VIEWPOINT DEFENSE CONTRACTING

Performance-Based Logistics: An Answer to The Readiness Conundrum

6/20/2017
By Tom Captain
The United Kingdom’s Ministry of Defence is employing a performance-based logistics contract for its CH-47 Chinook helicopter.

Photo: Wiki Commons

The military sustainment mission is vital to strengthening the U.S. competitive global military advantage, but the nation must recognize the sober reality of its challenges, how private industry can help resolve some of the U.S. military’s readiness challenges, and what changes in government contracting might be helpful.

Certain service chiefs, the administration and some in the media have stated that U.S. military mission capability and readiness could increasingly be considered a national security problem. Not enough ships and fighters, helicopters, refueling and transport aircraft, and too many of the ones the military has are often down for maintenance and repair.

U.S. Naval Institute Proceedings articles over the past year have stated that virtually all of the naval services’ helicopters, the F/A-18 and Harriers are at or below 50 percent readiness levels. Moreover, the number of ready based aircraft do not meet established platform readiness targets. The other two services face similar sustainment challenges on some of their weapon systems platforms.

This does not seem like an acceptable situation at a time when global threats may be more acute and danger could spring at the most inopportune time with no notice. The United States should have existing and very sophisticated military weapon system platforms ready to go when needed to help ensure global stability and safety, and when necessary, fight.
What is the problem and what is getting in the way? There are many causes, even some finger-pointing and some self-inflicted wounds that are to blame. How can the nation solve this problem?

First, military sustainment is shared between private companies and U.S. military depots, as well as the government’s intermediate and operational level maintainers. Title 10, USC 2466, is the defining statute that mandates that 50 percent of depot maintenance touch labor must be performed by a government employee, the so-called 50/50 law. Compliance is measured at the military department or defense agency level during each fiscal year.

Congress has also mandated for almost three decades that the government must maintain an organic readiness and sustainment capability for core sustainment activities.

Commercial airlines conduct sustainment, employing practices that result in better than 98 percent dispatch reliability. Many of them employ a “power by the hour” performance-based contracting mechanism, to ensure maximum aircraft readiness at a low and competitive cost per flight hour. Simply put, airlines care more about aircraft up-time, than owning and maintaining the aircraft or engines.

A few years ago, the deputy assistant secretary of defense for materiel readiness analyzed weapon systems, subsystems and components sustained using outcome or performance-based strategies, similar to what we see in commercial airline operations. The study found that weapon systems sustained through performance-based logistics delivered savings from 5 percent to 25 percent when compared to legacy sustainment approaches, and improved readiness up to 50 percent or more.

The United Kingdom’s Ministry of Defence is employing such a contract on its CH-47 Chinook helicopter. This is a 30-plus year contract with incentives to reduce the cost per flight hour and increase readiness.

Thus, performance-based logistics have worked in commercial industry, other governments and indeed within the U.S. government. What are the reasons that such partnerships between private industry and government can deliver such larger benefits in cost and mission readiness?

When a contractor is focused on delivering a warfighter-relevant outcome such as mission capability rates, in the context of a fixed-price contract, they are highly incentivized to maximize their own resources to obtain the desired outcome.

Also, when working towards achieving the desired performance outcome over many years, companies invest to earn a return on their investment during the life of the contract. Conversely, as is the norm on a one-year sustainment contract, there may be no incentive to invest in gaining better results over time and to expect a financial return on their investment.
That’s the good news. The bad news as stated earlier, is that U.S. military readiness seems to be reaching unacceptably low levels, with several root causes in play.

For one, Congress appropriates annually and prevents, with few exceptions, multi-year contracts — thus it can be difficult to obtain investments from contractors to improve performance over time.

There is also a tacit bias against outcome-based sustainment contracts, even though the Office of the Secretary of Defense’s Better Buying Power 3.0 states that it is the preferred method of sustainment contracting.

There is also a continued misunderstanding of how such contracts can be leveraged by the services to facilitate the 50/50 rule. Core compliance rules prevents optimal sustainment contracting to be provided by the best resource and capabilities.

For a partnership to work effectively, service logisticians are often entirely reliant on their commercial counterparts to deliver the readiness required by the military at a price that reflects sound financial stewardship. On the other hand, commercial sustainment suppliers are reliant on the Defense Department to deliver the profit and return-on-investment metrics their shareholders require. The very often strained and occasionally adversarial relationships between these two mutually reliant parties continues to result in less than optimal outcomes for both the services and commercial industry.

True partnerships typically require trusting, open, transparent and frank dialogue between two organizations that are genuinely seeking solutions that will meet the needs of both parties.

The following are some quotes by Defense Department leaders, as reported in recent National Defense articles. They give an opportunity to quickly identify some biases and misunderstandings that could be addressed.

• “The Pentagon will take increasingly tough negotiating positions.” Comment: That doesn’t sound like a win/win partnership approach.

• “We intend to push contractors into a corner.” Comment: Doesn’t sound like a collaborative trust-building tone.

• “The government will seek to regain leverage.” Comment: Challenging suppliers in a public forum will not likely engender a positive reaction. It is the government, not industry, that writes the contracts and industry predictably responds and reacts to the conditions of the contracts the government writes, rather than industry dictating the contractual conditions.

• “The department will be looking for ways to increase competition in the market.” Comment: Competition is good, but do not forget that the government created the conditions that resulted in a largely oligopolistic defense market. Let’s look to the commercial maintenance repair organizations marketplace to see how robust competition, with alignment of interests, has resulted in a set of strong suppliers who compete fiercely for sustainment contracts resulting in leading dispatch reliability rates and increasingly lower costs per flight hour.

• “The Pentagon expects industry to pour some of those returns [profit] into innovative technology.” Comment: This will be difficult if there is no assurance of return on investment or ownership of intellectual property and likely represents a fundamental misunderstanding of the capital markets.

• “We know companies are trying to protect the interests of shareholders. And we respect that. We expect them to. But we are trying to protect the interests of the United States taxpayers and its military. Sometimes those two interests collide.” Comment: That is an honorable position, and there could be an intersection of interests and no need for collision. Long-term, fixed-price arrangements that acquire outcomes rather than services and materiel is where that intersection of interests may be found.

• “We don’t buy industry’s argument that funding instability deters investment or that the DoD is far more expensive to support than commercial customers.” Comment: Again this seems to represents a fundamental misunderstanding of contracting reality. One only need to look at the regulations, colors of money, annually expiring funds, sequestration, continuing resolutions, time to award contracts and layers of bureaucracy that make the government a challenging customer. Government can learn from commercial airline sustainment procurement and contract award processes to see how it can work successfully.

• “We have to figure out how to energize the supply chain from the bottom up, not from the top down.” Comment: Going around the prime contractor to their second-, third- and fourth-tier suppliers seems to be the antithesis of open, trusting and transparent coll aboration. The best way to energize the supply chain may be to energize the commercial entity the government has entrusted with delivering the warfighter-relevant outcome — the prime contractor.

• “We have to figure out how to de-layer the supply chain. There is a lot to be gained in de-layering 1,300 suppliers. If not, the government is going to help them do it.” Comment: This view seems to demonstrate a fundamental misunderstanding of the capital markets. In Russia and China this can be done because the industry is owned and operated by the government. Despite the problems described here, the United States still has the leading and most efficient weapon systems platform development and sustainment business model globally. This is largely because the defense industry is primarily privatized due to the efficiency of capital allocation and the benefits of what competition can bring.

• “The Pentagon will look to manufacturers to deliver cost reductions.” Comment: As a customer who seeks better value for money spent, this is an honorable goal, but it is a two-way street. Competition will help. Increasing the potential for higher profits by giving incentives to contractors to invest in better performance at lower costs is a good path to follow.

Industry is not without fault. Often cited themes are that some contractors thinking only of their shareholders, possible bad behavior about bidding low and making it up on change orders or possibility of taking advantage of the depletion of acquisition talent and gaining an upper hand in negotiations.

However, the vast majority of Defense Department and industry personnel are hard-working, highly-skilled and want to do the right thing for the military and their country. There are excellent examples of how to reduce costs and improve mission readiness, but industry is having a hard time getting through to the other side. Readiness is a national asset and a geopolitical competitive advantage. Sustainment can be a force multiplier if it is allowed to be. It is worth preserving and strengthening.

The Defense Department is planning to spend on order of magnitude $200 billion this year on operations and maintenance. Perhaps at least half of that could be directly associated with sustainment. Recent studies show that less than 5 percent of that total will likely be spent on arrangements that acquire warfighter-relevant outcomes, which is defined as authentic performance-based logistics, despite their demonstrated effectiveness in improving readiness and driving down cost-per-unit of readiness.

As mentioned earlier, recent government-sponsored studies have demonstrated up to 25 percent cost savings and an improvement in readiness rates close to 50 percent are possible by shifting to outcome-based contracts.

Readiness levels improvements from a nominal 50 percent to 75 percent would provide a huge strategic advantage for the warfighter.

Not every weapon system is a logical candidate for an outcome-based contracting arrangement. Even so, a reasonable estimate is that the department could save $10 billion annually if the percent of spending on authentic outcomes or performance-based contracts were raised from the current estimate of less than 5 percent to a conservative 30 percent of the total. Most importantly, this could significantly improve readiness.

Are those numbers sufficiently desirable and achievable, enough to inspire the nation to do what is necessary to make this happen? Hopefully the collective answer is “yes.” Here are some recommendations that can make this happen.

Understand that performance-based logistics can be used to enable better compliance with Title 10, USC 2466, the 50/50 and core rules, and act to implement authentic contracts. Many of the more than 50 successful performance-based logistics contracts have some form of public-private partnership included in the arrangement. These partnerships are collaborative arrangements between industry and the government where industry is allowed to employ government resources, both property, plant and equipment, plus government sustainment personnel, in return for a cash payment to the government or repayment in kind.

Because one of industry’s most important metrics is return on investment, contractors are highly incentivized to drive down the amount of invested capital required to earn a given level of profit.

One way to do this is to move touch labor from their commercial plants into government depots. Often times, government depot labor rates are less than their commercial counterparts. Industry can deliver better results if contracted on long-term, fixed-price contracts, two key attributes of performance-based logistics that are not present in transactional contracts, with few exceptions.

Another recommendation: continue creative methods of implementing performance-based logistics; despite the constraints, many can be implemented under the current rules. After all, it is stated as the preferred method of sustainment.

In addition, hold departments accountable for implementation, with regular metrics and reporting.

Earlier, the term “authentic performance-based logistics” was included because there are a number of sustainment arrangements in existence that are labeled as such but would struggle to fit the definition. If a non-authentic performance-based logistics contract turns out poorly, it can incorrectly tarnish the effectiveness of an authentic strategy.

In summary, America is the only nation in the history of the world that has been able to place very large numbers of heavily armed warfighters anywhere on the planet and sustain them there in combat-ready condition. This has been America’s geopolitical competitive advantage. It has been an essential part of being able to protect our way of life. ND

Tom Captain is a recently retired vice chairman of a major defense contractor. These remarks were excerpted from a speech delivered at the National Defense Industrial Association’s 33rd Annual Logistics Forum in Tampa, Florida, in April.

Topics: Defense Contracting, Industrial Base