The Real Reason Defense Companies Hate Fixed-Price R&D Contracts

The Pentagon has embarked on its latest campaign to improve business practices, with a key focus being the transition from “cost-plus” contracts to fixed-price, incentive-fee contracts. Cost-plus contracts typically cover all the expenses a contractor incurs in performing work and provide an additional profit, usually with incentives for holding down costs. Fixed-price, incentive-fee contracts establish a firm ceiling on how much contractors can spend to complete work, above which they must absorb some or all of any extra costs; incentive fees are included to reward contractors who accomplish work early or below expected costs.

The defense industry is accustomed to producing weapons on fixed-price contracts, but it strongly resists using fixed-price arrangements for developing new systems. The industry says it isn’t feasible to predict costs until technologies are reasonably mature, because there are too many things that can go wrong in cutting edge R&D projects. Cynics say industry is trying to minimize accountability, while more sympathetic voices say it is simply trying to limit its risks. Much of the time, though, it isn’t the uncertainties surrounding new technology that worry industry so much as the capricious behavior of the government customer.

Pentagon policymakers decry the ways in which defense industry performance deviates from the behavior of some commercial companies without acknowledging that much of the deviation is traceable to government actions. Despite decades of trying to improve the professionalism of the acquisition corps, the reality is that the federal government is part of a political system, and political systems don’t behave like commercial customers. Washington routinely changes plans, rewrites budgets, alters specifications and modifies acquisition rules after contracts have been signed with little or no thought as to what impact those actions may have on contractors.

For instance, shortly after Lockheed Martin signed the contract to develop a now-canceled presidential helicopter, the government added hundreds of changes to the design aimed at enhancing various aspects of the aircraft’s performance. Not surprisingly, the program soon drifted off of its original development plan. When the same company signed a contract to develop the lead vessel in the Littoral Combat Ship program, the Navy was still writing the rules governing how the ship should be designed and built. That program too experienced cost growth that became a source of controversy. The challenge of developing and integrating new technology contributed to cost growth in both programs, but the real culprit was a government customer that is seemingly incapable of sticking with a plan once contracts are signed.

Every system integrator in the defense sector has similar horror stories. So you can understand why companies might be reluctant to sign fixed-price development contracts. Whatever else cost-plus vehicles may be, they are a form of insurance against the government customer’s often arbitrary behavior. You could also argue they help to discipline that customer’s behavior by requiring that any shifts in specifications or funding result in additional payments to contractors who could not have predicted how government plans would change. But under fixed pricing, even when incentive fees are provided, the risk shifts largely to the companies.

Because the weapons business is a monopsony market in which the government is the only customer, some Pentagon policymakers naively believe they can dictate whatever terms they want to their suppliers. But as Northrop Grumman’s pullout from the Air Force tanker competition earlier this year demonstrated, there is a point beyond which executives are unwilling to risk their enterprises by bidding on unattractive terms. Some of those executives are eying the fixed-price features of the development plan for the Army’s new Ground Combat Vehicle and asking themselves whether it makes sense to participate. In theory they could build a cushion into their bid to insulate against capricious customer behavior, but in practice that would mean being underbid by the bravest (or least responsible) bidder. That’s the dilemma fixed-price R&D contracts impose on industry, and it’s the reason why companies will need to consider diversification more seriously as the government tries to offload the risks associated with its ambitious technology projects.