Saturday, October 23, 2010

5 Ways to Make Government Contracting Cheaper

Since 2000, the US has doubled the amount it spends on contracted work (from $200B to $500B). According to the GAO, of the current 95 major defense acquisitions projects, one in four is overrun. Cost growth from these programs is valued at $295B.  In August 2010, the US Secretary of Defense, Robert Gates, announced sweeping efforts to reduce Defense spending. He announced base closures, overhead reduction targets for all branches of the military, the eradication of Joint Forces Command, and many other targeted reductions.

Because of my day job as a contractor, I see first-hand (or have talked to others who have seen) the system of cause and effect that prevents the current government/contractor system from incentivizing and institutionalizing cost savings. Let me explain a few of the forces at play (very simplified) and then elaborate on potential solutions to reduce the cost of NASA (and DoD) programs.

Background - Contractor:
  • Wall Street primarily judges large aerospace companies on three criteria. What are your “Orders”? What are your “Sales”? What is your “EBIT”?
  • Orders are the value of new contracts or the value of contract extensions you have won during this period. Usually orders represent work you have not yet done – kind of like “backlog”.
  • Sales equal the contract costs incurred plus profit you have earned during this period.  This is the value of your labor, your subs’ labor, any material you procured while executing your contract, and your expected profit for those costs.  Sales represents the volume of work you have completed.
  • EBIT is Earnings Before Income Tax – this is the contract profit you earned during the period.
  • With Wall Street quarterly judging large aerospace firms on Orders, Sales, and EBIT, companies insist their program managers meet quarterly Orders, Sales, and EBIT targets. 
  • Cost Plus Award Fee (CPAF) is the preferred contract vehicle for development contracts. Using this contract vehicle, the Government agrees to pay the contractor for their costs. Then periodically during the contract (at least annually), the contractor’s performance for that period will be judged. The resulting Award Fee (AF) score will dictate how much of each period’s award fee pool the contractor keeps as profit (e.g. 90% AF score would earn the contractor 90% of the AF pool for that period). This contract vehicle allows for easy and straightforward government contract scope changes because the contractor’s costs are covered regardless. Customer intimacy tends to be high with this contract type since the contractor is incentivized to work closely with the government to solve even small problems – growing the work scope and contract size in the process.
  • Most development programs are CPAF which means if contractors performing a CPAF contract identify a way to save the Government money, such savings would reduce the contract’s costs which will reduce the company’s Sales and maybe reduce their fee. Saving money on a CPAF contract would reduce at least one (and perhaps two) of the three primary ways Wall Street and upper management judge a program manager and in aggregate, judge the firm.
Background – Government:
  • Future budgets for Government programs are often based on current year spending. If you are not spending enough as a Government program manager, the perception will be that you don’t need as much money the following year. This may or may not be true. But such reductions, when they do happen, are usually seen as a bad thing within the local government program office. 
  • Politically, it is often better for a large development program to be "Low-Risk and High-Cost" rather than "High-Risk and Low-Cost." Cost saving ideas that increase risk to program execution will often be resisted. I am not saying government programs want to overrun. I am saying the penalties for programs that do not achieve their performance objectives are often greater than the penalties for overrunning programs. Dollar savings at the cost of increased program risk is rarely a gamble government program offices feel incentivized to make.
  • As a general rule, corporate profit-making is perceived in a negative light by government personnel. Many within the government feel that profit is the waste in the system.  If profit can be removed, optimum efficiency will be found.  This mindset is changing, but slowly.
5 Ways to Make Government Contracting Cheaper:
  1. Stop using Sales as a method for evaluating company performance. Change Wall Street’s focus from judging the industry on Orders, Sales, and EBIT to evaluating the industry on Orders and EBIT only. I believe the volume measurement that the "Sales" category provided is a faulty measurement anyway, and does not necessarily measure company health.  Orders and EBIT do measure company health.  Wall Street, focus on these. 
  2. Split cost savings between contractor and government. There are examples of this type of contract clause in use today – although it is used sparingly. The concept is this: If contractors can identify a method to save money on a contract and then demonstrate those savings for XX months, then all future savings could be shared equitably between both parties.
  3. Ensure that the government's portion of the cost savings can be kept locally either on the program itself for later enhancements or within the local command as a hedge against future risk. The Secretary of Defense is promising similar treatment of cost savings found in his recent DoD Overhead cost savings efforts. 
  4. Change the perception within the Government that profit is bad. In fact, I argue, the profit motive will drive cost savings. The more you can link cost savings to higher profits the more interest you will garner from for-profit companies.
  5. Increase the rigor of government proposal auditing. The government already evaluates development contract proposals. These auditors are very thorough, but if we start offering contractors the opportunity to make more money through cost savings, the cynics among us will complain, “if we make it possible for contractors to share in cost savings, contractors will simply pad their initial proposals and then a year later, identify their original proposal padding as 'cost savings'. Such behavior will not help the Government save money at all.” Cynic, I hear you! By ensuring optimum contract sizes to begin with, you will lessen the ability of the unscrupulous to cheat this new system I am proposing. Tough up-front proposal audits are key to maintaining a fair system that rewards heroes, not villains.
So here is a short story of my proposed system in action:

Acme Aerospace signs a Cost Plus Award Fee (CPAF) contract for $100M to provide ISR equipment maintenance on the XX military installation for the next five years. Although the company grumbled at the length and intensity of the government proposal audit, they knew this was a needed step. In the first year of the contract, Sally, the program manager, built a strong relationship with the local program office and organized her team to efficiently and effectively honor all aspects of their contract. At the beginning of her second year, working with her now experienced team, Sally identified several maintenance steps that could be streamlined to eliminate two people on her team, a savings of $200,000 per year ($100K each for easy math). Sally approached her counter-part in the government program office highlighting these potential savings. The government liked Sally’s ideas. The program office authorized Sally to make her staffing reductions as a part of a three-month trial.

After three months of monitored implementation, the staffing reductions had, in no way, adversely impacted maintenance efforts (consistent with Acme’s predictions).  The government program office agreed the probationary period was over. 3.75 years worth of cost savings (the amount of time left on the contract) equal to $750,000 ($200K x 3.75) were split evenly between Acme Aero and the US Government. Some within the government complained that Acme just got paid for “doing nothing”, but the program office reminded these critics that the government also got paid for “doing nothing” and encouraged all parties involved to find more savings of this type. Acme got a check for $375,000 which was recorded as EBIT and included in their upcoming quarterly update to Wall Street. Sally remembered a day when achieving such cost savings would have made her miss her quarterly Sales target, and was grateful for the changes in the way Wall Street measured her company and her program. The US Government directed the government’s portion of the savings ($375K) to be retained on the contract to be used to benefit the war fighter at the program office’s discretion which they used to perform a tech refresh on old ISR servers and equipment that were badly out of date.

If we do nothing…

Without such changes, you will continue to see the CPAF contract vehicle and Wall Street reporting requirements incentivizing contractors to spend every penny of each contract which will continue to leave no reserves in case of unexpected technical challenges which will continue to drive overruns.

But by making these changes (and other ideas not mentioned here), you unleash the power of commerce on the problem. I cannot think of more powerful tools than creativity and self-interest to help reduce contractual costs and save NASA and the DoD some money. 


  1. Uhhhh.... a couple of points.

    1. There are some common characteristics of aerospace firms, in large part due to the environment they operate in, which distinguish them from other organizations. One is the boom-and-bust nature of the defense/space business which causes MANY firms to expand and shrink over decade-long cycles as the need for military material grows and diminishes. Another is the growth and shrinkage of individual firms as contracts go from R&D to production and decline. As a consequence aerospace firms are undercapitalized by conventional standards, and they use a lot of government-suppplied resources (wind tunnel testing, stamping facilities, etc). Their self-financed R&D ratios are low (typically 2-3%). Etc. Competent stock market analysts are presumably aware of all this and factor it into their findings. Analysts and investors who confuse say Lockheed Martin with ADM or Johnson & Johnson deserve the financial returns they get.

    2. Crummy management and business methods are not limited to aerospace firms with government contracts in the USA. They're common to high tech enterprises of different sorts (architecture, software development, civil engineering, etc) throughout the world. Blaming NASA or Boeing or Pratt & Whitney for this sort of thing misses the basic point. From America to Zaire, high tech firms are routinely embaring on projects with implausible schedules, mistaken cost estimates, and poor understanding of environmental concerns.

    3. Moaning and groaning about costs and performance in the US defense industry has been commonplace ever since Eisenhower was president. Studies are made, errors detected, and reforms suggested at roughly biennial intervals -- and improvement never happens, however obvious the case for improvement seems.

    Something is clearly going wrong with government procurement, I agree. I think it's an error to assume fraud, incompetence, and malfeasance are the primary causes, and another error to think that simple fixes will solve the problem. There's something wrong with the way we identify problems that need government action, with the way we expect contractors to behave, with the economic and other tools we use to assess consequences. But I don't think we're smart enough or bold enough to do better.

  2. Mike:

    You say: “From America to Zaire, high tech firms are routinely embar[k]ing on projects with implausible schedules, mistaken cost estimates, and poor understanding of environmental concerns.”

    Agreed. And cost growth stemming from building one-of-a-kind-never-seen-before widgets for the Government can be forgiven. I am speaking of addressing reducing “controllable” cost growth.

    You say: “Studies are made, errors detected, and reforms suggested at roughly biennial intervals -- and improvement never happens, however obvious the case for improvement seems.”


    You say: “I think it's an error to assume fraud, incompetence, and malfeasance are the primary causes, and another error to think that simple fixes will solve the problem.”

    I am not necessarily talking about primary causes for all cost contracting cost growth (I should do a post on “requirements definition” sometime). I agree fixing the really big problems may be beyond the scope of a single blog post. But there are significant fixes that are possible.

    Within my post, I am not talking “fraud”, because the government received value within the scope of the contracts. I am not talking “incompetence”, adding competence on either the contractor or government’s side will not improve the scenarios I described within the post. I agree, “simple” fixes may not be possible, but I do believe “elegant” solutions are possible.

    I believe what I described in the post is possible, but think about how many people would have to be involved in that solution – Wall Street, Industry, Government. Yes, not simple – I agree. But possible. But this is not an ethics problem for the contractor, but a “systems” problem.

  3. SpaceX's Elon Musk echo's my thoughts:

    The cost-plus formula, he said, makes “good people do bad things... You’re creating an incentive to maximize costs up to the limit of the program being canceled.”

    Yep. Sad but true.