' ~. REPURT TO THE CHAIRMAN, PREPAREDNESS INVESTIGATING "<s ., SUBCOM, ITTTEE, SENATE COMMITTEE ON ARMED SERVICES -/~ ~ ~~.. ~ ~.>:ar. cr ; -. h is kep-t ...... , ' ;ecjior,F~.oications 81-a-lo, OAS Contractual Features And VDo Related Matters In The S-3A Aircraft Program ,.,,,0,, Department of the Navy FlI.E COPY - COMP EE BY THE COMPTROLLER GENERAL J OF THE UNITED STATES O/,'% /M HARCH29,1971 COMPTROLLER GENERAL OF THE UNITED STATES WASHINGTON. D.C. 20548 B-!63058 Dear Mr. Chairman: This is our report on contractual features and related matters in the Navy's S-3A aircraft program. Our review was made in response to your request dated July 9, 1970. The significant contents of the report are summarized in the digest which is bound in the report. During the course of our review we provided copies of our report draft to representatives of the Department of Defense and the Department of the Navy for review and discussion. We did not submit the report to officials of the Department of Defense for written comments. We plan to make no further distribution of this re- port unless copies are specifically requested, and then copies will be distributed only after your agreement has been obtained or public amntouncement has been made by you concerning the content s of the report. Sincerely yours, Comptroller General of the United States The Honorable John C. Stennis, Chairman Preparedness Inve stigating Subcommittee Committee on Armed Services United States Senate 50TH ANNIVERSARY 1921- 1971 COMPTROLLER GENERI.L'S CONTRACTUAL FEATURES AND REPORT TO 7HE CHAIRMAN, RELATED MATTERS IN THE PREPAREDNESS INVESTIGATING SUBCOhMMITTEE, S-3A AIRCRAFT PROGRAM SENATE COMITTEE ON ARMED SERVICES Department of the Navy B-163058 DIGEST WHY THE REVIEW WAS AMADE The Chairman of the Preparedness Investigating Subcommittee, Senate Com- mittee on Armed Services, asked the General Accounting Office (GAO) to assist the subcommittee in its analysis of the contractual features of the Navy's program for developing and producing a twin-jet, four-man- crew, carrier-based antisubmarine aircraft, the S-3A. It was suggested that GAO include in its review areas of the structure of the contract, cost and pricing provisions, management controls, and extent of concurrency between development and production; that is, how much production is under way before development of the aircraft is com- pleted. FINDINGS AND CONCLUSIONS Problems of inflexibility Essentially the contract is a "total package procurement," in that de- velopment of the aircraft and its production are tied together in one contract which was awarded after one competition. The contractor is the Lockheed-California Company of the Lockheed Corporation. From a strictly legal standpoint, the contract appears to protect the Government's interests adequately. However, a possible vulnerable feature is that the contract may be tightly drawn in favor of the Government to an unrealistic degree. Un- foreseen technical or financial problems, or both, may prove that to be true. (See p. 10.) Development by its very iature involves uncertainty, and there should be flexibility in the early stages of a development program. That flexi- bility should include appropriate pricing provisions and allowance for alternative approaches, with costs and technical factors being continually assessed by the Government and the contractor. When serious problems come to light in an inflexible contract situation, the attention of both parties tends to shift from the primary goal of Tear Sheet MARCH 29,1971 achieving an acceptable product. The contractor tends to search for ways to acquire additional funds, and the Government tends to concentrate on strict enforcement of the contract. The situation can deteriorate until the highest officials of the Depalt- ment of Defense, the Congress, or ultimately the courts must resolve the matter. By then, the Government is in an untenable position. It still needs the weapon system, and forcing the contractor out of business will not get it. The Government cannot easily begin ain with a new contrac- tor because that could bring prohibitive costs and delay; moreover, it is difficult to transfer technical and engineering knowledge from one con- tractor to another. The only viable course is to introduce flexibility, belatedly, by ignor- ing the original tight contract terms, relaxing specifications realisti- cally, and providing more money to get the job done. Contract structure The S-3A contract was developed in a period of transition between the former Department of Defense (DOD) administration and the present one. It contains features reflecting the procurement policies of both. On the one hand, it combines development and production in a single con- tract, and development is procured on a fixed-price incentive basis. (See p. 16.) On the other hand, it permits the Government to delay the start of various production phases until prescribed goals have been reached in development, or for 6 months, whichever is earlier. (See p. 22.) A full discussion of contractual features is in chapter 2, pages 8 to 42. The optimism that was characteristic of previous major weapon acquisi- tion programs seems to be present in the S-3A program. Department of- ficials have testified that, at the start of any development program, there are "driving forces" that make for a lack of realism and for a sense of optimism. Planners tend to overstate the threat, which means overstated requirements. Technical people, in both industry and Govern- ment, are always optimistic about achieving performance characteristics, the length of time development will take, and cost. The Government wants the weapon system and the contractor wants to produce it, so both have incentive to underestimate costs so that the project will be ap- proved. Evidences of optimistic pricing and a tightly drawn contract include the following facts. --Navy's cost estimate for the development effort was about $45 mil- lion, or 11 percent higher than Lockheed's estimate. (See p. 13.) --Navy's cost estimate for production option lots was $60 million, or 6.5 percent higher than Lockheed's estimate. (See p. 13.) --Lockheed's price for the development effort was some $30 million lower than its competitor, although the Lockheed proposal offered a more sophisticated weapon system. (See p. 13.) 2 --The records of negotiation clearly indicate that the Navy expects Lockheed will experience costs over target on the development work. (See p. 13.) --The basic aspects of the contract structure that impose substantial financial risks on the contractor are: 1. The development portion of the contract is on a fixed-price in- centive basis. In any major weapon system development, there is a significant degree of technical uncertainty. If unexpected technical problems are encountered, the contractor must bear a major portion of the resulting financial burden. 2. The contract provides options for production quantities of air- craft under binding ceiling prices. Under such an arrangement, the contractor is subject to the effect or production of unex- pected development problems. Although the Navy did not obtain more favorable prices from Lockheed during negotiations, it did require certain provisions that had not been mentioned in the request for proposals. These provisions increased Lockheed's financial risks, yet they were accepted at no increase in price. The new provisions included the Variable Quantity Option provi- sion and the Pricing of Changes clause. (See p. 14.) Additionally, Lockheed had predicated its proposal on the inclusion in the contract of a clause providing for abnormal economic inflation ad- justments to each of the production lot option prices. The Government agreed to adjustments for abnormal economic inflation only with respect to the last two option lots. Furthermore, the abnormal inflation cover- age that was agreed to is incomplete. (See pp. 30 to 32.) Management controls The management controls for the S-3A include Navy and contractor project management organizations, a contractor performance measuring and report- ing system, and various techniques for program assessment by top offi- cials of DOD. Generally, the controls appear adequate, if properly ap- plied. Extent of concurrency The extent of planned concurrency between development and production of the S-3A is described in chapter 4, pages 51 to 54.) MATTERS FOR CONSIDERATION BY THE SUBCOMMITTEE Potential problem areas are listed in chapter 5, pages 55 to 59. Some of the more important areas are described below. Tear Shect 3 Possible need for relief for contractor The conservative pricing and tight structuring of the contract may force the contractor to seek relief from the Government in order to continue work. (See pp. 8 to 15.) Potential events that could precipitate such a need and, thus, should be monitored by the Subcommittee, are --an increase in the rate of economic inflation or even a continuance of the present rate for a prolonged time (see p. 55); --the occurrence of major development problems (see p. 55); and --ordering by the Navy of minimum, or near minimum, quantities of the aircraft, as permitted under the production options (see p. 55.) Production decision A decision on whether the S-3A will go into production is scheduled in February or March 1972. That date may be premature and may not allow time for technical data from tests that would be available in a few months more to the decisionmakers. Also, it appears that the decision will be made in an atmosphere where program advocates are overly influ- ential. GAO believes that consideration should be given to conducting an assessment of the S-3A, independent of program management, prior to the production decision. (See p. 56.) Concurrency of dveZopment and production Under the plan to start production before development is completed, there is the real possibility that, after many aircraft are manufactured are needed or in production, tests will show that significant changes have to ensure an effective weapon system. Changes then would to be made to completed or partially completed units and would require sub- stantial additional amounts of time and money. (See p. 57.) Responsibility for total system performance The contract purports to impose total responsibility for performance of the S-3A system on the prime contractor (Lockheed). However, the Navy negotiator states that, under some circumstances, the Government must pay for modifying Government-furnished equipment so that it will be suitable for use in the S-3A. An attorney for the Naval Air Systems Command disagrees. The variance in interpretation indicates that a dispute may arise in that area. (See p. 58.) 4 C o n t e n t s Page DIGEST 1 CHAPTER 1 INTRODUCTION 5 The S-3A mission 5 2 CONTRACTUAL ARRANGEMENTS 8 Contract award background 8 Overall merits of contractual arrange- ments 10 Fixed price development with pro- duction options 12 Conservative pricing 13 Contract description 16 Key contract clauses 17 Clause granting options to pur- chase additional quantities 19 Project milestones 22 Ordering-Date Extension 26 Defects 26 Economic Escalation 30 Pricing of Changes 33 Installment Funding 36 Performance responsibility prime and associate contractor rela- tionships 38 Stop-Work Order 41 Restraint of Competition 41 3 MANAGEMENT CONTROLS 43 Project management organization 43 Performance measurement 43 Other management tools 45 Development Concept Paper 45 Thresholds 46 Defense Systems Acquisition Review Council 48 Independent assessment needed by Defense Systems Acquisition Review Council for production decision 49 CHAPTER Page 4 EXTENT OF CONCURRENCY 51 Areas of primary technical risk 53 5 POTENTIAL, PROBLEMS TO BE MONITORED 55 Possibility of need for extra con- tractual relief 55 Upcoming production decision 56 Concurrency of development and produc- tion 57 Cost threshold for production aircraft 57 Less than total system performance re- sponsibility 58 Possible side effects from the pricing of changes clause 58 Possible side effects from restraint of competition clause 59 6 SCOPE OF ANALYSIS 60 APPENDIX Letter dated July 9, 1970, from Chairman, Preparedness Investigating Subcommittee, Senate Committee on Armed Services 63 ABBREVIATIONS ASPR Armed Services Procurement Regulation AWACS Airborne Warning and Control System DOD Department of Defense GAO General Accounting Office COMPTROLLER GENERAL'S CONTRACTUAL FEATURES AND REPORT TO THE CHAIRMAN, RELATED MATTERS IN THE PREPAREDNESS INVESTIGATING SUBCOMMITTEE, S-3A AIRCRAFT PROGRAM SENATE COMMITTEE ON ARMED SERVICES Department of the Navy B-163058 DIGEST WHY THE REVIEW WAS MADE The Chairman of the Preparedness Investigating Subcommittee, Senate Com- mittee on Armed Services, asked the General Accounting Office (GAO) to assist the subcommittee in its analysis of the contractual features of the Navy's program for developing and producing a twin-jet, four-man- crew, carrier-based antisubmarine aircraft, the S-3A. Itwas suggested that GAO include in its review areas of the structure of the contract, cost and pricing provisions, management controls, and extent of concurrency between development and production; that is,how much production is under way before development of the aircraft is com- pleted. FINDI.,"7'S AND CONCLUSIONS ProbZems of inflexibiZity Essentially the contract is a "total package procurement," in that de- velopment of the aircraft and its production are tied together in one contract which was awarded after one competition. The contractor is the Lockheed-California Company of the Lockheed Corporation. From a strictly legal standpoint, the contract appears to protect the Government's interests adequately. However, a possible vulnerable feature is that the contract may be tightly drawn in favor of the Government to an unrealistic degree. Un- foreseen technical or financial problems, or both, may prove that to be true. (See p. 10.) Development by its very nature involves uncertainty, and there should be flexibility in the early stages of a development program. That flexi- bility should include appropriate pricing provisions and allowance for alternative approaches, with costs and technical factors being continually assessed by the Government and the contractor. When serious problems come to light in an inflexible contract situation, the attention of both parties tends to shift from the primary goal of I achieving an acceptable product. The contractor tends to search for ways to acquire additional funds, arid the Goecrnment tends to concentrate on strict enforcement of the contract. The situation can deteriorate until the highest officials of the Depart- ment of Defense, the Congress, or ultimately the courts must resolve the matter. By then, the Government is in an untenable position. It still needs the weapon system, and forcing the contractor out of business will not get it. The Government cannot easily begin again with a new contrac- tor because that could bring prohibitive costs and delay; moreover, it is difficult to transfer technical and engineering knowledge from one con- tractor to another. The only viable course is to introduce flexibility, belatedly, by ignor- ing the original tight contract terms, relaxing sppcif'cations realisti- cally, and providing more money to get the job done. Contract structure The S-3A contrat was developed in a period of transition between the former Department of Defense (DOD) administration and the present one. It contains features reflecting the procurement policies of both. On the one hand, it combines development and production in a single con- tract, and development is procured on a fixed-price incentive basis. (See p. 16.) On the other hand, it permits the Government to delay the start of various production phases until prescribed goals have been reached in development, or for 6 months, whichever is earlier. (See p. 22.) A full discussion of contractual features is in chapter 2, pages 8 to 42. The optimism that was characteristic of previous major weapon acquisi- tion programs seems to be present in the S-3A program. Department of- ficials have testified that, at the start of any development program, there are "driving forces" that make for a lack of realism and for a sense of optimism. Planners tend to overstate the threat, which means overstated requirements. Technical people, in bot;) industry and Govern- ment, are always optimistic about achieving performance characteristics, the length of time development will take, and cost. The Government wants the weapon system and the contractor wants to produce it, so both have incentive to underestimate costs so that the project will be ap- proved. Evidences of optimistic pricing and a tightly drawn contract include the following facts. --Navy's cost estimate for the development effort was about $45 mil- lion, or 11 percent higher than Lockheed's estimate. (See p. 13.) --Navy's cost estimate for production option lots was $60 million, or 6.5 percent higher than Lockheed's estimate. (See p. 13.) --Lockheed's price for the development effort was some $30 million lower than its competitor, although the Lockheed proposal offered a more sophisticated weapon system. (See p. 13.) 2 --The records of negotiation clearly indicate that the Navy expects Lockheed will experience costs over target on the development work. (See p. 13.) --The basic aspects of the contract structure that impose substantial financial risks on the contractor are: 1.The development portion of the contract is on a fixed-price in- centive basis. Inany major weapon system development, there is a significant degree of technical uncertainty. Ifunexpected technical problems are encountered, the contractor must bear a major portion of the resulting financial burden. 2.The contract provides options for production quantities of air- craft under binding ceiling prices. Under such an arrangement, the contractor is subject to the effect on production of unex- pected development problems. Although the Navy did not obtain more favorable prices from Lockheed during negotiations, it did require certain provisions that had not been mentioned in the request for proposals. These provisions increased Lockheed's financial risks, yet they were accepted at no increase in price. The new provisions included the Variable Quantity Option provi- sion and the Pricing of Changes clause. (See p. 14.) Additionally, Lockheed had predicated its proposal on the inclusion in the contract of a clause providing for abnormal economic inflation ad- justments to each of the production lot option prices. The Government agreed to adjustments for abnormal economic inflation only with respect to the last two option lots. Furthermore, the abnormal inflation cover- age that was agreed to is incomplete. (See pp. 30 to 32.) Management controls The management controls for the S-3A include Navy and contractor project management organizations, a contractor performance measuring and report- ing system, and various techniques for program assessment by top offi- cials of DOD. Generally, the controls appear adequate, ifproperly ap- plied. Entent of concurrency The extent of planned concurrency between development and production of the S-3A is described inchapter 4, pages 51 to 54.) MATTERS FOR CONSIDERATION BY THE SUBCOMMITTEE Potential problem areas are listed inchapter 5, pages 55 to 59. Some of the more important areas are described below. 3 Possible need for relief for contractor The conservative pricing and tight structuring of the contract may force Government in order to continue the contractor to seek relief from theevents work. (See pp. 8 to 15.) Potential that could precipitate such a need and, tlhus, should be monitored by the Subcommittee, are --an increase in the rate of economic inflation or even a continuance of the present rate for a prolonged time (see p. 55); --the occurrence of major development problems (see p. 55); and --ordering by the Navy of minimunl, or near minimum, quantities of the aircraft, as permitted under the production options (see p. 55.) Production decision A decision on whether the S-3A will go into production is scheduled in February or March 1972. That date may be premature and may not allow be available time for technical data from tests that would appears in a few months more to the decisionmakers. Also, it that the decision will be made in an atmosphere where program advocates are overly influ- ential. GAO believes that consideration should be given to conducting an assessment of the S-3A, independent of program management, prior to the production decision. (See p. 56.) Concurrency of deVel opment and production Under the plan to start production before development is completed, there is the real possibility that, after many aircraft are manufactured are needed or in production, tests will show that significant changes have to ensure an effective weapon system. Changes then would to be made to completed or partially completed units and would rr'uire sub- stantial additional amounts of time and money. (See p. 57 Responsibility for total system performance The contract purports to impose total responsibility for performance of the S-3A system on the prime contractor (Lockheed). However, the mustNavy negotiator states that. under some circumstances, the Government that it will be pay for modifying Government-furnished equipmenttheso Naval suitable for use in the S-3A. An attorney for Air Systems Command disagrees. The variance in interpretation indicates that a dispute may arise in that area. (See p, 58.) 4 CHAPTER 1 INTRODUCTION ihne General Accounting Office has performed an analysis o. the Department of the Navy contract for development and Prroduction of the S-3A aircraft weapon system. Our analysis was performed in response to the request dated July 9, 1970, from the Chairman, Preparedness Investigating Subcommittee, Committee on Armed Services, United States Senate. (See app. I.) In the same request, the Chairman also requested a similar analysis of the Department of the Air Force con- tract for development and production of the Airborne Warn- ing and Control System (AWACS). The AWACS analysis is the subject of a separate report. The Chairman expressed an interest in our opinions on the merits of the management and contractual aspects of the S-3A program and any potential problem areas that should be monitored. The Chairman wanted our analyses to include the areas of contractual structure, cost and pricing provisions, management controls and the extent of concurrency between development and production in the S-3A program. THE S-3A MISSION The mission of the S-3A is antisubmarine warfare: to seek and destroy hostile submarines. The S-3A is a twin- jet engine aircraft with a four-man crew, designed to oper-- ate from an aircraft carrier. The jet engines will be the newly developed TF-34-2 General Electric high-bypass turbo- fan engines developing about 9,000 pounds of thrust each. The heart of the S-3A weapon system will be its highly sophisticated and complex avionics (aviation electronics) subsystems. For example, one of the key avionics subsystems is the Univac general-purpose digital computer. This com- puter will do such things as preflight checkout of other subsystems, navigational computations, tactical data process- ing, acoustic contacts classification, and weapon trajecto- ries calculation and will indicate when one of the subsystems is malfunctioning. 5 We have included En illustration of the S-3A in order to describe the overall physical dimensions of the aircraft and point out such features as the folded wings and tail that are characteristic of carrier-based aircraft. (See fig. 1, p. 7.) 6 'VsE ' __ __ I &L 7 gg~~~~ U.~~~~~~~ 0) S~~~~~rmIDN~~t Sn ,m3%gm,.. 4 _~~~~~~~~~~~j Qomoe I *~~~ us c~~~ c: c: EL(~~~~~~~~ LL LL LL~~~~ CHAPTER 2 CONTRACTUAL ARRANGEMENTS CONTRACT AWARD BACKGROUND In late December 1967 the Navy issued requests for pro- posals to the aircraft industry. Five major defense con- tractors responded. Two of these contractors, the Convair Division of General Dynamics and the Lockheed-California Company of the Lockheed Corporation, were awarded contracts for contract definition in August 1968 and were requested to submit firm cost and technical proposals for engineering development and production of the S-3A. In August 1969 Lockheed was declared the winner of the competition and was awarded a fixed-price incentive contract for the engineering development of the S-3A and for six re- search and development aircraft at a ceiling price of $461 million. The contract also includes five options for additional aircraft. The first option lot (contract lot II) for two additional research and development aircraft was exercised on October 1, 1970. The other four options are for production aircraft. The contract was originally structured so that eight research and development aircraft were included in a single lot. However, for funding reasons, two of the research and development aircraft were placed in a second lot before con- tract award, with six aircraft remaining in lot I. The S-3A weapon system contract was the result of in- tensive competition during the contract definition phase. In 1969, which has been labeled by the financial community as a disaster year for the aerospace industry, the compe- tition was intensive because both contractors were seeking the award of a contract for development and production of the S-3A weapon system valued at about $1.7 billion. In a procurement environment such as this, the Govern- ment has considerable bargaining power in establishing con- trac't terms and conditions. Each contender tends to acqui- esce to the Government's conditions for fear that the other 8 contractor will accept and that this will result in the loss of the multibillion-dollar procurement prize to the reluc- tant contractor. The Government and defense contractors are well aware of the hazards of this procurement system. Both competitors for the S-3A program had encountered sig- nificant problems on prior Government programs: General Dynamics with its F-lll program and Lockheed with its C-5A transport, AH-56A Cheyenne helicopter, and Short Range At- tack Missile motor programs. The optimism that has characterized prior major weapon acquisition programs also seems to be present in the S-3A program. At congressional hearings DOD officials have tes- tified that, at the beginning of any new development pro- gram, there are "driving forces" which make for a lack of realism and a sense of optimism. Planners tend to overstate the threat, which means overstated requirements. Then the technical people, both in industry and in Government, are always optimistic about the performance characteristics they can achieve, how long the development will take, and what it will cost. The user wants the new weapon system and the contractor wants to produce it, so both have a great incen- tive to underestimate the cost so that the project will be approved. 9 OVERALL MERITS OF CONTRACTUAL ARRANGEMENTS From a strictly legal point of view, we are of the opin- ion that the S-3A contractual instrument adequately protects the interest of the Government in that, except for the mat- ter discussed on page 38, there are no obvious "loopholes" or ambiguities providing an opportunity for the contractor to evade the apparent intent of the contract clauses. It is our opinion that, if the S-3A contract does contain a vul- nerable feature, it is the possibility that unforeseen tech- nical and/or financial problems may prove that the contract is too tightly drawn in favor of the Government. The ultimate purpose of a contractual instrument is to define the rights and duties of the respective parties and, at least in Government contracts, to equitably allocate the financial risks to be assumed by the parties. A contract which places undue risk on the contractor--either by means of contract type or by means of too tightly drawn risk- allocating clauses--may fail because it will not allow deliv- ery of an acceptable product within contractual limitations. The result of such a contract is that the Government pays more than the contractual price for the end product and possibly more than the price for which the end product could have been secured had a more realistic contract orig- inally been entered into. Thus, the recent proposed "re- structuring" of the C-5A contract into a "fixed loss" con- tract, in effect, ignores the terms of the original contract document to allow delivery of an acceptable end product. While the financial pressure forcing such restructuring stems, in part, from the reduced levels of both defense and commercial business, the pressure may also be said to stem, at least in part, from overburdensome contracts. The apparent economy of a tightly drawn, tightly priced contract, therefore, may be illusory because the total cost to the Government may exceed the contractually stated amounts by the amount necessary to deliver acceptable end-items to the Government in the event extracontractual relief is agreed upon. Further, the efficiency of the contractor and, therefore, the interests of the Government, may decrease to a marked extent as contractor officials direct their atten- tion to the problem of searching out ways to acquire addi- tional funds, either by claims or changes within the 10 contract scope or by building a case for extracontractual assistance outside its scope. This management concentration on contractual concerns, as opposed to the more important concern of developing and producing an acceptable product, can also spread to Government management as more emphasis is placed on holding the contractor strictly to his contract rather than on using reason and judgment to arrive at equi- table solutions to problems. As indicated in the previous section, the S-3A contract was negotiated in a highly competitive atmosphere. The re- sult was that the contractor made concessions to the Govern- ment which otherwise might have been resisted. The S-3A contract, at least on paper, is a "tough" one, preservi;-,; to the Government the right to require performance within contractual cost constraints. The problem of "buy in"--the quoting of overoptimistic cost, schedule, and performance estimates with the hope of recouping during performance by means of changes--appears to have been prevented by the use of the modified-total-package-contract type requiring cost ceilings for development and production and the inclusion of a Pricing of Changes clause designed to control contractor- initiated changes. It remains to be seen, however, whether cost estimates made under the pressure of strong competition for Govern- ment business together with contractual terms barring later recoupment will become problems in the S-3A contract. Lock- heed has indicated confidence in its cost figures and its ability to meet schedule and performance requirements while remaining under ceiling. However, the conservative nature of Lockheed's cost proposal, the use of a fixed-price incen- tive features for the development portion of a contract call- ing for inclusion of a sophisticated avionics package in a carrier-based airplane, the options for production quantities of aircraft under binding ceiling prices, and the failure to provide for adjustment in the case of abnormal escalation in the economy until the 5th contract year, could all combine with Lockheed's already precarious financial condition to create a situation where extracontractual assistance may be necessary to allow completion of the contract. (Lockheed's financial report shows a net loss, after taxes, of $32.6 mil- lion in 1969. Final settlement with DOD to limit its losses under the C-5A and Cheyenne programs is still pending.) 11 We emphasize that we do not anticipate that this will be the case. However, it is our opinion that, if the contract becomes a problem in the S-3A procurement, it will be be- cause of the contract's tightness rather than its looseness. Fixed price development with production options In our opinion experience has shown that the use of fixed-price development contracts with binding production options, total package procurement, is generally inad- visable in a major weapon system procurement because of the risk that contractually imposed inflexibility will bring about contract failure if major development problems arise or if the contract is too tightly priced. The current phi- losophy within DOD is that development contracts should be on a cost-type basis as opposed to a fixed-price basis be- cause of the increased flexibility provided by the cost type. Additionally, recent pronouncements by top officials of DOD indicate that development and production of future weapon systems may be contracted for separately rather than purchased by so-called total package or modified total package con- tracts; in fact, the most recent major weapon system to go into engineering development, the B-1 bomber, contains no production options. The structuring of the S-3A contract took place before DOD established the policies described above. With the ex- ception of the clause providing that production options are to be slipped until certain development milestones have been passed or for 6 months, whichever is earlier, the S-3A contract generally reflects the procurement policies and practices which were in effect throughout most of the 1960's. In our opinion, if the development risk has been deter- mined to be sufficiently low and pricing is realistic, no impediment exists to the use of a fixed-price development contract or for that matter to the inclusion of development work with binding production options in a single contract. The Navy chose to use a fixed-price development con- tract with binding production options for the S-3A because, in the Navy's engineering judgment, the development risk in- volved was sufficiently low to ensure development within contractually required targets and/or ceilings. Our visits to Lockheed, to major subcontractors, and to the Naval 12 Development Test Center, Warminster, Permsylvania, disclosed no major development problems. We cannot conclude, there- fore, that the determination to use a fixed-price develop- ment contract with binding production options in the S-3A program was not a proper exercise of the discretion vested in the Navy contracting officials. Conservative pricing However, as indicated earlier, several interrelated factors including, but not limited to, the use of a fixed- price development contract with binding production options could, under certain circumstances, combine to result in contract failure. A review of the records of negotiations indicates that the prices accepted by Lockheed in the S-3A competition may actually have been so conservative as to lead to the possibility that, under adverse conditions, the contract ceilings could be breached. This view is supported by the fact that the Navy's in- dependent cost estimate for S-3A research and development (lot I, which at that time consisted of eight research and development aircraft) was some $45 million, or 11 percent, higher than the cost initially proposed by Lockheed. Fur- ther, Lockheed's price for this work was some $30 million lower than its competitor's although, according to negoti- ation records, the Lockheed proposal, technically speaking, called for a more sophisticated weapon system than its com- petitor. Finally, the Navy's cost estimate for lots II through V was some $60 million, or 6.5 percent, higher than Lockheed's cost estimate. The Headquarters, Naval Material Command, approval of the Request for Authority to Contract for the S-3A program stated, with respect to the conserva- tive nature of the Lockheed proposal, that, in view of the admitted probability that Lockheed would exceed target and possibly even reach ceiling on lots I and II, "it would be prudent, in this case, to budget on some other basis than target price" (the usual budget base). Also, the Request for Authority to Contract stated that Lockheed's assumption of a 70:30 cost-sharing ratio in the development portion of the contract (whereby Lockheed pays 30 percent of all costs over target up to ceiling), coupled with its conservative lot I estimate and its agreement to be bound by variable op- tion quantity production ceiling indicated, "a willingness to 13 assume considerably more cost risk than is ordinarily asso- ciated with fixed-price incentive contracts." Although the Navy made no attempt during negotiations to obtain more favorable prices from Lockheed, it did re- quire the contractor to accept certain provisions in the contract which had not been mentioned in the request for proposals. Although these provisions increased the con- tractor's financial risks under the contract, they were accepted by the contractor at no increase in price. The new provisions included the Variable Quantity Option provision and the Pricing of Changes clause. Additionally, Lockheed had predicated its proposal on the inclusion in the contract of a clause providing for adjustments to each of the production lot option prices for abnormal economic inflation. The Government, however, would agree to adjustments for abnormal economic inflation only with respect to the last two option lots, thus the prices of lots I through IV were left unprotected from abnormal infla- tion. Since negotiation of the contract, inflation has increased at a rate significantly in excess of that antic- ipated by either party. Although both the Navy and Lockheed have expressed confidence that ceilings through lot IV will not be exceeded in spite of the abnormal inflation experi- ence, the absorption of the unanticipated inflation within the unescalated ceilings obviously reduces the cost flexi- bility originally contemplated by the choice of a 130-per- cent ceiling. Finally, in April 1969, after negotiations had been completed but before the contract was awarded, the Director of Defense Research and Engineering was briefed on the re- sults of negotiations. At this meeting the Director stated his belief that the Navy should require that the contract include provisions for delay of production options until such time as major development milestones had been met. The Deputy Secretary of Defense subsequently agreed with this recommendation. The Navy then reopened negotiations and included the Project Milestones clause in the contract. Lockheed accepted inclusion of this clause at no increase 14 in price, although contractor financial risk was increased. It was agreed to include, in addition to the Project Mile- stone clause, a 6-months extension of the schedule for the research and development portion of the contract in order to render milestone accomplishments, particularly the avi- onics portion of the contract, less risky. This schedule stretch-out somewhat balances the increased financial risk represented by the milestone requirement. Is CONTRACT DESCRIPTION The S-3A prime contract continues the practice followed in recent major weapon system acquisitions of obtaining bind- ing production commitments at the same time development is contracted for. This practice was designed to obtain compe- tition in the pricing of both the development and production portions of the required effort. This feature is the most important element of the so-called total package procurement concept. The S-3A program was the next aircraft program in DOD to go into full-scale development following the F-14 program. Due to this proximity and to the fact that the F-14 is a Navy program, the F-14 contract served as the chief example for the Navy in structuring the S-3A contract. In most re- spects the two contracts are very much alike. Important differences are noted in following sections of this report. The S-3A contract with Lockheed is a fixed-price incen- tive contract. The initial phase of the contract (lots I and II) provides for design, development, and testing, and the furnishing of weapon system data and eight S-3A research and development aircraft at a target cost of $371.2 million, a target profit of $44.6 million or 12 percent of target cost, and a ceiling price of $482.6 million, or 130 percent of target cost. These target and ceiling prices reflect the movement of certain work from lot II to lot III and contract changes through November 29, 1970. Under the fixed-price incentive formula, the contractor is to receive 30 percent of the amount by which his costs underrun target costs and pay 30 percent of the amount by which his costs exceed the target cost. The Government receives or pays 70 percent of the amount of costs under or over target cost, as applicable. In a fixed-price incentive contract, the margin between tar- get and ceiling prices and the cost-sharing ratio are the two most important individual factors in the contract in al- locating risks between the contractor and the Government. The pricing features of the research and development portion of the S-3A contract are similar to those of the F-14 contract, except that the latter contract provides for a target profit of 10 percent and a price ceiling of 125 per- cent. 16 Unlike the F-14 contract, the S-3A contract provides for cost incentives only; that is, no provision is made for profit incentives based on demonstrated weapon system per- formance. The contract, however, does have a negative in- centive against the late delivery of the four aircraft sched- uled for the Navy's Board of Inspection and Survey tests (the first four aircraft in lot III). The contract provides that specified liquidated damages will be assessed against the contractor for each day each of the four aircraft is de- livered late up to a maximum of $3 million for all aircraft. The S-3A contract includes options for production air- craft in addition to the research and development efforts under lots I and II. These options are discussed in consid- erable detail under a separate heading. Progress payments will be made at the rate of 80 per- cent of the contractor's total costs incurred under the con- tract; however, the aggregate amount of progress payments may not exceed 71.5 percent of the total contract price. Research and development, in contrast to production, involves the delivery of relatively little hardware which could be billed to the Government as deliveries are made. Therefore, the S-3A contract provides that partial payments will be made for research and development effort (excluding lot II effort) on the basis of satisfactory accomplishment of specified events. KEY CONTRACT CLAUSES This section of the report is devoted to evaluation of the clauses and provisions of the S-3A contract, which ap- pear, in our judgment, to be most noteworthy. Most of these clauses are considered particularly important because they seek (as do the ceiling price margin and the cost-sharing ratio which were mentioned previously) to allocate the finan- cial risks of unexpected events in performance of the con- tract between the contractor and the Government. One clause, the Project Milestone clause, was selected because of the importance attached to it by to, officials in DOD. The S-3A marks the first use of this clause in a de- fense weapon contract. 17 The Restraint of Competition clause is discussed since it represents an attempt to avoid some of the past problems in subsequent purchases of spare parts and assemblies di- rectly from actual manufacturers rather than through the prime contractor. This clause is relatively new and has been used previously in only two or three defense contracts. 18 Cle.a e granting options to purchase additional quantities In addition to lots I and II, which cover research and development and the furnishing of eight developmental air- planes, the contract contains four options for production lots of aircraft. (See schedule below.) The option for the first production lot must be exercised by April 1, 1972, if the milestones have been successfully demonstrated. (See p. 23.) Schedule of Production Lot Options Ceiling prices Range of for quantities median rquantities Option Lots Minimum Maximum Quantity Ceiling price date III 7 26 17a $ 265,648,566 4-1-72 IV 23 92 52a 379,221,527 2-1-73 V 30 92 60 381,503,819 11-1-73 VI 30 92 62 383,243,983 10-1-74 90 302 191 $1,409,617,895 aCurrent plans indicate that four aircraft will be shifted from lot III to lot IV. Lots I and II are to be considered together for final pricing with the ceiling prices added together for this purpose. The price of each production lot option (lots III through VI) will be negotiated separately on a fixed-price or fixed-price incentive basis at the choice of the Govern- ment. The ceiling prices for the production lot options are contingent upon authorization of long-lead-time funding in accordance with a schedule set out in the contract. Long- lead-time funding is required to enable the contractor to begin production of components which take exceptionally long periods of time to produce. Failure to provide full and timely long-lead-time funding entitles the contractor to an adjustment in ceiling prices and delivery terms, as may be appropriate. 19 The contract provides that prices for the production However, lot options may not exceed the ceiling prices. as a result of the ceiling prices may be equitably adjusted as permitted change orders and contract modifications or such as under various contractual clauses or provisions, the the funding-delay adjustment mentioned above. Perhaps for ad- best example of such a clause is the one providing p. 30.) justments for abnormal economic escalati3n. (See Variable quantity option provision lot The number of aircraft in each production option or minus. For can be varied about 50 percent, either plus to order example, on lot III the Gocszunent has the right from seven to 26 aircraft. This is known as the variable prices have been estab- quantity option provision. Ceiling of air- lished in the contract for the varying quantities The unit craft which may be ordered under each option lot. or decrease price of each aircraft in the lot will increase quan- depending on the quantity ordered; that is, smaller quantities tities will mean higher unit prices and greater schedule is will mean lower ones. The prescribed delivery set also subject to adjustment in accordance with guidance forth in the contract. Gov- The variable quantity option provision allows the the con- ernment a considerable degree of flexibility under is not as tract. For example, if progress in development than the good as desired, the Government could order fewer alterna- medianquantitiesunder the option lots. The same by are imposed tive would be useful if funding constraints the Secretary of Defense or by the Congress. Extracon- the apparent tractual considerations, however, may reduce review of the flexibility provided by this provision. In our indi- F-14 aircraft program for the Subcommittee, we found tnder cations that, if the minimum lot quantities permitted find it that contract were ordered, the contractor might from necessary to seek extracontractual financial relief the Government. In connection with the S-3A program, Lockheed offi- cials have informed us that two of its major subcontractors simi- will not accept a variable quantity option provision the parties lar to the one contained in the prime contract; 20 are still negotiating this matter, however. Specifically, these subcontractors will not accept a subcontract which allows orders for less than the median quantities of the options as set out in the prime contract. This situation :onceivably could result in substantial losses to the prime contractor if the Government chose to exercise the produc- tion option lots in the minimum or near minimum quantities. Acceptance of design deficiencies The contract contains specific provisions concerning production aircraft in the event that the Government chooses not to require correction of a design deficiency following Navy acceptance tests (Board of Inspection and Survey trials) but, instead, desires to continue procuring the aircraft. The applicable specifications for all aircraft to be deliv- ered in the future will be changed to reflect the perfor- mance attained during the tests. The price of all aircraft on order, both delivered and undelivered, will be adjusted in accordance with the Inspection and the Defects clauses to reflect the design deficiency. The ceiling price of air- craft on option but not yet ordered will not be adjusted, the rationale apparently being that the design deficiency will be a factor in negotiating the firm price or firm target prices for the option lots when the options are exercised. On the other hand, if the Government chooses not to re- quire correction of a deficiency in delivered aircraft but to require its correction in all others, the specifications will remain unchanged. The nonrecurring cost of correcting the deficiency in all lots will be charged to lot I, and a downward equitable adjustment will be made in the price of those aircraft in which the correction is not required. The provisions discussed here concerning the treatment of design deficiencies are of interest primarily because they frankly suggest the possibility that the Government may choose to accept an S-3A system with less performance capability than that specified in the contract. The same provisions were used in the F-14 contract. The Navy advised us that use of such provisions in that contract was consid- ered realistic since the Government generally had accepted less performance capability in major weapon systems than initially specified. 21 Project milestones The S-3A program is the first major weapon system pro- gram to provide, by contract, strong Government remedies for the contractor's failure to meet specified development milestones (also variously called risk assessment milestones, project milestones, progress milestones, etc.). This fea- ture requires that, until the contractor demonstrates that development of the system has passed specified technical milestones, the Government may delay the actions it must take, such as allotment of funds and the exercising of op- tions for additional aircraft. No ordering date can be ex- tended more than 6 months, however, without loss of that option as well as future options. The development mile- stone provision represents an attempt to avoid the adverse situations associated with entering production before sig- nificant problems of development are solved. The development milestone feature subsequently has been included, in one form or another, in the following de- fense contracts for major weapon systems: Airborne Warning and Control System (AWACS), the F-15, the B-l, the AN/TPQ-27 ground-directed bombing system, and the AN/TPN-19 landing control system. Top officials of DOD have indicated that milestones will be included in all future major weapon system develop- ment contracts in which substantial degrees of development risk are present. A special study group established by the Deputy Assistant Secretary of Defense (Procurement) recently completed a review of development milestones as related to defense contracting. The group's recommendations for Armed Services Procurement Regulation (ASPR) coverage of mile- stones was communicated to the ASPR Committee. TLe proposed coverage is confined mainly to broad, policy-type discus- sion and provides flexibility to Government procurement of- ficials in devising milestones for particular contracts. We believe that the milestone provision, in appropriate cases, should be a useful device in helping the Government avoid committing large sums of money to production before major development problems are solved. The success of this new feature, in those cases where it has been used, can 22 only be determined by experience. Sufficient time has not -yet elapsed to permit such a determination. Top officials of DOD have recently announced changes in procedures for acquiring major weapon systems which, in our opinion, will greatly reduce the need for development milestone provisions in contracts. The important changes in this regard involve acquisition of a weapon system under separate development and production contracts and using a cost-type rather than a fixed-price-type contract for de- velopment where significant development risk is present. The most recent major aircraft weapon system to go into en- gineering development, the B-1 bomber, reflected these changes. The best application of the milestone concept in con- tracts appears to be where both development and production are covered under one contractual effort (i.e., total pack- age procurements). In contracts of this type, exercise of production options can be made dependent upon meeting the milestone development events. Development milestones are established by the B-1 contract; however, the contrac- tor's failure to meet these milestones results only in a lessened award fee. The use of a milestone provision in a contract for de- velopment only, seems even less useful if the contract is on a cost-type basis. This is because the Government bears essentially all financial risks under a cost-type contract, thus no strong penalties can be put into such a contract to motivate the contractor to meet the designated milestones. Milestones in the S-3A contract Five development milestones are provided for in the S-3A contract. The first two milestones, 1 and 2, are re- quired to be demonstrated on or before March 15, 1972, as a prerequisite to ordering production lot III by April 1, 1972. The critical antisubmarine warfare avionics data processing, control, and displays nrust be successfully in- tegrated in the laboratory for milestone 1. This means that critical avionic subsystems must be able to intercon- nect and to "talk to one another." It means also that, with a given laboratory signal input, the proper computer 23 actions must take place, data must properly interchange be- tween the various pieces of avionic equipment, and the proper information must be displayed on the televisionlike screens. Although this is an important demonstration, it does not guarantee that these critical avionic units will perform in the same manner outside the carefully con- trolled laboratory environment. Milestone 2 is a 30-minute first flight of the S-3A (the airframe and engines without avionics) to demonstrate the aircraft's ability to fly. The significance of these milestones is that the most risky elements of the avionic system will have been con-, figured and integrated to the point where they successfully meet mission requirements at least in the laboratory and that the engine and airframe have progressed to a point where all preflight requirements have been met and safe operation of the airframe and engine together are possible. The second two milestones, 3 and 4, are required to be demonstrated on or before January 15, 1973, as a prerequi- site to ordering production lot IV by February 1, 1973. Milestone 3 is an evaluation of the flying qualities and performance and a demonstration that the airframe and engine will fly within the design flight envelope; i.e., speed, altitude, loiter capability, fuel consumption, maneuver- ability, etc. Milestone 4 is an assessment of the avionics performance during the flight test program which utilizes a P-3 aircraft as a flying laboratory. It should be noted that these milestone events separately assess the flying qualities of the S-3A as an air vehicle and the performance of its avionics in the detection of submarines and in with- standing a typical flight environment. The fifth and final milestone is the delivery of S-3A aircraft configured for the Board of Inspection and Survey. This delivery is scheduled on or before October 15, 1973, as the prerequisite to the Navy's exercise of the option for 60 additional S-3A aircraft in lot V by November 1, 1973. It should be noted that this delivery is only the start of a series of Navy tests and evaluations culminating in the formal acceptance of the S-3A. This apparent concurrency risk should be tempered by the fact that, prior to Octo- ber 15, 1973, the Navy is planning to conduct a series of five preliminary evaluations to monitor and verify the 24 progress of Lockheed's flight test program on the original eight developmental S-3A aircraft. The purpose of these Navy preliminary evaluations is to provide assurance that the first four production air- craft are indeed ready for Board of Inspection and Survey trials. In recent years, the Navy has been modifying its development approach to place additional emphasis on the preliminary evaluations. The Board of Inspection and Sur- vey testing, which in itself requires the existence of pro- duction aircraft, is not a high-risk element in the complete evaluation sequence. 25 Ordering-Date Extension S-3A In addition to the Project Milestone clauise the sim- contract contains another new clause which is somewhat Exercising ilar in that it permits the Government to delay production options. This clause, called the Ordering-Date may unilaterally Extension clause, states that the Government aircraft for extend the ordering date for an optional lot of a reason other than one which would entitle it to such an clause. The maximum extension under the Project Milestone this clause is amount of time a date may be extended under to the 4 months. Little, if any, financial risk accrues must con- contractor due to this clause since the Government the option tinue to fund the contractor's progress during are slip. Contract prices or other terms of the contract under date not affected as a result of extending an ordering this clause. us that A DOD official acquainted with this clause told against it was included in the S-3A contract as protection The delay in the passage of a DOD appropriation bill. for funds to clause would serve to allow 4 additional months A similar become available to permit exercise of an option. That clause is included in the Air Force AWACS contract.4, months clause, however, allows a slip of 14, rather than lot. and applies only to the first production option Defects is The Defects clause contained in the S-3A contract in the the Navy essentially the same as the clause used by liability F-14 contract and is designed to extend contractor or for failure to for defects in workmanship or material acceptance. meet specifications beyond the time of Government tied to the Because the exercise of production options is not trials, completion of Navy Board of Irspection and Survey will be ac- the likelihood exists that production aircraft these cepted before these trials are completed. Since correc- trials can be expected to pinpoint defects requiringright to tion, the Defects clause extends the Government's last aircraft correction for either 1 year from the date the the date is accepted for Navy Board trials or 2 years from is earlier. the first such aircraft is accepted, whichever equitable Alternatively, the clause provides for downward 26 adjustment in contract price should the Government elect to accept defective or nonconforming supplies without correc- tion, during the warranty period. The clause disclaims any implied warranties of merchant- ability or fitness for a particular purpose and, in a de- parture from the standard ASPR Inspection clause, limits the Government's right to correction of latent defects (those not evident upon proper inspection), with regard to all but the first six research and development aircraft, to the same periods stated above for patent, or obvious, defects. Finally, the Defects clause states that the contrac- tor's liability, "for the destruction of or damage to an aircraft resulting from an accident proximately caused by a breach of the warranty," shall be limited to $100,000 for each occurrence. In return, the contractor warrants that no charge for insurance is included in the contract price for such damage. Although costs incurred for correction of defects are allowable for purposes of determining final contract price, no adjustments for correction of defects are permitted by the clause in target cost, target fee, or ceiling price nor is any adjustment permitted for defect correction after a final contract price is established. The purpose of the Defects clause is to provide the Government with time beyond acceptance to discover and re- quire the correction of defects and, at the same time, to provide assurance to the contractor that his liability will not extend beyond that explicitly set out in the contract. The limitation of potential contractor liability under warranty is an important consideration from the Government's viewpoint because it is designed to eliminate the inclusion of contingency amounts, either hidden or identified as such, in contractor proposals, particularly in areas where there is little likelihood that the Government would or could en- force contractual rights to correction or replacement. For example, in its request to the ASPR Committee for a blanket deviation from the ASPR requirement of unlimited 27 liability for latent defects, the Navy pointed out that, al- though contractors could justifiably be expected to include "substantial price increases" to cover unlimited latent de- fect liability, little likelihood existed that the Govern- ment would derive any benefit from such extended liability because of the probability that most latent defects would be discovered before the expiration of the warranty period and therefore be correctable and because of the difficulty of establishing that a defect discovered after the warranty pe- riod is, in fact, latent. Contractors have stated that in the past it has not been the practice of the Government to require contractor liability for poximate damages and that as a result contrac- tors have generally not insured against such liability nor have they included contingency amounts in their contract prices to cover such potential loss. However, the question of whether the Government should enforce proximate damage liability has been raised recently and has been brought to a head by a pending lawsuit in which it is contended that a Government prime contractor and a subcontractor are jointly liable for the value of an aircraft lost as a result of the malfunction of an inexpensive component part. The consensus of both Government and industry opinion seems to be that contractors--particularly relatively small subcontractors--should not be exposed to the potentially cat- astrophic financial loss which the loss of an aircraft or other proximate damage would impose on them and that such potential loss cannot be economically insured against. They feel that the Government should, therefore, be a self- insurer in this area. While the subject was being considered by the ASPR Committee, no regulation had been issued and the $100,000 limitation in the S-3A Defects clause appears to be a fair resolution of the problem. Although the warranty rights reserved to the Government by the Defects clause confer a potentially valuable benefit upon the Government, some question exists as to the extent to which the exercise of such rights is feasible. The prob- lems of identifying and correcting defects after field de- ployment could well result in the failure to correct defects for which correction would be required by the clause. One of the most significant of these problems is the one of 28 proving that an apparent defect in an the hands of the Government for some item which has been in time is an actual de- fect; that is, proving that the defect contractor rather than the Government. is the fault of the We understand S-3A contract at thethat the Defects clause was used in the insistence of the contractor. Presum- ably, the contractor prefers the treatmennt defects and proximate damages by the accorded latent Defects clause since, in other respects, the Defects clause to the Government than the Inspection seems more favorable clause. This is sig- nificant since it would indicate the more financial risk attached to latentcontractor believed defects and proximate damages than it did to the possibility of losses due to the additional time provided by the Defects covery and correction of patent defects clause for the dis- sion). (the warranty provi- 29 Economic Escalation The Economic Escalation clause provides, in effect, that, if future economic inflation varies significantly from that estimated for the purpose of pricing the contract, the contract ceiling price will be adjusted upward or downward, accordingly. This clause, however, is only applicable to the last two lots provided for by the contract--lots V and VI. The options for these lots are to be exercised in cal- endar years 1973 and 1974, respectively. The escalation clause provides protection to the con- tractor for only so-called abnormal inflation. Protection against ordinary or anticipated inflation is provided for in the prices negotiated for each contract lot. In prepar- ing its price proposal, Lockheed included a factor for in- flation based on a price rate increase of 4 percent per year for material and 3 and 3.5 percent per year for labor (depending on the type labor). In essence, the escalation clause provides for adjust- ments to the ceiling price of lot V if actual price levels at March 31, 1973, vary more than specified amounts from the levels predicted for this date. The option for lot V is to be exercised by November 1, 1973, some 7 months la- ter. The ceiling price for lot VI is similarly adjusted for actual price levels at March 31, 1974. The option for this lot must be exercised by October 1, 1974, or 6 months later. The significance of these dates is discussed in a subsequent paragraph. The predicted levels are based on rates slightly higher than those used by the contractor in preparing his propo.al, Price levels will be determined by reference to certain Bureau of Labor Statistics indexes. As calculated by Lockheed using the indexes specified in the escalation clause, inflation has been increasing at an annual rate of 6.22 percent for material and 6.35 per- cent for labor. These rates contrast sharply with the 4-percent rate for material and the 3- and 3.5-percent rates for labor which were used in establishing the option ceiling prices. The Lockheed calculation was based on ex- perience for the 3-year period ending September 1970 for material and for the 3-year period ending July 1970 for la- bor. 30 As noted above, the escalation clause is applicable only to the last two production lots. Based on median quantities, the ceiling prices of 69 production aircraft, or more than one third of the total production aircraft un- der option, are thus unprotected from abnormal inflation as are the prices for the two research and developme.. lots. If rates of economic inflation continue at present levels, the lack of abnormal inflation protection until lot V could place a heavy eccr'mic burden on the prime contractor. The contractor originally proposed inflation coverage on all lots, including lot I, applicable retroactively to actual costs. When the Government stated that this ar- rangement would not be accepted, Lockheed revised its pro- posal by raising its proposed profit rate in lot I from 10 percent to 12 percent (but with no increase in ceiling price). One of the Government negotiators of the S-3A con- tract advised us that the Government felt the 130-percent ceiling prices, together with the other pricing provisions in the contract, provided sufficient protection to the con- tractor in connection with work up to lot V. He explained that, in early 1969 when the contract was negotiated, no one anticipated that inflation would reach and stay at the level it has. He further stated, in retrospect, that ab- normal inflation coverage of the early lots should have been allowed. The abnormal inflation coverage for lots V and VI is incomplete. As noted on the previous page, these lots are required to be ordered 7 and 6 months, respectively, subse- quent to the dates on which any economic escalation adjust- ment to their prices will be determined. Production effort relative to each lot (except for relatively minor long- lead-time effort) occurs over an approximate 2-year period following option exercise. This means, assuming the op- tions are exercised at the latest dates possible, that work in connection with lots V and VI will not be completed un- til approximately 2% years after their prices have been adjusted for abnormal inflation and that no further adjust- ment will be made for any abnormal inflation occurring dur- ing these periods. Furthermore, the escalation clause does not allow slipping the dates which determine the escalation price adjustments in the event the option ordering dates are slipped under the Project Milestone or Ordering-Date 31 Extension clauses. This incomplete coverage of abnormal economic escalation on lots V and VI could also place a heavy economic burden on the prime contractor. 32 Pricing of Changes The Pricing of Changes clause was devised to age vast numbers of contractor-initiated engineering discour- change proposals and to provide stronger Government controls over technical changes deemed desirable or necessary. On many prior major weapon system programs, large numbers of tech- nical changes were made. The resulting contract changes were usually authorized by the Government before they were priced or, in many cases, even before formal estimates of their costs were rec ived. It was felt in many Goverrment quarters that contract changes were being used by major weapon system contractors to "get well" under contracts (eventually make a profit) which they had "bought into"; i.e. had accepted at unreasonably low prices. In the 16 months between the signing of the S-3A con- tract and November 29, 1970, only 18 contract modifications affecting price were made. These changes in creased the combined target price of lots I total de- and II by some $8 million. (Work valued at another $8 million ferred from lot II to lot III.) was trans- This is considered a very small number of changes in comparison with prior aircraft contracts which did not contain such a clause. The S-3A contracting officer attributes the relatively small number of changes to the Pricing of Changes clause and to the tightness of the S-3A program budget. This clause seeks to control engineering change pro- posals in four major respects. First, it provides that changes valued at $35,000 or less be made at no change in contract price and that changes valued between $35,000 and 1 percent of the original cost of the production lots af- fected by the change be negotiated at a lesser profit rate than would normally be expected. This feature was appar- ently designed to discourage an excessive number of small contractor-initiated engineering change proposals and also to reduce the administrative costs of processing such small changes. The second controlling feature of the clause stipu- lates that the price negotiated for each change shall not exceed the target price or ceiling originally proposed by the contractor for the change. In the case of changes 33 which would result in reduced rather than increased costs, the clause states that the price reduction negotiated for the change shall not be less than the price reduction pro- posed by the contractor. The third controlling feature of the clause provides that the binding price ceiling or minimum price reduction accompany the engineering change proposal when it is sub- mitted to the Government. The fourth feature is not ex- plicitly included in the clause. We were told by a Navy attorney, however, that it is implicitly included. This feature provides that the prices of proposed changes iden- tify the impact of the change not only on the authorized portions of the contract but on the options as well. The last three features discussed are designed to ensure that the Government will have available realistic, timely, and complete cost estimates when it makes its decision as to whether a contractor-proposed change should be adopted. The scope of the Pricing of Changes clause is narrowed by the fact that certain types of engineering change pro- posals are excluded from coverage. One of the most signif- icant exclusions has to do with proposals submitted by the contractor in connection with the value engineering pro- gram established by the contract. Value engineering pro- grams are established to encourage elimination of "nice to have" but unessential technical features. The clause does not apply to certain other types of engineering change pro- posals. Among these exclusions are proposals resulting from requirements for improvements in the S-3A aircraft which would overcome deficiencies in Government-furnished equipment and proposals which would change the basic mission of the S-3A system. Lockheed officials indicated to us that this clause, together with the current economic climate, makes it haz- ardous for the contractor to propose changes. These offi- cials stated that the provisions requiring binding price proposals at the time a change was proposed had already re- sulted in some losses to the company. They indicated that their course in regard to future change proposals would be (1) to not bother with smaller changes, (2) to make no change proposals at all unless they were relatively sure 34 the change would "sell" (a change proposal costs from $3,000 to $4,000 to prepare), and (3) to include a contin- gency factor of from 5 to 50 percent as a separate line item in all proposals in order to overcome the potential loss represented by the binding ceiling estimate. Government control over contract changes is further strengthened by the requirement that all engineering change proposals and all requests for deviations from or waivers of specifications must be prepared in accordance with MIL-STD-480 (Military Standard, Configuration Control- Engineering Changes, Deviations and Waivers) dated Octo- ber 30, 1968. We were advised that this military standard provides tighter Government control over contract changes than did the Navy document which it replaced. It seems likely that an undesirable side effect of the Pricing of Changes clause, and perhaps of MIL-STD-480 also, will be to discourage the contractor from proposing im- provements in the S-3A weapon system which the Navy would want and would approve if proposed. Another possibility is that the binding ceiling price provision may cause the con- tractor to propose inflated ceiling prices for changes, which could result in Navy disapproval. 35 Installment Funding This clause is designed to limit the Government's fi- nancial obligation to the contractor at any given time to predetermined amounts. Another purpose is to impose cost discipline on the contractor. The clause is limited to the research and development portion of the contract (lot I) since research and development is incrementally funded, whereas production if fully funded. This clause establishes a funding schedule by which the Government is required to obligate money to the contract for lot I. The schedule, as amended, shows the dates by which each of 18 funding installments will be made and the amounts of each. The total of these installments is the target price of lot I. The contractor may request that the Government provide funds at a more rapid rate than required by the schedule, but the Government is not obligated to satisfy such a request. Change orders affecting contract price similarly affect the funding schedule. This clause has the effect of limiting payments to the contractor in connection with lot I effort by limiting obli- gations in accordance with the schedule. Further, and most importantly, the clause specifically provides that, in the event of contract termination, the Government's termination liability to the contractor for lot I be limited to the total funds then obligated as provided in the schedule. As noted previously, the installment funding schedule is based on target price. This would indicate that, although the contract is on a fixed-price incentive basis and thus has a ceiling price higher than the target price, the contractor's reimbursement, in the event of termination, would be limited to target price. It seems unlikely, however, that the con- tractor would allow his funding protection, as provided by the Installment Funding clause, to lag significantly behind experienced costs before he would request the Navy to in- crease the amounts set forth in that clause. This stimulus to the contractor is beneficial to the Government in that it encourages the contractor to bring cost growth situa- tions to the Government's attention at an early date. The clause states that, if the Government fails to ob- ligate an instt'lment by the date specified, such action 36 shall have the effect of the contracting officer's ordering the contractor to stop all work under the contract pursuant to the Stop-Work-Order clause. Stop-work. orders can result in additional costs to the Government and to adjustments in the delivery schedule, as can other provisions of the con- tract. A similar clause is contained in the F-14 contract, A closely related clause known as the Limitation of Govern- ment Obligations clause has been used in recent Air Force contracts, including the F-15 and the AWACS contracts. The chief difference between the clauses used by the two ser- vices is that the Air Force clause requires that the con- tractor request adjustments in the specified funding several months (generally 17) in advance of the period in which the additional funding is required. Because of this feature the Air Force clause seems even more restrictive on the con- tractor than the Navy clause. 37 Performance responsibility-- prime and associate contractor relationships Under the terms of its prime contract, Lockheed is charged with responsibility for total system performance. The significance of a contractual provision placing perfor- mance responsibility on the prime contractor is governed by the amount of Government-furnished aeronautical equipment called for by the contract. The provision in the S-3A con- tract is of some significance because Government-furnished aeronautical equipment accounts for approximately 19 percent of the total program price. Engines and accessories, elec- tronics and communications, armament and support are all furnished by the Government. The prime contractor's responsibility for total system performance, however, is contingent on the Government's fur- nishing it with subsystems which are "suitable for intended use," which the contract states "shall be deemed to require that the Government- Furnished Aeronautical Equipment conform to the specifications and acceptance tests therefor cited in said detail specification." We were advised by an attorney in the Office of the General Counsel, Naval Air Systems Command, that the lan- guage contained in the S-3A contract was designeQ to over- come a jet engine integration problem encountered in the F-lll aircraft, in which a dispute arose as to whether the Government or the prime contractor was responsible for an engine problem which developed during flight testing. The intent of the language, in the eyes of its authors, is to clearly impose liability for later failure of Government- furnished aeronautical equipment on the prime contractor once the equipment has passed prescribed acceptance tests and has been accepted by the Government. Thus in the case of a jet engine, if acceptance testing is prescribed by the Government-furnished aeronautical equipment contract speci- fications to take place on the ground, failure to meet the requirements of the prime system specification for in-flight performance after delivery of the tested equipment to the prime contractor would be the prime contractor's responsi- bility. 38 However, the position taken by the Navy's contract ne- gotiator in discussions with us, which position is also sub- scribed to by the contractor, is that, if it can be shown that a subsystem--though meeting the specification and tests required by the subsystem contract--does not permit the system prime contractor to meet the prime system specifica- tion, then the prime contractor will be relieved of perfor- mance responsibility until the defect in design or workman- ship is corrected and the Government will bear the cost of correction. The Government has traditionally had problems in fur- nishing suitable equipment to contractors. Should a prob- lem occur in Government-furnished aeronautical equipment after delivery to Lockheed and should the stricter interpre- tation of prime contractor responsibility be advanced by the Government, a dispute almost certainly will arise as to whether the Government or Lockheed must bear the cost of correction. The approach taken by the Air Force in recent major system contracts accords with the strict interpretation placed on the Navy provision in that the Air Force places complete responsibility for the integrated performance of Government-furnished equipment on the prime contractor once the Government-furnished equipment has been formally ac- cepted by the prime contractor. Protection is provided the prime contractor, however, in that he is not required to accept Government-furnished equipment until he has agreed in writing as to the design and/or performance characteris- tics of the Government-furnished equipment; the inspection and acceptance test procedures specified; and the confor- mance of the Government-furnished equipment to such design, performance, and test requirements. No similar "sign off" protection is contained in the S-3A performance responsi- bility provision. To escape as many potential problems connected with this requirement as possible--particularly integration problems--the S-3A contract provides that Lockheed enter into written agreements with major Government-furnished aeronautical equipment suppliers (termed "associate con- tractors"), which are designed to encourage and/or require exchange of data and coordination between the prime and 39 associate contractors with respect to integration of Government-furnished aeronautical equipment with the prime weapon system; proposed specification changes, deviations, or waivers; and failure of Government-furnished aeronautical equipment to comply with specifications. Costs associated with the agreements between prime and associate contractors are allowable costs under the respective contracts. These agreements are implemented by the establishment of formal boards composed of representatives from the prime and associate contractors (but not from the Government), which monitor problems as they arise so that those problems can be resolved expeditiously. The requirement for a formal agreement was first used in the F-14 contract, although we were advised at the time our F-14 report was prepared that contractors have typically set up informal arrangements to accomplish the same purposes. 40 Stop-Work Order The Stop-Work-Order clause of the S-3A differs from the norm in that, while the ASPR-specified clause precludes ter- mination for default following a stop-work order, the S-3A clause confers on the Government the right to terminate the contract for either default or convenience at the expiration of a stipulated period. The ASPR stop-work-order clause states that the Government may stop work for up to 90 days, while reimbursing standby costs. At the end of that time, the Government must either cancel the stop-work order or terminate the contract for convenience. The S-3A clause, on the other hand, sets a 30-day limit on the stop-work order itself but provides an additional 60 days if termination is to be effected so that the Government may determine whether such termination should be for convenience or default. In its request to the ASPR Committee for a deviation from the prohibition against default termination following a work stoppage, the Navy stated that, upon determination that a program of the magnitude of S-3A should be canceled, additional time as allowed by the 60-day provision is ap- propriate for completion of the "formidable task" of assess- ing the feasibility of default as opposed to convenience terminat:t,.rn in order to save the extra expense which would be incurree if work were allowed to continue pending such assessment. Representatives of Lockheed, however, ex- pressed the apprehension that the 60-day provision could provide an incentive to the Government to strain to convert what would otherwise be a convenience termination to one for default by searching out technical '. not necessarily im- portant deviations from contractual requirements. Records show that the 60-day feature of the Stop-Work- Order clause was designed to come into play only in a situa- tion where termination is deemed necessary and that the 60 days provided by the provision was to be used for an analysis, in good faith, of whether the termination should be for convenience or default. Restraint of Competition The so-called Restraint of Competition clause requires that all data, including limited rights data (that which a 41 contractor furnishes to the Government or a subcontractor for explicitly limited purposes) furnished by the contrac- tor to vendors or subcontractors for use with regard to the S-3A contract, be furnished to the subcontractors and kept up to date without payment. This clause is included in order that the Government may purchase directly from the subcontractors and vendors additional supplies and/or ser- vices to be used in connection with the S-3A without paying fees or royalties to the prime contractor. Although this clause does not permit the general dis- semination of limited rights data, it does require the con- tractor to give up rights in the affected data for purposes of present or future buys of spare or replacement parts re- lated to the S-3A airplane. The clause has application to the present contract as well as to any follow-on contracts. This represents a departure from usual practice and requires the contractor to relinquish a right without any compensa- tion. The purpose of the clause is to grant the Government the right to make later purchases of spare or replacement parts for the S-3A from subcontractors or vendors where there is no contribution, other than the data, by the prime contractor. Also, the clause helps overcome the problem, at least with respect to subcontractor-furnished parts, of the wholesale marking by prime contractors of component part data as "proprietary" thereby placing on the Government the burden of challenging any markings considered to be inap- propriate through a rather cumbersome ASPR-required process if sole-source repurchase from the prime contractor is to be avoided. The Restraint of Competition clause is in the contract because it was demanded by the Government, and the Govern- ment's strong bargaining position resulted in its acceptance by Lockheed. A possible side effect of using the Restraint of Competition clause in prime contracts could be to en- courage the prime contractors to perform work in-house which otherwise would have been economically subcontracted. This incentive would be due to the prime contractor's desire to retain its data rights. Such an effect could work to the disadvantage of the Government in some cases and could have implications for the small business community. 42 CHAPTER 3 MANAGEMENT CONTROLS ?ROJECT MANAGEMENT ORGANIZATION As in other major weapons system acquisitions, manage- ment of the S-3A aircraft program is vested in a project manager. In accordance with usual Navy practices, the S-3A project is "horizontally" rather than "vertically" struc- tured. Accordingly, the S-3A Project Manager draws most of his support from other, organizationally independent, ele- ments within the Naval Air Systems Command rather than from a large staff which reports directly to him. Lockheed's S-3A project office has complete authority to direct and control its functional organizations. PERFORMANCE MEASUREMENT DOD Instruction 7000.2 provides for the application of uniform DOD criteria to contractor management systems under major weapons contracts. The instruction requires the use of cost/schedule control systems criteria by the contrac- tor's internal management to provide an adequate basis for responsible decisiornmaking by both contractor management and DOD components. The contractor management systems must provide data which (1) indicate work progress, (2) properly relate cost, schedule, and technical performance, (3) are valid, timely, and auditable, and (4) supply DOD managers with a practi- cable level of summarization. Subcontracts, excluding those that are firm fixed price, are selected for application of these criteria by mutual agreement between prime contrac- tors and the contracting DOD component, according to the criticality of the subcontract to the program. Addendum 6 to the S-3A prime contract embodies the re- quirement of Instruction 7000.2. Lockheed developed its planning and control system to comply with Instruction 7000.2. A demonstration review was held in March 1970 at Lockheed, and the Navy's validation team stated that the system met the criteria; however, the Office of Naval 43 Material questioned whether the Navy should continue to re- quire instruction 7000.2 or accept the system being utilized by Lockheed on its commercial L-1011 system. We were in- formed that the Office of Naval Material accepted Lockheed's planning and control system on October 20, 1970, but wanted the requirements reduced. The Navy has not yet formally approved (validated) the Lockheed system as being in accor- dance with the requirements of Instruction 7000.2. Addendum 6 was originally expected to be applied to the two major subcontractors, Univac and Vought; but the require- ment concerning Vought was removed before Addendum 6 could be applied, and a modification to Addendum 6 to reflect that deletion had resulted in a decrease in the contract of approximately $1.5 million. A modification of the require- ment is now being considered which would eliminate Univac. Lockheed initially asserted that strict compliance with Addendum 6 represents added work amounting to approxi- mately $4 million at the target cost level for the S-3A development program. Lockheed has not been able to sub- stantiate this estimate. Lockheed feels that its planning and control system does employ timely approaches for mea- .suring the impact of such significant program influences as inflation, technical problems, and subcontractor pricing; however, the system does not ensure that decisions regard- ing resolution of problems will recognize the impacts on cost, schedule, and technical performance in other parts of the management system. Such information is available but the system does not ensure its use. The planning and con- trol system provides the potential to furnish a wide vari- ety of additional reports which the Government might con- sider beneficial. The S-3A project manager stated that, in his opinion, DOD Instruction 7000.2 was a good idea, philosophically, but that he was against the strict interpretation being attempted by the Air Force. He believed that, as presently consti- tuted, Addendum 6 produced more data than was needed and that a proposed modification would delete some of the re- quirements. The data contained in the formal reports gen- erated by Instruction 7000.2 are, on the average, 45 days old and, therefore,the reports are not as dependable as the 44 other management tools applied. GAO intends to perform a separate review concerning Instruction 7000.2.1 OTHER MANAGEMENT TOOLS The S-3A project manager informed us that, in addition to using formal reports generated by Lockheed's planning and control system, he applies day-to-day management tools to ensure effective control of the project. Among these tools are (1) the weekly action and "re-action" reports which point out specific problem areas and their resolution, (2) monthly meetings with Lockheed project management, (3) direct-line-telephone and data-transmission hookup with the Lockheed project office, and (4) "hot line" reports in- dicating significant problem areas. The project office has not yet received any hot-line reports. It is the project manager's opinion that, if the first indication of a signif- icant problem must be reported via hot line, management is not doing its job. DEVELOPMENT CONCEPT PAPER The Development Concept Paper is considered by the project manager to be his "contract" with the Office of the Secretary of Defense to develop and produce a total S-3A weapon system within definable cost, schedule, and perfor- mance parameters. Other sections of the Development Con- cept Paper evaluate enemy threat, need for the weapon sys- tem, development risks, program management, etc. The De- velopment Concept Paper was signed by the Secretary of De- fense in November 1967 wh;n the system was approved for con- tract definition. As directed by the Secretary of Defense, the Develop- ment Concept Paper is being revised to include an updated justification for the system. This justification apparently 1 Thereport will include data developed at several contrac- tors' plants to evaluate the potential of 7000.2 for dis- closing early problems and their ultimate impact on cost, schedule, and performance to industry and DOD management. 45 will include a discussion if the P-3C and the proper mix of the two aircraft for antisubmarine warfare. The original submission date for this revision was September 1, 1970; .1owever, the submission date is now unknown The Develop- ment Concept Paper is required to be revised before April 1972 when the Defense Systems Acquisition Review Council meets to consider whether or not the S-3A should be released for production. THRESHOLDS One section of the Development Concept Paper sets forth program thresholds for cost, schedule, and performance. As long as the program stays within these thresholds, program management is left to the procuring service. Crossing a threshold may initiate a review of the program at the Office of the Secretary of Defense level. Thresholds are set by the Office of Defense Research and Engineering to indicate when a program might be out of control; that is, considerable degradation from performance guarantees, extreme schedule slippage, and substantial cost overruns. In light of the previous discussion of known ctimism in contract pricing and the fact that Lockheed is performing at 112 percent of target cost, the development cost thresh- old may be crossed as the program advances into the criti- Lal avionics integration phase. As is the practice of DOD, the cost threshold for the production aircraft is quoted at :he total program 3mount. The S_3A production cost threshold was set at ceiling price rather than between target and ceiling as was the threshold of the AWACS program. Assuming that the production options are exercised, the total production cost will not be known until substan- tial aircraft deliveries have been made. The selected ac- quisition report prepared by the project manager will, of course, reflect estimates to complete, at various points throughout the program cycle, and could presumably reveal an estimated overceii.ng situation; however, estimates in past programs have tended to be optimistic. if the total 46 production threshold is broken, it may occur late in the program, and any review will, by its nature, be made near the completion of the program. Thus, as a management tool, a total program cost thresh- old is largely ineffective during most of the production cycle. It would seem reasonable instead to break out the production threshold into a yearly, or similar, period con- sistent with economic production runs to provide a manage- ment gauge of production costs as the program proceeds. The -zhedulethresholds are set at 6 months beyond the contractual milestone dates. The performance thresholds involve four overall characteristics of the aircraft related to weight, approach speed (carrier landing), range, and en- durance. If these guarantees are exceeded by 10 percent for the first two or reduced by 15 percent for the last two, a review at the Secretary of Defense level is made. Two other performance thresholds apply to the avionics charac- teristics of signal recognition and search bearing accuracy. If these performance thresholds are reached but not crossed, the Navy will have an S-3A whose performance is less than anticipated under the contract. The performance thresholds, however, do represent an increase over present antisubmarine warfare effectiveness. Officials at the Na- val Air Development Center, Warminster, Pennsylvania, have stated that these thresholds were fair and offered reason- able management control at the Secretary of Defense level. 47 DEFENSE SYSTEMS ACQUISITION REVIEW C(CJNCIL The vehicle for program review at the Secretary of De- fense level is the Defense Systems Acquisition Review Coun- cil. Unless a program threshold has been crossed, as dis- cussed previously, or some other special circumstance de- mands, the Council reviews a program three times during its life, that is (1) prior to entering contract definition, (2) prior to initiating engineering development, and (3) prior to a production decision. The Council is scheduled to meet in February or March 1972 relative to a production decision on the S-3A. The contract calls for lot III to be exercised on or before April 1, 1972. If the contractually required development milestone provisions are met prior to this production de- cision, Lockheed (1) will have made a first flight of 30- minute duration without avionics and (2) will have substan- tially completed integration of the S-3A's complex avionics in a bench test under laboratory conditions. In addition, 6 to 8 months of airborne avionics testing utilizing a P-3 aircraft (test bed) will have occurred. The first full systems flight of the S-3A is scheduled to take place 3-1/2 months after the production option date. The first four aircraft in lot III will be used for various research, development, testing, and Board of Inspec- tion and Survey trials. However, because the Navy plans to recycle these aircraft for ultimate delivery to the fleet, these four aircraft are being considered as production air- craft and, thus, a production decision is demanded by the Defense Systems Acquisition Review Council. One of the contractual milestones, avionics integra- tion, will demonstrate only that the units will work to- gether and respond to laboratory-generated inputs and will not demonstrate whether the system has the capability to fully perform its intended antisubmarine warfare mission. First flight, the other milestone is concerned only with the basic flying qualities of the airplane. It should be noted that the flying avionics test bed mentioned above will undergo a Navy preliminary -. essment which is sched- tuled for completion only 2 months after the option date for lot III. 48 The results of the Navy preliminary assessment of the flying avionics test bed and the results of tracking expe- rience against friendly submarines as well as the knowledge gained from the initial full-system flights of the S-3A would offer a better basis for a production decision by the Defense Systems Acquisition Review Council. The project manager advised us that he and the prime contractor were of the opinion that to delay the production decision and consider additional test results would distract the prime contractor's attention from the laboratory avionics integration which they believed to be of primary importance. In our report to the Subcommittee on the F-14 aircraft program dated August 17, 1970 (B-168664), we disclosed an analogous situation where it appeared that the Defense Systems Acquisition Review Council was being called upon to make a premature production decision. Subsequent to our report it was decided at the Secretary of Defense level that the F-14 program wou'i be given only a preliminary, or in- terim, production dec .sion and that a full production go- ahead would be given only after considerable experience and flight testing had been accomplished. INDEPENDENT ASSESSMENT NEEDED BY THE DEFENSE SYSTEMS ACQUISITION REVIEW COUNCIL FOR PRODUCTION DECISION When the Defense Systems Acquisition Review Council convenes to pass on the production phase of the S-3A pro- gram, the status of the program will be presented by the S-3A Project Office. We have noted in connection with other weapon system programs that these submissions tended to be very optimistic and indicated that potential pro' lems could be readily overcome. No assessment independent of program management is given at this critical stage in the program. Various study groups, as well as our office, have rec- ommended in the past that DOD utilize independent oper- ational testing and evaluation groups to monitor the prog- ress of various weapon system programs thus neutralizing to some extent the climate of advocacy. The blue Ribbon Defense Panel, in its July 1970 report, recommended that DOD establish independent operational testing and 49 evaluation groups reporting directly to the Deputy Secretary of Defense. These groups would represent both the devel- oper and user but would remain organizationally independent of both. These groups could contribute significantly to decisionmaking at all levels and could participate in the production decisions which theretofore had been a forum for optimistic program advocacy. Both the S-3A Project Manager and an official of the Directorate, Defense Research and Engineering, believed the idea of an independent assessment to be impracticable due to a lack of individuals or organizations that are techni- cally qualified as well as unbiased. They believed that, at present, those organizations having a great deal of ex- pertise generally had a biased point of view and that those that were unbiased generally lacked in-depth knowledge of the technical aspects of a given program. Furthermore, the S-3A Project Manager expressed his opinion that an assess- ment independent of his office would conflict with the con- cept of project manager responsibility. We still believe that consideration should be given to establishing an independent means of determining the progress of development prior to entering production. 50 CHAPTER 4 EXTENT OF CONCURRENCY To illustrate the level of planned concurrency between development and production in the S-3A, cerpts from the program master schedule we have taken ex- in figure 2 on the following page of and presented them this report. In terms of calendar months, the period concurrency starts in May 1972, one of significant cise of the production option for lotmonth after the exer- III, and ends in Oc- tober 1973 witb the delivery of four aircraft configured for the Navy's test and evaluations via its Board of Inspec- tion and Survey trials. The ending date for purposes of concurrency measurement, of October 1973, Navy's contention that delivery of is based on the four Board of Inspection and Survey aircraft marks the completion of the development phase and that all significant development pleted by that date. In terms of productionshould be com- will be, according to Lockheed's estimate, aircraft, there 10 S-3A produc- tion aircraft through the start of the final assembly pro- cess at the beginning of Board trials as shown below: 4 completed and delivered to the Navy for Board trials, 4 completed and in Lockheed's production flight test phase, and 2 in final assembly. The significance of the start of final assembly is that ex- perience has shown that there is a dramatic increase in the cost of applying changes beyond this with any other point where changes point in comparison might be incorporated. In addition to the above 10 production are the eight development aircraft an!i aircraft, there two (static and fatigue) airframes purchased nonflying test of the S-3A program. under lots I and II In terms of the total numbers of aircraft planned to be ordered by the time Board that are trials are started, 51 1972 1973 1974 1969 1970 1971 J N oI D JAFFJ M I|A J A S O NDJ |FMA |S|oIN D J F|M M J J A| S ON D J F M |M S ! O AS| O NIODJ FIiMAIU J J IA I I A A FIRST FULL DELIVERY OF FIRST FLT- IS CONFIGURED AVIONICFLYING FIR ST FLT- SYS FL T. S-3A AIRCRAFr TEST BED I S-3 I V ~7 V TV 8-31 1-14 7.17 CRITICL COMPONENTS ORDERCRITICL AVAIL S T NO. I T7 EQUIP. 7 2.1 AVIONIC EQUIP. DEVELOP. SET NO.2 BENCN TEST LAB INTEGRATION RECEIVE SET N.HP Y COMPLETE FTB RAM STARTFTB R IVR 7-1E5J,31 T 7T i NPA-I 5-31 11 1.1 5 AVIONIC FLYING TEST BED DESION-FAB ACMOD NPA I AIRCRAFTNUMB RS U B STEM.INSTATIC 12999) 3001 ,ooe FATIGUE I 30001 PROJECTMILESTONES FOR LOT III OPTION |1*..............|...-.. . -. BIS TRIALS CONTROL, & AR ASWPROCESSING DISPLAY QUALPRIORTIES SUBSYSTEM.INTEGRATIONG TO 3- 72 PRIOR TO 33009 | | X . t .t 053 V FIR i TO FLIGHTPROR PRIO 3R , BED DEMONSTR 3-15 72 15TO 72 AVTIONICS 73 . FOR LOT IV OP ION V"' EVA) UATIONOF FLYINGQUALITIES & PERFORMANCE -PRIOR TO 1.13573 FLYING TEST BED AVIONICS ASSESSMENTPRIOR TO 1-15-73 FOR LOT V OPTION V DELIVERY OF RIS CONFIGURED AIRCRAFT-PRIOR TO 10-15-73 I [~W~~~~~100 3050 4.1 2-1 11-1 LOT Il 13 AC LOT IV 56A C LOT V 60 A C LE3;END OP I:ON DATE (CONTRACT DATE)I 1y I I I DEVELOPMENT(FAS OF TEST A C) CONCURRENCY M I TESTING PRODUCTION EXTENT OF CONCURRENCY S-3A PROGRAM Figure 2 52 the estimated number is 137, or about 68 percent of the total planned quantity of 199. The start of Board trials is scheduled for October 1, 1973, which is only 30 days prior to the order date of lot V. We have included lot V in the number of aircraft ordered prior to these trials because lot V is scheduled to be ordered when the four air- craft are delivered for the trials. The delivery of these four aircraft is the fifth and final contractual milestone. The following table presents the details of the planned program showing the numbers of aircraft that are planned to be ordered. Number of Date Lot aircraft Note Purpose Aug. 1, 1969 I 6 (a) Development Oct. 1, 1970 II 2 Development Apr. 1, 1972 III 13 (b) Production Feb. 1, 1973 IV 56 (c) Production Nov. 1, 1973 V 60 (c) Production Total 137 Oct. 1, 1974 VI 62 (c) Production Total 199 aThis does not include the two static and fatigue test air- frames. bThe original baseline quantity was 17, plus or minus 50 percent; however, the more recent estimate is 13. (See p. 19.) CThese are baseline quantities and can be varied plus or minus about 50 percent by the terms of the contract. (See p. 19.) AREAS OF PRIMARY TECHNICAL RISK The S-3A program is somewhat unique, as compared with other contemporary weapon system development efforts, in 53 that the technical risks are primarily centered within one major technological area; namely, avionics. Actually, the risks are concentrated even further within certain limited areas of avionics. By comparison to the C-5A, F-1ll, F-14, and F-15, this situation is somewhat nontypical. In these other programs, consequential structural, materials, aero- dynamic, tooling and manufacturing, and aircraft subsystem developments in engine and airframe were involved. In the S-3A program, these factors are not as risky since the Navy considers the engine and airframe to be low-risk items. This is particularly important because the lead time and cost impact for correcting avionic problems is generally less than that of major airframe components involving heavy tooling and manufacturing facilities. Many of the avionic problems can be addressed on the ground or in avionic flying test beds, neither of which is subject to grounding or intermittent operations which can occur when new airframes and engines are also being tested. This means that problem solution can continue in the avion- ics area to a considerable degree irrespective of other problem areas, particularly if the program provides for both adequate laboratory and flying test bed tools. With regard to the S-3A avionics, no special problems or difficulties are anticipated in some areas. For example, communication, navigation, and weapon/armament control equipment are considered to be within the current state of the art or to be repackaged or off-the-shelf items. The principal risks in the S-3A avionic system lie in six spe- cific areas, as follows: 1. The acoustic data processor. 2. The central data processor. 3. The sonobuoy reference system. 4. Total avionic system integration and software. 5. Degree of success in the man/machine integration and automation design. 6. Impact of the rugged carrier environment on all so- phisticated avionic equipment. 54 CHAPTER 5 POTENTIAL PROBLEMS TO BE MONITORED As requested, potential problem areas are described below. POSSIBILITY OF NEED FOR EXTRACONTRACTUAL RELIEF We believe there is a possibility that the conserva- tive pricing and tight structuring of the contract in com- bination with certain occurrences might force the contrac- tor to seek extracontractual relief from the Government to continue work under the contract. (See pp. 8 to 15.) We believe also that the following potential events could pre- cipitate the need for extracontractual relief and thus should be monitored by the Subcommittee: 1. An increase in the rate of economic inflation or even a continuance of the present rate for a pro- longed period. (See p. 30.) 2. The occurrence of major development problems. (See p. 11.) 3. Ordering the minimum or near minimum quantities permitted under the production options. (See p. 20.) Our opinion on this point is bolstered by the fact that two of the prime contractor's major subcontractors have refused to accept clauses with a variable quantity option provision similar to the one contained in the prime contract. Specifically, these subcontractors will not allow orders for less than the median option lot quantities set out in the prime contract. This situation conceivably could result in substantial losses to the prime contractor should the Government choose to exercise the production option lots in the minimum or near minimum quantities. 55 UPCOMING PRODUCTION DECISION A decision on whether the S-3A aircraft will go into production is scheduled to be made in February or March 1972. We believe that a decision by this date may be pre- mature. Further, it appears that this decision, in accor- dance with customary procedures of DOD for making important decisions relative to major weapon systems, will be made in an atmosphere wherein the program advocates will be overly influential. In our opinion, the risk of entering the production phase could be appreciably reduced if the production deci- sion were delayed 3 or 4 months beyond the presently sched- uled date for this decision. The contract would permit such a delay since it allows slipping the date for exercis- ing the first production option for up to 4 months, at no increase in contract price. If the production decision were delayed 4 months, ad- ditional technical data resulting from certain tests would become available to the decisionmakers. We noted that the first Navy preliminary assessment is scheduled for comple- tion some 3 months after the production decision and that the first flight of the full S-3A system will come about 4 or 5 months after the production decision. The delay would also permit more information resulting from the ongo- ing avionics laboratory integration tests and the avionics flying test bed to become available. The Navy's project manager and the prime contractor do not agree. They believe that to delay the production deci- sion and consider additional test results would distract at% .. tion from the laboratory avionics integration (mile- stone 1) which they consider to be of primary importance. In the past, major weapon system decisions have been made in an atmosphere dominated by advocates of the programs involved. We believe that an assessment independent of the program management should be made of the S-3A program prior to the production decision. The results of this assessment should be made available to the officials charged with mak- ing the decision. (See pp. 49 and 50.) 56 CONCURRENCY OF DEVELOPMENT AND PRODUCTION There would be an appreciable degree of development and production concurrency in the S-3A program even if the production decision were delayed as we suggested in point 2 above. If development, testing, and evaluation show that the S-3A system will perform as intended and that signifi- cant changes are not required, this concurrency should re- sult in the system's becoming operational qvicker than it would have otherwise. On the other hand, if evaluations disclose that significant changes the tests and must be made to ensure an operationally effective weapon system, problems of making the changes will be compounded. the The changes must be made not only to the developmental units but to all production units which have been manufactured or which are in the process of manufacture. This could require substantial amounts of additional time and money. (See ch. 4.) COST THRESHOLD FOR PRODUCTION AIRCRAFT The Development Concept Paper sets forth program thresholds for cost, schedule, and performance. As long as the S-3A program stays within these thresholds, program management is left to the Navy. Crossing a threshold tiates a review of the program by the Office ini- of the Secre- tary of Defense. As is the practice of DOD, the S-3A cost threshold production aircraft is set at the total program for amount. To- tal program production cost will not be known until a sub- stantial number of aircraft have been made. Reports pre- pared by the S-3A Project Manager will, of course, reflect estimates to complete and presumably could reveal mated cost exceeding the threshold; however, an esti- estimates in past programs have tended to be optimistic. Thus, as a management tool, a total program cost threshold very effective during most of the production may not be cycle. It would seem preferable to break down the planned by production lot or by some other subdivision program cost of the total production effort and have a separate cost threshold for each. (See p. 47.) 57 LESS THAN TOTAL SYSTEM PERFORMANCE RESPONSIBILITY Despite the fact that there is a provision in the con- tract which purports to impose total performance responsi- bility for the integrated weapon system, including Government-furnished equipment, on the system prime con- tractor, there is some question as to whether its responsi- bility for system performance is, in fact, total. (See p. 38.) UnDer some circumstances it is the position of the Navy negotiator, and concurred in by the contractor, that the Government must bear the cost of modifying Government- furnished equipment so that it will be suitable for use in the S-3A system. Further, it is the Navy negotiator's posi- tion that the system prime contractor is relieved of the af- fected system performance requirements until the Government- furnished equipment is corrected. On the other hand, we were advised by an attorney in the Office of the General Counsel, Naval Air Systems Com- mand, that the provision does, in fact, place total respon- sibility on the contractor. We mention this area because the Government has traditionally had problems in furnishing suitable equipment to contractors and because the variarce in interpretation of that contractual provision indicates that, should a problem with Government-furnished equipment arise and the performance responsibility provision be strictly interpreted, it will probably generate a dispute as to who is required to bear the cost of its resolution. POSSIBLE SIDE EFFECTS FROM THE PRICING OF CHANGES CLAUSE The Pricing of Changes clause was designed to ensure that the Government would have timely, complete, and realis- tic cost proposals for contractor-proposed engineering changes before they would be approved. (See p. 35.) There is a possibility that this clause may discourage the con- tractor from suggesting improvements in the S-3A weapon sys- tem which the Navy would want and would approve if suggested. Another possibility is that this clause may cause the con- tractor to propose inflated ceiling prices for changes which could result in Navy disapproval. 58 POSSIBLE SIDE EFFECTS FROM THE RESTRAINT OF COMPETITION CLAUSE The Restraint of Competition clause requires the sys- tem prime contractor to give up many of its data rights relative to items it obtains from subcontractors using the prime contractor's design. (See p. 42.) This could have the effect of encouraging the prime contractor to perform work in-house which it otherwise would have subcontracted. Such an effect could work to the disadvantage of the Gov- ernment in some cases and could have implications for the small business community. On the other hand, there is a possibility that the Restraint of Competition clause may not be effective in permitting the Government to reorder supply parts directly from the subcontractors. Information we have received indicates that, except for major items such as wings or engines, which are generally not repur- chased, direct procurement of spare or replacement parts may not be feasible because of the possession by the prime contractor of information and expertise other than the data covered by the clause necessary for intelligent parts pro- curement. 59 CHAPTER 6 SCOPE OF ANALYSIS In performing our analysis, we reviewed the S-3A con- tract N00019-69-C-0385 and other pertinent documentation and held discussions with key management personnel of the S-3A Systems Project Management Office and with contract negotiation, technical, and legal personnel of the Naval Air Systems Command. We also held discussions with per- sonnel. representing the prime contractor and selected sub- contractors of major S-3A subsystems. We discussed and researched kE;y contractual clauses from such sources as the ASPR Cormmittee. We attempted to gain an insight from other defense contractors on their prior experience with selected contr ctual clauses. We probed technical aspects of the S-3A with represen- tatives of the Office of the Director of Defense Research and Engineering and the U.S. Naval Air Developme-nt Center; however, our review did not include an in-depth analysis of development progress and technical risk. Our fieldwork was performed during the period August through December 1970, and therefore this report generally reflects the status of the S-3A program about 1 year after contract award. 60 APPENDIX 61 APPENDIX I JOH C. STr.Ni. MIss.. cI4ISN sInU S. m LL . MARNANITCASI ST, IM MAIN 0JINT SIVUINH1GTO. Mo. STROMTU ON. C. 14WAND W. CA o. nV. OA MUt y . I S M. MT OUNG.cHIo IANIL N. IN"UTE. HAWAII THOMAS J. MCIYRE, ".H. EOWAR W. St. GASSy OLOWAT RIC " ASS I D S. CHWEIK[S. PA. i c a fes ,e HARRYF. TYRO. JR.. VA. COMMlITTE ON ARMEDO ERVICES T.SORIANOD IMIAiW.L. J'A...CHin, EFO TA~nyP WASHINGTON. D.C. 20510 July 9, 1970 Honorable Elmer B. Staats Comptroller General of the United States General Accounting Office 441 G Street, N.W. Washington, D. C. Dear Mv. Staats: This letter is to request your office to provide assistance to the Preparedness Investigating Subcommittee in performing an analysis and interpretation of the contractual features of the contracts entered into for the S-3A and AWACS aircraft programs. The Preparedness Investigating Subcommittee has for some time been monitoring the status of the major weapon programs of the Department of Defense. In this regard, one segment of the Subcommittee's continued review has been to evaluate the contractual aspects of these programs. The Subcommittee is particularly interested in the progress being made in this area in the newer programs. As you are aware, your office has been assisting the Subcommittee in performing these contractual analyses on the F-14 and F-15 aircraft programs and providing the Subcommittee with opinions and viewpoints regarding these contractual matters. I am very pleased with the results that we have seen to date in this work and believe this to be an important area in our review program. We are again interested in your opinions on the merits of the manage- ment and contractual aspects of these programs and any potential problem areas that should be monitored. Your analyses should also include the areas of management controls, contractual structure and definiteness, cost and pricing provisions, and the extent of concurrency probable within the program structure. Your continued early response will provide great asslstatx-tortre Subcommittee's efforts in this area. S' ely, _ ~hn C. Stennis hairman, Preparedness Investigating Subcommittee U.. 3AO Wagh., D.C. 63
Contractual Features and Related Matters in the S-3A Aircraft Program
Published by the Government Accountability Office on 1971-03-29.
Below is a raw (and likely hideous) rendition of the original report. (PDF)