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Welcome to Apogee Consulting, Inc.

F-35 and Beyond

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From time to time I report on significant events related to certain Major Defense Acquisition Programs. One of those programs is the F-35 Lightning II joint strike fighter, a stealthy multi-role fighter intended to be sold to allies throughout the globe, including the United Kingdom, Italy, the Netherlands, Turkey, Australia, Norway, Denmark, Israel, Singapore, and Canada. It is a big deal—the program is funded in billions. When life-cycle sustainment (MRO) costs are added, the program cost is north of two trillion US dollars. (Source: GAO, May, 2024.)

It the F-35 worth the cost?

I don’t know if the jet is “worth” its price tag. I don’t have the necessary expertise to have an opinion. What I do know is that each jet currently is priced at $82.5 million (per Audrey Decker’s July, 2024, article at DefenseOne). However, the price may rise for future lots being negotiated now. Per BreakingDefense (Valere Insinna, September, 2024) negotiations are not going well. DoD and Lockheed Martin have been trying to settle on a price for more than a year. Originally, the parties anticipated shaking hands before the end of 2024; however, it now appears that won’t happen—prompting Lockheed Martin to warn shareholders of a hit to both forecasted revenue and cash flow.

Not to mention, the program has been significantly delayed. For much of 2023 and 2024, “completed” aircraft have been piling up on runways because DoD would not accept them. The contractor was unable to finish “Technology Refresh 3” in time and DoD refused to accept aircraft without the required TR3 updates. Citing a GAO report, Defense One reported that “the Pentagon has refused delivery of so many F-35s that Lockheed Martin is running out of places to put them.” News reports state that the Pentagon was withholding $7 million per undelivered plane. Even when deliveries started to be accepted (with incomplete or “truncated” TR3 updates), the Pentagon continues to withhold $5 million per jet (source: Defense One).

Speaking of deliveries, that same Defense One article reported that Lockheed Martin estimates it will take 12 to 18 months to “unwind” the backlog of undelivered aircraft. The article quoted Lockheed Martin executive Greg Ulmer as saying “The company plans to ‘unwind’ by delivering about 20 aircraft a month—13 newly-built aircraft and seven of the jets that were in storage.”

We may have heard this before.

From articles on Apogee Consulting’s website (available via keyword search)—

August 2009: “In its August 13, 3009 edition of Flight Daily News, Flight International magazine asks whether Lockheed Martin can actually ramp-up production of its F-35 “Lightning II” Joint Strike Fighter (JSF) from its current pace of one aircraft per month to an unprecedented pace of 20 aircraft per month, assembling three production variants on the same line while managing a global supply chain. … Flight International notes that ‘current acquisition plans call for dramatically raising output until a new fighter is delivered every working day, excluding holidays and weekends, or about 240 jets in a year.’”

April 2010: “… on April 16, 2010, InsideDefense.com reported to its subscribers that the Air Force had halted plans to increase JSF production to 110 aircraft per year, and has decided to ‘top-out’ its purchases at 80 planes per year, starting in GFY 2016. The article quotes Air Force Chief of Staff General Norton Schwartz as saying, ‘As the program continues to progress, we will analyze production capacity and available funding for potential production rate adjustment beyond the 80 aircraft per year rate reflected in the current program.’ The article further notes that Lockheed Martin stated ‘that once its … assembly line reaches its optimal production rate in 2016, it could build as many as 230 jets per year’—so LockMart is ready ‘to build more jets if requested.’

May 2016: “… according to … Defense One, ‘F-35 production is slated to hit full steam in 2019, and Lockheed Martin is reshaping its final assembly line to get ready. … By 2020, one year after the Fort Worth plant hits its full 17-jet-per-month stride, there will be more than 600 F-35s, including nearly 180 sent to U.S. allies.’”

March 2019: “… Lockheed Martin delivered 91 aircraft in 2018, which was about double its production of only two years before. Looking ahead, the JSF will enter ‘full rate production’ and LockMart has committed to deliver 130 aircraft before the end of 2019.”

Then COVID hit.

From Air & Space Forces Magazine.com, February, 2024: “Lockheed Martin expects that F-35 production will remain at about 156 aircraft per year through 2028…” according to executive Greg Ulmer.

So, what’s the point? The point is … nobody knows. Nobody knows what production at full capacity looks like for the F-35. Early (perhaps optimistic) forecasts said that number was 240 aircraft per year. More recently, Lockheed Martin said that number was 156 aircraft. However, now it seems as if we are back to 20 per month (240 per year), though only seven of those 20 will be “new” fresh off the line aircraft. Seven per month is 84 per year.

So … who knows? The Full Rate Production at full capacity number is all over the place.

No wonder it takes more than a year to negotiate the next buy.

Okay. Now to the reason I wrote this blog article.

I tracked F-35 contract actions during Government Fiscal Year 2024 (ending 30 Sept 2024). Each day, the Pentagon reports contract actions exceeding $5 million in value. I watched for F-35 activity, and I recorded what I saw in a spreadsheet.

Based on DoD reports, the Pentagon awarded $16.232 billion to Lockheed Martin and other F-35 contractors through 61 individual contract actions.

Lockheed Martin received the most, of course, at $12.972 billion. But RTX (including Raytheon and Pratt & Whitney) received $3.212 billion in that same period. BAE Systems received $77 million. And HDR Engineering received $16.4 million.

In one year.

Of the 61 reported contract actions, 18 were new contract awards. The remaining 43 actions were modifications to existing contracts. The new contract awards included Undefinitized Contract Actions (UCAs) as well as orders against previously placed Basic Ordering Agreements (BOAs). New contract awards were primarily focused on international program customer needs, though $348.5 million was awarded for Lot 18 spares—even though Lot 18 hasn’t been negotiated yet. Nothing like long-lead money, am I right?

Modifications included $70 million for TR-3 redesign efforts. One might have thought TR-3 was included in previous prices, since that is the reason DoD refused to accept new aircraft. Oh, well. Another mod (for $111.9 million) was to extend the period of performance for Block Four flight testing. It seems the more one delays, the more one gets paid.

Let’s wrap this up. The largest defense program in the history of the United States continues to move forward, albeit with schedule and technical delays, as well as with cost growth that stems from many causes, including (apparently) schedule and technical delays.

I will be happy to report on a stable, sustainable program, once one shows up.

 

It’s the People

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Hi there! It’s been a minute. Thanks for coming back here.

I have so much to write about—prominently the recent CAS Board activities. Not to mention, DCAA’s CAS cost impact audit guidance that was clearly written by lawyers instead of, you know, accountants or auditors. I’m going to get to all that stuff when time permits. But today I want to talk about people.

It’s crystal clear (in my mind, at least) that when we are discussing the triumvirate “people, process and technology,” people are the most important component. I know not everyone agrees. In June, at the Deltek/ProPricer Government Contract Pricing Summit (where I spoke on the topic of evaluating and negotiating profit), I heard a very well-known speaker assert that technology was the most important component. He said (paraphrasing) “technology is always moving forward; people and process both struggle to catch up.” Okay. He was a former Assistant Secretary of the Air Force and now CEO of an innovative start-up that has a very cool Lord of the Rings-related name, and I’m just me. Who am I to argue with him?

But he’s wrong.

People are the most important thing. Always and forever.

Corporations look to reduce costs wherever possible. All things being the same, reduced costs leads to greater margins. Investors like increasing margins and the increasing profits that result from cost-cutting. We know that’s not always true in the government contracting market space—especially in developmental efforts—where cost-type contracts mean that (generally speaking and with many exceptions), more costs equal more revenue. All things being equal, more revenue leads to a higher bottom-line profit. But most government contractor executives don’t have a clue about government contract accounting rules so they base decisions on what they’ve been taught in business school, which is that cost-cutting is a good thing.

As a result of that logic, they locate their engineering centers and factories in low-cost states, where employee compensation will be lower than in other states. That’s not the only reason—obviously. Political realities ensure that locating facilities in the states of certain politicians gives contractors a boost during budget time. There’s also the matter of locating facilities in states that are not friendly to unions, or that offer lower corporate taxes, or even full-on tax breaks for the right companies. But we don’t talk about that in the 10-K management discussions. Instead, we talk about cost-cutting.

Employee compensation (among other factors discuss noted) is why Lockheed Martin has so much work in Texas, Florida, and Georgia. (LockMart is in many other states, including California and Colorado, but that’s not the point.) Where does Lockheed Martin make the most money? In its Aeronautics Division. Where is that Aeronautics Division headquartered? Fort Worth, Texas.

Employee compensation is why Boeing builds its 787 Dreamliner in Charleston, South Carolina. From Wikipedia—

Boeing announced in October 2009 that it would build a new 787 Dreamliner final assembly and delivery line in North Charleston. Boeing said that the second production line was necessary to ‘meet the market demand for the airplane,’ but it came amid tense negotiations between the company and the International Association of Machinists and Aerospace Workers (IAM) union representing workers in Everett who had recently gone on strike. South Carolina's unionisation rates, the lowest in the country at 2.7%, were stated by Boeing management as a reason to transfer production to there. IAM said the decision was retaliatory and National Labor Relations Board agreed, filing a lawsuit against the company in April 2011. The lawsuit was dropped in December after IAM withdrew its complaint as part of a new contract with Boeing, clearing the way for production to begin in South Carolina. Since then, Boeing has continued to challenge the rights of unions to organize at the plant, and is alleged to have fired workers for their attempts to unionize.

(Footnotes omitted.)

Companies—particularly those who manufacture MILSPEC products—that have an unhealthy, misplaced focus on people tend to have long-term consequences from that manifest years later, long after the executives who made critical blunders in workforce management have left the companies, taking with them millions of dollars of incentive compensation.

Recently, the NASA Inspector General released report number IG-24-015, discussing the management of the Space Launch System (SLS) Block 1B development. The IG had many criticisms of NASA and its lead contractor, Boeing. The one we are going to focus on is NASA’s blunder to locate SLS core stage manufacturing at the 85-year-old plant in Michaud, Louisiana—located in New Orleans.

The SLS program is under cost pressure. In 2011, Congressional testimony estimated that SLS development costs through 2017 would be roughly $18 billion. As of 2017, $11.9 billion has been spent, of which 40% was spent developing the core stage. As of 2021, development of the core stage was expected to have cost $8.9 billion, twice the initially planned amount. (Source: Wikipedia.) The program is behind schedule and faults have been found in the welding of the core stage.

Let’s talk about the welding. The SLS core stage uses a brand-new welding method: friction stir welding. We don’t know that FSW is. All we know is what Wikipedia tells us; we are told that the new process can create unique risks, which can be mitigated by the quality of the tool design.

Okay. NASA decided to build a new core stage for a new rocket at an 85-year-old plant, and to do it with a new welding technology where attention to detail and tooling design is critical for success. What could go wrong?

The NASA IG answered the question in its report.

According to Safety and Mission Assurance officials at NASA and DCMA officials at Michaud, Boeing’s quality control issues are largely caused by its workforce having insufficient aerospace production experience. Michaud officials stated that it has been difficult to attract and retain a contractor workforce with aerospace manufacturing experience in part due to Michoud’s geographical location in New Orleans, Louisiana, and lower employee compensation relative to other aerospace competitors. Safety and Mission Assurance officials advised that Boeing provides training and work orders to its employees in an attempt to mitigate the challenges associated with an inexperienced workforce and help ensure that its workers comply with quality control standards. However, given the significant quality control deficiencies discussed above and our observations during a site visit to Michoud, we found both these efforts to be inadequate.

The NASA IG report added a footnote to the above. The footnote referenced AS9100D, Section 7.2, Competence. The inference is clear: Boeing’s Michoud assembly workforce management does not comply with the requirements of AS9100D. Our research indicates that Boeing has never been certified to be compliant with the requirements of AS9100—even though it requires its suppliers to hold that certification. Only in the past two months has the aerospace giant indicated that obtaining AS9100 certification is something its leadership wants to pursue. Ya think? (Source: Sean Broderick’s article in Aviation Week, 28 June 2024.)

So … you get what you pay for. If you want low-cost employees then don’t ask them to participate in innovative things. If you want to attract and retain a skilled workforce, then be prepared to pay for it. Don’t cheap-out on the hired help. It you want the best, then pay for the best. Learn to accept and to work with a unionized workforce. Your employees are not your enemy.

This issue is not confined to US aerospace/defense contractors. It is global.

Last week, I received an email from Kevin Craven, Chief Executive of ADS, the industry group that represents aerospace and defense companies in the United Kingdom. (Why am I part of a UK industry group? Long story but it’s also why my picture is on file at the MoD.) Mr. Craven had a simple topic he wanted to discuss, “everyone’s favourite subject: skills.”

We are all acutely aware of the difficulties we have as businesses to recruit the right talent, at the right time. Our industries employ - at last calculation - some 427,500 people throughout the country into well-paid, highly skilled, manufacturing, engineering and digital services jobs. Our success in recruiting, however, is mixed.

We know that there are 10,000 vacancies in our industries, as a minimum. We hear from our larger members that they can be oversubscribed in some roles - a fantastic achievement - while our smaller businesses, no less pivotal to our economy, can struggle. To address this imbalance, we’re actively seeking practical solutions to increase engagement across the board - to get those roles filled, capability delivered, and to secure the UK’s advanced manufacturing advantage.

… at ADS we are actively seeking partnerships - whether that’s through STEM events, widening participation schemes, mentoring programmes, policy agendas, practical job finding support, or partnerships with organisations who are leading the way in this area.

Back in the States, Huntington Ingalls Industries announced July 6 that it plans to add 2,000 heads to its current Pascagoula, Mississippi, workforce of 11,300. That’s about a 20 percent increase. On May 24, the VP of Human Resources (Xavier Biele) at HII’s Newport News Shipbuilding site in Hampton Roads, Virgina, announced that the shipbuilder needs to find more employees. Magan Eckstein’s article at Defense News reported:

The yard plans to hire 3,000 skilled tradespeople this year, but it needs to bring in 19,000 over the next decade, Beale said, adding that the existing training pipelines in the Hampton Roads region is unable to funnel enough new employees toward Newport News.

Beale said volume is only one issue when it comes to recruiting. When the COVID-19 pandemic struck the United States in 2020, a wave of highly experienced workers retired. Replacing those master tradespeople with recent high school graduates has affected productivity.

While it’s difficult to find talent with decades of shipbuilding experience, the next best thing might be finding talent with years of experience as welders or electricians outside of the shipbuilding-industrial base, Beale said.

Where I live in San Diego, we have trouble recruiting employees because of the insanely high cost of living. Everybody knows about California housing prices. And utility prices. And high state taxes. What fewer people know is that salaries tend to be commensurate with the cost of living, and the property taxes are relatively low in comparison to other states. (Hello, Texas: I’m looking at you.)

Aerospace and defense companies need to get over the notion that employee compensation cuts lead to lower prices. Maybe they do; but they also lead to production inefficiencies and delays, and potentially to serious quality issues. The US government can help by removing the “ceiling” on allowable employee compensation (FAR 31.205-6(p))—though almost no direct-charging employee is ever going to come close to that limit; it impacts executives, which may not be a bad thing if they keep on blundering around trying to increase shareholder value by attacking their own employees.

We need to get serious about attracting and retaining good people. If that means paying the rank-and-file more, then so be it. You can cover the costs of wage increases by cutting multi-million-dollar executive bonuses. (Ha! Like that’s ever going to happen.)

In addition, we need to reevaluate certain employee labor classes based on the true value they add in the 21st century. As noted above, skilled tradespeople are in high demand. It is absolutely viable to skip college (and student debt) in order to join an apprenticeship program that leads to a career in the trades. Touch labor is critical.

And what about our supply chain specialists, our buyers and source inspectors? Given the importance of the supply chain to program success, wouldn’t you think you would want to hire the best, train them, and keep them around for a long time? Sure. But if that’s true, why do you keep hiring former buyers from Sears, thinking they will make already trained supply chain specialists with deep FAR expertise. Let’s not be silly.

Think of a workforce as an inverted pyramid, with the direct-charging touch labor folks on the top and the executives on the bottom. There’s your true value-added illustration.

Why don’t we start managing that way?

Last Updated on Monday, 26 August 2024 17:02
 

Allowable Cost and Payment, Unilateral Decrement Factors: What We Now Know

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Here’s what we now know:

Item One: The Government cannot unilaterally impose an arbitrary decrement factor on a contractor that fails to submit its annual proposal to establish final billing rates, even if DCAA recommends that factor, unless it can support that factor. The Government has the burden of proof to show why any decrement factor is reasonably related to its risks that the contractor has overbilled its indirect cost rates.

Item Two: When dealing with Time & Materials (T&M) contract types, any DCAA-recommended decrement factor—no matter how calculated or supported—can only apply to indirect cost rates. Those indirect cost rates are applied to the reimbursable (“M”) side of the T&M contract costs. That factor simply cannot apply to the contractor’s fixed labor billings, the “T” side of contract costs. Nope. Can’t do it—those rates are fixed by contract terms and are simply not affected by any changes to allowable indirect cost rates.

Item Three: The Allowable Cost and Payment clause (52.216-7) applies to T&M contracts whether or not the clause is found in the contract at hand. Yes, readers: the clause will be read into the contract by operation of the Christian Doctrine.

Now, how do we know the foregoing?

We know about this stuff because Allard Nazarian Group, Inc., dba Granite State Manufacturing, appealed a contracting officer’s final decision to the ASBCA and Judge Stinson (writing for the Board) made those determinations in July, 2023.

A short history:

Scandia Manufacturing Company, Inc. (Scandia), had several government contracts—including three ID/IQ contracts that permitted issuance of only T&M task orders. In 2008, Allard purchased Scandia and all its contracts. A Novation Agreement was prepared and signed by an Administrative Contracting Officer. So far, so good.

In 2009, Allard was awarded a fourth contract of a similar nature: ID/IQ with T&M task orders. Unlike the other three, this contract incorporated clause 52.216-7 (“Allowable Cost and Payment”). Because T&M Task Orders were contemplated by the parties, all four contracts contained clause 52.232-7 (“Payments under Time-and-Material and Labor-Hour Contracts”). Okay so far?

Now it gets weird.

Apparently, Allard never submitted the annual proposals to establish final indirect billing rates (popularly but incorrectly called an “incurred cost submission”). Did it have to? Arguably, nothing in the three contracts it acquired from Scandia required the contractor to do so. With respect to the fourth contract—the one it entered into on its own—yes. Absolutely. 52.216-7 requires submission of a proposal to establish final billing rates.

If one contract requires submission, then that pretty much means you have to prepare a submission for the entire business entity. You’ve got to calculate final pools and bases; you’ve got claim (and certify) indirect costs. You’ve got to fill out the myriad Schedules we’ve all come to know and love. You signed the contract and so you have to submit the proposal and support it through audit.

But Allard never did.

Finally, the government lost patience.

By letter dated November 27, 2019, the Defense Contract Management Agency (DCMA) issued a contracting officer’s final decision and demand for payment of debt ‘resulting from Allard’s/Scandia’s failure to submit indirect cost rate proposals for Fiscal Years 2007-2009,’ stating that the ‘[d]ecision is applicable to all flexibly-priced contracts and subcontracts performed by Scandia/Allard during Fiscal Years 2007-2009’. According to the contracting officer ‘all reasonable efforts have been exhausted to obtain the subject matter final indirect cost rate proposals,’ and, therefore, the government had ‘unilaterally established . . . final indirect rates for Allard/Scandia fiscal years ending 31 December 2007, 31 December 2008, and 31 December 2009’.

(Internal citations omitted.)

In unilaterally establishing the Scandia/Allard final billing rates for FYs 2007, 2008, and 2009, the contracting officer applied a 20% decrement factor, as recommended by DCAA-Baltimore. With respect to the more current years (FYs 2010 through 2014), the contracting officer applied a decrement factor of 16.4%.

Importantly, the contracting officer’s unilateral rate determination did not limit application of the decrement to just appellant’s indirect costs, but rather applied the decrement factor against all invoiced amounts, including appellant’s direct, fixed rate labor costs.

Yeah, that’s gonna hurt.

Allard appealed. The company didn’t try to claim that it had actually submitted the required proposals; instead, it argued that the application of the unilateral decrement factor was flawed. That was the case in front of the Board, the case on which it ruled in a Partial Summary Judgment.

As part of pre-trial motion practice, the parties agreed to drop FYs 2007 and 2008 from the appeal. We’re thinking that was done because, to be honest, nothing in any Scandia/Allard contract required submission of a proposal to establish final billing rates. Whatever the parties intended, you couldn’t find it in the contract terms. So, at the end, the Board’s decision only covered FYs 2009 through 2014.

What did the Board rule?

  • When a government contracting officer unilaterally establishes a contractor’s final indirect billing rates (which, to be clear, is a thing that can be done), then those rate determinations are considered to be a government claim. Because they are a government claim against the contractor, the government has the burden of proof—and it must show its decrement factor is reasonable. “FAR 42.703-2 allows the government to set a unilateral rate aimed at ensuring the government does not reimburse a contractor for unallowable costs. Specifically, FAR 42.703-2(c) provides that any unilateral rate ‘should be - (i) [b]ased on audited historical data or other available data as long as unallowable costs are excluded; and (ii) [s]et low enough to ensure that unallowable costs will not be reimbursed.’ FAR 42.703-2(c)(2).

  • “… the government applied a decrement to appellant’s direct labor rate costs based upon appellant’s alleged failure to submit auditable indirect cost rate proposals. FAR 52.216-7(g) does not provide a proper justification, or regulatory authority, for the government’s actions taken here.” (Emphasis in original.) “The government’s imposition of an indirect cost rate decrement upon appellant’s fixed labor costs is unreasonable as not supported by the regulatory authorities cited by the government and contrary to the traditional demarcation between direct and indirect costs and the separate treatment of those costs.”

  • “… pursuant to the Christian doctrine, FAR 52.216-7 - as a mandatory time and materials contract clause specified in FAR 16.307(a) - is considered inserted into the contract by operation of law.”

  • “The express language of FAR 16.307(a)(1) dictates that FAR 52.216-7 applies ‘only to the portion of the contract that provides for reimbursement of materials (as defined in the clause at 52.232-7) at actual cost’.”

The Board also noted that submission of a proposal to establish final billing rates was not needed to evaluate the propriety of Allard’s direct labor billings. The contract clause 52.232-7 already gave the government audit rights in that area. It did not appear that the government availed itself of its contractual rights before deciding to apply its decrement factors.

So, readers, that’s how we know what we know.

 

Inflation and Your Supply Chain

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I’m getting too old for this stuff.

I’ve seen too much, and now I’m seeing too much stuff repeat. There’s no reason this stuff has to repeat except for incompetence. Not you. You’re good. It’s your boss. And their boss. Those folks are clowns and, if they weren’t so great at politics, they would be deservedly booted out from Executive Row on their well-padded derrieres.

So … here we go.

Nearly six months ago I published a blog article about inflation. Here’s a link to it. You remember that time, don’t you? Inflation was running at historic highs and everyone was concerned.

First Rant: “Historic highs” if you discount all the other times inflation was at similar—or even higher—rates. But since we have memories that are hazy about last week, it’s not really surprising that almost nobody remembers history. Hello? Whip Inflation Now? Anybody? Yeah, like that. History is dead. Nobody has any historical context anymore. Trust me, 8.5% inflation isn’t too bad in historical terms. In 1917, annual inflation almost hit 18%. In 1946, annual inflation did hit 18%. In the 1970’s inflation sucked. So, there is plenty of “lessons learned” related to managing contracts and suppliers in an inflationary environment. But none of you—and none of your bosses—implemented any of those lessons. How do I know that? Keep reading.

So, anyway. I published that article. I thought it had some interesting and potentially useful content. I even spoke on the topic to a fairly well-attended Government Contract Pricing conference. Well, the conference was well-attended. My presentation? Not so much. Everybody seemed to be at the other session, where DCAA and DCMA were talking about inflation using government-approved talking points that didn’t offer much in the way of new, innovative, thinking. (Okay. Do I sound bitter about that? I’m not. Not really. I mean, I understand the thought. Who is Nick Sanders, anyway? Nobody of any consequence.)

In that now aged and forgotten-in-the-sands-of-time article, I wrote—

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.

Now, I’m watching my prediction come true.

People’s Exhibit A: “Lockheed, Howmet Price Fight Over F-35 Titanium Goes Public.” (Source) As Michael Bruno wrote on 04 December 2023 in Aviation Week Online

Lockheed’s lawsuit—filed in U.S. District Court for Northern Texas—alleges Howmet in November demanded a ‘massive price increase’ on titanium materials used in the Joint Strike Fighter (JSF) and other systems, beyond the numbers specified in their underlying contract. The Fort Worth Star-Telegram reported that when Lockheed and other subcontractors refused to meet Howmet’s request, the company stopped supplying.

There’s more.

For its part, Howmet on Dec. 1 said it has complied with its contractual and regulatory obligations to Lockheed. The cornerstone supplier painted a picture of rising prices for materials, in part due to Russia’s invasion of Ukraine in February 2022.

‘Since 2022, Howmet has been transparent with Lockheed Martin about these challenges and has acted in good faith to attempt to reach a reasonable resolution for the benefit and long-term health of the F-35 Program,’ Howmet said in a public statement. ‘While such discussions were still ongoing, Lockheed Martin unfortunately chose to file a meritless lawsuit seeking to compel Howmet to continue to supply product at prices that no longer reflect commercial reality and on terms that Howmet believes it is not contractually obligated to provide.’

It’s ironic that Lockheed must contend—once again, 50 years later—with a supply chain issue that threatens the single largest defense contract currently being performed. Alanis Morissette should add a new lyric to her song.

Anyway, the latest news on the dispute is that Lockheed Martin attempted to invoke “national security” to force Howmet to provide titanium but the Judge said no to that.

The point I tried to make six months ago is that the subcontract language may be unenforceable—or winning the lawsuit may be a Pyrrhic victory for LockMart. What do I mean? If they force Howmet into bankruptcy then it doesn’t matter what the contract says. LockMart just becomes another creditor in the bankruptcy proceeding. Meanwhile: no titanium. No F-35 production. Other companies in the F-35 supply chain—those who rely on the raw titanium to process into bulkheads and suchlike—they have no input and therefore no output. They start to go under, as well. And for LockMart, they don’t have any more planes in shape to deliver to their customers. They start to incur liquidated damages or other penalties found in the prime contract. It’s not a pretty picture. In other words, LockMart can win and still lose everything.

Second Rant: They did this to themselves, quite frankly. I ain’t got no sympathy for them. You simply cannot expect to enforce a fixed-price subcontract in a highly inflationary environment. Airbus figured that out relatively quickly when it’s A380 supply chain was threatened. What did Airbus do? Did they drag their suppliers into court? Nope. What they did was to renegotiate the contracts so that it was economically feasible for the suppliers to perform. Lockheed Martin could have done that same thing, if they’d looked around for some historical lessons learned and implemented them. Lockheed Martin could have acted like smart business people and negotiated a solution. They might have had to eat some planned profit, but at least they’d keep their program intact. Instead, they listened to their lawyers. I ain’t got no sympathy for them. None.

People’s Exhibit B: “Bankrupt Co. Asks Court To Reject Gulfstream Supply Deal” (Source: Alyssa Aquino, Law360)

Incora, a bankrupt aerospace supply chain management company, urged a Texas court to immediately end a Gulfstream supply contract that became unprofitable during the COVID-19 epidemic, contesting Gulfstream’s claims that a contract termination clause must be honored for Incora to reject that deal.

To be clear, the supply contract with Gulfstream did not cause Incora to go bankrupt; but it was certainly a factor. Let’s dive a bit deeper.

June 9, 2023—about seven months ago—Ben Unglesbee, writing in SupplyChainDive, said—

Incora’s bankruptcy sends a warning signal to aerospace supply chains: Over the past year, the dollar value of late shipments from Incora’s suppliers has increased by ninefold, with on-time deliveries at around 50%.... Average lead time for shipments of parts has doubled to 18 months from nine months. That caused a major problem for Incora, ‘because its role in the aerospace industry (and some of its contracts) require it to maintain substantial inventory that manufacturers and maintenance service providers can call upon at any time,’ Carney noted.

Incora has taken on added costs because of shortfalls, in part by buying alternative supply at higher costs to fill gaps, leaning on expedited freight to move goods more quickly, and because of labor costs to turn late-arriving inventory faster, according to Carney.

Moreover, the company has had to pay higher prices for inputs as inflation spiked for raw materials, costs that Incora can’t pass on to its customers because of the timing of its contracts. Carney also said that ‘many suppliers of proprietary parts have exploited their position to raise prices in excess of general inflation rates.’ …

As for Incora, the company is looking to address its debt burden — partly a legacy of its leveraged buyout by Platinum Equity. The company also aims to use the Chapter 11 process to, as Carney put it, bring ‘unprofitable customer contracts’ in line with ‘current economic and commercial reality.’

Tip of the iceberg time, gentle readers. Tip of the iceberg. Two stories about different companies, both facing the economic realities of fixed-pricing contracts in a time of high inflation. Two suppliers with inflexible prime contractors. Two prime contractors with supply chain problems.

I bet you have some of those same challenges. What are you going to do? Are you going to enforce strictly the terms of your subcontracts, even if that means destroying your suppliers? Is that the hill you are going to die on?

Or are you going to negotiate some compromise that preserves your supply chain at the cost of short-terms profits?

Well, I bet I already know your answer. Here’s what you’ll say: “I’ll do what my boss tells me to do.”

And therein lies the true root cause of the problem.

Last Updated on Monday, 22 January 2024 19:53
 

Audit Access

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From time to time contractors attempt to limit auditor access to certain records, data, or documents. Generally, the attempted limits stem from a contract clause, or from a lack of a contract clause. Recently, the Civilian Board of Contract Appeals (CBCA) tackled another contractor attempt. In doing so, the CBCA established some interesting positions of which government accounting and compliance practitioners should be aware.

We could tell you that the July, 2023, CBCA decision in the matter of HPM Corp. v. Dept. of Energy will likely be of limited use as a precedent—but that wouldn’t be entirely accurate. While the decision was issued from the civilian BCA, it is well-written and could be persuasive to Judges of other fora. (I mean, what do I know? I’m not a lawyer. But the decision seems to me to be potentially persuasive. We’ll have to see.)

HPM was awarded a contract by DOE in 2018 “to perform occupational medical services at the Hanford Site in Washington state.” (There it is: Hanford. Again. What is it about that place, anyway?) What type of contract was it? Yes. It was all the types of contracts.

Here’s how the CBCA described HPM’s contract: “a performance-based Contract that includes Firm-Fixed-Price (FFP) Contract Transition, FFP Occupational Medical Services, Cost Reimbursement (CR) Occupational Medical Support Services, and Indefinite Delivery/Indefinite Quantity (IDIQ) Contract Line Item Numbers (CLIN).” A “hybrid contract,” in short.

Hybrid contracts are all the rage these days. It’s not really unusual at all. The question is: which contract clauses apply to which contract types within the hybrid contract? Do all clauses apply to all contract types? That cannot be the case! For example, it would be absurd to say that the Allowable Cost and Payment Clause (52.216-7)—which is a mandatory clause for all cost-type contracts—applies to the FFP portions of a contract. Similarly, we know (through judicial decisions) that, even though 52.216-7 is mandatory for T&M contract types, it really only applies to the cost-reimbursement portion and not to the FFP-per-labor-hour portion. So you can’t say that all clauses apply to everything everywhere in the contract. The question remains: which clauses apply to what?

Therein lies the gravamen of the dispute.

The CBCA noted that HPM’s contract included the FAR clause 52.215-2 (“Audits and Records–Negotiation,” Oct 2010). The contract also included the FAR clause 52.216-7 (“Allowable Cost and Payment,” Jun 2013) ”… but with a limiting notation (added in bold lettering) that states as follows: ‘Applies to Cost-Reimbursement.’”

The dispute started during DCAA’s audit of HPM’s FY2019 proposal to establish final billing rates. HPM was reluctant to provide DCAA with all requested supporting documents. The documents it did provide to the auditors were marked to prevent DCAA from providing them to others—i.e., to the DOE contracting officer. Apparently, HPM’s rationale was based on the fact that “because HPMC did not submit any cost or pricing data for the FFP portion of the hybrid contract, it should not need to provide proprietary information to DOE regarding fixed-price costs.”

Hmmm. Interesting position.

It is true and correct that certain cost data associated with FFP contracts awarded without submission of any cost or pricing data are exempt from audit. For example, FAR Part 14 sealed bid contracts are generally thought to be audit-exempt. Similarly, FAR Part 12 commercial product or services would likely be found to be exempt, as well. But it’s a large step to go from there to “my FFP CLINs are exempt from audit.” I mean … that’s some kind of chutzpah right there, isn’t it?

The dispute continued into the FY2020 proposal to establish final billing rates. As related by the CBCA—

For the FY 2020 incurred-cost audit, DOE designated Cohn Reznick (CRZ) as its auditor. On January 19, 2022, the DOE contracting officer, relying on the requirements of FAR 52.216-7 (clause I.36) and DEAR 970.5204-3 (clause I.173), directed HPMC to provide both CRZ and DOE with a final indirect-cost-rate proposal accompanied by ‘adequate supporting data’ that included ‘any firm fixed price data needed to evaluate the indirect cost pool and base costs used to calculate indirect cost rates.’ Counsel for HPMC responded on January 22, 2022, that the disputed information was proprietary and that DOE was not entitled to it. He argued that clause I.173 was intended to provide DOE with access only to materials related to environmental, safety, and health work plans to protect against ionizing radiation and radioactive materials. He indicated that HPMC would provide information necessary to the audit to CRZ but not to DOE.

(Internal citations omitted.)

Let’s stop right here. If your legal counsel is already involved before the audit has really gotten started … well, you can be pretty sure your audit is not going to go well. As a very experienced government audit liaison (some would say too experienced), I have to opine that some battles just ain’t worth fighting. When your counsel tells your auditor that they can’t have access to information they want to see (or that whatever they see can’t be shared with their customer, in this case DOE) the first thought that is going to pop into the auditor’s head is “those guys are hiding something they don’t want me or my DOE customer to see.”

Why would you want to create that thought in your auditor’s head? Yeah, don’t do that.

In fact, my advice (after 40 years of doing this shit) is to keep your legal counsel far, far, away from ongoing audits unless they must be involved because a huge issue has been alleged (or has been found-out). There is a place for attorneys in protecting the company; of course there is! But there is an unfortunate tendency for attorneys to polarize the parties while they’re carving-out their legal positions. They start preparing for litigation right away. Which is fine if you’re excited to litigate. But as for me? My job as audit liaison is, generally, to avoid litigation. Litigation is expensive; it is time-consuming. It takes a long time and, while you’re waiting for the judge’s decision, you’re stuck in limbo. Litigation is not something I enjoy; nor should you if your job is to make the audits run smoothly.

The attorneys were involved here and, fairly quickly, a nonmonetary claim was filed with the contracting officer. After rejection, an appeal was docketed at the CBCA.

I was interested in how the DOE contracting officer dealt with the issue. According to the CBCA,

The contracting officer found that, pursuant to the contract’s inspection and audit clauses, DOE is permitted access to what HPMC views as proprietary material during an incurred-cost audit, even if some of the material relates to the FFP portion of the hybrid contract. The contracting officer then indicated that ‘DOE will proceed with the remedy to remove all unsupported costs associated with the FY 2020 indirect rates and FY 2022 provisional billing rates.

(Internal citations omitted. Emphasis added.)

Yeah, that’s gonna hurt.

There’s a lot of stuff in the CBCA decision about whether the Board could even hear HPM’s claim. Here’s a summary:

HPMC is asking the Board to interpret its contract in a manner that would relieve HPMC from having to provide DOE with the audit support documents that DOE is demanding. Although HPMC presumably could continue to decline DOE’s production demand (as it now seems to be doing), wait for DOE to effectuate the indirect cost reductions that DOE has indicated it intends to impose, and then submit a monetary claim to recover that money, HPMC is not obligated to wait until DOE takes such action in order to seek a decision interpreting its audit production obligations under the contract.

Anyway, the CBCA Judges disagreed with HPM’s position. We’re going to quote extensively and you should read the quoted material, even though you probably won’t.

With regard to HPMC’s argument that these clauses only authorize DOE and its auditors to access information regarding the cost-reimbursement CLINs in its contract and that information associated with the FFP CLINs are completely off-limits, we disagree. HPMC’s contract expressly identifies one of the FAR clauses identified above (FAR 52.216-7) as being tied to the cost-reimbursement portions of HPMC’s contract, but the other FAR clause (FAR 52.215-2) provides generally for audits of ‘cost-reimbursement’ contracts. Although HPMC asks that we decide whether FAR 52.215-2 applies only to the cost reimbursement CLINs in its hybrid contract or to the contract as a whole, it is unnecessary to do so because, as far as we can tell, DOE’s auditors have not requested documents that would fall outside the context of a normal incurred-cost audit. Contractors’ incurred-cost submissions under cost-reimbursement contracts ‘are audited . . . to establish allowable direct costs and indirect cost rates for each fiscal year.’ Donald P. Arnavas, James J. Gildea & Normal E. Duquette, “DCAA Audits,” 94-09 Briefing Papers 1, 4 (Aug. 1994). DOE represents that ‘[a] well-known audit risk is misallocation and/or cost shifting between fixed price, cost reimbursable, and indirect work/costs’ and that ‘HPMC has had a history of misallocating costs between FFP and [cost-reimbursement] portions of the Contract.’ The audit in question is being undertaken to ensure that indirect costs being charged to the cost-reimbursement CLINs are appropriately allocated to those CLINs and have not been, through some type of accounting mechanism, moved away from FFP CLINs.

The Board is in no position to impose some type of myopic limitation on the scope of documentation that auditors need to support an audit of the cost-reimbursement aspects of this contract or of HPMC’s indirect cost rates. … HPMC has identified no basis upon which we would step into the shoes of the auditors and micromanage what documents they may, or may not, need to support their review or bar them from accessing certain categories of documents.

The Court of Claims made clear more than forty years ago that a contractor cannot complain during contract performance about the Government’s reliance upon audit access rights, including the right to access what the contractor views as proprietary information, created by contract clauses to which the contractor, prior to award, did not object [quoting SCM Corp. v. United States, 645 F.2d 893, 902 (Ct. Cl. 1981)] ….

HPMC tells us that the documents which the auditors are seeking are far beyond what should be needed to evaluate HPMC’s costs. Certainly, the Government’s audit rights under these clauses are not limitless and do not provide a basis for wide-ranging document requests for corporate records unrelated to the verification of actual costs. But the contractor does not get to stop an audit simply because it thinks that what it has produced is good enough.

(Internal citations omitted. Emphasis added.)

So, at the end of the day, HPM managed to delay some audit procedures, coax from the DOE contracting officer a threat to unilaterally establish both final rates and provisional billing rates by removing “unsupported” costs, and to upset the working relationship with its auditors and with its government customer.

Not the greatest job of audit liaison, in my view.

I hope you will do better.

 

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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.