Pentagon’s Strained Relationship With Vendors Getting Worse

By Sandra I. Erwin

Like many Pentagon contractors, Robertson Fuel Systems prides itself on its long history of selling hardware to the U.S. military.

But the company says it is now on the verge of exiting a presumably lucrative market because the burdens increasingly are outweighing the benefits.

Robertson makes auxiliary fuel tanks that are installed in helicopters to extend their range and endurance. The company has sold the tanks to the Defense Department for nearly four decades, and it is now questioning whether it should continue to bid on military deals following the adoption in recent years of stringent contracting policies.

The Defense Department had previously purchased the fuel tanks as commercial commodities that are sold on the open market. Over the past couple of years, the Pentagon determined that the fuel tanks do not fit its definition of “commercial” products and therefore the Defense Department has to conduct a full audit of the company’s expenses so it can verify that it is not being overcharged.

Companies such as Robertson, which design and manufacture products at their own expense, see these cost-accounting demands as unwarranted government overreach. They contend that the Defense Department has plenty of other means to verify whether a price is fair without examining a company’s internal costs, particularly when none of the products in question were built, tested or qualified at taxpayer expense.

When major defense contractors design and produce military-unique equipment with Pentagon funding, they are subject to cost auditing under federal procurement regulations. Companies that predominantly do business with the government employ armies of accountants and procurement specialists whose sole job is to produce “certified cost and pricing data” and respond to contracting officers and auditors’ questions. That cost is counted as overhead expense.

Commercial companies, conversely, are not organized to comply with government auditing. Standing up a cost-accounting compliance operation, commercial firms contend, would saddle them with extra costs and would drive up the prices they charge for products, thus undermining their ability to compete with leaner suppliers.

Pentagon officials defend these contracting policies as necessary to prevent price gouging. Still haunted by past procurement embarrassments like $600 toilet seats and $800 coffee pots, the Defense Department prefers to err on the side of caution.

This month, the Defense Department’s inspector general reported that the Army Contracting Command overpaid up to $3.3 million for communications equipment from Datron World Communications Inc. The Army bought the equipment for the Afghan National Security Forces. “This occurred because the contracting officers did not verify that proposed prices were fair and reasonable in accordance with the Defense Federal Acquisition Regulation,” the IG said in a July report.

The Defense Logistics Agency also was called out for paying excessive prices for commercial aviation spare parts made by Bell Helicopter. In this case, the IG said the contracting officer did not perform an adequate analysis of commercial parts, and used the previous purchase price without performing historical price analysis. DLA potentially overpaid Bell about $9 million on 33 of 35 sole-source commercial spare parts reviewed by the IG.

Confronted on this issue by members of the House Armed Services Committee July 10,  the Pentagon’s top weapons buyer Frank Kendall said the IG findings are an “ongoing and difficult problem to address.”

How to buy commercial items at fair prices has been challenging, he said, because many contracting officers might not be trained or skilled at pricing.

Even within the Pentagon, agencies disagree on what constitutes a fair price. The Defense Logistics Agency vehemently disagrees with the IG findings that the agency overpaid Bell Helicopter. DLA insists it paid less for parts than Bell's commercial customers. The agency "successfully negotiated a 35 percent discount off Bell's commercial price list,” DLA spokeswoman Mimi Schirmacher said in a statement to National Defense. The current contract requires a further reduction in DLA's price if a commercial customer is charged a lower price for the same item, she said. “The prices on this contract were determined fair and reasonable in accordance with current regulations for buying commercial items.”

Kendall said managers are encouraged to negotiate the best possible deals and to ensure contractors do not overcharge. But he conceded that demanding certified cost and pricing data might be counterproductive. “Our policy right now is fairly flexible. It says that the government can rely on commercially established prices for commercial products.” If the price is not found to be acceptable, the government can request certified cost and pricing data, which is a “very high requirement for people to meet, and which commercial companies normally are not in a position to provide,” said Kendall. “So that puts a burden on industry.”

Kendall recognizes that these demands on suppliers could drive some out of the defense market. “I have had companies, large companies who do a lot of commercial aerospace work, for example, say they will walk away from DoD business if they're forced to put certified cost and pricing data on all their commercial products,” he said. “It's just too big a burden for them, and the business isn't worth it to them.”

Short of auditing the company’s costs, there are other ways to verify prices are fair, Kendall said. “If there's an off-the-shelf product that meets our requirements, we do an analysis of the business environment.” When a product is widely sold, the market is efficient at setting the price, he said. “Where we get into trouble is with things that are kind of on the margins, where there may be a modified commercial product that even though it may be sold through a GSA catalogue, it's really unique.”

It has been difficult for the Pentagon to strike a balance between accepting commercial prices and doing due diligence to make sure those prices are reasonable, said Kendall. “We need some way to determine it's a fair and reasonable price. It doesn't have to be fully certified cost and pricing data.”

Kendall’s take on the issue should please executives like Owen Paepke, who is director of strategic planning at Robertson Fuel Systems in Tempe, Arizona. In the contracting trenches, government officials are not always willing to see both sides of the coin, Paepke said. Relationships between vendors and procurement officials have rarely been more adversarial, especially over questions of pricing and of what constitutes a fair profit for the industry.

Robertson’s fuel tanks fit the definition of a commercial item that Congress instituted in 1994 when it passed the Federal Acquisition Streamlining Act, Paepke said. But starting about two years ago,

Defense Department officials started questioning the proposed prices and demanded to see the company’s cost data. “That’s a big problem for a company like us, where cost is embedded in the development of new products, testing and qualification expenses.”

Under the rules, the Pentagon would pay for the production cost, plus a negotiated profit margin, but the company would get no credit for the research and development investment, he said. “Why would we ever develop another system for the U.S. military under the current situation?”

The Defense Department contends that Robertson’s fuel tanks are sold only to government buyers, and therefore it cannot treat them as commercial items. The company counters that the tanks are commercial in nature because they were developed with internal funding and have been sold over the past 25 years to defense contractors like Boeing and AgustaWestland as well as to foreign governments. “That is a huge pricing history,” Paepke said. “How plausible is it that all those buyers were overcharged?”

The government dismisses all this as irrelevant, he said. “They claim it does not meet the criteria for a commercial sale.”

Robertson executives, many of whom are military veterans, are disappointed, Paepke said. “We were always friends [with the Defense Department]. Now it' s turning into an adversarial relationship.”
If the government decides it will not buy Robertson’s products unless it has certified cost data, the company might have to walk away, he said. “Our business is very much on a commercial model. We develop products at our own expense and our own risk.” Allowing the government to audit internal costs, he said, “requires a great deal of overhead and expense and inefficiency to track your costs in specific projects.”

Contracting officers, although aware that the company developed the product at its own expense, will demand cost data even if the market price is always the best indicator, he said. “The issue is bubbling up. Industry will have to decide whether it can live with this guidance or not. We are not going to reinvent the company around one customer.” For Robertson, it would be “very painful to lose the U.S. military as a customer. … But policy makers are not considering our business model.” Large defense contractors, like utilities, have a business model that is based around cost, plus single digit profit margins. Commercial companies, he said, cannot operate that way.

Industry experts worry that the Defense Department’s zealous approach with commercial vendors might do more harm than good. “We never faced anything like that before,” said Jonathan L.

Etherton, industry consultant who served as a staff member of the Senate Armed Services Committee and helped write the 1994 federal procurement legislation.

The Defense Department has tried to open the market to commercial items over the years, but its interpretation of what is truly a commercial item has varied, Etherton said. “They're really narrowing what they consider to be a commercial item in ways we haven't done in the past,” he said. “The law itself has a broad definition. There's a lot of discretion there,” he added. “The intent of Congress was to have an open approach to commercial technologies.”

There are several techniques for determining price reasonableness, but the Defense Department often does not use them, said Etherton. Increasingly more companies are told they have to provide certified cost data for products that were developed with private funds. If these companies leave the market, it will undermine Defense Department efforts to recruit vendors that can supply innovative technology developed at their own expense, he said. To their credit, senior Defense Department officials under Kendall have “made a real effort to meet with companies and discuss commercial acquisitions,” Etherton added. “They're taking the issue very seriously.”

In the day-to-day procurement business, meanwhile, tensions are not likely to ease, industry insiders said, as there are deep-seated animosities between procurement officials and contractors.

A cultural gulf exists because government officials do not always understand the motivations of the private sector, said Mack McKinney, of Solid Thinking Corporation. The North Carolina-based company provides training courses on government procurement.

“They teach contracting officers that contractors only care about profits, that they don't care about the country, and that's not true," he said. The changing demographics of the Defense Department workforce also are a factor, as hordes of experienced managers retire and are replaced by largely inexperienced workers. The less experienced managers will impose every restrictive federal acquisition regulation clause they can think of to try to protect themselves from contractors overcharging, said McKinney. “Attorneys have created this adversarial environment. And contracts reinforce that.”

Topics: Business Trends, Doing Business with the Government, Procurement, Acquisition Reform, Defense Department

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