On May 31, 2011 the Defense Department announced that Shay Assad, Director of Defense Procurement and Acquisition Policy (DPAP) had been assigned to a new position, that of Director, Defense Pricing. Both positions report to the Under Secretary of Defense (Acquisition, Technology, and Logistics), so this is a lateral move. Reportedly, Mr. Assad will be replaced by Richard Ginman, one of his deputies.

Seems innocuous, doesn’t it? Not really. We’re going to dig a bit deeper to show you how this transition not only ties into many of the important issues on which we have routinely reported, but that it also establishes the future for DOD acquisition policy.

Mr. Assad has been either the subject of, or a key participant in, many blog articles on this site. A quick search returned 21 articles in which he has been mentioned. He’s been a key figure in our ongoing saga of Defense contractor oversight.

As DPAP Director, he established acquisition and cost policy for the Pentagon. For example, we reported that his Class Deviation implemented the Franken Amendment. Perhaps more importantly to regular readers, he emerged in late 2009 as the mediator in the public flame wars between the DCMA, DCAA, DOD IG, and Commission on Wartime Contracting (CWC). In another “for example,” in this article we reported that Mr. Assad had Chaired the DOD’s Taskforce on Wartime Contracting (TFWC), and that he had concluded that every concern raised by the CWC was already being addressed.

Mr. Assad had established himself as a key leader in the Pentagon’s contractor management. He had been involved in the highest profile issues facing DOD’s acquisition workforce. Recently, reports linked Mr. Assad to the travails of the F-25 JSF program. Reuters reported that—

Carter's deputy, Shay Assad, came to Fort Worth last week to review Lockheed's costs amid growing frustration that only about 15 percent of the plane's cost is linked to ‘touch labor,’ work on the plane actually done in the plant, with the rest linked to Lockheed's overhead.

We touched on these frustrations in our story on customer reactions to program cost/schedule increases. We quoted a report that stated—

Committee chairman Carl Levin said new estimates of ‘life-cycle’ F-35 costs, including development, operation and maintenance, now top $1 trillion. The committee has been a strong supporter of the program, but he asked Carter to present alternatives as a ‘backup’ option within a week. … Senator John McCain of Arizona, the panel's top Republican, described the F-35 program as ‘incredibly troubled’ and a ‘train wreck.’ He suggested the Pentagon think of alternatives to the F-35 program if its costs cannot be brought down. Carter, the undersecretary of defense for acquisition, responded that there were no good alternatives to the F-35, a multirole aircraft due to replace various aircraft in the military fleets of both the United States and its partners.

Mr. Assad’s lateral move to his new position—a position apparently created for him—portends something new in the Pentagon’s approach to establishing contract prices. The new approach was discussed in an interview of Mr. Assad, published online in Federal Computer Week. Mr. Assad said—

One of the things that we are looking at is creating within the DCMA a pricing center of excellence. It would include a market research branch. If people are looking for a particular service, these folks would be able to provide them guidance as to how to go about doing that market research.

Matthew Weigelt, author of the FCW story, summed up Assad’s new responsibilities thusly—

Ashton Carter, undersecretary of Defense for acquisition, technology and logistics, has sought to improve efficiency through the Better Buying Power initiative and other activities that drive down costs, such as increasing competition for contracts.

DOD has also focused on managing program costs. Senior officials are trying to control spending and comparing what an acquisition should cost and what it will cost in the end.

David Berteau, director of the Center for Strategic and International Studies' Defense-Industrial Initiatives Group, said Assad's new position will help reverse 15 years or more of a decline in managing defense contracts and controlling prices. Such a position is long overdue and will have lasting value for DOD.

‘It is central to the success of Carter's initiatives,’ he said. ‘But more importantly, it will have benefits across all $360 billion of DOD contract dollars.’

Aviation Week reported a Reuters story with an emphasis on weapon system cost control. It reported—

The Pentagon is stepping up efforts to get the best prices possible for up to $400 billion in weapons and services it buys each year, but officials insist they are not trying to slash contractors’ profits.

‘This isn’t a war on contractor profitability. This really is trying to figure out how do we pay less for the goods and services that we buy,’ Shay Assad, a top aide to the Pentagon’s chief weapons buyer, told Reuters after a news conference to discuss an organizational change that left him with the new title ‘director, defense pricing.’

‘The reality is we need to step up our game across the board, and so that’s what we’re doing,’ Assad told reporters. He said unlike profit margins, overhead costs would be fair game. ‘That’s cost. How do we get that out?’ …

Assad said his job was not to tighten the screws on contractors, but to help equip the service’s acquisition experts to achieve the best possible deal for taxpayers.

He said he would review all sole source acquisition deals valued at over $1 billion, and some others worth more than $500 million. He would also be involved with pricing for competitive deals, but another official would oversee those negotiations.

Over the next 18 to 24 months, for instance, the Pentagon is revamping its Defense Contracts Management Agency and building a database that will help contract officials compare their programs with those of other services.

DefenseNews reported the story with emphasis on Assad’s role in negotiating contract costs. It said—

There will be a new negotiator at the table as the Pentagon and Lockheed Martin hammer out a pricing deal for the latest batch of F-35 Joint Strike Fighters. Shay Assad, the newly named director of defense pricing, will help the U.S. Defense Department buy weapons at a lower cost than official budget estimates. The creation of the new position is part of the Pentagon's quest to drive down the cost of weapons at a time when defense budgets are constricting. In his new role, Assad will help program managers hit these should-cost targets, which will be set at levels less than official budget estimates.

In addition, he will spend more time improving the contracting and pricing work forces in ‘improving their skills on what it is we pay on the goods and services we buy.’

One of the major elements of this is to transform the Defense Contract Management Agency (DCMA), Assad said. DCMA has hired 300 pricing analysts who will assist contract officers during negotiations for weapons, sustainment, services and other contracts. It will take 18 to 24 months to bring this work force up to speed, Assad said.

Officials are also creating an online system that will ‘enable our contracting officers to get insight into the financial aspects of the companies that we deal with in a real-time way,’ he said. The system, which already includes rate data, is being tested. Currently, it could take contracting officers months or even a year to compile this type of data. Soon it will all be organized under one roof and should take minutes to retrieve. …

Assad will be ‘intimately involved’ supporting the acquisition of the F-35, the Pentagon's most expensive program. DoD converted the program to a fixed-price construct last year and has entered new negotiations for the fifth batch of production aircraft. The F-35 negotiations will likely not wrap up until this fall, Assad said.

We noted above that Mr. Assad’s transfer shows how the DOD intends to manage its contractors. Let’s list some of the strategies mentioned in the various stories above.

1. Allegedly, 85 percent of the F-35’s unit cost is “overhead”. That’s nonsense, of course, but it plays well. Assad’s intent is to drive down such “overhead” costs by focusing on what those various tasks “should cost” as opposed to what the contractor tells DOD it is actually costing.

2. Assad is going to focus on enhancing DCMA’s existing skillset in analyzing contractor proposals and their proposed prices, and in negotiating program prices. Reports mentioned that DCMA’s pricing analysts would be key to achieving those goals.

3. Another aspect of the transformation is to develop insight into contractors’ actual costs. To that end, a database has been created to permit rapid comparisons between contractors.

A couple of final thoughts on the foregoing:

• Omitted from any reports that we saw was mention of the role of Mr. Charlie Williams, Jr. (Director, DCMA) in the agency transformation. We can’t help but wonder whether Mr. Williams sees Mr. Assad’s new role as being one of additional, badly needed, support—or whether he sees Mr. Assad as stepping on his toes like an elephant at a sock hop.

• Omitted from any reports that we saw was mention of the role of DCAA in assuring fair and reasonable contract prices. Mr. Assad, who has been an effective mediator between DCMA and DCAA (and other stakeholders), is going to focus on DCMA and nobody has anything to say about DCAA. What’s that about? And while we’re on this topic, what about that DCMA/DCAA dispute resolution process that Mr. Assad was instrumental in crafting and in executing? What’s going to happen to that process without Mr. Assad?

• About that magic database. Surely the database cannot be intended for use in comparing contractor indirect rates. Nobody can compare contractors’ indirect cost rates because very few contractors have identical cost accounting practices. Some contractors have a lot of direct costs and others have a lot of overhead pools and special cost allocations. What matters is the bottom-line price and not how much is “overhead”. So there must be another purpose to that database….

Leveraging on the points above, let’s speculate wildly for your amusement.

Suppose—and we’re just speaking hypothetically here—just suppose DCMA wanted to stop relying on DCAA. Suppose DCMA was fed up with audit reports that arrived too late, and contained too little reliable information to permit effective contract negotiations. Suppose DCMA was tired with DCAA’s misplaced emphasis on compliance with GAGAS and maintenance of auditor independence. Suppose DCMA wanted to negotiate with contractors on issues ranging from forward pricing indirect cost rates to contractor proposals, and it wanted to conduct those negotiations on its own timetable, and be responsible for its own outcomes. What might DCMA do in that hypothetical situation?

It seems to us that DCMA might develop its own price analysis center of excellence. One that focused on analyzing contractor costs. One that was staffed with dedicated analysts who had been rigorously trained in cost and price analysis techniques—analysts who could match DCAA auditors in proposal analysis expertise. In that scenario, DCMA could conduct its own proposal analyses and negotiate with contractors without the need for a detailed DCAA audit.

And if DCMA wanted to move away from reliance on DCAA to negotiate contractor indirect cost rates—especially forward pricing rates—then DCMA might develop a database of historical contractor indirect cost rates. Such a database might be used for linear regression and other similar statistical analyses, so as to project future contractor indirect cost rates without relying on a detailed audit of contractor budgets. DCMA could negotiate from a position of strength based on its statistical analyses, and would no longer need to wait for a DCAA audit report.

As we’ve asserted before, our belief is that DCMA has given up on DCAA and is frantically trying to develop its own expertise so that Contracting Officers no longer need to rely on audit reports in order to sit down at the negotiating table.

From this viewpoint, Mr. Assad’s new role makes perfect sense: his new job is to get DCMA to “man-up” so that DCAA’s current role in contract pricing can safely be de-emphasized. From this viewpoint, Mr. Assad’s seemingly innocuous transfer portends a significant change for DOD contractor management, one that does not bode well for DCAA.

Watch DOD’s new pricing center of excellence carefully. Watch DCMA’s interaction with DCAA. Look for changes in the current roles and relationships. Those changes might be signs that we’re on the right track.

Hypothetically speaking.

It’s here.

Much like a long-expected—yet dreaded—phone call from your oncology specialist, or your spouse’s divorce lawyer, on May 18, 2011, the new DFARS rule covering contractor “business systems” (aka internal control systems) was published in the Federal Register.

This item has to be among the top two or three issues we’ve been writing about on this website, since we first took issue with the “independent” (but not bias-free) Commission on Wartime Contracting in Iraq and Afghanistan (“CWC”). We’ve published many articles related to this topic, including this notification of the proposed DFARS rule, our comments on that rule (as submitted to the DAR Council), the DAR Council’s revised draft rule, and our additional comments on the revised draft.

Suffice it to say, we’ve been all over this issue like white on rice.

And now we have an interim rule, with additional public comments solicited. (As if those comments are going to affect the rule.…)

DCAA has been holding off on performing its “ICAPS” system reviews for nearly two years, ostensibly awaiting this new rule. (Which is wrong on several levels—including the situation where at least one contractor was left with an “inadequate” accounting system (which kept it from winning new work) because DCAA wouldn’t return to perform a follow-up system review to confirm that all corrective actions had been effectively implemented.) So this new rule permits DCAA to gear-up and get back out there into the field, reviewing and assessing contractors’ systems of internal controls.

(Since DCAA hasn’t been auditing too many contractor internal control systems, and hasn’t been auditing too many contractor incurred cost submissions, one wonders just what the hell they have been auditing … but perhaps that’s a rant better left for another day.)

Let’s summarize the interim rule, remembering that, as a DFARS rule, it applies only to DOD and NASA contractors. If you’re a civilian agency contractor, you need not worry overmuch—though we bet DCAA will assert that the DFARS rule establishes a basis for the adequacy of any contractor’s business systems. In fact, the rule’s promulgating comments assert that, “Because they are designed to be consistent with GAGAS, while are based on standards developed by the American Institute of Certified Public Accountants (AICPA), the system criteria are applicable equally to DoD, NASA, and civilian contractors.” So don’t rest too easy, civilian agency contractors: your time may be coming sooner than you think.

Anyway, here’s our take on the rule:

1. There are now six (6) contractor business systems of internal control, not 10. They are: Accounting, Estimating, Purchasing, Earned Value Management, Material Management and Accounting, and Property Management. But that’s somewhat misleading, because the adequacy criteria formerly associated with some of the other internal control systems (e.g., Billing System, Timekeeping/Labor Accounting, etc.) now have been consolidated into the adequacy criteria associated with the Accounting System.

2. A new DFARS clause (252.342-7005, Contractor Business Systems) will be inserted into solicitations and contracts when the contract is a “covered contract” and the solicitation or contract includes one or more of the individual business system clauses (e.g., 252.215-7002, Cost Estimating System Requirements; 252.234-7002, Earned Value Management Systems; 252.242-7004, Material Management and Accounting System; 252.242-7006, Accounting System; 252.244-7001, Contractor Purchasing System Administration; or 252.245-7003, Contractor Property Management System Administration).

3. A “covered contract” is defined as any contract subject to Cost Accounting Standards (CAS). If you are not a CAS-covered contractor or your contract is exempt from CAS—congratulations! You don’t have to worry too much about this new rule. For example, small businesses are exempt from CAS. (In addition, educational institutions and Federally Funded Research and Development Centers (FFRDCs) also are expressly exempt from the rule’s requirements.)

4. The administration of the new rule is found at DFARS 242.70 (Contractor Business Systems); between that direction and the language found in the 242-7005 clause, this is how we think it will operate.

1. 1. DCAA, or other “functional specialists,” will perform reviews of the six business systems. Any “significant deficiencies” will be identified to the cognizant Administrative Contracting Officer (ACO).

   2. A “significant deficiency” is defined as “a shortcoming in the system that materially affects the ability of the Department of Defense to rely upon information produced by the system that is needed for management purposes.” But that definition is somewhat misleading. According to the promulgating comments, “DCAA policy is to report only deficiencies determined to be significant deficiencies” as defined both in the rule and in the Generally Accepted Government Auditing Standards (GAGAS). The promulgating comments note that, “Based on the definition in GAGAS, a significant deficiency is a deficiency, or combination of deficiencies, that adversely affects the entity’s ability to initiate, authorize, record, process, or report data reliably.” So note there is a separate, more detailed definition of “significant deficiency’ that DCAA will be using.

   3. The ACO will make an initial determination to approve or disapprove the business system(s) based on the identification of significant deficiencies by auditor or functional specialist.

   4. The contractor will have 30 days to respond to the initial determination.

   5. The ACO will evaluate the contractor’s response and issue a final determination. If the contractor’s response is unpersuasive, then the final determination will notify the contractor that (i) its system is being disapproved, and (ii) that payment withholds are being implemented.

   6. The ACO will identify “one or more” covered contracts from which the payments will be withheld. When there are multiple systems with significant deficiencies, the ACO is directed to ensure “that the total amount of payment withholding … does not exceed 10 percent of progress payments, performance-based payments, and interim payments … under each of the identified covered contracts.” Similarly, when only a single system is involved, then the withholding limit is five (5) percent of such payments. The ACO has “sole discretion” to identify the covered contracts from which to withhold payments.

   7. Payment withholds will be taken against in-process payments by the DOD, and the ACO will direct that the contractor deduct the payment withholds from prospective invoices that it generates. Payment withholds are not subject to interest payments under the Prompt Payment Act.

   8. The contractor has 45 days to submit a corrective action plan to the ACO. If the ACO “in consultation with the auditor or functional specialist” determines that the contractor is effectively implementing the corrective actions, then the payment withholds “will” be reduced to two (2) percent.

   9. Payment withholds will persist until the ACO “determines that the contractor has corrected all significant deficiencies as directed by the Contracting Officer’s final determination.” The contractor must notify the ACO in writing when it has made all the necessary corrections. At that point, the ACO may discontinue payment withholds and direct the contractor to bill for outstanding amounts due, but only if there is agreement that the significant deficiencies have been corrected; otherwise, the payment withholds will continue.

   10. If the ACO has not made a determination within 90 days, then whatever payment withholds exist must be reduced by “at least 50 percent.”

Looking at the individual business system clauses, we see quite a bit of familiar adequacy criteria. It’s also interesting to see how the granularity of the adequacy criteria varies system by system.

Within the Accounting System Administration clause (for example) we see eighteen (18) criteria that must be met, but none of the criteria are new: they were previously associated with either overall Accounting System adequacy or with one of the subsidiary systems (e.g., timekeeping/labor accounting). But we were impressed to note that there are twenty-four (24) adequacy criteria associated with Purchasing System adequacy.

The single adequacy criteria associated with Property Management is “The Contractor’s property management system shall be in accordance with paragraph (f) of the contract clause at Federal Acquisition Regulation 52.245-1.” But we all know that a DOD Property Administrator expects a contractor to have detailed command media that addresses a multitude of detailed criteria.

There are five (5) adequacy criteria associated with Estimating System requirements. There are two (2) adequacy criteria associated with Earned Value Management Systems—although we note that one of the two criteria references ANSI/EIA-748, which contains 32 criteria. There are three (3) MMAS adequacy criteria.

So to wrap it up, this interim rule seems to be written in such a way that defense and NASA contractors—and perhaps all contractors (as we noted above)—can live with it. That’s not to say that it is without risk. Indeed, we see considerable risk associated with implementation of this new rule. We see two sides to the risk: (1) the known risk associated with the rule language, and (2) the unknown risk associated with how the rule will be actually implemented in the field.

The known risks include:

• Whether DCAA will comply with the requirement to report only “significant deficiencies,” or if the audit agency will continue the unfortunate trend of reporting every small mistake as a glaring systemic problem.

• Whether the significant deficiencies will be reported “in sufficient detail” to permit the ACO and contractor to understand both the problem and necessary solution, or whether the contractor will be left in limbo, trying to correct a problem that it doesn’t understand.

• Whether the ACO will exercise the FAR-provided authority to implement payment withholds only when required—and reduce those payments in line with the rule’s guidance; or if the ACO will timidly await DCAA’s concurrence/permission to take any action.

The unknown risks include:

• Whether DCAA will apply these criteria to contracts not officially covered by the rule.

• Whether DCAA will apply pressure to DCMA Contracting Officers to implement payment withholds for relatively insignificant findings.

• Whether DCMA Contracting Officers will be eager to disapprove contractor systems, knowing the immediate cash flow hit as well as the more long-term undermining of the contractor’s competitive position.

• Whether the cash flow hit will be of such magnitude to force some contractors out of business.

This is a significant regulatory development. Your company’s cash flow is at risk. DCAA will be issuing audit guidance to implement the rule in the near future. Stay tuned for further details.