Crisis of Confidence as Questions Arise About U.S. Aircraft Program Costs

by: Matthew Potter
July 18, 2011

Category: Boeing, Business Line, Companies, Congress, Contract Additions, Contract Awards, Department of Defense, development program, EADS, Events, Federal Budget Process, Lockheed Martin, Military Aviation, Northrop Grumman Corp., production program, Restructuring, Services, U.S. Air Force, U.S. Marine Corps, U.S. Navy | RSS 2.0

As the debt limit discussion plays out in the background two major U.S. defense aircraft programs being led by two of the biggest defense contractors faced scrutiny these past few weeks as the extent of their cost growth becomes clear. In the past depending where the program was in its cycle the Government would absorb most of these costs protecting the contractor’s earnings and profits. In today’s budget environment that may not be the case which will have an affect on Boeing (BA) and Lockheed Martin (LMT) near term performance.

First was the new aerial tanker, the KC-46A, being developed and then produced by Boeing. The company won a hard fought contest with European rival EADS (EADS:P) last year for the first 179 new tankers to replace the aging KC-135 fleet. This was the third attempt by the U.S. Air Force to award this contract since 2001. First Boeing received a sole source lease that was overturned after investigations showed issues between the company and high ranking Air Force officials. Then in 2008 Northrop Grumman (NOC) and EADS won the contract but this was overturned by Boeing’s protest. Finally the third contest was won as Boeing bid a modified 767 airliner at rock bottom prices.

Now it looks like those prices were too good to be true. Boeing actually bid $300 million below the Air Force’s estimated cost for the initial development contract that includes the first 18 aircraft. In the last month the company and Defense Department have begun to inform Congress that not only will Boeing need the $300 million but that they may go over that to at least $4.3 billion. The first billion dollar increase over the $3.9 billion figure will be shared by the Government and the contractor and then Boeing will have to eat everything beyond that. While right now there is no guarantee that the costs will go up that much it does mean the U.S. could be on the hook for another $600 million in costs beyond what was budgeted. Needless to say Congress, especially Ranking Member of the Senate Armed Services Committee and budget “hawk”, John McCain (R-AZ), did not react positively to the announcement.

The situation with the premier aircraft acquisition program, Lockheed Martin’s F-35 Joint Strike Fighter, is even worse. This past week the Defense Department submitted a routine reprogramming request to Congress in order to move money around in their budget to fund priorities. Part of this was to move $264 million to cover cost overruns in the production of the JSF. On top of that a further $450 is needed to be found in the JSF budget as well as costs on the first three production batches have increased over $700 million. McCain almost immediately tweeted that fact and called it “Disgraceful”. He and the Democratic Chairman of the SASC followed this up with a letter to the Defense Department asking among other questions what the bill would be if the JSF program was terminated.

That is an extreme reaction to the situation although the JSF program has a history of schedule delays and increased funding requirements that have seen the total cost balloon to hundreds of billion of dollars and the entry into service delayed by years. Lockheed, if the program really was cancelled, would lose one of their major contracts with a significant affect on earnings and revenues. At a minimum they are facing the possibility of paying themselves for much of the cost increases, especially on future orders, which would have a negative effect on their near term performance.

Programs in their early development and production such as the KC-46A and F-35 often have cost sharing built in to cover these kinds of issues. The problem these two program face is that Congress is not willing to keep sharing. They feel at a time when the defense budget will be reduced that these types of increases are difficult and will put pressure on the rest of the budget. They also put more blame on the contractors then the Government who may have caused requirement or testing changes that increase schedule and cost.

In the KC-46A situation there are already concerns that Boeing deliberately bid it low to win with the goal of making up the costs through the cost sharing process and in production. That is a cynical path to go down and the Air Force needs the KC-46A as the U.S. needs the F-35 now as there are no other potential replacements without the increased cost of starting over.

No matter what the two important aerospace programs will face greater scrutiny and more pressure to keep costs down. Congress will also look at transferring risk and increases to the contractors rather then the Government as has been proposed with the next buy of F-35 production where Lockheed would be responsible for 100% of all cost growth beyond the initial contract price if the Senate gets there way.

Will Congress cancel either of these programs due to the budget difficulties? That is very doubtful but five years ago if you asked the Army if Future Combat Systems (FCS) would be gone they would have said no as would the Navy with the DDG-1000 program. The military has spent billions on programs that never reached fruition for a variety of reasons and cost growth certainly has been one down through the years.

Article first published as Boeing and Lockheed Face Crisis of Confidence: Cost Growth Questioned by Congress on Technorati.

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