The Budget Crunch, Fixed Price Contracts, and Lessons of the Past

There are  two general types of government contracts: fixed price and cost reimbursable. The key difference between them is their allocation of cost risk. Under a fixed-price contract, costs over the fixed price are borne as “red ink” by the contractor. However, because cost contracts are used when the work cannot be predicted with sufficient confidence to support a fixed price — typically involving complex, sophisticated, emerging systems — the contractor stops work when the funds are exhausted. The government can always decide to fund the cost growth, but in that event the contractor receives no added profit for the unanticipated costs it incurs.

Cost reimbursable contracts are a favorite target of politicians, who lament shameless cost overruns and declare that it is time to do away with cost-plus contracts. And that is precisely what the Obama administration has tried to do, with a presidential memorandum, an Office of Management and Budget memorandum, and revised procurement regulations uniformly criticizing cost-based contracting as high risk, wasteful and inefficient.

As a result, fixed-price contracting now is the strongly preferred approach, and administrative barriers have been erected to deter contracting professionals from using cost-based contracts.

The shift is an easy sell in the public’s eye. Contractors make convenient scapegoats, and fixed prices sound like an easy way to help alleviate the budget crisis.  

The government tries to defend its policy shift on the ground that cost-based contracting is unnecessary when a federal agency is sure of what it wants. And therein lies the rub, because the government rarely knows what it wants with sufficient specificity to support reasonable fixed prices for evolving, complex or sophisticated products to be delivered years later.  

Ask anyone who actually understands the process what can go wrong when agencies forget that fixed-price contracts are ill-suited to research-and-development efforts or to the production of something that has yet to be developed.

Although a fixed-price contract guarantees the government only what it actually bargained for, government buyers always want more. The results of development done concurrently with production will not match the fixed-price assumptions. Agencies will apply improper acceptance criteria, which ends up generating needless rework. Information and equipment promised by the agency fails to materialize on time. Congress fails to make funding available on time to support the fixed-price schedule.

This has all happened before.  The C-5A cargo aircraft for the U.S. Air Force nearly bankrupted Lockheed; the A-12 naval bomber never flew and resulted in marathon litigation. The Navy’s F-14 fighter, the Spruance destroyer, and the 688 class submarine were all ill-advised fixed-price programs that did not work out as planned. Recently, the Air Force purchased its new generation of tankers on a fixed-price basis. The result so far is that, in year one, the contractor is already forecasting a half-billion dollar overrun.  

The latest federal fascination with fixed prices will end like the others, i.e., badly — with delayed fielding of the products, contractors deeply damaged by inadequate cash flow, increased claims and litigation, and focused “bail outs” in which the government decides which of the wounded contractors deserves triage.

It has happened before. It will happen again. It is only a matter of time.

John Chierichella is a partner in the international law firm of Sheppard, Mullin, Richter & Hampton LLP.

Topics: Defense Department, DOD Budget