Cost Plus and Competition

guest blogger john hare

There have been many comments over the years on many sites about cost plus being used when nobody has any idea of the costs of a project or how to bid it. This morning on Clark’s site spacetransportnews.com he linked to an article claiming that getting bids was so uncertain that contractors would bid 50% higher than it would run to do the same project cost plus to make sure they didn’t lose money. That is an interesting claim. Cost plus is noted for budget over runs while straight bids, honestly enforced, cannot over run as the contractor wouldn’t get paid.

Considering the Constellation mess, wouldn’t it possibly have been cheaper back in 2005 to put the project out for bid? With the current projection of $35B to complete Ares, 50% more would have been a $52.5B  bid. If there was that much money on a fixed price contract, how many companies would have been willing to bid on the expectation of making a large profit? How much would they have been willing to cut to get the bid? This is when someone usually points out that there are only one or two companies qualified to bid on such a system. That should be a red flag. If you are specing a system with too few qualified bidders, then you are overspecing more often than not.

Cost plus seems to have a fairly low percentage of profit or even a fixed profit in the contract and requires extensive oversight to keep the contractors honest. I question whether the mandated low percentage itself eliminates potential contractors. Who wants to do a contract with a limit on potential profits when there is other work with much higher margins except the one or the few companies that are set up to do the insane paperwork and deal with the oversight? I think the profit limits in the name of taxpayer cost control end up costing far more than letting companies make higher profits or take their losses. If there were a half dozen or so companies bidding on the Ares, don’t you think it possible that some of them would think they could do the job for far less than $52.5B, or even $35B?

There are companies that are just better at cost control than others just as some people are smarter than others. I don’t think it is out of line to suggest that some companies can execute a rocket project for half of the cost of a competitor. If one qualified company bids $10.00 on a widget and another bids $9.00, go with the lower bid, and don’t pay if they don’t produce. Then if the second company has costs half that of the first, then they spend $4.50 in costs while the first spends $9.00. The second company has profits of 50% of income while the first has 10%. The government attitude seems to be that since this is taxpayer money, excessive profits are harmful to the taxpayer. With this attitude, the more expensive company has the edge since they will make twice as much profit as the better managed one at the same percentage.

If government contracting would quit worrying so much about how much profit a company makes, and start worrying about what is being delivered for the dollar, more companies would try for the contracts. A possible contract with 25-50% profit potential will attract more players. As more players enter a field, some will have better people or ideas which translates to lower costs, which becomes lower bids. When faced with real competition, Lockheed and Boeing can both find cost saving options when it is in their best interest to do so and they can make higher profit margins doing it.

In the long run, competition will cut into the possible profit potential and the end result will be a percentage similar to that mandated in cost plus except on a far lower total price. Financial oversight can be vastly reduced for further savings.

One objection many make is about quality when a simple low bid is the criteria. They believe that low cost is low quality. This has been demonstrated to be false anytime there is a competent purchasing agent involved. If the product doesn’t perform, don’t pay.

Another thing brought up all the time is dishonest contractors when there is no oversight, with the assumption that most contractors will cheat when no one is looking. Thomas Matula says that this is why the government must have a ten page spec for an ashtray. From rotten food to weapons that don’t work to vehicles that don’t run, he suggests that every single one of those specs is required due to suppliers cheating at one time or another. I believe this is a  poorly thought out objection. Every single time one of those suppliers cheated, there was a government official not doing his job of confirming an acceptable delivery. It is a matter of historical record that much of the time the particular official was corrupt. You want honest delivery, write a simple spec and have one (1) official responsible for the proper delivery. Responsible includes prison for corruption, which he can share with this supplier.

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johnhare

johnhare

I do construction for a living and aerospace as an occasional hobby. I am an inventor and a bit of an entrepreneur. I've been self employed since the 1980s and working in concrete since the 1970s. When I grow up, I want to work with rockets and spacecraft. I did a stupid rocket trick a few decades back and decided not to try another hot fire without adult supervision. Haven't located much of that as we are all big kids when working with our passions.
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16 Responses to Cost Plus and Competition

  1. Joe Williams says:

    It’s a common misperception that the Government worries about how much profit is to be made when deciding between fixed price and cost plus contract types. Consideration of profit, with the idea of somehow minimizing it, is not a factor in deciding contract type. The Federal Acquisition Regulations Part 16 governs the criteria used in deciding between contract types.

    Complexity of the requirement leading to uncertainty in pricing is a key criterion; I speculate this is the one that underlies the “50% greater” example cited in the above post. If there is that much uncertainty in the price, there are two likely outcomes if the contractor was to overrun by that much: (1) the Government holds the line on the original price, the contractor defaults, the Government cancels the contract, and no work is performed; or (2) the Government capitulates, the contractor and Government enter into an extensive, protracted, and contentious negotiation, all the while no work is being done until and agreement is reached (and such negotiations can take a long time). Also, if there is that much uncertainty in the price, that leaves a lot of room for competition to lead to a wide disparity of bid prices, decreasing the Government’s confidence that a bidder can actually perform the work at the proposed price. This is an example of a situation in which a fixed price contract would not lead to the best value, where value is a combination of performance (i.e., delivery of the good or service) and price or cost.

    The other key criterion is risk: how much risk is the Government willing to put on a contractor, and how much risk is a contractor willing to take? In the fixed price case, nearly all the risk is being carried by the contractor that it can deliver at the fixed price it bid; under-runs are profit, overruns come out of the hide of the company. Many firms look carefully at the risk trade based upon how well defined the requirements are and whether there is a track record established that will provide a pricing point. In cases where there are not well defined requirements nor an established track record, firms will shy away from a fixed price solicitation. This leads to a reduction in competition and an increased likelihood that the Government will not get the best value (again, value = performance + price).

    The challenges in soliciting crew transport services at a fixed price will be the following: (1) how well-defined and simple will the requirements be? (2) how likely will the Government not change those requirements during contract performance? (3) what is the track record of performance on those requirements that indicate with a high degree of confidence the likely price range? (4) How many firms are willing to bid a fixed price – do we get enough to take advantage of competition, both in approaches as well as in price?

    The article you mentioned – http://www.spacenews.com/commentaries/100714-blog-third-way-apex.html – makes an educated guess at the outcomes of the above; I conjecture that the answers in the mind of the author are (1) the requirement for crew transportation services may be complex; (2) the Government track record for further refining and changing complex requirements is quite high, so it is likely the Government may alter crew transportation service requirements during contract performance; (3) there is no established track record for commercial crew transportation services beyond the Russians using Soyuz, and we do not have adequate insight into its underlying cost model; and (4) (speculation here, yet I see it a tipping the hand a bit) the large aerospace firms may not be willing to entertain a traditional firm fixed price contract for crew transportation services. Therefore, one way proposed by the author in the Third Way article was to entertain a type of cost plus arrangement. I suspect that most larger firms realize the climate is not favorable for the more common types of cost plus types – cost plus award fee or cost plus fixed fee – that have dominated federal contracting for the types of products and services in conversation here. Yet there are other cost plus approaches that do shift more risk to the contractor, and it was one of these approaches proposed in the Third way article.

    I realize there are those who put a lot of stock in the commercial satellite launching business, many of which are performed under fixed price arrangements, and conclude that commercial crew transportation services are therefore viable under a fixed price arrangement. Such a conclusion assumes that the requirements for commercial satellite launching services are close enough to the same as crew transportation services so as not to impact price much. Until the requirements for commercial crew transportation services are established (they are in work now), such a conclusion is premature. I can envision requirements for ascent aborts, orbital rendezvous, g-constaints, life support, and re-entry (for example) leading to unique requirements for crew transportation services that are not met by existing performance under the commercial satellite launching business, thus leading to price uncertainty under the track record criterion.

    Part of the challenge will be a behavior change on the part of the Government to invest the work up front to define requirements that meet the need for commercial crew transportation services without over-specifying a point-solution, and to resist the temptation of refining requirements during contract performance. I speculate the people who are working the requirements today probably realize it; I’m less certain the same will be true once the contracts are awarded and executed.

  2. A_M_Swallow says:

    In a cost plus contract you can have stage payments. Make the pass fail criteria simple and do not pay until the criteria has been met. Keep the outfeeds useful.

  3. Here’s a suggestion: if the specifications are so complex then you should be doing less complex stuff. Progress the state of the art so that industry knows what you’re talking about and can offer *products* that you can buy off the shelf without having to specify *anything*.

    Ya know, like every other industry.

  4. johnhare john hare says:

    If there is that much uncertainty in the price, there are two likely outcomes if the contractor was to overrun by that much: (1) the Government holds the line on the original price, the contractor defaults, the Government cancels the contract, and no work is performed; or (2) the Government capitulates, the contractor and Government enter into an extensive, protracted, and contentious negotiation, all the while no work is being done until and agreement is reached (and such negotiations can take a long time).

    I see a third outcome, the contractor completes the contract on his own resources if he ever wants to get another Government contract. In case of default, the Government keeps all the work performed to date. That is the model used in the local construction business. While profits are sometimes high, incentive to complete is even higher.

    There is a lot of retoric about excessive or windfall profits around. I would be surprised if none of that penetrates to the cost plus attitude, though I won’t strongly argue the point here to generate more heat than light.

    From what I have seen of cost plus, it only works well for the customer when using firms that mostly do fixed price work, and have an existing good working relationship. Doing an occasional project with uncertainty works exactly as it should, win-win. As a subcontractor myself, contractors frequently have me do something extra on a bid job and just add it to the invoice. They trust me and I work to keep that trust.

    The contractors that do all cost plus have a number of problems in my experience. They will defer decisions to the customer with increases in time and cost. They will choose subcontractors based on how well they can fit in the customers preference more so than price and performance issues. They tend to not look for cost cutting methods as hard, especially for a hostile customer. A hostile customer is one that is difficult to work for and demands rather than communicates. They will put up with stupid requirements and pass on the cost more often than with fixed price. It is generally accepted locally that school board work will cost two-three times what it should.

    Worse with cost plus that I have seen is the ethical issues bordering on the illegal. Getting six bids instead of the required three and throwing out the three lowest so they can choose the fourth lowest bid to boost costs. Choosing an architecture with higher downstream costs to appear cheaper now. (1) Bid instructing to the subcontractors. (2) Adding layers of supervision and control to increase costs. Padding costs by charging off personel barely connected to that job. And so on for costs that frequently double or more the end result in a fairly competative construction environment.
    (1) Awning story. A contractor on a strip mall chose an awning company that was substantially cheaper than the competition. When an awning was damaged, the awning company sent out a crane truck to take the whole assemby down an sent it back to the factory for a rebuild at a substantial price. The competition would have unlaced the damaged canvas on site and replace the damaged frames with scaffold and wrenches and laced in new canvas for about 10% of the other method.
    (2) A subcontractor I know was told to adjust his bid up $20K and he would still be lowest. The very unspoken agreement was that some financial favors would find their way back to the contractor.

    Judging from the results of a lot of the cost plus, there must be a lot of actual illegal activity going on. These are smart people involved and it would be difficult if not impossible to prove any of it in court. The nine billion for Ares to date, and the half billion for the Ares 1X cannot be completely above board.

  5. Pingback: Cost plus contracting « The Four Part Land

  6. TimC says:

    Absolutely agree about the ‘% of a large sum is better than% of a small sum’ As a contractor supplying IT equipment to the govt (UK) I had to ask myself ‘why would we choose to offer that cheaper printer rather than this nice glossy expensive one?’. Luckily the customer had a cracking efficient lead manager who asked the right questions and kept us up to scratch!

  7. johnhare john hare says:

    Tim,
    Given an honest and efficient contract manager and supplier, cost plus is an effective solution. The troubles come from the ones that are not up to scratch (A), not totally ethical(A^2), or working in a straightjacket of rules and directives from above(A^3). It seems exponential to me.

  8. Joe Williams says:

    @Trent Waddington

    In a way, you hit the nail on the head. To drive towards doing “less complex stuff,” one needs to understand the distinction between inherent complexity and imposed complexity. The former means that complexity is part of the nature of the problem being solved (i.e., “it really IS rocket science”); the latter reflects complexity due to organizational structures, regulations, processes and procedures. Ideally, we’d like to minimize the latter as much as possible as a factor in an acquisition, which can be a challenge in Government contracting. Think of it this way: in large systems of systems acquisitions, we’re working a trade space between (1) a bunch of simple acquisitions that are integrated by the customer or by an integration contractor, or (2) acquisition of the systems of systems under a single contract. When the parts are commodities, the former makes sense; when not, the latter may make more sense from a complexity standpoint.

    @john hare

    The item I see addressed indirectly in your response is contract performance, which is a critical consideration. The customer wants good performance so that it gets the good or service it seeks; the supplier wants to perform well so that it is paid (milestone payments under fixed price, or fee arrangement under cost plus) and so that it will be eligible for consideration for future work. A bad contract type or poor working relationship is a detriment no matter the contract type. And in the interest of fairness, just as you perceive the potential for borderline ethical behavior under cost plus, similar behavior is possible under fixed price. In the latter, it is compromising on quality or safety to shave a few bucks on the product or service, which goes straight into the supplier’s pocket. As you point out, honesty and ethical behavior on the part of the contract manager and supplier is a must; my addition to this is that I perceive such behavior as independent of contract type and being no more influenced by one contract type or the other.

    Just so that you don’t get the impression that I’m a big cost plus advocate and anti-fixed price, I’d like to see greater use of fixed price arrangements where they make sense. Government-wide there is an over-reliance upon cost plus contracts. This is what led the Obama administration to issue a memo to the Heads of Agencies on this matter last year and why the OMB has issued targets to federal agencies to reduce their reliance on cost plus contracts by a target percentage, and to report on progress annually. Fixed price arrangements make budgeting and contract oversight so much easier than cost plus arrangement, and in NASA’s constrained budgetary environment, such a situation would bring some additional fiscal stability and certainty.

  9. umm. no. Nuclear reactors are complicated things. Nuclear submarines are complicated things. Neither are built by government contractors from blueprints provided by civil servants. The oversight for both is extreme but industry knows how to build these things now. Why? Because the DoE and the DoD know how to build industries.

  10. johnhare john hare says:

    Joe,
    In my limited exposure to it, cost plus has a few more avenues for unethical behavior. As you say though, there are methods of cheating any system. I feel quite strongly that the checks and balances are broken in most large scale government contracting at this time. Success stories tend to the smaller side with a competant individual in charge.

  11. Joe Williams says:

    @Trent Waddington

    I’m not sure what you are disagreeing with, except out of a principle that you somehow see NASA as failing to grow industries and that is somehow tied to contract type. I offer that market conditions, cost of entry, supply and demand, and return on investment have a greater influence on the rise and fall of industries than the contracts used as vehicles to solicit for goods and services.

    John

    I’m sorry to hear that you’ve been exposed to borderline to outright unethical behavior tied to contract type. The Government takes ethics seriously; general employees go through ethics training once per year, and employees who are involved in procurements go through specialized ethics training for each and every procurement, with the threat of civil and criminal penalties for violations hammered into us in both cases. The typical (but rare) case cited to us of unethical behavior is the steering of contracts to the benefit of the Government employee or his/her family. I’ve not been exposed to any case law or received any ethics training that ties increased ethical misbehavior or abuses to contract type. If there was, I’d take it quite seriously since I have a personal goal of being a good steward of the American taxpayer dollar.

  12. johnhare john hare says:

    The abuse I’ve seen on cost plus has been mostly commercial construction contracts. The companies that specialize in cost plus are avoided by most of us even when we are hurting for work like we are now.

    The government work I’ve been involved in has had so much oversight and poorly thought out requirements that we have to bid 2-3 times what we would to a normal contractor just to make any profit. I saw one building go from $8K for what an agg department actually wanted (livestock pole barn, no concrete) go to $80K for a fancy building. As concrete sub contractor, I had ~$10K in it for concrete labor alone, and lost money.

    The thought of government work that is also cost plus is a personal nightmare to me. When I see the massive waste in such things as the Ares I, I tend to base my impressions on both my personal experiences with cost plus and government contracting, and what I learn from various friends in the business in addition to the various blogs. When I think of the financial problems I’ve seen at my scale, and extend them to the billions involved in this subject, I find it difficult to believe that everything is completely above board. I find it impossible to believe that NASA couldn’t get far more for their money with better contract handling.

  13. mike shupp says:

    “Cost plus is noted for budget over runs while straight bids, honestly enforced, cannot over run as the contractor wouldn’t get paid.”

    This absolutely is not the way things work in my experience. Typically a “cost plus” contracting job has some sort of bid figure attached, usually in the form of a letter stating something like “We propose to remodel restrooms RM-203 and RW-205 as per your solicitation at a not-to-exceed cost of $xxxxx. This includes a markup of 20% for administrative costs and %5 for profit. Restrictions as per document AAA-BBB-CCC apply. We look forward to working with you.” If say the not-to-exceed cost is 20,000 and you actually complete it for 17,000, you final bill at 17,000. If you overrun, you MAY be able to get reimbursed at a higher cost if the firm you’re working for agrees this is reasonable (typical reasons, working on remodeling a additional restroom at customer request, unanticipated problems with excavating a site, changing the job from normal hours to “weekend only”, etc.) In either case, the contractor must submit an itemized bill.

    Fixed price jobs are simpler to bill. They generally provide more profit, if things go well, and leave the contractor with losses to pocket if things don’t go well. But even here, there will be SOME provision for extra charges if the work to be done differs in material ways from the work as bid (suppose the “empty field” you’re to excavate turns out to be 3 feet of dirt covering a 40-year old landing strip which the customer had managed to forget about?)

    It’s never as simple as walking into Home Depot and buying a circular saw for an advertised price of 179.95.

  14. If NASA did walk into Home Depot and buy circular saws more often there wouldn’t be companies charging a million for a space circular saw.

    And it’s not unprecedented, see the latest This Week In Space for an example of the fantastic success of walking into a jeweler and buying a dozen watches and picking the one that performs the best.

  15. johnhare john hare says:

    Cost plus with a cap locally for what you describe. Change orders for extras even on fixed price drives overruns similar to cost plus.

    So how is it that the Ares is billions over similar to so many other cost plus contracts?

    What would you say the underlying problem is with the excessive spending on seemingly straight forward projects?

  16. mike shupp says:

    Virtually all major R&D projects in the US (and elsewhere) seem to overrun their initial cost estimates. Partially that may be something — unreasoning optimism — built into our culture, or into our genes. Partially it may be an artifact of the whole contract-to-the-low-cost-bidder thing.

    For the software environment, Ed Yourdon has discussed this in a couple of his books. Frederick Brooks THE MYTHICAL MAN-MONTH is also worth reading. The literature and programmer memory is filled with recollections of ambitious computer projects from SAGE to IBM’s Stretch to Multics to Japan’s “Fifth Generation” programming effort to that failed to amount to much.

    In the space environment, it seems 30 to 60% cost and schedule overruns are unhappily common in the DoD/NSA world. NASA and ESA have both seen costs for unmanned scientific spacecraft double — or worse. Alan Stern has been known to address the topic. Fifteen years or so back, Iridium looked like a sure winner in the comsat business; it failed in conspicuous fashion, and managed to drag down both LMSC and Boeing’s plans for “commercial” EELV’s.

    Closer to earth, civil engineering costs estimates often come a cropper. Buildings routinely overun architect estimates. And I recall, digging a couple of miles of subway tunnel under the Santa Monica doubled in cost a few years ago here in LA, when the dirt that was to be excavated turned out to be remarkably solid granite.

    Two well known space related anecdotes, in settings where lowest cost and form of contract were NOT factors: In the first, James Webb doubled the “firm” cost estimates for Apollo from 10 to 20 billion dollars just minutes away from giving John Kennedy the cost. In the second, Werner von Braun asked NASA what sort of payload the Saturn V should lift, got a figure of 50 tons, and proceeded to build a launch vehicle with twice that capacity. History vindicated both of them

    The sad blunt fact is that most large projects are leaps into the dark, particularly those where the underlying technology is advancing. We do not have the tools to make reliable schedule and cost predictions in these cases; we do not have an agreed-upon understandable method for adequately conveying these uncertainties to decision makers. That’s been the case in aerospace ever since WWII — there’s a loooong list of government commissions and CBO reports to read if that’s your pleasure; I expect it to continue long into the future.

    We’d have these problems even if all men were angels. We’d have these problems even if men weren’t angels, even if every other contractor were forced into bankruptcy for nonperformance and their managers crucified on YouTube. NASA isn’t unique. Even NASA-with-Mike-Griffin-in-charge isn’t unique.

    What’s the cure, or pallative? (A) another century or so of actual widespread experience of working in space and constructing space hardware. (B) curtailment of the project managers-as-gods syndrome that permeates hierarachical human societies. (C) Estimating methods that provide the customer with realistic notions of schedules and costs and associated risks. (D) (My wild guess) Wide spread usage of crowd-sourcing a la SETI@home, open source software and hardware, project coordination via Facebook-like interfaces, documentation via blogs and wikis, etc. Non-capitalist non-socialist management tools, in other words. (E) And to tamp theory into practice and actually achieve economies, something resembling a true market, with numerous customers and numerous suppliers.

    None of this can be expected in the near future; none of this is even in the cards at present.

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