DOD Inches Closer to Fixed-Price Development Contracting
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.
DCAA Audit Quality: Lessons Learned from the Brouhaha
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.
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Boeing Commercial Aircraft Announces $1 Billion 3rd Quarter Charge
“A billion here, a billion there, and pretty soon you're talking about real money.” – Congressman Everett Dirksen
 On October 6, 2009 Boeing Aircraft Company announced it was recording a $1 Billion charge in its third quarter related to “increased production costs” and “difficult market conditions” leading to lower than expected demand for its new 747-8 Freighter aircraft. Because the program is in a loss position, Boeing must record its entire forecasted loss upon identification.
This is not the first hint of trouble for Boeing Commercial Aircraft (BCA) and its aircraft programs. We previously posted that delays and overruns of BCA’s 787 and 747-8 programs may have led to the early departure of BCA’s President, Scott Carson. The program delays and other issues (e.g., the Machinists’ strike) also contributed to EADS overtaking Boeing as the No. 1 Aerospace/Defense company in the world, as we reported that “Boeing Commercial Aircraft (BCA) suffered a sales drop of 15.3% while Airbus' sales rose 18.9% (or 11.2% after currency adjustment).” We also noted that companies connected to the Boeing supply chain did not fare well either. For instance, Spirit Aerosystems, Kawasaki Heavy Industries, Curtiss-Wright, and Fuji Heavy Industries each underperformed against their peers. In contrast, some Airbus suppliers such as Zodiac Aerospace, Latécoère, and Moog outperformed their peers.
What led to the charge being recorded? Boeing doesn’t have much to say on that score, offering only the explanation that “it became clear that late maturity of engineering designs has caused greater than expected re-work and disruption in manufacturing. This is resulting in additional resources being applied on the program and higher supplier expenses, which are the primary cost drivers.” Other reports, such as this one from Bloomberg.com, note that “about $640 million of the pretax charge reflects higher expenses to produce the 747-8 … Higher allocation of fixed expenses and volume- based penalties to suppliers are the main drivers of the additional costs … the remaining $360 million of the charge relates to ‘challenging market conditions’ and the decision to keep production at a rate of 1.5 airplanes per month for almost two years longer than planned, instead of increasing output to two per month.”
According to the Wall Street Journal, Boeing’s announcement “did not quell speculation that the U.S. aerospace company may still cancel the loss-making program as it wrestles with delays and production issues with its 787 Dreamliner, which, like the 747-8, has yet to fly.” Moreover, “The 747-8 replaces the profitable 747 jumbo and was seen as a simpler design challenge than the 787 as it involved stretching and adding new wings and other parts to the existing aircraft. However, Boeing has already had to boost investment in the program, which was hampered by a machinists strike last year, the need to pull some engineers onto the 787 program and supply-chain problems. “
Although Boeing’s announcement was careful to let investors know that it discovered its 747-8 problems in the 3rd quarter, some have speculated that Boeing was aware of looming problems earlier, and that the problems led to Mr. Carson’s ouster as BCA President. Obviously that is speculation without evidence, and Boeing would be in trouble with the SEC and other regulators if that were the case. Nonetheless, Boeing is developing a history of “program surprises” such as this one, and one can only wonder if the world’s premier program management company has lost the formula to managing large programs to successful outcomes.
Entering a Full-Spin Zone: Washington Insiders Offer Unique Perspectives on the DOD Oversight Situation
Our previous article recapped the varied activity over the past several weeks, as the DOD contract oversight process has come under fire from the Government Accountability Office (GAO), DOD Inspector General (DOD IG), the Commission on Wartime Contracting (CWC), and the Senate Committee on Homeland Security and Governmental Affairs (HSGA).
After we went to press another reaction emerged, one with such a unique perspective that we wanted to make it the subject of its own article. What we are talking about is a “commentary” published on FederalTimes.com entitled “Give DCAA More Resources”. Readers can find the entire commentary here. Calling it a commentary is misleading; a better description would be apologia, which is loosely defined as a defense or justification. According to Thesaurus.com, other possible synonyms for apologia might be: apology, excuse, explanation, rationalization, exculpation, fish story, jive, song and dance, and whitewash.
According to the commentary by Professor Charles Tiefer and Adjunct Professor Richard Loeb (both of the University of Baltimore Law School), DCAA is “a tough and independent auditor that does quality oversight on the biggest and potentially the most errant of defense contractors, from KBR in Iraq to the builders of major weapons systems plagued by cost overruns.” Apparently, we are to believe that all of DCAA’s problems stem from the government’s relaxation of “vital laws, regulations and practices in favor of contractors ….” The Professors assert that “now that the auditing risks in ‘acquisition reform,’ like the auditing risks in derivatives and mortgage instruments have been exposed, the public has less tolerance for the excesses of unregulated contracting.”
By implication, it is unnamed principals in “the government” whose “acquisition reform” (quotations in original) led to the current “unregulated contracting” environment. It was they who created an environment of “relaxed vital laws, regulations and practices” that “favor” defense contractors. Ignore the fact that these unnamed “government” officials included members of Congress; ignore the fact that as part of the public-rulemaking process, both DOD and DCAA had a chance to comment on the so-called “relaxed” laws and regulations. Let’s focus on the statement that the current contracting environment is “unregulated” akin to that experienced by Enron. (Think that comparison is an example of over-reaching? That’s the one they used.)
Anybody who works in the world of Defense contracting knows just how fully regulated that environment actually is. From the Truth-in-Negotiation Act (TINA) to the Federal Acquisition Regulation, and from the Cost Accounting Standards to the False Claims Act, there is hardly a more regulated environment in existence anywhere in the world. In the mid 90’s, Coopers & Lybrand estimated that DOD paid a price premium equal to roughly 20% over would it would have paid, but for the regulations imposed on its contractors. It is true that a part of the Clinton-era acquisition reforms was to emphasize acquisition of so-called “commercial items” with minimum regulatory oversight; but these reforms were based on lessons learned in the First Gulf War, where the DOD was unable to acquire items such as radios because the suppliers wouldn’t agree to provide such bureaucratic items as (for instance) “cost or pricing data” as was then required by TINA.
The point here is that, far from a series of negligent actions taken by “the government” or actions taken at the behest of defense industry lobbyists, Clinton-era acquisition reform was a studied roll-back of non value-added bureaucratic impediments that kept warfighters from receiving necessary equipment. Moreover, the DOD Defense Science Board (DSB) recently informed the Secretary of Defense that the DOD was still too bureaucratic to meet the needs of the warfighter. According to the DSB—
- The DOD is "not geared to acquire and field capabilities in a rapidly shifting threat environment."
- "Current long standing [DOD] business practices and regulations are poorly suited" to the dynamics of a “rapidly shifting threat environment."
- "Today, the DOD is saddled with processes and oversight built up over decades, and managers leading them who are often rewarded for risk aversion."
So, far from an “unregulated” contracting environment, as Professors Tiefer and Loeb allege, the DOD contracting environment still suffers from overregulation (at least according to the DSB). The answer to DCAA audit quality problems is not to add more regulations.
Nor is the answer to add more auditors. According to the two apologists, “Congress can assist the agency by providing adequate resources ….” While we agree that DCAA staffing has lagged DOD contract spending in a dramatic and unacceptable fashion, the same is also true of DCMA contracting officer staffing. Adding staff to both DOD agencies must be done to assure proper government oversight. But simply adding staff won’t change an organization’s culture. More is not different. If the seemingly pervasive audit quality problems are to be addressed in an effective manner, DCAA must do things differently. (More on that in an upcoming article.)
Further, we have seen the additional staff added this summer, and they are (almost without exception) brand new trainee auditors just out of school. There’s nothing wrong with these individuals and we wish them well. But what DCAA needs is seasoned, experienced auditors with the ability to use independent judgment to conduct appropriate audit procedures. The new trainees need training and mentoring; they won’t be able to use independent judgment for at least a few years. In the meantime, DCAA continues to churn out audit reports, hoping that multiple layers of management review will ensure that the agency complies with GAGAS.
The two apologists conclude with an assertion that “DCAA has intensified its audit work with contractors and contracting officers. These actions should be applauded.” It’s unclear what they mean by “intensified”. If “intensified” means to change audit guidance to reduce auditor discretion, to threaten contractors with forfeiture of outstanding contract payments for failure to turn over data fast enough, and to call one-off mistakes serious “control system deficiencies,” then yes, we agree DCAA has “intensified” its audit work. But another viewpoint is to see such changes as window-dressing that do not address the fundamental issues of generating audit reports of high quality based on accurate assessments of facts and circumstances. That’s what contractors want to see, and that’s what DCMA contracting officers want to receive.
It’s not really surprising that Professors Tiefer and Loeb are apologists for the DCAA. From the Iran-Contra scandal of the ‘80s to “Bosniagate,” Professor Tiefer has long been a vocal critic of DOD and its contractors. He has routinely offered testimony and regulatory comments advocating more oversight, and he has been quoted as saying, “Our Defense Department has continued to pay, through pliant contractors, for a flock of Iraqi political exiles as our paid political agents in Iraq.” Professor Loeb was former Acting Deputy Administrator of the Office of Federal Procurement Policy (OFPP)—and Executive Secretary of the Cost Accounting Standards Board. His high-handed management style drew a rebuke from the American Bar Association, who noted that the CAS Board did not follow the rule-making procedures required by law. While acting in his CAS Board role, Professor Loeb was directly responsible for implementing the revisions to the Cost Accounting Standards that exempted commercial item contracts from CAS. In other words, he is one of those government principals who is directly responsible for implementing the very regulatory changes of which he is now complaining.
Coming up: Are there any lessons to be learned from the brouhaha?
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