A P-8 maritime patrol aircraft undergoes assembly at Boeing’s Renton production line. Future E-7s, based on the 737 NG, will be slotted into this line for assembly. (Michael Marrow/Breaking Defense)

WASHINGTON — The Pentagon may be heading toward a reckoning with industry over the cost of parts, equipment and weapons, with defense companies less amenable to taking on financial risk in future contracts, the head of the Aerospace Industries Association warned on Thursday.

The defense industry has acted as an initial “shock absorber” for the Pentagon on inflation, taking the brunt of cost increases caused by rising labor costs and the price of high-demand commodities like titanium, Eric Fanning told reporters during a roundtable.

But companies have signaled that they have been forced to assume too much risk, and the Defense Department needs to prepare for a decrease in purchasing power that could challenge its ability to fund its modernization priorities, said Fanning, whose organization represents more than 330 aerospace and defense vendors.

“Eventually there’s new competitions, there’s new contracts, there’s new order quantities. If the price of a platform is variable and the Pentagon plans for three and isn’t really adjusting for inflation, eventually they’re going to realize they get two,” he said. “Eventually that dynamic is going to shift.”

Fanning added that this could come to a head in fiscal 2026, after the Pentagon is freed from congressionally mandated cost caps that kept budget increases to about 1 percent in FY25 —  a rate that doesn’t keep pace with inflation.

The aerospace and defense industries have seen demand skyrocket in the wake of the COVID-19 pandemic and Russia’s invasion of Ukraine, creating a stream of new orders at a time where the supply chain is still in recovery mode.

While industry leaders bemoan the impact of inflation, defense contractors have come under fire by leaders in the Pentagon and Congress, such as Navy Secretary Carlos Del Toro, who criticized companies for prioritizing share repurchases instead of making investments into capital expenditures and the suppliers.

Asked about the issue, Fanning countered that defense contractors had few other options, due to inflation and budget caps eating into the Pentagon’s purchasing power.

“The investments going into programs [are] shrinking. It’s not staying level. And so what are the options for the companies to show returns to their investors?” he said.

Large defense companies have told AIA they are already seeing inflation’s impact within their supply chain, with some suppliers opting to shift most of their capacity to the higher volume and higher margin commercial sector.

In other cases, Fanning said, companies reported that their suppliers would purposely violate the terms of a contract to shift work toward commercial business — even choosing to be fined — because the price of commercial work more than offset the financial penalties.

AIA released a list of legislative priorities this week, with items aimed at improving supply chain resiliency among the organization’s top priorities, Fanning said.

The priorities include enacting legislation that would encourage trade agreements with allies and partner nations on critical minerals and key components like semiconductors, as well as approving an existing bill that would temporarily remove the 15 percent tariff on titanium sponge imports.

Other proposed reforms involve another persistent boogeyman for the defense industry: fixed-price contracts, which require the contractor to take financial responsibility for cost overruns over a certain threshold. Inflation and labor costs have contributed to losses on some fixed-price development contracts over the past years, a fact some defense CEOs have lamented in recent earnings calls.

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AIA is proposing amending existing legislation to prohibit the Pentagon from ordering more than one lot of items in low-rate initial production under a fixed-price deal, as well as inserting in language that would require the department to assume the risk of loss for work in progress on fixed-price contracts where classification inhibits defense contractors from obtaining commercial insurance.

“We’re not saying get away from fixed price contracts,” Fanning said, adding that some sectors — particularly space — actually favor fixed-price agreements, as they can lead to higher margins when a product’s price is well understood. The problem is when the department forces industry to transition to a fixed-price arrangement too early, before the true costs of the program are known.

“That’s risky for both sides,” he said. “We tend to say, ‘Okay, well, thank God the burden is not on the government side, that the taxpayers aren’t being harmed.’ But you are doing harm to your industrial base over time. Why would we want to weaken the company because we got it into a bad contract?”