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Welcome to Apogee Consulting, Inc.

Oh, Boeing! What’s Happened to You?

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Hello! Well, hasn’t this just been the year? Over on this side of the monitor, in the past three months I’ve had both COVID and RSV. (Courtesy of my son’s high school.) But I’m through both now—and looking forward to next year.

Speaking of challenging years, though, let’s talk about The Boeing Company. Boeing Defense has had a very challenging year, a year that follows previous challenging years. In fact, Boeing as a company has had a challenging past few years and its stock price has reflected those challenges. The company’s stock price hit a high of just under $441 per share on March 1, 2019. In contrast, on December 16, 2022—less than four years later—the stock price stood at $185 per share. That’s a drop of nearly 60 percent.

That’s not the end of the story. In 2020, the company was paying shareholders a dividend of about $2.00 per share. Then dividends were suspended. In 2021, Boeing paid shareholders nothing. The story was the same for 2022.

Sucks to be a shareholder in The Boeing Company, right?

You know, we’ve made that point before. Oh, yes—we have!

For example, in a 2018 article, we wrote—

And what about big versus small contractors? If the Pentagon is going to award contracts based on the amount of investment that contractors are willing to make, then only the largest of contractors will win awards. The smaller contractors will be locked out of the ‘pay for play’ competitions.

To sum up these thoughts, it seems that certain larger contractors are willing to pay to play in long-term Pentagon contracts, betting that they will earn back developmental losses over the lives of the programs. They may be right; but we remember the story of that DOE contractor, whose program investments turned out to be larger than it ever dreamed of.

The point was (and still is): making a known investment to win a major program only works if your investment stays the same size as you first predicted. Should circumstances change and your initial investment prediction becomes “overtaken by events” then your initial Return on Investment (ROI) analysis is thrown in the trash can. At that point, you and your shareholders are well and truly screwed because you are now locked into a fixed-price (or FPIF) development program that you must deliver, regardless of supplier programs and regardless of COVID impacts and regardless of inflationary impacts on your budgeted costs. You must deliver, regardless of what it costs you.

If you don’t deliver, you will be Terminated for Default.

You have to deliver no matter what it costs; if you have schedule slips and subcontractor issues and technical issues that you thought you could solve (but which turned out to be tougher problems than your engineers predicted) and if you have ridiculous cost growth in materials and labor—and if you have labor shortages because your people are leaving in droves because you don’t pay them well or maybe they’re sick of a toxic (or inept) management culture—and if your cash-cow commercial side of your business tanks at the same time you need a cash infusion to cover your program losses … well, then. You just might be The Boeing Company.

Talk about grabbing a tiger by the tail!

In 2022, the tiger bit Boeing.

What do we mean?

Under Shadow of Financial Losses, Boeing Makes Sweeping Changes to Defense Biz (Breaking Defense, 11/17/2022)

The changes, including halving business divisions, come as Boeing’s defense sector [BDS] finds itself at a crossroads, with new leadership contending with systemic financial issues tied to its large number of fixed-price contracts with the US government. …

BDS has racked up about $4.4 billion in losses so far this year on fixed-price programs, primarily driven by the KC-46 tanker and the VC-25B programs (the latter effort better known as the next-generation Air Force One), but also including the T-7A Red Hawk trainer, MQ-25 tanker drone and Commercial Crew program with NASA.

Boeing Reorganizes Defense Business After Financial Troubles (Air & Space Forces Magazine, 11/17/22)

Boeing has faced companywide losses, including in its commercial sector. Its defense business has been a significant drag on the company’s recent financial performance following losses incurred on fixed-price government contracts. In October, Boeing reported a loss of $3.3 billion in the third quarter of 2023, with its defense business $2.8 billion in the red. …

The KC-46 and VC-25B, which will become the new Air Force One, have been a significant financial drag for Boeing. The KC-46 program lost $1.2 billion, and the VC-25B program lost $766 million in the third quarter. The KC-46 has been troubled from the start, problems in its refueling system requiring a revamp and leading to delays. The VC-25B program was priced too cheaply, according to Boeing, making it a loss generator for the company. Supply chain issues and labor shortages have increased problems.

Boeing Reorganizes Defense Division After Third-Quarter Losses (Aviation Week, 11/17/2022)

Boeing’s Defense, Space and Security (BDS) division announced an organizational streamlining on Nov. 17 as the $26.5 billion business unit seeks a return to growth and to curtail mounting losses on fixed-price development programs. … Boeing also announced the restructuring three weeks after BDS reported a 20% reduction in quarterly revenues and a $2.8 billion reach-forward loss on five fixed-price development programs. Those same programs have accounted for $11.5 billion in reach-forward losses overall since 2014.

But in addition to the impacts to shareholders, there are more subtle and perhaps far-reaching impacts from Boeing’s management mistakes. Richard Aboulafia discussed those impacts in a recent editorial at Aviation Week.

He wrote that Boeing’s current situation “is not good for the long-term health of the U.S. aerospace industry, the broader U.S. economy or the aerospace workforce. But one overlooked consequence of Boeing’s woes is the possible impact on U.S. defense.” He cites three potential impacts to the United States’ national security posture, as follows:

First, BDS execution problems mean the U.S. military services will have to keep using older, less reliable systems that are costly to operate. With KC-46 and T-7 delays, even the oldest KC-135 tankers and T-38 trainers will soldier on well past 60 years of age. Pentagon efforts to procure interim or supplemental systems—an Air Force/Navy trainer or the Air Force’s KC-Y tanker—are uncertain.

Second, an industrial base decision might have been made for the Pentagon, whether it wants one or not. BDS losses reflect low bids on relatively low-tech programs; it is not clear whether Boeing can hope to bid on new programs that require more advanced engineering, particularly if past performance is a key selection factor. … Boeing could also be disadvantaged by Pentagon concerns about the company’s in-house design capabilities. Boeing’s 2015 Long-Range Strike Bomber loss to Northrop Grumman in part reflected Air Force concerns about Boeing’s strategy of relying on Lockheed Martin for much of the design work. Relying on Saab for much of the T-7 design may be viewed as a risky tactic, too. … The Air Force’s Next-Generation Air Dominance program looms large over this. If it excludes Boeing, and if the Navy’s F/A-XX either stalls or excludes Boeing, we can assume there are now two competitors for new fixed-wing military contracts, not three. The Defense Department does not want less competition for future programs and has signaled opposition to mergers resulting in that outcome, but it might have to live with that reality anyway.

Finally, the nation’s ability to design large aircraft must be considered. The C-17 fleet is wearing out at a rate faster than expected, and the C-5M is getting quite old, too. Given the relevance of strategic airlifters for operations in the Pacific, the Pentagon will need to start funding a new program sometime in the next 10 years. … Calhoun’s new jetliner deferral means Boeing design teams will not hire new talent, resulting in smaller numbers and a much older demographic by the 2030s. We cannot rule out mass layoffs of these engineers, either. In the late 1980s and early 1990s, the C-17 program was plagued by serious overruns and delays, largely because McDonnell Douglas’s aircraft design teams were in a state of atrophy. Boeing is at risk of entering that phase and perhaps an even worse one.

So … is there a lesson or two that might be learned here?

Well, yeah. First of all, beware fixed-price (or FPIF) development contracts. We’ve sounded that warning before. (See this 2018 article.) Just … don’t.

Second, let’s talk about workforce decisions. As Aboulafia’s editorial noted, without a strong engineering workforce, you don’t get new products. You don’t get innovation. You don’t get clean-sheet anything. Somewhere along the line, The Boeing Company stopped being a engineering company and started being a for-profit company run by the business folks. (That’s not just our outsiders’ opinion. See Flying Blind: The 737 MAX Tragedy and the Fall of Boeing, by Peter Robison.)

You’d like to think that as older folks depart, they would be replaced by a cadre of young engineers, trained in the latest and greatest design tools. New blood, fresh energy, buzzing with ideas for the future. But where do those folks come from?

They don’t come from St. Louis.

No offense to St. Louis! But it’s not especially known for its depth of engineering talent. Not a lot of engineering schools in the area, compared to, say, Southern California. Which is where BDS’s headquarters used to be, before it moved to the St. Louis area in 1997. (We should note that the HQ moved from Hazelwood to Washington, D.C. in 2016, but that didn’t impact the engineering staff.)

  • In November, 2015, the final C-17 left Boeing’s Long Beach, CA, facility and 2,500 people were laid-off. Per a 2019 article, the C-17 plants in Wardlow “remain largely vacant.”

  • In 2016, Boeing moved 500 (unspecified) positions from Huntington Beach, CA to Hazelwood as part of a “facilities consolidation.”

  • In December of that same year, Boeing announced that 2,400 jobs would be leaving its Huntington Beach, CA, facility over the next four years (with some going to other Southern California facilities). Importantly, Boeing’s Huntington Beach campus “spread across some 28 buildings on 178 acres, include[d] a design and research center focused on space access, networked systems, cybersecurity, unmanned underwater vehicles and advanced manufacturing, along with key programs in the highly classified Phantom Works program.” In other words, exactly the engineering talent you would want to retain. However, Boeing was prepared for attrition. A company spokesperson was quoted as saying: “Most [job losses] would come from attrition. Some people will decide they don’t want to move and will leave the company. Some number will be layoffs. All will receive separation assistance.”

  • In 2021, Boeing announced that 150 “supply-chain related jobs” would be moving from California and Washington State to Texas.

In summary, Boeing made several decisions over the past twenty years that negatively impacted its critical engineering workforce. Seemingly driven by a need to cut costs, it made a decision to move away from its traditional facilities—places where the company had been for decades—and consolidate to less traditional areas. Critically, it consolidated in areas that didn’t have the same robust engineering talent feeders.

We get it. It’s popular to hate on California. It’s super-regulated. It’s practically a Socialist Paradise. It’s one of the most expensive places in the US to live, with high taxes imposed on both individuals and corporations. Most of those less-than-charitable accusations are true (to some extent). And yet … where is Cal-Tech located? Where is the Jet Propulsion Laboratory located? Where is Edwards Airforce Base located?

According to the 2023 graduate school rankings by U.S. News & World Report, four of the top ten engineering schools in the United States are located in California, as are six of the top twenty. Washington University in St. Louis is #48; Missouri University of Science and Technology (Rolla) is #92. Good schools, for sure! Yet …. We think you get the point.

The fact of the matter is that most people like living in Southern California. They like only dealing with snow when they choose to deal with it by driving an hour or two into the mountains. They like being able to walk on the beach if they want to, or to surf in the Pacific Ocean during January. They like living in close proximity to culture. They like it where they live and many of them don’t want to move away. They won’t move away if their jobs move; instead, they’ll find another job in a competitor.

You ever been to El Segundo? Northrop, Boeing, Raytheon Tech, Lockheed Martin – all with facilities located within two or three miles of each other’s. Sure, it’s not the same now as it was back in the day—but it’s still there, still an aerospace/defense engineering hub. The point is: if their job moves away, many people—including some of your high-potential, highly knowledgeable and experienced engineers—can just change employers without having to relocate from the West Coast to the Midwest. In fact, the better they are, the easier it will be to job-hop instead of relocate.

The question becomes: Do you put your facilities where costs are lower … or do you put them where the talent is? What’s the correct answer for the financial statements? What’s the correct answer for the future of your company?

In our view—and in the view of others—Boeing sold its future for short-term corporate profits long ago. What we are seeing now are the consequences of that decision. Unfortunately, that decision also seems to have had consequences for the national security posture of the United States.

Last Updated on Tuesday, 20 December 2022 13:51
 

Audit Rights and Record Retention

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Government contractors must comply with the requirements of many upon many contract clauses. It’s safe to say that the principle purpose of government contract compliance is to understand those requirements and to help the contractor adhere to them, and then demonstrate to the government auditors that the contractor has done so.

Two of the more important clauses are 52.215-2 (“Audit and Records-Negotiation”) and 52.216-7 (“Allowable Cost and Payment”). If you are a contract compliance professional you should have basically memorized those clauses. They are that important.

Generally speaking, 52.215-2 (which is a mandatory clause for all negotiated contracts unless the contract is exempted by 15.209(b)) is what gives auditors access to contractor records. It’s not unlimited access and you should understand the guardrails established by the clause. In addition, 52.216-7 (which is a mandatory clause for all cost-reimbursement contracts) establishes how billing rates are to be calculated, adjusted, and submitted for audit and finalization. It is also the clause that invokes the FAR Part 31 Cost Principles; without it contractors wouldn’t really need to worry about allowable and unallowable costs.

Both clauses are fundamental and you should study them thoroughly if you have not yet done so.

We have discussed both clauses before. One of interesting aspects of 52.215-2 is that it grants auditor access but that access may be worthless to the auditors. What do we mean? Well, in this ASBCA decision from 2017, we discussed the happy result that DCAA had audit access but the government was prevented from asserting a claim based on the DCAA’s audit findings, because the Contract Disputes Act (CDA) Statute of Limitations had been found to have passed before the contracting officer got around to asserting the claim. Oops!

We wrote:

But what about that 52.215-2 audit clause that gives the government the right to audit contractor costs up to three years after final payment? Sure. Absolutely correct. The clause requires that ‘The Contractor shall make available at its office at all reasonable times the records, materials, and other evidence … for examination, audit, or reproduction, until 3 years after final payment under this contract or for any shorter period specified in [FAR Subpart 4.7], or for any longer period required by statute or by other clauses of this contract.’ (Emphasis added.) Thus, the contractor has a duty to make documents available for audit and the government has the right to audit those documents, but the government does not have the right to assert a claim with respect to any audit findings related to costs that were invoiced and paid more than six years before. If the contractor’s final voucher doesn’t contain any new direct costs—which it shouldn’tthen the 52.215-2 audit right is essentially worthless—absent, perhaps, a claim of fraud.

So, in the case of Sparton deLeon Springs’s appeal of the Contracting Officer’s Final Decision (COFD), the government had moved too slowly to recoup any of the funds it believed had been insufficiently supported by the contractor. Sorry; not sorry.

More recently, the ASBCA dealt with a similar case that (largely) had a similar outcome.

Doubleshot, Inc., a small business, had at least four cost-type (or partially cost-type) contracts that were characterized as R&D contracts. The earliest of those contracts was awarded in 2006; the latest was awarded in 2008. Now, before awarding those contracts, the various government contracting officers were required to find that Doubleshot possessed and accounting system adequate to account for contract costs. (See FAR 16.301-3(a)(3).) The record is silent on this point, but it is not disputed that, when DCAA showed up to evaluate Doubleshot’s accounting system in January, 2010, the contractor did not fare well.1 More than a year later, a “Flash” Report was issued. (“The report identified what can only be characterized as major problems with Doubleshot’s recordkeeping, which it does not dispute. Among other things, DCAA observed that Doubleshot did not maintain a general ledger and that its ‘accounting system is non-existent’.”)2

One manifestation of Doubleshot’s problematic accounting system was that the contractor did not submit its proposals to establish final billing rates on time as required by 52.216-7.3 DCAA also told a contracting officer that the audit agency would not longer be approving interim vouchers submitted by Doubleshot. The contracting officer deobligated remaining funds on two of the four contracts via unilateral modification. It very much appeared that Doubleshot was out of the cost-reimbursable government contracting business. Oops!

The contracting officer also demanded that Doubleshot immediately submit its overdue final billing rate proposals, under the threat that its contract costs would be unilaterally established at values that were 20% below whatever Doubleshot might claim. (Note that 20% decrement would include both direct and indirect costs, so kind of a big stick to hit Doubleshot with. We’ve written about unilateral decrements before; we’re not fans.)

For whatever reason, Doubleshot submitted adequate “incurred cost proposals” for its Fiscal Years 2009 and 2010 15 months later, in August, 2013.4 DCAA found the proposals to be adequate within 24 hours, except for minor issues that were satisfied via revised submissions a month later. DCAA started to audit in November, 2015 and, as part of that audit, received Doubleshot’s general ledger for review on December 29, 2015.5 On June 12, 2017, DCAA issued its audit report, questioning various direct and indirect costs.6 It took the contracting officer a hair less than another year to issue the COFD, demanding repayment of $804,979. (“She concluded that Doubleshot had been overpaid direct and indirect costs on contract Nos. 416, 386, and 497, and had been underpaid on No. 295.”)

Doubleshot appealed. Its first argument was that the government should have been on notice as early as 2010 that Doubleshot didn’t know how to account for its costs properly, and that’s when the government should have known that it was likely to have overpaid its contractor. (“… Doubleshot attempts to turn what could be considered an embarrassment – a non-existent accounting system – to its benefit.”) The ASBCA didn’t buy that argument, finding that “The undisputed evidence shows that on or before May 29, 2012, the government was aware of the inadequacy of appellant’s accounting system, but it also shows that Doubleshot was eventually able to produce the ICPs and a general ledger. There is nothing in the record that identifies specific costs that the contracting officer knew, or should have known, had been overpaid as of that date.”

First motion for summary judgment denied. Motion for reconsideration denied.

Because the motion for summary judgment based on the CDA Statute of Limitations was denied, the appeal proceeded. More recently, the ASBCA considered further motions for summary judgment based on the facts that were before it.

The majority of the government claim ($633,397 out of $804,979) related to “inadequately supported costs”. Why were the costs inadequately supported? Because Doubleshot was unable to produce employee timecards as source documents for its labor transactions, even though it was able to prove that the employees had been paid. The government’s argument hinged on FAR 31.202-1(d), which requires a contractor to “maintain[ ] records, including supporting documentation, adequate to demonstrate that costs claimed have been incurred, are allocable to the contract, and comply with applicable cost principles in this subpart and agency supplements.”

Doubleshot argued that it was not required to have retained those timecards. In its analysis, the ASBCA looked at the language of 52.215-2, particularly paragraph (f) (“Availabilty”.) That paragraph states—

The Contractor shall make available at its office at all reasonable times the records, materials, and other evidence described in paragraphs (a), (b), (c), (d), and (e) of this clause, for examination, audit, or reproduction, until 3 years after final payment under this contract or for any shorter period specified in subpart 4.7, Contractor Records Retention, of the Federal Acquisition Regulation (FAR), or for any longer period required by statute or by other clauses of this contract. ….

(Emphasis added by the court in the decision.)

As the ASBC decision noted, “FAR 4.705 sets forth various retention periods based on the type of documents. As relevant here, it provides ‘Clock cards or other time and attendance cards: Retain 2 years.’ FAR 4.705-2(b). Thus, if a contractor submitted its final ICRP on time (six months after the end of the FY), it would have to retain the time cards for 18 months after that date.”

But remember, Doubleshot was late submitting its required final billing rate proposals. So, by operation of the FAR, the record retention period was extended. Still didn’t matter. The timecards were not required to be retained to support a delayed DCAA audit, according to the decision. (“Because Doubleshot no longer had any obligation to maintain these records, the government’s claim fails to the extent it is based on the lack of such records.”)

Summary judgment granted in Doubleshot’s favor on the majority of disputed costs. The disposition of the remaining costs will require further litigation.

A cautionary note: legal practitioners are citing to dicta in another appeal at the Civilian Board of Contract Appeals (CBCA) (Mission Support Alliance, CBCA 6477), in which it appears that, if presented with facts similar to Doubleshot’s appeal, the judges at the CBCA may have ruled in the government’s favor. Hmm. We believe—to the extent our layperson’s judgment has any merit—that the ASBCA got it right here.


1 Yeah, note the dates. It took DCAA nearly four years after the first contract was awarded to evaluate the contractor’s accounting system. In fairness, though, remember that, at that time, DCAA was not exactly operating on all cylinders. It was a period of turmoil at the audit agency. Not that we’re trying to excuse DCAA! As taxpayers, we’re appalled. But as practitioners, we understand.

2 Internal citations omitted. Note that it took DCAA more than a year to issue its Flash Report, which somewhat belies the name, doesn’t it? As we said supra, not firing on all cylinders.

3 Most people call the annual proposals to establish final billing rates “incurred cost proposals” because that’s what DCAA calls them. Why does DCAA call them that? Because the audit agency likes to pretend it also audits the claimed direct costs of a contractor’s cost-reimbursement contracts. The Section 809 Panel pointed out, correctly, that, in doing so, DCAA was conflating two separate and distinct requirements. (See Section 809 Panel Report, Volume 1, Recommendation #15.) Whatever. Nobody cares about that stuff. Certainly not DCAA.

4 What about FYs before that time? Remember, Doubleshot received its first cost-type contract in 2006. Nobody seems to care about the prior years’ claimed costs. Guess the contractor got away with an apparent noncompliance with the requirements of 52.216-7, right? SMH.

5 You’re kidding me, right? The audit didn’t start until the end of November, 2015? It took the auditor more than two years to get started, and to request and receive the contractor’s general ledger? Really? The record is silent regarding this issue and the contractor did not allege audit malpractice in its CDA Statute of Limitation arguments, so who knows?

6 There are many articles on this website discussing how long it used to take DCAA to perform its “incurred cost” audits, and why. This was all before Congress stepped in and told DCAA to get its audits done within a year or quit auditing—which was a significant process improvement, in our view. Too bad the process improvement had to be externally driven.

Last Updated on Tuesday, 11 October 2022 08:30
 

Defense Industrial Base Vulnerabilities

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Recent headlines:

April 11, 2022 – “JetBlue Crewmember Union Blasts Management 'Incompetence at the Highest Levels'” (Link). “’ "They’ve mismanaged their hiring, they’ve mismanaged the logistics of their company, of their system, and here we are with all of these massive problems," [Union President] Samuelsen said.”

May, 2022 – “Supply Chain, Labor Woes Confound Military, Industrial Base” (National Defense). “A nationwide labor shortage and problems with the supply chain continue to disrupt the delivery of materiel to the military and its industrial partners, logisticians at a recent conference said. … [According to the Vice Commander of Naval Supply Systems] “About 80 percent of his command’s suppliers are ‘single-source,’ meaning there is no other company that can produce the item.”

June 8 – “Boeing Can’t Find Enough Workers to Build the New Airforce One” (Defense One). “The company blames an ultra-competitive labor market, but also the high-level security clearances each employee needs since the program involves classified information about the president's travel procedures.”

June 10 – “Major Weapon Projects Face Delays” (Defense One). GAO’s annual assessment of 59 major DoD weapon programs did not paint a pretty picture. “More than half of the 59 programs reviewed reported ‘industrial base risks,’ but most ‘did not plan for an industrial base assessment … to be conducted specific to their program.’”

June 15 – “Boeing on the Hunt for Engineers and Talent, from Arlington to Brazil” (Aviation Week). “Boeing’s hunt for new engineering talent is taking it from suburban Washington to Brazil as it seeks to attract and retain a new generation of workers after the COVID-19 pandemic and production missteps.”

June 19 – “'Travel Armageddon' as flight delays, cancellations pile up: What's going on?” (USAToday). “[Travel Agency CEO] Ferrara said the loss of skilled positions, such as pilots and aircrew, is ‘really what's driving’ all of the airline issues. Pilot unions at Delta, American and Southwest have said airlines haven't been quick enough to replace pilots who retired or took leaves of absences when the pandemic began. ‘We're in a boom time for travel. We're blowing away all records all previous years. So you've got this surge in demand, and you've got limitations on staffing,’ Ferrara said.

July, 2022 – “Energetics Workforce is Graying Out” (National Defense). [‘Energetics’ is the thing that makes kinetic weapons kinetic, FYI.] “… one of the most pressing concerns among government and industry is developing the future workforce. Nowhere is that challenge greater that in the field of energetic materials—the chemicals used to make propellants, pyrotechnics and explosives.” And: “Panelists identified other factors that turn candidates away from the energetics industry such as outdated facilities, excessive bureaucracy—even in small tasks like purchasing needed materials—and jobs located in areas with little to offer young professionals and their families.”

In a survey sponsored by the National Defense Industrial Association (NDIA), and reported in the June, 2022, edition of National Defense magazine, 78% of respondents said the availability of skilled labor was a moderate or significant problem for them. 63% said the same for availability of cleared labor (hello, Boeing). Clearly, the current situation is not just a defense industrial base problem. It’s a pervasive problem across many industries. But the situation affects national security. Without workers (cleared or not), and without effective supply chains, defense programs are at risk of failure.

The same article in National Defense (written by Stephanie Halcrow and Nicholas Jones) offered some solutions to address the problems facing the defense industrial base. Among those possible solutions were:

  • Accelerate acquisition reform, including reforming the budget progress and implementing a two-year budget and appropriations cycle, and creating a new appropriations category (“color of money”) for software acquisitions.

  • Reform DoD’s approach to intellectual property rights

  • Increase the simplified acquisition threshold

  • Budget stability. (“72 percent of respondents said ‘the uncertain prospect of continuing volumes of business’ was a moderate or significant deterrence to devoting significant amounts of capacity to military production, up from 60 percent [in the previous year’s survey].”)

  • Maintaining innovation.

There were other suggested fixes, but you get the idea.

The sad thing about the list above is that nothing is new. All of these “prescriptions” have been suggested before—some many times before—in the previous decade or even longer. There’s nothing new here.

Before somebody tries to fix the serious problems facing not only the defense industry, but all of US industry, perhaps its time to do a root cause analysis.

If one were to perform such a root cause analysis, we believe the results might include the following:

  • Excessive focus on the short term in favor of long-term planning, especially amongst publicly traded companies where executive bonuses are tied to stock price.

  • Excessive emphasis on expense reduction at the expense of the overall mission. For example, an undue focus on “just-in-time” logistics that only saves money when the supply chain is working at 100%. Otherwise, the focus creates unacceptable levels of risk—especially when the supply chain is in jeopardy.

  • Excessive focus on controlling labor costs rather than a willingness to pay market wages—and even premiums for in-demand skillsets and clearances. The “human capital” crisis was predicted more than twenty years ago; yet corporate leadership appears to have failed to take effective action to mitigate it. Things are only going to get worse from here. Netflix famously issued its 120 -slide PowerPoint deck about how to manage a workforce in 2009—more than a decade ago. Why have defense contractors failed to implement its innovative practices?

Fundamentally, the root cause of many of the vulnerabilities facing the defense industrial base is a short-sighted leadership culture coupled with too many disincentives that impede change and adoption of new practices. There is a noticeable lack of accountability for poor leadership decisions; instead, huge bonuses are awarded even in the face of failure.

You want to change things? Change the leadership culture.

 

Inflationary Pressure

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According to the Department of Defense publication “Inflation and Escalation Best Practices for Cost Analysis,” estimates for future project costs must address (1) inflation, (2) real price change (RPC), and (3) escalation. Each of those terms has an official DoD definition, which we provide below:

Inflation means “a rise in the general price level over time, which is an economy-wide average over all goods and services transacted. Inflation represents a decrease in the value of money (i.e., the dollar), due to an increase in the supply of money and credit relative to available goods, resulting in a rise in the general price level.” The definition of “inflation” continues, as follows:

Key to the definition of inflation is that it measures the economy-wide change in price as opposed to the change in price of any specific good or service. The inflation index used in Federal budgeting is the Gross Domestic Product Chain-Type Price Index, known more commonly as the GDP Price Index …. The Bureau of Economic Analysis (BEA) of the Department of Commerce develops the index based on value-added prices of all final goods and services (sometimes referred to as a ‘market basket’) produced on US soil. It includes investment goods, consumption goods, services, and products exported overseas.

(Footnotes omitted)

Real price change (RPC) refers to the price movement of specific goods and services rather than to economy-wide changes. “While inflation affects all prices in the same proportion, prices for specific goods and services may change at different rates due to real price change …. Positive real price change indicates that the item has become more expensive relative to an economy-wide basket of goods and services …. The label ‘real’ in real price change refers to the fact that it is measured in inflation-adjusted dollars, also known as ‘real dollars.’

The DoD publication lists several factors that may drive RPC, including: market shifts; changes in the supplies of specific materials; changes to cost of doing business (e.g., overhead rates), for either contractors or the government; economies or diseconomies of scale; changes in the mix of the workforce, such as labor categories or skill levels; changes to inputs to production; rate effects and learning effects; technological change, such as increased automation of a production process.

Escalation is “the combined effect of inflation and real price change, as defined in the previous two sections.” According to the DoD: “Escalation may be positive, negative, or zero; since inflation is usually positive in a growing economy, the direction of escalation depends primarily on the magnitude and sign of real price change …. Escalation may also be equal to inflation in two cases: the market basket may be so broad that it approximates the entire economy (which, by definition, experiences inflation only), or the market basket experiences no real price change relative to the economy as a whole.”

Having defined our terms, let us offer the opinion that, when DCAA auditors and DCMA contracting officers negotiate escalation factors in a contractor’s proposal, they tend to focus on inflation and ignore RPC. Contractors are very aware of RPC. For example, contractors understand that the cost of labor has skyrocketed in recent months—especially in certain areas, such as software developers. Costs of certain goods and materials have similarly skyrocketed. However, when government auditors and analysts look at a contractor’s escalation rates, they tend to compare the proposed escalation only to inflation indices (e.g., Global Insight). Thus, there is tension because the cost of every good or service is increasing at the average, overall rate.

Everybody knows that inflation is on the rise. Even the Department of Defense acknowledges it. In May, 2022, the Principal Director, Defense Pricing and Estimating, issued a memo addressing the impacts of inflation on existing contract prices as well as on new contracts. The memo was, uh, unfortunate. Yes. That’s the term. Unfortunate.

First, the memo utterly ignored RPC, but maybe that’s because it was written by people who didn’t understand cost analysis. So, let’s call that a “nit.”

Second—and far more importantly—the memo utterly missed the point. It stuck to legalese and missed the true impact of cost escalation risks on the Department’s supply chain—and therefore the risks to the Department’s mission.

What do we mean?

The memo outlined Department policy with respect to firm, fixed-price contracts, using language that might as well have been lifted straight out of the FAR. The memo said—

… contractors performing under firm-fixed-price (FFP) contracts generally must bear the risk of cost increases, including those due to inflation. In the absence of an applicable contract clause, such as an EPA clause authorizing a contract price adjustment as a result of inflation, there is no authority for providing contractual relief for unanticipated inflation under an FFP contract. We are fielding questions about the possibility of using requests for equitable adjustment (REAs) under FFP contracts to address unanticipated inflation. REAs entail a contractor’s proposal to the CO seeking an equitable adjustment to the contract terms based on a contracting officer-directed change within the scope of the contract, in the areas defined by the applicable Changes clause, or by another contract clause that authorizes an equitable adjustment based on specific actions taken. Since cost impacts due to unanticipated inflation are not a result of a contracting officer-directed change, COs should not agree to contractor REAs submitted in response to changed economic conditions.

Sure, go there. That’s a nice legal position, but when your mid-tier and lower-tier suppliers—and your small business suppliers—begin to go bankrupt because the costs of performing the contracts exceed their available cash flow, and your “reprocurement costs” associated with Terminations for Default are meaningless because the suppliers are bankrupt and can’t pay—and in many cases there will be no other suppliers to perform in any case—and when your programs start to fall behind schedule and now you have to report Nunn-McCurdy breaches to Congress … well. At that point you will realize—far too late—that your lawyers’ advice wasn’t so smart after all, because you didn’t deliver your weapon systems and your contractor services to your warfighters, even though you adhered to contractual policies and procedures.

Not incidentally, delivering goods, services and weapon systems to the warfighters is, fundamentally, the entire job of the Department of Defense’s back office.

The memo seemingly ignores history, when inflationary pressures (among other factors) led to the United States Government bailing-out Lockheed via an Act of Congress. Don’t believe us? Google it. One salient fact was the imminent insolvency of Rolls-Royce, maker of aircraft engines. One report summarized the situation thusly: “If the engine supplier for the L-1011 was bankrupt, the contract for the RB.211-22 engine would be nullified.” Now, perhaps the crisis was driven by technical challenges in fixed-price development contracts, but the salient fact is that the contracts were fixed-price, and the contractors couldn’t absorb the associated losses. If the supply chain collapsed, the prime contractor (i.e., Lockheed) was toast.

There’s more in that May, 2022, memo about how to craft and negotiate Economic Price Adjustment (EPA) clauses in new contract awards, but every word of that guidance tells savvy readers that the authors never read the DoD’s publication on the topic—the publication we linked to in the first sentence of this article. If they’d read, and absorbed, the guidance in the publication, they wouldn’t be talking solely about inflation, they’d be talking about RPC, as well.

We guess the agency lawyers missed that one.

Anyway, perhaps having received feedback similar to ours, or perhaps after waking up in the morning, realizing what a bad idea the first memo was, a second memo was issued, which revised the first memo. While not admitting any missteps were previously made, the second memo walked-back some of the policy positions that had been taken, “[b]ased on feedback from the Department’s acquisition executives about how inflation is presently affecting the Defense Industrial Base and contractors’ ability to perform under existing firm-fixed-price contracts.”

The revised memo provides contracting officers with some flexibility—

… there may be circumstances where an accommodation can be reached by mutual agreement of the contracting parties, perhaps to address acute impacts on small business and other suppliers. For example, provided adequate consideration is obtained for the Government, such an accommodation may take the form of schedule relief or otherwise amending contractual requirements.

The revised memo also notes that—

For extraordinary circumstances where contractors have sought or may seek an upward adjustment to the price of an existing firm-fixed- price contract to account for current economic conditions, each of the Secretaries of Defense, Army, Navy and Air Force has authority under Public Law 85-804, as implemented by Part 50 of the Federal Acquisition Regulation (FAR) and the Defense FAR Supplement (DFARS), to afford Extraordinary Contractual Relief. While the law and regulation have established stringent criteria, the Department will consider contractor requests to employ this authority, subject, of course, to available funding.

Which is nice, but if you read closely, you’ll see that any extraordinary relief is limited by the amount of “available funding.” Meaning that it will essentially take an Act of Congress to grant it.

Mark Twain famously said, “History doesn’t repeat itself, but it often rhymes.” Here we are, fifty years after the Lockheed bailout and loan guarantees, and we have seemingly learned nothing. The mission is in jeopardy and, rather than addressing the real problem—which is that DoD is lacks the flexibility to quickly adapt to changing economic conditions—we have seemingly put the attorneys in charge.

In my view, we need to put the attorneys and policy-wonks on the back-burner right now, and get the practical business-people in positions to make tough decisions. But, you know, that’s just one opinion.

Last Updated on Monday, 19 September 2022 20:12
 

Defective Pricing and Statute of Limitations

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Recently, the Armed Services Board of Contract Appeals (ASBCA) entertained a motion of summary judgment in a matter involving alleged defective pricing. The Board’s discussion is interesting and we thought we’d share with our readers.

First, a couple of level-setting recaps:

  1. Defective pricing occurs whenever a contractor fails to disclose “all facts that, as of the date of agreement on the price of a contract . . . a prudent buyer or seller would reasonably expect to affect price negotiations significantly. Such term does not include information that is judgmental, but does include the factual information from which a judgment was derived.” (Quoting from the decision, which quotes from 10 U.S.C. § 2306a(h)(1).)

As we’ve posted before, the Truthful Cost or Pricing Data Act, which used to be the Truth in Negotiations Act (TINA), is a disclosure requirement, not a use requirement. The contractor’s basis of estimate doesn’t matter. What matters is that the contractor actually disclosed to the government all relevant facts and circumstances that would reasonably be expected to affect price negotiations significantly.

The contractor is required to certify that all cost or pricing data that was disclosed is “accurate, complete, and current.” If the contractor certifies as such, but the government believes the certification was inaccurate (because some or all cost or pricing data was not accurate, complete, or current as disclosed) then the contractor has “defectively priced” its contract.

In a defective pricing claim the government is required to prove that: (1) the information in dispute is ‘cost or pricing data’; (2) the cost or pricing data was not meaningfully disclosed; and (3) the government relied to its detriment upon the inaccurate, noncurrent or incomplete data presented by the contractor.

FAR contract clause 52.215-10 provides the remedy for defective pricing. In addition to the contractual remedy, we’ve noted in prior articles that the government may elect to pursue an allegation of violation of the False Claims act with respect to invoices submitted for a contract that was defectively priced.

In other words, it’s kind of a big deal.

  1. The Contract Disputes Act (CDA) contains a Statute of Limitations that a contractor may raise as an affirmative defense, asserting that a government’s claim for damages (related to defective pricing or other issues) is untimely. According to the CDA, claims must be submitted within six years after the accrual of the claim. “Claim accrual” is defined in FAR 33.201 as being “the date when all events, that fix the alleged liability of either the Government or the contractor and permit assertion of the claim, were known or should have been known.” (Emphasis added.)

We have written quite a bit about the CDA Statute of Limitations on this blog. There does not seem to be a bright line (at least to us, who are not attorneys). Instead, when the Statute of Limitations clock starts to run seems to be dependent on the facts and circumstances of the situation.

Okay. With the foregoing established, let’s talk about the appeal of AAI Corporation, doing business as Textron Systems, Unmanned Systems (Textron).

Textron sells unmanned aircraft systems (UAS) to the US Army under various contract. At issue here is Full Rate Production (FRP) contract IV. Obviously, there were previous contracts, including FRP I, II, and III. In other words, Textron had a wealth of contractual cost performance history to draw upon—i.e., the company had quite a lot of potential cost or pricing data to disclose.

According to the decision regarding dueling motions for summary judgment, “On January 11, 2006, the Army requested that Textron submit an FRP IV proposal for 11 TUAV systems by January 31, 2006. Subsequent amendments requested alternate pricing for 10 and 9 systems. Textron submitted a timely proposal.” In other words, the Army gave Textron less than a month to prepare and submit a proposal that ended up being worth more than $87 million dollars.

In order to meet that quite challenging deadline, Textron had to cut some corners. In particular, Textron informed its Army customer that—

… it based its labor and material costs on the FRP III Supplemental contract, which it had been awarded seven months earlier. Its FRP IV proposal stated that it had applied a 91.66% adjustment factor to account for the reduction in the number of systems from 12 in the FRP III Supplemental contract to 11 in FRP IV, and additional adjustment factors for 10 and 9 systems. Textron refers to this as its ‘parametric’ approach. After applying the adjustment factor, Textron then increased its prices to account for cost escalation

(Internal citations omitted, as always.)

In other words, in order to meet the really rather ridiculous timeline, Textron apparently based its FRP IV proposal on the cost or pricing data that it had recently submitted for the FRP III Supplemental contract. We say “apparently” because the wording is less than clear: it seems that Textron based its proposed price on what it had recently bid rather than, say, actual costs incurred under other FRPs or actual costs incurred so far under the FRP III Supplemental contract.

Basing a bid on a previous bid, rather than actual costs of previous work, is always going to be risky.

Anyway, that’s what Textron seems to have done. It took its last bid and made some mathematical adjustments and that was what it submitted to the Army that formed the basis of the $87 Million dollar contract award.

Along the way, DCAA took a look at Textron’s proposal and determined it to be good enough for negotiations. Negotiations were concluded in April, 2006.

Notably, DCAA did not look at what Textron did not submit. (Remember, TINA is a disclosure requirement, not a use requirement.) What Textron did not submit became the basis of a future defective pricing assertion.

As the ASBCA decision told us—

Nearly 11 years later, on March 8, 2017, contracting officer (CO) Gregory Wilson issued a final decision in which he determined that the government was entitled to a price adjustment of $7,190,376, plus interest, based on his conclusion that Textron had provided the government defective pricing. The CO based the final decision in large part upon a DCAA audit report dated January 8, 2014

There were three specific allegations of defective pricing, as follows.

  1. The POP payload (quantity 36). Textron proposed, and the government agreed to, a price of $181,558 per unit, which was an escalated price. However, at the time (as the government alleged), Textron had in its possession a subcontract that established a unit price of $165,855. Textron did not disclose its firm subcontractor pricing to the government.

  2. Ground control shelter costs. Textron apparently double-counted the costs of its shelters in the January 2006 cost proposal. As a result, the government agreed to a price that was $415,800 higher than it would have, had the shelter costs not be overstated.

  3. Inflated labor costs. As noted above, Textron used prior bid data, as adjusted. It did not use actual costs. In particular, it did not use historical labor costs. Since it didn’t use its actual cost history, it didn’t consider that information to be cost or pricing data worth submitting to the Army. Well, it turns out (according to the ASBCA decision) that “prior to submission of its FRP IV proposal, Textron had conducted an analysis of its actual labor hours per system produced for prior FRP lots, and compared them to its hours bid for the FRP IV system. Textron presented a document containing this information to its upper management on January 24, 2006, one week before submission of its FRP IV proposal.” Textron did not disclose the existence of this analysis to the Army negotiators.

Textron moved for summary judgment on the affirmative defense that the CDA Statute of Limitations made the government’s claim time-barred. On two of the three allegations, the court did not agree with Textron.

With respect to the POP payload, “[t]he record lacks undisputed facts to support a finding that in 2006 the CO knew or should have known about the actual $165,855 price because Textron failed to disclose it to him and he had no apparent way to learn of it on his own. Textron has not proposed a credible alternate date for the running of the statute prior to DCAA’s receipt of the relevant documents in 2013.” To Textron’s argument that it had disclosed its methodology to the CO, and that was sufficient to comply with TINA requirements, the Board disagreed, writing “The government has made a plausible case that Textron’s success in locking in a $165,855 price would have affected negotiations significantly.”

With respect to the labor costs, “The parties cannot be in roughly equal positions if one side has an analysis that distills years of data and the other does not.”

With respect to the shelter costs, “It is undisputed that in 2006 the government had all of the information upon which it would base its claim, namely the proposal itself. The government’s claim was merely the result of DCAA’s analysis of that proposal.” Further, “Even if the government did not immediately grasp the problem with the numbers in Textron’s proposal, it had six years to scrutinize it more closely. Claim accrual is not suspended simply because the government failed to appreciate the significance of what the contractor furnished.”

Summary judgment was granted to Textron on the shelter cost issue; it was denied on the other two issues. At this point, either the parties will negotiate a settlement or else they will proceed to a trial on the merits.

The lesson here is that, no matter what proposal methodology a contractor uses, it still must comply with the TINA requirement to disclose all relevant cost or pricing data—even if that data is not used in its proposal. Facts deemed relevant to price negotiations that are not provided to the government are going to create problems down the road. In this case, even though the contract was awarded in 2006, the government was not prevented from asserting its claims in 2017.

Last Updated on Sunday, 29 May 2022 08:01
 

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Newsflash

Effective January 1, 2019, Nick Sanders has been named as Editor of two reference books published by LexisNexis. The first book is Matthew Bender’s Accounting for Government Contracts: The Federal Acquisition Regulation. The second book is Matthew Bender’s Accounting for Government Contracts: The Cost Accounting Standards. Nick replaces Darrell Oyer, who has edited those books for many years.