James Hasik

How to Kill the Joint Strike Fighter

There are now very few options for Gates or Congress. Anything done will result in greater costs in the long run. They have made their bed and now they are stuck with having to sleep with doo-doo between the sheets. —        US congressional staff member quoted in Colin Clark, “Hill Reacts to F-​​35 IOC Shift,” DoD Buzz, 22 February 2010. 

Back in February, we all got to watch Congressman Todd Akin of Missouri, who represents the area around the factory that makes the F/A-18E/F Super Hornet, rather lecture US Defense Secretary Bob Gates about the difference between his favorite plane and the F-35 Joint Strike Fighter (JSF). Akin was particularly miffed that the secretary wouldn’t commit to another multiyear contract for Super Hornets, which would lower the cost per aircraft (according to Gates) by roughly six percent. As the congressman’s press release put it, “the Super Hornet [has] an active production line, and is dramatically cheaper than the JSF, which may not deliver anywhere close to on time.” 

Indeed, as Air Force Chief of Staff Gen. Norton Schwartz acknowledged on 18 February, the JSF program is breaching its Nunn-McCurdy spending limit. Moreover, it’s now not just hugely over budget, but another thirteen months behind schedule. As Defense News reported, the plane's system design and development will now run through at least 2015, two years after the US Air Force had planned to begin operating its F-35As. 

Having doubled down on his bet, but without all the information he should have gotten, Gates is understandably torqued. The secretary does have a reputation for results through righteous indignation: just witness the MRAP phenomenon. Thus did Bill Sweetman of Aviation Week cite Voltaire’s Candide in describing the defense secretary’s firing the JSF’s program manager, Major General of Marines David Heinz: dans ce pays-ci, il est bon de tuer de temps en temps un amiral pour encourager les autres. It is true, as Stephen Trimble of Flight Global pointed out, that Lockheed Martin’s program manager is still in place. But while “Dan Crowley doesn’t work for the secretary of defense,” as General Schwartz told him, “he’s short $600 million. That ain’t trivial.” 

Let’s take this a stage further. Would it be possible not just to shoot a general or a program manager, but rather, the whole program? The challenges appear overwhelmingly huge. In the United States, the leadership of the USAF and the USMC see no clear alternative to simply continuing to pour whatever money they must into the program. (The Navy is an exception, and I’ll get to that below.) But the US has a further problem: the airplane is not just joint, it’s international. Like the International Space Station, the JSF is still stumbling along in part because it’s too international to deorbit. 

Those partner countries that have signed up for the program do have alternatives, and that points to the list of parties with a commercial or political interest in termination. Even Lockheed Martin, though, should think long and hard about how its competitors might work this issue. Boeing could stand the most to gain, and has a particular interest in killing the F-35C, the tailhook version which competes for the Navy’s funding with the F/A-18E/F—an airplane for which the Navy has shown increased affection of late. Close behind though would stand Saab, Dassault, and EADS (as the one shareholder in Eurofighter GmbH with little interest in the JSF program). These three European companies have an interest in killing the F-35A, the conventional land-based version, as Norway, Denmark, the Netherlands, Italy, Canada, Turkey, and Australia would all open up as marketing targets (Belgium and even Portugal might eventually make that list as well). Northrop Grumman, BAE Systems, and Alenia are perhaps of split opinions, in that all are major subcontractors to Lockheed Martin for the F-35, but that each has interests in the X-47B or Eurofighter programs, which would stand to gain from the F-35’s loss. In short, most of the combat aircraft industry would arguably like to kill this thing, and the rest is at best dispassionate. 

So, whether as an ambition or a red-teaming exercise, just how would one go about trying to kill the JSF? There is a host of arguments to make to every government involved today, and there are two fronts on which to press:

1. Fracture international expectation
2. Skip that generation of weapons

These points cover what the JSF isn’t today, and won’t be in the future, so they’re worth considering in sequence. 

FRACTURING INTERNATIONAL EXPECTATION 

The first move, that is, may be best made overseas. If more than one participating state could be pulled off its commitment to JSF purchases, particularly before the JSF enters full-rate production, then the United States government’s commitment to see the program through for its partners could abate. The most tempting targets could be those countries with commitments both to recapitalize military equipment and for collective security activities overseas: money for troop carriers that certainly will be used is probably more emergent than that for fighter aircraft that probably won’t. And almost any alternative the the JSF—Eurofighter, Gripen, Rafale, Super Hornet, even Lockheed’s own F-16 Block 60—offers budgetary certainty that the JSF program cannot deliver. 

This gets to the first argument against the program, and in almost any country in the program (the possible exception is Australia). Today’s budgetary madness has to stop. It is almost amusing when Ashton Carter, the Pentagon’s procurement chief, says that military spending will keep on rising for the foreseeable future. It is slightly more reassuring when Pentagon comptroller Robert Hale admits that Pentagon budgets will drop, but less so when he claims that spending for the F-35 will be effectively ring-fenced. More realistically, any bipartisan commission for balancing the federal budget, as announced just last month, will not be able to avoid recommending military spending cuts, and the JSF is simply the unavoidably biggest part of the investment accounts. Thus, the response to any Nunn-McCurdy breach shouldn’t be another reach for the rubber stamp. [1] 

In light of the aforementioned misfortunes with the program, some bet-hedging in the US is already under way. As Andrea Shalal-Esa of Reuters wrote back in January, the draft Pentagon budget for fiscal year 2011 requests another 12 EA-18Gs and 22 F/A-18E/Fs for not quite $3 billion. That would bring total orders of -18s, both Growlers and Super Hornets, to 304 aircraft, at an average cost of about $86 million each. 

 This gets to the second argument against the program, and one which Boeing has been cautiously advancing so far. The JSF is just not militarily vital. Several years ago, I asked the head of strategy at a European aircraft manufacturer why his company had no obvious plans for a fighter beyond the current model. “All our customers,” he said, “have enough fighters for chasing Cessnas for the next fifty years.” The next generation of unmanned strike aircraft is alluring, but the air sovereignty mission is just not so compelling today. For frankly, there’s just no threat anywhere that calls for such a huge fleet of land-based fighter aircraft. 

 Consider the United States, just to start. The Air Force, Navy, and Marine Corps together have not just the most powerful air fleet in the world, but also the largest in number of jet-powered combat aircraft. The next largest armadas is probably Russia’s, with almost 2200 aircraft. Even if Russia were a plausible opponent, the rest of NATO has its air force outnumbered even without the US on board. And given Russia’s long-term finances and demographics, that number will be shrinking. China’s air fleet is of comparable size—read, smaller than America’s—but it’s also remarkably unimpressive. China’s most numerous jet fighter is a copy of the MiG-21. Then again, one doesn’t fight the Chinese without necessarily having either the Japanese or the Taiwanese—and their significant air forces—on board. After that, the ranks thin out fast. Sidestepping India (another implausible opponent), the next largest air force is North Korea’s: more than 600 aircraft on paper, but not so many that are flyable or fueled. Besides, South Korea has over 500 aircraft, and of far better quality in men and materiel. Iran? Not half that many flyable machines. 

Worst of all, the F-35 definitely fails to address the biggest deficiency in combat aviation today: electronic warfare. There’s no plan yet for an EF-35, and the idea of mating jamming pods to a stealthy airframe could be a little strange. Besides, as Shalal-Esa of Reuters noted, the FY11 budget has more EF-18G Growlers because “military commanders considered them an urgent need.” The JSF? Not so much. 

It’s notable that this anxiousness over flight line numbers doesn’t quite get called a gap. Not so with naval fighters, for naval aviation is far more important than land-based aviation. Go back, for the moment, to the point about China. If one does fight the Chinese, comparatively short-ranged land-based fighters like the F-35A won’t be of much help. Where would they fly from? Taiwan is over 1400 nautical miles from Guam. Worse, as a group of researchers at RAND noted in 2001,

         the current USAF base at Kadena [on Okinawa] is nearly 500 nautical miles away from the Strait. As a result, F-15 or F-16 fighters operating from that base would probably need to maintain combat air patrol (CAP) orbits near Taiwan, since they could not launch and transit in response to warnings of a Chinese air attack headed for Taiwan. This is in contrast to, say, a carrier stationed 50 nautical miles off Taiwan’s east coast, whose aircraft would need to fly only about 175 nm to get to the centerline and could therefore be more responsive to incoming raids.

         Kadena may also suffer from limitations in its ability to support high-tempo operations by a large force of combat aircraft. The base currently hosts two squadrons totaling 48 F-15C fighters, a special operations group, an air refueling squadron, a reconnaissance squadron, an AWACS squadron, and a search-and-rescue squadron. In addition, it is an important transit point for airlift activity in the Western Pacific. Kadena is, in other words, a busy place even day to day, and it is not clear how many more aircraft could be operated out of the base under combat conditions. [2] 

Change the phase to “two squadrons totaling 48 F-22 fighters,” and the result isn’t much different vis-à-vis the F-35A. That airfield is also an easy target for a SCUD-type missile, as the nearest Chinese territory is only 450 nautical miles away. So, until the American government develops the intestinal fortitude needed to actually offer the Taiwanese a USAF fighter wing on its home soil, there’s no point in talking about the utility of the F-35A against China. 

Of course, the F-35C—the tailhook shipboard version—could be very helpful, but that aircraft is said to have significant structural problems at this late stage in the game. Still, as the Royal Navy and the US Marines know, there is more than one way to send fighter aircraft to sea. It may be useful for Lockheed’s opponents to concede the value of the F-35B as a short takeoff, vertical landing (STOVL) aircraft. If crassly, it’s the one variant that directly offends neither the American (Boeing) nor European (Saab, Dassault, EADS) branches of any anti-Lockheed coalition. Indeed, as an Anglo-Italian-American airplane, it provides plenty of work to BAE Systems and Alenia. Encouraging the DoD and the MoD to pour their money into that corner could lessen enthusiasm for the F-35A, which is the least essential airplane for the Americans, and the only one that anyone outside those three countries wants. 

What everyone wants, though, is not just aircraft, but that which the JSF program explicitly denies. The F-35 offers no operational sovereignty to overseas customers. All three European alternatives the JSF—Eurofighter, Rafale, and Gripen—come with access to software codes that the US government steadfastly refuses to provide. Without those, the F-35 is not locally upgradeable.Worse, the JSF program expects everyone’s aircraft to fly to Texas for servicing, which means that it’s not locally maintainable either.

SKIPPING THAT GENERATION OF WEAPONS 

The whole situation is just plain crazy for customers, and particularly in the long run. Lockheed’s unflinching acceptance of the government’s withholding of funds is quite telling here. The JSF, after all, was supposed to put everyone but Lockheed and Sukhoi out of the fighter aircraft business. Six hundred million dollars is a small price to pay for that. This gets to the possibility, as presidential candidate George W. Bush spoke in September 1999, of skipping the generation of weapons of which the F-35 is a part. That time may seem a world away now, but as noted above, what hasn’t increased is potential enemies fighter aircraft fleets. If there are near-peer challengers out there, they lie over a decade away. There’s some safety, for now at least, in another ten year rule. 

In this context, the case against the JSF rests not just with its high costs, faltering schedule, and centralized control, but with what would be possible if a fraction of the money freed up. If the F-35A won’t be greatly helpful against the Chinese, then the Pentagon ought to get working on what would be. As they have gotten squeezed out of manned combat jet purchases around the world, Northrop and Boeing have turned towards pushing the envelope in the unmanned field. From here, striving for breakthrough performance with modest technical risk, but grounded in the existing asset base, assails the investment of so much money in Lockheed’s plane. Could an F-18F be equipped to control a wingman X-47B? Boeing and Northrop may find common ground to pursue such a demonstration. The Navy Department would have its own reasons for supporting such a project, as it would point to a future beyond the Super Hornet, but cost-effectively bridged by it. 

Northrop Grumman may not be the only partner in this enterprise. Specifically, we should ask whether Boeing ought to cooperate in this matter with Saab. Boeing, for the immediate future, doesn’t have a stake in anything but the -18 program. The Gripen and the Super Hornet could be reasonable cousins in respect of marketing, in that they are both pitched as affordable aircraft, well down the learning curve of production, that have proven upgradeable over time. Further, both companies have big problems with the F-35. Saab is competing against a single-engine machine whose program has been holding forth vast promises of (yet mostly unrealized) offset business for years. Boeing is competing for the future of its whole combat aircraft franchise. Perhaps critically, Saab and Boeing are arguably, on the international market, the least rivalrous of all the possible pairs. It’s a single engine versus multi-engine thing. 

For companies like Boeing, there is a political angle here as well. Todd Akin may merely be doing his Missourian duty in boosting Boeing, but it’s important to note that he’s also a Republican. Now that Barack Obama has permanently sundered the Democratic party’s illusions of being more fiscally responsible than the GOP, it’s worth wondering how Republican candidates might approach the question of military spending in not just 2010, but 2012. They can repeat the usual mantras, or they can actually argue for across the board cuts in all federal spending, including that for entitlements and the armed forces. Like the Tories today in the UK, preparing for the general election late this year, they can browbeat the government of the day on its management of military more than its commitment to it. They can argue for spending less money, but spending it smarter. And that’s a case that any politician can make with a straight face. 

 NOTES 

1.        See Jim Cooper and Russell Rumbaugh, “Real Acquisition Reform,” Joint Forces Quarterly, 4th quarter 2009. 

2.        Zalmay Khalilzad et al., The United States and Asia: Toward a New U.S. Strategy and Force Posture, RAND, 2001, pp. 70–71.

Why Northrop Grumman and EADS might just yet bid on the KC-X.

Might Northrop still bid on the tanker project? It may be that “all the evidence suggests otherwise,” as one journalist who has been covering the competition for years put it to me yesterday. The requirements in the RFP strongly favor a 767 over an A330, in that the evaluation process will penalize a larger aircraft for higher operating costs, but not reward it for higher fuel and cargo capacity. That may be the USAF’s business, but it is what it is. Northrop Grumman has therefore repeatedly declared its disinterest; according to Amy Butler of Aviation Week, the company’s “officials have apparently informed lawmakers that they predict a 96 to 98 percent chance of not bidding.”

But why say 96 to 98 percent? Why not just say, this is lame, we’re done, we’re going home? Is Northrop—or are Northrop and EADS—leaving open the possibility of a last-minute bid? It’s a reasonable idea. Frankly, if I were advising either company—and I’m not—I would suggest thinking about it, for four reasons:
        
Not bidding could really irritate EADS. As I am not privy to the marketing agreement between the two companies, I do not know if EADS would be precluded from bidding on its own if Northrop decided to pass. To win with this RFP, whoever is coming with an A330 would need to bid aggressively. EADS might see value in bidding at cost—the whole point of the project, then, would be to get the USAF to pay for Airbus to facilitize production in the dollar zone. With sales denominated in dollars, but costs substantially in euros, Airbus is subject to considerably more currency exchange rate risk than Boeing. Northrop lacks this strategic interest, and probably wouldn’t see much value to another big business making no money. (The company has enough of that problem on the Gulf Coast.) However, if EADS is for some reason precluded from bidding on its own, then Northrop’s refusal to proceed would pretty much sunder the already tense relationship between those companies. The KC-Y competition would certainly be an EADS-only affair.

Bidding would build goodwill with the customer and the community. That KC-Y and KC-Z competitions will come along, and EADS has known for some time that it has a much better opportunity at winning the replacement for the KC-10s. Thus, there may be value in playing the game now just to build some goodwill for the next rounds. EADS and Northrop might warm some hearts in Alabama if they brought in a bid at the last moment, just because they "owed it to the communities that had supported them" (or something to that effect.) EADS has done this once before. The company put in a bid back in 2003 even as several senior USAF officials were trading electronic hate mail about French airplanes. The point was to show the rational people within the customer organization and the congress that EADS was a team player, a good corporate citizen, and a responsive potential supplier. This time around, the USAF would at least appreciate that they were willing to be a stalking horse.

The costs could be limited. Contrary to what a few pundits have claimed, bidding need not be a hugely cost endeavor. The bidders only have 75 days to respond, and they know what they're bidding, so assembling a package shouldn't be outrageously expensive. They've had these program offices in place for years, and it’s not as though they need to disperse the staffs next week. They might as well do something before they all wrap up. If it’s really just supposed to prod Boeing into bidding aggressively, then the bid can be merely perfunctory. Indeed, the less aggressive the bid, the less care needs to go into writing it. A bigger margin can hide ex ante errors.

Boeing could get greedy. Then again, if they were willing to submit a sharp bid, or even one at cost, there's always the possibility that Boeing will assume that there’s no Airbus on offer, and bid with a fat margin. That could be made more likely by these repeated disavowals of any interest in the process. In that case, even the cost-disadvantaged A330 might come through. It did last time. Moreover, trying to explain to the shareholders why Northrop took its marbles and went home after all these years of competing could be difficult.

"Our South Africans are better than their South Africans."

On 12 February, Marine Corps Systems Command announced the award of three further contracts in the Mine Resistant, Ambush Protected (MRAP) vehicle program. MARSYSCOM, that is, is managing MRAP purchases program for all the services, but the individual services are by-and-large making their own decisions about what to buy. Including engineering changes for independent suspensions and other mobility improvements, the amounts were

• $752 million to Navistar Defense for 1,050 MaxxPro Dashes, to be built in Mississippi and Texas
• $227 million to General Dynamics for 250 RG-31A2s, to be built by BAE Systems in Gauteng Province, South Africa, with major subassembly work in Ohio and New York
• $91 million to BAE Systems for 58 RG-33s, to be built in Pennsylvania

Including their modifications, that’s about $716,000 for each MaxxPro, $910,000 for each RG-31A2, and $1,561,000 for each RG-33. To be fair, the numbers are hard to compare, as the contracts don’t all include the same things. General Dynamics Land Systems Canada, which holds an exclusive license to the RG-31 in North America, generally tricks its MRAPs out with more electronic systems in Ontario before shipping them to the US, adding an impressive margin to that business. The contract for BAE Systems’ RG-33s (the 4x4 version for Special Operations Command) also comes with a logistics support package, while that for the MaxxPros does not.

The orders for the RGs were not surprising, as the Army and SOCOM seem to have picked that family of vehicles as a preferred long-term solution. The RG-33, after all, is the basis of the Panther Medium Mine Protected Vehicle (MMPV), which the Army is procuring for its engineering troops in an actual program of record.

The order for the MaxxPros was leaked a few weeks ago from the office of Ashton Carter, the under secretary of defense for acquisition. Mobility seems to have been the selling point here, as the MaxxPro Dash is particularly interesting for Afghanistan. First, it was designed from the get-go to be lighter than the average MRAP. Second, following Oshkosh’s success with porting its TAK-4 independent suspension to military applications, Hendrickson and AxleTech (now a unit of General Dynamics) have teamed up to provide their DXM independent suspension to the new MaxxPros. Oshkosh, for its part, is producing its MRAP All Terrain Vehicles (M-ATVs) rather quickly, but wartime expediency sometimes leads to second sources and approaches to speed kit to the troops. It’s a reasonable matter for procurement strategy, but a more restrained approach than the order-from-everybody-qualified tack taken early in the MRAP program.

Indeed, as the Ares blog noted, a spokesman for MARSYSCOM noted that “future MRAP family of vehicle orders may also include additional M-ATVs.” What it has not included for some time is orders from manufacturers other than BAE, Oshhosh, and Navistar. That has been bad news for Force Protection in particular, which blazed a trail with both marketing and design in bringing the MRAP concept to the US some ten years ago. It’s no secret that the chief complaint about Force Protection’s Cougar, its best seller to date, has been its relative reliability. As I wrote in my book Arms and Innovation (University of Chicago Press, 2008), a colonel of marines in Iraq notably told Force Protection’s marketing representative a few years ago that while he loved the vehicle, “there are no land mines in my motor pool.”

Force Protection, of course, has been working hard to overcome both the perception and its root cause. For Navistar’s part—or Oshkosh’s for that matter—a worldwide customer base and worldwide commercial supply chain have been important selling points. Companies like Force Protection aren’t likely to duplicate those easily. What they can do is to master important and lucrative niche markets where single attributes stand out as dominating designs. Force Protection’s Buffalo A2 may have competition from claw-equipped versions of BAE’s RG33 and Thales ADI’s Bushmaster, but it clearly leads its category in sales. Moreover, it has earned the coveted status of a program of record, fulfilling the US Army’s enduring need for a Ground Standoff Mine Detection System, or GSTAMIDS. When poking possible mines, blast-resistance is the overwhelming requirement.

Thus, Force Protection came to lead that niche, and perhaps to fall short in others, by focusing so intently on protection. First-hand historical experience led the company in that direction. In thinking about this, it’s important to remember that the MRAP was not so much a conceptual innovation as an emulation. The strategy, the technology, and even the key people developing the vehicles have been South African in origin. South Africa’s military situation in the 1970s led that country’s arms industry to develop what Michael Porter termed a selective factor disadvantage: faced with an overwhelming threat from land mines, they got really good at designing and building vehicles that resisted land mines.

Emulation, though, generally suggests that entry barriers, if technically demanding, are eventually surmountable. In the film version of Tom Wolfe’s The Right Stuff, Senator Lyndon Johnson (played by Donald Moffat) asks a roomful of government officials stunned by the Sputnik launch whether it’s “their German scientists that got them up there first”. Werner von Braun (played by Scott Beach) steps from the shadows to calmly state “no, Senator. Our Germans are better than their Germans.” Eventually, the Americans’ rockets stopped blowing up on the pads.

To wit, this week at the Indian Defence Exposition, three local companies—Tata Motors, Ashok Leyland, and Defence Land Systems India—showed their own prototypes of mine-resistant wheeled troop carriers. Granted, DSL India is a joint venture of Mahindra & Mahindra and BAE Systems, and its Mine Protected Vehicle for India (MPV-I) is based on the technology in the RG series. But Tata and Ashok Leyland, whoever their suppliers may be, have ostensibly developed their vehicles on their own. This should be no surprise. For whosever South Africans or Americans or Indians are better, there are more than enough to go around now.

As I noted in Arms and Innovation, the technologies of blast-protection are challenging, but they are also somewhat leaky and somewhat observable. That’s encouraging of alliances in the short run, and conducive to the diffusion of military innovations in the long run. As their are more than a few heavy-duty truck companies in the world, we can expect that the structure of this industry will probably remain geographically distributed and meaningfully heterogeneous. That will leave more than enough room for small companies to specialize, and big companies to build for the mass market. In between, they might find continued opportunities to cooperate. That, after all, was part of what made the MRAP program so successful in the first place. And that will be very good for the troops.

Four issues with the USAF's tanker RFP, Part Three: alternatives for competitive OTS procurement

3.2.2.6.1    The KC-X shall provide a potable water system that supports maximum passenger load, patient, and aircrew requirements with running water available at each sink for 12 hours (473 milliliters per person per hour). (MANDATORY)

The boldfaced, block-capitalized emphasis in the extract above is the Air Force’s, and not mine. It is relieving to know that the service is minding the taxpayers’ dollars, and isn’t insisting on a rate of 474 milliliters per hour. Seriously, who is writing this stuff?

As strange as the current draft of the KC-X RFP really is, it is good to hear, as Aviation Week reported the other week, that the Pentagon is now backing away from its notion of an eighteen-year fixed price deal for new tanker aircraft. That approach constituted a 101 mistake in supply chain management, so it is good to see it gone. All the same, there would still be much work to be done if the government wanted to produce a sound RFP. As I will discuss below, it is not entirely clear that a sound RFP is the government’s objective. If it were, as I noted at the end of my last column on this subject (part two), the USAF could yet approach the problem with a radically simpler RFP, and one that induces much greater ex ante competition than the draft on the street today. In short, the Air Force should think about buying airliners a bit more like we all buy cars. I’ll get back to that at the end, but to show the logic, let’s work through the math, so to speak.

We can think about this in the familiar terms of supply and demand. In the classic market-clearing supply and demand model, sellers are generally willing to offer ever-increasing quantities only in return for higher prices per item, because eventually, all their production systems encounter diseconomies of scale.

This model isn’t so useful, however, in evaluating markets in which buyers need to choose whether to buy a lumpy quantity of a product or service, or not to buy it at all. Mass transit is a common case application: potential riders don’t select how many miles they want to travel to work, but whether or not to drive the car instead. The situation is actually similar to that in which the USAF finds itself today with the KC-X: the service wants to buy a fixed quantity of 179 Airbuses or 179 Boeings. In our model, we’ll consider a quasi-market with just one buyer and the two sellers, which we’ll transparently call A and B. As I’ll discuss further on, that’s rather close to the case in many aircraft procurement situations. Analyzing that discrete choice requires a hedonic model—one which matches price not to quantity, but quality. [1] Quality here is an aggregate of all the measurable qualities that a product might have, whether fuel capacity, cargo capacity, or fuel economy. It’s thus a rough measure, but a usefully illustrative one. In keeping with the USAF’s logical emphasis on the total cost of ownership (or in the service’s non-standard use, total adjusted price), we’ll also substitute TCO for price on the vertical axis.

The approach is certainly different; to begin, we’ll need multiple, firm-specific supply curves, because we’re trying to determine which firm will be doing the supplying. In this business in particular, the supply curves are essentially fixed in the short-term, as they are captive to the highly specific production systems of the aircraft manufacturers. They also show sharply increasing price-for-quality ratios, in that each production system can only customize its product—with more or less quality—to a certain degree without running up against the engineering limits of the design. An A330 or a 767 can only lift so much. With dissimilar designs, the supply curves probably don’t overlap: it’s essentially meaningless to wonder whether an A330 can haul as little fuel as a 767, and impractical to imagine, alternatively, how it could burn as little fuel per mile. There are, after all, differing aspects of quality endemic to both aircraft.

The demand curves are similarly specific to individual buyers; actually, we can draw multiple demand curves—indifference curves, actually—of increasing preference cascading into lower total costs for the same level of quality. In contrast to the supply curves, though, they are rather flexible in the short run, as they are driven by political objectives grounded by military judgement. That is, any given government or air arm, in formulating a corporate opinion about the sort of kit that it needs, comes to some decision of how much quality it prefers for how much money. The market clears where the last demand curve of increasing utility tangentially crosses one of the supply curves—thus identifying the winner of the contracting competition.

If the supply curves are fixed in the short run, then the customer’s decision—whether explicit or implicit—about the shape of his demand curve determines the winner and what will be bought. A slight shift in cost-sensitivity can hop the buyer’s preference from one supplier to another—even with a rather dissimilar product.

So much for the theory, which has been used widely in applications diverse as real estate appraisal and consumer price index adjustments. Its applicability in this case should be clear, but actual practice is rather curious. In the USAF’s KC-X RFP, rigid adherence to the fixed price approach has produced, whether the USAF’s strategists realize it or not, a nearly vertical demand curve. Leaving aside for the moment the analytical messiness of the one-percent-price-difference tie-breaker, the USAF is essentially saying that it has no demand for anything more than a fixed level of amalgamated quality, and will pay whatever it takes to get that (even though there must be some unstated budget limit). If, as is widely supposed, that level of quality is more closely matched to one of the pre-existing products being customized for the competition, it’s hard to imagine how the seller with the other product can successfully bid.

In the chart above, the price difference between what A and B can offer is pretty significant, and this is not mere modeling. With Northrop and EADS’s previous bid in hand, and an effectively vertical demand curve spelled out in the RFP, Boeing can raise its price and resulting TCO considerably, towards the lowest cost that B could offer under an RFP favoring A. Boeing lists its range of prices for 767-200ERs (the basis of the KC-767) as $127.5–139.0 million. Airbus lists its range of prices for A330-200s (the basis for the KC-45) as $176.3–185.5 million. We’re not certain as to the effective average price, or how they might differ, if Airbus and Boeing have differing discounting policies. Still, the effect is considerable. Excluding differences in how the offerors may choose to outfit their aircraft, the gap between the ends of those ranges is $37.3 million per plane, which gives Boeing a great deal of room for raising its profitability. After all, for all Boeing’s declarative strategy of launch-customer pricing, the actual pricing at launch may vary considerably with the likelihood that Northrop and EADS will actually submit a bid.

For the USAF’s attention, I will note that over a production run of 179 aircraft, that’s pricing headroom of $6.67 billion. One can call that the maximum effective price of writing a protest-proof RFP. It could be much less, as any offeror who wants the contract will be required to spell out its costs, and take no more than a 12.5 percent profit. However, in the absence of a bid from Northrop and EADS, we’ll never quite know how much less, as Boeing will have far more control over what is an allowable costs than the fact-checkers at the Defense Contract Audit Agency. It’s advertised costs may bake-in all sorts of minor inefficiencies to claim more dollars within that allowable 12.5 percent margin. And why not take a merely reasonable, rather than a vigorous, approach to cost-accounting? Boeing has shareholders, and the management they hire have a fiduciary responsibility to them. Driving a hard bargain is just good business. 

On the government’s side, doing good business means not getting taken by a supplier who knows that your BATNA—procurement shorthand for best alternative to a negotiated agreement—isn’t so good. The USAF could continue to fly airplanes that are already forty-something years old, and hope that none of them fall out of the sky in a flaming ball of JP-8, but that’s slowly becoming an increasingly tense position with time. (Bob Gates has signaled as much with his insistence that the competition get underway now.) Moreover, if Northrop and EADS do not lodge an effective bid, whatever extra profit Boeing accrues from the lack of competition will come without added quality in the product. The KC-767 is a fine plane, but there’s no reason to pay more for it.

So what to do? There are five steps that the government can take, on a short schedule, to improve the process, and almost certainly the outcome as well.

First, offer to pay for both bidders’ proposal costs, up to some prearranged and openly declared limit. Northrop and EADS’s disinterest in bidding is probably more than a gambit. Bidding on a tome of a requirement is a costly process. If there is really no real chance of winning, then spending the money on that such a bid would be economically unjustifiable. Even if Northrop and EADS are unlikely to win, inducing them to bid by offering to pay their reasonable bidding costs (or by just offering a flat fee for a reasonable bid) could inject a little more competition into the deal, and shave some basis points of  Boeing’s number. And if Northrop and EADS turn out to be stalking horses, then at least they won’t be able to complain after the fact about having been used: they will have been paid for his services.

Second, survey industry practice. Consider how this is done by people who buy airplanes for a living—the aircraft buyers at airlines. When airlines need new airliners, they generally do not release detailed RFPs to aircraft manufacturers. Some of these airlines have been bigger buyers of airliners for some time than the USAF, so their practices, melded by the discipline of the market, may be noteworthy. Airlines know full well that no manufacturer is going to design a plane from scratch for any single customer, so they recognize their choices are generally discrete, and often pairwise: A380 or B747, A330/340 or B777, CRJ-200 or ERJ-145, etc. In each market segment for commercial aircraft today, it is unusual to find more than two companies offering a product, and these products are readily identified. There is thus no reason to produce a detailed RFP, much less one specifying the flow rates of water in the heads, because these are what they are, and we can all read the specification sheets. RFPs are consequently broad, akin to asking we need roughly these kinds of airplanes, and about this many; what can you do for us?

Third, understand the economics. With this grasp of industry practice in mind, draw one more chart—a chart that conceptualizes how one would write the RFP. For broad guidance, the offerors will need the outlines of the qualities desired: minimal thresholds, maximal objectives, and the budget limit that they could infer anyway from the recently-published program objective memorandum (POM). What they should not have is the actual demand curve on which the government’s people will settle; that is, they should not have the actual grading criteria. With those criteria, the bidders could—as they can now—infer clearly which company’s product had the advantage, and the advantaged bidder could shade its bid accordingly.

Fourth, write a real RFP. To avoid this outcome, the government should consider writing an actual RFP. With so many mandatory criteria, and so little room to propose value-added improvements to the customer’s conception of what he needs, the request is not so much a request for proposal as a frighteningly complex request for quote (RFQ). In procurement theory and practice, the RFQ is much more useful when a customer needs an efficient arms-length transaction with a supplier for a relative commodity. Aerial tankers, however, are not resins. Specifying in so much detail both what is needed, and how much the customer is willing to pay relative to the next best option, surrenders a valuable informational asymmetry that could be used to extract competitive energy from at least one of the bidders.

Writing a real RFP, and not just a monstrous RFQ, can take military officers and procurement bureaucrats out of their comfort zones. Of course, this happened in the early 1990s when Al Gore decided to reinvent government and government procurement. That was a few years after he invented the Internet, of course—and while his involvement in the later project was probably more significant, the results were still pretty impressive. The Joint Direct Attack Munition (JDAM) program stands out as a poster child for how to do this right. The 1994 Federal Acquisition Streamlining Act specifically authorized the Secretary of Defense to waive any regulation not required by statute that might impede the efficiency of the contracting process. The JDAM System Program Office was then exempted from 25 provisions of the federal Acquisition Regulations (FARs) and another 25 of the Defense Department’s supplement to them (the DFARs). In their place, the government wrote an RFP that was little more than a two-page performance specification. [2]

Fifth, don’t hold an single-round auction; instead, negotiate. The results of the JDAM competition were impressive, but how they got that way is instructive. The USAF’s initial price estimate, based on parametric studies of past programs, was $68,000 per guidance kit (in 1994 terms). McDonnell Douglas, which was eventually to win the program, hoped that it could build them for $40,000 each. The USAF, however, had lent each the two companies that survived the first round of bidding several officials for its integrated product team (IPT). When McD-D proposed a way to get the price down to $28,000 per unit, the blue-suited people on the IPT hinted hard to their corporate colleagues that such a number wasn’t good enough. Lockheed, that is, was coming in with a bid of $18,000. McDonnell  eventually figured out a way to combine the functions of several parts into less expensive assemblies, and won with a final bid of just $14,000. [3]

At the time this was a shocking idea—though only in the government. In many industrial businesses, the concept was already then well-known, and by now, it’s old hat. Today, a considerable literature suggests that two-way trust and an efficient degree of communication are critical to making buyer-supplier collaboration work. [4] That may constitute an inconvenient truth, as at this point there may be little trust left in this three-way relationship. Further, the importance of forming these teams well should not be slighted. As Terry Little, the legendary initial manager of the JDAM program, told Government Executive magazine back in 1999, “a lot of people think being successful as a program manager is about making decisions, giving directions, good planning and having a good contract. I find none of that to be true. I find it is about people.” [5]

Yet still, the collaborate, multi-round approach may still give the willies to government procurement bureaucrats raised on the arms-length, single-round, sealed-bid auctions. After all, there is recent evidence from federal timber sales in the US that open auctions which recurrently feature the same bidders lead to tacit collusion, and less advantaged outcomes for the government. [6] In this case, though, the stakes in this single competition are so, the inherent rivalry in the observable conduct of the participating firms so obvious, that any kind of collusion is almost unthinkable.

Of course, that conclusion is a matter of who’s doing the colluding. In theory, the process could get disconnected, perhaps with cases of wine from either the Loire Valley or the Columbia Gorge. As a friend once from the aircraft-buying business put it to me recently, the party favors have been known to include “tickets to Riverdance (boring), a Christmas ornament (blah), a bottle of armagnac (always good)... and of course lots of dinners at Ruth Chris.” Ski vacations in the Cascades or the Alps shouldn’t be ruled out, either—presumably there are lots of “aircraft procurement symposia” (wink-wink, nudge-nudge) in both regions. Factors driving procurement decision-making may also very well include less untoward intangibles like egos, Buy-American sentiments, stick-it-to-Boeing sentiments, or previous employment by or connections to the manufacturers. 

Those concerns, though, shouldn’t disqualify the approach, as the airline industry has to deal with this stuff just the same. As Stephen Goldsmith, a former mayor of Indianapolis and current professor at Harvard’s Kennedy School of Government once put it, too much of government procurement regulation is still designed to keep civil servants from stealing money. [7] Darleen Druyuns are few and far between, and when they’re found, the regulations still are infrequently enough to keep their hands off the scales and out of the tills.

Finally, the concept of vague requirements, a hidden willingness-to-pay, and multiple rounds of negotiation shouldn’t be alien to anyone who has ever bought a car. Unless, that is, he bought all his cars from Saturn. That little division of GM that wouldn’t negotiate is no longer with us, and most everyone else has gone on haggling. There may just be some efficiency to this idea.

If the government really took this tack, would the KC-X program see a percentage of savings similar to that of the JDAM program? Of course not: the underlying products are far too mature for such a radical reengineering at this stage. Still, any effort expended on the heft of the revised RFP would be better spent in the analysis of the discrete alternatives available, and assembling government-supplier IPTs that could cooperatively refine the proposals into the best form possible, on each side of the bidding. There’s about six billion dollars on the table. This year, even in Washington, that’s real money.

NOTES

1. For the seminal paper on the concept, see Sherwin Rosen, “Hedonic Prices and Implicit Markets: Product Differentiation in Pure Competition,” Journal of Political Economy, January-February 1974.
2. A further two factors, rolling down-selection and contractor-supplied warranties, aren’t wholly applicable here. Excluding Ilyushin, are really only two suppliers capable to supplying the aircraft in question, so there’s no need for multiple down-selections. A warranty is an interesting idea, but since the maintenance costs of both 767s and A330s over time are readily knowable in advance, there’s little need, in terms of supposed informational asymmetries or quality incentives, to try to shift this risk from the customer to the supplier.
3. George Cahlink, “Birth of a Bomb: the Quest for Smart, Cheap, and Versatile Munitions,” Government Executive, 15 August 2003; and Cynthia Ingols and Lisa Brem, “Implementing Acquisition Reform: A Case Study on Joint Direct Attack Munitions,” Defense Systems Management College, July 1998. The JDAM procurement process was used for some time at the DSMC as a case study in how-to-do-things, so it’s not clear why the lessons have been forgotten so fast.
4. For a start, see Martin Hoegl and Stephan M. Wagner, “Buyer-Supplier Collaboration in Product Development,” Journal of Management, vol. 31, no. 4 (2005); Akbar Zaheer, Bill McEvily, and Vincenzo Perrone, “The Strategic Value of Buyer-Supplier Relationships,” Journal of Supply Chain Management, vol. 34, no. 3 (2006); and Chin-Chin Hsu, et al., “Information sharing, buyer-supplier relationships, and firm performance: a multi-region analysis,” International Journal of Physical Distribution & Logistics Management, vol. 38, no. 4 (2008).
5. Anne Laurent, “On Time, At Cost,” Government Executive, 1 September 1998. Terry Little is now a consultant with the Spectrum Group, so someone in the government ought to think about hiring him on this one.
6. Susan Athey and Jonathan Levin, “Information and Competition in U.S. Forest Service Timber Auctions,” Journal of Political Economy, April 2001.
7. Stephen Goldsmith, “Can Business Really Do Business with Government?”, Harvard Business Review, May-June 1997.

How the CG(X) cancellation simplifies the US Navy's planning

Defense Industry Daily, commenting on the rumors first surfaced by Andrea Shalal-Esa of Reuters, had this to say about the presumed presumed cancellation of the CG(X) cruiser program:

        The CG (X) follow-on cruiser... was initially supposed to replace the aging Reagan-era CG-47 Ticonderoga class with a larger version of the DDG-1000 Zumwalt class, before becoming the subject of resolutions from Congress requiring that it be nuclear powered. Stretched and modified DDG-51 Arleigh Burke class destroyers, whose 9,000-ton weight places them close to cruiser size anyway, are expected to replace it, while modernization efforts stretch the life of the Ticonderoga class. The effect of a CG(X) cancellation on related programs like the AMDR dual-band radar is not yet certain.

I have three comments myself about this bit of news, which is almost not news.

First, this was to be expected, as the US Navy has never laid out a convincing case that a ship larger than the Burkes would be required for any role but carrying the already-cancelled kinetic energy interceptor. That may have been a useful mission, but the Obama Administration has already left it behind. Moreover, the only navy with larger surface combatants today is Russia’s, and much of that fleet’s design concept is a holdover from the late Cold War. Everyone else seems to manage air defense just fine with a big frigate. This isn’t a criticism of the Burke class; it’s just a reasonable assertion that the ships aren’t undersized amongst the fleets of the world.

Second, the cancellation is further to be expected because the term cruiser is almost meaningless today. The US Navy’s only real distinction between cruisers and destroyers is that the former is supposed to be capable of serving as a flagship. Stretching an existing design to allow for a larger communications suite and a few more staterooms for the commodore or admiral’s staff does seem cheaper than starting fresh. After all, as the Zen Pundit put it last week, “America’s nine year drunken sailor spending spree is officially over,” so somebody had better start finding ways to save money, somewhere.

But perhaps most interestingly, canceling the CG(X) simplifies the Navy’s planning. If the service was to take those congressional resolutions seriously (as it more than occasionally does), then its next classes of cruisers and helicopter carriers would necessarily be designed with nuclear propulsion. For the relative merits of this policy, see my column “Nuclear-powered amphibs all around” of October 2008; what’s notable today is not the economics of the question, but its governance.

For a variety of reasons, the Navy is far less enthused about this policy than are the two congressmen behind it, Gene Taylor (D-Mississippi) and Roscoe Bartlett (R-Maryland). The next helicopter carrier to follow the America-class may not come for twenty years, so the Navy can continue to avoid the question with that type, if it continues to prefer gas turbines for these ships. Its options for the CG(X) were less clear. By basing the follow-on to the Ticonderogas on the Burkes, the Navy can reasonably call them destroyers, rather like the destroyer leaders of the early Cold War.

Back in 1975, the DLGs and DLGNs were reclassified as GGs and CGNs simply as a marketing move. The Soviet Navy had lots of smallish cruisers, so a few inconvenient congressmen were insisting that the Navy close the “cruiser gap”—by building more, larger surface combatants that the admiralty didn’t want. Reclassifying the ships neutralized that opposition with nothing more than some fresh ink for the hull numbers on the Naval Register. Today, the Navy is effectively repeating that move, whether it calls the future “command-and-control” Burkes DLGs or not. For the trouble of fudging the classifications lines a bit, the service gets to put off the nuclear propulsion question indefinitely.

Thus, the next time that a congressional committee wants to provide guidance that strong, the committee’s staff should take care in the language to delineate the boundaries tightly—not cruiser, but something like surface warship of greater than [insert preferred number] tons. Otherwise, the naval staff will play them yet again.

Should EADS's threats about the A400M program be taken seriously?

Over the past week or so, aviation and military writers have provided considerable coverage to EADS’s assertion that it might terminate the A400M airlifter program if more money is not forthcoming from its customers. This threat became more tangible yesterday when EADS CEO Louis Gallois told a press conference in Seville that

        We cannot continue beyond the end of January without knowing where we are going financially. I am sending a message of urgency to governments. We are ready to negotiate at any time. [1]

Speaking after his boss, Airbus CEO Tom Enders added that

        We cannot continue without a significant financial contribution from our customers. If we don't press for that it will jeopardize the whole of Airbus. The A400M as it is set up today will put the whole of Airbus in jeopardy and I will not go down that road. [2]

Strong stuff, and this threat of bankruptcy has worked before for manufacturers of big airplanes, both civil and military. As I argued in a paper a few years ago [3], the US Air Force seems to try to bail out an American manufacturer of commercial aircraft with a well-financed military program about every ten years:

• 1971: Lockheed, with the C-5A (and separate loan guarantees for the L-1011)
• 1982: McDonnell-Douglas, with the KC-10
• 1990: McDonnell-Douglas, with the C-17
• 2002: Boeing, with the KC-767 leasing deal

What hasn’t worked out so well is the underlying but implicit industrial policy of trying to keep players in the game: Lockheed exited the business anyway, the last remnant of Douglas in Long Beach is winding down with C-17 production, and Boeing’s tanker leasing debacle actually sent people to jail.

Of course, the C-17 could get a new lease on life if the A400M really doesn’t proceed past initial testing. Moreover, EADS has been making threats on this side of the Atlantic as well—as I discussed in my last column, if the USAF doesn’t change its RFP for tanker aircraft, Airbus and Northrop Grumman may not bid on the program. So, from the interest of the seven governments signed up to finance the A400M program (of Belgium, Britain, France, Germany, Luxembourg, Spain and Turkey), and from that of Boeing and its suppliers in the C-17 business, it’s worth asking just how seriously to take this latest threat.

For that, let’s consider a few facts about the program [4]:

• The initial fixed price was about €20 billion: roughly €6 billion for development, and €14 billion for production of 180 aircraft.
• EADS has received €5.7 billion in advance development payments, and has spent all of it.
• Pricewaterhouse Coopers estimates that EADS will need another €5 billion to finish the program; Enders suggested yesterday that this figure might be as much as €6 billion.
• EADS has already put aside provision on its balance sheet for a further charge of €2.4 billion related to the program.

This suggests that, by the auditor’s (lower) estimate, development will take another €2.4 billion, and production another €2.6 billion above the previously forecast cost—assuming that EADS’s charge is wholly related to development costs.

Now, to put this in some context, let’s consult EADS’s financials from the past years, courtesy of the company’s website:

EADS’s financial results (€MM)	2004	2005	2006	2007	2008
Revenues	31,761	34,206	39,434	39,123	43,265
Operating EBITDA	3,841	4,365	2,033	1,751	4,439
EBIT	2,432	2,852	399	52	2,830
Free Cash Flow	1,614	2,413	2,029	3,354	2,559
Net Cash	3,961	5,489	4,229	7,024	9,193

In absolute terms, EADS has the cash on hand that it needs to finance the A400M program, at the new cost projections, without hitting up its customers for more than they agreed to pay. Indeed, its cash position has been improving over the past few years, and its free cash flow could make up the deficit caused by the A400M mess in two or three years. More so, it’s reasonable for these governments to complain about these revelations, whatever unrealistic assumptions they encouraged previous management to make, because they had alternatives. The C-17 could be more airplane than most of them need for their transportation requirements, but if the A400M is to be 25 percent more expensive than they signed up to pay, then one of more of them might have bought some Boeings instead.

That said, recall the definition of free cash flow:

        FCF = NI + DepAmor – ∆WK – CapEx(req)

The question of required capital expenditure is important here. While the money on hand and soon to be generated may be enough to cover the A400M problem, it may not be enough to cover that and all of EADS’s other needs. As Enders told the news conference, “the A380 will remain a financial liability for Airbus for some years to come,” [5] and earlier this month, noted aviation industry analysis Scott Hamilton openly questioned whether the time has come “for Airbus to cut its losses and terminate the program.” [6] Further, while the Power 8 program has apparently provided billions of euros in cost savings, there is always more work to be done in a competitive but technologically demanding industry like jetliners.

In the short term, EADS looks more than sustainable. The A400M debacle is not enough to kill the company, and on the strict basis of considering what is best for its shareholders, the €5.7 billion that EADS would owe in prepayment liabilities (if it terminated the program) roughly matches the €5-6 billion that it would yet need to pay without a negotiated price increase. Given the potential for tremendous loss of goodwill and brand image, withdrawal from the deal is thus very unlikely, and EADS’s threat still callable financially.

In the long run, though, the twin drains of the A400M and the A380 are putting the company’s industrial health in some jeopardy. Indeed, the situation of EADS today is remarkably reminiscent of that of Lockheed in 1971. The company had signed up for a fixed-price development contract for the C-5A Galaxy airlifter program, had almost simultaneously launched the ill-advised L-1011 Tri Star airliner project. Then, as I wrote in my 2007 paper (slightly edited for clarity),

        Lockheed urgently petitioned the US government for $250 million in loan guarantees needed to launch the L-1011, and for $500 million in payments to finish its work on the C-5A. Informational asymmetry and a peculiar case of the winner’s curse combined to gravely damage the contractor’s finances: the USAF’s insistence on a fixed-price contract in the development of the C-5A transport would have forced Lockheed into bankruptcy, and this event was appealing to neither party. [7] ...To shore up its large aircraft business, Lockheed argued that it also desperately needed low-cost funding for the Tri Star, and Lockheed assured the Air Force and the US Congress that the project would break even at sales of 195 to 205 aircraft.

        The problem lay in what Lockheed knew, and when it knew it. Subsidy can be costly, as (amongst other problems) it is subject to sharp informational asymmetries: Lockheed knew more about the project than the government, and was able to color its estimates quite effectively to its own purposes. A less-impassioned analysis of Lockheed’s cost estimates—critically, including the company’s cost of capital—predicted break-even at nearly twice that number of aircraft. [8] Indeed, by 1981, when the company decided to terminate Tri Star production, Lockheed had amassed cumulative orders for 244 L-1011s (still not a large number in the context of the market), and the company expected to lose roughly $2.9 billion on the project overall. [9]

In the end, Lockheed could not manage the financing—even with a government bailout—to stay in both the military and civil transport aircraft businesses. Something had to go. The question in today’s context is what might happen to EADS and its flagship subsidiary, Airbus. While the threat may be callable financially, whether it is callable politically might have been considered, in times past, wholly another question. The trouble for EADS is that the blanket of dirigisme is not what it once was. While the consortium procurement approach worked well to bind customers into the Eurofighter program long after none of them deeply wanted that airplane, it is in this case creating a collective action problem. The Spanish government’s industrial enthusiasms are obvious. The French government indirectly owns 15 percent of EADS, and as such, would share in the losses (even if not up to what it has contributed in development funds so far). The British government, however, has precarious finances today, and the RAF already operates a squadron of six C-17s, with a seventh on order. How this is a crisis for the Belgian or Turkish government is even less clear. And as noted above, the track record for nudging aircraft firms back into particular market segments has been rather bad.

In the end, then, neither the A400M nor the A380 will sink EADS generally, and Enders was probably exaggerating when he claimed that “the whole of Airbus [is] in jeopardy”. Still, to paraphrase Robert Parr, given the stakes involved in large aircraft development programs, no matter how many times one saves companies like these, they always seem to get back in jeopardy again. These two financially messes might just, then, together force a serious reprioritization of Airbus’s future product portfolio. The frank admissions about the state of the A400M and A380 projects rather clearly show what we all have long suspected—that EADS and its forerunner, the Airbus consortium, have allowed politics to control too much of the decision-making over the years. The company may be a political creature, as many large military contractors are to some extent, so some of this may have been unavoidable. However, as Manfred Bischoff, a rather commercially-minded former chairman of the EADS once said, “often, the word strategic can be replaced with not making money.” [10] Exacerbating the natural commercial risks with political adventures is no path to glory. For EADS, that now must stop.

—————
Notes

1. Robert Wall, “A400M: EADS Waits For An Invitation To Negotiate,” Ares, 12 January 2010.


2. Murdo Morrison, “A400M 'cannot continue' without more funding, warns Airbus CEO,” Flight Global, 12 January 2010.


3. See my briefing “Unstated and Unsuccessful: Observations on thirty years of the United States Air Force’s efforts at industrial policy in the transport aircraft industry”, 14 April 2007.


4. Emma Vandore, “Airbus threatens to drop A400M military plane,” Associated Press, 5 January 2010.


5. David Pearson and Daniel Michaels, “Airbus Results Offset by A400M Woes,” the Wall Street Journal, 12 January 2010.


6. Scott Hamilton, “Outlook for Airbus, Boeing in 2010,” Leeham News & Comment, 4 January 2010.


7. Some insights courtesy of Mary Beth Savio of Charles River Associates.


8. U.E. Reinhardt, 'Break-Even Analysis for Lockheed's Tri Star: An Application of Financial Theory,' Journal of Finance, September 1973 (28 #4), p. 830.


9. Robert R. Ropelewski, ‘Heavy Losses Cited in Decision to Terminate L-1011s,’ Aviation Week & Space Technology, 14 December 1981 (115 #24), pp. 26-29.


10. Vago Muradian and Martin Agüera, “Interview: Manfred Bischoff, EADS Co-chairman,” Defense News, 22 March 2004.

Four issues with the USAF's tanker RFP, Part Two: an analysis of the split-buy concept

As I wrote in my last column on this subject, the US Air Force’s current request for proposals (RFP) in the KC-X tanker replacement program is troubling in four ways:

• It departs from value-for-money sensibility by equally weighting all the evaluation criteria
• It attempts to shift too much commodity and currency price risk to the supplier with a very long, fixed-price contract
• It pre-commits to a single supplier for that excessive duration
• It focuses on a perception of fairness to the bidders over value to the buyer

All of these problems could be dispatched by simply rewriting the RFP to reflect sound procurement practice. However, the Pentagon’s defense of the document has been as steadfast as it has been unsatisfactory, which is not generally a recipe for change. [1] It is entirely possible that the current RFP was hastily hatched from frustration with the GAO’s rejection of the Pentagon’s last attempt at grading papers. It has been suggested by supporters of Northrop and EADS’s bid that it is a veiled effort to steer the award to Boeing and its politically influential labor unions. Whatever the case, split procurement is not likely being proposed, even by its boosters, as the optimal solution, but the one with the best chance of successfully subverting the current process. Its efficacy and feasibility are further questions—and the subject of this essay.

The split procurement approach would effectively rerun a small competition every so often to keep, in theory, each contractor’s pencil sharp, awarding variable quantities based on each new bid and the relative past performance of the suppliers. It’s not uncommon practice in commercial procurement, though as I make clear below, there are good reasons that it’s not commonplace. Based on some of these, Ashton Carter, the US under secretary of defense for acquisition, and his boss Robert Gates have staked out adamant opposition to this idea. That said, split procurement has been recommended as offering at least seven advantages:

• Buying off political opposition
• Inducing potential bidders to bid
• Reducing bid prices (when managed carefully)
• Promoting a competitive industry
• Reducing the risk from correlated defects and uncertainty over future requirements
• Inducing faster innovation
• Delivering larger quantities faster

It is important to note that this is merely a relatively comprehensive list of the plausible arguments. To evaluate whether the approach is sound generally, and would further be useful in the KC-X competition, we will require some further discussion of the theory and evidence on hand.

THEORY

Buying off political opposition. Split procurement has been notably and recently forwarded by military and aviation analysts such as Loren Thompson and Richard Aboulafia as a convenient way to discourage further contract protests. [2] Using split procurement in this fashion is not, however, a new concept: the idea had similarly been suggested for the NATO AWACS program in the late 1970s. The British government (formed at the time by the Labour Party) insisted that the aircraft be based on the Hawker Siddeley Nimrod; the German and French governments had Airbuses in mind; but ultimately, the contract went to Boeing. [3] The story has obvious parallels to the last run of the KC-X competition beyond the mere similarity of the equipment: a rent-seeking company and its supportive labor union lobbied hard for a domestic solution, on all sorts of grounds supposedly “strategic”, but were ultimately rebuffed by a government which preferred value-for-money and good relations with trading partners and military allies. Further, while this move may be politically appealing, it is also, as I will explain further on, potentially politically dangerous.

Inducing potential bidders to bid. In part, this buying-off works by offering a consolation prize. When bidding is costly—and it is with large airliner projects—“the split award mechanism provides additional insurance against the possibility of losing the bid and, therefore, any bidding costs.” [4] Northrop and EADS seem at least interested in the concept, and generally speaking, contractors in two-horse races have often liked ongoing contract splits. As Bob Browning, CEO of Austal, said last year about the Littoral Combat Ship (LCS) program, “we'd rather have a 100 percent chance at building 27 ships than a 50 percent chance of building 55.” [5]

This may contravene a common, if simplistic, assumption in financial analysis of risk-neutrality. Ceteris paribus, the simple expected value of 27 certain units would seem slightly less than that of 55 half-likely units. In truth, though, few really expect the simple notion to hold, and for several possible reasons. Agency issues are probably present—managers like their jobs, many of which survive whether they build half the fleet or all of it. This builds in some incentive for bunting before swinging for the fences. Relatively concentrated ownership and control may play an issue as well, and in a similar way. Whether or not it is true about Austal or Boeing or EADS, there are certainly closely-held enterprises in which not all investors are equally widely diversified and risk-neutral. Investors who really are that passive aren’t likely to cause much trouble at the shareholders’ meeting, after all.

Expected values, though, are perhaps most notable for the Pentagon’s calculations. Offerers may think about these based on non-recurring investments. Assuming that the probability of half-the-deal were really 100 percent, those 27 ships in the LCS example could really be worth more than half as much as 55 awarded to a single company on a fixed-price, winner-take-all basis. That is because the Pentagon frequently pays contractors based on what they claim as their costs, and not what prices they can really deliver. So, if both contractors’ unit costs increase in a split award, the government could wind up paying for the same fixed costs twice—and for the margin that both earn on it.

Further, this stratagem only works when both contractors agree to play. After all, “a single bidder can effectively veto any non-sole-source spilt by submitting a relatively high price for its share of the split, thereby rendering the split unattractive to the buyer.” [6] That bidder might choose this strategy if he thought that his odds of winning all the production were so good that he need not offer to share it with his competitor.

Reducing bid prices (when managed carefully). Indeed, the usual approach to procurement assumes that buying from a single seller generally produces the lowest price. As alluded above, production scale economies suggest that the efficient outcome, ceteris paribus, will concentrate production in a single firm. This has been repeated argued theoretically in the literature, and shown empirically in military procurement in general, though with limited data sets. [7] That said, merely the threatened addition of a second source can be valuable to the buyer because it lends immediate credibility to the threat of switching suppliers. [8] Recent evidence from missile procurement in particular suggests that “dual sourcing as used in practice reduces procurement costs significantly, apparently spurring efforts at cost control that outweigh any lost economies of scale or learning that result from splitting production across two suppliers.” [9] Further, in a duopoly with long-lead contracts but soft current sales, one could theoretically do well to split procurement by capacity—each contractor might give a good deal to fill the remaining space in the factory, if other orders are unlikely to be forthcoming.

Promoting a competitive industry. Filling factories seems to have been a serious concern of the US Navy for some years now. Split awards have featured heavily in shipbuilding programs, but their track record has been mixed. Where required quantities are genuinely competed, as in the Arleigh Burke-class destroyer program, inflation-adjusted cost curves have often decreased over time—and shipyards focused on military production have remained in business for the next program opportunity. However, when the buyer has clearly signaled willingness “to pay a premium for a split award on strategic grounds, sole-source threats are not as effective in disciplining split prices.” [10] The Virginia-class submarine program may be the leading bad example here. Northrop Grumman’s Newport News Shipbuilding and General Dynamics’ Electric Boat Company were encouraged to divide the production of individual submarines between their yards in the interest of “preserving the industrial base.” If the next submarine program does not offer better scale economies than this one, then the current work sharing arrangement cannot be said to have eliminated competition in some hope of someday restoring it. Rather, it has likely induced collusion and increased costs to appease the politically connected.

What’s more, in the case of the KC-X competition, preserving competitiveness is at once unnecessary and unlikely. Both Airbus and Boeing reasonably can be expected to remain in the airliner business for some years to come, so neither will exit the market because of any purchasing decisions by this one customer. In the unlikely event that one actually did, it’s reasonable to expect entry into this segment, and probably from a company that already produces smaller airliners, such as Bombardier or Embraer. Further, the USAF’s projected quantities are actually quite limited compared to the necessary scale requirements of long-term, successful airliner production. [11] Thus, there is little room to expect that either contractor can or needs to be kept in the game with a hand-out award to promote some notion of a competitive industrial base.

Reducing the risk from correlated defects and uncertainty over future requirements. Second sources can be strong hedges against relying too strongly on any single supplier for quality and schedule performance. This is managed by gathering information over time related to correlated defects, and grading the contractors accordingly in the performance reviews. [12] In the KC-X competition, it could be particularly useful given Boeing’s recent past performance with tankers, which has not been fabulous. The company really did make a hash of its 767 tanker development for the Japanese and Italian Air Forces. Further, the problem was specifically with the refueling equipment, which is the core of what makes a tanker a tanker, and not just an airliner in military livery. [13] The same cannot be said about Airbus's recent work on its already-delivered A310 tankers for the Luftwaffe and the Canadian Air Force, or its A330 tankers for the Royal Air Force, the Royal Australian Air Force, the Royal Saudi Air Force, the UAE Air Force, and the Indian Air Force. While we should anticipate that Boeing will probably fix the Japanese and Italian problems convincingly, one cannot plausibly claim after these delays that the A330 represents a riskier option. But whatever the case, if either supplier’s aircraft showed systemic problems at some future date, the USAF would have more than one fleet of tanker aircraft (as it does now with the KC-135s and KC-10s) on which to rely, and running production lines from which to order more of the non-offending planes.

Material defects or delivery delays may not, however, be the most important risks to mitigate with split procurement. The strategic question of which aircraft is most suitable to US military needs may not be answered before quite a few years of production have passed. There are two aspects to this:

• Uncertainty over the need for fuel capacity. While dissatisfaction, if there has been any, over the KC-135’s fuel capacity did not drive the replacement decision in the first place, it is worth considering when re-equipping with a totally new type of airplane, as no one makes KC-135s (or 707s) anymore. The old Boeing’s fuel capacity was just about right for transpolar nuclear strike missions: each KC-135 Stratotanker would pair up with a single B-52 Stratofortress, and transfer as much fuel as it could through that high flow-rate boom before sending the bomber on. While there are other advantages, that is the leading reason that the USAF went with booms, rather than probe-and-drogues, which are cheaper and can refuel more aircraft at a time. Today, however, one can foresee potential advantage in the higher fuel capacity of the A330 (the KC-45). The forthcoming MQ-X program could be huge, and those unmanned reconnaissance-strike aircraft will frequently fly as long as they have fuel. The tankers will be in the fleet for decades, and we should anticipate that someone will figure out in the next few years how to get a drone to refuel reliably in mid-air. A relative shift in force structure towards drones could thus favor the A330; on the other hand, renewed enthusiasm for long-range manned bombers could, as outlined above, favor the 767.
• Uncertainty over the need for cargo capacity. Airbus has specifically been pitching the its tanker design as a Multi-Role Tanker-Transport (MRTT). The airplane carries all its fuel in the wings, as Airbus chose to put the larger wings of the four-engined A340 on the twin-engined A330-MRTT. That frees up a lot of internal cargo capacity, which allows for easy reconfiguration to lots of roles. Since the Defense Department appears intent on avoiding buying more C-17 Globemaster IIIs, whatever the intent of the Congress, there may be advantage in buying more cargo capacity. Most of the time, Air Mobility Command is flying stuff into long runways anyway.

Thus, the USAF could shade its grading in future competitions based of whether it found that it needed more or less fuel capacity, and more or less cargo capacity. But a reasonable counter-argument holds that the service could simply wait to discover whatever problems may emerge, and if necessary, switch suppliers at that point. Could not the USAF just be expected to do the right thing, and buy the right aircraft after its future requirements are further revealed? Cannot flexibility just flow from future intestinal fortitude?

Herein we might profitably be led, as the Viscount St. Albans wrote, to leave our managerial advice “much beholden to Machiavelli and others, that write what men do, and not what they ought to do.” [14] Establishing a new program in the presence of entrenched interest has often proven very difficult, so splitting the program ex ante could greatly aid shifting quantities ex post. Pre-committing to a diverse fleet now, to allow for a diverse fleet in the future, could rather be like the Pentagon’s privatization of much of its on-base housing in the 1990s. The government could have recapitalized its decrepit properties on its own, but the responsible offices in the Pentagon could never quite get the needed funding from the committees of the Congress that control military construction accounts. Privatization worked like a bond issue, mandating a certain level of expenditure over time for a guaranteed result now.

Inducing faster innovation. Pencils can be kept sharp not just for shading costs, but for designing the next new thing. Keeping more than one contractor in the game, the argument goes, can create a sort of internal market in which the competing suppliers repeatedly try to best one another’s innovations. Moreover, “when this incentive translates into large innovation expenditures and reductions in joint costs, the resulting price in a [split award] auction can be less than the price in the corresponding [winner-take-all] auction.” [15] Multiple rounds would thus keep multiple players in the game, and eager for business. On the other hand, second sourcing could reduce the innovative investments by reducing the suppliers’ rents from production. This has been long argued, dating back to Schumpeter’s claim that monopoly was the cost of progress, but the evidence is far from clear. [16]

Regardless of the theoretical efficacy, this argument falls a bit short when applied to the KC-X competition. Airbus and Boeing will continue to innovate, but the focus of those efforts will be on advances which will appeal to their more important customers, the airlines. Most of the value of those innovations will spill over into their military transport efforts, as air forces appreciate lower maintenance burdens, lower fuel consumption, and higher carrying capacity just the same. If a tanker fleet is eyed in the future for conversion to “multi-role tanker-transport-ISR” aircraft, Airbus and Boeing may offer innovative solutions, but so could Northrop Grumman or Thales. Installation of modular electronic systems on aircraft as large as these is a relatively separable matter.

Delivering greater quantities faster. In principle, engaging multiple factories will, as General Nathan Bedford Forest might have put it, build the most first. This was entirely the approach in the recent Mine-Resistant Ambush Protected (MRAP) vehicle program, in which the US Army and Marine Corps bought armored trucks in quantity for the same purpose from (depending on how one counts) three to five different contractors. Because the newest of the KC-135s are about 45 years old, there exists a prima facie case for replacing the aircraft relatively quickly—before one falls from the sky in a ball of fire. Dual sourcing, it is argued, could procure the planes twice as fast, if large quantities were ordered from both Boeing and Northrop. These could be variably awarded in the split procurement approach discussed, or they could even be awarded in even quantities, just to keep all the rent-seeking political, corporate, and labor groups happy.

The problem with this argument, though, is that dual sourcing may be useful for buying off political opposition, but it isn’t at all necessary to doubling the procurement rate. Boeing’s production of 767s has average 35 aircraft annually since 1982. As the RFP calls for about 10 aircraft annually, offering Boeing the opportunity to double production of a product that is otherwise being phased out would probably be met enthusiastically, and perhaps even with a decrease in unit price. Offering EADS the chance to build 20 militarized A330s annually in Alabama, instead of merely 10, would similarly draw no complaints of a lack of capacity. Boeing delivered 481 airliners last year; Airbus delivered 437. Neither company needs the other to relieve some supposed bottleneck that might result from another 10 orders.

EVIDENCE

That’s the theory, which one must say is mixed in its implications. So far, Ashton Carter and Robert Gates seem to be emphasizing the added cost and complexity of adding two types of aircraft to the USAF’s fleet, which can be easily imagined. Running a fleet with two new tankers (A330 and 767) and two old tankers (KC-135 and KC-10), each with parallel training organizations, parallel logistics flows, and different pools of aircrews and groundcrews, could seem daunting. This surely is problematic—but plenty of scheduled airlines fly several types of airliners. Southwest, as noted above, famously benefits from the simplicity of doing otherwise, but split procurements persist within organizations with considerably fewer aircraft and considerably greater cost pressures.

Just a few weeks ago, United Airlines announced its intention to buy billions of dollars of both 787s (from Boeing) and A350s (from Airbus) between 2016 and 2019. United’s shareholders don’t seem completely put off by that idea—rather, with extensive rights to cancel deliveries if the finances don’t work out, United will keep both manufacturers eager for its business. (This differs notably from keeping them in business, which as noted above is wholly unnecessary.) United may not be getting the launch customer pricing that Boeing is now proposing to offer the USAF, but it’s a pretty reasonable approach. [17] It’s particularly reasonable given that the Dreamliner only first flew last week, and the A350 is nothing more today than a so-called paper airplane. It also indicates how the generally efficient solution is not always and everywhere the specifically appropriate one.

Thus, we might conclude that the split-award concept is not a priori flawed, and that applying it to KC-X program would hardly be the “nightmare” that Bob Gates called it a year ago. [18] It is hardly a nightmare that the Luftwaffe flies A310-MRTTs while the Armée de l’Air next door flies KC-135s. These are much smaller fleets, but the investments are worth the money for air arms with different ideas about what a tanker ought to be—as the USAF might, if it wanted further options for tailoring its fleet to particular missions. The real question is whether, in the KC-X competition particularly, the sometime positive aspects of split procurement might outweigh the disadvantages.

ANALYSIS

To consider that question, let’s review how the theory applies. At least three of our original seven propositions don’t hold up very well in the context of Airbus, Boeing, and commercially-derivative military tanker-transports:

• Buying off political opposition
• Inducing potential bidders to bid
• Reducing bid prices (when managed carefully)
• Promoting a competitive industry
• Reducing the risk from correlated defects and uncertainty over future requirements
• Inducing faster innovation
• Delivering larger quantities faster

Given the very plausible threat that Northrop Grumman and EADS might choose not to bid, inducing potential bidders to bid would be primarily useful for, eo ipso, reducing bid prices. The alternative would be a negotiated solution with Boeing, but a solution in which Boeing would have no incentive to offer the USAF that launch customer pricing. After all, Northrop and EADS apparently underbid a possibly complacent Boeing by $15 million per plane in the last competition, and with a considerably heavier aircraft at that. [19] So, we might combine these two lines under the first heading, and proceed with a shorter list of justifications:

• Buying off political opposition
• Inducing potential bidders to bid, simply to reduce the prices bid
• Reducing the risk from correlated defects and uncertainty over future requirements

So what of those profound defects in the RFP? Do these managerial levers actually address them? The first tackles several, if indirectly. Buying off political opposition could slide the warring camps into shorter term contracts without an abrupt loss of face by the Pentagon’s leadership. This would eliminate the problems of misallocation of commodity and currency price risk, excessive pre-committment to a single supplier, and the obsession over fairness. The silly equal weighting of all criteria would need to fade away if the USAF came round to professing uncertainty over future requirements, and thus acknowledged that it would have to continually revise actual and meaningful weightings over time.

That’s how it could work, but that’s not necessarily working better. To begin, capitulating to transparent demands for patronage would make for stunningly bad public policy. If commercial and political interests in Washington State and Alabama could collude and conspire in this way, where would the line be drawn? We might then expect more federal congressmen to state baldly, as Massimo Fanucci might, that they would not need a lot, but that there could be trouble with political authority if they didn’t get it. Tolerating a little political rent-seeking may be the price of first-past-the-post elections; tolerating a lot would make the hullabaloo over earmarking oh-so humdrum.

The third lever seems intriguing, and hardly underhanded, and in one sense, the argument has already been accepted. There will almost certainly be a KC-Y competition in a few years, to replace the larger KC-10s, which can carry much more fuel and cargo than the KC-135s. Boeing would certainly have an opportunity in this competition as well, presumably with a tanker version of its 777, and Airbus would likely bring the A330-MRTT back again. If more, bigger tankers were considered important at that point, the quantities procured in the KC-X program could be held steady, and those in the KC-Y program could be increased. Indeed, the USAF might have considered holding these competitions concurrently, were not the KC-10s much younger, and had the federal military budget more slack.

With all this in mind, we might assess the split-sourcing idea thusly:

1. Just fixing the RFP could be easier, if the Pentagon can manage to get out of its own way.
2. If not, moving towards split sourcing could provide an excuse to rewrite the terms of the competition with criteria more conducive to keeping both contractors interested, which could have, as we saw from Boeing’s last bid, multi-billion dollar implications.
3. If split procurement is indeed pursued, the political appeasement angle must be downplayed to guard against a recurrence of this decade-long procurement debacle. The government should think seriously before offering any guarantees of minimum quantities.
4. In the end, procurement could effectively be split anyway, as Airbus could reasonably be favored to win the KC-Y competition, particularly if it occurs sooner than later.

There may be better strategies for tanker replacement than split procurement, but there are clearly worse ones as well.

PRACTICE

So how might this work in practice? While the Defense Department has run split procurements before, the peculiarities of the airliner market suggest that the government’s regulations for running these contests may not be wholly appropriate here. In my third (and perhaps final) column on this question, I’ll address how the USAF might approach the problem with a radically simpler RFP, and one that sidesteps the illusive notion of fairness.

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Notes

1. See US Senator Jeff Sessions’ comments in Andrea Shalal-Esa, “Mobile, Alabama officials frustrated by tanker process,” Reuters, 5 January 2010.
2. Julie Johnsson, “Split could seal Air Force aerial-refueling tanker contract,” Chicago Tribune, 19 July 2009.
3. Arnold Lee Tessmer, Politics of compromise: NATO and AWACS‎, National Defense University Press, 1988.
4. Dorothy E. Klotz and Kalyan Chatterjee, "Variable Split Awards in a Single-Stage Procurement Model," Group Decision and Negotiation, vol. 4 (1995), pp. 295–310
5. George Talbot, “Murtha talks of splitting LCS contract,” (Mobile) Press-Register, 30 January 2009.
6. James J. Anton and Dennis A. Yao, "Split Awards, Procurement, and Innovation," The RAND Journal of Economics, Vol. 20, no. 4 (Winter 1989), pp. 538–552. In a subsequent paper, the same authors term this implicit coordination. See "Coordination in Split Award Auctions," The Quarterly Journal of Economics, Vol. 107, Issue 2 (May 1992), pp. 681–707.
7. W. R. Greer and S. S. Liao, "An Analysis of Risk and Return in the Defense Market: Its Impact on Weapon System Competition," Management Science, vol. 32, no. 10 (1986), pp. 1259-1273.
8. James J. Anton and Dennis A. Yao, "Second Sourcing and the Experience Curve: Price Competition in Defense Procurement," The RAND Journal of Economics, vol. 18, no. 1 (Spring 1987), pp. 57–76. For Anton’s most recent work on the subject, see James J. Anton, Sandro Brusco, and Giuseppe Lopomo, “Split-Award Procurement Auctions with Uncertain Scale Economies: Theory and Data,” Games and Economic Behavior, forthcoming.
9. Thomas P. Lyon, “Does Dual Sourcing Lower Procurement Costs?” Journal of Industrial Economics, vol. LIV, no. 2 (June 2006), pp. 223–252. For more on the subject, see William B. Burnett and W.E. Kovacic, “Reform of United States Weapons Acquisition Policy: Competition, Teaming Agreements, and Dual-Sourcing,” Yale Journal on Regulation, vol. 6, no. 2 (July 1989), pp. 249-317; and E. Pyatt, “Procurement Competition at Work: The Navy’s Experience,’ Yale Journal on Regulation, vol. 6, no. 2 (July 1989), pp. 319-331.
10. Sudhindra Seshadri, Kalyan Chattterjee, and Gary L. Lilien, “Multiple Source Procurement Auctions,” Marketing Science, vol. 10, no. 3 (Summer 1991), pp. 246–263.
11. The USAF has been down this path before, awarding contracts to McDonnell Douglas and Lockheed in futile attempts to keep them in the airliner business. See James Hasik, “Unstated and Unsuccessful: Observations on thirty years of the United States Air Force’s efforts at industrial policy in the transport aircraft industry,” April 2007.
12. Andrew Yim, “Failure Risk and Quality Cost in the Choice of Single Versus Multiple Sourcing,” Department of Accountancy, Tilburg University, 9 September 2009, p. 8.
13. Tom Kington, “Italian Air Force Nicknames 1st Tanker 'I Have a Dream',” Defense News, 17 June 2009.
14. Francis Bacon, The Advancement of Learning, Book II, xxi, 9 (1605).
15. Anton and Yao, op. cit., 1989.
16. For more recent arguments in favor of keeping contractors’ profits up to encourage future innovation, see Jean-Jacques Laffont and Jean Tirole, A Theory of Incentives in Procurement and Regulation, The MIT Press, 1993; Michael H. Riordan and David E. M. Sappington, “Second Sourcing,” RAND Journal of Economics, vol. 20, no. 1 (Spring 1989), pp. 41-58; and William P. Rogerson, “Profit Regulation of Defense Contractors and Prizes for Innovation,” Journal of Political Economy, vol. 97, no. 6 (December 1989), pp. 1284-1305. For an interesting view of how the trusts of Schumpeter’s time may have had lasting, beneficial effects, see Tom Nicholas, “Why Schumpeter was Right: Innovation, Market Power, and Creative Destruction in 1920s America,” Journal of Economic History, vol. 63, no. 4 (December 2003), pp. 1023-1058.
17. Amy Butler, “Split-Buy USAF Tanker Concept Gaining Favor,” Aviation Week & Space Technology, 29 January 2009.
18. “Albaugh as BCA head will be key to Boeing tanker bid,” Leeham News & Comment, 19 December 2009.
19. Leeham News & Comment, op. cit.

Four issues with the USAF's tanker RFP, Part One

It’s hard to think about the USAF’s long-running effort to buy new tanker aircraft without facing some stiff headwinds of hot air, but the past few months have been particularly hot and breezy. Norm Dicks, predictably, says that the USAF is biased towards Northrop and Airbus. Dick Shelby, perhaps as predictably, says that the USAF is biased towards Boeing. Northrop and EADS’s people, understandably, are torqued about the disclosure of their pricing. The Boeing camp, naturally, wants the WTO’s recent ruling against Airbus factored in. Patty Murray says that the “subsidies are not only illegal, they are deeply unfair and anti-competitive.” And Jay Inslee thinks that sticking it to the French would be a good way to deal with unemployment in his district. Smoot-Hawley? Anyone? Anyone?*

All of this is probably something that a French friend of mine at EADS a few years ago called boule-sheet. I’m not exactly sure what he meant—pétanque on percale?—but it didn’t sound good. For a moment, I was happy that Ashton Carter, the US under secretary of defense for acquisition, was telling Inslee et alia to stuff it. But then, Northrop and EADS decided that they had had enough already anyway, and sent a letter to that effect. Thus was Air Force Secretary Mike Donley asking, effectively, if everyone could please just calm down.

Note that he wasn’t asking why they couldn’t all just get along. If only deeply anti-competitive were worse than merely illegal, that might be possible. No one can reasonably expect cordiality towards one another from Airbus and Boeing, possibly the most rivalrous pair of nearly duopolistic companies anywhere on Earth.** But quite aside from the ordinary complications of any politically-capitve agency trying to do business with two politically astute companies, this latest tanker RFP has caused serious alarm in at least four respects:

• All 373 criteria will be weighted equally. The USAF is asking for 373 attributes on each proposed aircraft, but all 373 will be evaluated as pass-fail criteria. Northrop Grumman has specifically complained that this considers the sink and toilet water flow rates on the same basis as fuel offload rates. The latter is rather more important, and with in-production aircraft like the 767 and the A330, we pretty much know that the former are adequate to the job. What’s embarrassing for the government is that no procurement professional outside the US federal bureaucracy would contemplate doing things this way. Sit in on any graduate class on procurement management at any of the leading schools in the field—Ohio State, Michigan State, Arizona State, Tennessee, etc.—ask about that approach, and watch the jaws drop around the room. It’s just crazy.
• It’s an eighteen-year fixed price deal. Ashton Carter is further saying that, whatever the case, one of those companies should sign up for an eighteen-year fixed-price contract. This may be what Wes Bush, in that letter to him, termed “contractual and financial burdens on the company that we simply cannot accept.” Indeed, we should ask if anyone can find another example of a similarly durable fixed-price contract—anywhere. It’s almost inconceivable. As a Texan politician asked me some weeks ago, would this contract be denominated in dollars or gold? Or euros, for that matter? Who could be found to take the counterparty risk of an eighteen-year contract denominated in dollars, at least for a bidder much of whose costs are paid in euros? One could darkly assert that this is just another protectionist Obamanista scheme—if Todd Tiahrt weren’t a such protectionist Republican—so instead, we’ll just call it crazy. Again.

• It has to be fair, right? Boeing is fulminating, as usual, about supposedly “illegal subsidies” to Airbus. As Joel Johnson noted in a response in early November to an article from Loren Thompson of the Lexington Institute, there are no illegal subsidies under the World Trade Organization accord—just prohibited, actionable, and allowable subsidies.*** Into which category Airbus’s launch aid falls is yet to be finally adjudicated, and the WTO accord specifically prohibits preemptive action before the entire process has been played out. But no matter: the team at the Pentagon may already be again getting worked up about this red herring. Deputy Defense Secretary Bill Lynn told an investors’ conference in New York City on 3 December how much “we want a fair competition; we want a balanced competition.” Fair and balanced? Deep down, I doubt that Todd Tiahrt, for one, wants anything fair and balanced, even if he does watch a lot of Fox News. That said, as I’ll explain in a later column, fairness is a structurally illusory concept in this instance.
• It’s a winner-take-all deal—for eighteen years. These preceding three issues notwithstanding, the length of the commitment to a single supplier is itself notable. Eighteen years is a long time to sign up with any one company for a commercially analogous product. It’s not a long time to stick with one supplier—as evidenced by relationships like Southwest Airlines’ with Boeing—it’s just a long period for precommitment, even if the products themselves are quite durable.

One alternative that might address all four of these issues is a split procurement. This has been touted as a solution by some interested politicians—and not just supporters of Airbus, but just folks who want all this contract protesting nonsense to stop so that the USAF can actually get some new airplanes. The split procurement approach would effectively rerun a small competition every so often to keep (in theory) each contractor’s pencil sharp, awarding variable quantities based on each new bid and the relative past performance of the suppliers. It’s not uncommon practice in commercial procurement, though there are good reasons that it’s not commonplace. All the same, Ashton and his boss Bob Gates have more staked out a firm position on the idea of splitting the awards. They’re opposed, and adamantly.

So it this idea eo ipso daft, or would there be merit under the particular set of conditions in which the USAF, the potential suppliers, and their political supporters find themselves? In my next column, I’ll review the economic theory and evidence behind that question, and apply it to this particular contracty competition.

—————

* Ben Stein is a national treasure, isn’t he?

** About those two companies—I do feel compelled at this point to state categorically that I am working for neither on this issue. This is simply a matter that is apparently not well understood legally or economically by the decision-makers involved, and which thus demands some serious exposition by someone without a vested interest in the outcome or even the process. I should also note that I am not explicitly endorsing the split procurement concept—I am merely arguing that it deserves a more thorough hearing than it appears to have gotten in the Pentagon to date.

*** Note to the public relations and legal departments in Chicago: as Johnson noted in his brief,
A good explanation of the WTO dispute settlement process can be found in a Congressional Research Service article by Jeanne Grimmett, legislative attorney, dated September 8, 2009. She specifically points out that the US, in its Uruguay Round Statement of Administrative Action (H.Doc 103-316), noted that the USTR would use its statutory discretion to implement Section 301 (retaliating against unfair trade practices) of the Trade Act of 1974, in a way that was in conformity with WTO obligations. This would appear to reinforce the notion that the US should not short-circuit the WTO dispute settlement process.

The Armies After FCS

This month, at the request of Canadian-American Security Review (CASR), we prepared an analysis of what might follow the demise of the US Army’s Future Combat System (FCS) program, and what relevance that might have for the Canadian Army.

In our estimation, the final end of the FCS has certainly opened opportunities for far more practical plans for armored vehicle modernization, as the US Army has replaced its formerly all-encompassing and over-reaching approach with a vector of perhaps ten separate efforts to update, extend, and recapitalize its fleet. For Canadian purposes, the large sums being invested in even these more modest efforts may be particularly useful beyond just American needs. In particular, upgrades to the Stryker, and development of so many designs for the MRAP All Terrain Vehicle (M-ATV) and Joint Light Tactical Vehicle (JLTV) programs, may be very valuable to two specific Canadian Army vehicle initiatives: LAV-III modernization and the Tactical Armored Patrol Vehicle (TAPV).

In the last several pages, we comment on the implications for the industry, and offer advice to the Canadian Department of National Defence on how to manage its limited equipment acquisition budget and staff. Our findings are available for free download at our firm’s website (link).

Just how did Hägglunds best Singapore Technologies in France?

Just this week, the French Direction Générale de l’Armement (DGA) selected BAE Systems’ BvS10 Viking to meet its requirement for a new Véhicule de Haute Mobilité (VHM), ultimately destined for the French Army’s Groupement Tactique Inter-Armés (GTIA) in Afghanistan. As the GTIA is significant force—composed of three infantry companies, a reconnaissance squadron, an engineering company, and a heavy mortar battery—the press release from the supplier noted that the deal could reach 129 vehicles for €220 million over five years.

The VHM award is a significant victory for BAE and its subsidiary Hägglunds in Örnsköldsvik, Sweden, particularly after losing the British Army and the Royal Marines as customers for the Viking about a year ago. After reportedly suffering ten fatalities in Vikings in Afghanistan to Taliban land mines, the Ministry of Defense turned to Singapore Technologies for its rather similar Bronco vehicle (termed the Warthog in British service) to replace the entire fleet. Britain was the single largest recent national customer in this market segment—what might be termed robust-but-affordable amphibious and adverse-terrain armored vehicles—so it’s worth asking how Hägglunds turned the business around so quickly.

To start, it isn’t obvious that BAE significantly underbid ST. The announcements suggest a price of €1.71 MM per vehicle, but don't indicate a great deal of extra electronic or weapons content on these Vikings. They also don’t indicate how much of this is attributable to parts and service estimates, but as these will be quite variable (see below), the aforementioned number could be substantially just the price for delivery. If so, it’s not exactly well below the going rate in the category. Rather, I suspect that four other factors may have combined to convince the DGA that Hägglunds was offering good value-for-the-money:

• Improved protection. From displays and announcements at DSEi and AUSA this past autumn, it is clear that Hägglunds has been working hard to improve the survivability of the Viking. As Jane’s put it, this Mark II version includes “greater payload, a higher level of protection due to a redesigned hull floor and a new armour package,” as well as “a more powerful Cummins engine and an upgraded electrical system” to handle the greater weight and increased power demand of more onboard systems. This is not to say that ST hasn’t been working hard as well; it’s just that Hägglunds understood that it needed to bring its best game for a customer as big and significant as France.
• A strong offsets package. While we don’t have the details of ST’s offer, Hägglunds has made a point of how it teamed up with Panhard and EADS in its bid. Indeed, Hägglunds is quite accomplished at offsets packages: in all its export sales of CV90 armored vehicles (to Norway, Finland, Denmark, the Netherlands, Switzerland, and Thailand), the company has arranged for a local partner to integrate the turret, which is a significant chunk of the total contract value. Individual armies can be pretty particular about whether they want a 30 mm, 35 mm, or 40 mm cannon; a 7.62 mm or 12.7 mm machinegun; and the details of vision blocks and cupolas. By keeping the more repeatable chassis assembly, engine installation, and electronics installation in Sweden, Hägglunds has been able to offer a blend of cost-efficient manufacturing and local industrial participation.
• Rapid fielding. through-life responsiveness. Though deliveries will not end until 2014, they will begin next year. When troops are having trouble negotiating difficult terrain and surviving land mine blasts, getting even a few vehicles into the field matters a great deal. Hägglunds has previously impressed customers in the CV90 program with its ability to get the first article out the door very quickly, and may have credibly promised the French Army something similar here.
• Through-life responsiveness. As the DGA’s announcement put it, “an innovative method of support was included in the contract, empowering the industrial prime contractor to deliver the ‘right spare parts at the right time and right place,’ with payments based on the attainment of reliability targets and adjusted to the number of miles actually traveled by vehicles in service.” I remember joking with a client ten years ago about how his boss thought that through-life support and service level agreements were innovative—they weren’t news then, and they’re no newer today. Rather, the DGA’s self-congratulations aside, this sort of contract represents a decisive and well-known trend in military supply. BAE in general has been emphasizing this sort of work, and may have offered the French Army a particularly compelling arrangement.

Taken together, these four factors say a good deal about marketing to the military in the coming decade. The main arena today is Afghanistan, and will likely remain so for several years to come, regardless of Canadian and American announcements of intent to wind down involvement. What war comes after that is anyone’s guess, but one will come, and it will very possibly involve chasing people with funny hats in difficult terrain while dodging Kalashnikov bullets, rocket grenades, and all manner of land mines. Since that war likely won’t be fought in Scotland or Jutland or North Dakota, staying expeditionary and responsive will be critical. Moreover, since every customer has a slightly different view of exactly how to best do all that, and a sovereign desire to be part of the industrial equation, knowing how to work with local companies will be part and parcel of the marketing process.

The Helicopters of Britain's Quick Defence Review: Rules of Reason for Wars of Duration

This past June, British Defence Procurement Minister Quentin Davis told Parliament that the government was considering dropping plans for extending the service lives of old helicopters, and instead moving up a plan to procure new medium lift rotorcraft. In keeping with the immediate needs of the troops on campaign in Afghanistan, but recognizing that such missions would probably continue to occupy British troops for years to come, he described the material acquisition strategy as “not an urgent operational requirement, but not the rather laborious full-scale classic international tender.”

We now have a much clearer idea of what he meant—and make that heavy lift, thank you. The centerpiece of last week’s announcement about the Ministry of Defence’s reprioritization of its equipment list was the intent to order 24 more Chinook helicopters for the Royal Air Force from Boeing, bringing the inventory up to fully 70 such aircraft. That’s a lot of lift for the Army and the Royal Marines, and as I note below, this says a great deal about Britain’s future military strategy, as well as its emerging military-industry strategy.

There were many changes other announced, but to keep things simple, we might focus on aviation. Also listed were plans to provide the RAF another five Reaper reconnaissance-attack drones (to add to the five in service) and a seventh C-17 Globemaster III. The costs would be offset by the retirement of a full nine-plane squadron of RAF GR9 Harriers, another squadron of either Harriers or Tornados (which would be replaced eventually by Lightning IIs and Typhoons, anyway), and the early retirement of the Nimrod MR2—about two years before the introduction of the forthcoming Nimrod MR4. Defense Minister Bob Ainsworth’s assertion that the gap in maritime patrol coverage would taken up by Hercules transports and the Royal Navy’s Merlin helicopters didn’t quite ring right—the capabilities of those aircraft are just really different.

Number one British supplier BAE Systems took the high road with its number one customer, stating (in part) how the company “acknowledges the Government's decision to reduce Tornado and Harrier numbers and will work with it to ensure that the capability of both aircraft is sustained until the end of their service life (sic).” Otherwise, the old guard of the industry mostly came out whingeing about the offsetting reductions. The UK’s Aerospace, Defense, and Security (ADS) trade association complained that the “announcement is like painting over the damp patches in your house, giving a superficial fix to a far deeper problem that will only re-emerge later and in a far worse condition.” The National Defence Association called the cuts “hasty and ill-conceived,” and then concluded its pronouncement with something about whether the government might “repeat the mistakes of the 1930s, when Britain neglected its defence, and risk similar appalling consequences”.

In truth, this sort of prattling—summoning the specter of Nazism—is a sign of intellectual bankruptcy within the military-industrial establishment. Cuts? What cuts? The long-run net change is an increase of at least three aircraft—just not the aircraft that silk-scarf enthusiasts prefer. Indeed, there was just nothing surprising about the government’s shift in priorities. It’s not just the war in Afghanistan that needs more rotary- and fixed-wing transport, more persistent overwatch from drones, and only as many carrier-capable aircraft as the carriers can carry. Those needs are likely those of the next war as well, wherever that might be. Further, there is not likely to be more money. As Max Hastings wrote in the Financial Times this past July, parsimony is part and parcel of British military history. As he noted, “while defence spending has fallen as a proportion of gross domestic product from 2.8 per cent in 1998 to 2.5 per cent today, this is still greater than the UK peacetime average over the past 150 years.”

What these financial constraints mean is the subject of considerable analysis of varying quality. In October, the Royal United Service Institution released a paper in October arguing that “the future mission of Britain’s armed forces may lie in assisting and reforming multilateral institutions such as the United Nations and NATO,” a concept it called a “radical new model.” Taking Suez and the Falklands as exceptions, there has been nothing radical or new about this since 1949. A bit more helpfully, RUSI argued in October that

        If defence spending remains at current levels, the hard choice for the UK’s military capability will be between two expeditionary options: the ‘global guardian’ option, which builds on the present demands for counter-insurgency in Afghanistan; or a maritime ‘strategic raiding’ option which looks to longer-term security challenges. If defence spending is reduced considerably, the UK will need to choose a ‘contributory’ option whereby the UK contributes bits and pieces of capabilities to multinational forces with no significant autonomous or leading role. If the government does not make the hard choice between the first two options, then the third option will become the default outcome, regardless of levels of defence spending, with big penalties for global influence and status.

Still, if this really were the choice, then how would those 70 Chinooks fit in? Will they be hauling the infantry regiments of the global guardian force from dirt fields in the wilds of failed states, or the paratroopers and marines of the strategic raiding force off HMS Ocean? Or, perhaps they will be hauling the Canadian or Danish infantry of the multinational contributory force—as they are arguably doing now. They are certainly critical now in high-and-hot Afghanistan, and everyone from Ankara to Abu Dhabi is ordering them.

Observe, then, how the Tories’ official reaction to the government’s announcement about the helicopters was both measured and well-aimed. Shadow Defence Minister Dr. Liam Fox “welcomed the announcement of new Chinook helicopters, but noted that they would not have been necessary if the Prime Minister had not, against all advice, cut £1.4bn from the helicopter programme in 2004.” That was indeed a strange decision, and it was one in a line of botched opportunities that led Gary Schmidt of the American Enterprise Institute, shortly after Hasting’s editorial in the FT, to write in the same paper that reductions in British military forces might “reduce Britain’s value as an ally” and lessen the significance of the Special Relationship. That’s conceivable, but it needn’t be the case if the Tories take the opportunity, as they will likely have from next spring, to set things on a different course.

As noted above, that course will not involve a great deal more money, and it will also not tack back towards nostalgia. Rather, it will depend on the application of what what an esteemed colleague of mine has called rules of reason for wars of duration. To start, I will nominate the following as the first one to heed:

The real Ten Year Rule holds that you will fight another messy, small war of attrition within ten years.

Realistically, it won’t take that long. Since the end of the Cold War, the United Kingdom has been involved in meaningful military campaigns every few years. Commitments to Bosnia (1992-95), Kosovo (1999), Sierra Leone (2000), Iraq (2003–07) and Afghanistan (2001–) collectively show how the Tories, Labour, and even the Liberal Democrats agree that something must be done for the cause of collective security. Because they put such long-term strain on the troops, those smaller, longer-duration wars are the more challenging ones for which to plan. But plan one must. As US Deputy Assistant Secretary of Defense for Plans Janine Davidson put it to a conference a few years ago, when one flies enough unplanned cargo sorties into odd corners of the globe (as she did as a pilot for the USAF), one really should start asking why they’re unplanned.

Planning for wars as these starts, then, with aircraft like the Chinook. Why? Because the Chinook is an aircraft for all climes and seasons. As the threat of mines makes road travel in Afghanistan dangerous, flying over them seems appealing. The Daily Mail noted in late October how Lieutenant Colonel Rupert Thorneloe, commander of the 1st Welsh Guards, complained in a despatch to London about how a lack of airlift was exposing his troops to more bombs than he cared—just a few months before one blew him up (along with his driver, Trooper Joshua Hammond). He thus became Britain’s highest-ranking fatality in Afghanistan to date. But one of the biggest near-disasters of the Falklands War—a near-peer, high-intensity conflict, as they call them—came when the container ship Atlantic Conveyor burned after an Argentine missile attack with three of her four Chinooks. The Marines and Paras had to yomp and tab from San Carlos to Stanley (though Marines and Paras being Paras and Marines, they did so splendidly). While helicopter movement is not always and everywhere preferred—General Jim Mattis chose in 2003 to drive his infantry towards Baghdad in trucks because he judged the anti-aircraft threat more serious—it is an essential tool of all forms of modern warfare.

What’s really notable for Britain is how this order represents a break with the carefully-crafted plans of the Defence Industrial Strategy of December 2005. Procurement of the Chinooks naturally involves no aforementioned “laborious full-scale classic international tender.” Only Sikorksy and Boeing make airplanes this large, and the RAF sensibly wasn’t about to introduce a second heavy-lift type into its inventory. After the painful experience of the Chinook Mark 3 program, these will also be relatively standard aircraft. As they will have relatively few specifically British requirements (rather unlike the Apache Mk 1s), there is thus no justification for a co-production deal for AgustaWestland—the ballyhooed recipient of a Strategic Partnering Agreement. These aircraft, rather, will come from Philadelphia.

The Tories now have the opportunity to make a virtue of this necessity. With wars to fight and a Treasury to rescue from Labour’s profligacy, there remains little room for fantasies of autarky. The next review of military priorities and military-industrial strategy must really put, in Malcom Rifkind’s line, the “front line first.” There are, to be sure, uniquely British requirements requiring British industrial capabilities, but they are fewer and more heterogeneous than the government has so far imagined. Much of the industry, then, may be in for a bit of shock.

The FMTV re-competition saga. Part Six: What comes next, and a few important victories for public policy

Every week I think that I finally may have cause to stop commenting on the FMTV contract dispute amongst the Army and its bidders: BAE Systems, Navistar, and Oshkosh. However, now that the GAO’s redacted decision is available, there are important aspects that bear further analysis. (Incidentally, those redactions were not difficult—the office mainly needed to excise Navistar’s bid, which has still never been released, and Oshkosh’s anticipated profit margin and overhead rate.)

The GAO upheld the protests on basically only two grounds:

1. Key Tooling and Equipment. Since Oshkosh didn’t already have all the tooling and equipment that it needed for the contract, the Army should not have rated that one aspect of the riskiness of its proposal as very low—the same, that is, as it rated BAE Systems. As I note below, this is probably a sound finding. As a result, the Army may also need to reexamine schedule risk under the Time-Phased Critical Path heading of the RFP.
2. Past Performance. It turns out that someone on the Army’s administrative staff inadvertently shredded the customer surveys that it used to evaluate Navistar’s past performance. As a result, the Army could not explain how it had evaluated Navistar’s performance in the MRAP program as merely adequate. (No extra points here for jokes about the MaxxPro.) It is reasonable to argue that there was a screw-up, and that Navistar deserves at least an explanation.

What will happen next? Two things, and probably only two things:

1. The Army will likely revise its evaluation of Oshkosh downward in this one area from excellent/very low risk to excellent/low risk. That is, it may still like the proposal just as much as BAE Systems’; it just should recognize that a running production line is almost always a less risky proposition than one that’s just getting tooled up. It may also rethink Oshkosh’s timeline to full-rate production, but not necessarily: there’s a lot of time between now and October 2010, and Oshkosh can reasonably assert that the stop-work order gives it some flexibility there.
2. The Army will likely call up the people who submitted the last customer surveys, and just ask them to fill them out again. Hopefully, someone will unplug, tag-out, and hide the shredders this time.

The whole contract award will then boil down to two questions:

1. Is a probable change from very low risk to low risk in key tooling and equipment, and a possible change in the evaluation of the time-phased critical path, enough to overcome a roughly $440 million difference in price over a five-year contract? Note that these factors account for but two of seven that make up just 26 percent of the overall evaluation scheme.
2. Is a possible change in Navistar’s past customer approval ratings—if there is any positive change at all—enough to make up for a still unknown difference in price?

In short, the protestors still have a steep wall to climb.

—————

What is really notable, and not just for this contract dispute, but for the interests of sound public policy, is what the GAO said was not relevant. One issue concerned BAE Systems’ complaint that Oshkosh was prototyping too much:

        While BAE argues that the agency should have been concerned that Oshkosh needed to build a second prototype to resolve difficulties experienced with its first, the agency viewed the approach of building a prototype as a strength because it allowed Oshkosh to identify risks prior to performance. On this record, we think the agency was within its discretion to view Oshkosh’s work on its prototype as a strength, rather than a risk.

Taking that complaint seriously could have chilled interest around the industry in prototyping—even at one’s own expense—and that would have made for a perverse incentive, even for military procurement.

Critically, the GAO also pretty much face-shot the complaint that Oshkosh would supposedly certainly lose money on the contract:

        Agencies are only required to perform a cost realism analysis when the solicitation anticipates the award of a cost-reimbursement contract... As a general matter, it is unobjectionable for an offeror to submit a below-cost proposal for a fixed-price contract, since fixed-price contracts generally are not subject to adjustment during performance and the contractor, not the agency, bears the financial risk of cost overruns. Crown Title Corp., B-298426, Sept. 21, 2006, 2006 CPD ¶ 145 at 5-6.

Now, I’m not a lawyer, but I think that BAE Systems and Navistar’s lawyers (Wiley Rein and Latham & Watkins, respectively) should have read the decision in “Crown Title Corp., B-298426,” before whining about bidding below perceived cost.

Moreover, the GAO didn’t merely state that Oshkosh’s price could be accepted at face value; it also noted that the Defense Contract Management Agency (DCMA) had, at the Army’s request, investigated Oshkosh’s financial health, and found it at least adequate for undertaking this work. As I have written before, that would have provided the only reasonable cause for rejecting a binding, fixed-price bid: that the offeror would quite possibly default. We don’t know who at the DCMA wrote the report, or on what methodology he relied, and even the Army’s contracting officer admitted to the GAO that he didn’t fully understand it all. Still, the Army took the report at face value, and the GAO called that reasonable. Not everyone in government understands everything. There’s such a thing as expert advice.

The FMTV re-competition saga. Part Five: the GAO upholds. Mostly.

The US Governmental Accountability Office (GAO) today upheld BAE Systems and Navistar’s protest of the award of the Family of Medium Tactical Vehicles (FMTV) contract to Oshkosh. In the short run, Oshkosh’s share price (NYSE:OSK) has dropped by about $7—roughly equivalent to the $7 gain it scored immediately after Oshkosh was awarded the contract in August. Broadly, that suggests that the average investor in the market is taking this rather harshly for Oshkosh, almost presuming that the contract will now be handed to someone else.

However, as I commented over this past weekend, it’s important to actually read the little that has been released from the GAO about its findings. Summarized, the GAO concluded

• that the Army didn’t properly evaluate Oshkosh’s capability (40 percent of the decision), and
• that the Army didn’t properly evaluate Navistar’s past performance (14 percent of the decision), but
• that the Army did properly evaluate Oshkosh’s price (40 percent of the decision).

The GAO rejected several other complaints by BAE and Navistar, but wasn’t specific about what those were. What comes next is notable. The GAO recommends that the Army not solicit new proposals (that would be expensive and time-consuming), but simply

• reevaluate the offerors’ [existing] proposals under the capability evaluation factor, in a manner consistent with the terms of the solicitation; and
• conduct a new evaluation of Navistar’s past performance that adequately documents the Army’s judgments.

The text of the whole decision is being withheld while competition-sensitive information is redacted, so it’s hard to say exactly what the GAO didn’t like. If the language can be taken literally, however, the GAO is saying that all the proposals need to be reevaluated for capability—not just Oshkosh’s—but that the Army only need review Navistar’s past performance, and this time just providing some justification for its findings.

So, it’s hard to say what will come of this new drill. After all, as noted in its boilerplate language at the bottom of the press release, the “decision should not be read to reflect a view as to the merits of the firms' respective approaches to produce the FMTV.” That’s not the GAO’s job, and as I hoped, it appears that the organization hewed relatively narrowly and reasonably to its commission. Indeed, the issue of price is particularly important for federal public policy in the United States. The FMTV re-competition was, after all, a fixed-price, mostly build-to-print deal. If the Army couldn’t take a fixed-price bid as a fixed-price bid—after accounting for the risk of financial distress on the part of the potential supplier—then it’s hard to imagine why the Defense Department would again bother trying to save money by switching contractors.

[Incidentally, in the interests of full disclosure, I’m going to state that none of the parties to the dispute are clients of mine, and that I’m not making recommendations about any company’s shares. I also don’t invest in firms which are significant suppliers to military forces—my mutual funds might, but I pay efficient disinterest to their holdings. Rather, I do advisory work in the industry: I refrain from investing so that I can keep a conflict-free perspective on matters.]

Thus, Oshkosh’s presumed eight-percent lead, ceteris paribus, remains intact. In a few weeks or months, we’ll know if the Army’s round turn on the capstan (to borrow a Navy phrase) will evaluate Navistar or BAE Systems as at least eight percent more capable. If not, the business will likely stay where it has gone.

Is Oshkosh's FMTV bid really a risky move for the US Army? Part Four: Waiting for the GAO

This Monday, the US Government Accountability Office (GAO) is due to issue an opinion on BAE Systems and Navistar’s protests of the award of the Family of Medium Tactical Vehicle (FMTV) contract to Oshkosh. It’s not clear whether the GAO will rule on both of the supplemental protests as well as the initial ones, but it may very well do so, just to provide some closure to the matter. There’s little need for armchair quarterbacking (generalship? bean-counting? procurement lawyering?) at this point, as the decision has probably already been taken, and is just getting socialized around the office. There is, though, some cause for comment on how that decision could be written—or maybe even yet edited tomorrow (!).

For some background, it’s worth noting that BAE Systems has recently brought a stronger game to its public relations efforts, making some staffing changes, and reaching out to some media outlets to make its case. (I must acknowledge that even I got a call.) In comments published in Defense Industry Daily on 19 November 2009, at industry conferences, and on the telephone with individual analysts, BAE Systems made some useful points that may not have gotten past the redactions in those protest documents. Navistar and Oshkosh have taken a different approach, generally refraining from comment, and largely allowing the process to play out within the government. (We’ll not count letters to the Defense Secretary from Wisconsin’s congressional delegation. Those are expected.)

For all these reasons, we’ll focus here on BAE Systems case. That case has not been very strong throughout the post-contract award complaining, but this new information brings up some useful questions about the Army’s acquisition strategy and its evaluation of the bids. Three of these questions are particularly noteworthy:

1.        Will the Army maintain access to BAE Systems’ intellectual property for the specialty variants? As DID first reported, the weapons system variants of the FMTV (those that carry the HIMARS rocket launchers, the SLAMRAAM air defense systems, and the MEADS air defense systems), and the Low-Velocity Airdrop version of the FMTV used by the paratroopers, were removed from the re-competition in February 2009. The program managers for those weapons systems (as well as presumably some guy with responsibility for air-droppable trucks) will manage those procurements separately. BAE has some unique design rights in each modification, and if BAE chooses to shut down its plant in Sealy after finally, definitely losing the general FMTV contract, the company says that it’s not clear where those trucks will come from. The individual program managers could buy them from another BAE Systems factory—at presumably higher cost—or it could ask an Oskhosh to reengineer them.

All that said, it’s a bit difficult to see BAE Systems refusing to license its designs to Oshkosh or Navistar or anyone else whom the Army asked to build FMTVs. Such a decision would be both a cranky, money-losing proposition and a sure way to infuriate the Pentagon, BAE Systems’ number one customer. So, this is a fair question, but it should be foreclose discussion of moving the contract. Whether the Army should have baked consideration of this into the re-competition is a matter of contracting strategy. For better or worse, the Army made its choice.

2.        Will the Army maintain access to BAE Systems’ intellectual property for the LTAS cab? A stronger point, however, could be made regarding the design of the Long-Term Armoring Strategy (LTAS) truck cab, which BAE Systems’ substantially designed at its own expense. BAE could more plausibly assert to the Army that the design was at least partially applicable to military trucks throughout the world. Granted, BAE would not want to irritate the Army unduly, because the Army has the first review on export authority for the LTAS cab, which sits on the State Department’s Munitions List. That said, the company has a prima facie case for guarding its intellectual property—it’s hard to see where this would stop if contractor could routinely expect that sort of shakedown from the government.

        Of course, Oshkosh has already designed its own LTAS cab, but likely hasn’t taken it through blast- and bullet-resistance testing yet, which BAE says makes it a risky proposition. That’s not alone a reason for sticking with a contractor who bid higher, but it does expose an embarrassing assertion in the Army’s review of the contract: that Oshkosh’s proposal was no riskier than BAE Systems’. Almost anytime one switches suppliers, there’s some increase in risk—that’s something that they teach in every credible introductory supply chain management class. (Presumably they teach that as well at the Defense Acquisition University.) The question is whether that increase in risk, and increases anywhere else in the proposal, were not worth 8 percent of the cost.

3.        Even if Oshkosh has an aggressive approach to cost reduction, doesn’t its success with the M-ATV lay to rest concerns about its capabilities? BAE Systems has questioned how Oshkosh can make money on the contract when 55 percent of the value of each FMTV comes through suppliers that have already been nominated by the government. Specifically, while the design of the M-ATV is Oshkosh’s, that of the FMTV is the Army’s. That’s why this was a fixed-price, (mostly) build-to-print competition. It’s harder to get changes approved on the Army’s prints than it is on your own. Take a look at the front bumper of every truck that rolls off the assembly line in Sealy; they’re still stamped “Stewart & Stevenson”, and that was two companies ago. If they can’t get the bumper changed, BAE would seem to be arguing, when there’s a good marketing reason to do so, can you imagine how strict the Army will be about swapping out any given supplier?

        Maybe. But as I argued in November, that’s quite possibly Oshkosh’s strategy: to manage its relationship with both its suppliers and its customer aggressively, leaning forward in its quest for cost reductions and operational improvements. That’s not to say that BAE Systems wasn’t doing so—it’s just that Oshkosh makes a lot of trucks every year, too, has had some time to observe BAE’s operations and customer management, and thinks that it can do better. It’s possible that Oshkosh has been too optimistic, but figuring out when a potential contractor has bid too aggressively is an inexact science.

All of these issues are worth debating, but they’re largely matters of substance, rather than process. The former might seem more important, but the latter is largely the limit of the GAO’s commission. The auditors have been asking themselves not whether the Army’s decision was the right one, but whether it followed its advertised process. This gets to the point about how the pending ruling will be written. The pronouncement won’t be binding, but the Defense Department almost always follows the GAO’s writ, and given the heat of the dispute this time, will probably do so again.

What the GAO writes will influence future procurements. Naturally, if the GAO rules for the Army, and thus ultimately for Oshkosh, it will allow the Army to signal that it’s serious about driving down costs, and thus encourage more Oshkoshes, Navistars, and others to jump into the competitive fray. As we saw during the MRAP experience, that’s really important for material military-industrial progress. Still, if the GAO rules against the Army, it could helpfully choose to write that opinion strictly, on the basis of some flaws that it found in the process, and not what it perceives as the merits of the individual competitors’ proposals. In that case, it may yet avoid discouraging potential entrants—and of course, this wouldn’t be over, as the Army would almost certainly rerun at least part of the competition. It certainly couldn’t just hand it back to BAE.

But we’ll have to wait for Monday. At some point next week, I’ll be back with some commentary on the long-term strategic effects of the decision.

Will the QDR be analytically lame? And will it matter?

On Wednesday, DoD Buzz claimed in its headline that the “QDR Likely Kills Two Carriers, EFV”:

        Word on Capitol Hill is that the Quadrennial Defense Review should result in the demise of two Navy carrier groups and the Marines' Expeditionary Fighting Vehicle. On top of that, the Joint Strike Fighter program is likely to lose a so-far uncertain number of planes and the Air Force looks to lose two air wings. Folks on the Hill are watching the carrier cuts particularly closely. They were willing to accept the temporary loss of one carrier but two groups may just be too much for lawmakers to swallow, though it would conveniently answer the hot debate about whether the Navy faces a fighter gap.

And regarding that supposed fighter gap, Inside Defense reported Wednesday (“DoD Issues Draft Directive Calling For Major Changes to F-35 Program”) that

        The Office of the Secretary of Defense has issued a draft directive that would require the services to fund the F-35 fighter program in accordance with the recommendations of recent independent reviews, a move that would extend development by at least a year, reduce production by approximately 100 aircraft and require the addition of billions of dollars to the effort through 2015, according to defense officials.

All that fits well a comment from a colleague that the Defense Secretary had gotten the recommendation last year to focus the QDR on force structure sizing. Perhaps that was the case, and that was the advice he took, but if so, it would make for a remarkably unenterprising approach. Just force sizing? What about the balance as to how those forces are composed? What about the new technologies to emphasize, or the security challenges to which to respond, that might alter the appropriate balance of forces? Lame, lame, LAME.

As for the EFV in particular, a distinguished engineer and consultant to the industry was insisting to me the other day that the problems with that developmental vehicle have mostly been solved. I don't know about that, but I do think that the reputation of that program is so bad that convincing folks otherwise may be very difficult. It also seems a bit crazy to spend that much money—still to come on the margin—on a section-carrying vehicle that doesn't actually fly. Besides, marines have other ways of getting ashore. Neither helicopters nor hovercraft require gradual beaches for landings, and as the Navy always taught us in amphibious operations classes, those cover only about six percent of coastlines worldwide. It would be nice to have another option, but what’s not possible is not desirable. So, I will not at all be surprised if the program is ended—and a new, much more modest effort started.

Retiring two supercarriers without replacement could really make some sense, particularly if they're due for refueling soon. The Enterprise, Abraham Lincoln and George Washington seem to be all nearing the end of their reactor lives, and as such, would be due to head to Newport News in the next few years. Enterprise is older than I am, so she may really be due for paying off. If the US government is finally figuring on economizing, this could make even more sense if the net loss of ships comes from Norfolk. Is there a good reason for all that carrier airpower in the Atlantic, when what's on the other side of the pond is the other half of NATO? Remember, back in the day of Mahanian concentration, the United States Fleet was based in California, and Virginia only hosted the North Atlantic Squadron.

Of course, winning that fight means going through Crazy Jim Webb, who stormed out office as Navy Secretary after Frank Carlucci told him to retire all the steam-driven frigates left over from the 1960s. (As Ronald Reagan wrote in his memoirs, none of us in the Navy were sorry to see him go. Those old ships were dangerous, and the guy has got a creepy misogynistic streak anyway.) Webb pretty much went nuts when the Navy proposed moving just one of the ten flattops in the Atlantic Fleet—Enterprise, Eisenhower, Roosevelt, Truman, Bush, Nassau, Wasp, Kearsarge, Bataan, Iwo Jima, take your pick—out of Hampton Roads. Message to Jim: ever heard of Pearl Harbor? Günther Prien in the U-47 sinking the Royal Oak at Scapa Flow in ‘39? Anyone? Anyone? Whatever the case, this will be fun to watch.

Now, if someone had wanted to do some hard, creative work, the Defense Department could have addressed, as I suggested above, the question of balance in airpower. Cutting two Air Force wings and two Navy wings? Yet more lame. Which are more likely to be useful in future military endeavors? Make some decisions, already. Or, if you’re not willing to make decisions, then at least get creative about it. As I’ve written before (“Why amphibs are like smart phones,” 11 June 2009), the Navy’s forced distinction between “carriers” and “general purpose amphibious ships” is unhelpful. They’ll all be carrying Lightning IIs as their fighter-bomber complement someday, whether F-35Cs or F-35Bs. At one point, the USAF’s leadership was talking aloud about buying four wings of those jump-jet F-35Bs. Would there be something profoundly difficult about training some of those guys as carrier-qualified naval aviators? That’s what the RAF does in the UK’s Joint Harrier Force—and the component squadrons of that formation have had some pretty outstanding accomplishments. Would that not close the fighter gap?

After all, it’s not as though the US has brought more than a fraction of its airpower to bear in any of its recent wars, but it’s certainly spending a lot to keep it going. Today, Inside Defense is leaking the Air National Guard’s modernization plan, and specifically its interest (“Guard Requirements Book Lists F-15 EA, SEAD Capability As ‘Essential’”) in adding electronic attack capability, air defense suppression capability, and conformal fuel tanks to its F-15C/Ds aircraft, which are currently useful pretty much just for downing other aircraft. Whether updating that particular old airplane (which occasionally come apart in mid-flight) is a good idea is another question—that it’s under consideration, though, says something.

That is, despite the Pentagon’s analytical lameness, there’s still a lesson here for industry—or two. Multifunction means even more now than it did a few years ago. Multifunction and inexpensive is even better. That’s the reason that those otherwise highly adaptable carriers aren’t fairing better in the budget reviews: they take thousands of crew to operate, and people are very expensive. Find a way to economize and extend capabilities, and even conservative military customers will take note.

All the same, one needs to exercise some care, and do some serious strategic thinking before committing too seriously to any line of investment. We know a fellow who at one point was very keen on investing in the supply chain for F-16s, figuring that those were capable, inexpensive fighters that were flown in more countries, and in greater numbers, than any other type. Besides, they cost less to operate (single engines only) and they didn't suffer from those aforementioned structural problems of the F-15s. So, they'd be around for a while, and as they aged, they’d need parts, right? Then, last May, Bob Gates famously and unfavorably compared F-16s to MQ-9s, noting how the drones flew three times as far, stayed on station five times as long, and cost one-fifth as much to buy. Now, the USAF is planning to replace at least 200 of the oldest (and thus most parts-hungry) Falcons with Reapers. I'm sure that didn't kill his business, but it may have put a hole in its valuation.

That’s part two of the lesson: multifunction and inexpensive are better—so long as there’s not some disruptive technology coming along that could really break through the performance curve. Predators and Reapers are useless in air-to-air combat (when one crew in 2003 got their plane too close to a MiG-25, the results were predictable), but they offer a phenomenal improvement on the other capabilities of certain manned aircraft. Those aircraft became operationally interesting after advanced in navigation and communications technology enabled pilots in Nevada to fly them over Iraq. Hereon, as money flows out of areas of overmatch, and into areas of continued high demand, like continual overwatch, the retirement of large chunks of those overmatching platforms will, in part, free up some money for breakthrough applications. If the rumors are right, the QDR may not say much about that, but the opportunities will unfold all the same.