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October 30, 2015
Is Northrop Grumman’s plan for developing the US Air Force’s new Long-Range Strike Bomber realistic? That’s another known unknown in this mystery plane program. We do know that the development contract will be cost-plus-reimbursable-incentive, meaning that a percentage will be added to the direct material, labor, and overhead costs in order to create a profit margin for the contractor. That percentage will vary with a subjective assessment of how well Northrop Grumman is performing as it works to design and test the prototypes. Loren Thompson of the Lexington Institute called that approach “out of sync” with the Obama Administration’s Better Buying Power (BBP) enthusiasm for fixed-price deals. However BBP has been interpreted throughout the bureaucracy, fixed-price was never meant as a panacea. For unfashionable is preferable to uneconomical, and some historical experiences suggests that the Air Force might be getting this right.

Earlier this year, Assistant Secretary of the Air Force (Acquisition) Bill LaPlante personally assured an understandably skeptical Congress that a cost-plus contract for development was the right choice. The decision turned on a single factor: the expected ex-post variance of the contractor’s actual costs from the ex-ante estimate. As he explained to the House Armed Services Committee in March,

If you’re on a fixed-price contract, it’s really important to have a good estimate of what you think it’s going to cost. If you’re wrong on it—let’s say you’re wrong 50 percent one way or the other—somebody is going to get really hurt. If the contractor ends up 50 percent over on a fixed price, they’re very hurt, and they might not survive. The opposite—we would get rightfully criticized [for] giving a windfall, buying something for twice what it costs. So you really want to have a good idea on the cost estimate for development.

Presumably, a well-informed contractor will not sign an undoable deal, so a fixed-price production contract may improve the credibility of any cost cap. With the LRS-B, the first four lots of production will be built under a fixed-price incentive fee arrangement. But fixed-price is not a panacea. The realism of the cost model makes all the difference, and ill-informed contractors sometimes do sign undoable deals.

Indeed, LaPlante has several times cited research by David McNicol of the Institute for Defense Analyses which has found that the choice of fixed-priced or cost-plus has not historically mattered to the size of the cost overrun (see Cost Growth, Acquisition Policy, and Budget Climate, May 2014.) If that seems surprising, it’s because the specific incentives and perceptions of the long-term availability of military spending matter more. When budgets are trending down, program managers and marketers may tend to over-promise in order to get their ambitious efforts approved. As the Government Accountability Office described the problem in a just-released study of the Ford-class aircraft carriers, “the decades-old culture of ndue optimism when starting programs is not the consequence of a broken process, but rather of a process in equilibrium that rewards unrealistic business cases, and thus, devalues sound practices.” Along the way, if the government wants something badly enough, the contract based on offered price can eventually become one based on actual cost.

The famous case is Lockheed’s fixed-priced development of the C-5A Galaxy, in which the company experienced a $2 billion dollar cost overrun. The company's solution to this problem was to extract a $500 million unilateral price increase from the government by threatening bankruptcy—and program termination—if the check didn’t come through (see Yossi Spiegel, “The Role of Debt in Procurement Contracts,” Journal of Economics and Management Strategy, Autumn 1996). The Air Force begrudgingly obliged, and production continued. On the other hand, there’s Boeing's recent fixed-price development of its KC-46A tanker. For a company that has been designing and building tanker aircraft since the 1950s, this seemed easy. But Boeing seriously underestimated the size of the required effort this time—and the USAF had been warning the company for years that its cost model was not realistic. With Boeing, the Air Force was unsympathetic, as the company'scash flow from commercial aircraft sales would easily cover the shortfall. As a result, Boeing is assuming nearly one billion dollars in overruns, and may make little or no profit on its initial deliveries.

This time, with Northrop and the LRS-B, there’s reason to believe that the cost model is sound. The bomber is, after all, being advertised as a plane to be built largely from existing technologies—if not wholly from publicly known technologies. Jeremiah Gentler of the Congressional Research Service has observed that the requested funding already “resembles a production program more than a typical development profile,” so we might wonder if some prototypes have already been built. Air Force officials have denied this, but it is possible that some technology demonstrators have flown—perhaps as those notable Flying Doritos over Texas—in risk reduction efforts. For while the Air Force has undertaken much more testing of the designs than is typical prior to a contract award, there are still subsystems that must be developed, which means that correctly budgeting for the price per bomber (as we noted yesterday) is still challenging.

Already resembles a production program, however, raises the specter of concurrency—beginning production while one is still developing and testing, with serious potential for costly rework and retrofitting. The USAF does have a long history of painful experiences here. As Michael Brown of George Washington University explained in Flying Blind: The Politics of the US Strategic Bomber Program (Cornell University Press, 1992), concurrency has worked poorly with great technological leaps forward. In the context of the Joint Strike Fighter program, Under Secretary (AT&L) Frank Kendall once called this “acquisition malpractice.” Concurrency is commendable, though, in modest engineering challenges, saving some time and thus money. Research by Donald Birchler, Gary Christle, and Eric Groo of the Center for Naval Analyses has indicated that the lowest cost overruns may be found in programs that spend 30 percent of their research, development, test, and evaluation (RDT&E) funds concurrently with some procurement funding (see “Investigating Concurrency in Weapons Programs,” Defense AT&L, September-October 2010).

With LRS-B, the relatively long development period—at least five years—suggests that what development remains will remain mostly separate from production, which is at least not disastrously concurrent. Keeping the contract vehicle for development separate from that for production is also a sound idea. The feasibility of developing an LRS-B within the independent cost estimates is still a known unknown for this program, but the little we know is at least encouraging.

James Hasík is a senior fellow and Rachel Rizzo is a researcher at the Brent Scowcroft Center on International Security. This essay is an update of our earlier short study “Why a Cost-Plus LRS-B Contract?” (March 2015).