Defense Acquisitions: DOD Wastes Billions of Dollars through	 
Poorly Structured Incentives (05-APR-06, GAO-06-409T).		 
                                                                 
With DOD spending over $200 billion annually to acquire products 
and services that include everything from spare parts to the	 
development of major weapon systems, our numerous, large, and	 
mounting fiscal challenges demand that DOD maximize its return on
investment and provide the warfighter with needed capabilities at
the best value for the taxpayer. In an effort to encourage	 
defense contractors to perform in an innovative, efficient, and  
effective way, DOD gives its contractors the opportunity to	 
collectively earn billions of dollars through monetary incentives
known as award and incentive fees. Using these incentives	 
properly--in concert with good acquisition practices--is a key to
minimizing waste, maximizing value, and getting our military	 
personnel what they need, when and where they need it. Congress  
asked GAO to testify on DOD's use of award and incentive fees and
the role they play in the acquisition system. This statement	 
highlights the risks of conducting business as usual and	 
identifies the actions DOD needs to take to use these fees more  
effectively. DOD concurred or partially concurred with the seven 
recommendations GAO made in a previously issued report on award  
and incentive fees. GAO looks forward to seeing DOD turn these	 
promised steps into actual policy and practice. 		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-409T					        
    ACCNO:   A50897						        
  TITLE:     Defense Acquisitions: DOD Wastes Billions of Dollars     
through Poorly Structured Incentives				 
     DATE:   04/05/2006 
  SUBJECT:   Accountability					 
	     Awards						 
	     Contract administration				 
	     Contract performance				 
	     Contractor payments				 
	     Cost plus award fee contracts			 
	     Cost plus incentive fee contracts			 
	     Defense procurement				 
	     Department of Defense contractors			 
	     Investment planning				 
	     Weapons systems					 
	     Incentive fees					 
	     Investment management				 
	     Comanche Helicopter				 
	     F/A-22 Aircraft					 
	     Joint Strike Fighter				 
	     RAH-66 Helicopter					 

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GAO-06-409T

     

     * Background
          * Prevalence and Use of Award and Incentive Fees
     * A System in Need of Reform
          * A Case for Change:Moving TowardOutcome-BasedAward-Fee Cri
          * A Case for Change:Motivating Excellent Contractor Performan
          * A Case for Change:Ensuring Practice Is Consistent with Poli
          * A Case for Change:Developing and Sharing Proven Incentive S
     * Conclusions
     * Recent DOD Actions
     * GAO's Mission
     * Obtaining Copies of GAO Reports and Testimony
          * Order by Mail or Phone
     * To Report Fraud, Waste, and Abuse in Federal Programs
     * Congressional Relations
     * Public Affairs

                 United States Government Accountability Office

Testimony

GAO

Before the Subcommittee on Readiness and Management Support, Committee on Armed
                             Services, U.S. Senate

For Release on Delivery                               DEFENSE ACQUISITIONS 
Expected at 3:00 p.m. EDT    
Wednesday April 5, 2006      
                                DOD Wastes Billions of Dollars through Poorly 
                                Structured Incentives                         
                                Statement of David M. Walker Comptroller      
                                General of the United States                  

GAO-06-409T

DEFENSE ACQUISITIONS

DOD Wastes Billions of Dollars through Poorly Structured Incentives

  What GAO Found

DOD's use of award and incentive fees is an issue at the nexus of two
areas that GAO has designated "high risk" for DOD-contract management and
weapon system acquisition. Contract management has been a long-standing
business management challenge for DOD because it often cannot assure that
it is using sound business practices to acquire the goods and services the
warfighter needs. For weapon system acquisitions, the persistent and
long-standing nature of acquisition problems has perhaps made a range of
key decision makers complacent about cost growth, schedule delays,
quantity reductions, and performance shortfalls. DOD's strategies for
incentivizing its contractors, especially for weapon system development
programs, reflect the challenges in these areas.

DOD programs routinely engage in award-fee practices that do not hold
contractors accountable for achieving desired outcomes and undermine
efforts to motivate contractor performance, such as

     o evaluating contractors on award-fee criteria that are not directly
       related to key acquisition outcomes (e.g., meeting cost and schedule
       goals and delivering desired capabilities to the warfighter);
     o paying contractors a significant portion of the available fee for what
       award-fee plans describe as "acceptable, average, expected, good, or
       satisfactory" performance; and
     o giving contractors at least a second opportunity to earn initially
       unearned or deferred fees.

As a result, DOD has paid out an estimated $8 billion in award fees on
contracts in GAO's study population, regardless of whether acquisition
outcomes fell short of, met, or exceeded DOD's expectations. Despite
paying billions of dollars, DOD has not compiled data or developed
performance measures to evaluate the validity of its belief that award and
incentive fees improve contractor performance and acquisition outcomes.

These issues, along with those GAO has identified in DOD's acquisition and
business management processes, present a compelling case for change. By
implementing the recommendations GAO has made on award and incentive fees,
DOD can improve incentives, increase transparency, and enhance
accountability for the fees it pays. At the same time, by working more
broadly to improve its acquisition practices, DOD can set the right
conditions for getting better acquisition outcomes and making more
efficient use of its resources in what is sure to be a more fiscally
constrained environment.

                 United States Government Accountability Office

Mr. Chairman and Members of the Subcommittee:

I am pleased to be here today to discuss the Department of Defense's (DOD)
use of monetary incentives known as award and incentive fees. With DOD
spending over $200 billion annually to acquire products and services that
include everything from spare parts to the development of major weapon
systems, our numerous, large, and mounting fiscal challenges demand that
DOD maximize its return on investment and provide the warfighter with
needed capabilities at the best value for the taxpayer. In an effort to
encourage defense contractors to perform in an innovative, efficient, and
effective way, DOD gives its contractors the opportunity to collectively
earn billions of dollars through monetary incentives known as award and
incentive fees. Using these incentives properly, in concert with sound
acquisition practices, is a key to minimizing waste, maximizing value, and
getting our military personnel what they need, when and where they need
it. Unfortunately, DOD has not used these incentives effectively. How they
have been used and how we believe they should be used is the focus of my
statement today.

To put the issues related to DOD's use of award and incentive fees in
context, I want to step back and look at some of the broader management
challenges that confront DOD. The department is facing a significant
number of recurring problems in managing its major weapon acquisitions.
Although U.S. weapons are the best in the world, DOD's acquisition process
for weapons programs consistently yields undesirable consequences-dramatic
cost increases, late deliveries to the warfighter, and performance
shortfalls. These problems occur, in part, because DOD tends to
consistently overpromise and underdeliver in connection with major
acquisition efforts. In addition, DOD's weapons programs do not capture,
early on, the requisite knowledge that is needed to efficiently and
effectively manage program risks. For example, programs lack clearly
defined and stable requirements, move forward with unrealistic program
cost and schedule estimates, use immature technologies in launching
product development, and fail to solidify design and manufacturing
processes at appropriate junctures in development. As a result, wants are
not always distinguished from needs; expectation gaps are the norm;
problems often surface late in the development process; and fixes tend to
be much more costly than if they were caught earlier.

Cost increases incurred while developing new weapon systems typically mean
that DOD cannot produce as many of those weapons as intended nor can it be
relied on to deliver them to the warfighter when promised and with the
initially advertised capabilities. In addition, military operations in
Afghanistan and Iraq are consuming a large share of DOD resources and
causing the department to invest more money sooner than expected to
replace or fix existing weapons. Meanwhile, DOD is intent on transforming
military operations and currently has its eye on multiple megasystems that
are expected to be the most expensive and complex ever. These new desires
and long-standing acquisition and contract management challenges are
running head-on into the nation's current imprudent and unsustainable
fiscal path. At the same time, DOD's numerous business management
weaknesses continue to result in reduced efficiencies and effectiveness
that waste billions of dollars every year. These business management
weaknesses touch on all of DOD's major business operations, ranging from
the department's inadequate management of its overall business
transformation effort to decades-old financial management and information
technology problems to various contracting and selected supply chain
challenges. In fact, all these areas and more are on GAO's 2005
"high-risk" list of programs and activities that need urgent attention and
fundamental transformation to ensure that our national government
functions in the most economical, efficient, and effective manner
possible.

DOD's use of award and incentive fees is an issue at the nexus of two of
these high-risk areas-DOD contract management and DOD weapon system
acquisition. Contract management has been a long-standing business
management challenge for the department. DOD is the government's largest
purchaser, yet it is often unable to assure that it is using sound
business practices to acquire the goods and services needed to meet the
warfighter's needs. For example, we have found that DOD has not used
various contracting tools and techniques effectively-such as
performance-based service contracting, multiple-award task order
contracts, purchase cards, and, most recently, award and incentive fees.
For DOD weapon system acquisitions, we have found the persistent and
long-standing nature of acquisition problems has perhaps made a range of
key players both in the Pentagon and the Congress complacent about cost
growth, schedule delays, quantity reductions, and performance shortfalls
in weapon system programs. DOD's strategies for incentivizing its
contractors, especially on weapon system development programs, reflect
this complacency and are symptomatic of the lack of discipline, oversight,
transparency, and accountability in DOD's acquisition process. As a
result, DOD programs routinely engage in practices that undermine efforts
to motivate positive contractor performance and that do not hold
contractors accountable for achieving desired acquisition outcomes, such
as meeting cost and schedule goals and delivering desired capabilities to
the warfighter.

Specifics follow:

     o DOD generally does not evaluate contractors based on award-fee
       criteria that are directly related to key acquisition outcomes. In
       addition, the link between the elements of contractor performance that
       are included in the criteria and these outcomes is not always clear.
       As a result, DOD paid out an estimated $8 billion in award fees over
       the life of the contracts in our study population (from their
       inception through our data collection phase), 1 regardless of whether
       acquisition outcomes fell short of, met, or exceeded DOD's
       expectations.
     o DOD programs engage in practices that undermine efforts to motivate
       excellent contractor performance by regularly paying contractors a
       significant portion of the available fee for what award-fee plans
       describe as "acceptable, average, expected, good, or satisfactory"
       performance. Although the definition of this level of performance
       varies by contract, these definitions are generally not related to
       outcomes. About half of the contracts in our sample, allowed 70
       percent or more of the available fee to be paid for this level of
       performance.
     o DOD award fee practices do not promote accountability. DOD programs
       gave contractors on about half of the award-fee contracts in our study
       population at least a second opportunity to earn an estimated $669
       million in initially unearned or deferred fees.

Taken together, DOD's acquisition, business, and contract management
practices are contrary to the purpose of performance-based contracting
concepts and have resulted and, if not corrected in both form and
practice, will continue to result in wasting billions of dollars in
taxpayer funds. My statement today will focus on what steps DOD must take
to strengthen the link between monetary incentives and acquisition
outcomes and by extension increase the transparency and accountability of
DOD programs for fees paid and of contractors for results achieved. This
testimony draws upon our recently issued report on DOD's use of award and
incentive fees as well as the GAO High-Risk series and our body of work on
weapon system acquisitions.

Estimates of total award fees earned are based on all evaluation periods
held from the inception of our sample contracts through our data
collection phase, not just those from fiscal years 1999 through 2003. The
oldest award fee contracts in our sample were signed in fiscal year 1991.
For some contracts, the data collection phase ended as early as November
2004. For at least one contract, data collection was not complete until
April 2005.

Page 3 GAO-06-409T DOD's Use of Award Fees

                                   Background

GAO's many acquisition-related reports over the years raise serious
questions about the reasonableness, appropriateness, and affordability of
DOD's current investment plans; the soundness of the acquisition process
which implements those plans; and the effectiveness of the practices DOD
uses to manage its contractors, including the use of award and incentive
fees. These reports collectively present a compelling case for change.

Appendix I contains information about the scope and methodology for
GAO-06-66, Defense Acquisitions: DOD Has Paid Billions in Award and
Incentive Fees Regardless of Acquisition Outcomes. The work was conducted
in accordance with generally accepted government auditing standards.

Federal agencies, including DOD, can choose among numerous contract types
to acquire products and services. One of the characteristics that vary
across contract types is the amount and nature of the fee that agencies
offer to the contractor for achieving or exceeding specified objectives or
goals. Of all the contract types available, only award- and incentive-fee
contracts allow an agency to adjust the amount of fee paid to contractors
based on the contractor's performance. 2

Federal acquisition regulations state that award- and incentive-fee
contracts should be used to achieve specific acquisition objectives, such
as delivering products and services on time or within cost goals and with
the promised capabilities. For award-fee contracts, the assumption
underlying the regulation is that the likelihood of meeting these
acquisition objectives will be enhanced by using a contract that
effectively motivates the contractor toward exceptional performance.
Typically, award-fee contracts emphasize multiple aspects of contractor
performance in a wide variety of areas, such as quality, timeliness,
technical ingenuity, and cost-effective management. 3 These areas are

2

Other contract types do not provide this same level of control over fees
and profits. The two most prevalent DOD contract types (based on the
number of contract actions) are firm-fixed-price and cost-plus-fixed-fee.
Under firm-fixed-price contracts, DOD and the contractor agree on a price
and the contractor assumes full responsibility for all costs and the
resulting profit or loss. Under cost-plus-fixed-fee contracts, DOD
provides payment for the contractor's allowable incurred costs, to the
extent prescribed in the contract, and the contractor receives a fee that
was negotiated and fixed at the inception of the contract.

3

Award-fee contracts are intended to be flexible, so award-fee plans allow
contracting and program officials to change the fee criteria in these
areas and the weight given to each criterion from evaluation period to
evaluation period.

susceptible to judgmental and qualitative measurement and evaluation, and
as a result, award-fee criteria and evaluations tend to be subjective. 4
Table 1 provides a description of the general process for evaluating the
contractor and determining the amount of award fee earned.

           Table 1: General Process for Determining Award-Fee Amounts

DOD officials provide input on the contractor's performance for an
evaluation period that just ended.

Program officials compile data and prepare briefing or summary for
award-fee evaluation board.a

Award-fee evaluation board convenes meeting; contractor has option to
submit a self-assessment and brief the board.

Award-fee evaluation board considers all the input and recommends a fee
rating for the contractor.

Fee-determining official (usually outside the program) makes an initial
fee determination and notifies contracting officer.b

Contracting officer notifies contractor of initial determination;
contractor has the option to appeal the decision to the fee-determining
official.

Fee-determining official makes final determination, including whether to
roll over unearned fee, and notifies contracting officer.c

Contracting officer issues final determination to contractor and processes
a contract modification authorizing payment.

Sources: Army Contracting Agency Award Fee Handbook, Air Force Award Fee
Guide, Navy/Marine Corps Award Fee Guide (data); GAO (analysis).

a

Award-fee evaluation board members may include personnel from key
organizations knowledgeable about the award-fee evaluation areas, such as:
engineering, logistics, program management, contracting quality assurance,
legal, and financial management; personnel from user organizations and
cognizant contract administration offices; and the local small business
office in cases where subcontracting goals are important. On major weapons
programs, the boards are generally made up of personnel from the program
office.

b

The fee-determining official is generally at a higher level
organizationally than those directly involved in the evaluation of the
contractor (e.g. award-fee board members). For instance, this official can
be the program executive officer for a weapons system acquisition contract
or a garrison commander on a base support services contract.

Rollover is the practice of moving unearned award fee from one evaluation
period to a subsequent evaluation period or periods, thus providing the
contractor an additional opportunity to earn previously unearned fee.

The Navy Award Fee Guide suggests that objective measures also be
utilized, to the maximum extent possible, to support the subjective
evaluation of the contractor's performance.

Page 5 GAO-06-409T DOD's Use of Award Fees

Prevalence and Use of Award and From fiscal year 1999 through fiscal year  
Incentive Fees                  2003, award- and incentive-fee contract    
                                   actions5 accounted for 4.6 percent of all  
                                   DOD contract actions over $25,000.         
                                   However, when taking into account the      
                                   dollars obligated-                         
                                   award- and incentive-fee contract actions  
                                   accounted for 20.6 percent of              
                                   the dollars obligated on actions over      
                                   $25,000, or over $157 billion, as          
                                   shown in figure 1. Our sample of 93        
                                   contracts includes $51.6 billion, or       
                                   almost one-third, of those obligated       
                                   award- and incentive-fee contract          
                                   dollars.6 These obligations include award- 
                                   and incentive-fee payments as              
                                   well as other contract costs.              

Figure 1: Prevalence of Award- and Incentive-Fee Contracts, Fiscal Years
1999-2003

    DOD contract actions over $25,000 DOD contract dollars obligated on actions
    over $25,000

(fiscal years 1999-2003) (fiscal years 1999-2003)

$157.2 billion (20.6%)

DOD award-and incentive-fee contracts

Cost-plusaward fee: 13.0% Fixed-price incentive: 5.1% Cost-plus incentive
fee: 2.5%

Other DOD contracts

Firm-fixed price: 51.4% Cost-plus fixed-fee: 11.9% Other: 16.1%

DOD award-and incentive-fee contractsOther DOD contracts

Sources: Federal Procurement DataSystem (data); GAO (analysisand presentation).

5

Contract actions include any action related to the purchasing, renting, or
leasing of supplies, services, or construction. Contract actions include
definitive contracts; letter contracts; purchase orders; orders made under
existing contracts or agreements; and contract modifications, which would
include the payment of award and incentive fees.

6

These contracts were selected as part of a probability sample of 93
contracts from a study population of 597 DOD award-fee and incentive-fee
contracts that were active between fiscal years 1999 and 2003 and had at
least one contract action coded as cost-plus-award-fee,
cost-plus-incentive-fee, fixed-price-award-fee, or fixed-price incentive
valued at $10 million or more during that time.

DOD utilized the contracts in our sample for a number of purposes. For
example, research and development contracts accounted for 51 percent (or
$26.4 billion) of the dollars obligated against contracts in our sample
from fiscal years 1999 through 2003; while non-research-and-development
services accounted for the highest number of contracts in our sample.
Further, we estimate that most of the contracts and most of the dollars in
our study population are related to the acquisition of weapon systems.

DOD has the flexibility to mix and match characteristics from different
contract types. The risks for both DOD and the contractor vary depending
on the exact combination chosen, which, according to the Federal
Acquisition Regulation, should reflect the uncertainties involved in
contract performance. Based on the results from our sample, about half of
the contracts in our study population were cost-plus-award-fee contracts.
The theory behind these contracts is that although the government assumes
most of the cost risk, it retains control over most or all of the
contractor's potential fee as leverage. On cost-plus-award-fee contracts,
the award fee is often the only source of potential fee for the
contractor. According to defense acquisition regulations, these contracts
can include a base fee-a fixed fee for performance paid to the
contractor-of anywhere from 0 to 3 percent of the value of the contract; 7
however, based on our sample results, we estimate that about 60 percent of
the cost-plus-award-fee contracts in our study population included zero
base fee. 8 There is no limit on the maximum percentage of the value of
the contract that can be made available in award fee, although the 20
percent included in the Space-Based Infrared Radar System High development
contract we examined was outside the norm. The available award fees on all
the award-fee contracts in our study population typically ranged from 7 to
15 percent of the estimated value of the contract.

DOD's use of award and incentive fees is symptomatic of an acquisition
system in need of fundamental reform. DOD's historical practice of Reform
routinely paying its contractors nearly all of the available award fee

creates an environment in which programs pay and contractors expect to

7The two F/A-22 development contracts in our sample included a 4 percent
base fee. The program office received a deviation from the Defense Federal
Acquisition Regulation Supplement, which allows for a maximum of 3 percent
base fee.

8

The 95 percent confidence interval surrounding this estimate ranges from
46 percent to 73 percent.

Page 7 GAO-06-409T DOD's Use of Award Fees

receive most of the available fee, regardless of acquisition outcomes.
This is occurring at a time when DOD is giving contractors increased
program management responsibilities to develop requirements, design
products, and select major system and subsystem contractors. Based on our
sample, we estimate that for DOD award-fee contracts, the median
percentage of available award fee paid to date (adjusted for rollover) 9
was 90 percent, representing an estimated $8 billion in award fees for
contracts active between fiscal years 1999 and 2003. Estimates of total
award fees earned are based on all evaluation periods held from the
inception of our sample contracts through our data collection phase, not
just those from fiscal years 1999 through 2003. 10 Figure 2 shows the
percentage of available fee earned for the 63 award-fee contracts in our
sample.

9

When calculating the percentage of award fee paid (i.e. percentage of
award fee paid = total fee paid to date / (total fee pool - remaining fee
pool)), we included rolled-over fees in the remaining fee pool when those
fees were still available to be earned in future evaluation periods.

10

The oldest award fee contracts in our sample were signed in fiscal year
1991. For some contracts, the data collection phase ended as early as
November 2004. For at least one contract, data collection was not complete
until April 2005.

Figure 2: Percentage of Available Fee Paid to Date for 63 Award-Fee
Contracts in GAO's Sample

      Percentage of available fee paid by DOD

                                      100

                                       80

                                       60

                                       40

                                       20

                            Contracts in GAO'ssample

Sources: DOD submissions to GAO and contract documentation (data); GAO
(analysis and presentation).

The pattern of consistently high award-fee payouts is also present in
DOD's fee decisions from evaluation period to evaluation period. This
pattern is evidence of reluctance among DOD programs to deny contractors
significant amounts of fee, even in the short term. We estimate that the
median percentage of award fee earned for each evaluation period was 93
percent and that the contractor received 70 percent or less of the
available fee in only 9 percent of the evaluation periods and none of the
available fee in only 1 percent of the evaluation periods.

    A Case for Change: Moving Toward Outcome-Based Award-Fee Criteria

Award fees have generally not been effective at helping DOD achieve its
desired acquisition outcomes, in large part, because award-fee criteria
are not linked to desired acquisition outcomes, such as meeting cost and
schedule goals and delivering desired capabilities. Instead, DOD programs
structure award fees to focus on the broad aspects of contractor
performance, such as technical and management performance and cost
control, that they view as keys to a successful program. In addition,
elements of the award-fee process, such as the frequency of evaluations
and the composition of award-fee boards, may also limit DOD's ability to
effectively and impartially evaluate the contractor's progress toward
acquisition outcomes. Most award-fee evaluations are time-based, generally
every six months, rather than event-based; and award-fee boards are made
up primarily of individuals directly connected to the program. As a result
of all these factors, DOD programs frequently paid most of the available
award fee for what they described as improved contractor performance,
regardless of whether acquisition outcomes fell short of, met, or exceeded
DOD's expectations.

High award-fee payouts on programs that have fallen or are falling well
short of meeting their stated goals are also indicative of DOD's failure
to implement award fees in a way that promotes positive performance and
adequate accountability. Several major development programs- accounting
for 52 percent of the available award-fee dollars in our sample and 46
percent of the award-fee dollars paid to date-are not achieving or have
not achieved their desired acquisition outcomes, yet contractors received
most of the available award fee. These programs-the Comanche helicopter,
F/A-22 and Joint Strike Fighter aircraft, and the Space-Based Infrared
System High satellite system-have experienced significant cost increases,
technical problems, and development delays, but the prime systems
contractors have received 85, 91, 100, and 74 percent of the award fee,
respectively to date (adjusted for rollover), totaling $1.7 billion (see
table 2).

Table 2: Program Performance and Award-Fee Payments on Selected DOD Development
                                    Programs

Comanche Acquisition reconnaissance outcomes attack helicopter

     F/A-22 Raptor Joint Strike Fighter Space-Based tactical fighter tactical
                               fighter Infrared System aircraft aircraft High

Research and development $3.7 billion $10.2 billion $10.1 billion $3.7
billion cost increase over original 41.2 percent 47.3 percent 30.1 percent
99.5 percent baseline

  Acquisition cycle time increase 33 months 27 months 11 months More than over
       original baseline 14.8 percent 13.3 percent 5.9 percent 12 monthsa

bNumber of program 14 1 rebaselines

Total award fee paid to prime $202.5 million $848.7 million $494.0 million
$160.4 millionc systems contractor paid through 2004

Percentage of award fee paid 85 percent 91 percent 100 percent 74 percent
to prime systems contractor of available fee (adjusted for rollover)d

Total award fee paid to prime No engine contractor $115 million $35.8
million No engine contractor engine contractor paid through 2004

Percentage of award fee paid N/A 89 percent 100 percent N/A to prime
engine contractor of the available fee (adjusted for rollover)d

Sources: DOD submissions to GAO, contract documentation, and GAO-05-301 (
data); GAO (analysis and presentation).

a

The Air Force Space Command has not specified the acquisition cycle time
for the Space-Based Infrared Radar System High program; however, the
delivery of the first two satellites has been delayed by more than a year.

b

Overall, there were five rebaselines for the Comanche program; however,
only one occurred after development start. The Comanche program was
canceled in 2004.

c

The program also utilizes incentive fees tied to cost and mission
successes. The award fee paid does not include fee earned through mission
success incentives. To date, the contractor has earned $3 million in these
fees and could earn over $70 million over the life of the contract.

d

When calculating the percentage of award fee paid to date (i.e.,
percentage of award fee paid to date = total fee paid to date / (total fee
pool - remaining fee pool)), we included rolled-over fees in the remaining
fee pool when those fees were still available to be earned in future
evaluation periods. For instance, even though the Joint Strike Fighter
prime contractor has not been paid 100 percent of the award fee that was
made available for each evaluation period, it retains the ability to
potentially earn all of this unearned fee at a later date. By reflecting
the continued availability of this unearned fee in the percentage
calculation, it becomes clear that the contractor has, in essence, earned
100 percent of the total award fee to date.

    A Case for Change: Motivating Excellent Contractor Performance and Promoting
    Accountability

DOD can ensure that fee payments are more representative of program
results by developing fee criteria that focus on its desired acquisition
outcomes. For instance, DOD's Missile Defense Agency attempted to hold
contractors accountable for program outcomes on the Airborne Laser
program. On this program, DOD revised the award-fee plan in June 2002 as
part of a program and contract restructuring. The award-fee plan was
changed to focus on achieving a successful system demonstration by
December 2004. Prior to the restructuring, the contractor had received 95
percent of the available award fee, even though the program had
experienced a series of cost increases and schedule delays. Importantly,
the contractor did not receive any of the $73.6 million award fee
available under the revised plan because it did not achieve the key
program outcome-successful system demonstration. 11

Recommendations made                  DOD response                         
o  Ensure that award-fee structures                                        
are                                   o  While DOD stated that award fee
motivating excellent contractor       arrangements should be structured to 
performance by only paying award fees encourage the contractor to earn the 
for above satisfactory performance    preponderance of fee by providing    
                                         excellent performance, it maintains  
                                         that paying a portion of the fee for 
                                         satisfactory performance is          
                                         appropriate to ensure that           
                                         contractors receive an               
                                         adequate fee on contracts. In its    
                                         March 29, 2006 policy memo, DOD      
                                         reiterated this position and         
                                         emphasized that less than            
                                         satisfactory performance is not      
                                         entitled to any award fee.           
o  Issue DOD guidance on when         o  In its March 29, 2006 policy      
rollover is                           memo,                                
appropriate                           DOD provided guidance and placed     
                                            several limitations on the use of 
                                                                    rollover. 

DOD programs routinely engage in award-fee practices that are inconsistent
with the intent of award fees, reduce the effectiveness of these fees as
motivators of performance, compromise the integrity of the fee process,
and waste billions in taxpayer money. Two practices, in particular, paying
significant amounts of fee for "acceptable, average, expected, good, or
satisfactory" performance and providing contractors multiple opportunities
to earn fees that were not earned when first made

11

According to DOD, the contract was restructured again in May 2004 and the
cost ceiling was increased from about $2 billion to $3.6 billion and the
period of performance of the contract was extended more than 3 years, from
June 2005 to December 2008.

Page 12 GAO-06-409T DOD's Use of Award Fees

available, undermine the effectiveness of fees as a motivational tool and
marginalize their use in holding contractors accountable for acquisition
outcomes.

Although DOD guidance and federal acquisition regulations state that award
fees should be used to motivate excellent contractor performance, most DOD
award-fee contracts pay a significant portion of the available fee for
what award-fee plans describe as "acceptable, average, expected, good, or
satisfactory" performance. Although the definition of this level of
performance varies by contract, these definitions are generally not
related to outcomes. Some plans for contracts in our sample did not even
require the contractor to meet all of the minimum standards or
requirements of the contract to receive one of these ratings. Some plans
also allowed for fee to be paid for marginal performance. Even
fixed-price-award-fee contracts, which already include a normal level of
profit in the price, paid out award fees for satisfactory performance.
Figure 3 shows the maximum percentage of award fee paid for "acceptable,
average, expected, good, or satisfactory" performance and the estimated
percentage of DOD award-fee contracts active between fiscal years 1999
through 2003 that paid these percentages.

Figure 3: Maximum Percentage of Award Fee Available for "Acceptable,
Average, Expected, Good, or Satisfactory" Performance and the Estimated
Percentage of DOD Contracts That Paid These Percentages

      Estimated percentage of DOD award-fee contracts

30

                                       26

25

22

22

20

15

12

10

8

6

4

5

0

                                     90-100

                                     40-49

                                     50-59

                                     60-69

                                     70-79

                                     80-89

0

Maximum percentage of award fee made available for "acceptable, average,
expected,good, or satisfactory" performance

Sources: Award-fee plansand contract documentation (data); GAO
(analysisand presentation).

Note: Sampling errors for percentages in this figure do not exceed plus or
minus 13 percentage points.

The use of rollover is another indication that DOD's management of
award-fees lacks the appropriate incentives, transparency, and
accountability necessary for an effective pay-for-performance system.
Rollover is the process of moving unearned available award fee from one
evaluation period to a subsequent evaluation period, thereby providing the
contractor an additional opportunity to earn that previously unearned
award-fee. We estimate that 52 percent of DOD award-fee contracts rolled
over unearned fees into subsequent evaluation periods, 12 and in 52
percent 13 of these periods, at least 99 percent of the unearned fee was
rolled over. Overall, for DOD award-fee contracts active between fiscal

12

 The 95 percent confidence interval for this estimate ranges from 40 percent to
                                  64 percent.

13

 The 95 percent confidence interval for this estimate ranges from 34 percent to
                                  69 percent.

                  Page 14 GAO-06-409T DOD's Use of Award Fees

    A Case for Change: Ensuring Practice Is Consistent with Policy

years 1999 through 2003, we estimate that the total dollars rolled over
across all evaluation periods that had been conducted by the time of our
review was $669 million.

The inconsistent application of DOD's existing policies on award fees and
weapon system development reinforce the need for increased transparency
and accountability in DOD's management of award fees. Although DOD
award-fee guidance and federal acquisition regulations state that award
fees should be used to motivate excellent contractor performance, most DOD
award-fee contracts still pay a significant portion of the available fee
for what award-fee plans describe as "acceptable, average, expected, good,
or satisfactory" performance. 14 Air Force, Army, and Navy guidance that
states rollover should rarely be used in order to avoid compromising the
integrity of the award-fee evaluation process; however, about half of the
contracts in our study population used rollover.

14

According to FAR 16.404(a)(1), in a fixed-price-award-fee contract, the
fixed price (including normal profit) will be paid for satisfactory
contract performance. Award fee earned (if any) will be paid in addition
to that fixed price. According to FAR 16.405-2(a)(2), a
cost-plus-award-fee contract should include an award amount that is
sufficient to provide motivation for excellence in such areas as quality,
timeliness, technical ingenuity, and costeffective management.

Page 15 GAO-06-409T DOD's Use of Award Fees

    A Case for Change: Developing and Sharing Proven Incentive Strategies

Recommendations made                  DOD response                         
o  Develop a mechanism for capturing  o  DOD will conduct an analysis of   
award- and incentive-fee data within  existing systems and determine       
                                         which, if any, is                    
existing data systems, such as the    best suited, to capture this type of 
Defense Acquisition Management        data and at what cost. DOD expects   
Information Retrieval system          to complete the study by June 1,     
                                         2006.                                
o  Develop performance measures to    o  DOD will review and identify      
evaluate the effectiveness of award   possible performance measures and    
and incentive fees as a tool for      determine the appropriate actions by 
improving                             June 1, 2006.                        
contractor performance and achieving  
desired program outcomes              
o  Develop a mechanism to share       o  In its March 29, 2006 policy      
proven incentive strategies for the   memo, DOD tasked Defense Acquisition 
acquisition of different types of     University to develop an online      
products and services                 
with contracting and program          repository for award- and            
officials across DOD                  incentive-fee policy information,    
                                         related training courses, and        
                                         examples of good award               
                                         fee arrangements.                    

Very little effort has gone into determining whether DOD's current use of
monetary incentives is effective. Over the past few years, officials
including the Undersecretary of Defense for Acquisition Technology and
Logistics and the Assistant Secretary of the Air Force for Acquisition
expressed concerns that contractors routinely earn high percentages of fee
while programs have experienced performance problems, schedule slips, and
cost growth. However, DOD has not compiled information, conducted
evaluations, shared lessons learned, or used performance measures to judge
how well award and incentive fees are improving or can improve contractor
performance and acquisition outcomes. The lack of data is exemplified by
the fact that DOD does not track such basic information as how much it
pays in award and incentive fees. Such information collection across DOD
is both necessary and appropriate.

                                  Conclusions

DOD's use of award-fee contracts, especially for weapon system
development, reflects the fundamental lack of knowledge and program
instability that we have consistently cited as the main reasons for DOD's
poor acquisition outcomes. DOD uses these fees in an attempt to mitigate
the risks that it creates through a flawed approach to major weapon system
development. The DOD requirements, acquisition, budgeting, and investment
processes are broken and need to be fixed. DOD's requirements process
generates much more demand for new programs than fiscal resources can
reasonably support. The acquisition environment encourages launching
product developments that promise the best capability, but embody too many
technical unknowns and too little knowledge about the performance and
production risks they entail. However, a new program will not be approved
unless its costs fall within forecasts of available funds and, therefore,
looks affordable. Further, because programs are funded annually and
departmentwide, cross-portfolio priorities have not been established,
competition for funding continues over time, forcing programs to view
success as the ability to secure the next funding increment rather than
delivering capabilities when expected and as promised.

The business cases to support weapon system programs that result from
these processes are in many cases not executable because the incentives
inherent in the current defense acquisition system are not conducive to
establishing realistic cost, schedule, and technical goals. As a result,
DOD has to date not been willing to hold its programs or its contractors
accountable for achieving its specified acquisition outcomes. Instead,
faced with a lack of knowledge and the lack of a sound business case, DOD
programs use award-fee contracts, which by their very nature allow DOD to
evaluate its contractors on a subjective basis. This results in billions
of dollars in wasteful payments because these evaluations are based on
contractors' ability to guide programs through a broken acquisition
system, not on achieving desired acquisition outcomes.

Implementing our recommendations on award and incentive fees will not fix
the broader problems DOD faces with its management of major weapons or
service acquisitions. However, by implementing our recommendations, DOD
can improve incentives, increase transparency, and enhance accountability
for the fees it pays. In particular, moving toward more outcome-based
award-fee criteria would give contractors an increased stake in helping
DOD to develop more realistic targets upfront or risk receiving less fee
when unrealistic cost, schedule, and performance targets are not met. To
make this new approach to incentives function as intended, DOD would also
need to address the more fundamental issues related to its management
approach, such as the lack of a sound business case, lack of well-defined
requirements, lack of product knowledge at key junctions in development,
and program instability caused by changing requirements and
across-the-board budget cuts. Working in concert, these steps can help DOD
set the right conditions for more successful acquisition outcomes and make
more efficient use of its resources in what is sure to be a more fiscally
constrained environment as the nation approaches the retirement of the
"baby boom" generation.

  Recent DOD Actions

Last week, DOD issued a policy memorandum on award-fee contracts that
takes steps towards addressing several of the recommendations made in our
report, and the department has indicated that further actions are planned
to address the remaining recommendations. This guidance is a positive
first step, but, like so many prior DOD concurrences, its effectiveness
will ultimately be determined by how well it is implemented. Identifying
who will be responsible for ensuring it is carried out and how progress
will be monitored and measured are key ingredients that are missing in the
new guidance. We continue to believe that DOD must designate appropriate
approving officials to review new contracts to ensure that award-fee
criteria are tied to desired acquisition outcomes; fees are used to
promote excellent performance; and the use of rollover provisions in
contracts is the exception not the rule. Changing DOD award-fee practices
will also require a change in culture and attitude. The policy
memorandum's position that it is appropriate to pay a portion of the
available award fee for satisfactory performance to ensure that
contractors receive an "adequate fee on contracts" is indicative of DOD's
resistance to cultural change. Finally, we encourage the department to
fully implement our remaining recommendations including developing a
mechanism to capture award- and incentive-fee data and developing
performance measures to evaluate the effectiveness of these fees.

Mr. Chairman and Members of the Committee, this concludes my prepared
statement. I would be happy to answer any questions you may have at this
time.

                       Appendix I: Scope and Methodology

In this statement, we examine fixed-price and cost-reimbursable award- and
incentive-fee contracts, as well as contracts that featured combinations
of these contract types. These contracts were selected as part of a
probability sample of 93 contracts from a study population of 597 DOD
award-fee and incentive-fee contracts that were active between fiscal
years 1999 and 2003 and had at least one contract action coded as
cost-plus-award-fee, cost-plus-incentive-fee, fixed-price-award-fee, or
fixed-price incentive valued at $10 million or more during that time.
Unless otherwise noted, the estimates in this statement pertain to (1)
this population of award- and incentive-fee contracts, (2) the
subpopulation of award-fee contracts, or (3) the evaluation periods
associated with contracts described in (1) or (2) that had been completed
at the time of our review. In the sample, 52 contracts contained only
award-fee provisions; 27 contracts contained only incentive-fee
provisions; and 14 contracts included both. Estimates of total award fees
earned and total award fees that contractors received at least two chances
to earn are based on all evaluation periods held from the inception of our
sample contracts through our data collection phase, 1 not just those from
fiscal years 1999 through 2003. Because the estimates in this report are
derived from a probability sample, they are subject to sampling error. All
percentage estimates from our review have margins of error not exceeding
plus or minus 10 percentage points unless otherwise noted. All numerical
estimates other than percentages (such as totals and ratios) have margins
of error not exceeding plus or minus 25 percent of the value of those
estimates.

1

For some contracts, the data collection phase ended as early as November
2004. For at least one contract, data collection was not complete until
April 2005.

(120517)

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