Semiconductor Manufacturing Becomes Problem for Defense Industry, Senate Armed Services Committee Says

Reliance on Asia for microelectronics, or semiconductors, is increasingly seen as a big problem for the Department of Defense (DoD). While the U.S. designs chips, they are mostly all offshored to be made in Asia, led by Taiwan and South Korea.

After inflation concerns, the semiconductor supply chain was the biggest defense industry concern discussed during Tuesday’s Senate Armed Services Committee hearing about the health of the U.S. defense industrial base.

Semiconductors are essential to a wide range of systems and capacity here has fallen from a high of 40% in the 1990s to local producers accounting for about 13% of the market today.

“China is investing heavily to dominate this industry, and you also have China’s interest in bringing Taiwan into the mainland fold. How does this shortage contribute to the challenges we face at the DoD? What can be done?” asked Senator Mark Kelly (D-AZ), a former Navy Captain.

Ellen Lord testifying before the Senate Armed Services Committee on April 26, 2022. She is a defense policy and defense industry expert, and former government official working in the Defense Department.

Ellen M. Lord, a former Under Secretary of Defense for Acquisition and Sustainment, was one of two people providing testimony. She said the global semiconductor shortage had “enormous ramifications for the DoD because almost everything produced uses them. We have offshored to the point where we are no longer in control of those supply chains. Even the most fundamental lower items like rare earth elements, we can get them out of the ground, but they are a very dirty process to make them useable. We need to prioritize things that get us those key elements…invest in the industrial base in tooling, in infrastructure, because if not…we will not be able to control our destinies here,” she warned. “There is more to be done than just one company can justify in its own business cycle. So while I’m not a very big fan of government getting involved in national industry, this is an emergency, and this is a sector that needs investment in order to be able to control our destiny.”

No one mentioned the CHIPS Act, which was part of the Senate “China bill” known as the U.S. Innovation and Competition Action, passed last year. Both the House and Senate versions of those bills, called the Bipartisan Innovation Act, are in committee with hopes of a compromise bill being voted on by July 4.

CPA supports the CHIPS Act. It would provide federal incentives to promote semiconductor manufacturing domestically and increase government-funded investments in semiconductor research to the tune of $52 billion.

Lord said that the U.S. intellectual property to make the chips is sent to Asia to be research-tested, and later packaged and sold. “These are all very important parts of the chain,” she said.

Senator Jacky Rosen (D-NV) said a lot of her constituents who manufacture for the defense department are complaining about shortages of microelectronics. “What steps can we take to increase microelectronics available to the DoD?” she asked.

Lord gave her a history lesson on American semiconductor production, reiterating what she had said earlier in the day.

“The primary issue is that we have outsourced our microelectronics, or semiconductor industry. Why did we do that? One was environmental reasons, another was cost of labor, another was cost of materials. The travesty is that most of the IP that goes into that is developed here but we have devices that are made offshore, and the chips are tested offshore. It takes enormous investment to get that back.” — Ellen M. Lord, former Under Secretary of Defense for Acquisition and Sustainment

She said long-term contracts to produce microelectronics today under Title III of the Defense Production Act might help. “This a problem that didn’t happen overnight; it happened over a long time. And for industry to get the trusted supply it needs we have to re-establish that supply chain. But businesses are not going to re-establish it themselves unless they can make a profit,” she said.

David Berteau, president, and Chief Executive Officer of the Professional Services Council, with more than 40 years’ experience in the space, including running the funding for the SEMATECH, the Reagan-era program in the 1980s that gave the semiconductor manufacturing sector a shot in the arm to make it a powerhouse in the 1990s. It quickly opted to keep the brain trust at home, while shipping the heavy lifting to Taiwanese, South Korean and Japanese manufacturers. Nowadays, it is China that is gaining prominence.

Senate Armed Services Committee Chairman, Jack Reed.

“The problem is that the DoD is such a small part of the market,” said Berteau. “I remember back in 2004-05 I did a study on printed circuit boards only to discover that we don’t buy enough of that at the defense level. And because it takes so long to buy things on contract, in regard to new generation chips, we are not doing that today (at the DoD). The one thing we never build into our (defense) budget is the cost of not doing something,” he said.

“The United States industrial base is core to our national security. America’s capacity for technological innovation and manufacturing has assured that our military is the finest in the world with benefits felt well behind the military sphere. From the internet to GPS to the microelectronics in our cell phones and computers many of the technologies made for our defense industrial base has contributed to our broader, national, wellbeing. But this status is not a given. It must be nurtured and maintained through careful investment. We have neglected that industrial base and assumed it would always be there. But it is not there, because of many different factors.” – Senator Jack Reed (D-RI), Chairman, Senate Armed Services Committee, April 26, 2022.

On a separate note, Senator Josh Hawley (R-MO) brought up China and wondered what the DoD was doing about the fact that some of the largest defense contract consultancies have similar advisory relations with China’s government.

“Should we be concerned about that?” Hawley asked, naming firms like McKinsey and Deloitte in particular.

“We think there are very serious concerns that need to be addressed in working for China and the U.S. governments,” Bertreau said, adding that he felt the DoD had the firewalls in place, but enforcement and actual investigation into any holes in those walls were probably lackluster. He said his firm was working on a white paper on companies doing government work with both countries.

David Berteau during testimony to the Senate Armed Services Committee on April 26, 2022.

As far as legislation goes, the only topic that Congress could address swiftly would be passing the CHIPS Act in the Bipartisan Innovation bill and get it signed by President Biden. The other issue was inflation’s toll on defense contracts.

Inflation “means that fixed-price contracts will not be completed as they were bid because there was no assumption that there would be 10% inflation on material costs, at least,” said Lord. “There are also enormous price increases in transportation and that puts fixed contracts at risk and cost-plus contracts are going to get more expensive. The most significant thing Congress can do now is authorize and appropriate budget increases to the ’22 budget right now to make up for inflation and think really hard about 2023.

Berteau said inflation was also part of a short workforce. “There’s not a lot of labor to go around. There are tens of thousands of jobs under contract today and companies cannot recruit or retain workers. This is not sustainable,” he said.

Senator Marsha Blackburn (R-TN) asked if this was a byproduct of vaccine requirements for workers at all defense contractors.

Lord said “absolutely” and added that many small to mid-sized contractors topped bidding. “Many others didn’t bother to enter the market at all,” she said.

A slow-moving government was the problem, but only as it related to China. China was the game changer on this, as the U.S. government was never designed to move fast. That was the private sector’s job to innovate, produce, and get things to market. With China waiting in the wings to replace the U.S. as a tech powerhouse, especially in Asian markets, the U.S. government will have to get more active. Defense contracts are one way to go about it.

“The problem is that everything government-related takes us so long and the threat of China doesn’t give us the luxury of time,” Berteau said. “Ten years ago, I submitted a report to Congress in a hearing about the pivot to Asia and said we’ve got seven to 10 years to keep ahead of China. Well, those years are gone now,” he noted, adding “It takes us three years to get something approved when it can take China three days.”

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