Build before you bill

Cost-plus contracting has long been part of U.S. defense procurement, especially where costs are difficult to estimate in advance. Under cost-plus-fixed-fee, the government reimburses allowable costs and pays an additional agreed fee. For genuinely uncertain R&D, this can be a sensible way to allocate risk. The problem is what happens when that model starts shaping how an industry builds.

Under firm-fixed-price contracts suppliers have a strong reason to reduce costs, i.e build more efficiently and then keep more of the upside, run over budget and they absorb the downside. Under cost-plus, more of that risk sits with the government. The Federal Acquisition Regulation (FAR) itself describes cost-plus-fixed-fee as providing only a minimum incentive to control costs.

A “normal” product company invests its own capital, builds something, proves it works, and benefits from making it cheaper, faster, and easier to produce at scale. A company built around government-funded development is more heavily rewarded for winning programs, meeting requirements, and managing reimbursable development. That model made more sense when the Pentagon was one of the world’s dominant sources of R&D. In 1960, U.S. defense-related R&D accounted for roughly 36% of global R&D. Now that share has fallen to around 3%.

This matters because many of the systems likely to shape future warfare, including autonomous systems, drones, sensors, software, and electronic warfare, improve through rapid iteration, falling unit costs, and the ability to deploy new versions quickly. Cost-plus still has a role in genuinely uncertain research, but it should be the exception rather than the model around which the next generation of defense companies is built. For many of these systems, companies should take more development risk themselves, build before they are paid to build, and compete on the strength of working products.

The winners should be the companies that can iterate faster, lower unit costs, improve continuously, and manufacture at scale. That creates a very different defense industry with one where companies are rewarded for building better products with better economics, rather than for becoming better at managing large reimbursable development programs.