Pentagon, Contractors Clash Over Profits

The pressure is on at the Pentagon to bring down the cost of military hardware. The dictum from acquisitions chief Frank Kendall is that “unaffordable” programs will be axed.

As expected, the scramble to slash costs is fueling tension and finger pointing between government officials and contractors. In a budget climate where the future is uncertain, relations between buyers and sellers appear to have hit rock bottom.

A sense of distrust from both sides was on display during a recent industry conference when Air Force Maj. Gen. Wendy Masiello, deputy assistant secretary for contracting, suggested that companies are making too much money on defense work and that some of that wealth should be returned to the taxpayers. After one industry executive asked her to elaborate, Masiello responded: “I’m not looking at taking money out of your pocket. But I have an obligation to make sure that what I’m paying is a fair and reasonable price.”

The Air Force is in a fiscal straightjacket. This year alone, it is more than $12 billion short of what it needs to pay its bills. At the same time, as Masiello noted, “Every day we read in the paper that the defense industry is still doing pretty well financially. … We have to figure out how to get a share of that.”

Masiello has ruffled feathers in industry circles for questioning some of the Air Force’s long-term contracts for the maintenance of weapon systems. She has challenged contractors to disclose their financial data so the government can see exactly how much money a company earns from a deal. Some firms find that level of scrutiny excessive, as long as they are delivering the products and services the government is seeking at agreed-upon prices.

Kendall and other senior Pentagon leaders have frequently reassured industry CEOs that there is no “war on profits.”

But the tension is palpable. In today’s contracting world, there is little trust in negotiations, said Lt. Gen. Charles R. Davis, the Air Force’s top military acquisitions official. “We are all focused on trying to shift the risk somewhere else,” he said. “We are often very suspect of each others’ motivations. When money was flowing freely, there was less pressure on government program officers to squeeze industry for a better deal. Things are different now.”

Davis clearly gets the irony of being a U.S. military officer who is challenging corporate profits.

 “These are wonderful elements of capitalism that we [the armed forces] try to defend every day,” he said at a conference hosted by Credit Suisse and McAleese & Associates.

Davis suggested there should be a better way to protect the collective interests of government and industry. But nobody has yet come up with a winning strategy for how to do that.

In the face of a shrinking bank account, Defense Department contracting officials are becoming unhappy with contractors who seem to have figured out ways to make more profit than the government thinks they should.

“I need to understand the cost and the resulting profit,” Masiello said. “It’s a little scary that we’ve never had that kind of insight. It can be a little threatening that they figured out how to make a lot more money and return on that investment than the government might have been reaping in that process.”

As Masiello spoke, she raised eyebrows in the audience. “That is not how free enterprise works,” whispered one executive.

Although the idea that a highly regulated defense industry is a free market might be a stretch, companies believe that they should be given incentives to make money, and that corporate efficiencies are ultimately returned to the customer via lower prices.

Masiello said she understands that concept, but she is still not certain that the government always gets a fair shake. “You are trying to make more profits and be more efficient. I want a little bit of that cut.”

The Pentagon’s latest procurement policy guidance, called Better Buying Power 2.0, might have unintentionally stirred up acrimony by recommending that buyers use, whenever possible, fixed-price contracts, which force the vendor to agree to a price upfront and absorb any future cost overruns. Such deals seem like a sure win for the government, but their misuse can backfire. The Pentagon has seen a hit parade of failed programs, including the infamous A-12 bomber, that were set up as fixed-price deals.

Following the release of BBP 2.0 and a subsequent uproar from industry, Kendall sought to roll back the emphasis on fixed-price contracting, in favor of agreements that provide incentives for industry to lower costs and that make sense for the particular product or service.

In another high-profile case of Pentagon buyers publicly shaming contractors, Lt. Gen. Christopher C. Bogdan, program executive officer of the Joint Strike Fighter, made worldwide headlines when he accused prime contractors Lockheed Martin Corp. and Pratt & Whitney of not helping him bring down the JSF’s spiraling price tag.

Bogdan later noted that he had spoken out of frustration and that, following some blunt discussions with senior company executives, he had confidence that the contractors were moving in the right direction. But Bogdan made it known that it was not until the government forced Lockheed to bear more risk that the cost and schedule trends started improving. In the latest low-rate production contract for JSF, the Pentagon is holding Lockheed responsible for 50 percent of the overruns. “Guess what happens when a contractor’s skin is in the game? Things improve magically sometimes,” said Bogdan.

Frank Cappuccio, a defense industry consultant and former executive vice president of Lockheed Martin, recalled a time when the Pentagon and contractors had a friendlier rapport. He noted that under the contract the Air Force signed with Lockheed for the maintenance of the F-117 stealth fighter, the company agreed to split the extra profits with the government. “I do believe the U.S. government and defense industry have to form a partnership,” he told National Defense. “But I think it has to be a valid partnership” where the risk is borne by both in an equitable way.

What is happening now, he said, is the government wanting to have it both ways with fixed-price contracts: If industry makes money unexpectedly, the Pentagon wants part of it. But if contractors overrun, it is too bad for them.

The key is to negotiate upfront, he said. Companies are not going to voluntarily surrender profits if it’s not written in the contract. “Once industry is given an incentive to save, they find a way to do it.”

Given the charged atmosphere today, the prospect of closer partnerships appears dim.
“We are trying to not get entrenched into an ‘us-versus-them’” stance, Masiello said. “But we are all faced with this budget environment.”

Topics: Defense Contracting, Defense Department, DOD Budget, Procurement