(FORTUNE Magazine) – Tim Langevin is in charge of an American tank platoon, and today his mission is simple: Escort a convoy of military supply trucks across the Tunisian desert. But things suddenly turn complicated when one of the American M-1A2 Abrams tanks catches shell fire from a group of hills ahead of the column. A squad of Russian-built T-72 tanks moves out from behind the hills and rolls toward the convoy, guns blazing. Ambush! In seconds, Langevin makes a series of critical decisions. He directs two of his tanks to engage the T-72s from the front while another pair hightail it around the hills to outflank the enemy. Then he orders a Kiowa helicopter to scout ahead for other enemy tanks. But as the battle gets heavier, Langevin makes a truly radical move. He taps some keys on his computer, freezing the enemy tanks in mid-motion, and goes for pizza.

You see, Tim Langevin is a software designer for Mak Technologies, a simulation-software maker in Cambridge, Mass. He was playing Spearhead, a $40 tank warfare game Mak recently released. It's highly realistic, with photographic-quality 3-D graphics and a display screen that replicates the control console in the Abrams tank. In fact, Spearhead is so authentic that the U.S. Army has commissioned a sequel, Spearhead II, and plans to use it to help train real-life tank crews at the U.S. Army Armory School at Fort Knox, Ky. Mak is even negotiating for the exceptionally rare right to strip a blurb reading AS USED BY U.S. ARMY TANK COMMANDERS across the front of the box.

Yes, there is something surreal in the image of combat-hardened tank officers sitting down to train on the same game your 12-year-old might play on the PC in his bedroom. But we had all better get used to this kind of thing. The fact is, nine years after laying the Soviet defense industry on its back, the Pentagon has all but surrendered to an even more formidable force: the commercial marketplace. The Department of Defense (DOD) is revolutionizing the dysfunctional way it buys weapons by embracing the tactics of business. In the process, the DOD is swinging the door open to innovative new companies like Mak and dramatically changing its relationship with traditional contractors like Lockheed Martin. "We need to adopt your best business practices," Secretary of Defense William Cohen told a roomful of CEOs at a recent FORTUNE 500 Forum in Pittsburgh. "We need your advice."

At the heart of these changes is the DOD's desire to "digitize" its air forces, ships, tanks, even foot soldiers (see the next story), with the latest in emerging technologies. The Pentagon wants better radar, better satellite communications and surveillance, and more accurate weapons, all of which it believes it needs to be more effective at latter-day missions such as peacekeeping, antiterrorism, and containing renegade countries like Iraq. Jacques Gansler, Under Secretary of Defense, says this isn't just another Pentagon wish list. The DOD's procurement budget since the end of the Cold War has shrunk 70%, leaving the military in need of a thorough IT overhaul. Indeed, Gansler took that message to Capitol Hill last fall and testified that military readiness had seriously eroded. Alarmed by the testimony (and emboldened by a budget surplus), Congress approved a $9 billion hike in defense spending, the largest since 1991. But to Gansler's chagrin, most of the money was earmarked for spy agencies, missile defense research, and congressional leaders' pet projects.

The truth is, the Pentagon, much like any company, must cut costs to undertake a new capital-spending program. The Pentagon will never get the cutting-edge stuff it needs without changing how it gets it. The acquisition process that has built up over the past 50 years is a monument to counterproductivity. Mindless design specs stretch development cycles out to an average of 13 years--an absurdity in a world where technology becomes obsolete within 18 months. The Pentagon's financial micromanagement alienates all but the hardiest contractors--again, a liability in a world where the next breakthrough is as likely to emerge from a Palo Alto garage as from a top-secret defense lab. The Pentagon knows it has to change. Deputy Secretary of Defense John Hamre told FORTUNE that the DOD wants nothing less than to dissolve the infamous "military-industrial complex" (too bad, Oliver Stone!) that has existed as a kind of parallel universe to civilian industry since the end of World War II. "We don't want a defense industrial base anymore," Hamre says. "We just want an American industrial base."

This new approach to defense contracting, known in the industry as "acquisition reform," was spearheaded by Defense Secretary William Perry in 1994. It is still, however, largely an experiment. It will take years for the changes to filter through a bureaucracy that at last count possessed a $270 billion annual budget--that's almost $100 billion bigger than General Motors' total 1997 sales. Still, the Pentagon has already launched at least 63 new weapons programs under reform rules, and the implications for corporate America are huge. Why? To put it simply, the Pentagon will spend $48 billion to $60 billion annually over the next five years on new products and upgrades, and much of that will be spent on off-the-shelf commercial technology. "We are really making an effort to change," says Gansler. "We want our contractors to use best commercial practices, and we want to bring other companies into the military as part of a broader industrial base."

There are other benefits to contractors, as Mak Technologies, the computer game company, can attest. In helping Mak design Spearhead II, the Army invited the company's designers to Fort Knox to digest the latest treatises on tank strategy and listen to war stories--literally--from veteran armor commanders. As a result, the new game will be more than just an arcade shoot-'em-up. It will test the ability of commanders to manage an entire battle situation, from grappling with logistical problems like fuel and ammunition levels to judging the quality of intelligence. All of this (not to mention the U.S. Army's possible endorsement) could give the game a critical advantage in a market where most entrants spend only a few weeks on store shelves before being cast out to the bargain bins. And the Army gets a superior product as well. "Being able to use this stuff commercially really motivates us to do a kick-butt job," says Ben Lubetsky, Mak's marketing chief.

The reformers' top priority is to rationalize the Pentagon's maddening system of design specifications. Put simply, the DOD insists on researching and designing from scratch virtually everything it buys. By the Gulf war, things had grown so out of control that military engineers were actually drafting pages of specs on how to bake chocolate chip cookies (at least two chips per cookie) and how to cut the lawns at bases (grass should be no higher than a quarter of an inch).

Under the circumstances, it's a wonder the military is able to acquire anything that works. The traditional system not only antagonizes contractors but also saps their incentive to innovate or cut costs. Even worse, the system never holds contractors accountable if their wares don't work. As long as the individual pieces conform to the Pentagon's specifications, the contractor isn't responsible for foul-ups on the final assembly.

The military's insanity on the issue of specs is matched only by its overbearing financial micromanagement. Because the DOD tends to contract on a cost-plus basis, the department's accountants inquire about virtually every cost the contractor incurs, however minute. Contractors are routinely asked to justify such mundane expenses as desk lamps. Companies like Hewlett-Packard have said "thanks but no thanks" to lucrative military R&D contracts because they weren't worth the trouble. Boeing decided to bifurcate its military aircraft business and its commercial aviation division, losing valuable economies of scale on the production lines, largely because the respective accounting standards couldn't be meshed. This level of oversight, of course, was designed to prevent overspending. But it doesn't work. Stanley Soloway, the DOD's Deputy Under Secretary for Acquisition, says the system, much more than old-fashioned corruption, is the real cause of such outrages as $640 toilet seats and $400 hammers. "Every major spending scandal at the Pentagon has occurred under these accounting standards," says Soloway. The Pentagon, in short, has spent billions to save millions.

Under the new rules of acquisition reform, traditional military specs are scrapped in favor of the performance standards that industry trade groups establish for their members in the commercial world. (For example, if a defense contractor makes a product that requires motor oil, it shouldn't have to refine the oil to comply with a set of military specs when the industry standards will do just fine.) Contractors are allowed to use as much hardware and software from the commercial world as they please, as long as it does the job. In exchange for the new flexibility, contractors have to guarantee their systems work. "If a new system doesn't perform its mission, then the contractor is on the hook," says Bud Forster, a retired three-star Army general and Air Cavalry pilot who now works for Northrop Grumman.

Not surprisingly, in many projects launched under reform rules, contractors have actually been able to develop next-generation weapon systems for less than original estimates. That's a radical departure from the automatic cost increases that usually befall any projects with the word "new" or "next" attached. On a major program to upgrade the fire control radars on 227 Apache attack helicopters, for example, the Army set aside much of the military specifications, and the contractors, Northrop Grumman and Lockheed Martin, were able to reduce the cost of the $540 million Longbow program by more than $80 million.

The Longbow radar is a prime example of the sophisticated technology the military is looking for. This isn't your father's round green scope that shows a blip with every pass of the ray. The Longbow's sphere-shaped sensor is mounted atop the rotor of the Apache and can sweep a 50-square-kilometer area in front of the craft in less than ten seconds. Inside the helicopter, which is used to attack tanks and other ground targets, the radar displays a photographic-quality image on a video screen in front of the pilot. The display shows the contours of the landscape down to a meter, overlaid with icons depicting moving and stationary enemy tanks, antiaircraft vehicles, and other ground traffic. The pilot can segregate a "no-fire zone" on the screen to show where friendly forces are positioned.

But the key to the Longbow system is its ability to instantly share data with other Apaches in the squadron, which means the Army doesn't have to put a Longbow on every copter. Moreover, the system can receive intelligence updates from command posts and additional radar data from other sources and share that too, enabling the pilots to "fly in a web of information," says James Roche, the president of Northrop Grumman's defense electronics business.

No one appreciates these advances more than the Apache pilots who flew in the Gulf war. In the Iraqi desert they had to expose themselves to fire as they directed a laser-guided weapon to the target. Now, in tandem with the Longbow Hellfire "fire and forget" missile, the radar will enable a pilot to hover behind a hill five miles from the target, stick the sensor atop the rotor above the hill line, pinpoint the target's position, relay it to nearby Apaches, and fire missiles at it, all without exposure to enemy fire. In recent tests the Longbow-equipped helicopter notched a survivability rate seven times higher than the normal Apache and hit its targets four times better. The older models also chalked up 34 "friendly kills," vs. zero for the Longbow.

One of the reformers' most notable successes has been to throw out the military's traditional segregation of military products and services from their off-the-shelf commercial counterparts. Thus, Mak Technologies is allowed to sell the general public a computer simulation developed for the Army. Other companies are selling the military products developed for commercial customers.

One of them is Space Imaging, a Denver company formed in 1994 by Lockheed Martin and Raytheon specifically to break into the budding commercial satellite imagery market. The companies had been dealing so long with the Pentagon's peculiar purchasing practices that they felt they could best reach civilian customers by jointly setting up a separate company outside their own walls. "If we wanted to develop a strong commercial business, we had to keep this away from the defense culture," says John Copple, Space Imaging's CEO. The company sells satellite-image-based products to an array of customers, from urban planners to oil exploration outfits. For 50 cents to $1.50 an acre, farmers can buy infrared-treated satellite images that highlight stressed-out sections of their croplands.

Thanks to acquisition reform, Space Imaging sells the same pictures to DOD's National Imagery and Mapping Agency (NIMA), which archives the unclassified images for defense agencies. The Air Force uses them as a base for developing 3-D training simulations for pilots. If a pilot is preparing to join the peacekeeping mission in Bosnia, for example, the Air Force can provide him or her with an accurate simulation of the airfields there.

Under the old rules, the military would have generated these pictures only by launching its own satellite after a lengthy (and we do mean lengthy), expensive design and production cycle. But today you can download old Soviet satellite reconnaissance pictures of Brooklyn--or the Pentagon for that matter--off the Internet. According to Merrill Lynch, the satellite imaging industry will grow more than 56%, to $2.5 billion, by 2003. So it hardly made sense for the Pentagon to reinvent the wheel.

In some cases the DOD has gone beyond simply buying civilian products and formed joint ventures to co-finance "dual use" projects. The Navy, for example, has developed a system called the Naval Earth Map Observer (NEMO), a $130 million satellite research project that had lacked funding. Space Technology Development, a space business based in Alexandria, Va., will launch the NEMO satellite in 2000. The Navy wants it to take highly detailed pictures of coastal regions the Marines may have to assault. NEMO's cameras can "see" the ocean floor from space down to a depth of 100 feet, providing charts and sandbar locations to Navy planners. But its key feature is a "hyperspectral" sensor, which can identify minerals, vegetation, or pollution in the water--all of great value to mining companies and even commodities traders looking to make long-term crop predictions. So the Navy put up 40% of the development costs, with Space Technology picking up the rest. The Navy's stake entitles it to a quarter of the satellite's images. But Space Technology will actually own NEMO after the launch, pay for its maintenance, and pocket 100% of the profits. "The Navy didn't have enough money to do it, and neither did we, but we came to an equitable agreement on the usage issue, and now we're in business," says CEO Paul Setze.

Some of acquisition reform's most important contributions have come where they matter most: in places where American troops are in harm's way. Bosnia has been a particularly active proving ground. In 1996, for example, United Nations peacekeeping forces were receiving excellent intelligence on Serb movements from U.S. airborne radar, drones, and other sources. But the ground commanders' ancient military modems took more than 30 minutes to receive a single reconnaissance photograph. Under new rules that permitted the military to use commercial products even in battle zones, the intelligence was beamed to commercial TV satellites and back down to dishes at the ground bases, providing the data almost instantly. Even better, senior U.N. commanders at the European Command Headquarters in Germany could review the same data simultaneously. "Rather than going off and building our own satellite for ten years, we just leased time on a commercial satellite," says Paul Kaminski, the Pentagon's acquisition czar in the first Clinton Administration.

In fact, the military had been sold on the value of civilian satellite communications ever since the Persian Gulf war. In that conflict, U.S. commanders got a rude surprise when they tried to use their own satellites to transmit data and received busy signals instead. It turned out that the massive deployment in the Gulf had soaked up the bandwidth on all military satellites. And when commanders turned to the commercial birds for capacity, they were too late: CNN and other news organizations had already grabbed the available capacity. So when Air Force generals in the Saudi desert wanted to send Navy carriers in the Gulf the latest air attack plans, they had to fly hard copies to the ships, just as in World War II. After the war the Pentagon decided to reserve military satellite capacity for critical "war-fighting" communications and use commercial bands as much as possible for logistics and "health, welfare, and morale" traffic.

That created a million-dollar opportunity for Arrowhead Space and Telecommunications, a Falls Church, Va., consulting firm founded in 1991 by Mary Ann Elliott, a onetime sales agent at Motorola. Arrowhead advises the DOD on commercial sat-com services, resells satellite capacity to various government agencies, and installs and maintains sat-com systems. In 1996, Arrowhead, in conjunction with AT&T, went into Bosnia ahead of U.S. peacekeeping forces and set up four telephone banks that used commercial satellites so the troops could easily place secure phone calls home. "In the past that kind of activity would have gone on a military satellite," says Elliott. "But since it's not mission critical, they now give it to us."

Promising as these reforms are, everyone knows it will be a struggle to institutionalize them. The General Accounting Office recently reported that the Pentagon still wastes billions of dollars in its day-to-day acquisition process; costs have risen even in many of the reform pilot programs. Moreover, rank-and-file acquisition officers are used to a system that rewarded them for pushing programs through, no matter what their cost or effectiveness. "The contract officers are being asked to implement a process that threatens their jobs," says Elliott. "It's going to take a lot of work to make these concepts a reality and not just talk."

Maybe so. But the reforms had better work, because more than saving money is at stake here. To hear the Pentagon brass tell it, it's a matter of national security.