Overcoming barriers to entering the defense industrial base

As inflation and interest rates rose last year, businesses turned to resilient markets to sustain their growth, and investors sought to diversify portfolios and protect their return on investment. Many companies that focused on the commercial marketplace found a recession-proof customer with spending power above $800 billion every year: the U.S. government.

However, entering this market is no easy feat. The government imposes many rules on contractors for eligibility to win and execute contracts. As a result, the government contracting ecosystem has high barriers to entry, and the defense industrial base has been consolidating over time, as shown in the table below:

Competition among contractors is vital to the U.S. government. It lowers prices, encourages innovation and, ultimately, strengthens national security.

Barriers to entry can vary depending on the industry, contract size and solution offered. Below we focus on U.S. middle market commercial companies looking to enter the Department of Defense (DOD) supply chain, with an emphasis on three major qualifications to participate in this competitive market: cybersecurity, cost accounting systems and domestic content compliance.

Safeguarding digital assets

The transition of the trade regime from hyperglobalization to friendshoring comes at a time when adversarial countries are trying to extract sensitive information from the U.S. government. These cyberattacks could compromise national security and the country’s competitive advantage on the global stage.

For its 2023 cybersecurity report, the CyberEdge Group conducted an international survey of 1,200 organizations, including over 300 U.S. commercial and governmental organizations across multiple industries. The report revealed that almost half of U.S. respondents had been compromised by six or more successful cyberattacks.

More than ever, safeguarding the storage, processing and transmission of critical information is vital to protect our nation, technology and global competitive advantage. Therefore, the U.S. government has created rules to safeguard critical data.

For commercial companies that will not hold classified contracts, federal contract information (FCI) or controlled unclassified information (CUI) will be two of the most important types of data to protect. The government’s framework for protecting FCI and CUI is the Cybersecurity Maturity Model Certification (CMMC).

Companies need to understand the types of information and level of compliance that government contracts require—from 15 requirements for companies handling FCI to over 120 requirements for those handling high-value CUI.

Setting up the control environment necessary for CMMC compliance may require a significant financial investment, depending on the applicable data-security level. Creating a strategic cost structure that aligns resource needs with the CMMC framework may allow the business to recover its investment through the indirect rates contractors estimate for reimbursement under cost-plus structured contracts.

Accumulating, estimating and reporting costs

U.S. generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS) provide the accounting rules for commercial companies. These are rules for reporting financial records such as income statements, balance sheets and cash flow statements.

In contrast, the DOD is concerned with how businesses accumulate, estimate and report direct and indirect costs. This is to establish consistency across multiple bidders when assessing prices, ensure the integrity of billings throughout the life of the contract, and ensure that the quoted price is fair and reasonable.

The ability to comply with accounting system requirements is important to the DOD, as evidenced by the Defense Contract Audit Agency including accounting systems and cost accounting standards compliance on its list of 2024 audit focus areas.

The strategic and compliant application of cost allocation rules allows organizations to bid on defense contracts, maximize cost recovery and design boundaries of the U.S. government’s audit scope.

Made in America

Many commercial companies outsourced component manufacturing during the era of hyperglobalization. The changing trade regime and new industrial policies focused on onshoring and friendshoring are transforming manufacturing supply chains.

The Infrastructure Investment and Jobs Act of 2021 mandates that all infrastructure projects funded by the federal government use only iron, steel, manufactured products and construction materials produced in the United States. Similarly, the Buy American Act requires products applicable to federal purchases to meet a minimum domestic content requirement of 65%, increasing to 75% by 2029.

Understanding how to apply domestic content restrictions to products, components and subcomponents helps organizations align their supplier network to the products they offer the DOD, supporting their eligibility to bid on contracts.

The takeaway

Volatility in commercial markets and changes in the U.S. trade regime are encouraging businesses to enter the U.S. government contracting market. Further, geopolitical turmoil is driving demand for defense-related contracts.

The DOD has tremendous purchasing power and constant demands for innovative defense technologies. Understanding the requirements for the defense industrial base helps companies make informed decisions on whether to enter this competitive market.

Companies that choose to enter the market must remember that a goal without a plan is just a wish. Successful new entrants will prepare a targeted strategy for entry into the defense industrial base and implement the operational tools and processes required to bid, win and execute.

More participants in the defense industrial base benefits the United States. The U.S. government, its citizens and its economy will benefit from the competition that drives productivity, efficiency and technological innovation.