Potomac Institute for Policy Studies is pleased to announce the October Issue of STEPS: Science, Technology, and Engineering Policy Studies. Please enjoy this featured article:

Stress Fractures

Most who have been involved in the early stages of research and development, commonly referred to as science and technology (S&T), would agree that it is the basis for a long-range vision. It is the mechanism by which the innovative thought of some clever individual or group of individuals is allowed to begin the process of manifesting itself as a useful product. In the majority of cases this sort of innovation is born in small businesses and in many cases, it is actually a single individual who is the visionary or champion.

 

Stress Fractures

Funding for S&T efforts in the DoD has been a hotly debated topic for decades. Policies come and go with all of their attendant “adjustments” in both the planning and execution arenas. The long-range vision of the innovative, entrepreneurial people and companies are often severely affected by these adjustments. Recently, some new policies in the execution arena of contracting have raised eyebrows and given pause to both Government and contractor personnel in virtually all sectors of the military industrial complex. The National Defense Industrial Association wrote a detailed complaint to DoD on some of the new policies.1 Although the policy pendulum swings regularly and sometimes wildly in the budgeting and contracting arenas, the latest “jihad” basically began with the Budget Control Act and sequestration.2 From a policy perspective, sequestration is a classical paradox because everyone understands how and why it happened and yet no one truly understands it. Nor does anyone understand its full impact. Suffice it to say that because no one could agree on necessary budget cuts, almost everything was cut. The purpose of this article is not to analyze the sequestration decision process, but rather to discuss what I consider to be some secondary or tertiary effects of the process used to implement those decisions on the S&T enterprise, and show how they are likely to have a profound effect on how we will do business for the foreseeable future. I would submit that they will have far reaching unintended negative consequences for the whole military industrial complex, S&T specialists included.

Budget cuts happen all the time and Program Managers on both sides of the fence understand them. This is not new. Science and technology projects, like all others are always subject to having their budgets cut. For all of the traditional reasons, the major acquisition programs, by and large, were protected in the latest round of budgetary gymnastics. The focus for major reductions was, as usual, on proposed new starts and services. Both are realms where S&T often resides.

One specific budget-reducing tactic was to establish new caps on the amount that the Government would pay for any given labor category. The caps became fondly known as “tripwires”. (See examples of Navy Tripwire Guidance in notes 3 and 4 of this article.3,4) The concept, by itself, was not particularly bothersome. Caps already existed, for the most part – they were just lowered. Some could legitimately argue that it was a logical, “common sense” approach to budget reduction, although many might argue with the wisdom upon which the limits were determined. S&T labor can, after all, be quite expensive compared to other categories due to the level of seniority and specialization that is often involved, but let us set that argument aside for the moment. If the new tripwire limits had been applied to all future contracts, then the issue would be simply whether the new values were reasonable. Some might not like it, but there would be no real substantive argument against new values, other than whether contracts could be negotiated that could fulfill the needs. The new limits could also have been applied to the exercise of options under current contracts, since the exercise of an option is an open invitation for negotiations under the contract from both sides. Again, folks might not like it, but the provisions for these kinds of changes have long been in place under the FAR. However, whereas both of these approaches were utilized, the Government also unilaterally changed many contracts in the middle of an execution year with what amounted to a “take it or leave it” attitude.5 This, in my opinion, was a foul ball. The first order effects of such a policy are obvious. There is an almost instantaneous unplanned and un-negotiated reduction in revenue on a contract that is currently being executed. The numbers of options for the contractor are fairly limited. Among the first to surface were:

  1. Forfeiture of the contract. The message sent to many contractors was that they basically had to accept the changes or the Government would cancel the contract all together “for convenience”. Some of the large businesses opted to forfeit immediately and the Government “mysteriously” found a way to exempt their contracts from the tripwire policy because they couldn’t afford to lose the support. Funny how that works, but they had the horsepower to play that card. Few small businesses enjoy the luxury of being able to simply walk away from a contract when the Government misbehaves. Of course, those small businesses whose portfolios are entirely in the services category were particularly vulnerable and forfeiture of the contract was tantamount to closing their doors.
  2. Absorb the loss. This is another choice that is really only available to large businesses and/or those who have particularly large cash reserves. However, in an environment where service providers are being beaten down to margins in the 6% realm as opposed to typical commercial margins in the 30% realm, even the large businesses were loath to even consider such a thing. Large cash reserves in a 6% profit environment for anybody are not common.
  3. Reduce salaries. This choice quickly becomes very complex and has first, second and third order effects of its own that will vary from one company to the next, but the overall impact on the services community and the Government is negative. First of all, many of the employees in question are operating under an employment contract which may have been violated by this unilateral decision unless provisions for these sorts of unexpected changes had been provided for in advance, which was not likely. In the case of senior level personnel, who are the most likely to be affected by this policy, salary reductions on the order of 40% occurred and were common. Ordinary negotiations on changes of this magnitude may not even be reasonable or possible. The employee may have no choice but to take his expertise elsewhere. Of course, the second order effect is that the contractor may not be able to perform under his contract without that expertise. The Government loses access to the expertise. The work stops. This is forfeiture of the contract by another name. It’s just slower and more painful. To my surprise, some small businesses were actually able to reduce salaries and maintain their staff and hold onto their contracts. The budgeteers probably claimed a major victory in those cases. My opinion is that the full spectrum of impacts are yet to be fully realized. 


There are at least three (and almost assuredly many more) second order effects of this policy implementation that, in my opinion, have done serious long term damage to the military industrial complex and require some measure of corrective action. Sooner would be better than later.

The first is the impact on the way cash is managed in support of DoD contracts. The “fiscal gymnastics” that causes money to flow from a Congressional appropriation to a contract vehicle is fraught with just about every sort of risk imaginable. Contrary to the Planning, Programming, and Budgeting System (PPBS) doctrine, there is absolutely nothing that gives a Government Program Manager any guarantee that the funds he needs to execute his program will be at the right place at the right time. After more than 30 years as a so-called Acquisition Management Professional, I think a more honest description would be that we are professionals in “hope management” when it comes to a budget. At the end of the day, you do your best to execute with what you’re given and that amount may not bear any resemblance to what you painstakingly estimated and requested. That said, after the funds reach the contract vehicle, the process for managing those funds in the execution of the work is very well defined, fairly predictable, and reasonably effective and efficient. Funds are allocated to a contract vehicle that is fully negotiated and executed. The fact that this action is called an “obligation” is germane. The Government is committed to distribute those funds based upon the fully negotiated and executed terms of the contract. It is important to note that these terms are the product of a bilateral agreement between the Government and the contractor. The subtle but critically important issue here is that this “signed Government contract” has become some of the best collateral available to the banking industry. Everyone knows that the Government is not always on time when it comes to paying invoices. The process has improved dramatically in recent years, but there are still any number of factors that can cause delays in payment and funds may not be available to the contractor to pay for salaries or other expenses when he needs them. That said, there is very little doubt that the invoice will be paid – eventually – because, after all, it’s a “signed Government contract”. You may just have to wait longer than you would like. For this reason, the cultural norm is to operate with a pre-approved line of credit from a bank. The terms upon which these lines of credit are based are now very well established by the banking industry. The military industrial complex has created an entire financial sector or subculture that is the fundamental enabler for businesses both large and small to provide products and services to the Government in spite of the schedule risks associated with the payment system.

For all its faults, the system actually works pretty well and it is at least reasonably predictable, so business and Government PMs can have a relatively high degree of confidence that the work can get done. But what should be becoming obvious at this point is that it is based entirely upon the perceived value of the “signed Government contract” in the eyes of the banker. The banker has nearly 100% confidence that any valid invoice under the contract will be paid, so his risk is very small. When the Government unilaterally decides that the terms of the contract, and particularly the amount that will be paid under the contract, are going to be changed, the banker’s confidence plummets. In effect, the Government has demonstrated that its word is no good. The term “obligation” loses its meaning. Some small businesses lost as much as 40% of the authorizations under their lines of credit overnight which, for all intents and purposes, shut them down.

Again, the major issue was not the fact that less money was being paid. The problem was in how the policy was implemented. In “normal” adjustments due to budget cuts, the Government and the contractor enter into some sort of negotiation. The Government Program Manager (PM) is given the authority and latitude to decide how the cuts would be distributed across his area of responsibility and contracts are modified based upon a bilateral negotiation. Options may be to reduce the scope of the contract, terminate it early, defer some work to a later date, etc., but the point is that the PM and the contractor both get a vote and the sanctity of the Government’s “obligation” is preserved. The modified contract still carries the full weight of the Government’s commitment. Even if a contract is cancelled all together “for convenience of the Government” because funds are no longer available, this clause is almost always included in a Government contract and that risk is known to both the contractor and the banker, but the invoices that are outstanding at the time the contract is cancelled are still paid according to the agreed upon terms and the banker’s confidence in the “signed Government contract” is intact. The contractor loses business, but the banker loses no money. However, in this case, neither the PM nor the contractor were given a vote. The decision as to how the cuts were to be applied was basically made by the budgeteers at the Service Secretary level (some might argue at the Congressional level) and imposed upon the rest of the community without regard for the impact on a program let alone the impact on the health and welfare of the military industrial complex or its foundational business norms. Comptrollers and contracting officers were left to make up their own rules in an almost desperate attempt to comply with the fiscal direction on very short notice. Predictably, the result was a well-intended but extremely short-sighted attempt at implementation of bad policy.

So why does the banker care? If a new policy requiring lower rates to be paid is applied to new contracts, the banker simply sees a smaller number on a contract and adjusts his commitment accordingly. Authorizations under the lines of credit are usually expressed as a percentage of the invoice, so nothing changes the banker’s confidence in the signed Government contract. However, when the Government basically says it’s just not going to honor the contract as negotiated and signed, its value as collateral is reduced dramatically. The banker not only sees that the Government has decided not uphold its end of a bargain for which his money is at risk, but he also sees that his client, the small business, is now at serious risk of not being able to perform on the contract which only portends more heartache in the future. Many banks have already changed their policies regarding Government contracts to guard against this new risk. In some cases, the amount they will lend has been reduced from 90% to 50% of an invoice. If the small business could afford to carry 50% of the Government’s payment obligation for a period of ninety days or so, they probably would not need the line of credit in the first place. The net effect is a loss in production capacity due to a loss of confidence in the Government’s integrity in the eyes of the financial community. This is ground that is now lost that will not be regained in the near future.

Another second order effect is caused by the Government’s contradictions of itself. There are many examples, but one that stands out is the fact that minimum standards for salary and fringe benefits are in existence; they are called “Wage Determinations”. They are developed and promulgated by the US Department of Labor in accordance with Public Law. Nearly every Government contract that buys labor is subject to these minimum standards. The DoD is not excepted.6 In some cases, the tripwires that were established by the budgeteers turned out to be lower than the established wage determinations for a given labor category. There were some small businesses who noted this discrepancy and brought this fact to the attention of their contracting officers, pointing out that their contracts required them to ensure that they met these minimum standards. In some cases, the contracting officer imposed the lower rate anyway in direct violation of the Department of Labor standards. In other cases, contracting officers “compensated” by lowering the fee that was to be paid on the overall contract, which is another commitment in the “signed Government contract” that the Government unilaterally decided not to honor. Both approaches were wrong, in my opinion, and I’m amazed that we don’t have a ten year backlog of lawsuits over it. Of course, when a small business is faced with the choice of “sucking it up” or closing the doors, the law of self-preservation usually prevails. Aside from the obvious administrative confusion that this sort of contradiction causes, the more sinister long-term effect is the additional erosion of confidence in the integrity of the Government as a whole.

Both of these effects contribute to a third effect: the impact all this confusion will have on future DCAA audits. The DCAA backlog is so severe that they are currently auditing books that were created in 2008 or earlier. A phenomenon that is already haunting DoD contractors due to this backlog is the fact that today’s auditors have no idea what the prevailing policies were seven years ago. Decisions made seven or more years ago were based on policies and conditions that are often much different than they are today. In fact, personnel turnover, recollection abilities, and other effects due to the elapsed time means that the audits are strained and difficult. This problem will be greatly exacerbated when today’s books are audited, perhaps a decade from now, assuming the companies survive that long. The culture associated with this process is already difficult, because any failure to comply with an auditor’s individual perception of what policy implementation should be is viewed as being tantamount to criminal intent. This of course makes for an adversarial relationship with the auditor from the outset. To the extent that contractors seek “innovative” ways to accommodate a poorly implemented policy, they will almost certainly run afoul of future auditors. Failure to comply with wage determination requirements is a good example. Of course, this will almost certainly cost the contractor some money, but because of the magnitude of the policy deviations involved, the amount of money at stake could be enough to drive otherwise healthy companies out of business a decade from now. But perhaps the greatest impact will be that future auditors will look at the erratic and sometimes desperate entries in today’s books and feel compelled to make new policy to ensure that the Government’s interests are protected. This will result in bad policy being based upon bad performance which was driven by bad policy – a cycle that can only produce bad results. These secondary and tertiary effects will permeate the entire defense industry, but will be particularly dire for companies providing services in the science, engineering, and technical assistance area, and for those performing S&T research.

Science and technology is supposed to be our investment in the future. It is therefore, by definition, the basis of a long range endeavor. In order for it to produce the desired results, it must be nurtured by a fiscal and contracting process that is at least stable. The near sighted fiscal and contracting policies we’ve seen implemented recently have produced stress fractures in the very foundation of how not only the S&T community, but the entire military industrial complex conducts business. Any structural engineer will tell you that the problem with stress fractures is their propensity to propagate, particularly in the presence of continuous stress. If they are detected, they can in some cases be repaired, but the structure will never be as strong as its original self. The fiscal stress we have endured in recent years is likely to continue for at least the next couple of budget cycles and maybe longer. The question is whether we have even noticed that the stress fractures have occurred. Failure to recognize the negative second and third order effects of our short-term vision is to fail to recognize that the stress fractures exist. Without the acknowledgement that they exist, it is a near certainty that they will continue to propagate.

Notes

1. NDIA Letter to the Honorable Frank Kendall dated 30 November, 2012. Accessed Aug 14, 2015.
2. Public Law 112–25–Aug. 2, 2011, Budget Control Act of 2011.
3. Naval Air Systems Command Instruction 4200.58, dated June 08, 2012.
4. Naval Space and Naval Warfare Systems Command Tripwire Implementation Guidance dated 23 October, 2012
5. Alan Chvotkin. “Navy trips over acquisition tripwires.” May 3, 2012.
6. Federal Acquisition Regulations Subpart 22.10-Service Contract Labor Standards.

 

STEPS is the technical publication of the Potomac Institute that encourages articles that introduce a bold and innovative idea in technology development, or that discuss policy implications in response to technology developments. We encourage you to read this issue of STEPS—Science, Technology, and Engineering Policy Studies. Please take a look at our website — http://www.potomacinstitute.org/steps and download the pdf. If you are interested in publishing in STEPS or if you wish to discuss a topic before completing an article please contact us at This email address is being protected from spambots. You need JavaScript enabled to view it..

 

 

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