Defense acquisition chief Ashton Carter’s plans for procurement reform center around sharing risk on big contracts. But, in sharing the pain and the gain, does it strike the right balance, or does it need tweaking?

Prologue: A New Era

Defense observers recognize it’s a new era for defense acquisition, ushered in by the necessity of an economic climate that has Pentagon leaders’ eyes fixed on the future as well as the bottom line.

It’s clear — Defense Secretary Robert M. Gates’ far-reaching efficiencies plan announced last August was only the beginning for government-contracting firms.

Now, observers looking for the latest tea leaves to read are eying Undersecretary of Defense for Acquisition, Technology and Logistics Ashton Carter, who has spoken of the need to “manage to a new reality.”

Going forward, DoD will need to get more bang for its buck on large contracts, Carter has said. With 400 billion of the department’s bucks going to contracted goods and services, the repercussions for the GovCon community will echo well into the future.

The proposals for Pentagon procurement reform — and there are many, from a preferred-supplier program to focusing on affordability right from the drawing board — boil down to the issue of sharing risk, between the government and industry, between DoD and its contracting partners.

It all hedges on “how to share the pain,” when a contract goes over budget or falls behind schedule, as Carter put it at a forum on defense procurement policies in November.

Even more recently, DoD grew closer to rolling out a penalty for contractors found to have “deficient” business systems, such as faulty contract accounting practices.

While the original rule, which would have cut 10 percent from a contractor’s payment, was later amended to a lower amount, many in the private sector are still dissatisfied with what they see as too vague and overly burdensome rules.

It’s clear the GovCon world will face DoD’s attempt to manage to a new reality in its bottom lines. But they will also demand to be equal partners with DoD in creating these new strategies for assessing risk.

To truly share the risk, DoD needs partners in sharing leadership.

Part I: The Share Line

The changes to DoD’s buying strategies — its amended shopping list, if you will — were laid out in a memo authored by Gates and Carter late last year. Above all, those changes reflect the era of tighter budgets the secretary has insisted are a part of DoD’s new reality.

One of the most macro-level proposals is changing the structure of contracts to share the cost of over-budget projects between DoD and contractors. For DoD, it’s about leveraging the right amount of both carrot and stick, or in Carter’s parlance, “pain” and “gain.”

“We’re trying to change the contract structure so that it has the right incentives,” he said.

That balancing act, detailed in the defense memo, comes out to an even 50-50 split.

“A 50-50 share line is a square deal,” Carter said. It’s an “even sharing of pain and gain around an agreed target.”

In more technical terms, it’s called a Fixed-Price Incentive Firm Target contract, and, according to the DoD memo, that’s what Gates and Carter want to see spelled out in contract ink going forward.

“Effective immediately, you will give greater consideration to using … [FPIF] contracts,” the memo states, “particularly for efforts moving from development to production,” which is a crucial stage, defense analysts say.

Historically, Pentagon acquisition teams have often used cost-reimbursement contracts for development efforts, then switched to firm-fixed-price contracts for the actual rollout of products.

In the former, DoD pays for what it gets. In the latter, the department sets a target price and contractors bid based on it. Too often, acquisition officials have not “adequately” considered using FPIF contracts — the 50/50 share line, the memo states.

Industry may generally agree with Carter on the use of a share line. Alan Chvotkin, executive vice president and counsel at the Professional Services Council, said share lines are an “essential part of any incentive contract.”

But he told GovConExec the key for the Defense Department is not merely to set the incentive and the share line and close up shop, but to “develop the appropriate baseline of contractual performance” and be clear about how the government will measure success.

There is a careful calculus that goes in to creating a fair share line. A steep one, where the contractor assumes more of the risk, is not fair, Carter said, because it allows the government to “load on additional requirements that [the contractor] has to pay for.” But, with a flat share line, the government is often left with the bill.

Chvotkin said contractors often look at 50-50 share lines with trepidation.

“The downside of the share line,” he explained, “is looked on by the contractor as the risk of failing to achieve the incentive over and above the baseline of contract performance.”

Dave Farling, director of the DoD and Intelligence Division at Intelligent Decisions in Ashburn, Va., went even further, saying FPIF contracts could be “very risky” for government contractors.

He said the key to proper risk assessment lies in setting requirements in the beginning stages of a contract.

“Properly determining the nature of the work to be performed on the front end and then keeping the work within that original scope,” is the biggest hurdle to getting contracts in on time and under budget, he said.

However, DoD has another solution for chronically behind-schedule contractors: a price ceiling.

“The ceiling is the most — I, the government — am going to assume in terms of risk of overrun,” Carter explained at the forum last fall, which the DoD memo sets at 120 percent of the contract’s original price. “When we [go beyond that], I’m out of Schlitz and it’s all yours,” he added.

Stan Soloway, president and CEO of PSC, which has often found itself staking out the ground opposite DoD’s new strategies, agrees risk is a key factor. In an editorial last year, he said the “essence of a business deal” revolves, in part around both risk — and reward.

“In some of Carter’s initiatives, however, that balance is in real question,” Soloway wrote.

The Fixed-Price Incentive Firm contract type is appropriate under some circumstances, industry analysts say, but “by definition, it means that risk is being shifted to the private sector,” he noted.

Part II: Fee Withholding, What’s Fair?

One of the touchiest areas for government contractors is the withholding of payments. Some view it as the government trying to make good on a promise. But, with a contract award going to bolster an often uncertain bottom line, it can feel like a company’s profits being held hostage by burdensome regulations (and an overzealous government).

That tension played out recently in DoD’s plans to withhold payments to contractors if internal company controls, such as accounting systems, are found to be sub par.

The original rule for “deficient” business systems (companies’ procedures for estimating, purchasing and management measures) would have lopped 10 percent from a contractor’s payment.

The new rule was spurred by the 2009 Commission on Wartime Contracting, which found that inadequate business systems supplied by contractors prevented DoD from detecting errors and abuse.

The new rule quickly drew significant outcry from industry circles and was later amended, the withholding amount reduced to 5 percent. But, in a public letter to DoD, a number of private-sector groups, represented by the Council of Defense and Space Industry Associations, advised the department to go back to the drawing board once again.

“While this second rule does a better job than the first proposed rule of identifying those system attributes and linking system deficiencies to elements of risk to the government,” the letter states, “there are still significant concerns with the attributes of the individual business systems and the withhold process that must be addressed.”

The rules for the various systems were too vague, the groups contended, making it difficult to know if theirs were approved or not. In addition, the withholding seemed more likely an arbitrary penalty than a legitimate way for the government to recoup losses from actual harm caused by faulty systems.

Epilogue: Partners in Risk

Carter and DoD’s plans are designed to both assess risk and better distribute it during the life of a multimillion-dollar contract. But, some industry observers say the Pentagon is playing with a loaded deck and asking its contracting partners to carry the burden

While government and industry appear helplessly at odds, there are areas of common agreement for both sides. Even as DoD seeks to codify the 50-50 share line into its standard business practices, both sides agree there remain ways to meet halfway.

And, PSC’s Chvotkin said it starts with well-meaning partners on both sides.

“When properly negotiated between knowledgeable parties, the share ratio can appropriately and fairly allocate risk and reward between the government and the performing contractor,” he said. ♦