By any "per-unit" measure, national defense is increasingly costly. The largest discretionary element of the federal budget, defense is on a collision course with other domestic spending priorities. The federal budget pays healthcare and retirement benefits to a steadily growing share of the population;

similarly, the most rapid growth in Department of Defense (DoD) spending--excluding the operations in Iraq and Afghanistan--is in providing deferred entitlements to military retirees. These retirees have served their nation invaluably while in uniform, but they and their dependents do not contribute to military readiness, and the money spent on their benefits reduces that available for buying and building new capabilities. Our Middle Eastern operations exacerbate this problem, generating future bills to recapitalize and "reset" the force. Current supplemental appropriations do not cover these must-fund bills, and the increasing costs of restoring preexisting military capabilities for years to come will inevitably eat away at the resources available to develop new ones.

Balancing the sometimes incompatible priorities of DoD, Congress, and the defense industry is extremely difficult. All parties benefit from a sustainable defense program, but using this mutuality of interest to rationalize defense spending has been a complex task. In 1993, early in what became DoD's last fiscal contraction, Secretary of Defense Les Aspin and Deputy Secretary William J. Perry brought together a group of defense industry leaders to explain that the budget was going to continue to decline and that the administration was aware, and did not care, that some companies would not survive. This blunt statement served as a warning that the old arguments about preserving the defense industrial base would carry no more weight. The consolidation of the defense industry since then makes fixing things even harder today.

Background

Making Decisions in DoD

The four services have always viewed how they contribute to the nation's defense differently. They have also made decisions about their budgets in distinctive ways. At its most basic, the central issue for the services has been how to balance "people" and "equipment" The Air Force, on one end of this continuum, has always spent much more on investment (procurement and research and development combined) than it has on manpower (Figure 1). In contrast, the Army has always spent more on people than on weapons. The Department of the Navy (which includes the Navy and Marine Corps) has also spent more on investment than on personnel, but not to the same degree as the Air Force.

[FIGURE 1 OMITTED]

The nature of the military equipment that the services use and buy-aircraft, tanks, ships-helps explain part of the difference. These patterns have remained consistent for a long time, complicating decisions in DoD that force tradeoffs between services. Since its inception in 1947, DoD has been tasked with effectively orchestrating the differences among the four uniformed services and the three military departments under which they fall. Until the 1960s and the introduction of the Planning, Programming, and Budgeting System (PPBS), the Office of the Secretary of Defense (OSD) served principally as a conduit for passing program and budget information to Congress and rarely made overarching decisions that altered the balance between the services.

Secretary of Defense Robert S. McNamara introduced PPBS in 1961 to enable the rational prioritization and use of resources DoD-wide. The first important PPBS product was a December 1962 decision to restructure the nuclear-based strategic retaliatory force. This decision, like others in the early years of PPBS, was based on careful analysis of evidence that focused on the central question of "How much is enough?" Employing a rigorous analytical method, the PPBS helped senior leaders make choices that reallocated resources across the services.

As the service staffs rapidly became more skilled at the computer-assisted systems analysis and operations research tools used by McNamara and his "whiz kids," program and budget decisions gradually evolved to where today they tend toward marginal changes and tinkering within the existing framework of the military departments' "fair shares." The transformational efforts of former Secretary Rumsfeld resulted in some program cancellations (Crusader, Comanche), but the potential that these decisions would foster a cultural shift in the Pentagon has been overtaken by events, as the United States has been continuously fighting wars in Afghanistan and Iraq and engaged in intense antiterrorist operations around the globe.

Dealing with Fiscal Stress

Since fiscal year (FY) 1955, DoD has faced two major fiscal crises, episodes where budgets declined in real terms over a prolonged period (seven or eight years), necessitating a restructuring of defense programs (Figure 2). The first occurred at the end of the Vietnam War. From its peak in FY 1969, military spending dropped Robin Farley, CDFM, CGFM, is an LMI research fellow, who leads work in federal financial management. He has a master's degree in public policy from the John F Kennedy School of Government, Harvard University, and is a PhD student at the School of Public Policy, George Mason University. He can be reached at rfarleyglmi.org. more than 35 percent by the time U.S. forces finally left Vietnam in April 1975. Over that span, military manpower dropped almost 40 percent. Defense spending did not grow again in real terms until the second half of the Carter administration. In FY 1981-86, defense spending rebounded, growing annually by 7 percent. At the end of the cold war (the Soviet Union collapsed in December 1991), defense spending again dropped precipitously, falling 36 percent in FY 1991-99. The "peace dividend" saw military manpower drop by almost one-third and saved nearly $1 trillion by FY 1999.

After reaching the lowest point in the last five decades in FY 1999, defense spending grew slightly (less than 2 percent a year) until 9/11. Since then, the service budgets (including funding provided in supplemental appropriations) have grown an average of more than 9 percent annually in real terms. Unlike during previous wars, the armed forces have not grown significantly in the last five years. Instead, increased funding has supported a mobilized National Guard and Reserve force, increased use of contractors to provide logistical and other operational support, and accelerated procurement of equipment.

[FIGURE 2 OMITTED]

In the last five years, the costs of operating the armed forces have grown dramatically, but not just because of the ongoing wars. Since FY 2001, the aver age manpower costs per active duty service member have increased 37 percent overall. The Army has had the greatest growth, an average of almost 70 percent ($67,000 to $113,000). Activation of the Army National Guard and Reserves explains much of this growth. However, according to a 2005 Congressional Research Service report, other components contributing to increased costs are permanent, including sustained pay raises over inflation, pay table reforms, and the long-term costs for military healthcare and Medicare premiums.

The Next Crisis

The experience of the last fifty years demonstrates that sustaining defense spending at current levels (upwards of $450 billion a year) is impossible for long. Inevitably, the defense budget will fall back, perhaps to pre-war levels. In real terms, current defense spending constitutes a very small percentage of gross domestic product (GDP), but it is the largest discretionary portion of the federal budget, today surpassing all other domestic (nonsecurity) discretionary spending combined. As such, when the defense budget grows beyond a certain level, other factors can be counted on to force spending down.

Regardless of the reason--declining commitments in Iraq and Afghanistan or an overall worsening fiscal environment--Pentagon decision makers are going to have to cope with shrinking budgets for the foreseeable future. Figure 3 outlines the dilemma DoD faces: average costs (dollars per active duty service member) have skyrocketed in the last five years. The nature of the increasing costs of personnel, operations, and investment in a force structure (which was considered in the early 1990s to constitute a minimally acceptable "base force") will make it even more difficult to make choices between people and equipment.

[FIGURE 3 OMITTED]

For decades, analysts have warned that the increasing per-unit costs of weapon systems are producing an unsustainable situation, in which new, expensive systems moving to the production stage will result in a procurement "bow wave"--unattainable procurement requirements that force hard choices. The department's investment programs survived these dire predictions in the past in a variety of ways. The Reagan administration added money to keep buying weapons in the early 1980s and ended the decade by stretching out procurements. The end of the cold war produced huge reductions in force structure, which were used in equal measure to reduce overall spending and support the procurement of even more expensive systems.

However, the next crisis may qualitatively differ. The rapid, simultaneous increases in the costs of personnel, operation and maintenance, and investment are without precedent and may finally be too much for the system to handle. Attempting to solve the next budget crisis by nibbling at the edges of multiple programs to avoid painful decisions will, at best, produce a less-than-optimal allocation of increasingly scarce resources; at worst, it will result in the inability to generate the capabilities needed to deal with emergent threats. The scale of the looming crisis is so great that a radically new approach is required, one that looks at problems in original ways, poses new questions, and

thoroughly and fairly considers imaginative solutions to increasingly intractable problems. In this environment, how will leaders in the services and OSD manage? Can DoD devise a method that forces better decisions to optimize resources across the services and agencies? Before the inevitable crisis hits, what can be done now to prepare? The LMI Executive Forum LMI periodically assembles senior government leaders and their peer experts in academia and industry in roundtable sessions, called "Executive Forums," to discuss emerging or perennial issues facing government. The latest LMI Executive Forum invited senior leaders from DoD, federal agencies, the academic community, and private industry to discuss the challenges and opportunities stemming from budget pressure on defense spending. The guest speakers, a former public-sector leader (now a senior leader in academia) and an industry executive, revealed that although the public and private sectors operate different business models, they have a mutually reinforcing desire to contain costs. To that end, our nation's national security strategy must be aligned with (but not driven by) fiscal reality.

The Fiscal Situation

The forum participants agreed that DoD is facing a future where pressure to restrict defense spending will grow. As stated previously, national defense is increasingly costly by any per-unit measure. As the largest discretionary element of the federal budget, it is also going to face stiffer competition from other spending priorities, especially mandatory programs that pay retirement and healthcare benefits to a rapidly aging population.

The growth in the cost of the defense program, especially that stemming from increasing manpower costs, was a frequent theme of the discussion. Another theme was the chronic growth of the gap between the country's national security strategy demands and the resources available to meet them. Everyone accepted the premise that DoD wants and needs are fundamentally mismatched with affordability and sustainability.

Clearly, DoD is not alone in facing fiscal challenges. Private-sector companies routinely deal with their own budget crises when they face increased competition from a rival firm or during a general downturn in the economy. Not surprisingly, they deal with declining revenue by cutting costs-in any way possible-including consolidations, reductions in frills and fringe benefits, layoffs, and other drastic means of lowering costs and sustaining profitability.

Perspectives

DoD participants were very familiar with the relentless drive to control costs in the department and shared their experiences in a lively discussion featuring the following:

* DoD's mission is to fight and win wars. It has no incentive to do so cheaply; in fact, the consequence of failure is so great that military leaders are disinclined to embrace cost-constrained approaches that may pose any risk. Especially during a war, cost-based decisions are an anathema. The result is requirement inflation, which drives costs up. "How much is enough?" is not a question asked by military leaders, who want the best no matter what the cost.

* The department has been cutting overhead and infrastructure since the 1990s and has probably already done everything obvious or easy to operate more efficiently.

* Since the end of the cold war, the military and civilian workforce has declined by more than one-third. The mission has not decreased, continually challenging the workforce to do more with less.

* A common method of sustaining operations in this environment is to outsource and privatize functions. The department's contractor workforce collectively costs more than the equivalent government (military and civilian) workforce. DoD has made this uneconomic choice because the size of the government workforce is capped, but contract dollars can be used to buy the workers needed for the steadily growing workload. DoD originally touted the reliance on contractors as a cost-saving measure. Although these savings did not materialize, the premium is sometimes justified by the ease of reducing the contractor workforce when the workload decreases.

* DoD does not know what it costs to do business. Despite prolonged and significant spending on financial visibility initiatives and information technology systems, it still has no quick, reliable way to identify the controllable costs of doing business and offer decision makers lower-cost alternatives.

* According to many participants, the department has demonstrated its ability to make choices to cut large amounts from the defense budget. In 2005, OSD made Program Budget Decision 753, which cut $30 billion from the FY 2006-11 defense program. Everyone agreed, however, that even larger cuts (approaching $10 billion a year) must be made to meet expectations placed on the department.

Congressional Influence

The discussion frequently returned to the issue of interaction with Congress. Dealing with the rapidly increasing costs of military entitlements is one of DoD's great challenges, but defense leaders see this problem as largely inflicted on them by legislation. As one participant explained, "The average soldier wants more pay today, but the move over the last several years has been to increase future compensation for retirees and their beneficiaries." Only a very small portion of the current force will stay in uniform long enough to collect those benefits, so the largest area of cost growth (apart from current wartime operations) is paying for people who are not currently contributing to military readiness. (The department seeks to provide full entitlements so that service members' compensation places them in the 90th percentile for equivalently educated workers.) The consensus was that this state of affairs was not entirely the department's fault. Convincing Congress that the department needs relief may be possible, but even an open-and-shut case might be trumped by the political influence of the military retiree community.

The group only briefly touched on the area of investment, but this discussion raised one interesting point. Most agreed that the continuing concentration in the defense industrial base, coupled with a relentless pursuit of superior technology and performance, is inexorably driving up weapon costs. Although they recognized industry and department mutuality of interest, the participants were afraid that decisions that consider long-term sustainability of the relationship are nearly impossible. Here again, congressional oversight often forces the department to do things it has chosen not to. One innovative idea for helping sustain the defense industry and support our national military strategy would be to sell more and better military equipment to our allies in the Pacific. Currently, foreign military sales and the national strategy are not linked.

Reaching a Solution

Forum participants said that preparing for the next budget crisis should be a high priority for senior leaders in the Pentagon. Of course, until the United States reduces its military presence in Iraq and Afghanistan, nothing else of lasting significance will happen. But when Middle Eastern operations drawdown, sustained budget reductions on the order of the two previous periods of decline would involve a cut of at least one-third ($100-$150 billion) from the defense budget, bringing it back to pre-war levels. DoD's typical response to a looming budget crunch-squeezing out savings in overhead, infrastructure, and other controllable costs-will not bridge the gap. The department has done this for nearly twenty years through intense cost-cutting measures-base closures and realignments, outsourcing, and privatizations--reaping all the reductions these means offer.

To manage defense spending to a constrained top line, DoD must attack the causes of unsustainable cost growth:

* Pursuing technical superiority without regard to procurement costs or the capacity to sustain a force over the long term

* Relying too much on contractors for technical and logistical support

* Rapidly increasing the cost of military personnel, especially by creating deferred entitlements that benefit retirees and do little for current capability.

Every year, the PPBES (which now includes "E" for "execution" in response to the Chief Financial Officers Act) offers Pentagon decision makers choices that tinker on the edge of the budget but don't grapple with what makes the program so costly. The decision-making process must abandon its current mania of squeezing the last 20 percent in efficiency from the supply chain (for example) and take on what is busting the budget-fighter planes, satellites, and combat systems. These increasingly expensive systems emerge from the relentless pursuit of overwhelming capability. Because the Joint Capabilities Integration and Development System UCIDS) process rarely blocks a proposed materiel solution, it enables (some would say fuels) costly requirement creep. Today, the U.S. military has no competition, so we, not potential adversaries, are pushing the envelope. We choose to build and sustain expensive planes and ships to defeat any enemy, a no-risk approach that is simply unaffordable.

Fair or not, the fallout from the $600 toilet seat has led the public to believe DoD is poorly managed. These management problems are not that simple, but the con sensus among experts in and outside the Pentagon is that the department doesn't make good decisions on how to spend money. Congressional involvement does not help. Over the last four decades, the cost of running the department has grown in every important category. Weapon systems the services buy are increasingly capable, regardless of the potential threats, and thus too expensive to buy and operate in the numbers originally sought. Operation and maintenance costs, which have exploded since FY 2001, reveal that relying on contractors to support the force is probably not nearly as cost-effective as originally imagined. Military personnel costs have increased dramatically, partly to pay for an almost fully mobilized reserve and guard force, but also to provide generous entitlements to military retirees.

Conclusion

DoD is the world's largest enterprise. Its annual expenditures dwarf the world's largest company Exxon-Mobil, and its GDP would make it the eighteenth largest country. For such a large organization, it runs remarkably well. Day-to-day operations are accomplished with great skill and creativity by a military and civilian workforce of nearly three million, augmented by as many contractors. The defense workforce executes the missions it is assigned. Now, the new secretary must tell them to design and build an affordable military.

The forum discussion accurately portrayed the big issues and intractable nature of the challenges DoD faces. One surprise was the general consensus that the services were not likely to face a declining top line (excluding supplementals) in the very near term due to ongoing operations. This belief could be a function of what one participant described as the department's typical response to a fiscal crisis: denial. More likely, as another participant explained, "too many people in the Pentagon think that it all boils down to making a better case that we (our particular service or program) need more money."

To maintain a financially viable DoD, as forum participants discussed, thought leaders in the iron triangle--DoD, Congress, and the defense industry--and the individual services must discard the notion that maximizing DoD funding, and each service's individual share, is the goal. They must instead look for technical solutions that consider procurement costs and long-term sustainability, lower the reliance on contractors, and examine ways to lessen the cost of deferred military entitlements.

Note

The budget figures in this article exclude funding for revolving and trust funds (Defense Working Capital Funds) and military construction and family housing accounts. Also excluded are funding for defense agencies, such as the military intelligence agencies, funded in defense appropriations. All figures have been adjusted to account for the effect of inflation.

References

Goldich, Robert L. Military Pay and Benefits Key Questions and Answers. Congressional Research Service, The Library of Congress. www.senate.gov/-hutchison/lB10089.pdf.

Tirpack, John A. "The Distillation of the Defense Industry." Air Force Journal, July 1988.