Navigating Affordability Challenges Amidst Rising Costs due to Rapid Interest Rate Increases
Edward Walsh
President & CEO
Pantheon Integrated Solutions, Inc.
Introduction
In an era of constrained fiscal environments and competing funding priorities, ensuring affordability is critical to effectively allocating limited resources without compromising national security objectives. However, amidst the various cost elements within defense programs, the Facilities Capital Cost of Money (FCCM) often remains neglected or receives insufficient attention.
This neglect can be attributed to limited understanding of its impact, the focus on other major cost drivers, or the limited knowledge of calculating the FCCM. Nevertheless, a confluence of two factors has elevated the significance of the FCCM: (1) the primary defense contractors have recently made and are undergoing substantial investments in facilities and infrastructure to support defense modernization efforts and support increased requirements, and (2) the Federal Reserve has increased the federal funds rate at the fastest rate in modern history. These events have raised the profile of the FCCM as a meaningful cost driver.
With defense contracts often being large-scale endeavors, even a modest increase in the FCCM can translate into significant cost implications, potentially amounting to tens or hundreds of millions of dollars over the contract's performance period. Recognizing these drivers becomes essential for decision-makers, enabling informed budgeting and negotiation strategies. By proactively addressing the FCCM and incorporating it into resource allocation and negotiation approaches, decision-makers can optimize budget allocation and mitigate potential cost overruns, thus ensuring the overall success of defense programs.
I. Unraveling the Role of Facilities Capital Cost of Money (FCCM): Addressing Opportunity Costs
The FCCM is an accounting concept developed by the Government to address the opportunity cost faced by contractors when deciding to invest in the modernization of facilities and equipment, thereby improving efficiency in government contracts. In the context of negotiations for fixed-price production contracts or cost reimbursable contracts, the primary focus tends to be on cost considerations rather than investments in enhancing production lines. This dynamic creates limited incentives for contractors to allocate resources towards initiatives aimed at reducing costs within the government production environment. In the long run, a sustained failure to invest in enhancing production lines will ultimately result in the less-efficient processes that will ultimately costs the Government more for inferior results.
The FCCM attempts to solve this perverse incentive structure where contractors are dissuaded from spending money to become more efficient. Contractors in government production often face alternative claims on their financial resources, including potential investments in commercial business activities, debt reduction, or avoiding interest payments. Put simply, expending funds to build a better mousetrap (something the Government wants) requires a contractor to forego other opportunities.
The FCCM is designed to recognize and account for the opportunity cost incurred by contractors who opt not to pursue these alternative paths. By providing compensation for this opportunity cost, the FCCM seeks to create a more equitable framework that encourages contractors to invest in the modernization and improvement of facilities, ultimately leading to increased efficiency in government contracts. This compensation mechanism acknowledges that by committing resources to government production lines, contractors are forgoing other potential avenues that could generate returns or reduce financial burdens.
By incorporating the FCCM into contract negotiations and cost structures, the Government aims to incentivize contractors to allocate resources towards enhancing government production lines. The FCCM acts as a financial instrument that recognizes the value of investments in modernization, cost reduction, and efficiency improvements. By compensating contractors for the opportunity cost associated with not pursuing alternative uses of resources, the FCCM acknowledges the importance of fostering competitiveness, innovation, and effectiveness in government contracts. It serves as a means to balance the equation between cost considerations and long-term investments, contributing to the overall success of government initiatives.
II. Facilities Investment in Defense Industry: A Closer Look at CAPEX Programs and Their Impact on Cost of Money Calculations
According to Cost Accounting Standard (CAS) 414, the calculation of the cost of money entails multiplying the net book value of the business unit's facilities investment by a designated cost of money rate, which is determined based on the interest rates specified semi-annually by the Secretary of the Treasury in accordance with Public Law 92-41.
The calculation is comprised of two primary components, the first being the net book value of facilities and equipment. In response to rising defense requirements, the need for equipment replacement due to wear and tear, and the adoption of emerging technologies, several leading defense companies have undertaken recent capital expenditure programs. Here are notable examples:
Lockheed Martin: In 2017, Lockheed Martin announced plans to invest over $1 billion in the establishment of new manufacturing facilities and infrastructure for their F-35 Lightning II fighter jet program. This investment aimed to increase production capacity and reduce costs for the F-35 program.
Boeing: In 2016, Boeing announced a $1 billion investment plan to expand their factory in South Carolina, USA. This investment was intended to support the production of their 787 Dreamliner aircraft, including the establishment of a new facility and the enhancement of existing infrastructure.
Northrop Grumman: Made investment in the development of the B-21 Raider stealth bomber program, which involved capital expenditures for new facilities, manufacturing capabilities, and advanced technologies.
General Dynamics Electric Boat: General Dynamics Electric Boat embarked on a significant capital investment plan to support the construction of the U.S. Navy's Columbia-class ballistic missile submarines. The company invested billions of dollars in facility expansions, infrastructure upgrades, and the modernization of their shipyard in Groton, Connecticut.
Huntington Ingalls: Embarked on a five-year, $850 million capital expenditure investment program at Ingalls known as “Shipyard of the Future”, which includes 3D modeling tools, and new laser-cutting and robotics technologies. Newport News Shipbuilding will be investing $1.9 billion in capital improvements between 2016 – 2025.
III. Riding the Wave: Federal Funds Rate Surge and the Ripple Effect on FCCM Calculation
The second aspect of the FCCM calculation pertains to the cost of money rate, which is applied to the total net book value of capitalized assets. This rate, published semi-annually by the Department of the Treasury, is influenced by the Federal Reserve and the federal funds rate. The Treasury interest rate, tied to the interest rate on Treasury securities, is determined based on the average market yield of specific-maturity Treasury securities. As the federal funds rate rises, it can impact the broader interest rate landscape, including Treasury rates.
Compared to previous tightening cycles in 1986, 1994, 1999, 2004, and 2015, the current rate has occurred at an unprecedented pace. These cycles involve the Federal Reserve raising the federal funds rate to manage inflation and maintain economic stability. The current increase stands out due to its remarkable speed and magnitude, with the Federal Reserve implementing a series of incremental rate hikes to achieve its monetary policy objectives in response to economic indicators such as employment levels, inflation trends, and overall economic growth.
The notable acceleration of the current federal funds rate increase sheds light on the corresponding rise in the FCCM rate. In the first half of 2021, the Cost of Money rate reached a low point at 0.88%. However, during the second half of 2022, it experienced a substantial surge from 1.63% to 4%, marking a staggering 145% increase. This rapid rise in the Cost of Money rate reflects the impact of the significant and swift increase in the federal funds rate, highlighting the interconnectedness of these variables and their influence on the FCCM calculation.
IV. FCCM Costs on the Rise: Potential Funding Issues for Contract Execution
The increase in the FCCM costs presents a funding challenge for contracts in progress. While the FCCM may be accounted for as a cost Contract Line-Item Number (CLIN), budgets are typically based on target prices. Therefore, the initial FCCM value used during contract awarding represents the level of funding allocated for program execution. Any additional costs incurred in the FCCM must be covered either by reallocating funds from existing budget lines or by requesting additional funds through the Program Objective Memorandum (POM) process.
Considering that contracts negotiated and awarded over the past decade were often done so during periods of declining or lower interest rates compared to the current rates, it is reasonable to anticipate an increase in FCCM expenses across most programs, assuming other factors remain constant. This implies that programs may face a growing financial burden due to higher FCCM costs, necessitating careful resource allocation and potential requests for supplementary funding to ensure program viability and successful execution.
V. Embracing the FCCM: Proactive Strategies to Navigate Rising Costs and Improve Program Success
Previously, the FCCM has received limited attention for various reasons discussed earlier in this article. Factors such as its association with rate calculations and thus under the purview of contracting officers rather than program managers, its formulaic calculation prescribed in the Federal Acquisition Regulation (FAR), and its relatively small cost element within broader contracts have contributed to its lesser focus. Furthermore, the FCCM has often served as a funding source for other programmatic needs as the Cost of Money Rate has historically remained low or experienced a downward trend.
However, the recent significant increase in the FCCM, particularly its rapid escalation, warrants renewed attention to this aspect. While the FCCM is primarily a rate calculation, proactive measures can be taken by program managers and programs to prevent it from becoming a significant liability in the future. For instance, during the development of cost estimates for future contracts and budget formulation, programs can consider estimating higher FCCM rates to incorporate a margin and accommodate potential scenarios of sustained higher interest rates. Alternatively, if FCCM is not factored into the specific target price, it can be treated as a risk variable, with outcome distributions skewed towards higher cost of money rates. This approach can facilitate strategic communication and potential discussions related to Program Objective Memorandum (POM) issues, by transparently outlining the negotiated price in terms of risk and initiating conversations with stakeholders regarding the need for additional funds in the event of interest rate increases. Since these variables lie beyond the control of both the Program and the contractor, early and clear communication of the associated risks can yield dividends in the future.
VI. Conclusion
In the current landscape of limited resources and competing funding priorities, it is crucial to prioritize affordability. However, one cost element that often goes unnoticed is the Facilities Capital Cost of Money (FCCM). Recent developments have brought the significance of FCCM to the forefront, including substantial investments by defense contractors in facilities and infrastructure and the notable increase in the federal funds rate.
This necessitates a closer examination of the FCCM and proactive measures to ensure optimal resource allocation and successful program execution.
The rise in FCCM costs presents funding challenges for contracts already in progress. With budgets typically based on target prices, any increase in FCCM expenses must be addressed through fund reallocation or additional funding requests. Considering that contracts negotiated in the past decade were often done so during periods of lower interest rates, it is expected that FCCM expenses will increase. To navigate this financial burden and support successful contract execution, programs must carefully allocate resources and potentially seek supplementary funding.
To tackle these challenges, program managers and programs should consider how to estimate the FCCM costs for future program budgets, potentially incorporating higher FCCM estimates. Additionally, treating the FCCM as a risk variable and effectively communicating associated risks can support strategic decision-making and foster discussions with stakeholders regarding potential funding needs. By embracing the importance of the FCCM and implementing proactive strategies, programs can effectively manage rising costs and enhance overall program success.
If interested in learning more on the topic of FCCM and risk associated with raising rates, please reach out to Pantheon.