From The Under Secretary Of Defense For Acquisition



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Defense AT&L: March-April 2013 2 From the Under Secretary of Defense for Acquisition, Technology and Logistics Use of Fixed-Price Incentive Firm (FPIF)Contracts in Development and ProductionFrank KendallThe choice of appropriate contract types is very situationally dependent, and a number of factors must be taken into account to determine the best contract type to use. From the perspective of both industry and the government, it makes a good deal of diff erence whether the Defense Department asks for Cost type, Fixed-Price In-centive (FPI), or Firm Fixed Price (FFP) propos-als. In the original Better Buying Power (BBP) initiatives, although Dr. Carter and I encouraged greater use of FPI, we also included the caveat “where appropriate.” BBP 2.0 modifies this guidance to stress using appropriate contract types while continuing to encourage use of FPI for early production. I would like to be more explicit about what “appropriate” means and how I believe we should analyze a given situation. In particular, I will address both Engineering and Manufactur-ing Development (EMD) and production situations.During the early 1990s, I had a lot of painful experience with fi xed-price development. The A-12 was a notorious case that ended badly. On another fi xed-price major program in devel-opment during the same timeframe, the program manager was relieved for fi nding creative but illegal ways to provide cash to the prime contractor who lacked the resources to complete development. FFP development tends to create sit-uations where neither the government nor the contractor has the fl exibility needed to make adjustments as they learn more about what is feasible and aff ordable as well as what needs to be done to achieve a design that meets requirements during a product’s design and testing phases. Any fi xed-price contract is basically a government “hands off ” contract. In simplistic terms, the government sets the requirements and the price and waits for delivery of a specifi cation-compliant product. While we can get reports and track progress, we have very Defense AT&L: March–April 2013 2

3 Defense AT&L: March-April 2013 little fl exibility to respond to cases where the contract re-quirements may be particularly diffi cult to achieve. Most sophisticated weapons systems development programs deal with maturing designs and challenging integration prob-lems. As a result, the government often will and should provide technical guidance and make tradeoff decisions during devel-opment. In EMD, we often do want to work closely with the prime contractor to achieve the best outcome for the govern-ment. While it certainly is possible to negotiate changes in a fi xed-price contract environment, the nature of development is such that informed decisions need to be made quickly and in close cooperation with our industry partners. The focus in a fi xed-price environment is squarely on the fi nancial aspects of the contract structure and not on fl exibly balancing fi nancial and technical outcomes.Risk is inherent in development, particularly for systems that push the state of the art. Even with strong risk reduction mea-sures in Technology Demonstration phases and with competi-tive risk reduction prototypes, there still is often a good deal of risk in EMD. By going to EMD contract award after Preliminary Design Review, as we routinely do now, we have partially re-duced the risks—but again, only partially. Our average EMD program for a Major Defense Acquisition Program (MDAP) over the last 20 years has overrun by a little under 30 percent. Industry can only bear so much of that risk, and in a govern-ment fi xed-price contract, industry cannot just stop work and walk away. A commercial fi rm doing development of a product on its own nickel has complete freedom to stop work whenever the business case changes. Firms on government contracts do not, at least not without some liabilty.For good reasons, I am conservative about the use of fi xed- price development, but it is appropriate in some cases. Here are the considerations I look for before I will approve a fi xed-price or FPI EMD program: Firm requirements: Cost vs. performance trades are es-sentially complete. In essence, we have a very clear under-standing of what we want the contractor to build, and we are confi dent that the conditions exist to permit the design of an aff ordable product that the user will be able to aff ord and is committed to acquiring. Low technical risk: Design content is established and the components are mature technologies. There are no signifi -cant unresolved design issues, no major integration risk, the external interfaces are well defi ned, and no serious risk exists of unknowns surfacing in developmental testing and causing major redesign. Quali ed suppliers: Bidders will be fi rms that have experi-ence with this kind of product and can be expected to bid rationally and perform to plan. Financial capacity to absorb overruns: Sometimes overruns will happen despite everyone’s best eff orts. We still want responsible contractors who have the capacity to continue and deliver the product despite potential overruns that may not have been foreseeable. Motivation to continue: A business case must be provided via a prospective reasonable return from production that will motivate suppliers to continue performance in the event of an unanticipated overrun. It is unrealistic to believe contrac-tors will simply accept large losses. They will not.As an example, the Air Force Tanker program met all of these criteria.Early or low-rate production have similar considerations, but here is where greater use of FPI contract vehicles makes the most sense as an alternative to cost-plus vehicles. Over the last 20 years, the average overrun for MDAPs in early production has been a little less than 10 percent. This is a reasonable risk level to share with industry in an FPI contract arrangement. I expect our program managers and contracting offi cers to have With the assistance of the Office of the Secretary of Defense, Defense AT&L magazine publishes the names of incoming and outgoing program managers for major defense acquisition programs (MDAPs) and major au-tomated information system (MAIS) programs. This an-nouncement lists all such changes of leadership, for both civilian and military program managers.U.S. NavyCapt. Scott D. Porter assumed the position of program manager of the Advanced Tactical Aircraft Protection Systems Program, (PMA-272), PEO(T) on Dec. 1, 2012.Capt. (select) Thomas J. Anderson became program manager of the Littoral Combat Ship Program (PMS-501), PEO(LCS) on Nov. 16, 2012.Ms. Valerie Carpenter became program manager of Navy Enterprise Resource Planning (ERP), (PMW-220), PEO(EIS) on Nov. 15, 2012. MDAP/MAIS Program Manager Changes

Defense AT&L: March-April 2013 4 meaningful, detailed discussions about the risks in contract performance over target cost. Determining a ceiling price is all about the fair recognition of risk in contract performance. Unlike an FFP contract, there needs to be a fair sharing of the risk—and the rewards—of performance.To be comfortable with a fi xed-price vehicle for early produc-tion, I would look for the following:• Firm requirements (as explained)• Design proven through developmental testing• Established manufacturing processes• Qualifi ed suppliers• Suppliers with the resources to absorb some degree of overrun• Adequate business case for suppliers to continue work if they get in troubleIt should be noted that some of the items on this list refl ect the “responsibility determination” that should be par t of ever y contract we sign. However, the decision I am talking about here is not the decision to award a contract or accept a proposal for consideration but rather the decision about what type of contract to employ.The above apply to FPIF procurements for which proposals are solicited at or near the end of EMD after we have been through Critical Design Review, built production representa-tive prototypes, and completed some signifi cant fraction of developmental test (DT). This is very diff erent from a case in which we are only at Milestone (MS) B when we ask for low-rate initial production (LRIP) options. In that case, designs are not usually fi rmly established, production representative pro-totypes have not been built, and DT has not yet been done. So when we ask for FPIF proposals as options at MS B, we have already failed criterion 2 at least. In those cases, we ought to have a low risk of completing EMD without major design changes that would aff ect cost. Again, the Air Force Tanker program serves as an example. Another example where this can be done is a Navy auxiliary, where the shipyards have a great deal of experience with similar designs and with the design process for that class of ships.FPIF LRIP can have a number of advantages, including better insight into contractor costs and an opportunity to share in contrac tor cost reduc tions . While it is at trac tive to secure FPIF prices at the time we award EMD contracts, as we usually still have competition at that point, we need to balance the benefi t with the risk. Optimism tends to prevail early in programs, both for government and industry, and we need to be realistic about the risks that remain before EMD has even begun. It also is an illusion to believe we can routinely transfer all the risk in our programs to industry. Industry has a fi nite capacity to absorb that risk and knows how to hire lawyers to help it avoid large losses.We can and should increase the use of FPIF contracting, but we need to approach with some caution FPIF contracting for EMD and for options on LRIP lots that are still years away from execution. During the transition to production, after suc-cessful DT has established that the design is stable and that production processes are under control, FPIF becomes a very attractive bridge to an FFP contracting regime.Finally, there also may be times during the mature produc-tion phase of a program when the use of FPI contracts would be preferred. Typically, mature production programs are well established in terms of requirements, design content, and production processes at both the prime contractor and subcontract level. This environment should provide for accurate pricing, and FFP contracts would seemingly be appropriate. However, if we have reasons to conclude there may be a poor correlation between negotiated and actual outcomes, the use of an FPI contract would be more appropriate. In that case, we would share the degree of uncertainty with the contractor. There could be several reasons why the correlation between negotiated and actual outcomes may be poor—e.g., inef-fective estimating techniques, unreliable actual cost predic-tions at either the prime and/or subcontract level, incom-plete audit fi ndings, or diminishing manufacturing sources for some components. In addition, there may be times (e.g., multiyear contracts) where the period of performance is long enough that it places too much uncertainty and risk on either party. The key is understanding the pricing environ-ment. If we have well-prepared contractor/subcontractor proposals, an environment where we have a solid actual cost history, and we have done the necessary analysis to ensure we have the price right, the use of FFP contracts is fi ne. If the environment is uncertain, the use of an FPI contract may make sense.Again, BBP 2.0 stresses use of the appropriate contract types. Unfortunately, sorting this out is not always easy. It is hoped that this discussion will be helpful as we all wrestle with the problem of getting the best answer to the question of what type of contract to use in a given situation, whether it is an MDAP or an Acquisition Category III product, and at any phase of the product life cycle. The focus in a fixed-price environment is squarely on the financial aspects of the contract structure and not on flexibly balancing financial and technical outcomes.

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