Industry and Government Butt Heads Over Weapons Maintenance Contracts

The Army’s Abrams main battle tank was introduced in 1980 and its projected retirement is in 2050. The Humvee combat truck began service in 1984 and will stay in the fleet until 2040, as will the Air Force’s B-52 bomber that first flew in 1955.

Cold-War era weapon systems are a mainstay of the Pentagon’s inventory, and could be around even longer than expected if the military is unable to replace them.

Repairing and maintaining decades-old inventory has been big business for the defense industry, and will continue to be despite funding cuts that will hit the Pentagon over the next several years. Industry analysts estimate the Defense Department will be spending about $90 billion a year on “sustainment” of equipment, and nearly $70 billion more on spare parts and logistics support.

How the Pentagon will manage that large pot of money is now the source of contentious debates within the office of the secretary of defense and the military services.

The Pentagon’s new procurement policy, known as “Better Buying Power 2.0,” calls for more efficient use of tax dollars, and endorses the concept of “performance-based logistics,” or PBL, as a mechanism to lower the cost of weapons maintenance. Defense contractors strongly favor the use of PBLs because they provide long-term work and create incentives for suppliers to cut costs. Under a PBL arrangement, a contractor will agree to provide a certain “outcome” for a pre-negotiated price, rather than get paid for individual products and services. If the PBL is for tank engines, for instance, the contractor would be held accountable for ensuring that a certain number of engines are available at any given time.

The Defense Department, however, has not warmed up to PBLs. Only 5 percent of the military’s maintenance work is performed under such deals. About 87 PBL contracts are in place today, compared to more than 200 in 2005. Critics assert that these arrangements do not give the government sufficient visibility into contractors’ true costs and create a monopolistic market dominated by a few large firms.

These philosophical differences are palpable and have polarized the logistics community.
Managers who oversee the Defense Department’s 17 major logistics depots, which cost the Pentagon $32 billion a year to operate, also worry that PBLs disproportionately favor the private sector. By law, the Pentagon must assign 50 percent of its “core” maintenance work to public depots, but the rules for such allocation are fuzzy and subject to interpretation.

A factious business environment is not unusual during times of declining budgets, says Nick Avdellas, a Pentagon adviser and program manager at LMI, a nonprofit consulting firm.
The war drawdown means there will be less money for combat-related equipment repairs and upgrades, he says. “Sustainment funding will probably be smaller and will have to be managed more efficiently.”

PBL supporters point to studies that show that the government could save 10 to 20 percent by shifting more maintenance work to performance-based deals. The jury is still out, Avdellas says. “We should always pay for good performance and good outcomes. That’s the wisdom behind PBL arrangements,” he adds. “Those have been very effective.” Regardless of who does the work, he says, contract awards should be based on performance.

At the root of the problem is a basic disagreement about who should bear more “risk,” says Joe Chenelle, managing director at Accenture, a global management consulting firm.

Risk is a huge concern in the defense logistics business, he says. Contractors worry that if they bid too low, they will lose money so they price the work to compensate for the risk they take.

In PBL contracts, industry is making an educated gamble that it can meet the responsibility and make a profit. “With a PBL, the military doesn’t have to stock excess or wrong inventory,” Chenelle says.

But many Pentagon buyers are uncomfortable with that approach. They become suspicious that suppliers are making excessive profits.

Government managers tend to favor price-based awards that reward the lowest bids, he says. A performance-based deal is more complex as other factors must be weighed besides price. Such arrangements are common in the commercial world, Chenelle says. “Corporations will try to create win-win situations.” Government contracting could benefit from greater collaboration and from not placing unrealistic expectations on buyers and sellers, such as unlimited liability, he adds.

Chenelle sees a deteriorating government-supplier relationship. “It’s usually about shifting the risk to the other party.” In the weapons maintenance world, contractors usually believe the government is trying to lay on suppliers the responsibility to forecast challenges that vendors do not have the visibility to predict correctly, he says. At the same time, government tries to shift liability to the contractor. “Without access to the right information and scope, the contractor feels it can’t place an effective price,” says Chenelle.

Major corporations have supply-chain relationships down to a science, he says. “It’s about having the right incentives. … Apple, for example, provides suppliers access to technology and exclusive relationships based on performance.”

Unlike commercial firms, the government cannot have an exclusive relationship with a supplier in perpetuity but can award long-term deals such as five-year base contracts with one-year options. The smart approach for the government, says Chenelle, is to move away from cost-plus arrangements — where the government bears all the risk — and from lowest-cost bids, in favor of fixed-price, performance based deals.

The Pentagon has a poor track record managing big weapons projects, he notes. Programs fail not because of technical challenges, but because of bad governance and leadership.
In times of declining budgets, the Pentagon needs to do a better job forecasting its future weapon maintenance needs and sharing that information with suppliers, says Jeffrey Miller, vice president of defense supply chain solutions at Accenture.

“The Defense Department is awash with data,” he says. The challenge is exploiting that data to make accurate projections of future requirements for spare parts and other maintenance needs. In cases when defense managers and suppliers have valuable data, they are hesitant to share it, Miller says.

“It may expose weaknesses on both sides that neither side wants to disclose,” he says. “If you haven’t been forecasting accurately, there are enormous costs in inventory.”

Not knowing the other guy’s cards makes PBL-like arrangements more difficult, he says. “In a lot of PBLs the government doesn’t truly understand if it’s cheaper.” If the Defense Department opened up its data vaults to industry, Miller says, contractors could be a lot more efficient.

Allan Banghart, defense supply chains lead at Deloitte Consulting, conducted a Pentagon-funded study to determine whether PBL contracts were saving the government money. Deloitte examined 21 programs and concluded that 17 had improved performance and lowered costs over time.

“Claims about the strengths and weaknesses of PBL have usually been based on emotionally charged anecdotal evidence and opinions, rather than facts,” Banghart writes in Defense Acquisition and Technology, a government journal.

A conservative estimate, he says, is that PBL saves 10 to 20 percent per year.

In an interview, Banghart predicts a turnaround in the use of performance-based contracting. “Two years ago, there was a lot of negative conversation about performance-based logistics,” he says. “A number of senior folks were not convinced PBL could deliver the cost results that the business model predicted.” The findings of the Deloitte study have helped to change many leaders’ minds, he says. “We are not seeing the resistance that we saw in the past.”

While senior Pentagon officials support PBLs, the resistance occurs at the working levels. Procurement managers are wary of awarding contracts that are not transaction based, says Banghart. “The organic workforce needs to make the transition from doing legacy transaction logistics to performance based logistics.”

Change could take a long time because the workforce has to be retrained, he says. Deloitte consultants are advising Sue Dryden, deputy assistant secretary of defense for materiel readiness, on how the Pentagon could best apply PBL contracts in the future. 

“We are looking at all weapon systems,” says Banghart. “The services are expected to go after platforms that have the highest maintenance cost and the worst performance problems,” he adds. “We are going to recommend the services tailor PBLs to go after the heavy hitters first.”

Because these contracts are complex to develop and manage, they work best when they are applied to narrowly defined components — such as engines, landing gear and electronics — rather than an entire weapons system, he says.

The Army recently awarded Lockheed Martin Corp. a $90.6 million PBL contract for the sustainment of the sensor-targeting system of the Apache helicopter. It is the first of three options, with a four-year contract value of $375 million.

Current negotiations over the maintenance of the Air Force C-17 cargo aircraft’s engine, however, confirm the Pentagon’s continuing doubts about PBLs.

Engine manufacturer Pratt & Whitney has maintained the entire inventory of 1,100 F117 engines under a PBL contract for nearly 15 years. The Air Force is now seeking to re-compete the work but is considering changing the contract from performance-based to a traditional pay-per-transaction arrangement.

Company officials over the past year have sought to make a case that transaction-based contracting would be a bad deal for the government. 

“PBL is more effective at aligning the customer’s goals with the contractor’s goals,” says Mark Buongiorno, director of domestic and aftermarket business development at Pratt & Whitney Military Engines.

The company’s current contract, which runs through the end of fiscal year 2014, provides “guaranteed engine availability” for a fixed price, he says. “We are inherently incentivized to improve the reliability of the product,” he says. “Over the time frame of this contract, we eliminated 1,000 shop visits.” Approximately 150 engines are overhauled each year.

When Pratt & Whitney’s contract option is up in 2014, the Air Force’s logistics center at Tinker Air Force Base, Okla. — which oversees all Air Force engine maintenance — is expected to solicit bids based on a fixed price per overhaul, rather than a readiness standard.

Buongiorno says the transactional approach does not benefit the government. “Inherently what that does is change the motivation,” he says. “Our motivation has been to keep engines in the wing and avoid the shop. Under this competition we would be paid per shop visit.”

The Defense Department’s ambivalence about PBLs is understandable in today’s environment of shrinking funds, Banghart says. But considering the data show performance-based contracts reduce costs, it would be foolish for the government to not adopt them more widely, he says.

Maintenance dollars will decline, sooner rather than later, he says. With a growing inventory of aging weapons, defense leaders have to decide if they are going to continue to do business as usual or try to embrace a better business model, Banhart says. “The budget crisis should serve as an incentive to use better business practices.”

Photo Credit: Air Force

Topics: Business Trends, Manufacturing, Procurement