human operators are rapidly being replaced by algorithms. Given the threat environment, all these changes are coming; the only question is how quickly.

The Pentagon is introducing new concepts that could help the U.S. regain its competitive edge. The Army wants a “hyper-networked” battlespace of sensors, robots, and automated command and control capabilities.¹¹ The Air Force seeks a family of low-cost, autonomous, and modular Skyborg drones.¹² These are two recent examples in a litany of new requests for capabilities that use more flexible contracting terms and target a diverse set of suppliers.¹³ The defense industry’s business model is optimized around long development lead times and years of sustainment opportunities via which to recoup investment. Most future operating environments will require higher volumes of systems delivered faster and with a greater focus on replenishment than on sustainment; they will also derive value and competitive advantage less from physical performance characteristics and more from software.

Such a future will be possible only with technologies such as artificial intelligence, quantum physics, micromechanics, and many more capabilities that are critical for broader economic sectors such as autonomous vehicles or smart cities, and thus attract predominantly commercial investment. Software will continue to “eat the world” and be a discriminating capability of any system.¹⁴ The broader economy, what the last NDS called the National Security Innovation Base, will then be able to provide both relevant enabling technologies and prime system level capabilities. The challenge for defense industrial base policy will be to incentivize a transition to new operating concepts enabled by next generation technologies, and to ensure that America continues to lead in them.

Quixotically Chasing Innovation

In its pursuit of cutting-edge commercial technology, the government established an innovation archipelago of new organizations and empowered them with alternative contracting vehicles with which to engage non-traditional suppliers. This, combined with some genuine process reform, provided the DoD with a toolkit to capture innovation. Today, there are dozens of organizations charged with engaging commercial firms that serve as a bridge between industry and end-users. There are more than 30 consortia that facilitate competitions for their member companies across almost 300 technology areas using other transaction agreements (OTAs).¹⁵ Since 2015, OTA awards have increased sevenfold, and 60 percent of them are managed by consortia.¹⁶ The practice of diversifying and disaggregating initiatives spreads risk, implying that many efforts will fail while only some will succeed, and that is wasteful. Accessing commercial innovation suboptimally will not be enough to retain the U.S. military technological advantage.

Engagement with commercial firms is the DoD’s hedge against China’s ability to fuse its military and industry interests and make scaled investments into future technologies.¹⁷ However, of the top 10 OTA awardees since 2015, 6 are traditional defense primes, 2 are scaled commercial firms, and 2 are global pharmaceuticals.¹⁸ Since 2015, less than 1 percent of the defense budget has been awarded via alternative contracting. DoD has engaged hundreds of companies, but only a few have built any meaningful inroads with military customers. While the DoD made accessing commercial innovation a priority, its efforts have demonstrated a great deal of activity but limited progress. Unsurprisingly, a group of investors recently penned an open letter asking the DoD for more commitment and fewer slogans.¹⁹

While the Pentagon has focused on engaging commercial firms, it has not incentivized its current suppliers to modernize. The defense industry is consistently criticized, but it is almost perfectly structured to deliver what its customer incentivizes it to produce. Defense industry investors reward this efficiency.²⁰ However, the cost of major programs has increased, while their quantity has fallen. As of 2019, more than two thirds of contracts that comprise 82 major DoD programs were not competed.²¹ If the DoD wants industry to produce different things, it must change its incentives.

The primary risk to modernizing the joint force in preparation for great power competition is twofold. First, the government may not commit or prioritize enough funds to enable a transition to new military operating concepts. Second, the Pentagon may not develop an incentive structure that builds a clear path for firms to profit from engagement with the military using commercial business models. A combination of constrained budgets and lack of clarity about future requirements will further reduce volumes for traditional suppliers, incentivizing even more consolidation and vertical integration, and may never make it attractive enough for commercial firms to invest, or for defense firms to pivot. Incentivizing change will require an industrial base policy that is clear about its objectives denoted in dollars and not statements; that outlines concrete operational viewpoints that demonstrate what new systems are needed and which older ones will need to sunset; that understands the economics of its new architectures, because higher volumes of interconnected systems are not necessarily less expensive than exquisite capabilities; and that explains how investment in enabling technologies will be a source of competitive military advantage.

Innovation Needs a Mission

Supporting science, the creation and diffusion of knowledge, is the best way to ensure America’s leadership. This fundamental point, proposed in 1945 by Vannevar Bush, who during World War II led the nation’s military R&D effort, changed the course of U.S. history.²² Innovations such as the transistor and the Internet, storied corporate labs at Bell and Xerox, and institutions such as the National Science Foundation (NSF) and Defense Advanced Research Projects Agency (DARPA) are all direct descendants and beneficiaries of Bush’s ethos.²³

The DoD is betting on the private sector to take advantage of larger investments and faster innovation cycles. This year, the corporate share of total U.S. R&D spending is almost 70 percent, while the government’s is just shy of 22 percent; in the 1960s, the ratio was reversed.²⁴ However, more than 75 percent of corporate R&D is focused on product or process development. Outside of select sectors, most firms do not engage in basic research at all, which requires long-term time horizons and investment. This is where the government and DoD can have an outsized impact. As a research team at Harvard Business School discovered in 2019, while government R&D as a percentage of gross domestic product (GDP) has declined over the past four decades, the percentage of government-backed patents has increased almost threefold. Their work also showed that most patents filed by companies, and more than a third submitted by startups, relied on government funded research, suggesting that government investment into basic research drives American ingenuity.²⁵

Although R&D differentiates the United States from China and Russia, if the United States is likely to experience a prolonged economic contraction due to COVID-19, then corporate research budgets may tighten. After the 2008 financial crash, corporate R&D fell by 10 percent.²⁶ Early stage venture capital funding declined by more than 40 percent and took several years to recover.²⁷ U.S. adversaries are building an advantage primarily in their application of commercially diffuse technologies. This game is likely to continue. The thing about science is that its breakthroughs stand on the shoulders of knowledge, and it is not possible to leapfrog basic research. The United States should capitalize on this source of advantage, while it still has it, and try to protect it in the event of a downturn.

Recommendations

To effectively transition to new military technologies in which America leads, the next NDS should outline four core priorities of national security industrial base policy:

Increase the volume and frequency of competitions

Accelerate the number and regularity of competitive awards for new capabilities required for next generation operating concepts.

Reward reduced development times

Create high-margin profit pools for contractors that can reduce lead times, thus incentivizing more corporate investment into R&D.

Fund projects with scaled transition opportunity

Fund development projects with scaled potential that can dynamically demonstrate a path from basic research to operational systems.

Support investment into basic research

Protect and grow defense basic research funds and promote a national-level program focused on science.

Bridging Prosperity with Security

A dynamic industrial base is needed to transition American ingenuity from the lab to the battlefield. But the government is asking for new competences while disproportionally funding the old. If future capabilities need to be produced at higher volumes, on faster innovation cycles, and enabled by software that can be continuously improved, then the government is asking for its industry to have technology sector operating models that hinge on perpetual market growth and high margins to enable re-investment into technology. Reducing lead times and increasing innovation in defense cannot be achieved under today’s incentive structures.

As a finite market that also serves as a steward of taxpayer dollars, defense will not provide commercial market or margin expansion opportunities to be an automatically attractive sector. The role of industrial base policy will be to substitute perpetual market growth with budget clarity and funding priorities; and to augment margin potential with increased volume and frequency of competitions. Creating programs and incentives for transitioning government funded scientific breakthroughs will also help attract investment and maintain America’s military advantage.

About the Author

Mikhail Grinberg is a Principal at Renaissance Strategic Advisors, a consultancy in the aerospace, defense, space, intelligence, and government services industries. He is also an Adjunct Senior Fellow at CNAS. Mikhail is a co-founder of The Strategy Bridge and currently serves on its board. As well, he is a board member of Young Professionals in Foreign Policy.

Learn More

From July to December 2020, CNAS will release new papers every week on the tough issues the next NDS should tackle. The goal of this project is to provide intellectual capital to the drafters of the 2022 NDS, focusing specifically on unfinished business from the past several defense strategies and areas where change is necessary but difficult.