The Buzz

America's New Super Lethal Stealth Bomber: Is It Affordable?

Is Northrop Grumman’s plan for developing the US Air Force’s new Long-Range Strike Bomber realistic? That’s another known unknown in this mystery plane program.

We do know that the development contract will be cost-plus-reimbursable-incentive, meaning that a percentage will be added to the direct material, labor, and overhead costs in order to create a profit margin for the contractor. That percentage will vary with a subjective assessment of how well Northrop Grumman is performing as it works to design and test the prototypes. Loren Thompson of the Lexington Institute called that approach “out of sync” with the Obama Administration’s Better Buying Power (BBP) enthusiasm for fixed-price deals. However BBP has been interpreted throughout the bureaucracy, fixed-price was never meant as a panacea. For unfashionable is preferable to uneconomical, and some historical experiences suggests that the Air Force might be getting this right.

Earlier this year, Assistant Secretary of the Air Force (Acquisition) Bill LaPlante personally assured an understandably skeptical Congress that a cost-plus contract for development was the right choice. The decision turned on a single factor: the expected ex-post variance of the contractor’s actual costs from the ex-ante estimate. As he explained to the House Armed Services Committee in March,

“If you're on a fixed-price contract, it's really important to have a good estimate of what you think it's going to cost. If you're wrong on it, let's say you're wrong 50 percent one way or the other, somebody is going to get really hurt. If a contractor ends up 50 percent over on a fixed price, they're very hurt, and they might not survive. The opposite, we would get rightfully criticized [for] giving a windfall, buying something for twice what it costs. So you really want to have a good idea on the cost estimate for development.”

Presumably, a well-informed contractor will not sign an undoable deal, so a fixed-price production contract may improve the credibility of any cost cap. With the LRS-B, the first four lots of production will be built under a fixed-price incentive fee arrangement. But fixed-price is not a panacea. The realism of the cost model makes all the difference, and ill-informed contractors sometimes do sign undoable deals.

Indeed, LaPlante has several times cited research by David McNicol of the Institute for Defense Analyses which has found that the choice of fixed-priced or cost-plus has not historically mattered to the size of the cost overrun (see Cost Growth, Acquisition Policy, and Budget Climate, May 2014.) If that seems surprising, it’s because the specific incentives and perceptions of the long-term availability of military spending matter more. When budgets are trending down, program managers and marketers may tend to over-promise in order to get their ambitious efforts approved. As the Government Accountability Office described the problem in a just-released study of the Ford-class aircraft carriers, “the decades-old culture of undue optimism when starting programs is not the consequence of a broken process, but rather of a process in equilibrium that rewards unrealistic business cases and, thus, devalues sound

practices.” Along the way, if the government wants something badly enough, the contract based on offered price can eventually become one based on actual cost.

The famous case is Lockheed’s fixed-priced development of the C-5A Galaxy, in which the company experienced a $2 billion dollar cost overrun. The company's solution to this problem was to extract a $500 million unilateral price increase from the government by threatening bankruptcy—and program termination—if the check didn’t come through (see Yossi Spiegel, “The Role of Debt in Procurement Contracts,” Journal of Economics and Management Strategy, Autumn 1996). The Air Force begrudgingly obliged, and production continued. On the other hand, there’s Boeing's recent fixed-price development of its KC-46A tanker. For a company that has been designing and building tanker aircraft since the 1950s, this seemed easy. But Boeing seriously underestimated the size of the required effort this time—and the USAF had been warning the company for years that its cost model was not realistic. With Boeing, the Air Force was unsympathetic, as the company's cash flow from commercial aircraft sales would easily cover the shortfall. As a result, Boeing is assuming nearly one billion dollars in overruns, and may make little or no profit on its initial deliveries.