The September 14, 2009 edition ofAviation Week & Space Technology magazine had an interesting article regarding implementation of fixed-price development contracting. A fixed-price contract is generally considered to be a type of contract where the agreed-upon price does not change, regardless of the contractor’s actual cost of performing the work. Of course, there are several flavors of fixed-price contracts and some actually do permit price redetermination in certain circumstances. Further, even a firm-fixed price contract may have its price changed if the Government makes a change to the underlying contract statement of work, through exercise of the contract’s Changes clause. That being said, a fixed-price contract type is not usually used for development contracts because it’s nearly impossible for the parties to agree on a fixed price when the work to be performed is only vaguely known at the time of negotiation. Thus, contractors take on enormous risks when they agree to such an arrangement and, as was demonstrated in the 1980’s when fixed-price development contracts were last in vogue, they have experienced enormous losses when doing so. (See, for one example, the history of the U.S. Navy A-12 stealth attack fighter.)

Regardless of history’s warning lessons, the Obama Administration and its Pentagon military chiefs have declared that fixed-price contracts—including fixed-price development contracts—are preferred contracting agreements, and that Federal agencies must cut-back on the use of such “high-risk contracting authorities” as cost-reimbursement, T&M, or labor-hour contract types. As we pointed at the time, that shift puts the risk of cost containment squarely on the shoulders of the contractors.

The Aviation Week article quoted David Berteau, of the Center for Strategic and International Studies, who says that successful implementation of the fixed-price development strategy will driven by the alignment of four elements:

• Stable, detailed, and technically sophisticated customer requirements definition
• Clear understanding of those requirements by the contractor(s)
• Savvy and skilled contract negotiating by the Government
• A willingness to adjust requirements to meet the fixed price, if necessary

In addition to the foregoing, Aviation Week asserted that “the theory is that technologies should be mature enough (technology readiness level 6, or tested in an operationally relevant environment …) to enable accurate cost and schedule estimates by industry bidders competing for a development contract. … For the Pentagon … requirements must be well-articulated and not altered … Once change orders are requested, leverage over contract price is lost.”

Aviation Week pointed out that the Small Diameter Bomb, Increment II (SDB II) (aka GBU-40) will be the “pathfinder” for fixed-price development contracting. The procurement history of the program was tainted by the Darlene Druyun scandal. Originally conceived as a competition between Lockheed Martin and Boeing, Ms. Druyun allegedly manipulated the moving target tracking requirements to favor Boeing, and then awarded Boeing the sole-source contract. Subsequently, the program evolved into a completion between a combined team of Boeing and Lockheed Martin versus Raytheon. In 2006 the DOD awarded 42-month, $250 million cost-plus-fixed-fee Risk Reduction contracts to each of the two teams, with the best resulting design expected to take the remainder of the development and production work. The selected contractor will be asked to perform on a fixed-price-incentive fee (FPIF) basis.

Aviation Week quoted Air Force Maj. Gen. Charles Davis, as saying that the Air Force believes “the maturity and technology [on the SDB II program] was to the point where it was of better interest to the government to go to a fixed-price with an incentive fee on that contract.” We note that Maj. Gen. Davis did not say that the technology was judged to be at readiness level 6. Aviation Week noted, however, that “concern about pricing development is not about immature technology—both teams have been … required to demonstrate key technologies in an operationally relevant environment.”

According to GlobalSecurity.org—

The Government is buying the SDB II based on contractor-developed, Government-approved System Performance Specification (SPS) which will become contractually binding at downselect. The contractor will be accountable for system performance as defined in the SPS [which] may include a system warranty. Accordingly, the contractor is responsible not only for the design of the weapon system, but also for planning and executing the Development Test and Evaluation (DT&E) program to verify the system performance. The Government formally arranges and funds the use of Government flight test support for DT&E. Although funded by the Government, flight test support funds are part of the negotiated commitment between the contractor and the Government ensuring the contractor is able to execute the DT&E Program according to the scope of the [Risk Reduction/System Design & Development] RR/SDD contract.

Based on the foregoing, there are number of variables that the final contractor will need to price into its cost estimate. Aviation Week noted that “industry executives have expressed some worry about pricing the contract and maintaining a competitive edge within the fixed-price constraint.” Among the variables that will have to be priced and managed will be the ability to arrange for timely flight test support from the Air Force. In addition to that issue, Aviation Week also noted that “the unknown in this particular contract will be integrating the SDB II onto the F-35, which itself is not fully developed.”

The Air Force is not oblivious to the contractors’ quandary. In the Aviation Week article, Maj. Gen. Davis opined, “You have to make sure that fixed-price contract is affordable. If the contractor is smart, he is going to price what he really thinks that is going to cost into [the bid]. So, the question becomes, did he price a lot of risk in there that he is not going to need, or did he price less than he will need and are we going to have a problem down the road?”

The issue with Maj. Gen. Davis’ remark is that it is self-contradictory. The Air Force wants an “affordable” contract, but expect the contractors to price some amount of “risk” into their bids. Risk is one of the hardest things to price out in the world of government contracting. In fact, the FAR (at 31.205-7) states that a “contingency” (defined as “a possible future event or condition arising from presently known or unknown causes, the outcome of which is indeterminable at the present time”) cannot be priced, but instead must be “disclosed separately … to facilitate the negotiation of appropriate contractual coverage.” So it’s difficult to understand how the contractors will be able to “price risk” into their bids.

What we are left with is the distinct impression that use of a fixed-price contract type on developmental programs is a mistake, one that will not lead to good financial results for the “winning” contractor. And the Pentagon will have yet another program with “cost growth” to explain to Congress. We are mindful of the policy statements in Part 35 of the FAR (concerning contracting for Research & Development efforts):

Although the Government ordinarily prefers fixed-price arrangements in contracting, this preference applies in R&D contracting only to the extent that goals, objectives, specifications, and cost estimates are sufficient to permit such a preference. The precision with which the goals, performance objectives, and specifications for the work can be defined will largely determine the type of contract employed. The contract type must be selected to fit the work required.

Because the absence of precise specifications and difficulties in estimating costs with accuracy (resulting in a lack of confidence in cost estimates) normally precludes using fixed-price contracting for R&D, the use of cost-reimbursement contracts is usually appropriate …. The nature of development work often requires a cost-reimbursement completion arrangement …. When the use of cost and performance incentives is desirable and practicable, fixed-price incentive and cost-plus-incentive-fee contracts should be considered in that order of preference.

Projects having production requirements as a follow-on to R&D efforts normally should progress from cost-reimbursement contracts to fixed-price contracts as designs become more firmly established, risks are reduced, and production tooling, equipment, and processes are developed and proven .…

In its zeal to control program costs, the Pentagon seems to have forgotten the policy statements quoted above, as well as the painful lessons of 20 years ago. Congress and the Obama Administration seem to have forgotten them as well. We expect we’ll be hearing more about the SDB II program (and other similar fixed-price development programs) in the future.

Having waded through reports, testimony and reaction, we thought we’d see if there are any lessons to be learned from all the brouhaha surrounding alleged failures of DCAA audit quality and DOD contractor oversight.

Contractor Internal Control Systems

Generally, everybody got it right that the key to controlling the unholy trinity of waste, fraud, and abuse is the robustness of contractors’ internal control systems.  The Commission on Wartime Contracting said that “contractor business systems and internal controls are the first line of defense … weak control systems increase the risk of unallowable and unreasonable costs on government contracts.”

But there was some confusion regarding exactly which “key business systems” a DOD contractor was supposed to have.  The Commission on Wartime Contracting (CWC) listed ten control systems from right out of the DCAA Contract Audit Manual (CAM).  But the Government Accountability Office (GAO) noted that not every contractor has every one of these ten systems and pointed out how DCAA auditors had wasted considerable time auditing one Federally Funded Research and Development Center’s nonexistent billing system according to the requirements of the DCAA standard audit program, and recommended that the billing system be determined to be “adequate” even though it didn’t exist.

As the GAO reported, “a contractor must have an adequate accounting system to be awarded a government cost-reimbursement contract, an adequate billing system to submit invoices for payment without government review, and an acceptable estimating system to support a contracting officer’s approval of pricing proposals.”  Other systems, such as purchasing controls, are mandated by FAR requirements.  It is not at all clear why the other systems in the list of controls are audited by DCAA.

Lesson Learned: DCAA needs to determine which internal control systems it will audit, and ground that determination in the requirements of the acquisition system.  (Indeed, Director Stephenson testified that “we are currently assessing the type of systems DCAA will need to audit and the type of opinion to be provided.”)  Further, DCAA needs to build flexibility into its standard audit programs.  Not every contractor will have the same slate of business systems, and part of learning about a contractor should be the documentation of the contractor’s unique approach to establishing its internal controls.

Evaluating Contractors’ Internal Control Systems

This is another area that most stakeholders got right.  The part they got right was agreeing that DCAA hasn’t gotten it right.  DCAA’s December 2008 change to its audit programs, establishing a binary “pass/fail” rating system for contractor internal control systems has led to audit reports that “are not informative enough to help contracting officers make effective decisions,” according to the CWC.  The CWC asserted that the new guidance resulted in “many more adverse audit opinions,” but also “undermined the significance of audit findings and weakening their effectiveness.”  The DCAA’s approach “does not adequately depict relative degrees of impact … [and] contracting officers need audit opinions with clear and quantifiable risk information.”  Further, DCAA’s failure to always “estimate a cost impact for the deficiencies it has identified” does not help the contracting officers who “balances the cost risk against the importance of the mission.” Finally, the CWC also noted that “there is no regulatory requirement for DCAA to render an overall opinion regarding the adequacy of many of the 10 business systems audited by DCAA. In fact, with respect to audit resolution procedures, DoD FAR Supplement (DFARS) 242.7502 instructs the contracting officer to consider significant deficiencies as opposed to an overall opinion regarding adequacy.”

The GAO agreed, reporting that “professional standards have long recognized different levels of severity with regard to reporting deficiencies and material weaknesses in internal controls.”  Moreover, the GAO stated—

By eliminating the “inadequate-in-part” opinion, the new policy does not recognize different levels of severity and could unfairly penalize contractors whose systems have less severe deficiencies by giving them the same opinion—”inadequate”—as contractors having material weaknesses or serious deficiencies that in combination would constitute a material weakness.

Lesson Learned: The DCAA needs to revise its audit guidance with respect to evaluations of contractors’ internal control systems. The audit agency needs to focus on identification of control weaknesses and system deficiencies, and on giving DCMA contracting officers the necessary information to evaluate the overall adequacy of the control systems.  If they feel compelled to make a recommendation to the contracting officers, it should be solidly grounded in testing of the internal controls.

Evaluating Contractors’ Codes of Ethics/Business Conduct and Internal Control Systems

The GAO surveyed 57 DOD contractors and found nearly 100% had established compliant codes of ethics and business conduct, as well as related internal control systems. The GAO report found that there was a bit of a gap in the verification of contractor compliance with the requirements; DCMA is relying on DCAA’s evaluation (which takes place as part of DCAA’s evaluation of the overall control environment and accounting system controls) but DCAA will be issuing its current “pass/fail” rating—which, as noted above—will not be particularly helpful to the DCMA contracting officers.

The GAO noted that ““the sentencing guidelines … state that the failure to prevent or detect a particular offense does not necessarily mean that the program is generally ineffective in preventing and detecting criminal conduct.”  Since the contractor ethics and disclosure requirements are based on those sentencing guidelines, one would hope that DCAA audit guidance would incorporate that philosophy.  Unfortunately (as we reported), such is not the case. The current pass/fail DCAA system rating approach will not mesh with the U.S. Sentencing Commission guidance and, unless DCAA changes its approach, contracting officers are going to be stuck in the middle (once again).

Lesson Learned: DCAA needs to pull its evaluation of codes of ethics/business conduct and related contractor controls out of its current audit program and create a separate audit program to focus on this area.  The audit program should accept that no system of internal controls will be perfect, and permit the reporting of individual deficiencies instead of an overall system rating.