Better Price Does Not Lead to More Profit

by: Matthew Potter
August 9, 2011

Category: BAE Systems, Boeing, Business Line, Companies, Contract Additions, Contract Awards, Department of Defense, development program, EADS, Earnings, Events, Federal Budget Process, Military Aviation, Navistar, Oshkosh Truck Corp, production program, Services, U.S. Air Force, U.S. Army, U.S. Marine Corps | RSS 2.0

The Department of Defense uses different source selection criteria for different programs depending on what phase they are at in the acquisition cycle or how stable a product they are. One factor that is constant though is they are looking for the best price and value for their dollar. This doesn’t mean that they will always accept the lowest bid but they will accept the most technical constant at the lowest bid.

This means that in some cases companies can win work by aggressively offering a low price by minimizing their overhead costs and factoring in a small amount for profit. This pricing strategy does have as an issue that while it may lead to the contractor winning the work it may mean little or even no profit on the contract. With the new focus by DoD on price this means that margins are going to be squeezed even more while budgetary pressures may reduce the amount of large contracts available for any contractor to win.

Two recent contracts illustrate this issue for different companies.

The first is the Family of Medium Tactical Vehicle (FMTV) truck production for the U.S. Army and U.S. Marine Corps. Oshkosh (OSK) aggressively bid on this work to win it away from BAE Systems (BAE:LSE). Oshkosh’s win was protested by the losers, including BAE and Navistar (NAV), with one of the concerns being the low price offered. The GAO denied the protest and Oshkosh has now built hundreds of the trucks and trailers for the U.S. military.

Oshkosh hoped to offset declines in its commercial specialty truck business with military work and was able to win this contract and another for Mine Resistant Ambush Protected (MRAP) vehicles. The two led to large amounts of revenue for the company but unfortunately the MRAP work is winding down and it turns out that Oshkosh’s price is so low on the FMTV that they are struggling to make money off of it. Their revenues and profit saw steep declines in the last quarter partially due to this issue.

Boeing (BA) recently won the new aerial tanker contract with their 767 derivative KC-46A. They bid $3.6 billion for the development and early production contract that the Air Force estimated would cost $3.9 billion. It was hard for the other bidder, EADS (EADS:P), to match this price. There were concerns raised that Boeing had deliberately bid low to make sure that they won since the contest would ultimately come down to price.

The current estimate for this phase is now around $5.2 billion. It may end up being lower in the end but not by more then a few percent. This means that the Government and Boeing share the cost of the first billion increase and Boeing pays everything above $4.9 billion. If the current price is correct Boeing will lose $300 million. Boeing recently reported a good quarter with earnings up 20% and profits nineteen cents a share.

In Boeing’s case commercial sales as well as their diverse defense product line will offset the overruns in the KC-46A. Oshkosh does not necessarily have that luxury with the FMTV as their commercial vehicle sales are dependent on construction activity and government investment in equipment. Both have fallen off with the current economic situation in the U.S. and probably will be down for a few more years.

While the Government wants companies to make profits and stay in business they are not going to factor that in when they make awards. If a companies offer a low, best price they will take that. It is up to the bidder to calculate the price that offers the best chance of winning while generating revenue and profit. These examples show that is not always the easiest thing to do.

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