The market for defense R&D is imperfect and fails to provide a reliable mechanism by which the government can automatically secure performance at or near minimum cost. Cost control of work done under contract is therefore an important aim for defense R&D management.
In the past, two methods of cost control have been relied on by the government: (1) direct control through involvement in the firm’s financial and technical operations, and (2) indirect control through incentives (usually profit-sharing incentives) provided in the development contract.
This Memorandum contends that both of these methods are inadequate to ensure low-cost performance. Because of the uncertainty surrounding development tasks as generally contracted for, a wide margin of discretionary choice is available to both government and contractor representatives. These opportunities for discretion (the author concludes) permit the contractor to develop adaptive responses which frequently render for direct and indirect controls ineffective. An alternative approach suggested here is to restructure the problem by partitioning the development task into technically separable component separately contracted for, and thereby to decrease uncertainty and increase the objectivity of cost negotiations and measures of performance… From a contractual point of view at least, the ‘systems approach’ to weapons procurement which has prevailed since 1953 appears to be distinctly suboptimal.
That was Oliver Williamson at RAND in 1965, who later became a father of transaction cost economics and a Noble prize winner, in Defense contracts: an analysis of adaptive response.
Of course, the direct controls Williamson alludes to includes audits as well as what is now called Earned Value Management and should cost studies. Indirect controls like incentives may not be as intrusive to the contractor, but still requires an estimated “target cost” from which profit sharing is calculated. Both methods require a lot of upfront project planning, and so tend toward the “total responsibility” contract concept where an entire development is contracted to a single prime.
The same year Williamson wrote this article, the Air Force experimented with the Total Package Procurement concept with Lockheed on the C-5A. One large development contract and one large production contract were negotiated. When technical issues cropped up, the contractor’s adaptive response indeed thwarted both direct and indirect controls. Lockheed was bailed out of the program. A congressional report determined that “Total-package and other large contracts should be broken down into smaller, more manageable segments.”
Although Williamson’s recommendation to partition tasks was largely ignored, Congress put modularity into law in 1996 for information technology programs. Title 41 US Code §2308 states, “To the maximum extent practicable, the head of an executive agency should use modular contracting for an acquisition of a major system of information technology.” This is reflected in FAR 39.103, making modular contracting the preferred approach for digital products and services.
Oliver Williamson got me interested in modular contracting, and I go into much more implementation detail in the Mason GovCon’s Acquisition NEXT playbook. It is also one of the topics on contracting for modern software that will be discussed at an excellent event on Tuesday March 22, 2022 at 1:00pm ET! Be sure to register here.
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