A. The Latest Trend
One of the most alarming developments in defense acquisition policy over the past year has been the increased use of fixed-price development contracts. The KC-X Tanker Modernization procurement is the most high-profile example of this policy shift. This $35 billion procurement has already had its fair share of drama – from political intrigue to bribery scandals to international trade disputes. Regardless of which side you are on, you have to admit this procurement has gotten a lot of attention.
Of course, the KC-X saga is far from finished, and the current round includes one very onerous change from the last two attempts: the Air Force now intends to procure this new plane under a fixed-price development contract. In other words, the Air Force is asking Boeing and its competitors to commit to fixed prices for the development effort and 13 production lots, reaching 18 years into the future. As anyone experienced in Government contracting knows very well, contract type is an essential factor in the risk equation, and this particular type of contract is one of the reasons Northrop Grumman has dropped out of the competition – the contract type was too risky for the effort. This particular facet of the "Tanker Debate" is actually part of a larger trend across the industry, stemming from a law that recently ended a 20- year prohibition on fixed-price development contracts.
B. A Historical Perspective
The idea of fixed-price development was pioneered in the development of the C-5A Galaxy by Lockheed in the 1960's. The "Total Package Procurement Concept" was designed to procure the design, development and production of 58 enormous aircraft using a fixed-price incentive contract. The DOD advertised the concept as "Womb to Tomb Contracting." Since acquisition policy reserves fixed-price contracting for situations where the specifications are reasonably definite, the Air Force justified the fixed-price approach for the C-5A by explaining that the designs could be extrapolated from the much smaller C-130 already flying. Before long, the enormous size created weight issues (a frequent problem in aircraft development), which in turn created cost pressures. Because Lockheed did not have unlimited resources to commit, the program was forced to make compromises that led to structural weaknesses. Ultimately, the Galaxy was the subject of a $250 million restructuring effort that put it years behind schedule and temporarily killed the Total Package Procurement Concept (and giving unintended meaning to the "Womb to Tomb" slogan).
By the 1980s, the lessons from the Galaxy were long forgotten and fixed-price development contracting was resurrected with the C-17. The C-17 was another gigantic military transport plane that was marketed by McDonnell Douglas as a commercial derivative applying mature technology. Because the next step was so reliant on this mature technology, a fixed-price development contract was deemed appropriate. But there was a hitch: The way the technology was being used was very new. The ensuing technical difficulties led to cost overruns, missed milestones and, ultimately, another restructuring that cut the planned buy in half.
McDonnell Douglas had other issues to deal with in the 1980s since it had also teamed with General Dynamics ("GD") on the A-12, which was certainly not a commercially-derivative aircraft. The A-12 was to be an all-weather, carrier-based stealth bomber. The contractors and the Navy were well aware of the rules about reducing risks and uncertainties in development programs prior to utilizing fixed-priced contracts, but the Navy flexed its competitive buying power to push for a fixed-price development contract, and McDonnell and GD went along. Like its predecessors, the A-12 program faced severe issues, and as with its predecessors, a restructuring negotiation was attempted. McDonnell Douglas and GD offered to accept a $1.5 billion loss if the Navy would restructure the contract to cost-reimbursement, but the Navy refused (wanting $2.1 billion) and terminated the contract for default (at the direction of then- Secretary of Defense Dick Cheney). That termination has been the subject of litigation ever since, and is now headed for the Supreme Court some 20 years after the termination.
As a direct result of these issues, the 1988 National Defense Authorization Act placed a prohibition on fixed-price development contracts for systems over $10 million. This is where the law remained for nearly 20 years.
C. Déjà Vu?
Congress made an about-face in 2007, and we are starting to see the effects in acquisition plans. With major acquisitions, such as the Joint Strike Fighter, facing enormous overruns, the politically popular response was to point the finger at defense contractors, admonish cost-type development as wasteful and hold contractors responsible. So the 2007 National Defense Authorization Act reversed the fixed-price development prohibition. The law now makes fixed-price contracts the new standard, unless the agency can thoroughly justify that ensuing technical challenges increase program risk so much that only a cost-based contract is possible. Of course, if an agency pursues that justification it will risk not receiving approval to move from the technology development phase into the Engineering and Manufacturing Development phase, and agencies are not about to go down that path.
The tide clearly has turned. DOD 5000.02 Instruction, the guide for major system acquisitions, was revised in December 2008 to express a preference for fixed-price contracts, and a revision to the Defense Federal Acquisition Regulation Supplement followed shortly thereafter. Industry groups have been fighting the changes, but President Obama's memorandum last spring to all executive agencies stated that obligations to the taxpayers require curtailing the use of cost-type contracts. The Office of Management and Budget followed suit in October, mandating a reduction in cost-type contracts and directing agencies to follow a fixed-price contract preference.
D. What Can Contractors Do?
Experienced executives know that the most important part of a development program is the relationship between the contractor and the Government. The ability to communicate honestly—as well as combine the necessary expertise and resources to overcome obstacles—is a large part of the battle in development programs. This cooperative effort in the initial phase pays huge dividends downstream. Unfortunately, this entire concept is pushed aside in a fixedprice development program. The traps are obvious and cumulative. First, the Government perceives these contracts as a way to hold the contractor's "feet to the fire" at the contracting officer level (as with the A-12) and/or somewhere higher up the chain.
This adversarial attitude escalates pressure and strains relationships. At the same time, it discourages the contractor from honestly discussing problems and potential solutions because, after all, the Government will not provide more money for a solution. In addition, despite a common misperception in the media, contractors do not have limitless resources to spend. Therefore, shortcuts are inevitably taken, which cause oversights and often become the subject of claims for equitable adjustments that, in turn, delay performance and snowball into procurements like the A-12.
It is often said that history is prologue, and if that proves to be true here, there are some difficult times ahead for the KC-X program. The truly unfortunate aspect of this tale is that every contracting officer learns in the first week of training that the selection of contract type must be done with great care. They also are taught that the concept of a "fair and reasonable" price goes hand in hand with the contract type and that a mismatch can spell trouble—big trouble. In this case, where political factors appear to be the driving force behind the use of a fixed-price development contract, these very basic principles of contract management are going to be ignored, and that does not bode well for the contractor, the Government or the taxpayers.
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