Panel 2
Direct and Indirect Offsets

Moderator: Gregory Martin,

Manager of Corporate Offset Administration, Lockheed Martin Corp.

Gregory Martin stated that the purpose of this session was to provide an operational view of offsets from three practitioners. This panel's goal was to understand what offsets are and how they really work before moving on to policy issues. The panelists were to talk about customer demand, the details of offset agreements, the development and implementation of offset programs, and why they do what they do. At the end of the session, the final panelist would highlight assumptions and raise questions. To assure a complete and candid flow of information, the three industry participants would be speaking on background only.4

Operational Perspectives

Industry Speaker #1

The first speaker began by stating that industry participants on the panel are practitioners, not analysts. As such, their job is to protect their companies and to provide benefit to the shareholders and employees, adding that they, and many others, are both shareholders and employees.

Reflecting the effect of defense downsizing on the company over the past ten years, international sales have risen from 30 to 70 percent. These international sales are supported by offsets. Companies do offsets not because they love them, but because they have to. The speaker asserted that they believe they are the best in the world in doing offsets and thereby gain a competitive advantage. Because foreign competitors are happy to provide offsets in order to win sales, U.S. firms can no longer compete on just cost, delivery, and quality, but must also compete on offsets. In one case, in a developing country, offsets are 40 percent of the selection criteria. These offsets are part of the procurement laws in many countries and therefore cannot be waived as part of a negotiation. It is important to remember, the speaker stressed, that it is their money, not U.S. government funds, that is spent to acquire these defense systems.

Defining an offset as an agreement between a company and a government to place some degree of benefit in that purchasing country, country requirements vary greatly, from marketing assistance to training to coproduction. Direct offsets are arrangements involving the actual defense article or service. They do not necessarily involve the off-loading of production. An offset could be a training agreement, which does not take production from anyone. It is important to understand that $100 in offset credits does not necessarily equal $100 of actual work. The value of the work could be much less, based on multipliers used by the foreign governments. For example, a foreign government may give a multiplier for work placed in a certain segment or in a high unemployment area.

There are many forms of offsets. Indirect offsets are anything not delivered inside the article. Among direct offsets, coproduction agreements are the most well known, followed by licensed production, often for the production of a particular part. Technology transfer is the least understood. It does not mean giving up the most advanced technology; it could involve something as simple as showing foreign workers how to operate a particular piece of equipment. The speaker stressed that companies do not give away their technological advantage—the stockholders would not allow that.

Other types of offsets include commercial arrangements. These commercial practices do not necessarily displace U.S. domestic products. For example, an offset agreement might involve placing a Swiss product in Luxembourg, displacing a German supplier. Counter-trade and barter involve the purchase of other goods—

4  

For this reason, the individual speakers are not identified in this text. They did not speak in the order listed in the table of contents, where they are identified, and the summaries of their remarks are not necessarily in the same order as they were delivered.



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Panel 2 Direct and Indirect Offsets Moderator: Gregory Martin, Manager of Corporate Offset Administration, Lockheed Martin Corp. Gregory Martin stated that the purpose of this session was to provide an operational view of offsets from three practitioners. This panel's goal was to understand what offsets are and how they really work before moving on to policy issues. The panelists were to talk about customer demand, the details of offset agreements, the development and implementation of offset programs, and why they do what they do. At the end of the session, the final panelist would highlight assumptions and raise questions. To assure a complete and candid flow of information, the three industry participants would be speaking on background only.4 Operational Perspectives Industry Speaker #1 The first speaker began by stating that industry participants on the panel are practitioners, not analysts. As such, their job is to protect their companies and to provide benefit to the shareholders and employees, adding that they, and many others, are both shareholders and employees. Reflecting the effect of defense downsizing on the company over the past ten years, international sales have risen from 30 to 70 percent. These international sales are supported by offsets. Companies do offsets not because they love them, but because they have to. The speaker asserted that they believe they are the best in the world in doing offsets and thereby gain a competitive advantage. Because foreign competitors are happy to provide offsets in order to win sales, U.S. firms can no longer compete on just cost, delivery, and quality, but must also compete on offsets. In one case, in a developing country, offsets are 40 percent of the selection criteria. These offsets are part of the procurement laws in many countries and therefore cannot be waived as part of a negotiation. It is important to remember, the speaker stressed, that it is their money, not U.S. government funds, that is spent to acquire these defense systems. Defining an offset as an agreement between a company and a government to place some degree of benefit in that purchasing country, country requirements vary greatly, from marketing assistance to training to coproduction. Direct offsets are arrangements involving the actual defense article or service. They do not necessarily involve the off-loading of production. An offset could be a training agreement, which does not take production from anyone. It is important to understand that $100 in offset credits does not necessarily equal $100 of actual work. The value of the work could be much less, based on multipliers used by the foreign governments. For example, a foreign government may give a multiplier for work placed in a certain segment or in a high unemployment area. There are many forms of offsets. Indirect offsets are anything not delivered inside the article. Among direct offsets, coproduction agreements are the most well known, followed by licensed production, often for the production of a particular part. Technology transfer is the least understood. It does not mean giving up the most advanced technology; it could involve something as simple as showing foreign workers how to operate a particular piece of equipment. The speaker stressed that companies do not give away their technological advantage—the stockholders would not allow that. Other types of offsets include commercial arrangements. These commercial practices do not necessarily displace U.S. domestic products. For example, an offset agreement might involve placing a Swiss product in Luxembourg, displacing a German supplier. Counter-trade and barter involve the purchase of other goods— 4   For this reason, the individual speakers are not identified in this text. They did not speak in the order listed in the table of contents, where they are identified, and the summaries of their remarks are not necessarily in the same order as they were delivered.

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jams, hams, etc.—or the taking of goods, such as oil, rather than money, in payment. Every country, including the U.S., has some form of domestic performance requirements. Even though the U.S. says it does not have an offset policy, the issue of U.S. requirements is often raised by foreign competitors. The speaker then gave two examples of subcontracts with no direct foreign offsets. These deals require some inventive actions by the company, but do not involve technology transfer or the off-loading of production. The speaker closed by stressing that offsets are a reality of the international business—and that the international business is very important to the company and its workers. Industry Speaker #2 The second industry panelist began by stressing the importance of globalization to the industry and to his company. In this context, the term "offsets" has come to have a negative connotation of "give-aways" and ''set-asides," yet, from a businessperson's view, these agreements should be seen as a form of international cooperation. As such, any cooperation agreements must make good business sense before they are accepted. Each deal must involve a strategy, but there is no specific blueprint. There are many one-of-a-kind deals, depending on the needs of the country. Negotiators must be skilled and creative. But all deals must survive the company's rigorous scrutiny. The bottom line for the company is that if it does not bid, not only does it lose the sale and the profit but also any aftermarket and follow-on work—which are important to sustain the business in the future. If the company wins, then the company can maintain jobs, make a profit, reduce overhead, and sustain sales in the future. Offset arrangements are not simple deals, but require the negotiators to base their actions on a great amount of information. They may take five to six years to negotiate and may require political actions—for example, a Swiss parliamentary vote on a particular aircraft sale. Such deals are carefully monitored and reviewed by upper management. After the sale, the company must follow through on its offset agreement. Failure to do so would harm the company's long-term interests. The use of indirect offsets is clearly increasing. Domestic sales are going down for U.S. companies, and foreign governments are increasing their requirements. This has forced U.S. companies to be more creative in their offset agreements. In one case, a foreign government wanted to develop a medical equipment industry. In response, the company could either outsource the project or work on it in-house, if it felt it had the needed expertise and resources. In another case, a European government wanted help in upgrading its police force's command and control system—which would cost the company $1 million to develop. The manager could ascertain the market value of the system off-the-shelf and then negotiate a 10 times multiplier for an offset credit of $20 million. Or the manager could argue for a higher multiplier because the cost to the foreign government to develop the system domestically would be prohibitive. If a company finds it cannot meet an offset obligation itself, it can go to an offset broker. The broker arranges for the project, possibly finding the technology, securing the license agreement, developing the market and finding the investors. In the end, the company pays the broker a service fee. The speaker closed by stressing that the process has become very complex. As a result, the measurement of the impact is very difficult. He urged that the dialogue between different perspectives on the issue should continue. Industry Speaker #3 After giving some background information on the company, the third industry panelist stated that more often than not they are involved in some form of offset in their international sales—which accounts for 40 percent of their business. Negotiations do not begin with an offset offer; they are offered when it is required to get the sale. When negotiating an offset agreement, every attempt is made to minimize the requirement in order to protect the company's domestic labor force, its established supplier base, and its core technologies. It is also important that the offset commitment be completed satisfactorily, as these companies live by their reputations. Offset negotiations are very complex, with both sides having different goals. For example, the customers want large programs approaching 100 percent offsets; the company wants to negotiate that number down. The customers want work for their domestic aerospace industry; the company wants to spread the projects around to protect their existing supplier base by splitting the procurement or giving indirect offsets. The customers want state-of-the-art technology; the company wants to transfer older technology. The customers want assistance in export sales of their own aerospace products; the company seeks not to be involved. The customers want help in identifying and attracting investments and joint ventures; the company will enter into these types of arrangements only if it makes good business sense. The customers want general industrial benefits; the company tries to be creative. Finally, the customers want all of these benefits at no additional costs; the company wants to use training programs and other soft offsets, which cost the company little, to negotiate high multipliers for their

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offset credits, and to make sure that the contract covers the costs of the offsets. In one example, the company included training at the company's training facility, as an offset at little additional cost to the company. In another case, the company took phosphate ore as payment in a countertrade arrangement. One other case had the company meeting a 100 percent offset requirement through preexisting procurement agreements within the customer's country. A different case had the company transferring old technology, which even the IMF agreed would be a significant economic benefit to the receiving country. In another example, the company transferred old technical documents and surplus equipment at company expense to fulfill an offset requirement. On the other hand, the company has refused to bid on sales in that country when the technology transfer requirements became too high. The speaker closed with the observation that offsets are an unavoidable part of international sales. Those sales are important, since they are a large percentage of what keeps this company's workers fed. Offset managers, like this individual, try hard and are successful at softening foreign governments' offset requirement in order to protect the interests of the company and its workers. Assumptions and Questions Randy Barber President, Center for Economic Organizing Mr. Barber characterized his job on the panel as raising questions and looking at underlying assumptions based on his work as a consultant to unions and workers. He stated that his focus was neither on domestic outsourcing of work nor on international outsourcing for economic reasons. He also stressed that members of organized labor are not Luddites, but seek answers to fundamental questions about the roles and interests of unions, workers, and management in negotiating offsets. Likewise, the key is not ''how do we make the rest of the world act as we do," that is, an attempt by the U.S. to dictate what the rest of the world should do. Rather, the key issue is what the U.S. should do in the face of mandatory foreign government offset requirements and a global market where U.S. companies find it easier to make sales if they offer "voluntary" offsets. Questioning the assumption that the choice facing companies is either to grant the offset to obtain 100 percent of the order, or to give no offset and lose the entire sale, Barber suggested there is a point in between. Indeed, we had just previously been told that some offsets are refused and efforts are made to reduce their costs and impact. A more realistic calculation would acknowledge that while some sales may be lost due to a refusal to grant (some) offsets, it is not likely that a company would lose all potential sales. This more realistic calculation could include an estimate of total sales—and jobs—that would be lost if offsets are resisted, compared to the impact on employment, including subcontractors, at a given level of offsets. The problem in making this calculation is the lack of information about how to judge the outcome. The companies are essentially saying "trust us—we will get you the best deal" to the workers, communities, and suppliers. But the assumptions and criteria to be applied are not at all clear. Mr. Barber pointed out that previous speakers have said that offsets are a necessary evil for some companies, a fact of life for others, and a marvelous marketing tool for still others. This suggests the decision process is unclear. While the argument often given emphasizes the number of jobs saved, no one is suggesting that employment actually is, or even should be, the main criterion used by business in evaluating these decisions. To make a decision on these agreements requires making a judgment on several diverse criteria, such as: What is the company's core technology? How would such a deal encourage or discourage potential future competition? What are the potential future sales resulting from this deal? What is the future profitability from this deal? What are the potential follow-on deals? In short, companies make these decisions based on their obligations to shareholders rather than on the basis of concerns about employment. Moreover, companies have no fiduciary responsibility to their suppliers in making or disclosing these judgments. To illustrate his view of the decision process, Mr. Barber outlined his "salami theory" of how companies make these decisions. In essence, for each deal they give just a little slice (of offsets) to get the sale. The danger is that eventually they slice the salami so many times that the net effect on their own employees, and those of their subcontractors, is a negative one. Other countries seem to be following a "reverse salami theory." In each deal, they take a little bit here and a little bit there and put it all together to create their own "salami," that is, their own industry. From a strategic perspective, the danger is not that one particular company gives away something that in and of itself is the crown jewel, but that they give away pieces that can be combined to make the crown jewel. China is an example of this gradual building of competencies. They started with Russian technology. Then, they did coproduction for McDonnell Douglas.

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Next they started doing minor pieces for Boeing. Now they are doing rear fuselage and tail pieces for Boeing. And they have entered into a memorandum of agreement with the Europeans and other Asian nations to build a 100-seat aircraft—an aircraft for which 43 percent of the market is in North America. This process of competency building could have happened without offsets, but not as quickly. From the workers' point of view, they are not at the table when these decisions on granting offsets are made, even though these decisions may eliminate a great many jobs. In fact, many workers do not even know that a table exists where jobs are being traded—nor do the subcontractors. In this context, it is important to challenge what Mr. Barber feels are some unsustainable assumptions. First is the assumption that U.S. companies will lose all sales if they fail to grant offsets. There needs to be a look at what the calculation is between zero and 100 percent. A second assumption concerns the protection of core technologies—a focus on the "latest" cutting edge technology may be missing the point. In some cases, next-best technology, combined with government financial support, control of access to the market, and increasingly competent domestic producers, can lead to a serious erosion of market share for U.S. companies. Mr. Barber then raised a number of questions: First, what are the legitimate interests of the government, the public, and workers in offset "marketing" decisions by companies to transfer technology, production, and/or skills in exchange for sales? Second, how can these interests be reasonably, but effectively, asserted? Third, what are the threshold criteria for public concern with offsets—the impact on market share? the sensitivity of the technology involved? the strategic importance of the industry? the likely impact on existing productive capacity and employment? Fourth, if an industry claims strategic importance, and accepts public support for R&D and export finance as a result, does it not then have certain public obligations as well? What information should be required to be disclosed about these decisions, and how should competitively sensitive information be handled? Fifth, is there any reason to believe that we can negotiate with other nations on offsets to stop this economic and technological race to the bottom—and get rid of this trade-distorting activity? Finally, and most fundamentally, do offsets really work? Do they really increase net sales and discourage the growth of other competitors? McDonnell Douglas did not expand market share in China when it gave offsets. The use of offsets by Boeing in China did not keep Airbus out of the market. In closing, Mr. Barber suggested that, rather than helping the companies make future sales, offsets may only raise customers' expectations and cause them to demand even more concessions the next time. Discussion One audience member suggested that the discussion should be expanded to include U.S. production requirements, including state incentive programs. This is common in many industries, and especially common in the auto industry. The U.S. must be careful when complaining about actions of others when we do the same thing. A related question is the impact of offsets on smaller U.S. companies that follow larger U.S. companies overseas. In many cases, this has given smaller companies the chance to access global markets. One of the industry panelists responded that offsets have given that panelist's company opportunities to get into new markets. Especially important in that regard has been the NATO interoperability requirement, which has allowed the company to penetrate certain NATO procurements that might not have been otherwise possible. Another industry panelist talked about how his company often goes outside the aerospace industry to meet offset requirements. He cited the example where his company is helping environmental technology companies enter into a joint venture in another country as part of fulfilling an offset requirement. One industry panelist took issue with Mr. Barber's assertion concerning a lack of information. He pointed out that there have been many studies on offsets. He also expressed his belief that it may not be possible to put the issue into terms of clear-cut economic calculus, given the complexity of the process. In closing, the panelists affirmed that the U.S. economy is doing quite well, and the labor market is good in part because U.S. companies have readjusted to deal with globalization and are succeeding.