Pricing and Contract Integration: Procurement

Procurement: Pricing and Contract Integration

Federal procurement contracting has over the last few years been a subject of increased public and congressional interest, particularly because of the growing concern that noncompetitive procurement practices may be on the rise in the assignment of government contracts. The rising number of cases and public reports implicating federal agencies in alleged misconduct involving non-competitive contracts has drawn the attention of both Congress and the Executive arm of government. President Obama, in his 2009 memorandum on federal contracting, emphasized the need to use competition in the award of federal procurement tenders. The Competition in Contracting Act (CICA) of 1984 was enacted to keep federal agencies in check by ensuring that they i) develop their procurement procedures as expressly required by statute and ii) use full and open competition in the issuance of procurement contracts (Manuel, 2011). There, however, are exceptional circumstances under which the full and open competition requirement does not apply and agencies are permitted to use noncompetitive procedures. These include i) when there is a single source for the supply of a required commodity, ii) when the procurement faces compelling and unusual urgency, iii) when the agency is seeking to maintain its industrial base, iv) when international agreements permit anticompetitive procedures, v) when the acquisition involves a brand-name meant for resale, vi) when the acquisition is a matter of national security, and vii) when the contract or acquisition is necessitated by public interest (Manuel, 2011).

The Department of Defense (DoD) accounts for over 70% of annual federal procurement spending, and is also one of the greatest users of noncompetitive procedures, conducting a bulk of its contract actions on a sole-source basis. As a result of this overreliance on noncompetitive procurement procedures, the department has seen its acquisition costs rise steadily over the last few years (Harrison, 2012). Its supply chain management system has also come under intense criticism for inefficient inventory management, inaccurate demand forecasting, and the maintenance of "high levels of inventory beyond what is needed to support requirements" (GAO, 2010, p. 1). This text uses the case study of the SPM400-02-D-9407 and SPM4A1-09-G-0004 sole-source contracts awarded to Boeing Inc. By the Defense Logistics Agency (DLA) for the supply of spare parts to demonstrate the weaknesses inherent in sole-source arrangements. It uses game theory to show how the acquisition costs differ when competition and sole-source procedures are used to acquire goods and services. Harrison (2012), however, cautions against overvaluing the aspect of competition in procurement. He argues that in as much as competition can reduce costs and serve as an incentive for improving contractor performance; it ought not to be seen as a cure-all solution to the supply chain problems that plague the DoD. In his view, competition would only achieve positive outcomes if it is structured in such a way that the competitive pressure sufficiently balances the additional costs of having multiple contractors. In this regard, this text will also focus on showing how competition needs to be structured to improve federal procurement spending in the DoD.

Definitions of Terms

Before embarking on the main discussion, it would be prudent to provide a concise definition of the various key terms that I will be making use of in this text. Well, the terms may have been defined differently by different researchers; however, for purposes of this text, the definitions presented below will be adopted.

Procurement: the process by which government agencies obtain from private vendors goods and services that they do not provide or produce for themselves (Manuel, 2011).

Sole-Source Procurement: a form of procurement where purchases are made from only one vendor either because they are the only one capable of providing the same, or because the agency is tied to that particular vendor by specific, justifiable reasons. The latter case is more specifically referred to as single-source procurement. The main feature of sole-source procurement agreements is that there is no possibility of obtaining competitive bids (Manuel, 2011).

Competitive Procurement: a form of procurement where an agency determines whom to contract with and whom to purchase from by soliciting offers from multiple vendors, subjecting them to critical evaluation, and then selecting the option with the highest relative value (Manuel, 2011).

The aim of this research paper is to show that i) despite the inherent benefits of competition, sole-source procurement is still the most cost-effective mode of acquisition in the defense industry; and ii) that the effectiveness of competition in the defense industry (should the option be considered) depends on how it (the competition) is structured.

Case Study: The DLA's Sole-Source Spare Part Procurement from Boeing

Contract SP0400-02-D-9407: The DLA (Defense Logistics Agency) is the DoD's largest support agency. It purchases and stores spare part supplies in large quantities as a means of ensuring that the country's military forces have access to the right equipment and the right items whenever need arises (GAO, 2010). In May 2002, the DLA awarded, on a sole-source basis, contract SP0400-02-D-9407 for the supply of aviation spare parts to Boeing Inc. This was a requirements-type contract in which Boeing was to supply the DLA with spare parts purchase requirements with the option of extending the contract to May, 2014 (The DoD, 2013). The contract initially included fifty-seven spare parts (both stock parts ad direct vendor delivery parts); and the two parties established a price for each in the initial phase. These very prices were used in the subsequent phase of the contract; and by June, 2006, DLA had procured approximately 2,300 spare parts valued at $205.4 million (The DoD, 2013).

Contract SPM4A1-09-G-0004: In March, 2009 DLA awarded another contract SPM4A1-09-G-0004 to Boeing for the supply of subassemblies, assemblies, components, and spare parts to support multiple missile programs (The DoD, 2013). This was a basic-ordering contract agreement, which provided an option for extension until March 2015 (The DoD, 2013). A basic ordering agreement was signed indicating that the clauses as well as the terms and conditions agreed upon in the initial contract would apply to all future orders (The DoD, 2013). Orders were treated independently and as such, the DLA was required to handle each order as a separate contract. Under the contract, Boeing would quote its price and DLA would carry out a stand-alone price-determination to determine its viability (The DoD, 2013). By June, 2012, about 3,400 spare parts valued at $142 million had been procured on the contract (The DoD, 2013).

The Audit: In June, 2013, the Office of the Inspector General conducted an audit to determine whether the DLA's contract with Boeing for the two procurements above had been fair and reasonable (The DoD, 2013). More specifically, the audit sought to determine whether the price paid for the orders on the contracts was fair and reasonable, and whether the agency had obtained the best value. The costs of 60 spare parts drawn from the two contracts and valued at approximately $81.1 million were reviewed in the audit (The DoD, 2013).

The Findings: it was found that the contracting officers at DLA had not negotiated reasonable and fair prices on approximately three-quarter of the 2,600 delivery orders that were subjected to audit review (The DoD, 2013). As a result, the agency had not obtained fair and reasonable value from the two contracts. Further, the contracting officers were found not to have conducted a reasonable and fair price analysis before accepting Boeing's quotation for either of the two contracts (The DoD, 2013). This was in part because the DLA procurement guidelines did not oblige contracting officers to i) review older histories of contractor purchases in their determination of reasonable and fair prices, and ii) complete subsequent pricing reviews if the nature of the contract allowed for extension (The DoD, 2013). The audit further revealed that the contracting officers had failed to conduct efficient contract oversight, and this had essentially opened up avenues for Boeing not to maintain complete cost and pricing data for their delivery orders (The DoD, 2013).

As a result, the DLA was found to have "paid approximately $13.7 million in excess of fair and reasonable prices for 1,469 delivery orders" (The DoD, 2013, p. i). It was further established that if prices were not reviewed, the agency would continue to overpay for future orders on the two contracts (The DoD, 2013).

Well, this situation would obviously have been avoided had the agency employed competitive procedures; why so? To begin with, the contracting officers would have multiple vendors to choose from, which basically means that they would have the ability to evaluate the price options of several vendors through the process of price analysis and eventually choose the option that provides the best relative benefits (Harrison, 2012). This would have enabled the agency to obtain fair and reasonable value for orders in either contract. Moreover, presented with multiple vendor options, the contracting officers would have had the opportunity to compare the product capabilities of different vendors and the respective price differences, and they would then be able to make value judgments on the option that provides the most reasonable value (Harrison, 2012). Alternatively, the agency could quote a fixed-price that it deems fair and reasonable for a particular order, and then pick the vendor(s) who are willing to subscribe to the same. Both actions would go a long way in incentivizing vendors to produce high-quality merchandise, or at least that which sufficiently meets the minimum specifications and requirements of the agency, which will then have substantial bargaining power over the vendors. This would in turn ensure that taxpayers' money is spent in a fair and reasonable manner and only on the most viable contractors.

Procedures of Competitive Pricing

Having outlined the cost and value benefits that would have accrued from using competitive procedures as opposed to sole-sourcing techniques, it would be prudent to give a brief overview of the specific procedures that the agency would have undertaken if it had awarded the two contracts on a competitive basis.

Understanding the dynamics and characteristics of the market: The very first step in competitive procurement is to understand the pricing features, as well as the factors influencing pricing decisions in the industry within which the agency operates. An agency's ability to obtain best-value, fair, and reasonable prices depends on i) how well its contracting officers know their commercial marketplace and the specific products that their industry has to offer; ii) how well they understand the government's needs and essential requirements; and iii) how well they can use market leverage to make the government an attractive buyer (Office of the Secretary of Defense, n.d.). An agency could increase its leverage in several ways, including committing to long-term partnership with promising vendors, minimizing unique specifications and requirements in its contracts and agreements, taking advantage of full commodity lines available, and purchasing in larger quantities. Such actions would make the agency an attractive buyer, increases its chances of winning the favor of world-class companies, and give it more bargaining power to negotiate lower payments and prices as well as more favorable contracting terms (Office of the Secretary of Defense, n.d.).

Conducting market research to obtain pricing information: pricing information can be obtained from numerous sources including industry association databases, company historical records, audit personnel and government pricing catalogs, parametric analyses on correlation and price range, analogies, comparative information on the competitive environment and competitors, government electronic malls, and supplier catalogs (Office of the Secretary of Defense, n.d.). Table 1 below presents some of the price-related elements that contracting officers ought to consider during the pre-award and the planning phases of a contract.

Table 1: Pricing Factors to be considered before a Contract is Awarded

Pre-award Pricing Factors for Consideration (Market Research)

Research Factor

Elements for consideration

Pricing History

How do the prices paid by the Government relate to those paid other buyers? What information is available concerning past prices paid for the service or item of supply and about changes in the supply item or service or market since then?

Overall Value

What is the relationship between price and the overall value to the Government?

Problems

What performance problems have they faced in the past?

Have similar acquisitions been characterized by cost overruns?

Delivery/

Performance Terms

What are the commercial lead-times?

What are current transportation costs?

What are the current distribution channels?

Supply or Service

Characteristics

How do features relate with price?

What features distinguish one service or item of supply from another?

Sources of Supplies or Services

Which vendors are the most (or least) likely to submit offers to the government ?

Pricing Strategies & Incentives

What types of incentives are used by firms in the commercial market?

What discounts are available for quantity buys?

What are the pricing strategies of firms in the commercial market

Other Market Forces Expected to Affect Contract Price

What forces might drive up prices in the near future? Legislative action? Raw material shortages Strikes? Labor shortages? Subcontractor bottlenecks? Energy shortages?

What forces might lead the Government to expect lower prices in the future? Industry downturn? Rising unemployment?

Pattern of Demand

Would a delay in procurement result in lower prices than an immediate award?

Is there a cyclical pattern to supply and demand?

Trends in Supply and Demand

Will supply capacity keep pace with demand?

Will demand be higher or lower at the time of award than now?

Demand Levels

Is the procurement for items at the back edge or at the leading edge of market demand

Will the planned volume be so large as to induce unanticipated inflation?

Will the planned volume induce lower prices of the seller's increased economies of scale?

How does the quantity the Government intends to buy relate with the quantities that others buy?

Competitive

Conditions

Are other companies expected to enter the market?

How many buyers are in the market?

How many sellers are in the market?

Ownership Costs

What are the historical repair and historical maintenance costs for each item?

What are the commercial warranty terms and conditions (if any)?

(Source: Office of the Secretary of Defense, n.d., pp. 36-37)

Carrying out price analysis to determine the most reasonable price: price analysis is based on the information and data collected through market research. There are several price analysis techniques from which contracting officers can choose. The most common ones include:

i) Comparing price bids of multiple sellers to identify the one that provides the most reasonable value. The contracting officer will at times be forced to consider valuable information other than pricing data. This is especially so if competition is limited or where the bids by vendors are so vastly different that they are more or less incomparable (Office of the Secretary of Defense, n.d.).

ii) Comparing vendors' price bids with published rebate or discount arrangements, similar indexes, as well as published market prices and price lists. A price does not become fair and reasonable just because it is listed in a vendor's catalogue. In assessing reasonability, the contracting officer has to take into consideration a number of other factors, including whether the product or service has been sold to the government before, the price at which that previous sale was made, and the amount of discount offered (if any) (Office of the Secretary of Defense, n.d.). This information is accessed from vendor supply catalogs.

iii) Comparing vendor bids with the price estimates presented in government catalogs (IGCEs) to assess how past estimates related with actual prices paid

All these procedures increase the likelihood of obtaining fair and reasonable value through competitive procurement procedures. So, why then does the DLA still dwell on sole-source procurement mechanisms? The answer is simple -- the defense industry cannot be regarded a free market with limited regulations and an infinite number of buyers and sellers, yet competition seems to work best in free market systems. The subsequent sections attempt to explain why this is so.

The Myths and Facts of Competitive Procurement

There is a popular myth that competition would certainly drive down the costs of acquisition as it forces vendors to undercut each other through lower bids. The underlying assumption is that since there are many vendors supplying similar commodities, the agency will have substantial bargaining power, and will be in a better position to negotiate lower prices and at the same time command high value (Harrison, 2012).

Research has, however, shown that this widely-held perception about competitive procurement is not entirely true, particularly for markets such as the defense industry, which lack the characteristics of the traditional free market system (Harrison, 2012).

The Rigid Nature of the Defense Industry

As mentioned elsewhere in this text, the defense industry is not a free market system characterized by limited regulation and numerous sellers and buyers. In fact, the industry can more rightly be classified as a monopsony, where the government is not only the chief regulator, but also the sole customer for most of the weapon systems; and even in cases where partner nations and allies to the U.S. purchase the same from the U.S. market, the sales will often still require the government's approval (Harrison, 2012). Further, the number of sellers is limited owing to the fact that there are only very few world-class vendors are capable of producing the weaponry system that defense requires.

The traditional free market system is characterized by among other things, numerous buyers who exert control over suppliers through patronage, and a competitive pricing system where prices are determined by the free interaction of the forces of demand and supply. The defense industry is, however, quite different -- prices are based on the cost of contractual activities, and the DoD (the sole consumer) exerts substantial control over vendors, first through patronage, and secondly, through regulating their production activities. Simply stated, in addition to buying weapon systems, the DoD also plays an active role in the designing and the production of such weapons (Harrison, 2012). It is this rigid nature of the defense market that makes it unable to respond to market as effectively as a free market would (Harrison, 2012).

The Rigidity of the Defense Industry and Cost-Reduction

Harrison (2012) explains how this rigidity prevents "competition from having the desired effect of reducing costs in defense acquisitions" (p. 3). He identifies three factors that contribute to this effect -- the learning curve phenomenon, the cost of redundant development work, and the manner in which competition itself is structured.

The Burden of Redundant Development Work: as mentioned earlier on, the DoD plays an active role in the development of weapon systems; in fact, as the sole consumer, it almost single-handedly meets the entire cost of weapon development (Harrison, 2012). If it wishes to open up avenues for competition, it will have to either pay multiple contractors to work on the same system or engage a build-to-print approach, where different contractors develop the same system separately. Either option would require the DoD to pay for multiple production lines and would have the effect of increasing the overall cost of weapon development (Harrison, 2012).

The Learning Curve Phenomenon: the learning curve phenomenon suggests that as more and more units of a particular commodity are produced, the cost of producing subsequent units decreases (Harrison, 2012). If the DoD wishes to create competition in the defense industry, it would allow the establishment of multiple vendor companies, but would still eventually be forced to down-select to a single producer through competitive procedures. The learning curve effect grants the winning company an edge over its competitors, making it better-placed to negotiate lower prices, attract the DoD and in the long-term establish a monopoly (Harrison, 2012). As shown in fig 1, the learning percentage (b) represents the slope of the learning curve. A value of 65 would, for instance, be interpreted to mean that whenever the quantity produced doubles, the cost per unit is 65% of the initial cost.

Fig 1: Learning Curve Example

Cn = CFnlog2b

CAVG (ns to nf) = CF (nf (1 + log2b) - ns (1 + log2b))

CF

(nf - ns) (1+ log2 b)

Unit cost

(Cn) where;

CF =cost of first unit b = learning percent ns = starting unit number nf = final unit number

CAVG =average unit cost from ns to nf ns nf

Number of units produced

The Structure of the Competition: in as much as competitive procurement may not result in cost reduction in the defense industry, research has shown that the structure of the competition determines, to a large extent, how industry costs will behave in the long-term. Using game theory, and the model presented in fig 1 above, we can demonstrate this phenomenon. We will compare a hypothetical sole-source acquisition to two alternative case scenarios (company A and B) where vendors compete for weapon system production work, with the aim of determining which one yields the lowest total cost to the government and hence, the highest value for the taxpayer. The two alternative cases exhibit varying competition structures -- in one case, the winning vendor takes all; and in the other, the award is split equally between the competing vendors (50-50 proportion). We will assume the values presented in table 2 below for the model parameters.

Table 2: Measurement Parameters

First unit cost

(CF)

Learning % (b)

Maximum profit (P max)

Minimum profit (Pmin)

Total procurement in units (Q)

Initial development cost (CDEV)

$1,000

85%

10%

-10%

$2,000

The following four assumptions will also be made:

i) Both companies A and B. meet the minimum requirements set by the DoD's procurement unit

ii) The two companies have identical cost structures, and have perfect knowledge about their own, as well as their competitors' learning percentages and first unit costs

iii) The two companies bid at the same time, such that there is no possibility of either company obtaining information on the other's bid value

iv) If the companies place bids for exactly the same price, the contract is awarded to company A

i) The total Cost for the Sole-Source Award

If the contractor makes zero profit on the contract, the total acquisition cost would be calculated as;

CTOTAL = CDEV + Q x CAVG (0 to Q)

= $2,000 + 100 ($1,000 x 100 (1+log 2-0.85) / (100 x (1 + log2 0.85))

= $46,372

Assuming he makes maximum profit (10% profit), the total cost would be;

CTOTAL = CDEV + Q x (1 +P max) x CAVG (0 to Q)

=$2,000+ 100 x (1 +0.1) x ($1,000 x 100 (1+log 2-0.85) / (100 x (1 + log2 0.85))

= $50, 809

Implication: the total cost to the taxpayer would be between $46,372 and $50, 809, depending on the percentage of profit the parties agree upon