Financial Analysis of Commercial


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Financial Analysis of Commercial

  1. 1. FINANCIAL ANALYSIS OF COMMERCIAL TRAINING SIMULATION SERVICE (CTSS) CONTRACTS Stephen I. Robertson L-3 Communications Corporation Link Simulation and Training Division Arlington, TX ABSTRACT The US Air Force recently awarded CTSS contracts under FAR Part 12 for flight simulator training for F-15 and F- 16 pilots and AWACS combat crewmembers using contractor-owned training systems. Under CTSS, the contractors invest up-front to deploy the training systems and are paid monthly for the number of hours that these systems are available for training. The contractors are expected to amortize their up-front investment over the initial years of the contract and to upgrade and support the training systems for up to fifteen years. The concept of CTSS was developed for the Air Force’s Distributed Mission Training (DMT) program. DMT is a training philosophy that focuses on creating distributed virtual environments (DVE’s) at Air Force combat wings around the world. These DVE’s enable the diverse elements of the aerial warfare team to train together at home station through local and wide area networks. The CTSS approach is designed to establish long-term relationships with contractors, which the Government believes will result in better training, reduced government oversight, and more flexibility in fielding and upgrading training systems. CTSS contractors are faced with new challenges in funding and selling this acquisition strategy to their shareholders. The large up-front investment needed to deploy the training systems, the length of time required to recover the investment, and the uncertainty of the annual funding that sustains service contracts poses significant business challenges. To determine if a CTSS contract is a viable investment, sophisticated financial analysis must be done to balance risk and return against other business opportunities. If this new acquisition strategy is to be a long-term success, it must be fully embraced throughout the defense contracting community as a viable alternative to existing contracting methods. This paper discusses the history of CTSS, how businesses evaluate potential opportunities, CTSS financial planning, and the business issues raised by the CTSS approach. ABOUT THE AUTHOR Steve Robertson is a program manager with L3 communications, Link Simulation and Training Division. He joined L3 communications in 1997 after completing a successful career in the US Air Force, where he served as a fighter pilot and staff officer in many varied assignments around the world. One of his last responsibilities in the Air Force was leading the ACC DMT program. Steve joined L3 communications as a Business Development Manager, and he currently manages flight simulator programs in support of overseas customers. Steve received a BS in Mechanical Engineering and a Masters of Engineering Management from Virginia Tech. He also holds an MBA from the University of Utah.
  2. 2. FINANCIAL ANALYSIS OF COMMERCIAL TRAINING SIMULATION SERVICE (CTSS) CONTRACTS Stephen I. Robertson, L-3 Communications Corporation Link Simulation and Training Division Arlington, TX BACKGROUND OF DISTRIBUTED MISSION they faced was the significant legacy of out-of-date TRAINING (DMT) AND CTSS flight simulators that had been procured over the past 20 years. The experiences of a generation of Air Force The origins of CTSS go back to the early 1990’s when aviators in these devices cast a shadow on any new the Air Force began looking for ways to improve flight simulator initiative, and the DMT team struggled aircrew training through modeling and simulation to find sponsorship within the Air Force. They were (M&S). To focus the Air Force on the importance of largely unsuccessful until August 29, 1996, when the M&S, a 4-Star M&S Summit was held in July of 1993. new ACC Commander, General Hawley, responded to It resulted in the formation of the HQ USAF a staff briefing by enthusiastically endorsing the DMT Directorate of Modeling, Simulation, and Analysis concept. He described a vision for realistic training (AF/XOM). Its charter was to “investigate advanced that included four flight simulators at each fighter base simulation technologies and establish mechanisms to using high fidelity cockpits and visual displays. Gen advance Air Force M&S within existing resources Hawley directed funding to the program and he agreed (emphasis added) (United States Air Force 1995). One to a study on trading flying hours for simulation. He early XOM concept was an operational test bed, where believed DMT could improve training, conserve flight simulators at flying wings would be used to resources, and reduce ACC’s high ops tempo evaluate new training technologies. This concept (Robertson 1996). evolved into the DMT program. Since the emphasis on M&S began when DoD was in the largest force ACC Simulator Industry Day reduction since World War II, it was understood that everything had to be accomplished within the existing To convince the defense industry that ACC was serious budget. about DMT, General Hawley sponsored an Industry Day on January 21, 1997. Major simulator contractors A second 4-Star Summit in 1995 established a “New and supporting industries were invited to present their Vector” for Air Force M&S. General Fogleman, Air visions of the future of simulation. General Hawley Force Chief of Staff, said M&S would “improve opened the conference with his vision. He emphasized readiness and reduce costs for the nation because it will that it would be tough to launch new initiatives in the allow us to demonstrate the flexibility, responsiveness, current fiscal environment. Therefore, he proposed and utility of air power in peace and war.” (United paying for DMT by trading up to 25-30% of the ACC States Air Force 1995) Initiatives from this summit flying hour budget for a new generation of advanced included the Air Force Agency for Modeling and flight simulators. The flying hour budget was the only Simulation and Air Combat Command’s (ACC) Air pool of money available to fund such an ambitious Combat Simulation Training Program. This program program, and he believed traditional procurement could received $9.3M in seed money to start an operational take up to 10 years to produce a product (Air Combat test bed and to plan for multiple networked simulators Command Simulator Industry Day 1997). for each wing in the Air Force (United States Air Force 1995) Acquisition Strategy Planning Development of the New Simulator Initiative On January 27, 1997, General Hawley was briefed on a plan to meet his vision. He directed the DMT team to To manage the new simulator initiative, AF/XOM, the look at the following two options for acquiring the new Air Force Research Laboratory’s Aircrew Training simulation systems (Robertson 1997). Research Division (AFRL/HEA) at Mesa, AZ, • Lease with Buy-out Clause. This first option Aeronautical Systems Center’s Training Systems leased simulators with 3400 money (O&M Product Group (ASC/TSPG), Ogden Air Logistics dollars). The buy-out clause was funded annually Center (OO-ALC/LIR), and ACC’s Directorate of with 3010 money (procurement dollars). Fencing Operations (ACC/DOS) formed a team to make the this much money each year for a potential vision of DMT a reality. One of the greatest obstacles obligation made this option unattractive.
  3. 3. • Task Order Contract for Services. This second • Will you capitalize development using proven option created a Contracted Training System technology? Yes (CTS) that would provide complete training • How long a period will you carry an investment? services in one package. The equipment would be Must see a return on investment within 2-3 years owned and operated by the contractor using a long- maximum. This does not mean all costs are term contract with an award fee. The government recovered, just some return realized. would pay for services once the systems were on- The dominant theme was that the major training line and the contractor would be paid to insert new companies saw themselves as integrators of systems technologies during the life of the contract. Since and technology, not as developers of new technology. this acquisition option would be a service contract, it would not require the cost-benefit analysis that is The first CTSS contract was awarded for the F-15 in normally done during lease-buy evaluations. 1997. Subsequent awards provide training for AWACS mission crews and F-16 pilots. To avoid To support ACC’s vision, on February 14, 1997 the confusion, it should be emphasized at this point that Assistant Secretary of the Air Force for Acquisition CTSS and DMT are two entirely different things. was briefed on a new simulator acquisition philosophy CTSS is a contracting strategy and DMT is a training that (Cunningham 1997-1): philosophy. Each can exist independently of the other. • Shifted accountability and responsibility to industry Current CTSS Contracts • Reduced the level of government oversight • Cut cycle times The latest CTSS contract was awarded for F-16 Block • Provided overall best-value decisions 40 and 50 aircraft in June 1999 with the following • Produced the minimum number of contracts characteristics: • Featured contracts of maximum length • The Government pays an hourly rate for training • Allowed up-front visibility of ownership costs service to be available during specific time periods. • Provided a single focus for the training system The contractor is paid as long as the service is available, regardless of its actual usage, minus Three alternative acquisition strategies were presented adjustments for nonavailable equipment to implement the new simulation acquisition • All equipment is owned and operated by the philosophy: contractor. The Government has insight but not • Traditional procurement and sustainment oversight of the contractor’s training system, and • Lease hardware, contract for logistics support. the Government has no rights to anything developed under the contract. The contractor is • Contract training services incentivized through annual contract extensions to maintain the service current and on-line. The decision was made to proceed with a Contract for Training Simulation Services (CTSS) under FAR Part • A Firm fixed price (FFP) contract for seven years 12 with the following characteristics (Cunningham is awarded with eight annual FFP options 1997-2): • It is a requirements contract as defined in FAR • Government buys service instead of equipment 16.503 in that it “provides for filling all …purchase requirements of designated • Contractor operates the training system Government Activities for supplies or services • Contractor owns the hardware and maintains the during a specified contract period, with deliveries trainers concurrent with the aircraft or performance to be scheduled by placing orders • An award fee provides incentive for technology with the contractor.” upgrades and increases in quality of service It can be seen from this short history that CTSS was a One of the issues raised by this new acquisition strategy deliberate strategy designed to quickly get the DMT was whether industry would really do it. The senior program started using the only large pool of money executives of the five largest training providers were available. CTSS also has the potential to address the contacted by ASC and asked the following questions: continuing problem of finding funds to keep simulators • Will you capitalize high-risk research and concurrent with aircraft configuration changes. The development? Industry will not capitalize high challenge to industry is to balance the risks and rewards cost and risk core technology development. when evaluating a CTSS opportunity. • Will you capitalize technology insertion given that the technology exists? Yes
  4. 4. HOW BUSINESS LOOKS AT and grow. Every potential investment is evaluated POTENTIAL OPPORTUNITIES on its impact on corporate cash flow. In fact, the cash flow sequence for the entire program often When evaluating alternative business opportunities, a drives the up-front cash and profit requirements. If corporation must consider its fiduciary responsibilities the cash flow is negative, borrowing is required to to increase shareholder value, develop employees, and maintain the status quo. Borrowing adds to the satisfy customers. This requires fact-based decision cost of the project being considered. making that balances risk and return while managing • Debt. Will this create debt? If so, how will it the important factors discussed below. affect the balance sheet? Will it impact credit ratings? Is the IRR high enough to justify it? Factors That Drive Business Investment Decisions • Core or Non Core Business. Is this a new business area? Is it something that makes sense to do in Every business investment decision is a tradeoff among light of core business requirements? options that have the potential to produce a return for TABLE 1 shareholders. If a new opportunity produces a 5% IRR Example return, but the corporation can make 6% by investing Scenario 1 Scenario 2 on Wall Street, there is little reason to invest in the new Sell Price 200 200 opportunity. This investment reality is why companies Total Cost (B) (160) (160) have what is commonly known as a “hurdle rate”. This is the minimum return an opportunity must provide if is Net Profit(A) 40 40 going to be considered. In addition to the hurdle rate, many business investment factors must be evaluated. Annual Cash Flow Business Investment Factors Year 1 (160) (160) • Risk Factors. The formula for risk is very simple: Year 2 100 25 Risk = Dollars. Every risk can be translated into a Year 3 100 25 cost function that is added to the hurdle rate to Year 4 25 determine minimum acceptable return. Following Year 5 25 are typical questions that must be answered in Year 6 25 analyzing risks: Year 7 25 What is the probability of making the return Year 8 25 Is new, unproven technology involved Year 9 25 How many new lines of software code must be Year 10 25 written Are there new processes involved and is this a Net Cash Flow 40 40 new business area Are there contractual risks Profit Margin(A/B) 25% 25% How long before a return can be realized What is the payback period IRR 16% 5% • Return on investment. For most opportunities that • Strategic Impact. Will this have a strategic involve a series of regular cash flows over time, impact? How will it position the company in the Internal Rate of Return (IRR) is the best gauge of market place if it is successful? What risk should value. IRR is the interest rate achieved for an be accepted to make a strategic impact? investment consisting of a series of payments and • Competition. What is the competition doing? revenues recognized at regular intervals. IRR is How will this impact them? What will they do to closely related to Net Present Value (NPV), as the win and what must happen to keep them from internal rate of return is the rate that gives a $0 winning? NPV for the stream of dollars being evaluated. Table 1 shows the positive impact of getting as The Confluence of Business Factors much cash as early as possible. Scenario 1 has a The factors above and others that are specific to the significantly higher IRR because all revenue is opportunity at hand must be evaluated for their generated within two years of system deployment. importance and impact on the company. The relevance • Cash Flow. Cash is the life-blood of business: it of the factors varies depending on the market place, the determines how long you can stay in business and if you have the ability to invest in new products
  5. 5. company culture, its financial performance, its position in the industry, and its degree of risk aversion. Each decision is different, and the rate of return required will of 3400 money. Major modifications may be acquired be specific to that decision. All parties to a business through separate competitive procurements. arrangement must understand each party’s perceptions Under this type of contract, progress payments are and business limitations if it is to be a success. made under FAR 32.5, as modified by DFARS 232.5, which specifies that customary uniform progress That said, due to the high potential for negative impacts payment for DoD contractors is 75 percent for large on cash flow, debt ratios, balance sheets, and the businesses. The remaining cost and all profit is paid overall health of a company, CTSS may well limit the after delivery and acceptance. The contractor must number of competitors to only a few, very large finance any negative cash flow resulting from the corporations. difference between progress payments and actual costs. COMPARING TRADITIONAL DoD Financial Impact of Procurement Strategies CONTRACTING WITH FAR PART 12 CTSS The cleanest way to provide a common baseline for Characteristics of a FAR Part 12 CTSS Acquisition financial analysis of the CTSS and progress payment approaches is to look at the resulting cash flows. Since In addition to the characteristics mentioned earlier, positive cash flow is critical to the long-term health of CTSS contracts have the following characteristics that any business, the analysis of potential investments must differentiate them from what is normally found in begin with the impact on cash flow. traditional DoD FAR Part 15 contracting. • Solicitation via the Commerce Business Daily Chart 1 illustrates the typical cash flow from a CTSS • Maximum use of commercial terms and conditions • Uniform Contract Format not required Chart 1 Typical Cash Flow For A CTSS Contractor • All reference material is available on the ASC Preaward Information Exchange System (PIXS) Annual After-Tax Cash Flow Web Site ( First System Deployed Initial Investment Recovered • Market research determines if the service is $0 commercially available • Competitive range determined by span of bids Base 7 Year • A “should cost” analysis is not required Contract Ends The contractor develops and builds the flight simulators 1 2 3 4 5 6 7 8 9 and associated equipment with its own funding. In the Contract Year last two awarded CTSS contracts, the government made 1 up-front payments intended to offset 30-50% of the investment. It assumes an up-front investment by the development costs. The contractor amortizes the contractor for development and fielding of new training remaining costs so as to meet corporate business systems and up-front government payments. Chart 1 objectives. If the contractor is continually developing also shows the significant negative cash flow caused by and deploying new systems for much of the life of the CTSS contracts. This occurs for new installations as contract, positive cash flow can take years to occur, and well as major upgrades. The need for early investment profit might not be realized until late in the contract. recovery drives the hourly rate schedule shown in Chart 2. The high hourly rates immediately after deployment Traditional FAR Part 15 Simulator Contracting Chart 2 CTSS Typical Hourly Rate Structure Under FAR Part 15, most products are bought with R&D (3600) or Procurement (3010) funds. Cost-plus or FFP contracts are awarded and concurrency modifications are often funded through the aircraft Dollars Per Hour budget. Unlike a CTSS contract, the Government owns the simulators and contracts separately for logistics support services. These service contracts generally have a 5-year life. With all years after the first being options. They are funded with the annual appropriation Years After Simulator Deployment 2
  6. 6. reduce contractor and government cost and risk. • The sustainment costs Chart 3 uses the same assumptions as Chart 1 in comparing a traditional FAR Part 15 progress payment Each of these cost functions must be fully defined and sale to a CTSS acquisition. It assumes 75 percent of optimized according to the contractor’s corporate production period costs are billed monthly. Chart 3 requirements. These requirements might include such shows that the CTSS contractor must borrow twice as things as: much to finance the development, production, and • minimum rate of return (IRR) for the risk involved deployment of the systems, and does not go cash • maximum limits on hourly rate costs positive until 5 years after a comparable FAR Part 15 • maximum period to payback the initial investment sale. This high, continuous debt results in a CTSS sell • limits on the debt that can be created price that can be 40-60 percent higher than that of a • impact on cash flow traditional sale. While the contractor receives higher • the amount of risk that the corporate culture will out-year payments, their impact is less due to the time accept value of money. Businesses are also under increased • the relationship of the investment to other risk due to the inherent nature of the CTSS acquisition corporate investment opportunities and business strategy: annual funding, no termination liability, no lines guarantee that additional systems will be procured, no • competitive pricing readily available after-market for the trainers, and • matching government budget profiles uncertain financial markets. Because of all the factors that must be considered before entering a CTSS • minimum time to design and build the products arrangement, extensive financial planning must be • expected residual value conducted. • potential for additional use above the base contract • lease/buy policy for certain capital assets Chart 3 Traditional Sale As Compared to CTSS Acquisition CTSS Requires Twice As Much Debt In a CTSS situation, each cost function is essentially an CTSS Acquisition Traditional Acquisition independent differential equation that describes money flow, performance, constraints, and other factors over After Tax Cash Flow time for its part of the total system. For instance, the sustainment cost function for one site might have the $0 following components in its equation. • spare parts cost • repair factors (e.g. MTTR, MTBF) • upgrade costs Contract Year • obsolescence costs (how long do you keep it before FY 1 2 3 4 5 6 7 8 9 it is replaced and where does the replacement come 3 from) • technology insertion costs CTSS FINANCIAL PLANNING • site maintenance costs • availability constraints Financial planning for CTSS acquisitions can become • potential surge hours very complex depending on the number of options, the • staffing costs length of the contract, and the risks that the contractor Staffing costs, for example, are a separate cost function must incorporate into the bid. This section describes that relates reliability, availability, and other factors to some of the financial modeling and business challenges personnel costs, work schedules, parts availability, and that can occur. a variety of other situational unique factors. Financial Modeling Challenges Each site will have a different solution because of its unique requirements. For instance, staffing will vary Cost Functions between sites depending on location, number of CTSS financial modeling challenges are formidable. simulators, availability of technical support in the local There are essentially three different types of cost area, local wage rates, simulator availability functions that drive CTSS pricing: requirements, and so forth. Parts requirements will • The cost of the base contract and associated sites vary depending on the same variables along with the • The cost for each option site or option clause overall maintenance concept for the entire system of simulators.
  7. 7. Other tax options include counting the CTSS contract As the reader can see, in the purist sense the optimum as a fee-for-service arrangement for tax purposes. With system-level pricing structure is a multivariate, this approach, all expenses are deducted as incurred nonlinear, constrained optimization problem that could except for development and production costs, which are be the topic of a Ph.D. dissertation. What really capitalized and depreciated. Or, the contract could be happens is that a series of approximations and viewed as an operating lease whereby the production judgement calls creates a real-world solution that meets and development costs are depreciated over a life equal corporate goals and optimizes the most significant to 125% of the lease term. There are even instances factors. where the project could be split into several pieces (simulators, visuals, and labor), with each having a Business Challenges different tax treatment. Because of the nature of CTSS, unique funding Any tax treatment in CTSS contracting is very specific considerations, taxes and depreciation, and business to the point in time that it occurs and to the tax situation alliances can be used to maximize contractor return. of the company involved. Different companies can make alternative tax decisions on the same project and Funding Considerations get the same or different results. The ones in this paper Funding plans and the business structure used to are for example only. implement them are inseparable. For the purposes of this discussion, funding plans will be addressed in Business Alliances terms of internal or external funding. The decision on There are many types of alliances that can be formed to which funding plan to use can depend on the following pursue a CTSS contract. In most instances, alliances factors. are formed to reduce risk, gain access to funding or • The Cost of Money. Large financial institutions proprietary technologies, to reduce debt, and/or to may have access to significant amounts of funding maintain a healthy balance sheet. The following three at rates that are better than many corporations types of alliances are the most common, but business could generate from within. At the same time, arrangements are only limited by the imagination of the perceived risks associated with the CTSS approach dealmakers. might require premiums or equity arrangements that are unacceptable to the contractor. Joint Venture Corporation. In this scenario, the • Balance Sheet Impact. Is the corporation averse to contractor assigns his rights and obligations under the assuming more debt? What will the project do to contract to the Joint Venture (JV) at a non-controlling debt ratios and credit ratings? If it is a problem, ownership interest level. The other member(s) of the external-financing arrangements might be required. JV provide funding to the JV and have a controlling • Opportunity Cost of Internal Financing. A ownership interest through equity that exceeds 50%. company with several projects might have to The JV holds debt incurred in executing the CTSS choose which to fund internally and which project contract and builds the simulation equipment. The to go to the markets to fund. This decision is based advantage of the JV is that it holds all debt and on risk, return, cash flow, debt limits, credit therefore keeps it off of the contractor’s balance sheet. ratings, and other such factors. However, the JV could result in a higher borrowing rate and provide lower total revenues to the contractor; Income Tax and Depreciation therefore, a JV could add up to 4-6% to the sell price. Many options are available for classifying expenses and revenues in order to obtain the optimum tax posture. Synthetic Lease: With a synthetic lease, the contractor The case for each decision is unique to the corporate builds the simulators and sells them to a third party tax structure, Internal Revenue Service rules, and the financial institution. This third party then leases the usage of the resources in question. For instance, non- simulators back to the contractor at the start of training recurring engineering development costs can be services to the Government. At the end of the lease classified as research and development with the term, the contractor buys the simulators for the lease resulting expenses deducted as they are incurred. Or balance or some pre-negotiated fee. This type of they could be capitalized and depreciated. This is arrangement is often used to keep debt off of the because the research and development definition under balance sheet. However, it is inefficient for many small the General Accepted Accounting Practices (GAAP) is contracts because the fees and other charges to set it up different than the definition used by the IRS. can grow quickly, and it is not the type of arrangement
  8. 8. that could be used for the entire 15-year life of a typical involve a significant amount of development work. CTSS contract. Transferring all risk to the contractor without contractual or financial relief valves can have negative Equity Partnership: This arrangement involves impacts on system performance, delivery schedules, corporations joining the prime contractor in the and the ability to maintain currency with the aircraft. production of the training systems and accepting a The government could then be at risk of having its share of the revenue stream or other similar primary ground based training system not meet the compensation after the systems are fielded. There are needs of the warfighters. The allocation of risks must many ways to structure this type of agreement, but they be carefully approached if costs are to be controlled and all involve shared risk and shared revenue. For a CTSS the training systems are to meet the user’s expectations. contract, this approach could be very risky depending on how much confidence the partners have in the CTSS Business Issues ability of the prime to deliver on time, on cost, and within the desired schedule. Development problems, The following discussion highlights areas where risks subcontractor delays, and a myriad of other factors and benefits must be balanced if the CTSS concept is to could create a difficult financial situation for all be a long-term success. involved. Large Up-front Capital Investment BUSINESS ISSUES RAISED BY Of all the business issues, this can be the most difficult THE CTSS APPROACH to manage. Even with initial government service payments, industry could be required to finance tens of Risk millions of dollars for the initial contract period, and significantly more if many closely spaced options are CTSS comes with its own unique set of risks and exercised. This uncovered investment poses a large benefits. As noted earlier, industry describes all risks risk to many companies, and extraordinary means are in terms of dollars. Chart 4 (Ministry of Defence, sometimes needed to obtain permission to pursue such United Kingdom) illustrates the principle that the contracts. Not only does this large investment create a higher the risk, the more it costs to borrow the funds to significant risk for large contractors, as mentioned up-front finance a contract. The cost of CTSS risk is a earlier, but it also precludes many smaller businesses direct add to the cost of the contract. This can become from competing in the CTSS arena at all. a significant factor because of the amount of initial investment that is required, the time to recover that Termination Liability investment, and the possibility of continuous debt due CTSS contracts are funded annually and have no to the exercise of contract options. penalties for termination for convenience by the Government beyond the funding already appropriated Chart 4 for that year. This risk is mitigated by the fact that the Risk Impact on CTSS Cost Structure contractor is the sole provider of the service to the government (unless contractual exceptions are taken to Cost the requirements clause by the Government). However, of Money Commercial Financing Costs it is difficult for a contractor to plan on options being exercised and services being provided beyond the basic contract period given the continuous changes that take Cost of CTSS Risk place in the military, political, technological, and economic aspects of the defense industry. Until costs Government Debt Cost have been recovered and profit realized, this unsecured, up-front investment is a large risk to industry. While termination gives the Government the ability to Risk reallocate resources as the immediate fiscal environment dictates, it is one of the hardest risks for industry to absorb. Even though up-front payments In most instances, risks should be allocated to the party from the government somewhat mitigate this risk, they best able to understand and manage them. In high-risk typically cover less than 25-35% of the costs incurred. areas, many times this involves a government- contractor team using a cost-plus contract. This is not Contractor Ownership of Simulator Baseline the case in CTSS, even though current contracts do
  9. 9. The contractor is sole owner of the training system In addition to the option years, there are usually options hardware and software. The Government has no rights to put additional training sites into service. Again, to any of the intellectual property other than it can because these options are not guaranteed, the contractor negotiate to buy it if the contract is terminated. Any is forced to price each option as a stand alone program CTSS contract changes, therefore, will be in a sole or accept increased price risk because some may not be source environment, and recompetition is very unlikely put on contract. This drives up costs to both parties. due to the 3-4 year lead-time required to field a new design. This reduces risk for the contractor and Competition increases cost to the government. Competition is key to meeting the Government’s goal of selecting the best value contractor. It forces 15 Year, FFP Contract contractors to take calculated risks in their pricing The contractor is required to provide a FFP proposal strategy and technical solutions to remain competitive. for hourly rates to cover all expenses, upgrades, and If costs are forced so far down that there exists no logistics support for 15 years without any margin for error by the contractor, the risk increases for acknowledged means to reopen the contract for the Government that the system might not meet user negotiation. This places major risks on the contractor expectations. This could be due to contractor cost for obvious reasons: unknown inflation rates, cutting, reinterpretation of performance specifications, political/military climate changes, parts obsolescence, or the technical inability to meet the requirements. A corporate business changes, and unknown aircraft 15-year FFP contract that is in bad financial shape from updates to name a few. Since these programs are bid in the start could turn out to be both parties’ worse a competitive environment, contractors are under nightmare. Lowest cost does not always equate to long tremendous pressure from their shareholders to mitigate term best value, especially in a contract without a risk at the same time that they must bid on a 15-year renegotiation clause. FFP contract. Requirements Clause If the Government exercises options for simulation sites This clause is intended to establish the contractor as the beyond the basic contract, the contractor is faced with sole provider of the specific training services to the an unknown cost of money for extended periods. Also, government. This reduces the contractor’s risk and the requirement to pre-price all anticipated training encourages continued product improvement. If the system concurrency modifications in the basic contract, Government, however, excludes portions of the before some of the modifications are defined or potential market from the contract requirements clause, scheduled, significantly increases risk. Some of the this increases contractor risk and cost, as he could ways that a contractor can approach this risk include: potentially have to compete for these sites in the future. a.) assume that future concurrency modifications will mirror the scope, schedule, and cost of past Performance-Based Requirements modifications; b.) provide a specific amount of dollars One of the acquisition reform initiatives that CTSS for concurrency modifications and assume the incorporates is the use of performance-based government will pay more when the dollars are requirements. The contractor is provided the aircraft exhausted; or c.) minimally price out-year currency training task list and a broadly written Simulation modifications and bet that they will change so much Capability Requirements Document and from these he that the Government will be forced to open the contract is expected to derive a performance specification that for negotiations. None of these options share the risk will result in training at the appropriate level of among all parties. The lowest risk and cost approach to performance. For example, the recent F-16 Block this issue might be to have all undefined upgrades 40/50 MTC RFP Simulation Capability Requirements handled as changes to the contract. This reduces the Document dated 22 January 1999 contained a price and equitably shares the risk among all parties. requirement that the system “shall support F-16 air-to- surface and air-to-air mission tasks.” This broad No Guarantees on Options statement is intended to provide parameters within The standard CTSS contract contains a seven-year base which a contractor can provide innovative, best-value period with eight annual service options. This means training solutions. that the contractor must plan on recovering all of its initial investment in the base contract term because While this philosophy provides the contractor with there is no guarantee that any option years will be maximum design flexibility, it also allows for a wide awarded. range of interpretations by both parties. For instance, in the F-16 MTC contract (F33657-99-D-2025, dated
  10. 10. June 11, 1999), the specification for the visual system degree the technical expertise needed to properly image resolution, paragraph, says, “The evaluate complex training systems such as these has visual system shall have sufficient resolution to meet eroded. It is as important to industry as it is to the the training requirements of the TTL.” The visual government to have competent, knowledgeable, and resolution required to train a task is a function of many independent government technical experts evaluating factors, including the pilot’s eyesight, display contrast the design and performance of training systems. and brightness, database density, target fidelity, etc. Because the successful performance of a training While the contractor is free to optimize at the system system depends on the reactions generated by the level for visual resolution, that is only one of many person being trained, the system is always a factors that determine how well a task can be trained in compromise between cost, performance, and simulation. The real test of the system’s training technology. The evaluation of these tradeoffs by the capability will be after it has been fielded and used by Government, based on a sound understanding of the line aircrews for a year. underlying technologies, is critical to the overall success of the program. All parties must understand Technology Insertion this point and work together to make sure that qualified CTSS contracts generally have a clause that requires people participate in the program. the contractor to suggest candidate technologies for insertion into the training system each year. The cost Commercial Service Contract of the inserted items is paid for from money that the The use of commercial service contracts to provide contractor bid to set aside annually for such purposes. training is a step in the right direction. Such contracts The intent is to keep the training system in line with have the potential to lower costs by a.) requiring less training technology growth and therefore continue to Government oversight and documentation; b.) increase training capabilities. providing system upgrades without an extensive engineering change proposal process; c.) giving the Most contractors, once their systems have been contractor the latitude to make instant tradeoffs to accepted by the government, will insert technology reduce cost (e.g. using refurbished equipment). That only if it reduces cost, is needed for concurrency with said, the contractors will still use their established the aircraft, or replaces obsolete items. Any additional engineering design, development, and review technologies or capabilities inserted will require a processes, since good engineering practices do not separate logistics support tail, documentation, and all of change because a new contracting method is invented. the other things that go into doing an engineering Regardless of the type of contract, it still takes a certain upgrade to an existing system. This type of effort is amount of time to write a line of software code, to generally beyond the funding capability of the annual manage subcontractors, and to integrate a complex amount set aside at contract award. The real issue training system. Because of this and all of the becomes what more is required if the training system previously mentioned factors, careful judgements must has been accepted by the government as being capable be made before savings from this contracting method of fulfilling all of the required tasks. Incorporation of can be claimed. the latest technology does not necessarily mean that the system will be able to do a better job of training the Interoperability aircrew member in the seat. It also needs to be Simulation systems must be able to interoperate with emphasized that the low level of technology insertion both similar and different systems at other locations. provided by the contractor cannot replace Government While the contractor must agree to meet distributed research and development of core, high-risk training training interoperability standards, no such standards technologies which can raise the technology bar across have been established. This introduces significant all training systems. financial risk depending on the compatibility of the solution that is developed with each contractor’s Government Manpower design. The defense force reduction over the last decade has significantly reduced the size of the acquisition work TOWARD THE FUTURE force and the in-house engineering and technical capabilities of the military. While the CTSS concept Is CTSS a step in the right direction? Does it lock the was not part of the calculus that Congress used to Government into 15-year sole-source contracts, which determine service end strengths, it may allow will only increase in cost over time? Are the financial government program management with fewer people. risks in CTSS so significant that only the largest The real concern on both sides of the contract is to what defense contractors can participate? Will the systems
  11. 11. that are delivered be minimalist designs that barely While performance specifications allow the contractor meet user expectations, or will they be of the highest to optimize system performance to meet user needs, fidelity, no matter what the cost is to the contractor? more technical definition of key performance The answers to these and other questions raised in this parameters might give the Government, contractor, and paper will not be fully apparent until after the contracts user more confidence that the system will provide the have been in force for at least three to five years. training that all expect. If the contractor was providing another copy of what is already on the shelf, this would CTSS does have tremendous potential. Its supporters not be an issue. But, so far in the CTSS world, this has say that it attempts to work within the existing not been the case. regulatory and fiscal environment to provide training In the end, successful implementation of CTSS will systems in record time. These systems are planned to require a true long-term partnership between all have unparalleled fidelity and clear paths to stakeholders. This involves mitigation of risk through concurrency while transferring much of the operations financial and contractual safeguards, performance by and management responsibility to industry. They the contractor, use of commercial management believe that this acquisition strategy has the potential to standards by the Government, control of expectations, provide significantly better training for the warfighters. and judgement in resolving disputes. The most compelling issue for industry is the allocation REFERENCES of risk that results from the limitations of the CTSS concept. For instance, the guidelines for Improving Air Combat Command Simulator Industry Day (1997). Business Terms and Conditions contained in Section Remarks by Commander, Air Combat Command. 2.2 of the Contract Pricing Reference Guide, Volume 1 (Air Force Institute of Technology 1999) suggest Air Force Institute of Technology, School of Systems basing the contract type on risk analysis. It states that and Logistics, Department of Quantitative Analysis and “Analysis of the risk inherent in the contracting Federal Acquisition Institute. (1999) Contract Pricing situation is the key element in the selection of contract Reference Guide (Volume 1), Price Analysis. type.” The guidelines go on to state that FFP contracts Available on CD: Defense Acquisition Deskbook, should be used when the costs of performance can be Version 3.2, Winter 2000. Also refer to estimated with a high degree of confidence, the requirement is well defined, it is a commercial item, contractors are experienced in meeting it, market Cunningham, James A. (1997). Acquisition Strategy for conditions are stable, and financial risks are otherwise Distributed Mission Training. Presentation to insignificant. Clearly this paper demonstrates that SAF/AQ. contractors believe they face significant financial risks in CTSS contracts. In fact, the market will not allow Cunningham, James A. (1997). Distributed Mission contractors to price in all risks and still be competitive. Training. Presentation to Commander, Air Combat Therefore, the parties to the contract bet on the fact that Command. all the technology will be ready on time and perform as advertised, all upgrades will be as defined at the start of Ministry of Defence, United Kingdom. Public/Private the contract, and the financial markets will not go to Partnerships. Available at extremes during the term of the contract. Over 15 years, all of these things will happen at least once. Robertson, Stephen I. (1997). ACC Distributed The most effective way to share risk is to provide Mission Training Program. Presentation to contractual protections for both parties. These could Commander, Air Combat Command. include such things as a.) trip clauses for equitable adjustments based on unforeseen circumstances, b.) Robertson, Stephen I (1996), Revolutionizing Training. pre-priced options for the government to buy the Presentation to Commander, Air Combat Command. system’s data at the end of the contract, c.) limitations on termination liability, and d.) separately priced United States Air Force (1995). Air Force Modeling contract changes to incorporate major modifications and Simulation, A New Vector. Pamphlet distributed at that exceed the scope anticipated at initial contract I/ITSEC 1995. award.