Sunday, July 21, 2024

Contract losses have defense contractors saying no to their biggest customer

by BIZ Magazine

(The Center Square) – As the Pentagon looks to shift the risk of cost overruns to contractors, some are sitting on the sidelines instead of bidding on projects from their best client: The U.S. Department of Defense.

The hesitancy comes in the wake of several high-profile contract losses.

Northrop Grumman Corp. took a $1.56 billion pre-tax loss in January on the B-21 Raider program. The company bid on the U.S. Air Force project in 2015, before the pandemic, inflation and supply chain issues, which have led to cost overruns that the company has to eat under the terms of its contract.

“We have passed on some high-profile programs,” Northrop Grumman Chief Executive Kathy Warden said on an investor call earlier this year.

Boeing lost $7 billion after winning a fixed-price development program for the U.S. Air Force’s next-generation tanker, the KC-46. The contract was firm-fixed-price, meaning Boeing was on the hook if costs ran higher than expected. The total value of the contract was $4.9 billion.

Since then, Boeing has said it won’t enter into new fixed-price contracts for the development stage of weapons citing unpredictability in designing and testing a new product.

At first, the KC-46 contract seemed relatively straight forward. The U.S. Air Force needed a new tanker to refuel planes in midair. The Air Force used a fixed-price incentive development contract “because KC-46 development was considered to be a relatively low-risk effort to integrate mostly mature military technologies onto an aircraft designed for commercial use. The contract limits the government’s financial liability and provides the contractor incentives to reduce costs to earn more profit,” according to a 2022 report from the U.S. Government Accountability Office.

The Department of Defense uses what are called cost-plus contracts to develop new weapons systems. Companies earn a fixed profit while the government covers unexpected expenses. Once the Pentagon knows what it wants and the weapon is developed, it switches to fixed-price deals. In fixed-price deals, the parties agree on a price and the contractor is on the hook if costs run higher.

In the KC-46 contract, problems with the planes and their components have led to delays. Among the problems were issues that relate to the aircraft’s remote vision system. The system’s cameras and display allow operators to see and reposition the boom – a rigid telescope that delivers fuel to the receiver aircraft. But issues with the system along with other problems made the project more complex.

“Despite delays, the government’s financial risk has generally been limited to the ceiling price of its contract with Boeing,” according to that 2022 GAO report.

That’s good news for taxpayers, but Boeing wasn’t pleased. Boeing Chief Financial Officer Brian West said in October 2023: “Rest assured, we haven’t signed any fixed-price development contracts nor (do we) intend to.”

The U.S. Government Accountability Office, which serves as the investigative arm of Congress, often recommends fixed-price contracts.

“Our prior work has shown that fixed-priced contracts are beneficial because the government generally pays a set price and the contractor generally assumes the risk and responsibility for any cost overruns,” according to a 2023 Government Accountability Office report.

L3Harris Technologies, a defense contractor with 50,000 employees, told investors last year that it passed on some Pentagon contracts that it would have otherwise pursued.

“It’s very hard to commit to a fixed price development program when you don’t know the spec,” L3Harris Technologies CEO Chris Kubasik said in a 2023 earnings call. “I think we all look back at all the write-offs and losses and more times than not they’re tied to that. So we will not be playing that game.”

Kubasik said that over time he expected others to get out of the game as well.

“We’re not going to bid,” he said. “And I would think over time others aren’t going to bid. And ultimately we’ll go back to the appropriate contracting vehicle for the appropriate opportunity.”

Boeing and other defense contractors are large companies with big balance sheets. Boeing has more than 170,000 employees in the U.S. and more than 65 countries. It had revenues of $77.8 billion in fiscal year 2023.

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