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Pentagon Seeks New Weapons to Combat Waste in Contracting
By Sandra I. Erwin

It’s been the accepted wisdom in defense contracting that incentives — such as award fees and performance-based payments — motivate suppliers to cut cost and meet schedules. Defense Department analysts suggest in a new study, however, that traditional incentive contracting does not always work as intended and that the Pentagon needs to use other methods to cut waste from weapon programs.

Defense Department analysts have crunched loads of data from hundreds of major weapons programs and found little statistical correlation between industry profit margins, and program performance in cost and schedule. “Not all incentives work,” noted Undersecretary of Defense for Acquisition, Technology and Logistics Frank Kendall in the 2014 annual report on the performance of the defense acquisition system.

Kendall said incentive-type contracts are central to the Pentagon’s efforts to control rising costs and stem schedule delays in programs. “But we don't always employ those incentives as effectively as we could,” Kendall said June 13 as he unveiled the report at a Pentagon news conference.

In some cases, he said, incentives are “not effective at all. In other cases, they even appear to be counterproductive. So we've got to look at that carefully and try to do better there.”

Kendall’s latest report card on defense acquisitions comes at a time of growing political and fiscal pressures to turn around poor performance in the Pentagon’s annual $300 billion in contract awards.

According to Congressional Research Service analyst Moshe Schwartz, Pentagon development contracts since 1993 have experienced a median of 32 percent cost growth — not adjusted for inflation. Since 1997, 31 percent of major defense acquisition programs have had cost growth of at least 15 percent. Schwartz observed that every year between 1996 and 2010, the Army spent more than $1 billion on programs that were ultimately canceled.

Kendall insisted that, as a result of a major effort to improve contracting known as “better buying power,” the Pentagon expects to see a turnaround. Contractor incentives are key to this initiative, he said. “I've got a number of things going on to improve incentives across the board for using contract types more flexibly and trying to use the appropriate contract types, and I think we're having some success with that.”

To make this happen, procurement officials have to learn to identify what contract incentives work best with specific products or services being acquired. “I think we've done a lot to educate the workforce and train the workforce to be thoughtful and creative and think critically about the right type of contract to use and the right incentives to put in place,” Kendall said. “We need to make sure we're aligning profitability with good performance and not bad.”

While it is generally assumed that the government benefits from fixed-price contracts, versus “cost-plus” deals where the government agrees to pay for all expenses, the reality is more complex. “Cost-plus versus fixed-price” is a red herring, the Pentagon report said. “The distinction between cost-plus and fixed-price contracts is not the divide on effectiveness. Rather, the emphasis should be on matching incentives to the situation at hand instead of expecting fixed-price contracting to be a magic bullet.”

Fixed-price contracts have lower costs because they are used in lower-risk situations, not because they control costs better, the study said. Prices on fixed-price contracts are only “fixed” if the deliverables remain static, which is often not the case. “Our analysis showed that objectively determined incentives were the factors that controlled costs, not selecting cost-plus or fixed-price contracts.” Fixed-price agreements provide vendors a strong incentive to control costs, especially in production, the study said. “However, taxpayers do not share in those cost savings, unless the negotiated price took into account actual prior costs and margins, as well as the contractor’s anticipated ability to continue cost reduction.” To use fixed-price contracts effectively, Kendall stressed, “We must fully understand actual costs when negotiating subsequent production lots.”

A competitive marketplace also is a centerpiece of the Pentagon’s better-buying effort. But Kendall recognized that, as the defense budget shrinks and the industry consolidates, it is not realistic to expect multiple competitors in every program.
“We continue to try to promote effective competition,” he said. ‘We are not increasing our level of competition, direct competition, and I'm disappointed in that. I think that's partly the result of the budget situation we're in.”

The data show that, when the government gives sole-source awards and there is no competition, “we get less effective results than when we have just the threat of competition. … If you're worried about losing your business, you're going to work a little bit harder to make sure that you hang on to it. And that's the result that we're after. So that's what we mean by a competitive environment.”

Motivating contractors, the report said, requires an understanding of industry’s compensation system, such as cash bonuses, stock options and stock values. “We fully expect profit and fee earned on contracts to have some effect on motivating industry performance, but we recognize other market incentives are also at work.” Analysis of prime contractors in the last decade, the study said, found that realized profit and fee levels — expressed as margin percentages of price or cost, respectively — were not generally contingent on performance. Cost, price and schedule growth were not linked statistically to final margin.

As part of a new initiative designed to offer positive reinforcement, the Pentagon will publish a list of “superior suppliers.” Navy Acquisition Executive Sean Stackley came up with the idea, Kendall said. “One of the other things we're doing to incentivize industry is to start recognizing our better performers,” he said. “We decided to give the Navy the opportunity to do a pilot program in that area.” The other services will be asked to join.

The Navy’s highest rated suppliers include General Dynamics Combat Systems, General Dynamics Marine Systems, General Electric Aviation, Lockheed Mission Systems and Training, MHSCo Sikorsky Lockheed Partnership, Northrop Grumman Aerospace Systems, Raytheon Integrated Defense Systems, Raytheon Intelligence, Information and Services and Rolls-Royce Defense Aerospace.

They were selected based on the Navy’s existing evaluation system, called CPARS, (contractor performance and appraisal review system). The CPARS is "well understood and we don't expect too much debate,” Stackley said at the Pentagon news conference.

“Public recognition is a very strong incentive,” he said.

Kendall added that he expects the list to “shift around” over time. “I think people will respond. I think the people that will respond the most are the people in the bottom tier, frankly. People that want to get out of that tier, and that's -- that's exactly the kind of behavior we want to see from people.”

Being on the “superior performer” list, though, does not necessarily give a supplier a leg up in competitions, Kendall said. “We want our competitions to be fair, and we didn't want this to influence source selection. So this is largely about past performance, not future performance.”

Chart credit: Defense Dept.


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