Northrop Grumman Leader Warns On Move To Fixed-Price Contracts

By | June 5, 2006 | Uncategorized

By Dave Ahearn

Lawmakers and Pentagon leaders should avoid any headlong rush to impose fixed-price contracts on the aerospace industry, according to a top defense executive.

Using fixed-price contracting for some risky development programs might dissuade some companies from bidding on the work for fear of losing money, Ronald Sugar, chairman and CEO of Northrop Grumman [NOC], the third-largest defense contractor, said last week.

He also said he sees no impending huge collapse in defense spending, though he cautioned that projecting military outlays years in advance is difficult, adding that Northrop Grumman isn’t highly dependent on funding from supplemental budgets that may be reduced in coming years.

And, he said that Northrop Grumman, while it is concentrating heavily on information technology and systems, still likes its military hardware programs. “It turns out platforms are good for you if you have good platforms,” he said.

Speaking before a Bear Stearns aerospace and defense investors conference, which Northrop Grumman webcast, Sugar said that defense company CEOs aren’t going to bid on contracts where the companies will lose money, damaging the corporations. He added, though, that there wouldn’t be any collusion in the industry to avoid bidding for fixed- price work. Sugar also is chairman of the board of the Aerospace Industries Association.

Prices have soared on some existing contracts, ranging from space platforms to ballistic missile defense systems, aircraft, ground assets, ships and submarines. That sticker shock has led some lawmakers and Pentagon procurement policymakers to rip the industry for huge growth in price tags on various types of hardware.

The critics say the armed services, Missile Defense Agency and other purchasers of pricey platforms should stop awarding contracts that reimburse defense companies for their costs, plus a profit margin, or other types of flexible pricing such as incentive fees. Rather, the critics favor fixed-price contracts where a defense company promises to deliver a certain system with a given capability at a set price, by a date certain.

Sen. John McCain (R-Ariz.), a senior member of the Senate Armed Services Committee, has criticized many procurement programs for soaring costs. As well, the Government Accountability Office, inspectors general and other watchdogs have assailed programs where costs have soared more than 25 percent over original estimates, including a polar- orbiting satellite constellation.

While a fixed-price approach may be warranted in some instances, it may not make financial sense in some development programs, Sugar said.

Further, he added, critics shouldn’t get carried away in worrying about increased prices.

Out of thousands and thousands of procurement programs, he observed, only a handful are in breach of the so-called Nunn-McCurdy Act, which calls for notification of lawmakers when program costs exceed original estimates by 15 percent or more, and also calls for possible program cancellation when costs are 25 percent or more over estimates, unless the secretary of defense makes certain certifications.

“The vast majority of programs are successful,” Sugar said, commenting in response to questions.

He bridled at the implication by critics that cost overruns are a hallmark of a profiteering aerospace industry. In fact, he said, “we don’t make money on overruns.”

He said that contractors are but one of the multiple causes of cost increases. Others include Pentagon or other federal agencies changing requirements for programs; unrealistic price estimates that agencies provide as they seek congressional approval of programs; and unstable funding.

For example, if Congress approves a program for a destroyer or airplane with projections of the government buying a certain number of them each year, but lawmakers later slash that expected buy, then costs are spread over fewer numbers of those assets, and their unit price rises.

That said, Sugar realizes that in this, an election year, “the political focus will definitely be on contractors,” as critics complain about rising program costs.

It would, however, ill serve government to become unreasonable in a cost-cutting drive, Sugar said. He recalled that a couple of decades ago, a similar outcry against program costs led to an environment where contractors would submit bid prices they knew were too low, for fear of going out of business for lack of work if they didn’t win the contracts.

In some instances, however, the contractors then wound up in later years losing money on those programs.

This was, Sugar asserted, “a disastrous experiment.”

And, he predicted, this won’t happen again. The current crop of aerospace industry CEOs is “a pretty savvy bunch of guys” who won’t make “the same kind of desperation plays” seen in bids for some contracts in the 1980s, Sugar predicted.

Then, there was a game of “limbo: how low can you go,” Sugar said.

An industry leader then might confront a painful choice: submit a realistic bid price and know another company would underbid it and win the contract, or submit a too-low bid and wind up losing money on the contract in future years.

Sugar said the aerospace industry will work hard to “make sure that legislation [in Congress] doesn’t inadvertently push us in that direction.”

Further, he said, Northrop Grumman and other companies will decline to bid on fixed-price contracts that would wind up losing money for the firm.

“We won’t collaborate or collude” in such decisions, but CEOs will reach those decisions individually based on their responsibilities to their companies, he indicated.

That is not to say, however, that Sugar is opposed entirely to fixed price contracts. For example, on some programs, it would make sense to move to fixed price arrangements over time, as risky development phases of programs end, and routine production begins.

That move to fixed pricing might be accompanied by “large block buys of materials” needed for production of platforms well into the future, to lock in favorable supplier prices, he said.

On Northrop Grumman itself, a company formed from a score of mergers over two decades, Sugar said the firm isn’t on the prowl looking for new acquisition targets. If a bright prospect comes to light, Northrop Grumman might buy a company. But it will have to be a profit-maker, he said.

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