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Defense Industry Mergers Earn New Look

By Jim Garamone
American Forces Press Service

WASHINGTON, Jan. 31, 1997 – DoD is not concerned about mergers in defense industries but will step back and examine the situation, the department's top acquisition official said during a recent interview.

Paul G. Kaminski, undersecretary for acquisition and technology, said DoD is worried about "vertical integration" in the industry and he is waiting for the results of a Defense Science Board inquiry before making any decisions.

The number of mergers in the defense industry has skyrocketed in recent years. For example, Lockheed and Martin-Marietta merged to form Lockheed Martin -- the largest defense contractor. Grumman and Northrop merged to form the Northrop Grumman Corp. There is a proposal to merge Boeing and McDonnell-Douglas, and another that would merge Raytheon, Texas Instruments and Hughes.

In part, mergers occurred because DoD allows the companies to claim certain restructuring costs that involve long-term savings to the department. "We are trying to provide some incentives for our industry to be more efficient," Kaminski said. This is not new, he said. DoD has always allowed companies to claim reasonable restructuring costs.

The savings to the department come in reduced overhead. Overhead are those charges companies cannot assign to a particular contract: administration, lab work and other costs of doing business. Streamlined, consolidated operations derive savings because overhead declines over time and the burden on each contract decreases, he said.

When the program started, the department allowed the companies to claim restructuring costs if the savings exceeded the costs. In the 1996 budget cycle, Congress changed this: Savings must be twice the restructuring costs. "This is not a big impediment," Kaminski said, "because the ratio to date has been about 5-to-1."

He said productivity in the restructured companies is up 15 percent. He put savings to DoD at about $4 billion, with the department allowing $72 million in restructuring costs.

DoD allows restructuring costs such as severance pay, early retirements, relocation expenses for employees, relocation expenses for plants and expenses for continued medical, life and dental insurance for employees. DoD does not allow interest costs to finance acquisitions, lavish severance packages for senior executives or the cost of the changes to the financial structures of the companies. "This is not 'payoffs for layoffs' as some people charge," Kaminski said. "And it has worked very well."

Now, however, the department wants to examine industry and the policy.

Kaminski said he is not surprised at the number of mergers. "When we looked at things, we started out with seven or eight aircraft [prime contractors], we're now headed down to three," he said. "If we look at fields like missiles, we have eight today. If [the proposed mergers go ahead], we're headed toward five." Kaminski said the department must look at each merger market-by-market because the prime contractors may go down to one or two in some markets.

"I think it is time to take a broad look at where we are," he said. "Enough has happened in the past three years. I am going back to my staff and looking at the big picture. I want them to push back from the table a bit and examine the situation."

One aspect that needs more study is vertical integration, which occurs when a company has all the resources needed to build a system. "If we have a [prime contractor] company that makes tanks, for example, they would make the tanks, they would make the propulsion systems, they would make the target acquisition systems, they'd make the guns, the treads -- everything on the tank," he said.

Because DoD is not buying many tanks, there can only be one prime contractor. Competition, which drives prices down, must come at the subcontractor level. If a company is vertically integrated, there would be no competition between subcontractors to supply these systems.

Kaminski asked the Defense Science Board to look at policies and see if there is some way to set up an early warning net. He said he expects a draft of the report in February.

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