Policy Issues in Aerospace Offsets: Report of a Workshop (1997)

Moderator: Christine Fisher,

Director, Industrial Capabilities Support Office, Department of Defense

Dr. Wessner introduced the moderator for the panel, Christine Fisher, the Director of the Office of Industrial Capabilities and Support in the Defense Department, who serves under John Goodman, the Deputy Under Secretary of Defense for Industrial Affairs and Installations. Following the recent round of mergers and consolidations in the industry, the Industrial Capabilities and Support Office has taken a closer interest in sub-tier companies, normally several levels down from the primes. In response to a request from then—Under Secretary Kaminski, the Defense Science Board undertook a study of vertical integration issues in the industry. The Board recently issued a report whose recommendations are now being implemented.⁹ As part of this implementation, Ms. Fisher's office will begin more intensive monitoring of sub-tiers on individual programs and on a cross-Depart-mental basis.

After brief introductions of each panelist, Ms. Fisher turned to the first member of her panel, Dr. Kirk Bozdogan.

Kirk Bozdogan

Lean Aircraft Initiative, Center for Technology, Policy, and Industrial Development, Massachusetts Institute of Technology

Dr. Bozdogan opened his presentation with a disclaimer, noting that it represents his personal views, though it draws on research carried out under the Lean Aircraft Initiative at MIT. The purpose of this program is to bring about fundamental performance improvements throughout the defense aircraft value chain. The program seeks to encourage improved efficiency, higher quality, greater affordability, enhanced technological superiority, and a more robust U.S. supplier base. The program involves a working partnership between MIT and 10 U.S. government agencies and 19 aerospace companies, with MIT acting as a neutral catalyst. It derived from MIT's work in the 1980s on the global auto industry, summarized in the 1990 publication The Machine That Changed the World.¹⁰ The current aircraft program is well into its second phase.

Bozdogan observed that he intended to provide an "inside-out" perspective (rather than the "outside-in" perspective which had characterized the discussion thus far) in order to frame the debate within the larger context of fundamental changes affecting the U.S. industrial base. He noted that the U.S. aircraft industry supplier base has experienced rapid and fundamental change—caused by a consolidation and reduction of the supplier base, driven primarily by defense cutbacks and a slowdown in the commercial sector. In this larger context, offsets as an issue are "not even on the radar screen." However, he suggested that the situation very likely will change as offsets become a major factor over the next decade or two. The main points of his presentation were:

• offsets will increase and will pose serious risks for the U.S. supplier base, as well as offering some—but not many—opportunities;
• there will be increasing friction between national and private sector interests;
• a disconnect may well occur between U.S. trade and technology policies; and,
• there may be increasing conflict between U.S. national security interests and the demands of alliance politics.

With regard to the structural change in the aerospace sector, Bozdogan observed that a deep, sweeping reduction has taken place in the U.S. supplier base. Working from a chart covering the period 1991-95, he pointed to a 50 percent decline of direct production suppliers including sub-tiers per business unit (his survey covered 80 large firms, each with $100 million of revenues per year and/or 1000+ employees), in both the defense and commercial sectors. The same data also showed that the decline was equally severe—a 50 percent reduction in the supplier base—across all aerospace sub-sectors during that period, including airframes, avionics, and engines.

Concurrently, there has been a rationalization of the supplier base. Major firms have adopted a wider approach to supply chain management that goes beyond procurement to strategic supplier integration. Streamlining of business divisions, integration of internal supply chain management functions, and centralization of supply chain management operations have all taken place.

As major firms have reduced the numbers of their direct suppliers, the synchronization of deliveries from, and the assurance of quality by, those suppliers has become more important and has led primes to place a strong emphasis on certification systems and process integration. Majors have devolved increasing responsibility onto their suppliers for inspection, production, and design, based on a reassessment of their core competencies. The central characteristic of this change is the emergence of a sense of close, cooperative, long-term, strategic partnerships—becoming widespread in the industry—that embody more extensive communication, information exchanges, long-term commitments, and the sharing of risks and benefits. A key feature has been early supplier integration into design and development activities, leading to an integrated, virtually seamless team approach.

In this larger context, offsets have played a relatively minor role in the restructuring of the U.S. industry. In the future, however, their importance is very likely to increase as foreign markets come to dominate both commercial and military aircraft sales. Market access, rising costs, and the drive by some countries to create their own aircraft industries will increase both the demand and the opportunities for offsets, pushing established manufacturers to grant offsets. Derivatives will become the biggest growth area, with few new aircraft programs coming on line.

Bozdogan suggested these developments pose substantial risks for the U.S. supplier base, especially sub-tier suppliers. Foreign programs and offset requirements are likely to exacerbate global overcapacity, increasing cost and competitive pressures on U.S. suppliers. These U.S. suppliers, having already gone through a "leaning down" period, will face increased competitive pressure from new entrants. Particularly in countries such as China and Japan, heavy government subsidies, combined with strategic industrial programs, military/commercial synergies, and the integration of technological and production advances from other sectors, will combine to put U.S. suppliers at progressively increased risk.

Bozdogan concluded by noting the policy implications of the changes he had described:

• a particularly difficult policy challenge will be how to manage increasing friction between private sector and national interests, as individual company interests and core competencies diverge from national strategic interests;
• net technology transfers from the U.S. are likely to grow as primes and suppliers both expand their international alliances, and as the future model of seamless integration between primes and suppliers becomes more conducive to knowledge integration and technology transfer;
• achieving closer integration between U.S. trade and technology policies will become imperative; and,
• the preservation of long-term U.S. national security requires that attention, nourishment, and protection be given to the critical supplier and sub-tier base of the aircraft industry.

John Terranova

Chief Executive Officer, Tolo, Inc.

Taking issue with an earlier description of Litton Industries as "a small company," Mr. Terranova affirmed that his company, with 220 employees, is a "true" small business. Tolo Inc., makes aircraft structures and components, such as APUs, along with providing engineering services. The company has long-term teaming agreements with many of the major aerospace firms.

After suffering through a period of decline in the late 1980s, Tolo looked both to expand its geographic reach and to develop new products. It devised new design structures and offered new engineering services, as well as munitions redesign. It developed an innovative "grid-lock" structure (two opposed surfaces with integral ribbing that interlock with each other) which has been adopted for such uses as simpler bulkhead fabrication. (Mr. Terranova here gave a detailed presentation, accompanied by slides, of the design and fabrication, various uses, and advantages of "grid-lock" and also gave examples of its adoption for specific components of various aircraft.)

Mr. Terranova noted that, as a sub-tier supplier, Tolo's growth was dependent on finding a means to team with aerospace partners. Increasingly, it is necessary to find a means to team with offshore manufacturers, mainly European companies, through collaboration with U.S. firms with business in these markets. Direct sales are difficult—not to say impossible—in light of the structure of the industry and the size of Tolo. Consequently, there are substantial pressures for technology transfer, especially through licensing.

Karen Zuckerstein

Assistant Director, Defense Acquisitions Issues, General Accounting Office

Ms. Zuckerstein summarized a General Accounting Office (GAO) report¹¹ on defense offsets done in 1996 for the Senate Armed Services Committee and the House Small Business Committee. The study looked at offset goals and strategies of major foreign buyers over the past ten years and how they have changed, as well as at the kinds of offset demands being made and the types of activities undertaken by U.S. companies to meet those demands. Case studies of offset agreements between ten major buying countries and selected U.S. defense firms included evaluation of the specific terms of offset agreements and the written requirements presented by the buying countries.

The GAO report concluded that offset demands had increased, due in part to new entrants to the market, and included growing demands for technology transfer, targeting of assistance to particular sectors, more local content requirements, and greater nonperformance penalties. Also noted was significant variance, from region to region, in the types of offsets requested and provided.

For Canada and Europe, the strongest interest is still in defense and aerospace offsets. Subcontracting and coproduction are key characteristics of agreements. For example, the U.K. will coproduce the Apache helicopter, and $350 million of U.K.-built equipment will be used in the production of U.S.-built aircraft. In Asia, the emphasis is on technology transfer. Korea and Singapore target defense technologies, and coproduction is a major feature of offset agreements. The Persian Gulf countries tend to use offsets in new ways, notably to promote economic diversification by requiring aerospace companies to sponsor many kinds of investment projects, including infrastructure building and environmental enterprises, and other ventures far afield from aerospace. Although the average offset demand was roughly 30 percent of the total sales package, the nature of the offsets required could be extremely demanding in terms of types of technologies transferred and how to value them.

Ms. Zuckerstein observed that, despite these differences, a number of characteristics of offset programs were similar among the countries studied. She enumerated several common expectations of foreign governments relating to the use of offsets. These include:

• long-term benefits to foreign nations' industrial policy goals,
• supplier relationships that extend beyond the life of a single program or procurement,
• more competitive industries as a result of government-induced technology transfer,
• continuing requirements for investment projects, and
• a growing presence by foreign firms in the U.S. market as a result of marketing assistance provided as an offset by U.S. companies.

The critical question is how such offsets affect the U.S. supplier base. To address this, one needs to differentiate among types of offsets. Indirect offsets such as those associated with Persian Gulf countries, while difficult to implement and financially risky for primes, present little threat to U.S. aerospace suppliers. Other forms of indirect offsets, including assistance in the marketing of non-defense products in the U.S. or substituting foreign-made goods for U.S. purchases, may adversely affect U.S. non-defense producers. This occurred in the paper-making machinery case, referred to earlier by Senator Bingaman, where incentive payments were used to subsidize European exporters of equipment. This type of incentive payment is now prohibited by the 1994 Feingold Amendment to the Arms Export Control Act. Other forms of offset include having U.S. firms hire consultants to do market analyses or to help design marketing strategies for the foreign producer. Zuckerstein noted that such activities have begun to spill over from the aerospace sector into other industrial sectors. The result is that American defense companies are assisting foreign governments, through leveraging their resources, to help foreign producers compete with other U.S. firms in non-aerospace markets.

Lower tier U.S. producers in the defense sector are similarly affected. Primes, under the pressures or incentives of offsets, look more closely at partnering with, or procuring from, foreign suppliers of components, not only for export products, but also for systems purchased by the U.S. Defense Department. Primes encourage their suppliers to help them meet offset obligations. Primes also factor supplier willingness to assist in offsets into their supplier evaluation

system. This encourages increased supplier interaction with foreign suppliers.

Ms. Zuckerstein observed, however, that defense offsets can create benefits for lower-tier producers by building foreign political and public support for large, costly offshore procurements in which the subs take part. Offsets also can lead to additional sales and increased foreign market access that would not otherwise have occurred, thus providing more work for the sub-tier firms. The challenge is not to forego the benefit of such sales, but to neutralize the incentives for foreign sourcing created by such sales.

Lora Lumpe

Director, Arms Sales Monitoring Project, Federation of American Scientists

Ms. Lumpe began by saying that, as head of the Arms Sales Monitoring Project of the Federation of American Scientists, she shared Secretary Reinsch's concern about whose job it is to weigh potentially competing corporate and national interests, and particularly whether the public has a ''seat at the table" in weighing those interests, principally countertrade. The public has a stake and is affected in two ways. First, business opportunities and jobs in both defense and non-defense industries are directly affected by indirect offsets. And second, public monies are used to underwrite the development, marketing, and sometimes the financing of overseas arms sales which can trade away market access and U.S. employment. She affirmed that these are more than sufficient reasons for a more extensive public role in the debate on offsets.

The public's interest is also engaged because foreign arms exports have increasingly been sought and approved on the basis of claims that such sales aid the U.S. economy and employment. Serious questions exist about the validity of those claims. The growth of indirect offsets, particularly in the aerospace sector, is of concern because it appears to lead to countertrade or investments in non-defense products that are directly competitive with U.S.-made goods and U.S. markets. Providing several examples of this trend from different parts of the world, Lumpe noted that U.S. aerospace suppliers have been negatively affected by indirect offsets, judging from their public comments and from data in the Commerce Department's 1996 survey report on offsets. Lumpe observed that American workers were also protesting the practice, as evidenced in recent strikes at Boeing and McDonnell Douglas, in which a key issue was offset-related foreign outsourcing. She also cited several examples from the Commerce study where non-defense firms were negatively impacted by defense company offsets, though in other cases, U.S. firms had benefited from direct offsets. At the same time, she noted that indirect offsets do not always affect U.S. firms.

Improved information is required. In addition to the existing requirement (under the Feingold Amendment) that Congressional notification of pending arms sales include notification as to whether the sale is accompanied by an offset, Lumpe recommended that there be greater public disclosure of offsets as a first step in obtaining more information about them. Another aspect of offsets needing reform is the practice of granting offsets on sales of arms that are financed by the U.S. government. About $4 billion annually is provided in foreign military aid for weapons purchases, the major portion of which must be applied to purchases of U.S.-made equipment. In this situation, it is the norm for U.S. companies to bid against each other with offset packages in order to secure the sales, leading to the bizarre result that the American public is asked to pay for the design, development, manufacturing, and foreign transfer of arms whose "sale" then costs them still more in lost jobs and markets.

The moderator opened the floor to questions at this point. The first, to Mr. Terranova, asked whether Tolo was teaming with European firms because of the reluctance of Europeans to buy products made in the U.S., or because of Tolo's small size prevented the company from pursuing effective overseas marketing efforts. Mr. Terranova was also asked whether Tolo's experience was typical of small firms in the aerospace sector.

Terranova responded that, since Tolo was essentially a "job shop," it lacked the marketing staff, financial depth, and experience to compete effectively for overseas sales. It is simply very difficult for small manufacturing companies to do business offshore. Tolo has been successful because it has a proprietary product to sell at precisely the time when there is a window of opportunity in the global market (i.e., a growing recognition by major companies of the need for, and cost-effectiveness of, using Tolo's product). Tolo does not have the wherewithal to produce and market globally; hence, its reliance on teaming with foreign companies that are already in the target markets. He has never encountered resistance due to the fact that Tolo is a California company.

Another questioner asked whether any primes have asked Tolo to participate in an offset by transferring technology or jobs overseas. Terranova replied that Tolo has had opportunities to do technology transfer, and does not feel the technology itself is worth nearly

as much as its testing and the process knowledge of how to use it. Tolo is very loyal to its primes, however, and if one of them could be helped in securing an offshore contract through Tolo's technology transfer—especially if it held the potential of creating new business and jobs at home for Tolo—the firm would gladly pursue the opportunity.

Another participant questioned Ms. Lumpe's use of data in her remarks about the percentage of suppliers who responded, in the Commerce Department survey, that they were negatively impacted by offsets.

Another questioner asked, rhetorically, whether there was a general assumption that the foreign sales, and company revenues and jobs created and sustained by those sales, would have occurred without manufacturers' concurrence in offset agreements.

Ms. Lumpe replied that this type of assumption was too black and white; in fact there were "many shades of gray" involved in such sales. While offsets were realistically part of doing business, her concern was that there should be adequate public disclosure of the impact of offsets on non-defense industries, especially to balance manufacturers' claims that offsets were job-sustaining. Since defense manufacturers receive substantial assistance in a variety of forms from the government, it is only fair that the public and policymakers be aware of any potential or actual harm to public interests traceable to offsets.