To Avoid Airbus A400M Contract Problems, Turn to "Performance-based Contracting"December 23, 2009
 The Airbus A400M military transporter finally flew for the first time earlier this month, but the contract for building the aircraft—an inflexible fixed-price deal—continues drag down the relationship between the buyers and Airbus. Yet, the fixed-price contract, which was largely abandoned in defense because of cost overruns and delays, might make a comeback as the U.S. Defense Department considers ways to contain escalating costs that are inevitable when big projects run into delays, according to an article in The Wall Street Journal. As the Airbus A400M deal shows, fixed-price contracts are fraught with problems. The European Aeronautic Defense & Space Co., (EADS) Airbus’ parent, agreed to build 180 transporters for $29 billion and promised to absorb any cost overruns. The project has since been mired in delays and has overshot the budget. EADS is now working with the buyers to find some way to share the burden it promised to swallow on its own, according to the Journal. The problem with fixed-price contracts, critics contend, is that defense programs take decades to complete while technology continues to evolve. Costs inevitably increase as the contractor and the Pentagon try to incorporate new technology into the program. The Journal article noted that an alternative to the fixed-price contract is the cost-plus approach, which pays supplier expenses and guarantees a fixed profit margin that rises as costs rise. But that approach does not control costs. While the article laid out the pros and cons of fixed-price and cost-plus contracts, Morris A. Cohen, a professor of operations and information management at Wharton, notes that the Journal appears to ignore another type of contract that is increasingly the standard for big projects: performance-based contracting (PBC). PBC has emerged as a mandated requirement for federal government services procurement, including defense systems. "The most famous example of this type of contract is the Power by the Hour contract made famous by Rolls Royce for its aircraft engines," says Cohen. He added that Wharton research (“Performance Contracting in After-sales Service Supply Chains,” Management Science, Volume 53, No. 12, December, 2007) indicates that the optimal form of contracting is a blend of cost-plus, fixed-price and PBC components. The mix, moreover, varies as a program matures. "Cost-plus tends to dominate at the early stages—when risk is greatest—and fixed-price is preferred when a program reaches stability," says Cohen. "The bottom line is that contracts act to transfer risk between customer and supplier, and performance-based terms act to align incentives between the two parties. The best contracts balance risk and align incentives with a mix of approaches." While the emphasis on PBC in aerospace and defense has been for post-sales system management—and not for initial procurement—Cohen says that the principles still apply. "As this [A400M] debate illustrates, it is difficult to enforce fixed-price contracts when new technology is being developed, especially in the limited marketplace of weapon system procurement," says Cohen. "At the same time, the government is pushing back against the notion that they have to bear the majority of the risk as they would in a cost-plus scenario." (U.S. Air Force photo/Staff Sgt. Robert Barney (RELEASED)) |
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