Sole-Source vs. Competitive Procurement in Defense Contracts

Introduction to Federal Procurement and Competition

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 noncompetitive contracts has drawn the attention of both Congress and the Executive branch. 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 are, however, 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 item 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 large proportion 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 paper uses the case study of contracts SP0400-02-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 applies game theory to show how acquisition costs differ when competition and sole-source procedures are used to acquire goods and services. Harrison (2012), however, cautions against overvaluing the role of competition in procurement. He argues that while 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 achieves positive outcomes only if it is structured in such a way that competitive pressure sufficiently balances the additional costs of having multiple contractors. Accordingly, this paper also examines how competition needs to be structured to improve federal procurement spending in the DoD.

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 that vendor is the only one capable of providing the required item, 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 defining 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 those offers to critical evaluation, and then selecting the option with the highest relative value (Manuel, 2011).

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

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

The DLA (Defense Logistics Agency) is the DoD's largest support agency. It purchases and stores spare part supplies in large quantities to ensure that the country's military forces have access to the right equipment and the right items whenever the 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 under which Boeing would supply the DLA's spare parts purchase requirements, with an option to extend the contract to May 2014 (The DoD, 2013). The contract initially included fifty-seven spare parts (both stock parts and direct vendor delivery parts), and the two parties established a price for each in the initial phase. These same prices were used in the subsequent phase of the contract, and by June 2006, the DLA had procured approximately 2,300 spare parts valued at $205.4 million (The DoD, 2013).

In March 2009, the DLA awarded a second 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 agreement, which provided an option for extension until March 2015 (The DoD, 2013). A basic ordering agreement was signed indicating that the clauses and the terms and conditions agreed upon in the initial contract would apply to all future orders (The DoD, 2013). Orders were treated independently, and the DLA was required to handle each order as a separate contract. Under the contract, Boeing would quote its price and the DLA would carry out a stand-alone price determination to assess its viability (The DoD, 2013). By June 2012, approximately 3,400 spare parts valued at $142 million had been procured under the contract (The DoD, 2013).

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

The audit found that contracting officers at the DLA had not negotiated reasonable and fair prices on approximately three-quarters of the 2,600 delivery orders that were subjected to review (The DoD, 2013). As a result, the agency had not obtained fair and reasonable value from the two contracts. Furthermore, the contracting officers were found not to have conducted a reasonable and fair price analysis before accepting Boeing's quotations for either contract (The DoD, 2013). This was in part because DLA procurement guidelines did not oblige contracting officers to (i) review older histories of contractor purchases when determining reasonable and fair prices, or (ii) complete subsequent pricing reviews if the nature of the contract allowed for extension (The DoD, 2013). The audit also revealed that contracting officers had failed to conduct efficient contract oversight, which had opened avenues for Boeing to avoid maintaining 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).

This situation would likely have been avoided had the agency employed competitive procedures. With multiple vendors to choose from, contracting officers would have been able to evaluate the price options of several vendors through price analysis and ultimately select the option providing the best relative benefits (Harrison, 2012). This would have enabled the agency to obtain fair and reasonable value for orders under either contract. Moreover, with multiple vendor options available, contracting officers could have compared the product capabilities of different vendors alongside respective price differences, making value judgments about the most reasonable option (Harrison, 2012). Alternatively, the agency could have quoted a fixed price deemed fair and reasonable for a particular order and then selected the vendor or vendors willing to accept it. Either approach would incentivize vendors to produce high-quality merchandise that meets the agency's minimum specifications and requirements, while giving the agency substantial bargaining power. This would in turn ensure that taxpayer 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 rather than sole-source techniques, it is useful to provide a brief overview of the specific procedures the agency would have followed had it awarded the two contracts on a competitive basis.

The first step in competitive procurement is to understand the pricing features and the factors influencing pricing decisions in the relevant industry. 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 partnerships with promising vendors, minimizing unique specifications and requirements in its contracts, taking advantage of full commodity lines available, and purchasing in larger quantities. Such actions would make the agency a more attractive buyer, increase its chances of winning the favor of world-class companies, and give it greater bargaining power to negotiate lower prices and more favorable contracting terms (Office of the Secretary of Defense, n.d.).

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 procurement platforms, and supplier catalogs (Office of the Secretary of Defense, n.d.). The table below presents some of the price-related elements that contracting officers should consider during the pre-award and planning phases of a contract.

Table 1: Pricing Factors to Be Considered Before a Contract Is Awarded

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

Overall Value: What is the relationship between price and the overall value to the government?

Problems: What performance problems have been 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 product features relate to price? What features distinguish one service or supply item from another?

Sources of Supplies or Services: Which vendors are the most (or least) likely to submit offers to the government?

Pricing Strategies and Incentives: What types of incentives are used by firms in the commercial market? What discounts are available for quantity purchases? 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, or energy shortages? What forces might lead the government to expect lower prices — industry downturns or 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 it is now?

Demand Levels: Is the procurement for items at the leading or trailing edge of market demand? Will the planned volume be so large as to induce unanticipated inflation, or large enough to induce lower prices through economies of scale? How does the quantity the government intends to buy compare with the quantities that others buy?

Competitive Conditions: Are other companies expected to enter the market? How many buyers and sellers are in the market?

Ownership Costs: What are the historical repair and 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)

Price analysis is based on the information and data collected through market research. Several price analysis techniques are available to contracting officers. The most common include:

(i) Comparing price bids of multiple sellers to identify the one that provides the most reasonable value. The contracting officer will at times need to consider information beyond pricing data — particularly if competition is limited or if vendor bids differ so substantially that direct comparison is impractical (Office of the Secretary of Defense, n.d.).

(ii) Comparing vendors' price bids with published rebate or discount arrangements, similar indexes, and published market prices and price lists. A price does not become fair and reasonable simply because it appears in a vendor's catalog. In assessing reasonableness, the contracting officer must consider whether the product or service has been sold to the government before, the price at which that previous sale was made, and any discount offered (Office of the Secretary of Defense, n.d.). This information is typically accessed from vendor supply catalogs.

(iii) Comparing vendor bids with the price estimates presented in government catalogs (Independent Government Cost Estimates) to assess how past estimates related to actual prices paid.

All of these procedures increase the likelihood of obtaining fair and reasonable value through competitive procurement. So why does the DLA continue to rely on sole-source procurement mechanisms? The answer lies in the fundamental nature of the defense industry: it cannot be regarded as a free market with limited regulation and an infinite number of buyers and sellers, yet competition tends to work best in precisely such free market systems. The following sections explain why.

Conclusion

There is growing concern that noncompetitive procurement practices are on the rise in federal agencies. This has drawn the attention of Congress, which has called for the streamlining of federal acquisition procedures. Competitive procurement gives the government sufficient leverage to regulate vendors through patronage and to negotiate lower and more reasonable prices for its acquisitions. Despite these inherent benefits, competition has been found not to lead to cost reduction when used in the procurement of goods and services in the defense industry. For this reason, the DLA — the DoD's primary procurement agency — has repeatedly relied on sole-source procedures to acquire weapon systems.

Research has nonetheless shown that if the defense industry were to introduce competition, structuring it using the winner-takes-all approach could realize significant cost savings and increased taxpayer value. In the absence of competition, the DLA should adopt the policy recommendations outlined above to ensure that its sole-source procurement procedures are sufficiently robust to deliver fair and reasonable value on each contract it awards.

GAO. (2010). Defense Inventory: Defense Logistics Agency Needs to Expand on Efforts to More Effectively Manage Spare Parts. United States Government Accountability Office. Retrieved 19 January 2015 from http://www.gao.gov/new.items/d10469.pdf

Harrison, T. (2012). The Effects of Competition on Defense Acquisitions. University Research Symposium 2012. Retrieved 21 January 2015 from http://www.dau.mil/research/symposiumdocs/Harrison%20--%20Competitive%20Pricing%20Model%20paper.pdf

Manuel, K. T. (2011). Competition in Federal Contracting: An Overview of the Legal Requirements. Congressional Research Service. Retrieved 20 January 2015 from https://www.fas.org/sgp/crs/misc/R40516.pdf

Office of the Secretary of Defense. (n.d.). Commercial Item Handbook (Version 2). The Department of Defense. Retrieved 21 January 2015 from http://www.acq.osd.mil/dpap/cpic/draftcihandbook08012011.docx

The DoD. (2013). Improved Guidance Needed to Obtain Fair and Reasonable Prices for Sole-Source Spare Parts Procured by the Defense Logistics Agency from the Boeing Company. Office of the Inspector General, Department of Defense. Retrieved 19 January 2015 from http://www.dodig.mil/pubs/documents/DODIG-2013-090.pdf