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During the opening days of the Iran conflict, the United States and its allies expended an estimated 225 Patriot interceptors per day, against a production capacity of fewer than two per day.
Companies have little incentive to invest in more production when they cannot be certain that new capacity will be sufficiently utilized in the long term. The United States has a national interest in incentivizing the primes to build more production capacity through concrete purchase agreements and outright payments for maintaining available capacity in key munitions.
Backlogs Are Critical for Primes
A substantial backlog, such as Lockheed Martin’s $230 billion, signals unfulfilled demand and offers significant future revenue visibility. In 2023, Aerojet Rocketdyne had a $6.8 billion backlog, three times its annual revenue. Even with a clear demand signal, the company did not independently finance and build more capacity to fulfill orders more quickly. Adding more lines requires investor capital today, reduces existing revenue visibility by accelerating fulfillment of the backlog, and exposes the business to underutilized capacity when demand dries up. The Pentagon had to provide a $216 million agreement to incentivize more production, with a follow-on $1 billion investment in 2026.
Capital Intensity
The current administration has criticized the amount the primes have spent on buybacks. However, management rationally compares the risk-adjusted return on new factories relative to other uses of capital. The DOW must make reinvestment rational for management teams, and that requires offering higher returns on capital for shareholders than the current system provides.
After the Cold War, procurement fell ~52% from its 1987 peak. The number of tactical missile primes dropped from 13 to 3, which left the munitions industrial base in its present state.
Companies underwrite capacity investments today against the risk of a similar demand cliff tomorrow. Therefore, the cost of capacity must be paid in some way, whether that be through outright capacity payments or long-term take-or-pay-style contracts.
Munitions Stockpiles Amplify the Problem
Using the Joint Air-to-Surface Standoff Missile as an example, the Department of Defense decided to build an inventory of 10,700 units. To a prime, this could look like five years of 2,000 units ordered per year, resembling a real, long-term demand signal that it would invest to meet. As soon as the stockpile target is hit, the previously recurring demand collapses to whatever the peacetime replenishment demand is, leaving production assets underutilized. Primes must operate with the understanding that while demand may be elevated today, the increase is more likely cyclical than structural.
Multi-Year Procurement Shortcomings
The ideal contract type is a long-term take-or-pay agreement. The Pentagon cannot unilaterally enter into such contracts due to the Anti-Deficiency Act, which prohibits legally committing funds for the future that have yet to be appropriated by Congress.
Given that procurement dollars are appropriated one fiscal year at a time, any agreement beyond the current year can be terminated if Congress simply chooses not to fund it. The exception is multiyear procurement, which can reimburse primes for certain non-recurring costs incurred if purchase targets are not met.
Although a good first step, these multiyear agreements are insufficiently firm. Primes may not feel comfortable entering into contracts with subcontractors further down the supply chain, who also face significant challenges in scaling production.
Proposed Reforms
Instead of reimbursing some capital investment, the multiyear agreements should be structured as minimum-revenue contracts, satisfied by any combination of outright purchases and capacity payments. In years when the Pentagon orders large quantities, there are no capacity payments, but if orders decline, capacity payments rise in lockstep. A dedicated fund backed by permanent appropriations and not subject to the annual budget process is necessary to credibly back the minimum-revenue contracts.
Companies must be required to maintain tooling, trained labor, qualified suppliers, and a predefined surge schedule. Companies should also pass periodic tests demonstrating their ability to produce as a condition of eligibility for capacity payments. Multiyear procurement authority should be extended from five to ten years for most munitions.
Primes must have sufficient certainty that capacity payments will be funded, which annual appropriations cannot provide. Instead, we propose creating a munitions industrial capacity surcharge on all foreign military sales, with proceeds retained in a fund exclusively for capacity payments. On a base of $104 billion in FY2025 foreign military sales, a three percent fee would produce $3 billion in annual proceeds, which would accumulate during years of tight supply and be drawn down during slowdowns, effectively functioning as countercyclical insurance.
The current system, born from the remnants of the post-Cold War drawdown, incentivizes restraint, caution, and treating backlogs as an asset. The Pentagon cannot expect the defense industry to act irrationally against its own interests; minimum revenue guarantees, extended multiyear procurement authority, and imposing a surcharge on foreign military sales would better prepare the munitions industrial base for sustained great-power conflict.
