As a naval captain friend once told me from his experience in buying ships, there are just three leading Rules of Management:
- Know how they’re going to screw you.
- Share the pain.
- Remember that hope is not a strategy.
The third rule is useful counsel today for those (as I recently suggested) watching the Joint Strike Fighter program, and for anyone who voted for that Obama guy. The second rule has been shown stunningly this week by Airbus Military: its penance for the disastrous A400M development contract is to be a few billion euros more from its customers. The first rule, though, is the overarching one that will hopefully preserve you from needing to invoke the others. It’s also now one for consideration at the Pentagon in regards to the KC-X program.
That is, the US Defense Department has willingly wedged itself into a difficult spot. Deputy Secretary Bill Lynn said yesterday that he was “disappointed” that Northrop Grumman would be declining to bid. As a salty former naval person, I’m inclined to suggest that Bill pack sand; if the government had really wanted Northrop and EADS to bid, it could have written an RFP that would induce a bid. It didn’t, so now it’s stuck with that awkward problem of double monopoly: one buyer, one interested seller, and a Kabuki dance of bilateral contracting relations on the way.
Using the hedonic framework that I introduced in that essay of 9 February, the situation has now migrated from that of an undesirable vertical demand curve and dissimilar supply curves—
—to a vertical demand curve but only one supply curve—
As indicated, the net effect ex ante, in the absence of potential countermoves by the customer, should be an even higher price from the remaining bidder. Once the contract is signed, Boeing will have a price against which it must deliver, and limited potential for adjustments based on changes in commodity input prices. Until then, Boeing may feel like a monopolist: the only game in town, and one who knows it. Until then, I must say that I will not envy Air Force Secretary Michael Donley in his position. So, because dealing with a monopolist is rarely less onerous ex post, I offer two bits of managerial advice—in an economic context—on what signals to send and not send Boeing before it submits that bid.
Don’t pretend that the DCAA will save you. One could be tempted to hope (there’s that word again) that once the legion problems at the Defense Contract Audit Agency (DCAA) are corrected, the watchdog will reclaim its teeth. Sure, it’s a fixed price contract, but Boeing must disclose both its costs and its profit margin, so even without competition from Northrop and EADS, the government will get a good deal, no? Eh, no. The problem is that effective regulatory regimes are generally elusive, and for four reasons:
This is true in the first place because the informational asymmetries in regulation are severe, so the perspectives that regulators develop on their subjects are almost always distorted. In theory, the government needn’t spend too much time and effort trying to gin up should-cost numbers for the 767, as that airplane has been in production for 30 years. However, with a large, technically complex, and sun-setting system like the KC-X, the problem is serious. As relative prices shift, and commercial customers for this plane that no one else wants fall away, what it should cost becomes anyone’s guess.
Further, the appropriate contracting mechanisms are not obvious. Whether contractors are regulated according to price or cost, they, their managers, or their labor forces generally find some way of gaming the system to extract at least a portion of the rents they desire. Auditors and regulators can set rules, but smart people will always find a way around them.
Besides, regulatory capture is a near certainty. Regulators are very frequently observed to go native in the firms they regulate. The problem is particularly severe in technologically intensive industries where the regulators, by virtue of the domain knowledge required to participate in the regulatory process, most frequently hail from the industry itself. Sooner or later, factions within the KC-X program office, the DCAA, and AFCAA, and any other organization with what people on Capitol Hill like to call “oversight” would come to think about Boeing’s interests as synonymous with the Air Force’s interests. It’s an industrial base thing.
Finally, the regulatory burden itself is costly, which contributes to the overall cost of the project, even if no further rents accrue to Boeing. Ultimately, the Air Force has to pay for those squadrons of bean-counters and fact-checkers, and all those clipboards and green eye shades cost money. But more significantly, at a certain point, the managerial cost of the added oversight, through gummed-up processes and drawn-out schedules, exceeds its marginal returns.
Instead, threaten to do as Northrop does: to take your marbles and go home. Boeing had earlier made noises about “launch customer pricing” for the KC-767. At this stage, the folks there may think that the only number they must beat is the $184 million per plane that Northrop said that it would have bid. Exceeding that could embarrass even the machinists’ union. More practically, it would lead to immediate insistence in the congress for a reopening of the competition on terms more conducive to a bid from Airbus.
That is, for all the Pentagon’s insistence that tanker replacement must start yesterday, the RFP does contain this standard boilerplate (on page 8 of Section M):
2.3.1.1. A price analysis will be conducted in accordance with FAR 15.404-1 in order to ensure a fair and reasonable price has been proposed. The government may determine that an offer is unacceptable, and therefore unawardable, if prices are found to be not fair and reasonable.
Should-cost, as I note above, is guesswork. Fair and reasonable, however, are so vague and subjective as to lack all meaning. As a professor under whom I studied in graduate school once put it to us, fairness basically means “I like it”. And that’s the beauty of the language here: if the Air Force doesn’t like the price, it can balk, and tell Boeing to pack sand. Then, the Pentagon can restart the process with an RFP more likely to solicit competitive bids.
Late last month, I offered several reasons for why Northrop Grumman might decide to bid after all, even though the cards were so clearly stacked against them in this RFP. Herein, we may have a good reason for not bidding: it’s just possible that Boeing will get greedy, price like it’s a monopolist, and wind up with yet another restart. It’s unlikely, but it’s arguably a better shot than bidding a ten-pound hog in a seven-pound contest.
Then again, as one reads carefully, that press release from EADS nowhere says that the company won’t bid on the KC-X alone. After all, as its own prime contractor in the already-successful Light Utility Helicopter program, and corporate citizenship established through its American board of directors, there’s little to stop EADS North America from undercutting a complacent Boeing at the last minute.
Either way, there’s ample reason for Boeing to keep its pencil sharp—and the Air Force might do well to firmly reinforce that point.
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