Penny Pinching at the Pentagon May Cost Contractors

by: Matthew Potter
June 29, 2010

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Foreseeing a near term future where the defense budget will begin its long predicted decline the U.S. Defense Department held a meeting with contractors and then announced to the public a goal of saving $20 billion a year through better acquisition. The idea is to plow that money back into new weapon system acquisition and development. While the goal is laudable it may be hard to implement and the loss of this money to defense contractors may hurt the industry in the long run.

The defense budget is coming under pressure from both internal and external sources. Internally the growth of the ground forces and the ten year plus deployments to Iraq and Afghanistan are causing personnel and operations cost to grow every year. The Department like the U.S. as a whole is also facing large health care related bills. Externally the U.S. cannot keep on spending billions a year that it doesn’t have. The total budget will face cuts and since defense spending is the largest discretionary piece of the pie it will have to be reduced or limited in growth.

DoD is hoping that by doing better work awarding contracts they can save a portion of the $20 billion. They are looking for their industry partners to provide the rest through efficiencies in management and production costs. One issue that will be dominant is a goal to begin maximizing the use of fixed price contracts over cost plus and time and material ones. This is the part that will be hardest for industry to swallow or adjust too.

Cost plus and time and material contracts have their place in the realm of government acquisition. Cost plus are normally used for development efforts and the transition to steady state production. They are used because the risk is high to both the government and contractor in the areas of schedule and cost. Buying and developing new capabilities are hard and expensive. Schedule slips cost money and using fixed price contracts puts all of the cost risk on the contractor — not the government. In the past using fixed price for development work have been a failure. Contractors find themselves bearing all of the cost overruns which leads to program’s either being canceled or new contracts with more money being negotiated.

Time and materials sound like what they are. The government buys services by paying for the labor and materials used to provide it. Fixed price might limit the contractor in what services they can provide or who they can hire.

Fixed price contracts force everything to be managed to price and cost. If the contractor doesn’t do a good job of pricing the original contract it can get messy very fast.

Certainly it should be possible to eke out $20 billion from the $400 billion spent a year this applies too. That means some contracts and programs may be eliminated or cut back which will hurt the providers.

Congress too will play a role as eventually they decide what the Defense Department spends. Just by eliminating earmarks the money could be found fairly easily in the total budget. Unfortunately Congress earmarks because they want to. It is hard for them to not do it. They will fund the programs they want to fund to the level they desire no matter what the Pentagon requests.

Certainly the idea of leaning out production is viable. This though happens when a program is in steady state and costs are well understood. The problem with development programs is that their costs are estimated at various stages using the best models around, but often problems happen that are not expected. Problems lead to cost growth and schedule growth.

In the end it might just be easier for the Pentagon to cut $20 billion in spending by eliminating programs. Then that money can be put into those that are favored. That will cost some defense contractor a contract and a service a modernization program that they need.

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