Experts suggest that for South Korea to emerge as a powerhouse in the defense industry, weapon system research and development contracts should be structured to align performance with profits. They advocate for the implementation of performance-based contracts, similar to those used in the U.S., to stimulate innovation and boost productivity among defense contractors while ensuring cost-effective use of national resources.
On Monday, Choi Soo-dong, a former senior researcher at the Korea Institute for Defense Analysis (KIDA), released a report titled, Directions for Developing Weapon System Research and Development (R&D) Contracts: Including a Comparison of South Korean and U.S. Practices. The report highlights that the current contract system primarily determines profits based on costs rather than performance.
Defense procurement contracts are classified as either fixed-price or cost-reimbursement, depending on whether the contract price is determined at signing. Fixed-price contracts establish the price upfront, while cost-reimbursement contracts are used for prototypes, final products, or research services where advance pricing is impractical. In these cases, an initial payment is set, with the final amount confirmed post-execution. Performance-based contracts, a subset of cost-reimbursement contracts, include cost-saving incentive agreements.
Despite institutional provisions for performance-based contracts in South Korea, most agreements are still executed as fixed-price or certain types of cost-reimbursement contracts where profits are determined by costs.
The Defense Acquisition Program Administration guidelines allow for various contract types across different phases of weapon system development and production. These include general fixed-price, cost-saving incentive, and general cost-reimbursement contracts during R&D; general fixed-price, mid-term fixed-price, and certain indefinite contracts in initial production; and a mix of these in subsequent production phases.
However, 2024 statistics reveal that 57.0% of all defense material contracts in South Korea were general fixed-price agreements. Contracts with cost assessments at signing, midpoint, or completion, such as certain indefinite and general cost-reimbursement contracts, accounted for 43%. In stark contrast, performance-based contracts made up a mere 0.1% of the total.
Choi noted that unlike the U.S., South Korea rarely employs contract types that incentivize cost reduction, such as performance-based agreements. This means its not effectively using contract structures that could drive better outcomes in acquisition projects through enhanced innovation and productivity among defense contractors.
The report highlighted that U.S. defense contracts actively utilize performance-based models to maximize profits based on contractor performance. The Department of Defense currently executes about 40% of its defense contracts on a performance basis, fostering efficient acquisition processes and encouraging cost savings through innovation and productivity enhancements.
Choi recommended that the South Korean military should look to the U.S. system to activate performance-based contracts in weapon system R&D. The U.S. categorizes contracts into six types based on acquisition risk, with cost-plus-award-fee (CPAF) and cost-plus-incentive-fee (CPIF) contracts being particularly relevant.
CPAF allows contractors to receive performance-based fee awards through government evaluation, applicable in technology exploration and system development stages. CPIF operates on a structure that increases incentive fees as target costs decrease, with profit-sharing based on target achievement. This approach is highly suitable for weapon system development.
Choi emphasized that given the increased defense improvement budget and the need for efficient spending amid rising national debt, enhancing the export competitiveness of defense contractors through innovation and productivity improvements is crucial. He concluded that implementing a performance-based contract system should aim to reduce government expenditures while enabling defense contractors to generate higher profits.