oversight

B-2 Bomber: Contract Structure and Selected Provisions

Published by the Government Accountability Office on 1990-08-17.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

            I

                                                                             .‘i
        :

-   .                      United   States   General   Accounting   Office


GAO                        Fact Sheet for the Chairman,
                           Committee on Armed Services,
                           House of Representatives


August          1990
                           B-2 BOMBER
                           Contract Structure and
                           Selected Provisions




GAO,‘NSIAD90-230FS

                       c
                   United States
GAO                General Accounting Office
                   Washington, D.C. 20548

                   National Security and
                   International Affairs Division

                   B-224698

                   August 17,199O

                   The Honorable Les Aspin
                   Chairman, Committee on Armed Services
                   House of Representatives

                   Dear Mr. Chairman:

                   As requested, we have developed information on the contract structure
                   and selected provisions affecting contractor and government risks under
                   the B-2 low-rate initial production contract. Currently, five B-2s are
                   included under this fixed-price incentive contract with Northrop Corpo-
                   ration’s B-2 Division, and the Air Force is in the process of negotiating
                   with Northrop to add five additional aircraft to the contract. Six aircraft
                   are also being acquired under a development contract.


                   Northrop, the prime contractor, is responsible for ensuring that the B-2
Results in Brief   meets system specifications and for managing major subcontracts. Cur-
                   rent legislation requires that contracts include warranty provisions that
                   provide coverage for design and manufacturing requirements and pro-
                   tect against defects in material and workmanship. Although not
                   required by law, the low-rate initial production contract also provides a
                   performance warranty. However, the government’s ability to enforce
                   the performance warranty may be affected by the test program. As of
                   June 1990, under the present delivery schedule, testing is scheduled for
                   completion 10 to 18 months after the warranties for the initial five pro-
                   duction aircraft expire.

                   The low-rate initial production contract establishes a cost-sharing
                   arrangement that also applies to warranty costs. Unless Northrop has a
                   substantial cost overrun, the Air Force would pay 80 percent and
                   Northrop 20 percent of allowable warranty costs. Northrop’s liability
                   under the warranty provision is limited to $100 million for the five air-
                   craft. The Air Force pays for all costs to identify, develop, and test cor-
                   rective actions for deficiencies under its full-scale development contract,
                   which is a cost-reimbursable contract.

                   According to Air Force officials, the B-2 warranty was obtained at no
                   additional cost to the government. Regarding the warranty being consid-
                   ered for the next five aircraft, the Air Force has asked Northrop to pro-
                   pose a warranty in which Northrop would assume much greater
                   responsibility for the cost of corrective actions.


                   Page 1                                         GAO/NSL4DSO-23OFS   RZ (‘ontracts
B-224698




Please contact me at (202) 2754268 if you or your staff have any ques-
tions concerning this fact sheet. Major contributors to this fact sheet are
listed in appendix II.

Sincerely yours,




tf!fIZ*y
Director
Air Force Issues




Page 3                                         GAO/NSIAB9W?39FS   B2 Contracts
                     Appmdix      I
                     Low-Rate    Initial Fhduction   contract
                     Structure   and Pmviaions




                     table I. 1 is primarily the result of the change in the B-2 schedule. Addi-
                     tional cost increases due to a subcontractor strike, a decision to shift
                     aircraft buys to later years, and the purchase of other B-2 related items
                     are yet to be negotiated. Consequently, the program office estimates the
                     low-rate initial production contract costs will increase substantially.


                     Under the contract, Northrop has total system performance responsi-
Total System         bility. Northrop is responsible for integrating the B-2, its subsystems,
Performance          components (hardware and software), and government-furnished prop-
Responsibility and   erty. It must also undertake any actions necessary to ensure that the
                     total system will meet all requirements. Northrop is also responsible for
Subcontractor        selecting subcontractors and effectively managing the subcontracts
Management           required to perform the work. Northrop is required to monitor the major
                     subcontractors’ performance and provide reasonable assurance to the
                     Air Force that contract requirements will be met.


                     10 USC. 2403 requires contractors to guarantee that weapon systems
Warranty Coverage    conform to design and manufacturing requirements and are free from
                     defects in materials and workmanship. Also, if the weapon system pro-
                     gram is in mature full-scale production-that   is, production of more
                     than 10 percent of the total number planned or the initial production
                     quantity, whichever is less-a performance warranty is necessary. The
                     B-2 low-rate initial production contract covers these three areas. How-
                     ever, the performance warranty was not necessary because only 5 of the
                     127 planned production aircraft were included in the contract.
                     According to Air Force officials, the warranty obtained was at no addi-
                     tional cost to the government.

                      The Air Force plans to add five additional aircraft to the contract by
                      October 1990 and has requested that Northrop propose a cost estimate
                      for these aircraft, which were authorized by the Congress in fiscal years
                      1989 and 1990. It has also asked Northrop to propose costs for a new,
                      more stringent warranty provision for the aircraft. The Secretary of
                      Defense advised the Congress on May 20, 1990, that the Air Force
                      intends to comply with the increased warranty requirements in the
                      National Defense Authorization Act for fiscal years 1990 and 199 1.


Current Warranty      The current warranty provides that Northrop must be notified about
                      defects or performance problems within 6 months after the Air Force
                      accepts an aircraft. When a problem is identified, the costs to design,


                      Page 5                                         GAO/NSIAD-96.236FS   B-2 Contracts
                                    Appendh    I
                                    Low-Rate  Initial Production   Gmtract
                                    Structure and Provisions




                                    not been tested by the time the warranty period expires. Program offi-
                                    cials believe sufficient testing will be completed early enough to ensure
                                    compliance with most specifications and requirements. If not, the offi-
                                    cials agree the government would have to pay the total cost to fix a
                                    defect.

Table 1.3: Comparison of Warranty
Periods to Flight Test Program                                                                                     Months remaining
                                                                                      Warranty expiration          between warranty
                                                                          Delivery         date (6 months              expiration and
                                    Aircraft   no.                             date         after delivery)    completior! -__--
                                                                                                                             of testing
                                    1                                    Apr 1992                  Ott 1992                            18
                                    2                                   June1992                  Dee 1992                             16
                                    3                                   Aug 1992                  Feb   1993     .__~______
                                                                                                                                       14
                                                                                                                                      ~~
                                                                                                   ______
                                    4
                                    ____                                 act 1992            -     Apr. 1993                           12
                                    5                                   Dee 1992                  June1993                             10




Future Warranty                     The National Defense Authorization Act for fiscal years 1990 and 1991
                                    directed the Secretary of Defense to report on the implementation of
                                    current warranty provisions in the B-2 program. In addition, it required
                                    that the Secretary report on warranties planned for future contracts.

                                    The Secretary of Defense reported to the Congress on May 20, 1990, that
                                    the Air Force has asked Northrop to propose the cost for warranty cov-
                                    erage on the next five aircraft. The proposal should be for a warranty
                                    with a cost liability limit equal to Northrop’s profit. This would then
                                    become Northrop’s financial liability for correcting defects. Further, any
                                    costs incurred by Northrop to correct defects would not be covered by
                                    the cost-sharing arrangement of the contract and would not be shared
                                    by the Air Force, as they would be under the current warranty.

                                     The Air Force cannot exclude or limit this coverage unless (1) it is deter-
                                     mined that a waiver is necessary in the interest of national defense or
                                     (2) an analysis shows the costs outweigh the benefits of the warranty.
                                     In either case, the Secretary must notify the Congress of any exclusions
                                     or limitations in the warranty coverage.

                                     Also, under the existing contract clauses, the warranty allows the Air
                                     Force 6 months to discover defects after accepting an aircraft. Under
                                     the planned warranty, Northrop will be asked to accept 1 year as the
                                     length of time the Air Force has to discover defects.




                                     Page 7                                                       GAO/NSIAD9@239Fs        B-2 Contracts
                           Appenb       I
                           Low-Rate    Initial Production   contract
                           Structure   and Provisions




Business Base Adjustment   A contract price adjustment is allowed if Northrop’s B-2 Division busi-
                           ness base changes due to government actions to delay, reduce, or termi-
                           nate the B-2 contract. This provision allows Northrop an equitable
                           adjustment if the B-2 Division’s business base changes by at least 5 per-
                           cent because of government actions. The provision was included because
                           Northrop based its price for the contract on producing 132 aircraft. The
                           proposed reduction to 75 aircraft would therefore affect the pricing of
                           this contract. This provision will be in effect in future contracts through
                           delivery of the 72nd aircraft. To date, this provision has not been used
                           to increase or decrease contract prices.


Other Termination          The Federal Acquisition Regulation requires standard contract termina-
                           tion provisions. The regulation allows the Air Force to terminate the
Provisions                 contract if Northrop fails to meet contract requirements or for the gov-
                           ernment’s convenience. Under these provisions, the government must
                           notify Northrop of the termination action and details. Costs are usually
                           determined through negotiations between the government and the con-
                           tractor. The contractor has 1 year after the notice of termination to
                           submit a proposal for costs incurred.


                           The government’s liability under these provisions depends on specific
Termination Costs and      termination scenarios. Before the recent proposal to reduce the number
Government Liability       of aircraft to 75, the B-2 program office estimated total liability for
                           stopping the program at various times. The total government liability at
                           the time of scheduled production decisions in fiscal years 1991, 1992,
                           and 1993 was estimated by the program office to be $24 billion, $29
                           billion, and $36 billion, respectively.

                           These estimates represent cumulative costs incurred at those decision
                           points plus additional costs necessary to close out the contract. In addi-
                           tion to any aircraft delivered, the Air Force would take possession of
                           any aircraft sections and parts that were in the manufacturing process.
                           The estimates were based on actual expenditure rates in the B-2 pro-
                           gram for fiscal years 1987 and 1988 plus other estimating factors. We
                           did not attempt to verify the estimates.




                            Page 9                                        GAO/NSIAE96%3WS   B2 Contracts
           -,,....,.

      a,               .




                           Requests    for copies of   GAO   reports   should be sent to:

                           U.S. General Accounting       Office
                           Post Office Box 6015
                           Gaithersburg, Maryland       20877

                           Telephone    202-275-6241


 ..                        The first five copies of each report        are free. Additional   copies are

1)                         $2.00 each.

                           There is a 25% discount      on orders for 100 or more copies mailed to a
                           single address.

                           Orders must be prepaid by cash or by check or
                           ,ty “II ” .n ‘w,m.:.~nlll’~llR llr! ~“I lllll~lll~
                                                      ..



United States                         First-Class Mail
General Accounting    Office        Postage & Fees Paid
Washington,   D.C. 20548                      GAO
                                      Permit No. GlOO
Official   Business
Penalty    for Private   Use $300
Appendix

Major Contributors to This Report


National Security and   Joseph C. Bohan, Assistant Director
International Affairs
Division, Washington,
D.C.

Cincinnati Regional     Michael J. Hazard. Evaluator-in-Charge
Office                  Michael J. Sullivan, Evaluator




 (392630)               Page 10                                  GAO/NSWW23OFS   B2 Contracts
                           Appendix     I
                           Lmv-Rate    Initial Production   contract
                           Structure   and Pnwisions




                           The contract includes provisions intended to protect Northrop’s invest-
Termination                ments and limit the government’s liability if the program is terminated
Provisions in the          or delayed for a significant period of time. On April 26, 1990, the Secre-
Contract                   tary of Defense reduced the number of aircraft in the B-2 program from
                            132 to 75. This action could require further negotiations under some of
                           these provisions.


Protection of Contractor   Two provisions protect Northrop’s investment in capital and leased
                           equipment if the government terminates the contract. In fiscal year
Capital Investments and    1990, the maximum government obligation under these provisions is
Leases                     $215 million. This amount decreases to $194 million and $167 million in
                           fiscal years 1991 and 1992, respectively. B-2 program officials stated
                           that if the contract is terminated, these ceiling amounts would probably
                           be reached by the current value of applicable equipment and leases.

                           The purpose of these provisions was to give Northrop an incentive to
                           invest up front in enough plant and equipment to produce the entire B-2
                           program. Coverage under these provisions exists through December 31,
                            1992, or delivery of the 74th production aircraft, whichever occurs first.
                           The government will purchase the equipment items or leases covered if
                           (1) the government does not buy through delivery of at least the 74th
                           production aircraft, as evidenced by the second consecutive annual
                           appropriation act that excludes procurement of B-2 production aircraft,
                           or (2) if the contract is terminated for the government’s convenience
                           before delivery of the 74th production aircraft. The Air Force has indi-
                           cated that buying 75 B2s, 70 of which are production aircraft, could
                           cause further negotiations under these provisions.


Reimbursement for Idle      Northrop is to be reimbursed for 3 years for the cost of idle facilities if
Facilities or Capacity      the B-2 program is curtailed. The payment to be made under this provi-
                            sion is based on a formula that includes the cost of floor space, cost to
                            occupy the space, equipment depreciation, and equipment utilization
                            factors. Coverage decreases 25 percent each of the 3 years after curtail-
                            ment, from 100 percent in the first year to 50 percent ln the third year.


Equipment and Tooling       Under this provision, the negotiated price of the contract excludes the
Disposition Costs           costs to remove, store, and transport government-owned equipment and
                            tooling in case the contract is terminated, delayed, or reduced. This is a
                            standard provision in production contracts. The Air Force has limited
                            the liability under this provision to $430 million.


                            Page 8                                          GAO/NSL4DSB23OFs   82 Contracts
                                              Appendix     I
                                              Low-Rate    Initial Production   Contract
                                              Structure   and Provisions




                                              develop, and test a corrective action are paid by the Air Force under the
                                              development contract, which is a cost-reimbursable contract. The costs
                                              to retrofit the approved corrective action into production aircraft are
                                              chargeable to the low-rate initial production contract. However, these
                                              warranty costs are limited to $100 million for the five aircraft.

                                              Unless Northrop substantially overruns target cost, the government
                                              would be responsible for 80 percent of the allowable warranty costs.
                                              The actual sharing of these costs, however, depends on Northrop’s cost
                                              performance on the contract. Contract cost sharing and profit provisions
                                              establish that once target cost is exceeded, Northrop’s profit is reduced
                                              as costs increase until Northrop is totally responsible for all additional
                                              costs. For example, if Northrop produces at target cost before the $100
                                              million warranty costs are incurred, the government’s share would be
                                              $80 million, and Northrop’s profits would be reduced by $20 million.
                                              Table I.2 shows that this ratio continues until program costs reach the
                                              point at which Northrop would assume all costs, including the $100 mil-
                                              lion warranty cost.

Table 1.2: Distribution   of Warranty Costs
                                              Dollars in mdlions                               --
                                                                                          Contrr;;    Profit before    Contractor’s       Profit after
                                              Contractor’s   Derformance                                   warrantv            share        warrantv
                                              At target cost                                 $2,216           L-p $251            $20             $231
                                              At lo-percent overrun                           2,436         -      207          -- 20    -~ -~.-~.-187
                                              At 20.percent overrun                           2,659                162              20             142
                                              At ceiling                                      2,992                  0            100            -100


                                               tinder the contract, Northrop’s share of warranty costs would remain at
                                               $20 million unless costs began to approach the ceiling price. Under the
                                               current cost-sharing arrangements, this would not occur until target cost
                                               was exceeded by about $650 million, or about a 30-percent overrun of
                                               target cost.

                                               The 6-month period of coverage on warranty provisions may limit the
                                               government’s ability to enforce the performance warranty. Under cur-
                                               rent plans, the Air Force will not complete performance testing until
                                               April 1994, which is after the five low-rate initial production aircraft
                                               are to be accepted. As shown in table 1.3, flight testing of the develop-
                                               ment aircraft will not be completed until between 10 and 18 months
                                               after the warranties for these aircraft have expired. This could limit the
                                               Air Force’s ability to enforce the performance requirements that have



                                               Page 6                                                           GAO/NSIAD9@230FS         B2 Gmtmcts
Appendix I

Low-Rate Initial Production Contract Structure
and Provisions

                                   The low-rate initial production contract, awarded in November 1987, is
                                   a fixed-price incentive contract that sets initial cost and profit targets
                                   and has a firm ceiling price. Firm targets for cost and profit will be set
                                   after the third development aircraft is delivered in 1991. The contract
                                   also establishes a cost-sharing arrangement to motivate Northrop to con-
                                   trol contract costs. If Northrop’s actual cost is below target cost, profits
                                   are increased proportionately, but if the actual cost exceeds target cost,
                                   profits are reduced proportionately. The contract values negotiated ini-
                                   tially, increases agreed upon in June 1990, and the current values are
                                   shown in table I. 1.

Table 1.1: B-2 Contract   Values
                                   Dollars m bihons
                                                                                 Initial    Increase       -- Current
                                   Target cost                                  $2.020         $0.196          $2216
                                   Target proflt                                  0.251              0-0
                                   Target price                                 $2.271         $0.196    --    $2.467
                                   Ceiling pnce                                  2.727          0 265           2992


                                   The Air Force and Northrop negotiated initial target cost based on pre-
                                   liminary cost data from the development program. The target price is
                                   the target cost plus a profit factor. The Air Force and Northrop also
                                   agreed that the ceiling price would be 135 percent of the target cost.
                                   Under the cost-sharing arrangement, the Air Force pays 80 percent of
                                   all costs that exceed the target cost, and Northrop pays 20 percent until
                                   the total contract cost approaches the ceiling price of $2.992 billion.
                                   Northrop is solely responsible for costs beyond the ceiling price. Also,
                                   the Air Force and Northrop will share any underruns below target cost
                                   by the same 80:20 ratio.

                                   The final target cost and profit amounts will be negotiated after the
                                   third development aircraft is delivered because more cost information
                                   should be available at that time. Also, the third aircraft will contain
                                   equipment not on the first two and will more closely resemble the
                                   planned aircraft design.

                                   In 1987, at the time the low-rate initial production contract was being
                                   negotiated, a B-month schedule extension was being considered. As a
                                   result, a provision was included for a one-time increase in contract
                                   targets. The provision stated that Northrop would be responsible for the
                                   cost of 3 months of the delay and the government would be responsible
                                   for the balance. The $196 million increase in the target cost shown in



                                   Page 4                                          GAO/NSIAlB@-23O)oFs   WZ Contracts
              5224698




              The low-rate initial production contract includes provisions to renego-
              tiate the contract if a prescribed number of aircraft are not purchased.
              It also includes termination provisions to protect Northrop’s invest-
              ments and limit the government’s liability if the program is terminated
              or delayed. The recent reduction in the total number of B-2 aircraft from
               132 to 75 could require further negotiations under these provisions. The
              Air Force estimates that the low-rate initial production contract costs
              will increase substantially due to the reduction in the number of aircraft
              as well as schedule and other changes. Appendix I provides more details
              about this contract.


              To obtain the information for this fact sheet, we reviewed the low-rate
Scope and     initial production contract structure and provisions for warranties and
Methodology   contract termination or program delay. In addition, we discussed con-
              tract provisions with contracting officials from the B-2 program office
              and the Product Performance Agreement Center at Wright-Patterson Air
              Force Base, Ohio, and Northrop Corporation’s B-2 Division, Pica Rivera,
              California.

              As requested, we did not obtain agency comments on this fact sheet.
              However, we provided B-2 program officials with a draft of this fact
              sheet and incorporated their comments where appropriate.



              We are sending copies of this fact sheet to the Chairman, Senate Com-
              mittee on Armed Services; the Chairmen, Subcommittees on Defense,
              House and Senate Committees on Appropriations; appropriate congres-
              sional committees; the Secretaries of the Defense and the Air Force; and
              the Director, Office of Management and Budget.




              Page 2                                        GAO/NSL4MJO-230FS   B2 Contracts