Senator John McCain, the Chairman of the Senate Armed Services Committee (SASC), has been focused on reforming defense acquisitions. The Senator has slammed the Department of Defense (DOD) for wasting money, and has been particularly incensed at problems with the production of the Ford-class aircraft carrier, the Littoral Combat Ship, and the F-35 Joint Strike Fighter. These problems have led the Senator to propose bold acquisition reform with wide-ranging ramifications. Addressing acquisition dysfunction is important because of both the high levels of unexpected money spent, and the delays to fielding equipment make responding to new threats challenging. However, some of the Senator’s proposals could backfire—one of which is his desire to make every defense contract “fixed-price.”
Senator McCain and his aides argue that fixed-price contracts would force defense contractors to work as efficiently as possible. They say that the way the DOD does business is out of step with innovation centers like Silicon Valley, and that the Department is addicted to cost-plus contracts. This is a key reason in why, they contend, several recent major programs have suffered from delays and ballooning costs.
However, there are several issues with this argument. First, contract types are not the only way DOD business differs from other industries in private sector. For many defense contractors, the DOD is the only consumer of their products—an economic environment referred to as a monopsony. This puts these contractors in an usual position. They need DOD business to stay viable. While this can lead to overly optimistic initial estimates to win contracts, it also forces the contractors to be accommodative of changes made during the development and production stages.
A recent Government Accountability Office (GAO) report found sixteen examples of major defense acquisition programs with large cost increases during the production phase of the program. In eleven of these cases, the costs were incurred because of the addition of unplanned capabilities. In other examples, it may also be true that the requirements side of the equation is driving cost increases, rather than the acquisition side.
In this acquisition environment, contract types are more of a symptom of the problem rather than a driver. Defense contractors push for cost-plus contracts to offset the risks of requirement changes or requirements that demand untested or immature technology. This is also why cost-plus contracts are preferred for programs with high technical risk. Most of the programs considered acquisition debacles—the F-35 JSF, the littoral combat ship’s modules, the new catapult on the Ford-class carrier—fit this characterization. So, if cost-plus contracts are used to offset risks to contractors being asked to deliver exquisite programs or programs that may be changed, what would happen if these programs were awarded under fixed cost contracts?
According to experts, the DOD might see increased costs and decreased innovation. The cost question is tricky, but it is likely that contractors would increase their bids under a fixed cost contract to account for the new risks they would be handling. Cost growth then may be lower, as the level of optimism is reduced and the initial bid incorporates likely cost growth, but the final costs of the program might not be all that different from a cost-plus contract with more cost growth. This is based on the assumption that fixed-cost contracts produce less cost growth, yet this remains unproven. An Institute for Defense Analyses (IDA) report found no statistically significant evidence that fixed-cost contracts resulted in better performance than cost-plus contracts. IDA highlighted that other factors were in play, but that their analysis at that time could not identify them. The RAND Corporation also found no evidence that fixed cost contracts led to less cost growth. In fact, they highlighted that the rise of cost-plus contracts came out of a series of disastrous fixed-cost programs in the 1980s.
Cost growth then seems more tied to individual programs, their operational requirements, and even factors outside the acquisition process. What about innovation? Well, the DOD has partly focused on reforming its acquisition process by attracting new start-ups and small businesses. The limited types of contracts used are likely to make the defense business less attractive to these firms. While SASC staff has argued that avoiding cost-plus contracts would reduce the use of unique government accounting that scares off small businesses and start-ups, fixed-cost contracts also include burdensome financial requirements that do the same. Additionally, without the government covering the risks of unknown developmental issues, small companies are likely to stay away. Even large defense contractors may shift more towards providing bare-bones capability.
This is not to say that only cost-plus contracts should be used—there is a time and place for everything. Some programs are ideal for fixed-cost contracts, and some require the flexibility of cost-plus contracts. The focus should be on making sure that the right contracts are applied in the correct situations, and then that the rest of the process does not lead to poor performance. Reforms in authority and accountability for outcomes are a good step, as are the encouragement (but not mandating) of prototyping and upgradable systems. Making contracts appropriate for programs is important, but so is making the programs appropriate for business.