## Sunday, April 17, 2011

### Acquisition Death Spirals

This isn't about the normal death spiral of increasing unit costs driving production cuts, which increases unit costs, which drives production cuts, which.... It's about another sort of price spiral caused by the US government's infatuation with sole-sourcing critical capabilities. I think this is largely due to technocrats trusting simple, static industrial-age cost models which support decisions dominated by returns from economies of scale. The basic logic of the decisions these models support (an equilibrium solution) is: "things will be cheaper with one supplier because the overhead will be amortized over bigger quantities."

The basic mistake these models make is neglecting the dynamics. Price is a dynamic thing. If the capability is very critical, and there is only one supplier, then there is almost no ceiling on how high the price can rise. The price level reached under those dynamics is just below the point where you'd stop paying for the capability in favor of a more important one (I'll call this the buyer's "level of pain"). The alternative dynamics occurs when there are multiple competing suppliers. The price reached under these dynamics asymptotes towards the economic costs (this takes into account barriers to entry / opportunity costs). Here's a simple graph illustrating price behavior under these two situations.

 Price Dynamics
This price increase doesn't happen because the contractors are evil. It happens because the contractors have a duty to their shareholders to maximize profit. This is, in fact, the ethical thing for them to do. If their customer is foolish and decides to create a little monopoly for them with every procurement, well, too bad for the customer's shareholders (taxpayers in this case)...

We see these dynamics play out in a variety of defense acquisitions. The F-35 engine program and the Evolved Expendable Launch Vehicle program are two exemplars that are currently making the news.

The F-35 engine procurement was initially structured to support two suppliers during development, much like the engine programs for F-15 and F-16. There are operational advantages to having two engines. If a problem is found in one model, only half of the Air Force's tactical aircraft would have to be grounded while the solution is found. The other advantage comes from the suppliers competing with each other on price for various lots of engines. A disadvantage is overhead and development cost for the two suppliers and possibly increased logistics footprint for supporting two different engine models.

The recent news is that the budget does not include funds for the second engine. Not a week after this budget is passed which makes the engine buy a sole-source deal, we have an Undersecretary of Defense for Acquisition complaining about the price from the remaining supplier.

"I'm not happy, as I am with so many parts of all our programs, with (the P&W engine's) cost performance so far," Carter told the House of Representatives Appropriations subcommittee on defense on Wednesday. "We need to drive the costs down." [...] "Our analysis does not show the payback," Carter told the subcommittee. He added that "people of good will come to different conclusions on this issue." U.S. "not happy" with F-35 engine cost overruns
Did the analysis include the second supplier offering to assume the risks and go fixed price on the development? Is complaining about the price, being really unhappy about paying it, but paying it anyway because there is no alternative anything but empty political theater? Makes for great content in the trade rags: Acquisition Official gives contractor a stern talking to! Contractor hangs head in a suitably chastened way, "yes, our prices are very high for these unique capabilities, we are working hard to contain the costs for our customer." Much harrumphing is heard from various congresscritters, meanwhile the price continues to spiral higher...

In the case of the EELV, despite the fact that the Air Force paid for two parallel rocket development programs we now have just a single supplier. The two launch service providers were so expensive, they could not compete in the commercial market. The business case for the two rockets hinged on them being able to make money in the commercial market and get their launch rates up. When no other customers but the US government could afford their high prices they had to combine into the single consortium: ULA. So it's sole-source with two vehicles. Recall the various advantages and disadvantages of developing two products discussed above in the case of the F-35 engine. Now EELV has the worst of both worlds: high overhead and logistics costs to support two vehicles, and no competition or customer diversification to get flight rates up and bring prices down.

Launch-service providers agree that their viability, as well as their ability to keep costs down, is based on launch rhythm. The more often a vehicle launches, the more reliable it becomes. Scale economies are introduced as well in a virtuous cycle. One U.S. government official agreed that if SpaceX is now allowed to break ULA’s monopoly on U.S. government satellite launches as indicated by the memorandum of agreement, it could force ULA’s already high prices even higher as it eats into ULA’s current market. “In the longer term we may be faced with questions about whether one of them [ULA or SpaceX] can remain viable without direct subsidies — the same questions we faced with ULA,” this official said. “Then what do we do? We have a policy of assured access to space, which means at least two vehicles. The demand for launches has not increased since ULA was formed, so we could be heading toward a nearly identical situation in a few years. But we are spending taxpayers’ money and if we can find reliable launches that are less expensive, we are not going to ignore that.” SpaceX Receives Boost in Bid To Loft National Security Satellites
It is interesting to note the thinking of the unnamed government official. He doesn't recognize the dynamics of the situation. He's living in a sole-source mindset, it just happens that he's going to change to this new, lower cost source.

NASA has a pricing model that shows savings from "outsourcing development", but not because of any interesting dynamics that they've included. The justification is the same as those underlying the broken decisions about aircraft engines: "returns from economies of scale". The dynamics of competition remains ignored.

NASA Deputy Administrator Lori Garver, in a separate presentation here April 12, said the agency’s policy of pushing rocket-development work onto the private sector will only reach maximum benefit if other customers also purchase the vehicles developed initially with NASA funding. Referring specifically to SpaceX, Garver said a conventional NASA procurement of a Falcon 9-class rocket would cost nearly $4.5 billion according to a NASA-U.S. Air Force cost model that includes the vehicle’s first flight. Outsourcing development to SpaceX, she said, would cut that figure by 60 percent, but only if other customers purchase the vehicle, thus permitting scale economies to reach maximum effect. After Servicing Space Station SpaceXs Priority is Taking on EELV The way out of the death spiral is program dependent. In the EELV case it took a new entrant who has signed commercial contracts in addition to chasing the government launches (from a couple different agencies). SpaceX has built in significant customer diversification that ULA never developed (though this was hoped for in the early justifications of the program structure). Why did Lockheed-Martin and Boeing, and subsequently ULA never develop this customer diversification? Because they didn't have to. The government guaranteed their continued existence. SpaceX, on the other hand, has no such guarantee. The only option for their continued existence is to make a profit from more than one customer. In the F-35 engine case, DoD has decided that even the assumption of development risk by the second supplier under a fixed price contract is not enough to close the case. This puzzles me. Maybe the second engine has become a symbol of "duplication and waste" rather than "competition and efficiency". If so, then DoD has given the primary engine supplier a way to "frame" their competition out of existence with political argument (removing the need for them to earn market share honestly). The outlook for lower cost space access looks good. However, as long as the DoD is stuck in its current frame, there is great opportunity for political theater that will serve mainly as a content generator for defense trade publications and a distraction from the root cause of steadily rising tactical aircraft engine costs into the future. #### 9 comments: 1. Bloomberg News (4/26, Capaccio) reports, "The US Defense Department told General Electric Co. (GE) and Rolls-Royce Group Plc (RR/) it was ending their 14-year-old project on a second engine for the F-35 Joint Strike Fighter." A GE spokesperson said the company would try to get Congressional supporters to reinstate the funds in the 2012 budget. 2. Network World (5/4, Cooney) reports, "The Air Force today said it will host a space test program meeting next week ahead of expected contract offerings, or Broad Agency Announcements looking to recruit commercial space providers." These meetings will "provide interested companies with an overview of specific areas of interest, promote an early exchange of information, and provide an opportunity for both the government and industry to gather more information prior to the request for studies" 3. Lawmakers Attempting To Reinstate F-35 Alternate Engine Program. Bloomberg News (5/4, Tiron) reports that members of the House want to reinstate funds in the 2012 defense authorization bill for the alternate F-35 jet engine being developed by GE and Rolls Royce. Rep. Roscoe Bartlett of the House Armed Services Committee, which is writing the bill, wants "to limit money spent on improving the F-35 Joint Strike Fighter engine unless the secretary of defense makes funds available for 'two options' for the F-35 propulsion system." However, even if the program was restarted, it "would entail having the companies fund the work themselves for at least the remainder of 2011 and during 2012, according to GE Aviation spokesman Rick Kennedy." 4. Agencies Working To Develop Requirements For New Launchers. Bloomberg News (5/6, McGarry, Capaccio) reports that in collaboration with NASA and the National Reconnaissance Office, the US Air Force wants "to develop common certification requirements for possible new entrants" in the military and spy satellite launch business because until now there has been a "monopoly" by the United Launch Alliance. SpaceX and Orbital Sciences are developing rockets that could compete for contracts since ULA "has failed to drum up enough nongovernment business to achieve targeted launch costs of$150 million to $170 million, says" Teal Group analyst Marco Caceres. The article notes the USAF "plans to bid out several launches, beginning with the National Oceanic and Atmospheric Administration's Deep Space Climate Observatory satellite, scheduled for fiscal 2012." 5. In some circles, this sort of sanity is criticized: In other words, contrary to Thompson's account, there is no huge risk in relying on SpaceX, because NASA is not relying on SpaceX -- it has a diversified portfolio of other players, including the Boeing Corporation, on which it can fall back if SpaceX does (contrary to its history) somehow falter. NASA has little riding right now on SpaceX, except$75 million, and the bet is not risky because it's spread it across the table.
Legacy Space Companies Running Scared

6. ...technocrats trusting simple, static industrial-age cost models which support decisions dominated by...
NASA Analysis: Falcon 9 Much Cheaper Than Traditional Approach: "NASA recently conducted a predicted cost estimate of the Falcon 9 launch vehicle using the NASA-Air Force Cost Model (NAFCOM). NAFCOM is the primary cost estimating tool NASA uses to predict the costs for launch vehicles, crewed vehicles, planetary landers, rovers, and other flight hardware elements prior to the development of these systems. NAFCOM is a parametric cost estimating tool with a historical database of over 130 NASA and Air Force space flight hardware projects. It has been developed and refined over the past 13 years with 10 releases providing increased accuracy, data content, and functionality. NAFCOM uses a number of technical inputs in the estimating process. These include mass of components, manufacturing methods, engineering management, test approach, integration complexity, and pre-development studies. Another variable is the relationship between the Government and the contractor during development. At one end, NAFCOM can model an approach that incorporates a heavy involvement on the part of the Government, which is a more traditional approach for unique development efforts with advanced technology. At the other end, more commercial-like practices can be assumed for the cost estimate where the contractor has more responsibility during the development effort."

And even when they attempt to model more "commercial-like" processes, they are still too expensive by a factor of 3 or so...

7. New York Times
June 2, 2011
Defense Procurement

To the Editor:
Your May 24 editorial “More Spending, Fewer F-35s” states that the “competition has already been won” for an engine for the F-35 aircraft. Readers might conclude that a competitive bidding process took place, which is not the case.

Last March, the most senior acquisition official in the Defense Department, Ashton Carter, testified before Congress that Pratt & Whitney had been awarded a noncompetitive contract for the engine. And even Pratt & Whitney’s contracts with the Department of Defense clearly state “not competitively procured.”

In your editorial, you say “competition can cut costs.” Nowhere is this more valid than in reforming the defense procurement process. The competing engine, created by G.E. and Rolls-Royce, is 80 percent complete, and the companies recently offered to finance continued development through fiscal year 2012 at no cost to the taxpayer.

This is acquisition reform in action. Congress should accept it.

ROBERT ANDREWS
, Washington, May 26, 2011

The writer is a Democratic congressman from New Jersey.

8. The effort to maintain that monopoly is based on a line of reasoning which, like any good fiction, requires a willful suspension of disbelief. In this case, ULA’s contention that a block buy is necessary because the industrial base is threatened asks one to accept the proposition that SpaceX, the Merlin engine, and the Falcon 9 booster are somehow not a part of the industrial base, whereas the Atlas V’s Russian-supplied RD-180 engine is.
Competition and the future of the EELV program