Wharton Aerospace & Defense Report

Quick Analysis: Fixed-price Contracting Heading to SpaceApril 22, 2010

Senior Defense officials told a gathering of executives at the National Space Symposium in Colorado Springs, that the Pentagon is about to make major changes how it structures business contracts with space companies.

The biggest change, according to an article in the Federal Times, is the growth in the number of fixed-price contracts and away from the existing cost-plus awards. Fixed-price contracts allow the Pentagon to force a defense contractor to assume the risk of delays and cost overruns. The current standard, cost-plus, promises a fixed price plus any increased costs that are incurred from delays and development detours. Critics contend that cost-plus contracts offer no incentives to control costs since companies are guaranteed fixed profit margin.

The U.S. Air Force's chief space commander, General Robert Kehler, said the government must replace Cold War era incentives and start to stress budgets and timely performance.

Deputy Defense Secretary William Lynn rang the alarm by telling the audience that unless the industry and the Pentagon become more efficient at conceptualizing and implementing new space systems, the U.S. could ultimately have diminished space capabilities, according to the article.

Dennis Muilenburg, president of Boeing's space and security division, said during his speech at the symposium that fixed-price contracts are "very challenging…. We know that when you do fixed-price contracting, the only way to make it work for both the industry and the customer is [that] you've got to understand the requirements, understand the technology and have program stability," according to the Federal Times. "If we can have those three things, we can make fixed-price work, and the block approach has that."

Morris Cohen, a professor of operations and information management at Wharton, has previously noted that the Pentagon 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 some defense systems. He cited Wharton research (“Performance Contracting in After-sales Service Supply Chains,” Management Science, Volume 53, No. 12, December, 2007) that indicates that the optimal form of contracting is in fact a blend of cost-plus, fixed-price and performance-based 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," he said. "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."