One of the many lessons learned from the ongoing war in Ukraine is the inadequacy of the U.S. defense industrial base to keep pace with high-intensity conflict.

In October 2023, the defense industrial base (DIB) could produce approximately 28,000 155mm artillery shells per month. During World War II, that would have been one artillery shell per artillery piece deployed by the Soviet Union at the Battle of Kursk in 1943.

While increasing access to mineral resources is a good step toward lessening the defense industrial base’s vulnerability, it won’t resolve the DIB’s inadequate output.

Fixing the defense industrial base isn’t a task that any single entity can accomplish. Rather, it will require a coordinated effort between the Department of Defense (DOD), Congress, and industry. As stated in a recent report from The Heritage Foundation, structural reforms will be required, not just policy tweaks.

Among the most pressing challenges facing the DIB is its financial structure, and inconsistent demand resulting from the year-by-year nature of the congressional appropriations process is a key part of the problem. This creates weak or conflicting demand signals for industry, deterring investments in new manufacturing capacity.

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While the Congressional Appropriations process leaves an unclear demand signal, changing Department of Defense requirements stifle innovation and drive up costs. The military rightfully imposes strict requirements on weapon systems. However, rather than mandating certain capabilities and performance standards, it will often dictate to the industry how to achieve those goals, stifling their ability to develop innovative solutions.

DOD also regularly changes design requirements mid-production—best exemplified by the Constellation Class Frigate program—increasing costs and causing delays. While recent congressional efforts have made minor changes to curb unnecessary design changes, the efficacy of these measures remains to be seen.

Cost-Plus Contracting

The defense industrial base also faces another structural issue: the frequent use of cost-plus contracting. Under cost-plus contracting, the government reimburses production costs—something that removes incentives for efficiency. Since companies are guaranteed reimbursement, there is little motivation to cut costs or develop more efficient production methods.

The research and development process is also largely reimbursed, which discourages innovation for the same reasons—cost savings have de-minimus or no benefit to the company.

Reversing DIB Decline

Yet despite these structural challenges, the DIB’s decline is reversible. Practical policy changes can realign incentives, increase production capacity, and encourage innovation.

First, DOD should expand the use of fixed-price contracts. Unlike cost-plus contracts, fixed-price agreements incentivize firms to lower production expenses and improve efficiency because their profitability depends on minimizing their costs. Eventually, some of these savings are passed on to the government and taxpayers, creating a win-win situation.

However, for this system to work, the DOD must ensure that its requirements focus on capabilities, not on specific processes. Defense industrial base producers must be allowed the freedom to meet DOD requirements and standards in any way that makes sense, not in a specific way dictated by DOD.

Addressing inconsistency in defense procurement may prove more complicated. 

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One way to create marginal improvement is by shifting some funding from research and development to procurement. This would provide additional demand for manufacturers. However, a more long-term solution needs to address the underlying structural issues that lead to uncertain demand.

Output-Based Grants

One way to do this is by implementing output-based grants. Under this system, the DOD would set a target production level for key defense platforms (e.g., four submarines per year). If procurement falls below this target (e.g., only three submarines are ordered), the government would provide a grant covering the cost of unused capacity.

This would serve a dual purpose, both ensuring manufacturers can maintain workforce and supply chain stability and eliminating most risks entailed in investing in new manufacturing capacity related to inconsistent demand. This approach ensures that the DOD retains flexibility in its procurement decisions while keeping industry ready to scale production quickly when needed (such as if the United States were at war).

Industry must be willing to invest in new production capacity and innovation, but that can only happen if Congress and the DOD reform the incentive structures governing defense production.

By stabilizing demand, switching to fixed-price contracting, and reducing the role of government in production, the United States can restore its defense industrial base, ensuring that America achieves peace through strength and prosperity—the twin pillars of the American Golden Age.