The use of fixed-price contracts—such as the Air Force's high-profile KC-46 development—is helping the government limit its financial exposure in projects. But the service still has work to do in allocating what will likely be more limited funding as the federal government struggles to address an unacceptably high federal debt.

Air Force officials are seeking to stem rising support costs and reduce contractors' abilities to sharply boost profits—to as much as 30%—in production lots toward the end of a manufacturing run. These measures are aimed at keeping down costs as the threat of sequestration, which could kick in as early as March, has created a “wasteful churn” of what-if spending drills, says Air Force Secretary Michael Donley.

In the near term, the Air Force is taking measures such as delaying the purchase of information technology and office furniture and limiting military flights to only mission-essential ones. This means fighters will be a no-show at sporting and other special events.

There will be an impact on flying-hour accounts, but the service is doing what it can to safeguard readiness-related funding. “We're trying to protect maintenance for aircraft and weapons systems sustainability as long as we can into the fiscal year,” Donley says. “We will have to look at what the third- and fourth-quarter execution will look like [and assess the number] of aircraft that we take into our depots and what the expected output is, and what has the most or least impact on readiness.” At units across the globe, commanders are also prioritizing what skills are most critical for airmen to stay current, and leaving other skills unaddressed.

An inevitable result of sequestration or other cuts is a further pinch on the accounts the service uses to develop and buy new technology and platforms. Air Force leadership remains committed to funding upgrades to the F-22 and developing and buying the F-35, both Lockheed Martin products, as well as working on the KC-46, a next-generation aerial refueler being developed by Boeing. It also plans to continue developing the next-generation bomber over the “long term,” Donley says without adding any clarification on timing. “We are going to try to keep programs like that on track,” he says.

As leaders grapple with making painful trades among programs and accounts, the Air Force acquisition corps is preparing to spend strategically what money it may have in the future. After a decade of some very high-profile procurement missteps—including a handful of successful challenges to source selections—this could be an opportunity for the Air Force to prove it has turned around. That would be especially welcome after a decade of bloated cost-plus contracts where companies seemingly got a blank check for overrunning contracts.

Whether or not the sequestration cuts occur, the Air Force plans to protect the integrity of its fixed-price, incentive-fee contract with Boeing to develop the KC-46, says Air Force Lt. Gen. C.R. Davis, military deputy for acquisition. “If [sequestration] had started at the beginning of the year and had been as high as [a] 12% [cut], there would have been challenges with the tanker program,” Davis tells Aviation Week. “We are not going to reopen and renegotiate the contract by any stretch of the imagination.”

The Air Force's decision to issue a fixed-price, incentive-fee development contract was controversial at the time of the KC-X competition. Contractors balked, claiming that a fixed-price development put too much financial risk on them. In the end, however, Boeing underbid rival EADS by about 10% to win the competition and opted to put as much as $400 million of its own funding into the program because its estimates exceeded the government ceiling of $4.9 billion (including the Air Force share of the target overrun).

Reopening the KC-46 contract could expose the Air Force to major cost escalation, as it would give Boeing a chance to recoup its losses and seek compensation for any unplanned work that has been discovered since the contract was issued nearly two years ago.

“There is nothing that says at March 1, if sequestration kicks in, we will not have enough money to pay Boeing,” Davis says. This is because the value of the program line item that funds the tanker is greater than the anticipated annual cost of progress and incentive payments to Boeing. Those excess funds are for such items as management reserve. So, while the program line item could be reduced, the service would first decrease funding not related to the contract.

“Any amount of sequestration would just about take any reserve [that] all of the programs have to make any changes or [address] any unknowns . . . . So you have no [management reserve], you have no ability to handle change proposals, you have no ability to handle a failed test,” Davis says. “I still think tanker is going to lose a lot of its flexibility at the program level to handle [these issues, but] of course, the idea of tanker is not to have any evolutionary changes.”

Similarly, the service would trim funds around multiyear programs—gutting spares and ancillary equipment purchases for a program—rather than cutting into those contracts, Davis says.

The Pentagon, and particularly the Air Force, has made a concerted effort to sharpen its contracting skills to limit financial exposure and share risk and reward with the contractor. This produced such fixed-price contracts as the KC-46 and Raytheon's Small-Diameter Bomb II. “We didn't necessarily implement that strategy to drive behavior,” Davis says. “We implemented that strategy because we believed the maturity of the program or the technology . . . warranted it.” But the shift is driving changes in how contractors work.

“It is forcing both the contractor and the program to be more realistic in their assessment of what is doable and what is not,” he says. “And if the contractor chooses to devote some of his funds or some of his profit to be competitive in the program, that bears out as well. . . . . They also have to decide how much of the profit they have to put in the bid. That is something, I think, contractors ought to have a willingness to do.”

Davis notes that fixed-price, incentive-fee contracts are not a panacea. The trick is in knowing the right contracting mechanism for each project, based on a technology's maturity and/or production readiness. While the Air Force has improved its contracting skills, there remains much for it to learn. For example, the service would like to gain better insight into the costs of a program as they bear out, lot over lot during production, which is generally when the price decreases substantially as the contractor progresses along a learning curve and companies can increase profit.

“We want to do fixed-price [contracts] so the contractor will invest and improve the quality of the product and improve the cost of it, and then we want to make sure we have enough insight into it so that all of that just does not instantly roll into windfall profits on the contractor side,” Davis says. “We want to figure out ways to be able to share all of this great work they are doing, so that when we negotiate a profit of 12-15%, over years—if we don't make some adjustments to it—that 12-15% can climb quite rapidly to 20, 25, 30%.” He adds that “you need to pay attention to what is happening lot over lot so that it is fair. The contractor continues to make a fair and increasing profit and the government continues to see a fair and decreasing cost of the item, and they both share in that.”

Davis says these seemingly runaway profits have been seen in programs such as munitions, which often have very long production runs, and, in some cases, in multiyear programs. Late in a production run, contractors often benefit from a learning curve, when processes and personnel are operating most efficiently.

And the service is now focusing on the operations and sustainment world, where contractors earn billions maintaining aircraft fleets. In sustainment, Davis says,“I don't think we have gone to the same level of sophistication of these contracts as we need to.”

The cost of maintaining weapon systems is increasing year over year, he says, in part because the fleet is aging more rapidly than it can be replaced. But the service is studying a peculiar trend it has discovered: The cost of maintaining weapon systems through contractor logistics support—maintenance done by a company—is increasing faster than the cost of maintaining them through the government's own depot system. “We are just trying to [get] at what are the true costs of sustainment,” says Davis.

This review is especially important as the Pentagon struggles to determine the forthcoming expense of maintaining and operating the F-35 fleet. The Air Force has not reduced its planned buy of 1,763 aircraft, despite the funding crunch. Last year, Naval Air Systems Command arrived at a sustainment figure exceeding $1 trillion for 50 years of service, stunning Pentagon officials and lawmakers. The services are now refining those numbers.

But, according to some Pentagon officials, just as important as the cost of maintenance is implementing contracts that can manage the government's exposure. While near-term work to better understand contractor logistics support and the depot maintenance costs will impact programs on the books today, they are sure to be a training ground for the F-35 maintenance plan.

The F-35 Joint Program Office held an industry day last year to explore various ideas for maintaining the massive fleet, though no results have been released by program officials.