RAND Finds Little Hope Fixed Price Deals Control Costs

By , and on September 16, 2015 at 4:01 AM

KC-46 tanker in air

The Program Executive Officer for the KC-46, Brig. Gen. Duke Richardson, made a rare public appearance today at the Air Force Association to discuss his program, which has been hammered by schedule programs and cost growth. Fortunately, none of this costs the taxpayer a dime because it’s a fixed price contract. But the problems have cost Boeing at least $1.2 billion so far. Do fixed price contracts work for major defense programs? Three experts at RAND address the KC-46 problems and how the Air Force might best handle the program going forward. Read on! The Editor.

Boeing costs of developing the KC-46A Pegasus aerial refueling aircraft recently have risen by about $800 million to address problems with the integrated fuel system. That comes on top of the approximately $400 million cost of addressing wiring problems reported previously. Boeing is developing the KC-46A under a form of fixed price contracting; the cost to the Air Force for engineering and manufacturing development for this system is capped at $4.9 billion. So, to date, Boeing has had to absorb approximately $1.2 billion in cost overruns.

Industry experts assert Boeing took a calculated risk in its bid, willing to absorb some level of development cost overruns to win, thus ensuring that it remains relevant within the global market for tanker aircraft. Nonetheless, as the system progresses toward production and sustainment, the Air Force will need to stay the course, continuing to maintain close control over the development contract, and manage future contract negotiations for the KC-46A to ensure that losses during development are not recovered through future contracts.

The use of fixed price contracts to control cost growth during the development phase of weapon system acquisition has been tried before. A Defense Business Board analysis cites notable examples in the 1960s, as part of Total Package Procurement, including the C-5A, F-14, SRAM missile, Cheyenne Helicopter, LHA ship, and the F-111. Yet significant cost growth occurred within these programs, contributing to severe financial strain on two contractors.

The pendulum swung back toward cost-based contracts in the 1970s. Then in the 1980s, in response to cost growth in these cost-based development contracts, the Department of Defense (DoD) tried fixed price development contracts again for the A-12, V-22, F-14D, T-45, T-46, C-17, AMRAAM, and DIVAD programs. Significant cost growth occurred again, with another contractor in financial jeopardy. The A-12 program was particularly problematic, resulting in cancellation of the program and decades of litigation.

The pendulum again swung back toward cost-based contracts in the 1990s before fixed price development contracts again gained traction in the 2000s. The one constant across these decades and acquisition approaches was the presence of cost growth during development. RAND analyses of development cost growth across the 1970s, 1980s, and 1990s found no significant change in cost growth across these decades. And a recent study by the Institute for Defense Analyses found no significant relationship between the type of contract and cost growth.

The prognosis is not hopeful .Looking across a wide range of weapon system acquisition case studies conducted over several decades at RAND, we are unable to find examples of fixed price contracts successfully reducing costs to the DoD associated with developing complex weapon systems. Sooner or later, through one mechanism or another, the government has ended up paying for much of the cost growth originally absorbed by the contractor, often during the production phase (or the program was cancelled or significantly cut back).

This does not necessarily mean that KC-46A will follow in the footsteps of prior programs, but the historical perspective does highlight the challenge the Air Force faces and suggests ways that it can shape its approach to the KC-46A program moving forward. In particular, experience suggests that the Air Force should pay particular attention to the following:

Hold The Line On System Requirements.

To date, the Air Force has successfully prevented changes to KC-46A system requirements, timing and funding to avoid opening the contract to further negotiation that could lead to higher costs to the Air Force. This should continue to be a high priority for Air Force leadership, requiring the buy-in of the Air Force’s operational and life cycle management communities and the other Services that depend on USAF tankers. Should new operational requirements become necessary, the Air Force should assess the cost implications of re-opening the contract during the development phase versus upgrading the system through a modification program in the future. If they choose, OSD leadership and Congress could also play a stabilizing role in the near term by deliberately avoiding new guidance that delays the current schedule or changes authorized quantities.

Don’t Save Now To Pay Later.

The DoD acquisition system naturally emphasizes near-term costs more highly than relatively uncertain future costs. Boeing’s recent development losses will increase its incentives to find opportunities for close-in savings. The Air Force will need to evaluate the effects of such development cost reduction initiatives on the costs associated with operating and supporting the system over its multiple decades of service life. Experience has shown that operating and support costs can be substantial, even when one accounts for their timing in the future.

Red Team Future Production Pricing Vulnerabilities.

In the past, some programs have seen development losses recouped during production.As the Air Force enters negotiations for future production lots and sustainment activities, it will want to understand the details of mechanisms through which Boeing could potentially seek to recoup development losses later in the KC-46A life cycle. This includes careful analysis of the underlying costs of the system and the opportunities for cost improvement throughout production. While the cost of future production lots is capped, the challenge for the Air Force will be to limit contractor attempts to recoup development losses by driving production costs all the way to the not-to-exceed prices.

Each of these recommendations sounds simple and intuitive, yet they have proven challenging time and time again in execution of large and complex military system acquisition programs. Given the importance of the KC-46A program within its overall investment portfolio, the Air Force cannot afford to waver, and key stakeholders in OSD and Congress could play a critical role in bolstering and enabling the Air Force’s efforts to limit cost growth.

Laura Baldwin, a senior economist, Mark Lorell, a senior political scientist, and Obaid Younossi all are defense experts at the nonprofit, nonpartisan RAND Corporation.

Comments

  • Bobsomm

    The lack of competent procurement officers and COTRs and the ability of contractors to OWN program managers has prevented us from effectively using CPFF with “not to exceed” clauses. I recall a program that had about 12 time extensions with cost growth that was ridiculous, delaying completion until the threat that the program was to defeat disappeared, replaced by a much more difficult threat scenario, but the development continued. Finally, when about 45 days into the last time extension, the contractor completed the pre-production phase years behind the original contract due date. All of the government project personnel running the program were given substantial awards for beating their deadline, i.e. the Nth extension. LRIP began for about 10 systems which were immediately fielded with a great amount of fanfare and it typically required about 4 hours of fixing for each hour of operation. Commanders just parked the systems out on the back 40 and the program silently died. And there were other programs that were a lot worse. Need to have much more savvy project people, common sense would help. We were told to avoid CPFF, but I simply used that vehicle frequently coming in ahead of schedule and under budget. Our project people and procurement folks are less qualified than we need. It is among the greatest waste factors in the military. Smart honest folks could solve the problem, but many in government got there because industry would not hire them because they defined the bottom 1/4th of the Bell Curve. 100% of our military’s rare earth materials come from China. If that doesn’t scare you, then you just do not get it. There is a bill that had bipartisant support to solve this, but the DoD convinced congress to vote it down. Who should investigate these things?

  • Robert Warner

    Contract claims have always been the basic growth industry in DOD that one can bet money on. Inventiveness, creativity, and out of the box thinking at it’s very best best.

  • Don Bacon

    The Pentagon has all sorts of ways to shovel money to contractors using modifications to previous contracts, including cost-plus mods to fixed-price contracts.

    –United Technologies Corp., Pratt & Whitney Military Engines, East Hartford, Connecticut, is being awarded a $105,492,976 cost-plus-incentive-fee modification to the previously awarded fixed-price-incentive-firm target contract N00019-13-C-0016.
    –United Technologies Corp., Pratt & Whitney Military Engines, East Hartford, Connecticut, is being awarded a $47,208,684 cost-plus-incentive-fee modification to the previously awarded fixed-price-incentive-firm target contract N00019-13-C-0016.

    They also issue contracts for tooling, spares etc. . With concurrrency, when the contractor is performing development and manufacturing, both R&D-funded and procurement-funded contracts are issued and who knows where the money ends up — the Pentagon doesn’t do audits. This also applies when the contractor has multiple procurement contracts. You send money to Lockheed. Who ends up spending it, and for what? A new yacht in the harbor for Hewson, perhaps.

    So the original contract, even fixed-price, means nothing. I just counted the contracts issued to Lockheed and Pratt for one production lot of F-35 airframes and engines, plus support and development, LRIP-8 — 29 contracts of various sorts, most of them mods to previous contracts. The contractor gets on the horn: “Send us some more money.” –And in it comes.

    • SMSgt Mac

      Don, Don, Donny, Donner-boy. You manage to turn every post into a general screed against anything and everything and somehow manage to also slur your way through a rant about the F-35–no matter what the topic. Aside from consistently making stuff up or doing a bizarro-world interpretation of the world (I especially enjoy you using your own thesaurus to make established definitions fit YOUR perverted sense of ‘right’) what DO you do when you’re not drooling on your keyboard about things which you know NOTHING about?
      I ask, because it seems you’ve kind of expanded your range over the web while still remaining out of your depth, so I think maybe the public needs to know some more about the ramblin’ rant-boy that Is ‘Don Bacon’.
      What is your history BEFORE you started ‘Freedom From War’? (and Is that the same ‘Freedom From War’ that is now “Teach Peace’?) Just asking.
      Admit it Donno, You’re just another aging anti-military peace-at-any-price hipster sitting in a shabby kum-ba-frickin-ya trailer park full of other aging hipsters somewhere at the end of a desert road and howling at the moon–Just because you can’t function in the real world. Poor you.
      Suck in the gut, put on some pants and go into town. Talk to people who aren’t delusional for a change. Maybe some sanity will rub off on you.

      • herbloke

        He who works on a major weapons project will have the most positive things to say about military contracts. Rip the government off much there senior airman Mac?

      • leroy

        I read your post on “basement dwellers” and the link to this BD article. The guys over at F-16.net really don’t get this Bacon guy do they – you being the informed exception (thank God). Read this and tell your friends at F-16 a little more about who they are dealing with. His anti-military “peace” agenda (it is actually a surrender agenda – IMHO). The comments speak for themselves:

        Don Bacon

        April 10, 2013 at 12:39 pm

        Some people relate bullying to militarism.

        I once had the popular view that militarism is uniforms and guns and worship of all things military. Then almost ten years ago I decided to make some effort to stop wars. I had read about Smedley Butler and read his book War Is A Racket, in a military library of all places. So I learned html and did a very basic website for my Smedley Butler Society, dedicated to stopping war. I contacted some similar groups. One was COMD — Committee Opposed to Militarism and the Draft — in San Diego.

        I corresponded with COMD, mentioning my traditional views on militarism, but the COMD respondent disagreed with my definition of militarism. Imagine that! He wrote that militarism, and its basic cause, goes much deeper than the normal view of it. It involves competition, and winners, and praise for the strongest. He was adamant about it. Shook me a little. I’d been in the military twenty years and I should know what militarism is.

        The COMD website is apparently dead. I can’t raise it. [http://www.comdsd.org/militarism.htm] But this is a part of the COMD definition of militarism: “Militarism is a value system that stresses the superiority of some people over others. . .Militarism derides cooperation, equality and nonviolence, and instead enforces strict hierarchical relationships.”

        So I look at militarism differently now. In its more basic form, thinking of schools, it involves bullying and traditional male role models, for example. Sports as ‘winning is everything.’ Kill ’em. etc.

        https://consortiumnews.com/2013/04/10/the-root-of-american-bullying/

        Oh – and read the following. I think it will explain a lot!

        http://www.warisaracket.org/

        http://www.warisaracket.org/benefits1.html

        … and this:

        “What can we do to stop the madness? First, fight recruiting and the coming draft. Studies for the Army show parents are the top obstacles to recruiting. “Opposition to . . . military service is increasing significantly among both moms and dads,” says a study of 1,200 potential recruits by the firm Millward Brown. Another look at potential recruits, by GfK Custom Research, found that the biggest influences in candidates’ decisions to join were mothers, named by 81% of respondents, followed by fathers, at 70%. “Reach the parents with the Army’s new message, particularly moms,” the study urges. But General Butler had another message.” etc etc.

        http://www.warisaracket.org/do.html

        Yeah – I’d say you’ve got his number. Stuck in the Summer of love!

  • Powder29968

    A great discussion on PRICE (what a customer is willing to pay) & COST (what a producer must pay to produce a process, product, service).

    I believe that Fixed Price sets a great STANDARD that drives aggressive performance from both customer & producer.

    Management of cost, schedule, and performance becomes simple (but by no means easy) when the customer is getting exactly what the customer formally agrees to accept.

    In turn, the producer willingly controls performance, tighten schedules, and reduce cost in order to optimize the difference between overall PRICE & COST.

    This is why Corporate Risk Management (producer & customer) is so important to successful overall product introduction.

    This is why Fixed Price Contracts are in place (Risk Control): to set clear expectations for both Customer & Producer.

    TAKEAWAY: In a strategic sense, the Department of Defense (DoD) must carefully consider:

    – COST (sum of the value to the Enterprise) for producing the KC-46A Pegasus Aerial Refueling aircraft
    – PRICE (what an Enterprise must give up to acquire a process, product, or service) a new state of the art KC-46A Pegasus Aerial Refueling aircraft.

    IF the DoD is willing to spend several multi-billion dollars on new fighter aircraft that require state of the art in-flight refueling THEN the DoD must be willing to balance the overall PRICE of the new fighter aircraft to cover the COST of the new KC-46A Pegasus Aerial Refueling aircraft.

    There is a significant strategic procurement imbalance within the Department of Defense.

    Procuring multi-billion dollars worth of new fighter aircraft (PRICE) without greater concern for future in-flight refueling capability (COST) reflects a strategic (Price/Cost) imbalance.

  • vincedc

    Just a reminder….Boeing was not the original first choice. It took Congressional intervention to get us into this bind. 4 billion dollars to develop a system that has been flying for 30 years and already is used as a tanker by another country. Something tells me those figures are significantly padded.

    • herbloke

      You mean the Airbus fiasco? They fired a government employee over that one.

  • originalone

    As I’ve stated before, the revolving door breeds this situation. Feeding at the public trough has become the villain in this. Oh well, it’s only money, right, even if it belongs to the taxpayer who drives on those pot hole roads in the U.S.

  • Reginald Bronner

    So Boeing didn’t get its original estimates correct in the first place? I know, estimation is an “unknown” which they have to relearn over and over. Get real. Boeing is definitely part of the problem. Where do you think Congress and the DOD gets its numbers?

    • herbloke

      Boeing built eleven tankers. The Japanese recieved the latest four. Don’t tell me they went brain dead and lost all their records from those deals. Granted the USAF wanted more fuel tanks but they should have been able to make good extimates.

  • Jeffery Surratt

    “the Air Force will need to stay the course, continuing to maintain close control over the development contract, and manage future contract negotiations for the KC-46A to ensure that losses during development are not recovered through future contracts.” Wishing in one hand and crapping in the other, tell me which one is going to fill up first. When has the Air Force ever saved any money on any contract? Even if Boeing is not able to shift the losses into future AF contracts or other DoD or civilian contracts; it is still a loss to the government in reduced tax payments from Boeing.

  • John King

    Powder’s discussion and breakout about the difference between COST and PRICE is very critical to understanding the problem of “cost growth.” When the company can’t do what they promised on time, that’s schedule variance, leading to paying for the same basic work multiple times. The various “studies” did not properly address that underlying dynamic and, to me, are thus invalid.
    There really is no such thing as “cost growth.” It’s actually the underestimation of the true magnitude of what needs to be done from an engineering and schedule perspective. If the true costs of such activities were included in the baseline program estimates, then the Pentagon could only afford half its fancy toys. Now, the real issue is whether its intentional low balling by government program managers and their cost estimating enablers, or political by defense contractors, who obviously, as the article points out, do take some risk. I assign a large portion of that blame to the cost estimators (at the program, department and OSD levels), who all believe their own BS about the “accuracy” of their estimates using statistical methods. (My quote: “Cost estimating is the astrology of statistics.”)

    As to Boeing’s absorption of “cost overruns” early in the program, good. We need more of this from the government side, especially to maintain a sense of cost control. And we have to look at the entire development and production funding profiles to make sense of the true growth; not just look at individual contracts, which are really just subsets of the totals. Using short, fixed price contracts helps manage that longer cost control problem and should be maintained as a management tool.

    • On Dre

      “Cost estimating is the astrology of statistics.”
      Brilliant.

      • John King

        Thanks. It was the result of years of sitting at the top of the Navy’s weapons systems budget food chain, performing program due diligence reviews before sending program budgets to Congress to get that year’s money. There’s a problem and the overly optimistic cost-estimates are a symptom. The OSD CAPE still doesn’t get it.

        A classic book on that subject from almost 40 years ago from Fred Brooks, an IBM software systems designer, “The Mythical Man-Month,” said whatever your initial estimate, it will actually take three times as long and cost five times as much. Google it. One of his central themes is that “adding manpower to a late software project makes it later.”
        Andrew below locks on some of the problem. Why are modern systems so maintenance dependent (10 hours maintenance for every one hour flight time, etc.). Lots is cutting edge versus state-of-the-art technology driven. Initial estimates are really only a SWAG, which over time become very real and really expensive.

        My problem with the RAND conclusion is that they’re saying the type of contract in relation to cost growth doesn’t matter, which may be true but not because of any direct causal relationship. The technology (complexity) and schedule (doability) are the drivers for both cost-plus and fixed-price contracts (which are often modified and not so fixed price) so that the total costs under either contract format eventually converge. The study did not delve into the primary cost drivers, which is why I said it’s invalid.

  • Andrew_M_Swallow

    What goes wrong when time and cost are estimated?
    Can the development problems be detected earlier, when it is cheaper to fix them?

    Why does modern military equipment spend more time being maintained than operating? Can whatever causes the maintenance be designed out? Or minimised?

  • jack

    If it wasn’t a corrupt procurement system, they would have gone with what the air force wanted and got the airbus built in the US

  • http://popularsovranty.org/ Malcolm Kantzler

    .