On July 26, 2010, the Commission on Wartime Contracting in Iraq and Afghanistan (CWC) held a hearing entitled “Subcontracting: Who’s Minding the Store” to address concerns about the subcontracting process in Southwest Asia.  As the Commission Co-Chairs noted, “Poorly conceived, poorly structured, poorly conducted, and poorly monitored subcontracting can lead to poor choices in security measures and damage to U.S. foreign-policy objectives, among other problems.”  Accordingly, the Commission explored “whether, especially in a high-risk, contingency environment, the government needs additional controls over, or more visibility into, subcontractor performance and costs to ensure the prime contractor is adequately managing its subcontractors.”

(We have reported on several of the CWC hearings and reports before.  To find those stories, type “CWC” in the search window on the website.)

Before we delve into DCAA’s testimony, we want to note a statement made by the Commission Co-Chairs (Shays and Thibault).  They said that the Commission “will issue a major report with proposals for statutory and administrative changes in December, followed by our final report to Congress in July 2011.”  So we are in our final year of CWC activity.  We look forward (with more than a little trepidation) to reading the Commission’s recommendations for “statutory and administrative changes.”  Now on to the hearing….

The hearing consisted of three panels, logically arranged into (1) Government, (2) Prime Contractors, and (3) Subcontractors.  Looking at the first panel, we were less than impressed with the “motherhood and apple pie” written statements from most of the participants.  DCAA Director Patrick Fitzgerald’s written statement, however, piqued our interest.  Lying amongst his platitudes and smooth-talk were some gems of note.  Let’s look at those, shall we?

Director Fitzgerald told the Commission that DCAA has 34 full-time auditors assigned to audit contingency contractors in Iraq, Kuwait, and Afghanistan.  17 are assigned to the Afghanistan Branch Office (ABO) and 17 are assigned to the Iraqi Branch Office (IBO).  By the end of GFY 2010 (September 30, 2010), DCAA expects to increase its workforce to 40 full-time auditors.

Director Fitzgerald also testified that, “As noted in the Commission’s interim report (June 2009), adequate contractor business systems are the first line of defense against waste, fraud and abuse. In the realm of subcontracting, we find this statement to be profoundly true.”  What did he mean by that statement?

As Director Fitzgerald explained to the Commissioners, “With respect to the three LOGCAP IV performance contractors, DCAA has reported all the estimating systems as inadequate and cited their estimating practices as being deficient for ensuring fair and reasonable subcontract prices.”  In addition, “DCAA has performed contractors’ purchasing system reviews (CPSRs) for the Defense Contract Management Agency (DCMA) Administrative Contracting Officer (ACO) at all of the three LOGCAP IV performance contractors and has found each system to be inadequate.”  Moreover, Director Fitzgerald told the Commission, “During our review of prime contractor billings and incurred cost audits, DCAA has identified situations where the prime contractor has not awarded its fixed-price subcontracts based on fair and reasonable prices leading to unreasonable or unallowable costs being paid by the Government.”

Reasonableness of Subcontractor Costs

It is one of the few unavoidable requirements placed on Government contractors that, prior to making a subcontract award, the prime must first make a written determination that the price it proposes to pay is fair and reasonable. (See FAR 15.404-3(b), which requires a prime contractor (or higher-tier subcontractor) to “conduct appropriate cost or price analyses to establish the reasonableness of proposed subcontract prices.”)  So when Director Fitzgerald says the LOGCAP IV prime contractors are failing in their duty to perform the requisite analyses, that statement gets our attention.

Director Fitzgerald provided some details to support his assertion.  He told the Commission—

In March 2010, DCAA reported estimating system deficiencies at DynCorp related to the inclusion of unsupported subcontract costs … for Corps Logistics and Support Service, Theatre Transportation Mission and Postal Operations in Iraq (commonly referred to as the CTP proposal). During the audit of the CTP proposal, the auditors found the subcontract proposal from DynCorp’s then “team member” subcontractor, Agility, to be inadequate. An examination of the U.S.-based Agility business unit disclosed that approximately 40 percent of the proposed direct costs were unsupported. That is, the subcontractor, Agility, was unable to support the reasonableness of the proposed direct labor costs proposed as part of the CTP proposal. Further, in its proposal to the prime contractor, Agility included lower-tier subcontractors to perform the bulk of the subcontract effort. In fact, Agility proposed to use two foreign-based Agility-affiliated subcontractors (sister business units). … During the review of one affiliate’s proposal, the Iraq Branch found the lower-tier subcontractor had only prepared a rough order magnitude proposal without supporting detailed data. In the case of the other lower-tier subcontractor, the Iraq Branch was initially denied access supposedly on the basis that its prices were commercial prices and exempt from any requirement for the submission of cost or pricing data. As a result, the auditors determined that almost all of the proposed Agility (and its affiliated subcontractor) costs were unsupported. … As a result, the DCAA audit report classified over $800 million of the proposed subcontract costs predominately related to Agility and its affiliates as unsupported. It is important to point out that the prime contractor had not performed adequate subcontract cost or price analyses. The DCAA reported the contractor proposal was not adequate for the basis of negotiating/awarding a fair and reasonable contract price.

But DynCorp wasn’t alone.  As Director Fitzgerald told the Commissioners—

Our audits of KBR proposals have disclosed similar significant unsupported subcontract costs. In May 2010, DCAA issued its report on the LOGCAP III Task Order (TO) 151 extension proposal. We identified over $48 million of unsupported subcontract costs. KBR failed to obtain subcontract proposals and conduct the required price or cost analyses. The contractor’s failure to obtain adequate support from its prospective subcontractors on this sole-source procurement increases the likelihood of subcontract prices being unreasonable in amount. Similarly, earlier this month, we completed an audit of Fluor’s “rebaseline” proposal under LOGCAP IV TO 0002 that incorporated the impact of numerous change orders on the total task order price. The change orders included proposed subcontract costs of approximately $35 million. DCAA reported over 40 percent of the proposed subcontract costs as unsupported because the prime contractor’s proposal lacked sufficient supporting documentation (e.g., cost or price analysis, competitive quotations). The majority of the proposed subcontract costs that we reported as unsupported were from foreign subcontractors of Fluor where, despite the sole source nature of the contracting action, Fluor did not obtain cost or pricing data from the related subcontractors.

DCAA’s procedures did not stop at evaluating the adequacy and reasonableness of proposed pricing.  Indeed, DCAA proposed to disallow the cost of paying already-awarded subcontracts when price reasonableness could not be established.  As Director Fitzgerald stated—

During our review of prime contractor billings and incurred cost audits, DCAA has identified situations where the prime contractor has not awarded its fixed-price subcontracts based on fair and reasonable prices leading to unreasonable or unallowable costs being paid by the Government. For example, DCAA has identified several cases where the prime contractor asserted the subcontract price was based on adequate competition; however, our audit disclosed that adequate competition did not exist. Although the prime contractor is required to pay its fixed price subcontract amount, FAR 52.216-7 and the FAR 31.2 principles state the Government only makes payments of amounts determined to be allowable and reasonable. Therefore, where DCAA has determined that the subcontract price is not fair and reasonable DCAA has attempted to calculate a reasonable amount for reimbursement of the contractor’s billings attributed to subcontractor costs. However, in those cases where the subcontract is sole source, it is often difficult to obtain cost data to ascertain the reasonable costs without access to the subcontractor’s books and records. DCAA access to subcontractor books and records is generally limited and dependent on the flow down by prime contractor to the subcontractor of the appropriate FAR clauses, and in instances of fixed price subcontracts, virtually nonexistent. For example, during DCAA’s reviews of Fluor vouchers submitted for payment under a LOGCAP IV Task Order, the prime contractor was unable to show the prices paid to its subcontractor for DFAC and other services were fair and reasonable in amount. Since DCAA does not have access to the subcontractor’s books and records, we were unable to determine through other processes the reasonableness of the prices being paid to the subcontractor and subsequently passed on to the Government for reimbursement. As a result, the DCAA auditors have suspended much of the subcontractor’s costs from payment on vouchers (invoices) submitted for payment by Fluor. In addition, the contractor has been withholding a portion of the subcontractor billings, so that in total approximately $24.5 million is being withheld from payment until the issue is settled. The FAR audit access clause does not provide for Government access to the subcontractor’s costs records when the subcontract is firm-fixed-price.

To wrap up our review of Director Fitzgerald’s testimony, we want to recap a couple of his concluding remarks.  The following are direct quotes from his written statement.

• Prime contractors have the responsibility to manage their subcontracts (FAR 42.202(e)(2)) and also have a fiduciary responsibility to monitor subcontractor performance and control costs to ensure the U.S. taxpayer resources are used wisely and appropriately. … we have found that prime contractors have not consistently monitored subcontractor performance and subcontractor billings submitted to the prime contractor for inclusion in the prime contractor’s billings to the Government. Although the FAR requires the management of subcontracts by the prime contractor and higher tier subcontractors, DCAA intends to recommend a review to the Director, Defense Procurement and Acquisition Policy, of the feasibility of specific contract clauses that would implement the basic FAR provision on management of subcontracts. For example, prime contractors should have systems or processes in place to review subcontractor billing processes to ensure subcontract billings are in accordance with subcontract terms and conditions.

• Based on our audit results we question whether there was adequate/true competition considering the limitations that the contractors have in a contingency environment. In Iraq and Afghanistan, U.S. and coalition military organizations most likely have consumed almost all of the capacity of most or all subcontractors capable of performing in-theater. Therefore, at best, competition within the area of a contingency is limited because the Government-required goods and services generally exceeded vendor capacities (that is, the Government is the sole or major purchaser of goods and services from all vendors) and all vendors are provided a portion of the requirements in order to satisfy the Government’s needs. In such circumstance, we do not believe competition and/or market forces provide better prices to the Government and believe cost data should be provided to determine fair and reasonable subcontract prices.

• DCAA has taken exceptions to several subcontract pricing actions where the prime contractor asserted a fair and reasonable subcontract price based on “adequate competition” where in fact only one bid was received by the prime contractor. DCAA is concerned about the risks created by current regulations permitting awards to subcontractors using competitive pricing procedures when only one bid is actually received. Again, in these cases, we believe it would be beneficial for the prime contractor and contracting officer to have access to subcontractor cost data to determine fair and reasonable contract prices. The Adequate Pricing Subcommittee under Mr. Assad’s Panel on Contracting Integrity is taking a look into this area. They are ascertaining the need to revise this “loophole” in the regulation that we believe leads to subcontract prices being awarded at unreasonable prices. I will continue to work this issue as the Chair of this Subcommittee.

We Take Issue with Some of Director Fitzgerald’s Statements

This is much to think about in the written testimony of Director Fitzgerald.  We completely agree with him that adequate price or cost analysis must be performed by contractors, in order to determine price reasonableness, prior to awarding subcontracts valued in excess of certain dollar thresholds.  But we also note that, far too often, government acquisition schedules fail to allow contractors sufficient time to perform the required analyses.  As a result, contractors often sacrifice some of the administrative requirements.  We’re not saying they’re correct in doing so, but critics need to look at the driver(s) of improper activities—and one of those drivers is the government’s rushed RFP turn-around times.

We also take issue with Director Fitzgerald’s statements that DCAA “has performed” CPSRs for the DCMA and, as a result of its audit procedures, “has found each system to be inadequate.”  First of all, DCAA auditors don’t perform CPSRs.  At most, they perform some procedures to assist the DCMA functional specialists with the purchasing system review, under the auspices of the cognizant contract administration office.  Don’t believe us?  Check out the DCAA Contract Audit Manual (CAM) at 5-603. 

Even when DCAA independently reviews a contractor’s purchasing system—and it can only do so when the cognizant Administrative Contracting Officer approves the audit activity—the auditors are not performing a CPSR.  As the CAM states, “Where the ACO agrees with DCAA concerns, the auditor should perform a purchasing system internal control audit (not CPSR) ….”  We will not recite the control objectives and control activities DCAA believes constitute an adequate set of purchasing internal controls.  Suffice to say that they are not dissimilar from other DCAA internal control matrices, and are actually worth reviewing when establishing a purchasing system.

But the fact remains that DCAA lacks regulatory authority to determine that any contractor’s purchasing system is inadequate.  That authority is vested in the cognizant ACO.  (See FAR 44.305-1: “The cognizant ACO is responsible for granting, withholding, or withdrawing approval of a contractor’s purchasing system.”)

We are also concerned with Director Fitzgerald’s unsupported assertion that the current FAR Part 15.403-1 definition of “adequate competition” somehow creates a “loophole” that permits contractors to award contracts at other than fair and reasonable prices.  There was no evidence provided to support that assertion.  Moreover, based on Director Fitzgerald’s own testimony, the root cause was not a lack of competition, but instead failure to perform adequate price or cost analysis.

Look, we don’t know all the facts and circumstances.  All we have is the testimony proffered to the Commission.  But we get very concerned when we hear somebody say that Contractors followed the regulatory requirements to the letter, but somehow that the results were found to be improper by the audit agency.  If the so-called “loophole” is to be closed by new statutory or revised regulatory language, then we need to see some solid evidence that such a change is necessary.  And we need to be convinced that doing so will fix the alleged problem.  Failing that, we suggest DCAA get back to auditing and let the DCMA functional specialists handle this area.

Conclusion

One has only to search this site for the phrase “supply chain management” to see the importance we place on the topic.  Proper management of subcontractors is absolutely crucial to assuring adequate program execution.  Part of that task is to put subcontractors under contract—to identify sources, to evaluate bids, and to negotiate (and document) why the resulting subcontract prices are fair and reasonable.  In fact, in November 2008, we told a small gathering at the local NCMA Chapter that, “Acquisition professionals must own all pre-award activities … Don’t be afraid of cost analysis.  Dig deep into supplier bids.  Take whatever time is necessary to gain the proper understanding.”  So when DCAA tells the CWC that this is an area that needs to be addressed, we have to agree.

Clearly, subcontractor management—ranging from pre-award activities to post-award performance management—is a topic of increasing interest to DOD and other oversight officials.  Look for recommended changes and increased emphasis on this area from DCMA, DCAA, and others.  If you believe your procedures can be enhanced, then by all means we urge you to get started right away.  But we can’t help noting that, if you’ve been reading this site, you would have been sensitized to this issue long ago.

The status and future of the aerospace/defense industry has been a popular topic here at Apogee Consulting, Inc.  Whether it has been a reported DOD funding shortfall, a report from AW&ST forecasting an industry-wide downturn, or a similar report from Forecast International, or another AW&ST forecast of a 10% industry-wide workforce reduction, readers of this site are (naturally) interested in what lies in store for the A&D industry. 

And we’ve not been entirely pessimistic, either.  In one article, we noted that several A&D companies were actually adding to their executive ranks, under the theory that an enhanced focus on program performance and customer relationships would differentiate them from the competition.  In another article, we linked to a report by the Project on Defense Alternatives that postulated a defense spending plateau that would be at least five percent higher than recent history, even after adjusting for inflation.  So even as we report on industry layoffs and corporate restructurings, we also continue to be guardedly optimistic that some sectors of the industry will maintain current business levels, while other sectors may even thrive in the near-term future.

The seeming contradiction between forecasted spending cuts and cautious optimism continues and may well define the rest of 2010 and 2011 as well.  On July 22, 2010, the New York Times published an article entitled “Pentagon Faces Growing Pressures to Trim Budget.”  The article reports—

Mr. Gates is calling for the Pentagon’s budget to keep growing in the long run at 1 percent a year after inflation, plus the costs of the war. It has averaged an inflation-adjusted growth rate of 7 percent a year over the last decade (nearly 12 percent a year without adjusting for inflation), including the costs of the wars. So far, Mr. Obama has asked Congress for an increase in total spending next year of 2.2 percent, to $708 billion — 6.1 percent higher than the peak under the Bush administration.

Mr. Gates is arguing that if the Pentagon budget is allowed to keep growing by 1 percent a year, he can find 2 percent or 3 percent in savings in the department’s bureaucracy to reinvest in the military — and that will be sufficient money to meet national security needs. In one of the paradoxes of Washington budget battles, Mr. Gates, even as he tries to forestall deeper cuts, is trying to kill weapons programs he says the military does not need over the objections of members of Congress who want to protect jobs. …

At the moment, the administration projects that the Pentagon’s base budget and the extra war spending will peak at $708 billion in the coming fiscal year, though analysts say it is likely that the Pentagon will need at least $30 billion more in supplemental war financing then.

Two-thirds of Pentagon spending is on personnel costs. It is possible that the Pentagon will have to look for the first time at cuts to the health benefits provided to active and retired military personnel and their families.

Some analysts said the Pentagon would eventually come under pressure to reduce the size of the armed forces.

Readers of this site may notice something interesting in the quoted sections of the article, above—the bit about personnel costs.  We first brought the personnel cost issue to your attention here, where we reported on an editorial from Dr. Loren Thompson of the Lexington Institute.  We subsequently reported on a GAO comparison between the costs of using private security forces versus costs of the use of State Department security personnel—and we reported that GAO found huge cost increases when government personnel were used, in almost every case it studied.  So keep that fact in mind when you hear about Government “insourcing” and hiring of more Pentagon personnel.

This July 2010 study by Deloitte’s Global Aerospace & Defense practice summed up the state of the A&D industry thusly—

Sales in 2009 were essentially flat with a small 1.3% increase, while earnings were down 15.3% from 2008. If not for the large program related write-offs, asset impairments, or regulatory fines at a few of the largest firms, industry profits would have been essentially flat as well. This financial performance could be viewed as positive when compared to the significant negative economic impact of the global recession. The industry continues to demonstrate its resiliency in the face of uncertain economic conditions.  The global aerospace and defense (A&D) industry as of midyear 2010 is experiencing the same ‘flat’ financial performance that was seen in 2009, although results varied widely by individual companies. For the top 25 global A&D firms that have issued quarterly financial statements thus far in calendar 2010 as a group, sales revenue growth was -1.01%, operating profits were -1.94%, and operating margins were -0.94% …. Holding steady on these key financial performance metrics indicates that the global industry has largely held up to the continued downward pressure on defense spending, managed its way through difficult and large-scale product introductions, and experienced continued slow sales in the commercial aircraft and business jet segments.

With respect to the defense sector in particular, the Deloitte report stated—

Some programs of record may be terminated due to cost and schedule overruns or determinations may be made that certain weapons programs conceived to fight the Cold War are no longer necessary. Conversely, programs that can be developed and fielded quickly to address the type of irregular warfare with insurgents and invisible adversaries are becoming more frequent and may attract funding.

For defense contractors, new areas will generate growth in 2010 and beyond. In particular, the number and variety of large hardware-based platforms is expected to decline and more innovation and capability will be found in software integration. Mission capability will increasingly be created by information technology services firms, which are well poised to create competitive advantage through innovation in battle space simulation, directed energy, precision engagement, threat identification, as well as energy and infrastructure security.

We recommend that readers download this report for themselves, as it contains quite a bit of excellent information.

Similarly, Jim McAleese recently briefed on this topic at NCMA’s World Congress.  We’ll hold a detailed review of Jim’s presentation for a later article, but we want to note some of his points that seem relevant to this topic.  Jim made the following points (which we copy ‘n’ paste unedited)—

• Secretary Gates did not formally-target large cost savings within RDT&E and Procurement Accounts. To the contrary, those Modernization Accounts were intended to be the beneficiary from cuts to manpower-intensive Headquarters, plus O&M.
• The majority of the upcoming Service negotiations on 2012-2016 POM will be conducted by DoD Comptroller; CAPE/PA&E; Joint Staff; and USD(Policy). However, USD(AT&L) has unique Statutory authorities over critical “go/no-go” Milestone-Decision-Authority, transitioning large-dollar Weapons Programs from one phase of the Acquisition cycle into the next, (ranging from Technology Development; to critical Engineering Manufacturing Development; and ultimately Production).
• Specifically, Dr. Carter is statutorily-responsible for making Milestone Decisions on several large-dollar RDT&E Development Programs that are about to be kicked-off by the Military Services. These include Army Ground Combat Vehicle; continued production of hardware under Army’s Brigade Combat Team Modernization; Navy VXX; Navy SSBN(X); USAF Long-Range-Strike; and Airborne ISR/SIGINT Platforms.
• This initiative will undoubtedly cause concerns over potential reduction in defense contractor Profits. However, as a general rule, for each dollar of actual labor, hardware contractors often have another 80%-100% Overhead, plus another 25%-33% of Corporate G&A, before Profit is even negotiated. This explains why Dr. Carter is so focused on attacking both exquisite Requirements by the Services, in parallel with pockets of low-value Contractor Overhead/G&A. Ultimately, Contractor Profits pale by comparison, against both excessive Service Requirements, and duplicative Contractor Overhead.
• This means that the future ‘Discriminator’ in valuing defense contractors, will become those contractors who outperform negotiated Schedule and target Costs, to actually produce larger quantities of affordable platforms, at greater overall Profit.

We note that Jim’s conclusion—that those contactors who “outperform … Schedule and target Costs, to … produce larger quantities of affordable platforms”—will not only have a competitive advantage in the A&D marketplace, but will also enjoy “greater overall Profit,” is pretty much exactly what we’ve been posting here for nearly two years.  Let’s repeat together:  program performance equals profits.

Continuing our theme of the dichotomy between budget cuts and opportunities to grow and thrive, we offer this Reuters story (compliments of Defense Industry Daily).  It points out that U.S. defense budgets may be flattening with respect to domestic sales, but that U.S. defense export sales may well surge in the near future, according to Vice Admiral Jeffrey Wieringa, head of the Defense Security Cooperation Agency (DSCA).  The article states that Vice Admiral Wieringa said in an interview with the news agency that, “U.S. arms sales will be little changed in fiscal 2010 but could surge by nearly one-third to $50 billion next year.”  The article quotes Wieringa as saying, “A lot of countries have built up cash reserves and they intend to continue buying.”  (We think those countries primarily are located in the Middle East, and the article also mentions India and Brazil.)

To address the expected growth in arms exports, the article notes that DSCA has been growing.  According to the article, “Wieringa has worked hard to expand training and staffing for U.S. military and civilian workers involved in global arms sales, boosting his agency's budget from $373 million in fiscal 2007 to an estimated $850 million in the fiscal 2012 budget being drafted now.”  That growth rate is commensurate with the growth rate experienced by U.S. defense exporters … but we can’t help wondering what Secretary Gates thinks of those numbers, when he has recently told the Defense Department to get rid of its bureaucracy.  But perhaps that’s an uncharitable thought, since U.S. A&D companies may well be relying on DSCA to champion their arms exports, and thus keep their top lines healthy and workforces intact.

To summarize, we have tried to present in this article different vectors of analysis on the health of the A&D industry.  While times may appear to be tough—and, indeed, we expect vigorous attempts to shed non-value-added overhead functions (and associated headcount)—the picture is not entirely gloomy.  Certain sectors will continue to grow, and those companies that perform well in those sectors should survive and even thrive.