The Bargains the Air Force is Getting from Boeing and Northrop Could Backfire
(Source: Forbes; issued Oct 02, 2018)
When it comes to buying weapons, nobody drives a harder bargain than the U.S. Air Force. That skill was on display last week, when Boeing won the competition for a future Air Force training system (planes and simulators) by bidding less than half of what the service had expected the program to cost.

There isn't much doubt that Boeing (a contributor to my think tank) deserved to win and has the financial resources to successfully execute the program. Its plane was the only offering designed specifically to meet Air Force specifications. And at the price the company signed up for, the savings were eye-popping. A program that the Air Force had estimated would cost taxpayers nearly $20 billion will instead cost only $9.2 billion -- a price so low that the Air Force could elect to buy many more planes than it had been planning.

As Air Force Secretary Heather Wilson put it, "through competition we will save at least $10 billion." Only days earlier, her service had scored a similar success by awarding a helicopter contract to a Boeing-Leonardo team for 42% less than the service had estimated it might cost. And since both program awards involve the use of fixed-price contracts, it is the companies rather than taxpayers that would have to foot the bill for any cost overruns.

Clearly, the Air Force has come a long way from the time, only ten years ago, when critics like Senator John McCain accused its acquisition community of giving away the store. Imagine buying a house or a car for half the price that you thought it was going to cost you, without giving up any of the options you wanted. Would you think you got a good deal? No, you'd think you got a great deal.

However, there may be a downside here. Air Force cost estimates are fairly rigorous, based on historical data from the most relevant past competitions. So in order to make the kind of aggressive bids Boeing did in both cases, a series of sporty assumptions are required. After all, Boeing is not in the business of subsidizing government operations.

First, the company had to assume it could achieve unprecedented efficiencies in executing the program by applying innovative technologies and practices not available in those past competitions. Then it had to make a series of guesses about what additional revenues might be generated outside the scope of the program -- for example, by one day using the same airframe to replace Navy trainers, or by selling training systems to U.S. allies.

I don't know what all those assumptions were, but they led Boeing to bid a price that competitors couldn't match -- or at least, weren't willing to match. It will be many years before Boeing executives know whether the assumptions underpinning their very aggressive bid were valid. But when you drive contractors to the lowest possible price on program after program the way the Air Force has, you may be building risk into your modernization portfolio.

Consider the Air Force's next-generation tanker, a program Boeing won in 2011 by bidding aggressively against Airbus, a subsidized European plane maker. The tanker specifications were unusually demanding, but the way the competition was set up, it was what people in the business call a "price shootout" -- in other words, if offerors met the performance thresholds, then the lowest bidder would prevail.

Northrop Grumman, the company that had originally teamed with Airbus in the tanker competition to offer an alternative to a Boeing jet, backed out citing risks. And sure enough, seven years later Boeing has incurred billions of dollars in unexpected costs developing the tanker that it will have to absorb. Because development was conducted under a fixed-price contract, the Air Force doesn't pay a penny over what it agreed to even though development was more expensive than Boeing had hoped.

It turned out that at least some of the assumptions Boeing made going into the tanker competition were too optimistic. The company still expects to make good money building and sustaining the tankers over a service life that may last nearly a century, but clearly it will have to wait longer that it wanted to break even on the program. And its hope that a win would dissuade Airbus from setting up commercial transport production in the U.S. was dashed.

The Air Force never should have made Boeing compete against a subsidized foreign company. The World Trade Organization has ruled every jetliner Airbus ever brought to market was illegally subsidized, and Boeing planners had to assume the European company would exhibit the same behavior in the tanker competition. So Boeing was forced to bid an unusually low price, and now must live with the consequences.

It's easy to say Boeing made mis-steps in developing the tanker, but if it hadn't been under so much pressure to bid a rock-bottom price, it undoubtedly would have built more risk margin into its bid. The tanker in question -- now designated the KC-46 Pegasus -- was intended to be by far the most capable aerial refueling system ever built. So there were sure to be risks in developing it.

Which brings me to the biggest question mark in the Air Force modernization portfolio, the B-21 bomber -- itself expected to be the most capable aircraft of its type ever built. The B-21 is being built by Northrop Grumman, which bested a Boeing-Lockheed Martin team in 2015 to win the competition for what was then called the Long Range Strike Bomber.

Northrop Grumman won the bomber program the same way Boeing won the tanker and trainer programs. It bid aggressively. How aggressively? As I wrote in Forbes at the time, it agreed to develop the B-21 for less than half of what the Air Force expected development would cost, and it offered a unit price for production aircraft less than half of the $550 million per plane that the Air Force had set as an upper limit on cost.

Obviously, Northrop had to make some fairly heroic assumptions to bid this way, because it did not have the deep pockets of the Boeing-Lockheed team and it had largely exited the aircraft business by the time the bomber competition came along. Those assumptions will probably not come back to haunt it during development, since that phase of the program will be conducted under a cost-plus contract rather than a fixed-price vehicle. In other words, Northrop would not have to absorb all of the costs of exceeding its development bid.

That's good, because issues have already arisen in development -- as they always do when high-performance aircraft are developed. For instance, it take hundreds of days to get newly hired engineers cleared into a "black" program where every facet of the work is considered sensitive. If the cost of development greatly exceeds what Northrop signed up for, it will have to share some of the additional cost burden with the government, but it probably will not have to take the kind of charges that Boeing did on the tanker.

When it comes time to build production bombers, though, the contract changes to a fixed-price arrangement, and that could be a serious problem for the company. If you propose to deliver the world's most advanced strike aircraft for less than the list price of most commercial jetliners, that's a lot of risk. It probably is no coincidence that in the years since it won the bomber program, Northrop has repeatedly avoided bidding on other programs like the trainer that would have added more risk to its portfolio.

For all I know, Northrop Grumman has an elegant plan that will enable it to successfully navigate the risks associated with producing the B-21. If it doesn't though, and things go awry, at least part of the blame will rest with an Air Force acquisition culture that puts too much emphasis on price while under-emphasizing risk. That doesn't just apply to the way the Air Force buys planes, it also is reflected in how launch services and other items are acquired.

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