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Defense spending: Pentagon gravy train has less gravy

The Pentagon is hardly broke. Under the worst-case scenario, it will only have $496 billion to spend this year.

However, that's less money than it used to have, and less money than it expected.

It's tough to run the military industrial complex — or run anything — when you don't know what your budget is. "The department's under a lot of stress," said Frank Kendall, under secretary of defense for acquisition, technology and logistics.

Kendall returned to the Department of Defense in 2010 and has been in charge of writing checks for weapons programs. Over the last five years, he has worked to bring costs down, to make contractors more accountable for overruns, and to bring some sanity to a system where everything always take too long and costs too much.

The U.S. Navy variant of the F-35 Joint Strike Fighter.
Source: U.S. Airforce
The U.S. Navy variant of the F-35 Joint Strike Fighter.

It has become his job to keep people honest about budget projections, and every area of contracting is worth looking into. For example, Kendall's staff has done research revealing that weapons programs that are started during lean budget times end up seeing costs soar three times more than programs started in the middle of fatter budgets.

"People become more optimistic in their projections when times are lean and money is tight," Kendall said. His research also revealed that subcontractor profit margins are much higher than those of prime contractors, and Kendall is talking with major defense companies about how they can more efficiently work with their subs.

At the same time, Kendall is worried that the crackdown on costs is having unintended consequences.

In the same research report, Kendall said that both buyers and sellers in the defense industry are becoming overly cautious. "In my view, our new-product pipeline is not as robust as it should be at a time when our technological superiority is being seriously challenged by potential adversaries," he wrote. "Not all cost growth is bad; we need to respond to changing and emerging threats."

He reiterated that opinion in a wide-ranging interview with CNBC at the Pentagon. "We need to be taking more risk if we're going to be the No. 1 military power on the planet," Kendall said. "If we're going to have cutting-edge technology in the hands of our warfighters that is generations ahead of everybody else's out there, we have to take risks."

In the meantime, if Congress doesn't pass a new budget, and the Pentagon has to operate with the same amount of money it had last year under a Continuing Resolution, Kendall will have to find his own cost cuts. He said he'll need to take $20 billion out of planned purchases and development. Hundreds of programs could be hit. "It has a pretty devastating impact," he said.

Here's a look at some of the programs that could be most affected.

The F-35

The F-35 Joint Strike Fighter is the most ambitious program in recent Pentagon history, and certainly its most expensive — a jet that comes in three variations, one each for the Air Force, Navy and Marines. It has been plagued by years of glitches and software tweaks, but the Marines have now taken possession of their first combat-ready F-35s, with the Air Force expected to follow next year.

"It's not one of the programs that keeps me up at night anymore," said Kendall. "We've got a lot of work left to do ... but I'm not, at this point in time, terribly worried about the F-35."

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Still, the Defense Department has learned some hard lessons during the program, which was not started under Kendall's watch. "There are several things I would have done differently," he said. For one thing, while it may have seemed cost-effective to have one company — Lockheed Martin — make all three versions of the jet, it basically ended the fighter jet business for other contractors, leaving the Pentagon with only one vendor.

Then there's what Kendall has called "acquisition malpractice" in the way the program unfolded. "The decision to start production before we were confident we had a stable design, before we had flight test results to tell us we had a stable design, I think was a mistake," he said. "I would've delayed the start of production."

Kendall said that while he has been able to work with Lockheed to bring down the cost of the F-35, "The big problem with the F-35 is that we're trying to increase the production rate." Higher production drives down the cost per plane, but without a new budget from Congress, the Pentagon will slash its F-35 purchase this fiscal year by 19 jets. That will result in a lower overall payment, but a higher cost per plane. This could make the F-35 less attractive overall not only to the United States, but international buyers.

The new bomber

The defense industry has been anxiously waiting for a decision by the Air Force to choose a next-generation bomber. A team from Boeing and Lockheed Martin is competing against Northrop Grumman for a contract potentially worth 100 planes and at least $55 billion.

The decision to pick a winner has been delayed for months, but Kendall told CNBC, "I think you can look for it hopefully by the end of this month."

Even the lack of a new budget won't stop the Defense Department from moving forward on the bomber. "We still have the funds — we could make that commitment — to start full-scale development."

Air Force tanker

If the continuing resolution continues all year, the Air Force won't have enough money to buy as many new tankers from Boeing as it planned. It's just one more strike against the long-delayed aircraft.

Boeing first won the contract for a new tanker in 2002, only to have it revoked in scandal. Then, in 2008, when the Air Force awarded Northrop Grumman the contract for the tanker, Boeing supporters howled in protest and the company challenged the award to the Government Accountability Office.

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Boeing won the challenge, and eventually won the contract, but it has also lost much along the way. The tanker has taken longer to develop and cost more to get off the ground, and the contract was capped in such a way that Boeing is now absorbing all of the cost overruns.

"They've written off $1.2 billion so far on the aircraft," said Kendall. "They may have to write off some more before they're done, but Boeing is committed to finishing the aircraft." When asked if Boeing will actually make money on the tanker, Kendall replied the company will turn a profit in production, "but they need to get to production before they can do that."

Silicon Valley

Finally, Kendall is trying to find the right investments in cybersecurity. He said there are thousands of attempts to hack into the U.S. military every day, and some are successful. "It's a battlefield right now; it's a battlefield every single day," he said.

Cybersecurity is just one reason the Defense Department is reaching out to Silicon Valley, where the Pentagon has even set up an office. Defense Secretary Ash Carter is trying to convince skeptical tech engineers that there is money to be made working with the military.

"I think people are a little bit in a 'wait and see' mode to see if this is real and what's going to come out of it, but the initial response has been very positive," Kendall said. Tech companies may see a good revenue stream at a time when some speculate there's a bubble brewing in the Bay Area and investment capital is more cautious.

"There are a lot of people very interested in doing business right now," Kendall said. "We've got to meet them in the middle, and we've got to provide opportunities for them."