Tuesday, March 9, 2010

Advice for the Air Force - Don't Rely on DCAA to Ensure Fair Prices

James Hasik (Hasik Analytical, LLC) has some advice for the Air Force now that Northrup has dropped out of the competition for the new air refueling tanker leaving Boeing the only remaining bidder. Asking the question of how to ensure a fair and reasonable price for the planes when there is only one buyer (the 767 is a 30 year old plane and commercial customers have stopped ordering them) and one seller, Hasik warns that the Air Force should not pretend that DCAA (the auditors) will save it. Hasik writes:

One could be tempted to hope  ... that once the legion problems at the Defense Contract Audit Agency (DCAA) are corrected, the watchdog will reclaim its teeth. Sure, it’s a fixed price contract, but Boeing must disclose both its costs and its profit margin, so even without competition from Northrop and EADS, the government will get a good deal, no? Eh, no. The problem is that effective regulatory regimes are generally elusive, and for four reasons:

This is true in the first place because the informational asymmetries in regulation are severe, so the perspectives that regulators develop on their subjects are almost always distorted. In theory, the government needn’t spend too much time and effort trying to gin up should-cost numbers for the 767, as that airplane has been in production for 30 years. However, with a large, technically complex, and sun-setting system like the KC-X, the problem is serious. As relative prices shift, and commercial customers for this plane that no one else wants fall away, what it should cost becomes anyone’s guess.

Further, the appropriate contracting mechanisms are not obvious. Whether contractors are regulated according to price or cost, they, their managers, or their labor forces generally find some way of gaming the system to extract at least a portion of the rents they desire. Auditors and regulators can set rules, but smart people will always find a way around them.

Besides, regulatory capture is a near certainty. Regulators are very frequently observed to go native in the firms they regulate. The problem is particularly severe in technologically intensive industries where the regulators, by virtue of the domain knowledge required to participate in the regulatory process, most frequently hail from the industry itself. Sooner or later, factions within the KC-X program office, the DCAA, and AFCAA, and any other organization with what people on Capitol Hill like to call “oversight” would come to think about Boeing’s interests as synonymous with the Air Force’s interests. It’s an industrial base thing.

Finally, the regulatory burden itself is costly, which contributes to the overall cost of the project, even if no further rents accrue to Boeing. Ultimately, the Air Force has to pay for those squadrons of bean-counters and fact-checkers, and all those clipboards and green eye shades cost money. But more significantly, at a certain point, the managerial cost of the added oversight, through gummed-up processes and drawn-out schedules, exceeds its marginal returns.

To read Hasik's entire article, click here.

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