Pentagon Will Demand 'Fair Prices' From Commercial Vendors

The Defense Department spends $60 billion a year — nearly a third of its annual purchases — on everyday products sold in the open market by commercial companies. It also buys items that are not sold to the general public and fall into the narrower category of "commercial of a type."

Determining whether "of a type" products are being fairly priced has become a thorn in the side of Pentagon procurement officers, and has made negotiations with contractors increasingly contentious. Government officials are pressing vendors to provide detailed justification for their prices, and suppliers view these actions as intrusive and unwarranted.Some are contemplating whether to exit the military market.

Director of Defense Pricing Shay D. Assad says these complaints are a "smokescreen" that distracts from the real issue, which is that some vendors are abusing commercial "of a type" contracting and are overcharging for their products.

"Our policy is simple," Assad tells National Defense. "If you have a market based price that can be substantiated through sales in the commercial marketplace, we pay what the market pays."

While that sounds straightforward enough, things can get messy in the contracting trenches. Companies that develop high-tech products and customize them for the defense market, for instance, argue that their offerings are commercial because they were funded by the private sector. But unless they can document that the products were sold in the commercial marketplace and at what prices, the government is not satisfied that it is being charged a fair price.

In the 2014 National Defense Authorization Act, Congress mandated that the Pentagon provide clear guidance regarding commercial items. Assad has updated those guidelines, and they are now being reviewed by Undersecretary of Defense for Acquisition, Technology and Logistics Frank Kendall.  

"There are thousands of contracting officers in the field right now who do not believe they have gotten a good deal" from vendors over the past several years, Assad says. "So they are starting to challenge." Contracting officers across the military commands, he adds, believe they need to get a "better deal for the taxpayers."

The government is going to press vendors to provide foolproof evidence of what the market pays for the product, Assad insists. And vendors often cannot provide it in a satisfactory manner.

Contractors have raised hackles about what they regard as arbitrary application of existing laws that encourage the Pentagon to buy commercially available products instead of paying a traditional defense contractor to develop customized systems. They contend the Pentagon is driving a hard bargain by demanding "certified cost and pricing data" from commercial vendors as justification for their prices.

Manufacturers that for years have sold spare parts to the Defense Department under commercial deals have questioned why the Pentagon is changing their contracts to "military unique," even though nothing about the product, service or basis of pricing has changed. If the government determines that the company's commercial historical data is no longer valid, these suppliers say, it demands "certified cost and pricing data." Industry considers this impractical or even impossible because commercial products and services were developed under commercial rules and accounting systems. Most commercial firms cannot comply with accounting standards demanded by federal contracting regulations.

Assad pushes back on these claims. Defense contracting officers only ask for certified cost and pricing data from commercial companies as a last resort, when all other options have been exhausted. "The idea that we somehow don't know how to buy commercial things is fiction," he asserts. "The issue for us is when a company sets a price that it can't substantiate as a market based price, with no justification."

The Pentagon has no problems dealing with the vast majority of its commercial vendors, Assad says. The friction occurs within a narrow sector of the aerospace industry, "about 20 companies," that are unhappy about the government challenging their prices, he says. "This is not a massive [industry-wide] issue."

Based on feedback he has received from many of the Pentagon's 27,000 contracting officers, Assad believes the real reason for vendors' frustrations is that they are losing leverage in their negotiations with the government. In the spare parts business, it is not uncommon for defense agencies to pay whatever price is quoted to them by a supplier.  With the military at war for more than a decade, officials have been under pressure to have equipment ready around the clock, and when war funding was flowing unconstrained, it was easy to sign a contract and not spend too much time haggling over prices.

Assad says there have been cases of contractors overcharging for spare parts knowing that the government was under pressure to place the order. "Companies know exactly what they're doing," he says. "If you called 10 contracting officers from our buying commands they would say this is absolutely true."

Pricing disputes tend to escalate over products that might be commercially developed but are mostly sold to government agencies. Pricing justification based only on government sales is not sufficient proof that the price is fair, says Assad. Most likely, he says, those are inflated prices that are passing for market data. "The law is very specific. Price justification is based on sales in the commercial market, not to other government entities."

There might be cases when government sales data is credible if the "underlying basis for paying that price was reasonable," he says. "Just the fact that you sold it to a government entity doesn't make it right. But the contractor could offer the price data that was given to other government agencies. If that seems reasonable, we are good to go."

In order to stop overpaying for items, the Pentagon will issue new guidelines to contracting officers. "They will be out shortly," says Assad. Contracting officers are being instructed that it is "unacceptable to simply accept the price that is offered to you, irrespective of what your budget is." The revised policy will specify what pricing information will be allowed from commercial vendors. If the contractor provides "reasonable data," the contracting officer has discretion to agree to the price and there is no requirement for certified cost and pricing data unless all other options fail.

Any company that claims cost and pricing data are the default option is either lying or misguided, he says. "It's nonsense. We're not trying to do that. If a contracting officer out there does that, we find out and we stop it." The new guidance should help clear up current confusion about what can be bought as a commercial of a type item.

Some companies resent the government challenging their prices and allege the Pentagon wants to audit their costs but "that is absolutely not the case," says Assad. "The company needs to provide what the law defines as 'other than cost and pricing data' that proves it is charging a reasonable price.

How the Pentagon defines "reasonable," though, is not cut and dried. "The standard should be whether a reasonable business person looking at that data would conclude that it's a fair and legitimate price," says Assad. "The commercial companies we deal with, the vast majority of them, have no problems. They provide relevant pricing history, or purchase orders" to back up their bids. Relevant, in this case, means that purchase orders must be relatively recent and for comparable quantities. "I'll pay what the market pays," he says. "But if you can't provide data then it's up to you, contractor, to explain why I should pay that price."

Assad insists it is a misconception that just because a product was developed at company expense, the Pentagon should treat is as a commercial item. If there is no commercial sales history for that product, then the company is going to have to provide other rationale for its pricing.

Contractors that complain it takes too long for government officials to decide whether a sale should be commercial or commercial of a type do have a legitimate gripe, he says. "It shouldn't take more than 10 business days to figure out if it's 'of a type.'" Contracting officers should spend less time on that and devote more attention to pricing issues. "Don't spend months wrangling over whether this is a commercial item, and get to the point of why should I pay that price," he says.

A subtext to this discussion is that the Pentagon's procurement rules discourage companies from investing research and development dollars in products that might be useful to the military.

Assad recognizes that the Defense Department is seeking to attract nontraditional vendors to boost market competition. His boss Kendall repeatedly has called for the government to remove "barriers to entry" to newcomers. But this is a separate matter that has little to do with fair pricing issues, Assad says. "There are companies that have developed products we want but we can't buy." He blames this problem on a five-year old law that restricts the Pentagon from buying "non-development" items from the private sector unless there are multiple competitors.

"We have companies that have exclusively developed a product on their own nickel," he says. But if there are no other competitors, the Pentagon cannot buy it, according to section 831 of the 2011 National Defense Authorization Act, called "pilot program on acquisition of military purpose non-developmental items."

Under the MPNDI pilot program, contractors are not required to provide certified cost or pricing data but would have to provide other data for the purpose of determining price reasonableness.

Assad says this law “doesn't have any practical use” because there is usually no more than one bidder. “It would be better if it simply said the contracting officer can use his judgment" and award a sole-source contract, he says. "We've tried to compete but it doesn’t work. … That's the fundamental problem we have with that. We are going to ask that the law be modified."

In the 2014 National Defense Authorization Act, Congress extended the MPNDI pilot program until December 31, 2019. In its version of the bill, the House Armed Services Committee chided the Pentagon for not taking advantage of the program. “The committee is concerned that the program has been implemented in a manner that discourages use of the MPNDI authority,” the bill says. “The committee is aware that there may be confusion about the requirement that a contract under the MPNDI pilot program has to be awarded using competitive procedures.”

The bill points out that the competition requirement can be waived and suggests that Kendall review the MPNDI implementation guidance and clarify that exceptions to competition may be used as appropriate. “The committee is disappointed that the Department of Defense has not yet utilized the authorities provided.”

The Defense Business Board, made up of senior industry leaders, recently blasted Pentagon leaders for allowing regulations to increase barriers to innovation. In a recent report, the panel criticized the Defense Department’s bias toward "contracts by negotiation," instead of buying commercial products from the open market. "The Defense Department lacks sufficient understanding of business operating models and drivers of innovation," the panel concluded. If technological superiority is the goal, the Defense Department must "elevate mission above process."

Assad categorically disagrees. The Defense Business Board's rhetoric is off the mark, he says. He intends to talk to board members to present his side of the story.

In the private sector, there is growing exasperation about the Pentagon's approach to commercial procurements of high-tech products. Most of what the Pentagon buys commercially today are commodities like food rations and military uniforms. The issues raised by the Defense Science Board apply to commercial procurements of advanced technology, where the Pentagon has lagged.

Executives hear Kendall and other leaders warn about staid technology in the defense sector and the need to inject private-sector innovation, but they do not see that talk translate into action.

"Many times that action is walking backwards from the talk," says William J. Broderick, chief financial officer of AGI, a supplier of commercial modeling and analysis software for the space, defense and intelligence communities.

"What we have seen is the Defense Department narrow the definition of commercial of a type items and disincentivize the commercial industry from making R&D investments," Broderick tells National Defense. "That's a source of frustration for us."

The attitude seems to be that commercial companies are greedy, make too much profit and have to "open up their numbers," he says. The reality is that commercially funded products could save the Pentagon billions of dollars if the government were willing to give them a try. While Kendall is asking the Defense Department's acquisition workforce to encourage commercial procurements, officers in the field are doing the opposite, he says. Instead of trying to understand the features and capabilities of products, DoD officials will spend most of their time arguing "that we are not a commercial company because our predominant source of revenue is from government sales ... even though all our products were built at private expense."

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