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Inflation: How defense companies can

support national security

November 11, 2022
| Article

By Eric Chewning , Patrick Forrester, Jess Harrington, and Jesse Klempner

A solid understanding of risk exposure and the contract portfolio can

help defense companies support national-security interests.

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Article (6 pages)

T
his 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.[ 3 ]

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.

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 ]
Exhibit 1

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
guidance[ 8 ]
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.
Exhibit 2

In 2021, most products and services were covered under fixed-price contracts.
Products Services

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.
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.
1.
“Consumer price index summary,” US Bureau of Labor Statistics, October 13, 2022.
2.
The producer price index data are for the 12 months ending August 2022, from “Producer price
index news release,” US Bureau of Labor Statistics, October 12, 2022.
3.
“The $773 billion question: Inflation’s impact on defense spending,” McKinsey, March 28, 2022.
4.
Jonnelle Marte and Catarina Saraiva, “Fed hikes 75 basis points second time, signals third is
possible,” Bloomberg, July 27, 2022.
5.
Federal Acquisition Regulation (FAR) Part 15 requires government agencies to ensure that the
goods they obtain are of sufficient quality and value; this applies to unique products covered by
disclosure contracts. FAR-12, by contrast, states that the government is exempt from some
documentation requirements for purchases of relatively small value, or for goods and services that
already have a widely accepted price on the commercial market and that are covered by commercial
contracts. A contract’s terms may vary depending on whether it is covered by FAR-12 or FAR-15.
6.
Includes average prime contract obligation value by contract type awarded to BAE Systems,
Boeing, General Dynamics, Huntington Ingalls Industries, L3Harris Technologies, Lockheed Martin,
Northrop Grumman, and Raytheon Technologies from 2016 to 2021.
7.
An amendment to the US Senate’s version of the National Defense Authorization Act would
provide contractors with an economic price adjustment with existing FFP contracts, but the bill still
needs to be reconciled in conference and signed by the president before it could become law.
8.
“Guidance on inflation and economic price adjustments,” US Department of Defense, May 2022.
9.
“Updated guidance on managing the effects of inflation with existing contracts,” US Department
of Defense, September 12, 2022.
 ABOUT THE AUTHOR(S)
Eric Chewning and Jesse Klempner are partners in McKinsey’s Washington,
DC, office, where Patrick Forrester is a consultant and Jess Harrington is a
solution manager.

This article was edited by Eileen Hannigan, a senior editor in the Waltham
office.

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