{"id":3053159,"date":"2024-01-09T06:00:00","date_gmt":"2024-01-09T11:00:00","guid":{"rendered":"https:\/\/platoaistream.com\/plato-data\/cautionary-tale-how-boeing-won-a-us-air-force-program-and-lost-7b\/"},"modified":"2024-01-09T06:00:00","modified_gmt":"2024-01-09T11:00:00","slug":"cautionary-tale-how-boeing-won-a-us-air-force-program-and-lost-7b","status":"publish","type":"station","link":"https:\/\/platoaistream.com\/plato-data\/cautionary-tale-how-boeing-won-a-us-air-force-program-and-lost-7b\/","title":{"rendered":"\u2018Cautionary tale\u2019: How Boeing won a US Air Force program and lost $7B"},"content":{"rendered":"
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WASHINGTON \u2014 The U.S. Air Force\u2019s next-generation tanker was supposed to be the ideal candidate for a fixed-price development program.<\/p>\n

Indeed, when Boeing first won the deal to build what\u2019s now known as the KC-46<\/a>, the defense contractor said it would use a \u201clow-risk approach,\u201d basing its design on the existing Boeing 767 commercial airplane. The contract was firm-fixed-price, meaning Boeing was on the hook if costs ran higher than expected.<\/p>\n

Nearly 13 years later, Boeing has absorbed $7 billion in cost overruns<\/a>, far more than the contract value of $4.9 billion. For years, the tanker, designed to refuel aircraft in flight, has been plagued by delays, production errors and a faulty vision system that required a complete redesign.<\/p>\n

While Boeing has paid the financial price, the company and the Air Force have spent years trying to make the program work. The initial contract award called for the combat-ready tankers to arrive in August 2017; the first arrived in January 2019.<\/p>\n

In the years that followed, the KC-46 program was beset by further delays, including production line problems that regularly stalled deliveries and an underperforming vision system. That system is years behind schedule and expected to come in October 2025.<\/p>\n

Boeing\u2019s experience with the KC-46 and other programs in recent years has turned into a \u201ccautionary tale\u201d on the risks of entering into fixed-price development contracts, said Steven Grundman, a former Pentagon industrial base chief who now works as a senior fellow at the Atlantic Council think tank.<\/p>\n

The KC-46 story \u201cmakes both sides of the market \u2014 the Pentagon and the contractors \u2014 sharpen their pencils,\u201d Grundman said. \u201cThe Pentagon will be more cautious about programs that it thinks [lend themselves to] an efficient and effective fixed-price contract type. And contractors will be more discerning about the readiness of their engineering chops and the ability of their balance sheets to absorb risk.\u201d<\/p>\n

While analysts don\u2019t expect the Pentagon to entirely shy away from fixed-price contracts, they said the military and businesses will think long and hard about which future deals make sense for such a contract structure \u2014 and when another path might better serve a program.<\/p>\n

Air Force Secretary Frank Kendall, who was the Pentagon\u2019s deputy acquisition chief when the original tanker contract was awarded, has said the service didn\u2019t look closely enough at some design elements and wasn\u2019t skeptical enough of the rosy picture Boeing painted.<\/p>\n

And he has acknowledged a cost-plus contract, meaning one that covers a company\u2019s expenses as well as some profit, might have been a better choice \u2014 for both sides.<\/p>\n

\u201cIn a fixed-price, you\u2019ve got to let the contractor kind of do what it wants because he\u2019s taking the risk associated with the cost,\u201d Kendall said.<\/p>\n

L3Harris Technologies\u2019 chief executive told investors in an April earnings call that concerns over the risk of fixed-price contracts prompted the company to pass on two opportunities it otherwise found \u201cexciting.\u201d<\/p>\n

\u201cIt\u2019s very hard to commit to a fixed-price development program when you don\u2019t know the spec,\u201d Chris Kubasik said. \u201cWe all look back at all the write-offs and losses, and more times than not they\u2019re tied to that. So we will not be playing that game.\u201d<\/p>\n

\u2018No quarter\u2019 for fixed-price mistakes<\/h2>\n

Under firm-fixed-price contracts of the kind Boeing received to build the KC-46, the contractor agrees to deliver a product or service for a hard-and-fast price, and shoulders the cost of any overruns or changes that weren\u2019t originally agreed upon with the government.<\/p>\n

But while the contractor bears the brunt of the risk under a fixed-price deal, it can also pay off considerably if the company plays its cards right. While other forms of contracts limit profit margins to between 5% and 12%, under a fixed-price contract, companies can keep any leftover money. If they come in under cost, they reap all the benefits.<\/p>\n

Bryan Clark, the director of the Center for Defense Concepts and Technology at the Hudson Institute think tank, said there will always be a place in the Pentagon for fixed-price contracts.<\/p>\n

\u201cThe idea of fixed-price contracts is still very popular within the [Department of Defense] because contracting officers like it; it\u2019s a good way to show that you\u2019re holding the line\u201d against cost overruns, Clark said.<\/p>\n

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A KC-46 Pegasus refuels an F-16 at night, as seen through the updated version of the Remote Vision System, or RVS 2.0. (Boeing) <\/span><\/p>\n<\/figcaption><\/figure>\n

Some contracting experts said fixed-price deals can make sense for straightforward projects, but more complicated development programs are not necessarily an ideal fit.<\/p>\n

Defense industry analyst Loren Thompson said if a company can\u2019t turn a profit on a program \u2014 or worse, starts bleeding cash as it spirals \u2014 the company might start looking for places to cut corners to save. That, he explained, can lead to moves detrimental to the program over the long run \u2014 and perhaps years of delays and headaches for the client, even if they\u2019re not financially on the hook.<\/p>\n

\u201cIf you\u2019re not breaking even on a program, then you start thinking: What don\u2019t I have to do that was in my original plan?\u201d Thompson said. \u201cAnd it can lead to trouble.\u201d<\/p>\n

(Thompson previously consulted for Lockheed Martin, though he no longer does so. Lockheed and Boeing contribute to the Lexington Institute think tank, where Thompson is chief operating officer.)<\/p>\n

Boeing\u2019s KC-46 experience shows companies can\u2019t expect the Pentagon to bail them out if things start to go sideways on a fixed-price contract, Grundman told Defense News. During the Cold War, he said, the Pentagon was more willing to help when such a contract started to balloon out of control and endanger a company. But those days are gone, he noted, ever since the wave of industry consolidations led to mega-firms with multibillion-dollar revenues<\/a>.<\/p>\n

\u201cThe Pentagon is going to give no quarter to companies that make mistakes in how they bid on these things,\u201d Grundman said. \u201cThese [primes] are big boy companies, [with] big balance sheets that the Pentagon can ask to bear more risk.\u201d<\/p>\n

In recent years, Boeing has made more than one big bet on a fixed-price program. In 2018, the company won deals for the T-7A Red Hawk trainer<\/a>, MQ-25A Stingray tanker drone<\/a> and VC-25B Air Force One<\/a> programs, all fixed-price efforts that have contributed to billions of dollars in charges for Boeing.<\/p>\n

\u201cBoeing wanted to win the work, so they went for these fixed-price [research and development] contracts and lowballed it, and now they\u2019re suffering,\u201d Clark said.<\/p>\n

Lockheed Martin lost three major contracts to Boeing in 2018, including the T-7 and MQ-25. Lockheed\u2019s chief executive at the time, Marillyn Hewson, told investors that if the company had matched Boeing\u2019s price, then Lockheed would have lost more than $5 billion.<\/p>\n

The Trump administration\u2019s hardball renegotiating of the VC-25B contract with Boeing \u2014 which CEO Dave Calhoun has publicly lamented \u2014 also ratcheted up the company\u2019s risk.<\/p>\n

\u201cThere was a lot of risk in that [Air Force One project] because it\u2019s not easy to convert a plane that already exists to perform a different function,\u201d Clark said. \u201cThe government squeezed them pretty hard to give them a fixed price, and [Boeing] had to lowball it, and now they\u2019re having to take those losses.\u201d<\/p>\n

Boeing, still smarting from the contracting licks it took \u2014 and, for now, will continue taking \u2014 is going to great lengths to show its investors it learned lessons.<\/p>\n

\u201cRest assured, we haven\u2019t signed any fixed-price development contracts, nor [do we] intend to,\u201d Boeing\u2019s chief financial officer, Brian West, said in the company\u2019s October earnings call.<\/p>\n

And on Dec. 4, a Boeing spokesperson confirmed the company is no longer competing to provide the Air Force with a successor to the E-4B Nightwatch, a so-called doomsday plane meant to serve as a survivable command, control and communications center during nuclear war.<\/p>\n

\u201cWe are approaching all new contract opportunities with added discipline to ensure we can meet our commitments and support the long-term health of our business,\u201d the spokesperson told Defense News.<\/p>\n

\n

Boeing CEO Dave Calhoun is recognized during a ceremony to sign a trade agreement between the U.S. and China at the White House on Jan. 15, 2020. (Mandel Ngan\/AFP via Getty Images) <\/span><\/p>\n<\/figcaption><\/figure>\n

Reuters reported<\/a> the service\u2019s insistence on using a fixed-price structure for the contract, which Boeing has sworn off, was an insurmountable disagreement.<\/p>\n

Boeing declined to confirm whether a fixed-price dispute was a factor, and the Air Force declined to comment on the ongoing competition.<\/p>\n

Clark said Boeing\u2019s experience has prompted firms to be more wary of fixed-price contracts and more reluctant to accept those kinds of deals during the higher-risk research and development phase.<\/p>\n

\u201cThere\u2019s definitely been a new openness on the part of DoD contracting officers to accept cost-plus [contracts] on the R&D side,\u201d he said. Companies now say they \u201cwant R&D to be a cost-plus endeavor, where we\u2019re getting covered in terms of our overruns. Because the government always asks for something pretty ambitious, therefore, it makes sense that the government helps to pay for or cover the risk associated with those ambitious goals.\u201d<\/p>\n

No \u2018vanilla Wedgetail\u2019<\/h2>\n

For its B-21 Raider bomber, the Air Force has applied both a cost-plus and fixed-price approach. The service used a cost-plus approach for the 2015 contract it awarded Northrop to develop the Raider, and the soon-expected low-rate initial production contract will use a fixed-price structure.<\/p>\n

That cost-plus structure raised eyebrows at the time, particularly from the late Sen. John McCain, R-Ariz., who worried it would lead to cost overruns and schedule slips. But after the Raider\u2019s on-time and on-budget rollout in December 2022, former Air Force Secretary Deborah Lee James said it was clear the cost-plus structure and the way the Air Force had managed Northrop Grumman\u2019s incentives worked.<\/p>\n

Clark also praised the Air Force\u2019s contracting approach.<\/p>\n

\u201cThat\u2019s obviously partly a function of Northrop Grumman\u2019s superior execution, but it\u2019s also a function of the contracting in a way that\u2019s sustainable for the company,\u201d he said.<\/p>\n

But Thompson, the defense analyst, said rockier roads could lie ahead for Northrop in the production phase. Several times last year, the contractor\u2019s chief executive, Kathy Warden, cautioned investors it\u2019s unlikely the B-21 will initially turn a profit, and that Northrop could lose up to $1.2 billion on the low-rate initial production contract.<\/p>\n

In January 2023, Warden attributed the rising cost estimates for the low-rate initial production contract to \u201cunprecedented\u201d inflation, supply chain disruptions and labor issues. However, she expressed confidence the B-21 would keep driving future growth for Northrop.<\/p>\n

But Thompson said inflation isn\u2019t the entire story here, as Northrop had bid aggressively to win the coveted and highly advanced bomber contract.<\/p>\n

Northrop \u201cactually underbid an aggressive proposal from Boeing and Lockheed,\u201d Thompson said. Now \u201cthey\u2019re concerned about how little money they may make on production. The way they presented this publicly is, \u2018Oh, we forgot to put an inflation clause in the contract.\u2019 And maybe that\u2019s close to it, but when you have a very challenging concept for a future program and you bid fixed price, it\u2019s a crapshoot.\u201d<\/p>\n

The Air Force\u2019s $1.2 billion deal in March for Boeing to start rapid prototyping of the E-7A battle management aircraft took a different approach. That deal uses the cost-plus structure, the Air Force said.<\/p>\n

\n

An artist\u2019s rendering shows the U.S. Defense Department\u2019s planned E-7A battle management aircraft. (Staff Sgt. Nicolas Erwin\/U.S. Air Force) <\/span><\/p>\n<\/figcaption><\/figure>\n

In a statement to Defense News, the Air Force said it chose that approach to balance the risk between the service and Boeing, and because of modifications the American version of the E-7 will require.<\/p>\n

The Air Force\u2019s E-7 will be based on the configuration Boeing is already making for the United Kingdom, the service said, but its design will be tweaked to meet the United States\u2019 standards for satellite communication, military GPS, and cybersecurity and program protection requirements.<\/p>\n

The Air Force\u2019s use of a cost-plus contract for E-7s, which will replace its aging and retiring E-3 Sentry fleet, makes sense because of the modifications, Clark and Thompson said. Australia also flies the E-7, which it dubbed Wedgetail, but its version too differs in several ways from the American one.<\/p>\n

\u201cThis is not going to be a vanilla Wedgetail,\u201d Thompson said. \u201cWedgetail has been flying a long time, and it\u2019s a sole source for Boeing. From the Air Force\u2019s point of view, those two facts make \u2026 going fixed price sound more reasonable. But I think that underestimates how much uncertainty there is in the integration and future evolution of the airframe.\u201d<\/p>\n

If the Air Force conducts rigorous oversight on the E-7\u2032s prototyping, Thompson said, the cost-plus structure could give Boeing the flexibility it needs to meet the cost requirements while netting a decent return. And in return, he said, the Air Force could get a better product out of Boeing.<\/p>\n

\u201cWedgetail presents an opportunity to rigorously balance the concerns of the customer with those of the contractor,\u201d Thompson said. \u201cAs long as that [government oversight] happens, giving the contractors a little more flexibility can pay big dividends.\u201d<\/p>\n

Boeing had a stronger hand with which to negotiate, Clark said, since there wasn\u2019t another ideal candidate to replace the older airborne warning and control system aircraft. Boeing was \u201cin a good position and felt like they didn\u2019t need to underbid everyone else,\u201d he added.<\/p>\n

But Thompson said the Air Force\u2019s move to a cost-plus structure for the E-7 may be a sign of lessons learned about the risks that can come with fixed-price contracts.<\/p>\n

\u201cKendall understands acquisition better than anybody else in the [Pentagon\u2019s] E ring,\u201d Thompson said, referring to the building\u2019s outer ring of hallways where many of the military\u2019s most senior leaders have their offices. \u201cAnd I think he has relearned an old lesson: You get what you pay for. You can either pay for it up front or you can pay for it down the road, but at the end, you get what you pay for.\u201d<\/p>\n

\n

Stephen Losey is the air warfare reporter for Defense News. He previously covered leadership and personnel issues at Air Force Times, and the Pentagon, special operations and air warfare at Military.com. He has traveled to the Middle East to cover U.S. Air Force operations.<\/p>\n<\/div>\n