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EADS A400M Offers A Cautionary Tale On Fixed Price Contracts

One of the reforms proposed by the Obama Administration and actually many others in the past is to have the Defense Department award more fixed price contracts. This means the contractor will receive a certain amount of money for the product no matter what. The other alternative is a cost plus one where the actual costs of the contractor are paid with some fee added to provide profit. These contracts have fallen in-and-out of favor but one of the biggest criticisms of them is that they reward failure.

If a program takes longer to develop or produce the contractor doesn't get financially punished for that but continues to receive all of their costs. The counter argument is that often delays occur because the Government adds requirements or work to the contract causing it to grow in length and cost.

The two contracts are different as they assign the risk to different entities. The fixed price to contractors and that is why they are normally used to pay for things already developed and in steady state production where costs are known. Cost plus moves the risks back to the Government and are used for development and test programs where the final outcome is not defined and there could be cost and schedule growth. In the past a few development programs have tried fixed price contracts with the result being the contractor losing money on them.

EADS (EADS.P) was contracted six years ago to develop and produce the A400M transport aircraft for several different European countries. The contract was a fixed price one for about twenty billion Euros or $29 billion at current exchange rates. The schedule called for first flight in 2007. The buying countries put up money at the beginning to jump start the program with a contract clause saying that if the schedule was not met then EADS would have to pay back some of this money. Needless to say the A400M program is two years behind schedule due to engine and software integration problems.

The buyers and EADS have been in a year long discussion as to what to do to resolve the contract. These customers have so far postponed being paid back while they discuss renegotiating the contract. The A400M is heading for its first flight this week.

EADS has proposed increasing the contract price by another five billion Euros to complete the program. This would ensure that the company is able to deliver the aircraft and in general remain strong. There is no motivation other then receiving the aircraft for the customers to take this deal. They have the right currently to demand the pay back from EADS and go look for another solution. South Africa one of the two foriegn customers has already canceled their order.

The A400M provides yet another illustration as if there needs to be one why fixed price contracts don't always work for new programs. The A400M was supposed to be the premier aerospace program in Europe and provide a way for EADS to compete with the C-130J made by Lockheed Martin (LMT) for international sales. This aircraft has been in production for several years and garnered several orders from around the globe as well as the U.S. Air Force and Marines. Unfortunately because of the technical complexity EADS was not able to meet the original schedule.

It may be that the new price is agreed to and the contract will continue and the A400M will begin deliveries in 2011. It may also be that countries like England and Germany who are facing budgetary pressures may have to end or cut their orders. Some may also demand that EADS honor the original contract and pay back the funds. No matter what it demonstrates yet again that a company takes on a great deal of risk when it accepts a firm fixed price contract for a complex, new program.

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