The Air Force's decision to issue a fixed-price, incentive-fee development contract was controversial at the time of the KC-X competition. Contractors balked, claiming that a fixed-price development put too much financial risk on them. In the end, however, Boeing underbid rival EADS by about 10% to win the competition and opted to put as much as $400 million of its own funding into the program because its estimates exceeded the government ceiling of $4.9 billion (including the Air Force share of the target overrun).
Reopening the KC-46 contract could expose the Air Force to major cost escalation, as it would give Boeing a chance to recoup its losses and seek compensation for any unplanned work that has been discovered since the contract was issued nearly two years ago.
“There is nothing that says at March 1, if sequestration kicks in, we will not have enough money to pay Boeing,” Davis says. This is because the value of the program line item that funds the tanker is greater than the anticipated annual cost of progress and incentive payments to Boeing. Those excess funds are for such items as management reserve. So, while the program line item could be reduced, the service would first decrease funding not related to the contract.
“Any amount of sequestration would just about take any reserve [that] all of the programs have to make any changes or [address] any unknowns . . . . So you have no [management reserve], you have no ability to handle change proposals, you have no ability to handle a failed test,” Davis says. “I still think tanker is going to lose a lot of its flexibility at the program level to handle [these issues, but] of course, the idea of tanker is not to have any evolutionary changes.”
Similarly, the service would trim funds around multiyear programs—gutting spares and ancillary equipment purchases for a program—rather than cutting into those contracts, Davis says.
The Pentagon, and particularly the Air Force, has made a concerted effort to sharpen its contracting skills to limit financial exposure and share risk and reward with the contractor. This produced such fixed-price contracts as the KC-46 and Raytheon's Small-Diameter Bomb II. “We didn't necessarily implement that strategy to drive behavior,” Davis says. “We implemented that strategy because we believed the maturity of the program or the technology . . . warranted it.” But the shift is driving changes in how contractors work.
“It is forcing both the contractor and the program to be more realistic in their assessment of what is doable and what is not,” he says. “And if the contractor chooses to devote some of his funds or some of his profit to be competitive in the program, that bears out as well. . . . . They also have to decide how much of the profit they have to put in the bid. That is something, I think, contractors ought to have a willingness to do.”
Davis notes that fixed-price, incentive-fee contracts are not a panacea. The trick is in knowing the right contracting mechanism for each project, based on a technology's maturity and/or production readiness. While the Air Force has improved its contracting skills, there remains much for it to learn. For example, the service would like to gain better insight into the costs of a program as they bear out, lot over lot during production, which is generally when the price decreases substantially as the contractor progresses along a learning curve and companies can increase profit.
“We want to do fixed-price [contracts] so the contractor will invest and improve the quality of the product and improve the cost of it, and then we want to make sure we have enough insight into it so that all of that just does not instantly roll into windfall profits on the contractor side,” Davis says. “We want to figure out ways to be able to share all of this great work they are doing, so that when we negotiate a profit of 12-15%, over years—if we don't make some adjustments to it—that 12-15% can climb quite rapidly to 20, 25, 30%.” He adds that “you need to pay attention to what is happening lot over lot so that it is fair. The contractor continues to make a fair and increasing profit and the government continues to see a fair and decreasing cost of the item, and they both share in that.”