Why a Cost-Plus LRS-B Contract?
The Senate Armed Services Air-Land Subcommittee will be holding a hearing next week on structure and modernization in the US Air Force. One of the issues sure to arise is the Air Force’s procurement plan for its long-planned Long-Range Strike Bomber (LRS-B). William LaPlante, assistant secretary for acquisition, last week told the House Armed Services Subcommittee on Seapower and Projection Forces that the service will "most likely" use a cost-plus approach, rather than a fixed-price agreement, when it awards a contract for the LRS-B sometime this summer. That’s intriguing; as Aaron Mehta observed last month, “the US Air Force's single biggest research program is also its most mysterious.” But for several years, we’ve repeatedly heard two things: former Defense Secretary Robert Gates had set a price-cap of $550 million per aircraft, and the design of the aircraft would not require a great technological leap forward. Thus Congresswoman Jackie Speier of California thinks the cost-plus contracting strategy means that the Air Force isn’t serious about either promise. Is that a fair assessment?
Think about the plan for the LRS-B as a promise made in terms of three objective functions: cost, quality, and time. This is the better-faster-cheaper paradigm of weapons development; of those three, we generally expect to get at most two. Using only proven technologies might mean moderating the ultimate qualities of the final product—what the LRS-B could do in combat. But in moderating its goals, the USAF has hoped to control costs, and perhaps even deliver on a real timeline. Loren Thompson, who is consulting for the Boeing-Lockheed Martin team, thinks that the price-cap might stick at $550 million, though adjusted for inflation, and excluding RDT&E costs. And as the Wall Street Journal reported, LaPlante himself insisted to that House subcommittee that the cap was still firmly in place.
So, price cap and mature technologies suggests fixed-price, no? Frankly, price cap or mature technologies would seem to say fixed-price. Until perhaps just now, the Obama Administration’s Defense Department had been keen on fixed-price contracts. The Air Force may have had some crazy contracting strategies in the past, but LaPlante is a smart guy, so there must be some method to the apparent madness. As he told the assembled congressmen, the decision came down to a single factor: certainty of final costs, or the expected ex post variance of the contractor’s actual costs from the ex ante estimate. A big overrun—presumably not foreseen with that price cap—could unreasonably threaten a contractor’s solvency.
Hmmm. LaPlante also said, citing some yet-unpublished research by the Institute for Defense Analyses, that the choice of fixed-priced or cost-plus in the contracting really hasn’t historically mattered to the size of the cost overrun. It’s really a matter of the specific incentives. If that seems a surprising finding, it’s because the specific incentives are sometimes lacking. As Yossi Spiegel wrote in his noted article "The Role of Debt in Procurement Contracts” (Journal of Economics and Management Strategy, Autumn 1996), if the government wants something badly enough, a fixed-price contract that goes awry won’t really be fixed-price. One of the famous cases is Lockheed’s fixed-priced development of the C-5A Galaxy. The company extracted a $500 million unilateral price increase from the Air Force Department by threatening bankruptcy—and program termination—if the check didn’t come through.
But that’s really not part of the price-capped plan. So let’s suppose that this time could be different, and that the winner could be held to such a price. Why might the government still choose cost-plus? LaPlante also noted that the windfall of a big under-run (those do occasionally happen) would leave money on the table, and annoy Congressmen and taxpayers alike. So how might that happen? Variable costs can generally be modeled as a function of three input factors: the labor, capital, and process technologies involved in the manufacturing. Often the uncertainty is assumed found in the fixed costs, and endemic to the challenge in developing the new product technologies that the military “requires”. But we can also have uncertain costs with relatively certain technologies—when the requirements themselves are uncertain, say in the amount of labor required. Thus are time-and-materials contracts frequently employed in professional services work.
Another possibility is uncertainty in the amount and type of capital required. Perhaps some possibility exists for a breakthrough in manufacturing processes. Does one of the bidding teams think that it can make these LRS-Bs with a gigantic 3D printer? Probably not, but there may be some alternative out there to the heretofore very costly autoclaving of laminated carbon fibers. Northrop Grumman’s investments in companies like Scaled Composites may provide a clue to what the underdog bidder is offering. And as mysterious as some of those Flying Doritos have been over Texas, we don’t really know what any of the big firms have been doing behind closed doors. So it’s just possible that LaPlante’s people have no idea what this will ultimately cost—just that they’re determined that it won’t be more than $550 million. In fiscal year 2010 terms, of course.
I offer just one more thought. Because it’s a bomber, perhaps this time the winning contractor will fit-check the bombs in the bomb bay before they move from prototype to production. We can hope.