Northrop Grumman Sticks To Guns On Transferring Risk

(MoneyWatch)  Less then two weeks ago Northrop Grumman (NOC) and its partner EADS (EADS.P), the parent company of Airbus, sent a letter to the Department of Defense stating that they may not submit a bid for the latest attempt to buy a new large tanker for the U.S. Air Force. The actual letter may be found here. This is the third attempt since the 200o to award a contract for this capability. Northrop and EADS won the contract last year but lost it on protest by Boeing (BA).

Northrop's concerns with the current draft Request for Proposal (RFP) are two fold. First they feel the requirements as laid out bias the competition to the smaller, cheaper Boeing K-767 aircraft rather then the larger, more capable Airbus 330 based tanker they proposed last time and will this time as well. Secondly their is concern that the Defense Department is trying to keep costs down by using a fixed price development contract for the aircraft. This approach transfers a great deal of the cost risk to the contractor as if there are schedule or technical problems they cannot necessarily make any money as the fixed amount will get spent. The recent A400M program by EADS illustrates this problem.

The CEO of Northrop, Ron Sugar, will be retiring by the New Year followed up this letter with an interview with various media outlets where he continued to stress the folly of moving to fixed price contracts for risky programs. Mr. Sugar pointed out that in the past many programs were not finished due to cost and schedule issues and the use of fixed development contracts was not appropriate. He used the example of the A-12 and TRISAM programs which were canceled by the Government after problems. In the A-12 case which ended almost twenty years ago the contractors and the Government are going to the Supreme Court to settle the costs related to ending the program early.

Mr. Sugar pointed out as well that fidelity to share holders might mean less chance that contractors will bid on these programs due to the risk. He did not specifically mention the KC-X contract but that must be a concern. While both the 767 and A330 based aircraft are in development for other countries there will be some risk involved in making the necessary modification to meet U.S. specific requirements that may cause costs and time to increase.

Fixed price contracts have been advocated before as a way for the Government to save money and control costs. Unfortunately they are based on the need for a high fidelity cost estimate at the beginning of the program which historically has proven hard to develop. There is also budgetary and political pressures to have the lowest cost possible for these kind of programs at the beginning. This makes it easier to sell to Congress and get things started. Then if costs grow it is hard for the Government to not fund it as the system is considered necessary. Most of the canceled programs get ended because it becomes clear that they will not meet requirements in the near term or at a reasonable cost increase. There have been cases though when programs are continued and do deliver useful capability but at a cost much higher then originally projected.

There are some analysts who feel Northrop is bluffing and will continue to participate in the KC-X contest. There is no other contract out there that has this amount of money and work. The Pentagon needs them too as they want competition. Unfortunately when there are only two Western companies with the necessary product this is a situation that will arise. The Government wants a contest that won't end in a protest and will deliver needed tanker capability and performance as soon as it can. They may be disappointed one way or another.

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