FY17 NDAA Penalties for Cost-Type Contracts and Preference for Fixed-Price Contracts

The US Senate Armed Services Committee’s (SASC) recent proposals to restructure defense acquisition, which were adopted by the full Senate today,  reflect a concern that the Department of Defense (DoD) is overly reliant on cost-plus contracts, and aim to improve innovation and accountability. The US Senate version of the Fiscal Year 2017 National Defense Authorization Act (FY17 NDAA)¹ penalizes cost-type contracts to limit their use to exceptional circumstances and mandates a preference for fixed-price contracts. Critics of the proposals, including the Obama Administration, however, argue that the proposals lack a clear understanding of the current contracting process.

Penalties for Cost-Type Contracts

The Senate version of the FY17 NDAA would require the secretary of each military department and the head of each of the defense agencies to pay a penalty for most uses of cost-type contracts -- including cost no fee, cost plus award fee, cost plus fixed fee, and cost plus incentive fee contracts -- that are awarded in fiscal years 2018 to 2021.  

The penalty would be two percent of obligated funds for contracts using procurement funds or one percent of obligated funds for contracts using research, development, test, and evaluation funds. The fees would be assessed from the military or defense contracting account that incurs obligations for cost-type contracts, and would be credited to the DoD Rapid Prototyping Fund to support innovative military technologies.

The bill provides limited exemptions to the penalty. It exempts first lead ships in a class from the penalty. The bill also delays applicability of the penalties until fiscal year 2019 for contracts awarded under the Small Business Innovation Research (SBIR) and Small Business Technology Transfer Program (STTR) and for contracts awarded using funds under the Basic Research, Applied Research, and Advanced Technology Development budget activity titles.  

Preference for Fixed-Price Contracts

The Senate bill includes a preference for fixed-price contracts, including fixed-price incentive fee contracts, in the Defense Federal Acquisition Regulation Supplement (DFARS) not later than 180 days after the NDAA’s enactment. The Senate bill includes the following specific recommendations to establish a preference for fixed-price contracts:

• any undefinitized contract must be awarded on a fixed-price level of effort basis;
• contracts for foreign military sales must be of firm fixed-price, unless the Secretary of Defense certifies that a different type of contract is in the best interest of the US taxpayers;
• acquisitions of commercial items may not use cost-type contracts and should use fixed-price contracts to the maximum extent practicable;
• the Air Force will receive limited funds for the Joint Surveillance Target Attack Radar System (JSTARS) recapitalization program unless the Air Force uses a fixed-price contract for engineering and manufacturing development; and
• contracts or agreements executed under the pilot program, “commercial solutions opening pilot program”, must be fixed-price, including fixed-price incentive fee.

Further, a DoD contracting officer would have to obtain approval to use a cost-type contract either from the Service Acquisition Executive, for a contract entered into by a military service, or from the Under Secretary of Defense for Acquisition, Technology, and Logistics, for a defense agency contract that is in excess of $50 million if entered into before October 1, 2018, $20 million for contracts entered into between October 1, 2018 and September 30, 2019, and $5 million for contracts entered into on and after October 1, 2019.

Unintended Effects?

SASC wants to reallocate risk between the Government and the contractor by shifting from cost-type contracts to fixed-price contracts, but some critics believe that its proposals likely will hinder innovation and increase costs. SASC’s underlying rationale for preferencing fixed-price contracts and penalizing cost-type contracts is that cost-type contracts generally use unique government accounting and financial systems, which create an expensive barrier to entry and limit the competitive pool to traditional defense contractors.

The Obama Administration objects to FY17 NDAA’s penalties for the use of cost-type contracts and preference for fixed-price contracts.² The Administration believes that the penalties would unnecessarily constrain the Government’s flexibility to tailor contract types for a given requirement. The penalty provision also would create a complex financial transaction process that would require extremely burdensome procedures.

DFARS already dictates when and why the Government should use certain contract types. It also has protections for non-traditional, small business, and commercial contractors, including exemption from DoD’s Cost Accounting Standards.³ Stripping the military department and defense agencies’ flexibility to craft incentives in contracts likely will reduce their ability to promote innovation and accountability.

Increased emphasis on fixed-price contracting may stifle innovation because contractors will provide the cheapest and simplest solution, rather than the innovative approaches that cost-type contracts can bring to bear. There are major programs that warrant cost-based contracting. Cost contracts reduce the contractor’s risk and encourage the contractor to invest in innovative solutions. Cost-type contracts also offer a level of fiscal oversight generally not available for fixed-price contracts.

SASC argues that DoD will be able to develop and implement guidelines that will create the appropriate flexibility to support the research and development necessary for defense innovation and cutting-edge military technology under fixed-price vehicles. The mandatory preference for fixed-price contracts, however, could result in fixed-price incentive contracts evolving to resemble cost-type contracts as agencies attempt to build in added incentives and innovation clauses.

SASC’s efforts to reform defense acquisitions would allocate increased risk to the contractor while demanding increased value and innovation in a less flexible environment. We will continue to monitor the status of the FY17 NDAA legislation as it moves forward through Congress.

*Emma K. Dinan contributed to this article. She is a Columbia Law School graduate employed at Arnold & Porter LLP. Ms. Dinan is not admitted to the bar.