by Vernon J. Edwards

Special to Where in Federal Contracting?

If you work in defense acquisition or if you are a regular reader of publications like The Government Contractor (GC) and Federal Contracts Report (FCR), then you have heard of "price-based acquisition," and you know that some Department of Defense (DOD) acquisition managers want their contracting officers to switch from a cost-based to a price-based approach to contract pricing.  This means that they want to get rid of the red tape associated with the Truth in Negotiations Act (TINA), the Federal Acquisition Regulation (FAR) cost principles, the cost accounting standards (CAS), and the Defense Contract Audit Agency (DCAA).

The leading voice for the switch to price-based acquisition has been Dr. Jacques Gansler, the Under Secretary of Defense, Acquisition and Technology.  In order to understand why he thinks that DOD should change the way it prices contracts, you have to understand the larger context of his thinking, which has to do with the changes to the threat to the United States since the end of the Cold War.  He thinks that new threats demand a "revolution in military affairs."

Briefly, Dr. Gansler’s argument goes like this:  The U.S. is no longer threatened by large-scale warfare between NATO and the Warsaw Pact, but by the possibility of having to fight in several "low intensity" conflicts in different places at the same time.  In order to cope with the new threat, our forces must be able to strike fast and hard anywhere in the world with a variety of inexpensive but effective weapons.  We can no longer rely on the nuclear triad to protect our global interests, which is why we need a revolution in military affairs. 

In order to bring about the revolution in military affairs at a reasonable cost, Dr. Gansler says that DOD weapon designers will have to take advantage of the best technologies that are available in the commercial marketplace.  This will require "civilian/military industrial integration," which he described in a speech at the Defense Systems Management College on May 12, 1998, as follows:

We seek a greatly expanded partnership with a revived and prospering commercial industry — not a partnership in which we become simply the purchasers of commercial products and processes, but a dynamic and vigorous engagement that, through R&D, creates advanced products and systems with common technological bases and that, through the use of flexible manufacturing, allows production of our low-volume defense-unique items on the same lines with high-volume commercial items.

Civilian/military integration will be difficult, according to Dr. Gansler and others, because commercial firms dislike DOD’s intrusive and expensive cost-based pricing policies and procedures.  Thus, DOD needs what Dr. Gansler calls a "revolution in business affairs."  He says that DOD must adopt commercial practices in order to get the technologies that it needs at costs that it can afford, and a key plank in his revolutionary platform is price-based acquisition. 

On October 15 1998, Dr. Gansler issued a memorandum that established a study group "to analyze implementation of a price-based acquisition system on a Department wide basis."  In that memo he defined price-based acquisition as "the establishment of contractual relationships using price instead of cost."  He said, "Price may be established by comparisons to prices of other offers, market prices, competitive alternatives, and parametric analysis based on price, rather than cost."  He said that cost-based acquisition means "contracts that are based on costs incurred or projected to be incurred by the contractor…," and that such contracts "require the tracking and allocation of costs, often in Government-unique accounting systems, governed by Federal Cost Accounting Standards (CAS) and that an offeror often provides certified cost or pricing data."  In short, price-based acquisition means determining price reasonableness on the basis of price analysis and eliminating the four elements of cost-based acquisition:  TINA, the FAR Part 31 contract cost principles, CAS, and DCAA audits.

In a December 3, 1998, speech to the National Contract Management Association in Washington DC, Dr. Gansler said: 

To achieve [civilian/military integration], we must change over to price-based acquisition practices— to establish contractual relationships that use price analysis as compared to cost analysis (either incurred or anticipated).  This is the primary way the commercial world functions.  This will be the primary way we must function too.  Price-based acquisition must become the norm — with cost-based acquisition the rare exception….  We want to see price-based acquisition and standard commercial practices as the norm; and require permission to use cost-based contracting with special auditing.  Doing so will remove one of the most significant barriers to full civil/military integration. 

In that regard, I might mention that I am working with the General Accounting Office, the Defense Contract Audit Agency, and others to help us stimulate integration by frequently doing away with, and, in all cases, greatly simplifying, many specialized government accounting and auditing procedures.  We cannot expect to be successful in bringing together the commercial and military sectors unless we remove antiquated defense-unique requirements that discourage world-class companies from doing business with DOD.

Now, if all this is about is using price analysis instead of cost analysis and the associated cost-based pricing policies and procedures, then the solution is simple — all the Defense Department has to do is award firm-fixed-price contracts on the basis of adequate price competition.  That would eliminate all of the elements of cost-based acquisition.  Of course, therein lies the rub, because many contractors and defense officials do not want to undertake risky development work under firm-fixed-price contracts.  They have tried that and it has not worked well.  When Dr. Gansler established the price-based acquisition study group, he directed the group to deliver its final report by March 1, 1999.  As of November 26, they apparently had not done so, having postponed its delivery several times.  News reports indicate that disagreements about the fixed-pricing issue are at the heart of the delay (see 41 GC ¶ 444, October 27, 1999). 

It is easy to get around TINA.  The adequate price competition exemption applies to contracts of all types, including cost-reimbursement contracts, as long as they are awarded on the basis of adequate price competition.  You might even be able to avoid TINA when negotiating contract modifications and claims settlements if you can say that they are priced "based on" adequate price competition.  However, when using cost-reimbursement contracts and negotiating large contract modifications and claims there is no easy way around the contract cost principles, CAS, and DCAA audits, not without changes in the governing statutes and regulations.

If Dr. Gansler thinks that the elimination of cost-based acquisition system is essential to national security, as he clearly does, then why not take his case to Congress and ask it to repeal or revise the statutes on which that system is based?  The answer is that not everyone shares Dr. Gansler’s enthusiasm for price-based acquisition.  William H. Reed, the Director of DCAA, sent a memo to Dr. Gansler on May 22, 1998, expressing concern about priced-based acquisition.  According to a June 1998 report in FCR, Mr. Reed warned Dr. Gansler that advocacy of price-based acquisition:

[P]resupposes that effective competition exists to the point that predatory pricing practices or other pricing strategies that are not in the public interest where national security is involved are detectable and can be avoided. This state of effective competition does not and has never existed for military unique equipment or that produced by a handful of dominant defense contractors. It certainly is even more unlikely today given the contraction of the defense industry.

A market system is essential to effective competition.  The greatest study ever made of weapons acquisition, which was conducted in the late 1950s and early 1960s by Harvard University’s Graduate School of Business Administration and headed by the distinguished scholars Merton J. Peck and Frederic M. Scherer, described the role of a market system as follows:

[A] market system decentralizes decisions on what to produce and what the price should be among many buyers and sellers. In this way the impersonality of the market is substituted for the rigidities and arbitrariness of centralized planning. Furthermore, a market provides a very workable set of incentives….  

It is the existence of a market and the information it produces that enable buyers to determine whether or not a price is fair and reasonable without resorting to cost-based pricing.  After studying the weapons acquisition process, Peck and Scherer concluded:

It is not only that a market system does not now exist in the weapons acquisition process. We can state the proposition more strongly.  A market system in its entirety can never exist for the acquisition of weapons. [Emphasis added.]

The authors then give four reasons in support of their conclusion:

• First, weapons development requires such large expenditures that contractors are unable to obtain private financing.  The government has to finance weapons development.
  
  

• Second, the financing problem is exacerbated by the many unique uncertainties associated with weapons development, both technical and political, which repel stockholders and other investors.
  
  

• Third, centralized planning is essential to the determination of weapon system performance and design requirements, but centralized planning is inconsistent with a market system.
  
  

• Fourth, the government is the only buyer of weapon systems, so the many buyers-many sellers dynamic of a market system is not present to set prices.

(See: Merton J. Peck and Frederic M. Scherer, The Weapons Acquisition Process: An Economic Analysis (Boston: Harvard University, 1962), Chapter 3.)

The Government’s cost-based pricing policies and procedures evolved during many decades from World War I through the present day.  They evolved in response to the absence of market forces in weapons acquisition and they stand in for those forces.  The cost-based acquisition system was the direct result of the fact that the Government often cannot award firm-fixed-price contracts or obtain market pricing information when hiring contractors to develop and produce weapon systems.

Critics of the government’s cost-based pricing policies and procedures (which include this author) have long complained that they (1) discourage commercial firms from doing business with the government and (2) cost more money than they save.  The first complaint is undoubtedly true, although cost-based pricing has not prevented the Defense Department from satisfying its requirements.  In any event, cost-based pricing is one of only many features of government contracting that make it unattractive to commercial firms — see the October 25, 1999 issue of FCR (72 FCR 466)

The second complaint is more problematical, since we lack the data needed to make a sound cost-benefit analysis.  But it seems fair to question whether or not the "savings" or "cost avoidances" that have been attributed to TINA, the cost principles, CAS, and contract audits have equaled or exceeded the costs of those policies and procedures.  Those costs arise from millions of labor hours that have been devoted to collecting, preparing, analyzing, arguing about, and litigating about contractor cost information and accounting procedures.

If the costs of the pricing safeguards have exceeded their benefits, it is undoubtedly due in part to overzealous application.  For many years after the passage of TINA, contracting officers routinely demanded the submission and certification of cost or pricing data in competitive negotiated procurements in excess of the TINA dollar thresholds despite the fact that there was likely to be adequate price competition.  This was due in part to ignorance, in part to the desire to speed up the process in the event that adequate price competition did not occur, and in part to the the belief that one was more likely to be criticized for not getting cost or pricing data than for getting it unnecessarily.  The overzealous application of TINA between 1963 and 1993 may have cost the government hundreds of millions of dollars in excess costs.  (Interestingly, competing offerors rarely protested such unreasonable requirements.  But in one case a protester successfully challenged a Defense Logistics Agency demand for cost or pricing data.  See: C3, Inc., GSBCA No. 10066-P, June 30, 1989, 1989 BPD ¶ 189.)

As long as the U.S. relies on military superiority through technological superiority, the risks of weapons development will require the Defense Department to contract for weapons development on a cost-reimbursement basis.  As long as there are cost-reimbursement contracts, the contracting parties will need to agree about what costs will be reimbursed and how costs will be estimated and measured, and as long as DOD uses tax dollars to pay for weapons political issues will drive the process as much as technological issues.  It remains to be seen whether or not the "incremental" or "evolutionary" development processes advocated by the Defense Science Board will enable the Defense Department to use fixed-price contracts effectively when buying weapons development services.

These difficulties do not mean that nothing can be done to reduce the burden of the cost-based pricing system.  There are several things that can be done.

• First and foremost, agencies should buy commercial items and award firm-fixed-price contracts based on adequate price competition whenever feasible and appropriate.
  
  
• Second, Congress should revise TINA to apply it only to contracts of $25,000,000 or more that are part of a large aerospace-defense development program, while retaining the existing exemptions and waiver authority.  This would not mean that contracting officers could not demand cost information for other contracts; it just means that firms would not be required to submit and certify "cost or pricing data," as defined by FAR, for any but the most significant contracts. (However, according to a recent news report, a draft proposal by the price-based acquisition study group to raise the TINA threshold to $10 million met with "strong" internal opposition.  See 72 FCR 467, Oct. 25, 1999.)
  
  
• Third, Congress should apply the cost accounting standards on a programmatic basis, and only to large aerospace-defense programs such as the F-22 and the Joint Strike Fighter.  Applicability should no longer be determined on the basis of dollar thresholds specified in standing regulations.  The determination to apply CAS should be done as part of the legislative program authorization process, so that defense officials and industry representatives could testify about the costs and benefits of applying the cost accounting standards to the particular program.
  
  
• Fourth, the FAR Council should delete FAR 31.102, which applies the cost principles to the pricing of fixed-price contracts.  The cost principles should continue to apply to the determination of cost allowability under cost-reimbursement contracts and in the settlement of claims when the parties cannot reach agreement through negotiation.
  
  
• Fifth, the Defense Department should direct DCAA to focus its efforts on only the largest and most significant aerospace-defense contracts.
  
  
• Sixth, the Defense Department should improve the training in pricing and negotiation that it gives its contracting personnel.  The training that the Department currently provides them is entirely inadequate.  Contracting personnel need better education in microeconomics, mathematics, marketing, and the strategy and tactics of setting prices.
  
  
• Finally, the Defense Department should review its use of cost-reimbursement contracts for non-weapons work and find out under what circumstances the commercial sector uses cost-plus contracts — they use them more extensively than is commonly supposed — and how commercial parties determine costs and cost allowability under such contracts.

If Dr. Gansler is right that government pricing policies and procedures are an obstacle to civilian/military integration, then in order to achieve his objectives he will have to persuade people in his Department and in Congress that making price-based acquisition the "norm" will not result in widespread fraud, waste, and abuse.  The fact that his own study group seems to be having trouble reaching a consensus on the issues indicates that this will not be easy.  Dr. Gansler considers cost-based pricing policies and procedures to be needless red tape.  But, as Herbert Kaufman said in his wonderful little book, Red Tape: Its Origins, Uses, and Abuses, "One person’s ‘red tape’ may be another’s treasured safeguard."