Hanging lightbulbs represent Baker Tilly professional's thoughts on TransDigm.

Uncommon Sense | TransDigm: politics vs. market economics in government contracting

We watched the TransDigm matter with great interest. We had heard whispers of it for years. And it unfolded pretty much as expected. The company knew the rules and followed them, perhaps too well. Then the government heaped shame on it for cheating. Welcome to government contracting. Let’s zoom out and try to make some sense of this.

In our view, TransDigm created a brilliant commercial business model – the exclusive source of many military aircraft parts. These are new parts for old aircraft, which represents a small disaggregated market; thus, it’s not economically viable for other companies to compete. This gives TransDigm significant pricing power – a concept we learned in Econ 101 – that generally occurs at two phases of a product’s life cycle, as illustrated below:

Most should be familiar with this concept – it’s how the commercial marketplace organizes itself in a capitalist economy. It’s the engine that drives both technological advancement (new) and restoration (renewal). Companies that master their markets and manage the risks at either end of the bell curve earn the biggest profits. But the TransDigm matter teaches us that a brilliant commercial business model can become a political target in the government market, which features a unique, unwritten social contract: don’t gouge the taxpayer, either in appearance or in fact.

While the government’s irresistible urge to villainize 'excessive profits' keeps the traditional government contracting community in check, it is perhaps the largest factor that deters commercial companies from entering the government market.

The government contracting community knows and understands this social contract. We test compliance with it by means of “The Washington Post test,” where we wonder what might happen if [insert scenario here] was reported on the front page. When the paper hits the newsstands, facts become irrelevant, trials occur in the courts of political and public opinion and corporate reputations circle the bowl. We don’t know if TransDigm knew of the social contract or this test, but it does now. With the Department of Defense Inspector General’s (DODIG) arbitrary 15 percent allowance for “reasonable” profit, TransDigm acutely feels the government’s power and wrath.

While the government’s irresistible urge to villainize “excessive profits” keeps the traditional government contracting community in check, it is perhaps the largest factor that deters commercial companies from entering the government market. The current FY2020 NDAA bill, if passed, authorizes the DODIG to root out excessive profits in “sole source, commercial depot maintenance contracts, including parts, supplies, equipment and maintenance services.” Ironically, for many years Congress has bemoaned government’s inability to acquire the cutting-edge technologies it needs from the commercial marketplace. And they just reminded us why. 

Study the above illustration carefully. New cutting-edge technologies reside on the opposite side of the product lifecycle from TransDigm (and others in DODIG’s sights), where commercial companies also have significant pricing power. After watching this fiasco unfold, commercial companies with new technologies will be even more reluctant to sell to the government if it embraces DODIG’s arbitrary “reasonable” profit benchmark. Companies do not take big risks to make a modest 15 percent profit. If the government isn’t willing to pay ultra-premium prices where high risks demand them, then the government will get what it pays for.

We will let each reader (i.e., taxpayer) decide if that’s a wise thing for its government to do.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

Brent Calhoon
Partner, CPA
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