DoD Mulls Changes to Weapons Maintenance Contracts

The Pentagon's top weapons buyer Frank Kendall hammers home to his staff the importance of "incentivizing" contractors to cut costs in every way possible.

One area where he hopes to squeeze significant savings is in weapons maintenance, a $170 billion a year business that is, by most accounts, fraught with inefficiency. 

Kendall, who is undersecretary of defense for acquisition, technology and logistics, has directed procurement officials to investigate commercial-like approaches to maintaining equipment as an alternative to traditional contracts. The commercial method, known as "performance-based logistics," was in vogue in the 1990s but fell out of favor in recent years.

According to the consulting firm Deloitte LLP, the Defense Department could save up to $20 billion a year by switching many of its current support contracts to performance-based logistics, or PBL, arrangements.

Within the Pentagon's $170 billion logistics budget, $79.5 billion is for equipment maintenance, $68.4 billion is for spare parts and supplies and $23.1 billion goes to transportation. PBLs would offer savings of between 10 to 20 percent in the first two areas, Deloitte estimated.

To realize these savings, the Defense Department would have to switch the way it uses carrots and sticks. In a traditional transactional contract, the government pays for products or services delivered. In a PBL contract, a vendor is paid for a pre-agreed outcome that it must provide at a fixed price. For example, a PBL might require that a certain number of aircraft in a fighter wing be available to fly, for a set price per hour. Other PBLs deal with weapon components like sensors or engines. Many foreign militaries use PBLs for wholesale weapons maintenance and for operator training.

Critics of the current system argue that the Defense Department pays far more for equipment sustainment and experiences poorer service than if it used PBL contracts. This criticism, however, often falls on deaf ears. Fewer than 90 PBL contracts are in place today — less than half the number that existed in 2005. Few new PBLs are being pursued, and the military services are choosing to not renew some existing PBLs. Deloitte analysts, who conducted a study on performance-based logistics for the Pentagon two years ago, concluded that government buyers have soured on PBLs because these contracts are complex and not well understood.

Kendall agreed that PBLs can be a steep learning curve. A key struggle for managers is to define performance and determine if the price offered by the contractor is fair. "We will define performance in a way that is relevant to the operational community and reward people for doing a better job," Kendall told an industry conference. "Contract types that are tailored for doing that are the essence," he said. "Our research shows it works in some cases but it doesn't work in cases when people have not written a good contract and haven't enforced that contract."

Kendall suggested that the Pentagon will sign more PBL deals in the future, but it could take time to train the government workforce how to write these contracts. "I'm a firm believer in incentivizing industry. We just have to be smart about how we lay those incentives out."

After a contract is awarded, government managers have to make sure the contractor is living up to the promises, and must punish nonperformers, he said. "Everyone who has a contract ought to be worried about losing that contract next time around. If you are going to do a PBL, you have to do it correctly. You have to define the metrics of success."

Defense procurement experts warn that Kendall might be underestimating the challenge of using performance-based contracts, even if, in theory, they make financial sense.

“PBL contracts have a lot of potential to save money,” said defense budget analyst Todd Harrison, of the Center for Strategic and Budgetary Assessments. “If you do the contract right, it creates better incentives for the contractor.”

The rub, though, is that these contracts demand a considerable level of trust between government managers and suppliers. Defense officials have to let contractors decide how the work should be done, as long as they deliver the performance that was agreed upon, Harrison observed. The government also has less control over the contractor’s profits, which can irk some officials. “If aircraft don't break as much, the company can make more money. Right now, under traditional contracts, we pay contractors every time something breaks,” said Harrison. Contractors make more money the more the equipment breaks down under the conventional contracting system, so there is no incentive for the contractor to invest in more reliable components. “PBL turns this on its head. It gives a company incentive to improve parts. They get paid the same but repair less. … It's a matter of setting up the incentives right.”

Defense Department officials have a hard time wrapping their heads around this, said Harrison, because industry will come to them with a bid price, and the government is not sure if it is getting a good deal. “They want to know the cost, not the price, so they can determine how much profit the company is making,” he said. “The point I would make to the Defense Department is that it shouldn't concern itself with the actual cost, all that matters to you is the price you pay. If the company can deliver the service you want at a price you're willing to pay, who cares what profit margins they're making as long as you're getting what you paid for, at a fair price.”

Another caveat that could stall PBLs is that contractors expect these deals to be multiyear contracts. Companies will not want to invest in improvements that are going to pay off outside the window of their contract. Both the Defense Department and Congress have wavered on the merits of multiyear contracts. They question whether long-term deals promote complacency. The reality is that there is limited competition in the defense market, and the Pentagon has to accept that, said Harrison. The original manufacturer of a weapon system is going to always have a huge advantage. “Especially in highly regulated systems, not anyone can build parts,” he said. If competition is artificially created by allowing vendors to bid based on buying parts from the OEM and selling them to the government, that just adds a middleman. “How's that supposed to save money?” Harrison asked. “When there's a natural monopoly, the Defense Department is better off giving OEMs incentives to lower cost, and long-term incentives.” The Pentagon has to figure out how to pay more for higher levels of equipment readiness and less for lower levels of readiness, and write a contract accordingly, he said.

Al Banghart, senior adviser at Deloitte Consulting LLP, has been working with the Pentagon's procurement office for years, and led a study that quantified the savings that could be wrung from PBL deals. He is seeing signs from Kendall’s office that there is high-level support for PBL contracts.

The recent publication of the “Department of Defense PBL Guidebook” is proof of that, he said. “Until just last month, program offices did not have any substantive tools to help guide them through the PBL deployment process,” said Banghart. “Today, as a result of inside-the-Beltway actions, they have a professional guide/workshop manual.”

Training the workforce on PBLs is “critical,” he said. “The performance-based strategy is substantially different from contemporary logistics practices. It is more complex, and it is not intuitive.” In addition to classroom training, procurement professionals will need to be involved in actual PBL contract negotiations and executions before they become comfortable, he said.

Contractors that intend to play in the PBL arena also have to make major investments, said Banghart. First they must invest in the personnel resources and time to work with the government to establish a performance based arrangement, he said. The costs to industry to bid on a PBL arrangement are higher than going after a single transactional contract. But over the life of a weapon system, transactional logistics require hundreds and often thousands of contract actions, whereas systems maintained under PBL arrangements will have just a handful. “By itself, the elimination of the bureaucracy associated with legacy transactional logistics contracting make PBLs a desirable option,” he said.

Suppliers also have to drive down costs in order to boost profits, said Banghart. Commercial firms do this in two primary ways: improving equipment quality to minimize the number of repairs required and adjusting repair production lines processes to make them more efficient. “And oh, by the way, this is exactly what the government wants industry to do,” he added.

A potential obstacle for PBLs is that many government officials do not trust contractors, and are wary of over-privatization. “There's a debate within the Army about contractor logistics support,” said Lt. Gen. Raymond Mason, Army deputy chief of staff for logistics. “Where's the right balance?” he asked. “In some cases, our assessment is that we have gone too far contracting out certain skill sets and capabilities.” The Army has a huge stake in the logistics market because it owns several major maintenance depots, and it has to worry about keeping them viable, without necessarily competing with the private sector, said Mason. “We want to specialize in certain areas in our depots, not duplicate,” he said. “We have to have a cultural change for greater cooperation with industry. The problem is we have commanders who want to keep contractors at arm's length because they are concerned about political and legal issues,” he said. “I don't have a perfect solution for that. It's education.”

One industry executive who asked to not be quoted by name said he is skeptical about the future of PBLs. While Kendall officially endorses this approach, his influence might not trickle down into the lower tiers of the procurement bureaucracy, where government-industry relations are a bit more tense. “Extended contracts needed to make PBLs work conflict with Pentagon policy for shorter contracts to increase opportunities for competition,” the executive said. He said Kendall’s strong emphasis on competition is “anathema to PBL, which depends on trust and partnership to work.

Without a strong champion in the Pentagon, acquisition professionals have little incentive to take on PBLs.”

Topics: Business Trends, Doing Business with the Government, Logistics, Manufacturing, Procurement