Wednesday, June 18, 2014

Annual Performance Report on the Defense Acquisition System

Last week, the Department of Defense issued its 2014 annual report  on the performance of the Defense Acquisition System. For a full copy of the report, click here. The focus of this year's report was "incentives" - particularly those from contract types and profits (or fees). Ever wonder how the Government selects the type of contract to use in a given situation. Typically, its based on what the Government thinks will incentivize the contractor to perform effectively and economically. This well-written and informative report will provide some insights into the selection process. The conclusions are very interesting and for the most part, something we always knew intuitively but never had the facts and data to back it up. Here then are the report conclusions.

Not all incentives work. Contractual incentives are effective if (i) we use them, (ii) they are significant, stable, and predictable; and (iii) the are tied directly to our objectives.

Cost-plus versus fixed-price is a red herring. The distinction between cost-plus and fixed-price contracts is not the divide on effectiveness. Rather, the emphasis should be on matching incentives to the situation at hand instead of expecting fixed-price contracting to be a magic bullet. Fixed-price contract have lower costs because they are used in lower-risk situations, not because they control costs better. Moreover, prices on fixed-price contracts are only "fixed" if the contractual work content and deliverables remain fixed, which is often no the case. Our analysis showed that objectively determined incentives were the factors that controlled costs, not selecting cost-plus or fixed-price contract types.

CPIF and FPIF contracts perform well and share realized savings. These contract types control cost, price, and schedule as well as, or better than, other types - and with generally lower margins. We pay for the technical risks on our development systems - unlike the private sector, where companies pay for R&D on new products. This is partly due to the fact that we are, to some degree, the only customer for new military products . Thus it makes sense to use incentives that (i) link profit to performance, (ii) control price, and (iii) share in cost savings, especially in production when the risks are low. Specific incentive structures may not be appropriate in certain cases, so professional judgment is needed as always in matching contract type and incentives to the desired outcome.

FFP contracting requires knowledge of actual costs. FFP contracts provide vendors a strong incentive to control costs, especially in production, where they are most common. However, taxpayers do not share in those cost savings, unless the negotiated price took into account actual prior costs and margins, as well as the contractor's anticipated ability to continue cost reduction. Thus, to use FFP contracts effectively, we must fully understand actual costs when negotiating subsequent production lots.

Competition is effective - when viable. Competed contracts perform better on cost, price, and schedule growth than new sole-sourced or one-bidder contracts in development. Thus, we must continue our efforts to seek competitive environments in creative ways. Unfortunately, direct competition on some contracts is not viable - especially in production, where significant entry costs, technical data rights, or infrastructure may be barriers. In response, we are seeking ways in which competitive environments and open-system architectures will allow us to introduce competitive pressures.

Production margins may help minimize development time. Our analysis indicates that the prospect of high margins in production may motivate contractors to complete development as soon as possible. Unfortunately, this assertion is hard to test quantitatively given the predominance of higher margins in all production contracts. However, we did find significant examples where production margins were smaller when development schedules slipped despite an explicit policy to this effect.

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