Why Is the U.S. Defense Industrial Base So Isolated from the U.S. Economy

Commentary by Gregory C. AllenandDoug Berenson

Published August 20, 2024

In April 2022, Deputy Secretary of Defense Kathleen Hicks expressed concern about the "substantial decline" in competition within the U.S. defense industrial base. A February 2022 study by the Department of Defense (DOD) found that after decades of consolidation, the number of defense prime contractors had shrunk from 51 to fewer than 10. Further, many segments of the defense market have become controlled by companies with monopoly or near-monopoly positions. While Hicks is a leader in the Democratic administration, her concerns are bipartisan: Former president Donald Trump stated in 2019 that U.S. defense companies have "all merged in so it's hard to negotiate. . . . It's already not competitive."

Excessive defense industry consolidation and inadequate competition are real challenges for the DOD, but there is another closely related problem that is often overlooked and understudied: the isolation of the defense industrial base from the wider commercial economy. This limits capital investment in defense-related technology, curbs the DOD's access to the dynamism of emerging commercial technology sectors, and leaves traditional defense companies with enormous leverage vis-à-vis their government customers.

In 2024, the DOD and other national security agencies will spend more than $800 billion-more than 1 out of every 30 dollars in the U.S. economy. Despite this incredible scale, the U.S. government and its private sector suppliers are more isolated from the broader, nondefense U.S. economy than at any other time in U.S. history. The United States is in a new era of geopolitical and technological competition. Yet, its defense industrial base is very different from the one that helped win the Cold War, when commercial companies were frequently leaders in both defense and nondefense markets.

The numbers tell the story. DOD acquisition spending is overwhelmingly in the hands of a core group of traditional defense contractors. Longtime defense industry consultant Martin Bollinger developed a dataset that tracks DOD expenditure on so-called Major Defense Acquisition Programs (MDAPs) back to 1977. The data identifies program prime contractors by their industrial base sector. Defense specialists-firms with little or no commercial business-account for 61 percent of the DOD's major programs by value in 2024, up from just 6 percent when the Berlin Wall fell in 1989. When including firms whose only commercial exposure is in aerospace (such as Boeing or Textron), traditional DOD suppliers account for 86 percent of major program spending in 2024. By contrast, firms with wider commercial interests are barely represented. See Figure 1.

How did this massive shift happen? Major cuts in defense budgets after the end of the Cold War led U.S. companies that were marquee brands in both commercial and defense markets to sell off their defense divisions. In the process, those companies that elected to stay in the defense sector consolidated programs and operations. For example, the automotive giant Ford Motor Company had a subsidiary, Ford Aerospace, which manufactured missiles and satellites. Ford sold off the subsidiary in 1990 and exited the defense market. Ford's defense business was bought by Loral Corporation, an aerospace and defense company, which itself later sold off its defense operations to Lockheed Martin in 1996.

These divestitures and consolidations happened with the explicit support of U.S. national security leaders. With the Soviet Union gone, DOD leaders worried that declining defense budgets would be unable sustain the breadth and depth of the industry that had expanded through the 1980s. Consolidation was seen as necessary to gain efficiency and to preserve the defense industry's technological and operational know-how.

However, consolidation and de-commercialization continued even after defense spending growth returned. In the decade after the terrorist attacks of September 11, 2001, defense spending increased by 50 percent, adjusted for inflation. Even during this period, leading commercial companies continued to divest their defense subsidiaries. For example, Kodak, a household name throughout the twentieth century for its consumer film and cameras, also built the high-performance optical equipment at the heart of U.S. spy satellites. Kodak sold its national security business off in 2004 to ITT Inc., which in turn spun off its defense business as a separate entity in 2011. The legacy Kodak defense business has been a part of two more defense industry mergers since then, and is now part of L3Harris, the sixth-largest U.S. defense contractor.

Companies that specialize in defense-and some broader federal markets like IT services and government facilities-may not know much about commercial sectors, but they know a lot about the art of selling to the government. They have invested in specialized accounting systems, cyber and information security systems, and sprawling teams of professionals who are trained to understand how the government buys and what it wants. The expertise to engage in complex government contracting is expensive to develop and maintain, and many commercial firms avoid it altogether. Financial analysts often refer to a "moat" as a dynamic that serves to deter new entrants to a given market; U.S. government compliance is a wide, deep, and shark-infested moat behind which defense specialists compete mainly against each other.

These complex regulatory factors help explain why the defense market is often dominated by specialist firms, even in sectors where the customers are buying goods and services, like janitorial services and office supplies, that are essentially identical to commercial offerings aside from government process compliance challenges.

Having cracked the code to sell to DOD customers, defense specialists have become highly diversified in their defense portfolios, allowing them to capture as much government value as possible. For example, General Dynamics (GD) not only builds military-unique products like nuclear submarines, tanks, and munitions; it also has a large IT services division that, among other things, integrates and manages DOD IT infrastructure.

Some of the DOD's major suppliers do engage in commercial aviation as a near adjacency to defense. Boeing, Textron, GD (which owns business jet maker Gulfstream), and RTX (which combined Raytheon and United Technologies in 2020) are major players in both defense and commercial aviation. The technical synergies between commercial and military aviation are obvious, but the need to manage complex relationships with U.S. government regulators also influences many commercial aviation companies to serve government markets.

While many commercial firms are deterred from serving the DOD due to the heavy regulatory burden, they may also be deterred by limited financial upside. Although defense contracts can be huge in dollar terms and associated revenue, they usually involve significantly lower profit margins than many other businesses. In 2023, Lockheed Martin, whose business is heavily geared to the U.S. government, earned about 10.9 percent operating margins. By contrast, in 2023 iPhone-maker Apple earned margins of over 44.0 percent. Limits on defense contractor profitability make sense, given that the government bears most of the investment risk in defense technology. However, the financial realities of government contracting are another reason why many commercial firms are wary of defense.

Of course, there are a handful of other defense sectors that have been strongly influenced by commercial technologies, companies, and business practices. Space technology, for example, has been revolutionized by a new generation of companies that barely existed 20 years ago, like SpaceX, PlanetLabs, Maxar, and others. Many of these emerging space firms grew partly on the strength of commercial demand for remote sensing, satellite communications, and other space-derived services that have broad commercial applications. As the DOD lurches toward capabilities in areas like cloud computing, artificial intelligence (AI), and quantum, it is trying to attract a mix of start-ups and established commercial firms.

A central critique of the defense industry today is that while its primary customer emphasizes the need for innovation, defense companies focus on mitigating financial risk to themselves and their investors. Although the defense market is rarely a source of rapid growth or outsized profit margins, it does offer its investors something that can be almost as valuable: predictability and low risk. For example, cost-plus contracts shield companies from the risk involved in cost overruns or delays on complex projects. The DOD communicates its midterm modernization plans to suppliers in great detail. In contrast to many commercial customers, the DOD always pays its bills reliably. Defense companies minimize their internal research and development spending, knowing that the DOD will cover most technology development costs for the weapon systems it wants. Many firms will avoid bidding on contracts for which they fear requirements are misaligned with their proposed solutions or when the financial terms being offered are not favorable. In market segments that have narrowed to just a handful of competitors, defense companies have gained substantial leverage over their DOD customers.

Investors evaluate stocks not just on their expected financial return but also on the level of risk associated with a given investment. A potential investment becomes more attractive when either the expected return goes up or when the risk to invested capital declines. Defense companies have become experts in mitigating risk for their investors. A 2022 study led by defense industry consultant Martin Bollinger on behalf of the DOD found that financial returns of defense stocks during the 2000-2019 period offered a significantly better risk-adjusted rate of return than companies in many other sectors, even those enjoying faster growth and higher profit margins.

In recent years, the DOD has launched a bevy of initiatives to entice start-ups and commercial technology firms to enter the national security market. There is evidence that these moves-new organizations to engage with nontraditional players, new contracting mechanisms that involve fewer bureaucratic hurdles, and acquisition practices that emphasize speed over process-are starting to draw in a wider set of suppliers. DOD leaders understand that that the technologies that may decide future wars-AI, machine learning, 5G networking, additive manufacturing-are being developed predominantly among commercial companies.

The innovation that the Pentagon is now trying to foster conflicts with a countervailing DOD priority: protecting taxpayer money. Enticing commercial companies to dip their toes into the defense marketplace may mean easing some of the practices intended to safeguard the U.S. government, such as ceding control over intellectual property and allowing higher profit margins. It might also require reducing emphasis on priorities like spreading the money around by requiring a share of each defense contract to meet mandatory revenue-share quotas of so-called set-aside subcontracts to small businesses. The question is whether the sense of urgency on the part of the DOD and Congress is sufficient to contemplate changes like these.

Gregory C. Allen is the director of the Wadhwani Center for AI and Advanced Technologies at the Center for Strategic and International Studies in Washington, D.C. Doug Berenson is a partner in the Aerospace, Defense and Government Services practice at Oliver Wyman.

The authors would like to thank Marty Bollinger for sharing his original dataset and insights on this topic.

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