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Cost-type Contracts in the Cross-hairs at DoD

Published: February 28, 2013

Acquisition ReformUSAFARMYCONGRESSDEFENSEDISAForecasts and SpendingNational Defense Authorization ActNAVYPolicy and Legislation

Although the current focus in the federal market centers on budgetary issues like sequestration, continuing resolutions, and the outlook for the fiscal year (FY) 2014 budget there is another aspect that will push agencies to spend less and achieve economies and value for their contract dollar. Here I am referring to acquisition policy – how agencies contract for goods and services with private sector suppliers. Legislators and policymakers have been looking for ways to drive costs out of the system and one recent mandate targets the use of cost-type contracts.

Background
 
Cost-type, or cost-plus, contracts exist when a contractor is paid for all of their allowable expenses to a pre-set limit plus an additional payment to allow for a profit. These are sometimes referred to as cost reimbursement contracts. By contrast, fixed-price contracts are those in which the contractor is paid a pre-negotiated amount for the work or product regardless of their expenses. Cost-type contracts may include several sub-types, including Cost Plus Fixed Fee, Cost Plus Award Fee, Cost Plus Incentive Fee, Cost No Fee, and Cost Sharing. These cost-type contracts are popular for programs that have unclear or fast-changing requirements or for technologies that are so new that there is insufficient information to accurately estimate development or production costs. Due to these uncertainties, the agency driving the requirement assumes the financial risk of programs changes – often resulting in cost overruns and schedule delays.
 
Congress Targets Cost-type Contracts
 
Given growing budget pressures, Congress, OMB and federal agencies are looking to shift some of this risk back to contractors and limit the potential higher-cost implications of cost-type contracts. In fact, Congress recently put limits on their use at the Department of Defense (DOD). In the FY 2013 National Defense Authorization Act that was enacted in January, Congress set in motion several provisions addressing various areas of federal acquisition and contracting policy that will impact major procurements, including one singling out Cost-type contracts.   
 
Section 811 on the Limitation on Use of Cost-type Contracts requires the Secretary of Defense to modify acquisition regulations by May 2013 to prohibit the DoD from entering into cost-type contracts for the production of major defense acquisition programs. The limitation is not all-encompassing. It does not include individual line items for segregable efforts or contracts for the incremental improvement of systems that are already in production (other than contracts for major upgrades that are themselves major defense acquisition programs.) The law allows the Under Secretary of Defense for Acquisition, Technology, and Logistics (USD AT&L) to grant exceptions if justification is provided to the relevant congressional defense committees. The policy change will apply to contracts effective on or after 1 October 2014, (i.e. beginning in FY 2015.)
 
IT Cost-type Contracts at the Department of Defense
 
To gain a perspective of the potential impact of the new regulation on IT contracts at the DoD I pulled up data on the reported IT contract obligations over the last five years for the various contract types used. (See chart below.)
 
 
Observations
  • Cost-type contracts are second only to Fixed Price contracts as far as total dollar obligations are concerned.
  • While the percentage of yearly total obligations made up by Fixed Price contracts grew modestly from 47% to 53% over the period the percentage of total yearly obligations made up of cost-type contracts grew from 21% to 37%.
  • Cost-type contracts have grown by more than 65% from FY 2008 to FY 2012, compared to Fixed Price contract types which have increased 8% during the same period.
 
Recent Cost-type Contract Usage for IT
 
Drilling a bit deeper specifically into the use of cost-type contracts at the four major defense components provides a more focused perspective. (See chart below.)
 
 
Observations
  • Army’s use of cost-type contracts doubled over the period where Navy’s cost-type use increased by nearly 60%. OSD’s usage has grown most dramatically at 3X, but the relative dollars in this category is modest by comparison. The Air Force’s usage has been most modest of the four at roughly 10%.
  • On average, the Navy makes up more than half of DoD’s yearly IT cost-type contract obligations over the period, compared to Air Force and Army making up approximately 20% each.
 
Implications
 
There are several implications for defense IT programs that may result from the new restriction. The limitation may reinforce the growing trend of using short-term fixed-price contracts to meet program milestone goals. Naturally, using firm fixed-priced contracts for long-term IT investments increases the risk for vendors.  This has been an explicit goal of several federal agencies that are feeling the pressure of increased scrutiny for poorly performing IT programs. 
 
The limitation may also multiply the effect of budget constraints in prolonging the lifespan of outdated legacy systems over the development or acquisition of updated technologies and systems. This could further delay needed modernization and/or consolidation of legacy systems and reduce efficiencies.
 
In our broad analysis of the federal IT market implications of the FY 2013 NDAA we identified this and several other areas of federal IT market impact, including cybersecurity, network operations, software use and licensing, and additional areas of IT procurement. The impact is not all negative from a spending perspective. Congress is prepared to fund key IT priorities, but competition is likely to be intense as funding shifts.