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More Cost-Plus Contracting Thoughts

In comments at the previous post on this subject, Karl Hallowell comments:

It's not government's job to suck up risk for a contractor. As I see it, if contractors really were giving their best cost estimates, then they're regularly overestimate prices not consistently underestimate them.

The other commenters who seem to think that designing a brand new UAV, or the first successful hit to kill missile (SRHIT/ERINT/PAC-3, not the dead end HOE), or an autonomous helicopter (all things I've been heavily involved with) is something that can and should be done on a fixed-price contract (after all, one bridge is like any other, right?) . . . it can maybe be done, but only if you're willing to let system development take a lot longer.

I don't know who posted this, but it's unrealistic.

Let's give an example of how the real world works in salvaging ships on the high seas:

Salvage work has long been viewed as a form of legal piracy. The insurers of a disabled ship with valuable cargo will offer from 10 to 70 percent of the value of the ship and its cargo to anyone who can save it. If the salvage effort fails, they don't pay a dime. It's a risky business: As ships have gotten bigger and cargo more valuable, the expertise and resources required to mount a salvage effort have steadily increased. When a job went bad in 2004, Titan ended up with little more than the ship's bell as a souvenir. Around the company's headquarters in Fort Lauderdale, Florida, it's known as the $11.6 million bell.

Exactly the scenario where it is claimed that fixed price contracts can't work. Huge risk, lots of uncertainty, time pressure. A similar example is oil well firefighters. As I see it, there's almost no circumstances when government needs to help the contractor with risk. The money, paid when the job is done right, does that. If it's not enough, then nobody takes the contract. Simple as that.

Yes. The reason that cost-plus contracts are preferred by government is that government, by its nature, has an aversion to profit. It's the same sort of economic ignorance that drives things like idiotic "anti-gouging" laws, and it results in the same false economy for the citizens and taxpayers.

The problem isn't that companies are unwilling to bid fixed price on high-tech ventures. The problem is that, in order to do so, they have to build enough profit into the bid to make it worth the risk. But the government views any profit over the standard one in cost-plus contracts (generally less than ten percent) as "obscene," and to allow a company to make more profit than that from a taxpayer-funded project is a "ripoff." So instead, they cap the profit, and reimburse costs, while also having to put into place an onerous oversight process, in terms of cost accounting and periodic customer reviews, that dramatically increases cost to the taxpayer, probably far beyond what they would be if they simply let it out fixed price and ignored the profit. I would argue that instead of the current model of cost-plus, lowest bidder, an acceptance of bid based on the technical merits of the proposal, history and quality of the bidding team, even if the bid cost is higher, will ultimately result in lower costs to the government (and taxpayer).

As I understand it, this is the battle that XCOR (hardly a risk-averse company, at least from a business standpoint) has been waging with NASA for years. XCOR wants to bid fixed price, and accept the risk (and the profits if they can hit their internal cost targets), while NASA wants them to be a cost-plus contractor, with all of the attendant increases in costs, and changes in corporate culture implied by that status.

This is the debate that will have to occur if John McCain wants to make any headway in his stated desire Friday night to get rid of cost-plus contracts. Unfortunately, he's not in a very good philosophical position to argue his case, because he's one of those economic simpletons in Washington who think that making money is ignoble, and that profits are evil, particularly when they're so high as to be "obscene."


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Profit is a synonym for productivity, when the government hampers profitability, it destroys productivity.

doctorg wrote:

There's another issue with fixed-price contracts, in addition to their needing to be profitable enough to justify taking the risk, and that's the question of specs. In order to deliver a product and get paid on a fixed-price contract, the specs for the product need to be clearly defined up front. That way there's no question at the end about whether the delivered item should be paid for. But government buyers often like to change the specs partway through development, which is one big reason that cost-plus contracts often end up much higher than the original estimate. Also, for developments that push the limits of the state of the art, it's not always clear up front whether the product that the government really wants can actually be built. Changing to a fixed-price development regime would require a lot more discipline on the part of the buyers, and probably less ambitious product goals.

john hare wrote:

"Also, for developments that push the limits of the state of the art, it's not always clear up front whether the product that the government really wants can actually be built. Changing to a fixed-price development regime would require a lot more discipline on the part of the buyers, and probably less ambitious product goals."

With multi trillion dollar budgets refered to as 'tight', don't you think it is past time for the buyers to demonstrate more discipline?

Wouldn't it be preferable to set less ambitious product goals in favor of more capable product delivered?

Jack Okie wrote:

Why does it have to be either / or? Pushing the envelope can be done with a series of proof-of-concept or proof-of-materials cost-plus contracts. Having Boeing build tankers based on existing airframes can be firm-fixed-price. I would never do R&D at the "bleeding edge" except on a cost-plus basis.

DensityDuck wrote:

I'm not sure what point Karl is trying to make by posting that anecdote. He seems to be saying "here is a risky activity which is getting more expensive as time goes by, including an example of a tremendously expensive failure. This PROVES that fixed-price is a workable method for handling high-risk contracts!"


Dennis Wingo wrote:

Here is an example of a great fixed price contract.

A bridge was knocked down by a truck on a major interstate interchange in Birmingham Alabama. The governor signed a contract with a construction company that stated that if they got the bridge completely rebuilt, to specs, and with the state highway department signing off on the quality, they would get their money and a bonus of several million dollars. If they did not get it done in 30 days they would get financially penalized for every single day of slip.

Guess what, the company got the bridge up in 28 days and got to pocket the extra two days of money plus the bonus.

In the old days before cost plus became the rule, Aerospace companies performed much better. Today, it is the rule to underbid and then underperform as that is the way to maximize shareholder value, which is the REASON companies exist.

Who would bet me that if there had been a $3 billion dollar bonus check to get SBIRS flying on time and on budget with financial penalties for not performing that it would not have happened?

The overruns on SBIRS has been far more than this. Same thing with NPOESS.

The Aerospace procurement system is broken. That $3 billion dollar bonus would go straight to the stockholders and does anyone want to dispute that this is not an incentive to do good work, on time, and on specification?

Exactimundo, Rand.

When NASA spun off out of (mostly) the Army's missile R&D plant in Huntsville, it internalized the DOD way of doing things. This works as long as price is no object (think, World War II or Apollo). It's also monumentally inefficient (the military was still paying to store some World War II overstocks in the 1980s), but it's effective.

The peacetime oversight of DOD type contracts seeks efficiency, not effectiveness, but it does it in a counterproductive manner. Needless to say, neither goal is served.

Compare the results (technical and commercial) of Scaled, for example, with those of Lockheed and Lockheed Martin over the same period. In that match-up, Lockheed is distinctly number two at innovation, at cost effectiveness, at hitting financial targets either in contracts or overall, and -- most especially -- at returning value to shareholders. It failed out of the airliner business; it would have gone paws up several times in the 60s, 70s, 80s and 90s if it hadn't had the electronics and satellites division and their unconventional sole-source contracts and black projects to prop it up.

Part of it is scale, of course. A company large enough to support all the (productivity-sapping and otherwise useless) lawyers and lobbyists required to secure government business is too large to compete with entrepreneurial businesses. The DOD primes are aware of this, hence the move to semi-autonomous special projects incubators a la Skunk Works, Lockheed's "other" success (besides the classified sat work).

RM3 Frisker FTN wrote:

Cost plus does have some benefits ... it allows DOD to shroud super Mulder spooky stuff. Becomes very difficult for an outsider to trace where the money is really going.

Were all the Space Shuttle 'cost overruns' really DOD contractor gouging or were they ways to fund the 'stealth fighter' and the 'stealth bomber' and 'SDI star wars' without the Soviets really knowing what was going on?

What government contracts are currently suffering 'cost plus' overruns today (include Iraq in that list)? Maybe Iraq really isn't costing so much but it appears to.

Remember this a decade from now when you marvel at some new dual-use "black swan" widget that actually might look like a black swan.

Karl Hallowell wrote:


Look at the quote I mention (BTW it is from the first "cthulhu" post whoever that was). He is claiming that cost plus is faster than fixed price. I merely gave a couple of real world counterexamples. When speed is essential, you don't want to be bogged down worrying about whether some activity is going to be reimbursed or not.

Here, as I see it, are the problems with cost plus contracts.

  • Cost plus provides incentives for the contractor to drive up costs.
  • Cost plus doesn't provide the incentive to get the job done as soon as possible. Or even to complete the job.
  • There's a lot of overhead in monitoring cost plus contracts. To keep the contractor from inflating cost figures, you have to maintain a closer watch on what the contractor does.
  • Cost plus allows for more dithering and changes than a fixed price contract. Lack of discipline in the contract decision makers can greatly increase costs. This is also another avenue for contractors to subvert cost plus contracts by funneling kickbacks to the decision makers in exchange for spec changes that drive up overall cost (and profit).

In other words, the cost plus contract by default creates a variety of conflicts of interest in the contractor. In order to mitigate this problem, the contracting agency has to spend more resources to oversee the contract. One only needs to look at the private world to see their preference. Almost no contracts are cost plus.

Larry J wrote:

Compare the results (technical and commercial) of Scaled, for example, with those of Lockheed and Lockheed Martin over the same period. In that match-up, Lockheed is distinctly number two at innovation, at cost effectiveness, at hitting financial targets either in contracts or overall, and -- most especially -- at returning value to shareholders. It failed out of the airliner business; it would have gone paws up several times in the 60s, 70s, 80s and 90s if it hadn't had the electronics and satellites division and their unconventional sole-source contracts and black projects to prop it up.

Perhaps a closer comparison would be when the same company develops something on its own verses for the government. A case in point happened when McDonald Douglas was developing (at roughly the same time) the C-17 and the MD-11. While it's true that the MD-11 was an outgrowth of the DC-10, the C-17 wasn't exactly a breakthrough piece of engineering. Many of the concepts and technologies had been built and proven on the YC-15.

Guess which project came in essentially on time and budget. Guess which program came in late, expensive, heavy, and whose wings broke earlier than expected in load tests. Hint: People tend to take greater care when they're spending their own money.

Talon84 wrote:

As a contracting officer with the Air Force, I definitely took notice to McCain's mention of cost plus contracts and wondered if anyone besides acquisition weenies like myself even gave the matter much thought. Here's my take, from the AF perspective anyway.

We have various contract types available for use in gov contracts. None should ever be completely removed from our "menu". Within my particular piece of the AF organization at least, I would not say that there is an inherent, widespread preference for or against any specific contract type. Most of us try hard to choose the best contract type from the choices available, and usually solicit input from potential offerors as we make that choice.

The way that the acquisition regs (again, at least within DoD/AF - I can't speak to NASA) approach profit is entirely based upon the amount of risk the contractor is perceived to be taking on. There is even a formula that we must use, feeding in data such as cost elements, length of the effort, type of financing, level of cost/technical risk, etc., that then spits out recommended profit percentages for use in negotiating the contract. So we are forced to look at negotiating profit as solely a measure of risk. (And I might add, that mandatory calculation is known to provide recommended rates that are too low, so we have to use our own judgment in setting negotiation objectives.)

Of course, that approach fails to account at all for how businesses view profit. In the past couple of years, my organization has been making a concerted effort to better train our acquisition personnel on how our contractor counterparts perceive both profit and risk. I've found that this helps to arrive at better business arrangements during our negotiations.

COst plus has been abused at times, though in my experience I think mostly it's simply been misapplied due to poor traing and misunderstanding (on both gov and contractor sides). Though fixed price contract types have been misapplied as well. On some occasions, contractors have pushed for me to make a cost plus contract when I wanted fixed price, and vice versa.

Interestingly, I once had a situation much like what you describe with XCOR. Preliminary discussions with industry indicated a cost plus fixed fee contract would be the best fit. However a particular offeror proposed firm fixed price, had a good rationale, and we went with it. Turned out fine.

The AF no longer uses lowest bid (except in some limited circumstances). Everything from office computer purchases to major systems development and production, is based upon a best value evaluation of factors such as technical capability, systems engineering, past performance, and cost. Cost is often the least important factor. I think it has worked our quite well. As Rand indicated, going with the cheapest one can be pennywise and pound foolish.

Bottom line, I agree that the government needs to reevaluate how it approaches negotiating profit in contracts. I'm not sure what the best answer is, though I'm not convinced that simply banning cost type contracts is the way to go. My opinion is that better training, and (as Rand mentions) a shift in basic philosophy toward profit would be more effective.

I haven't heard much about what, if anything, Obama would do to change government acquisition. Of course, I'm really, really hoping we never get the opportunity to find out.

ken anthony wrote:

Forgive me if I'm wrong, but I get the sense that people think cost-plus applies mainly to high risk projects.

In the early 1980's I did some volunteer work for a Major Davidson at the USAF base in Hellinikon Greece. Boeing had a cost plus contract for base maintenance which included small engine repair, building repair and that sort of thing. Not much risk there.

I wrote some programs on a CPM-86 machine that helped to determine bonuses on their contract. Which was kind of funny since Boeing had just turned me down when I applied for a job with them. No, I didn't do anything vindictive (could have, but didn't)

cthulhu wrote:

ken anthony: "Forgive me if I'm wrong, but I get the sense that people think cost-plus applies mainly to high risk projects."

You're forgiven :-/.

My original post: "However, cost plus should NEVER be used unless there is significant requirements and/or technology risk, and you have to take the concurrent development risk. Buying bullets on cost plus - crazy."

Of course there is massive abuse (intentional and/or just misguided) of cost plus. But I maintain my original point that for programs that (a) substantially push the state of the art (e.g., hit-to-kill missiles in the '80s), or (b) have very uncertain requirements (the services are always coming up with new or changed requirements for their UAV programs, based heavily on in-the-field usage feeding back to development programs), cost-plus will generally get a usable product quicker (not cheaper) than fixed price.

I don't see the relevance of the ship salvage story to my post, either from the technology side or the money side. Losing $11.6 mil on a failed salvage - lots of companies can absorb that, albeit with varying degrees of pain. How about a $500 million new aircraft development program? In the private sector, a company won't launch a new airliner development until they have commitments from customers. If some of the original customers back out, you have the possibility of selling to others. In the DoD world, if your customer backs out, you often have NOBODY else you can sell to; hell, if it's a classified program, you can't even TELL other potential customers your product exists!

In the '90s, DARPA awarded the Tier II+ Phase 2 contract, for the design, development, and flight test of two high altitude long endurance (HALE) UAVs (this is what became the Global Hawk program). The contract was a modified fixed price, with the gov't and the contractor sharing any cost overruns 50-50. Did that keep the government from changing the requirements? ROFL...The rumor was that the gov't eventually ate the contractor's share of the overrun as part of the settlement after the Air Force inadvertently terminated a perfectly good airplane in March 1999 during the flight test program.

A true fixed-price development contract for DoD can work if the requirements are steady and the technology is reasonably mature. The original FSD (full-scale development) contract for the Army Tactical Missile System (ATACMS) was fixed price, and was completed on time and on budget. But there was little that was particularly new about that program, more like refinement of existing technology.

Disclaimer that I should have made in my original post: my experience is strictly in the DoD aerospace world; I've never worked a NASA program (thank God!).

Jon Card wrote:

If I can throw some thoughts in, and I hope I didn't just miss somebody saying this another way, you also have a serious problem using "cost plus" when you're trying to build an industry, like astronautical engineering. When your only customer (at first) is the government and they're prepared to absorb high costs in order jumpstart the industry (I'm thinking of the common refrain that "government is the only one with enough money to 'do space' right now"), "cost plus" not only costs the taxpayers more when it runs the costs of projects up, but it also encourages over-design and poor cost management in the new industry, so that it stays a government only industry. I know that it's not in NASA's charter to promote a space industry, but many people assume that the experience working for NASA will help and that Boeing and Honeywell and the like will take a lead "as soon as they wake up", and I'm not really convinced of that.

This probably doesn't help with the defense discussion, but that's not really my interest.

Astra wrote:

Fixed-price contracts would be a challenge for those of us in academia, as our universities are unwilling to accept the risk of carrying significant cost overruns.

Doctororg has it right, too: the NASA project I work on is significantly more expensive than originally proposed, largely due to modifications demanded by GSFC.

Jim Muncy wrote:


Please tell AFRL Contracting that they should not be afraid to use firm fixed price for Phase II SBIR contracts with commercial companies that have other revenues to back-stop their SBIR effort.

They don't get it.

- Jim

Andy Janes wrote:

Here in the UK it became governement policy to only offer fixed price contracts in the 90's (IIRC).

It doesn't help that BAE is pretty much the only defence company left here, so there is a lot of pressure to give them contracts to 'save British jobs'.

The end result is that is that BAE underbids to get the contract, then when overruns occur demand more more cash or they sracp the project (AFIK this has happened with Nimrod MR4 and Astute class submarines, and probably a few more too)

Ryan Olcott wrote:


Phase II SBIRs? They ARE fixed price. You'll likely not get what you want out of them (this is a welfare program after all), but everyone understands the fiscal caps on a SBIR. There is no 'cost' only the 750K (+ any plus ups).

Do you really want to badmouth AFRL contracting?? They are... pleasurable... enough to work with as is. [who am I kidding, they don't read, here]

Although it made me smile when I heard McCain bring up Cost Plus contracts during the debate, I really don't think more than a couple % of his audience (at best) understood what he was talking about.

As for Cost Plus being necessary because those of us in government acquisition can't keep to the requirements we let the contract for in the first place... coddling our childish impulses to pile on more items from our wish list obviously isn't doing the taxpayers any favors.

In my experience, the program office is forced to spend more time slapping hands from reaching into the requirements cookie jar.

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This page contains a single entry by Rand Simberg published on September 28, 2008 10:34 AM.

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