"Admiral Rickover. I reccall a recent experience with this type of thinking "the nickle letters." In August of this year the Navy proposed to place a $50 million contract with a company at a profit of 2.29 percent.
"Chairman Proxmire. Let me understand the 2.29 percent figure. Was that the percentage of profit to sales or to cost?
"Admiral Rickover. It is 2.29 percent of estimated cost. That may sound like a low profit --
"Chairman Proxmire. It does indeed. In testimony yersterday, the Department of Defense witness said that the average profit on defense work was 9.4 percent.
"Admiral Rickover. Actually, it was quite adequate under the circumstances. The contract incolved no risk for the company and almost no investment, and the Navy has been working on the same terms with this company for many years.
"In any event, because of the amount oof this contract, it had to be approved by higher authority. When I submitted the contract for approval, I received a formal letter stating the contract was disapproved because the profit was too low....However, in order to have the contract approved, I was willing to increase the fee on this $50 million contract from $1,147,023 to 1,147,023.05 -- and increase from 2.29 percent to 2.29000001 percent."The nickle letter from Rickover shows the DoD's obsession with profit because it have no understanding of value. Rickover quoted Oliver Cromwell who said: "I beeseach you, in the bowels of Christ, to think it possible you have been mistaken." He had to fight the Navy to let a contract that the firm already agreed to!
Today, there does not seem to be the exact same issue. For example, in billion dollar service contracts where there is little or no risk, there is no question the government will pay a small fee in percentage terms, but a huge one in dollar terms.
As Rickover later showed, almost all of the contract to the prime would be subcontracted out. The prime would only incur $1.473 million in labor costs and receive $1.147 million in profit. Of course, the prime's overhead costs outweighed its labor costs. But that's closer to 50% profit on capital invested. Not too shabby.
The general popint is that the meaningful measure of profitability is the percentage profit on invested capital, and not total sales. Retailers such as Amazon or Wal Mart may make far less profit in percentage terms to their total sales because they are not as "vertically integrated" as, say, commodity producers are. They contribute little end value to the item, so their profits should be lower.
This outcome is natural in market competition, but needs to be willfully imposed in the non-market environment of defense procurement.
It appears forgotten in Rickover's biographies just how sophisticated he was in contracting and procurement. In this hearing, Rickover had no preparation (because he was not initially aware they were occuring) and he still provided an absurdly detailed discussion on a vast array of issues.
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