Why is the Pentagon buying fake foreign-made parts?

Guest blogger Michele Nash-Hoff

Last week, the Senate Armed Services Committee reported that an investigation found and examined about 1800 cases of suspected counterfeit electronic parts dating from 2009 to last year, totaling about a million individual components.  Tracing the supply chain, 70% of the components came through China, where a variety of methods were used to misrepresent the parts as new and genuine.  Hearings now being conducted by Senator Carl Levin (D-Michigan) and Senator John McCain (R-Arizona)

 

At a news conference on Monday, November 7, 2011, Sen. Carl Levin told reporters, "There's a flood of counterfeit parts entering the defense supply chain.  It is endangering our troops and it is costing us a fortune."

Sen. John McCain said the investigation documents the alarming "threat counterfeit parts pose to the safety of our men and women in uniform, to national security and to our economy."  He added, "We can't tolerate the risk of a ballistic missile interceptor failing to hit its target, a helicopter pilot unable to fire his missiles, or any other mission failure because of a counterfeit part."

This dangerous state of affairs has taken over 20 years to develop and is a complex web of unintended consequences of seemingly innocuous changes in policies.  There are four main reasons for the problem of Chinese counterfeit components:

1.      Mil. Spec. qualified components replaced by off the shelf components

2.      "Buy American" requirements relaxed

3.      Manufacturing outsourced offshore, mainly in China

4.      Rapid obsolescence of components, especially micro chips

It all started with the scandals of the 1980s over the $600 toilet seats and $400 wrenches that President Reagan's Defense Departmentwas accused of wasting its money on by the Congress.

 At the time, the news media ignored reasonable voices pointing out that tooling often has to be made to produce parts in certain manufacturing processes.  This tooling cost then has to be amortized into the piece price of the part; i.e., tooling cost divided by the number of parts ordered plus piece price equals selling price. Since defense and military parts are produced in much lower volume than commercial products, the amortized tooling costs add much more to the part cost than it does for commercial parts.

Because of the public outcry over these scandals, the procurement regulations were changed.  The Defense Department, branches of the military, and their supply chain of vendors were allowed to purchase commercial off the shelf parts (COTS) if they met the same fit and function of parts made to strict military specifications.  In the early 1990s, most commercial parts were still being made in the United States, with some outsourcing to the Philippines, Hong Kong, and Singapore, so this change was pretty safe.  Permitting commercial parts to replace Mil. Spec. parts probably drove out of business the small companies that catered exclusively to the military and that provided traceability, per Mil. Spec., for parts supplied to government agencies, military contractors, and subcontractors.  This was all done in the name of cost savings.  Now, however, most commercial electronic components and micro chips are fabricated in China. 

 Second, after the end of the Cold War and the subsequent Gulf War, the provisions of the "Buy American Act" were eased to allow purchasing off the shelf commercial parts from foreign countries by the Defense Department and other government agencies.  Previously, parts, assemblies, and systems were required to be substantially made in the United States or in a NATO country, such as Great Britain, France, and Germany.

This led to parts being made in China as more and more American companies started to outsource manufacturing in China either by selecting Chinese companies as vendors or setting up their own manufacturing plants in China.   This trend accelerated after China received "most favored nation" status with the approval of the World Trade Organization treaty in the year 2000, and American companies started to build semiconductor wafer fab plants in China to produce micro chips.

The problem with counterfeit parts is not something new to industry - there were always a small number of rejected parts that went out the "back door" of companies to be sold on the black or "gray" markets by individual employees.  What is new is the purposeful production of counterfeit parts by a foreign government, namely, China, as a form of economic warfare and counter espionage.

Brian Toohey, president of the Semiconductor Industry Association (SIA), testified Tuesday before the Senate Armed Services Committee calling counterfeit parts "a ticking time bomb."   He added, "The catastrophic failure risk inherently found in counterfeit semiconductors places our citizens and military personnel in unreasonable peril," said Toohey. The SIA estimates that counterfeits cost US-based semiconductor companies more than $7.5 billion a year.

EBN Editor, Barbara Jorgensen wrote in her blog, "Counterfeits have been appearing in the consumer and industrial sectors for as long as anyone can remember, but their presence in mission-critical defense equipment and military and passenger aircraft threatens lives  The efforts have a ways to go, but the dialogue between industry associations such as the SIA and the Defense Department and Justice Department are a major step in the right direction."

Bruce Rayner, Contributing Editor, EE Times, wrote "counterfeiting is on the rise and it is getting harder to detect.  Counterfeit computer hardware, including chips, was one of the top commodities seized in 2010 by the US Immigration and Customs Enforcement agency (ICE) ... up five-fold over 2009...The reason for the increase is that there's a lot of money to be made.  Many obsolete components are in demand by the military because they need to repair very old equipment, such as 1980s-vintage fighter jets.  But the parts are no longer manufactured, and only a few authorized distributors stock the vintage components.  In some cases, the only place to buy these chips is from independent distributors or brokers who don't have formal relationships with the original component manufacturer. They buy them over the Internet from sources they don't know and who can't validate their authenticity."

The August 2011 issue of Industry Week reported, "In 2010, government agents seized fake goods totaling $188.1 million, which if genuine would have been worth $1.4 billion.  Goods from China accounted for 66% of the value of seizures by U. S. Customs and Border Protection."  In the same article, Wes Shepherd, CEO of Channel IQ, said that the outsourcing of manufacturing in China combined with online selling "introduced the specter of counterfeiting as a much more serious problem."

Joe O'Neill, owner of O'Neill Technologies and formerly with Intel, Samsung and Toshiba, told me in an interview, "the counterfeit problem is a product life cycle mismatch between consumer and more traditional applications, such as industrial, medical, and defense.  The life cycle of micro chips, also known as micro processors and controllers, are very short in the networking, computer, and telecommunications industries.  The life cycle of a cell phone model may range from six to 12 months, while industrial and military products may have a life cycle of decades.  Products for the military are a small piece of the market so there is a real problem with part obsolescence.  Availability of these parts that have been made 'end of life' force manufacturers to go into the Gray Market or other non-traditional sources to keep their factories supplied with parts.  There are a few companies that specialize in making obsolescent microprocessors for industrial, medical or military manufacturers by "cloning" the parts." One such company is Innovasic, which makes the X86 series of Intel and AMD micro processors.

During the Senate hearings, part of which I watched after work, photos of bins of electronic parts were shown as Thomas Sharpe, V. P. of SMT Corporation, described visiting electronic component marketplaces in July 2008, where scrapped electronic parts were washed in rivers or left for the daily monsoon rains, dried on river banks, and collected in bins to be ready for counterfeit processing.  Counterfeiters buy used parts for pennies in the street markets of Shenzhen and other Chinese cities, re-mark them, fix broken leads and buff them up, then ship them to brokers in the West who unknowingly or knowingly sell them to other brokers or to OEMs for multiples of what they paid.

 Last year, the Department of Justice's Task Force on Intellectual Property was created specifically to prosecute counterfeiters, and last week Stephanie McCloskey was sentenced to 38 months in federal prison for her role in a scheme by VisionTech Components to import fake chips from China into the U. S. that were sold to a variety of customers including defense contractors and the military.

Until we implement more stringent procurement regulations, strengthen "Buy American" procurement regulations for defense and military components, and return more manufacturing to the United States from offshore, it will be up to manufacturers to have a system to detect and deter counterfeits.  Many defense contractors have put in place strict regimen for inspecting, testing, and reporting counterfeits, but all companies need to be vigilant by inspecting, testing, and reporting.

 

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