Cost-Cutting Undermining U.S. Weapons Programs

When Rockwell International won a contract in 1987 to develop a new gunship for the Air Force, it appeared that the big aerospace firm had broken into an important business and had succeeded in at least partly offsetting the decline of its B-1 bomber program.

But today the company is mired in a colossal cost overrun--reportedly about $90 million--and has fallen behind schedule as it attempts to complete the first of the gunships, The Times has learned. The Air Force has notified Rockwell that it intends to withhold contract payments on the program.

Meanwhile, Rockwell has retained the defense industry law firm of McKenna, Conner & Cuneo to conduct a legal review of its contract with the Air Force, based on concerns that the contract might be flawed, Rockwell executives said in a recent interview. Among the issues under review is whether the contract fails to specify all the work necessary to develop the gunship.

The troubled program to produce the gunship, an aircraft known as the AC-130U, appears to be a case study of how the Pentagon’s efforts in recent years to create aggressive competition and to drive down the price of weapons have created costly trauma, not only for industry, but also for the military services.

The legacy of the Reagan Administration’s effort to drive down contractor prices and profits is a trail of sick weapons programs across the nation. Even though the Pentagon recently has moderated its adversarial methods, the contract pipeline is full of programs carrying significant liabilities for the industry.

“The defense industry is not like a department store, where you can take a few loss leaders,” said retired Rear Adm. Stuart Platt, who helped set the competitive policies for the Navy. “The government is dealing with too powerful a hand. It has to remember that it has responsibility for stewardship of this industry.”

At the same time, some defense contractors have become desperate to obtain new business in an era of tight Pentagon budgets, leading them sometimes to make fixed-price bids that are unrealistically low in their price projections and risky on technical issues.

“It shows what happens when you have aerospace companies without any business--they are willing to bid anything to get a contract,” said Paine Webber aerospace analyst Joseph Campbell, who estimates that the defense industry faces more than $6 billion in losses on fixed-price development contracts.

For example:

- Former Navy Secretary John F. Lehman Jr. once boasted that he cut the development cost of the T-45 trainer aircraft in half with aggressive negotiating. But, as a result, McDonnell Douglas had to forgo wind-tunnel tests of the aircraft, among other things. Now, the Navy has discovered that the aircraft is unstable and needs engine modifications to even land on an aircraft carrier.

- Grumman, a Long Island aircraft builder, agreed to develop a new version of the F-14 fighter plane without any profit and under a fixed-price contract. It suffered a $120-million cost overrun, though it ultimately persuaded the Navy to absorb half the loss.

- The Norden unit of United Technologies was stung with a loss of several hundred million dollars on a fixed-price contract to develop new radar.

- Hughes Aircraft suffered a $250-million loss on a new tactical missile for the Air Force.

- Five major aircraft companies, organized in two teams, will collectively lose an estimated $2 billion on a project to develop a new Air Force fighter, which now faces delays because the government does not have enough money to keep it on track.

Surprisingly, the Pentagon has no administrative system to even monitor such losses, even though it so often expresses concern about its industrial base. A study by the Defense Science Board, a government advisory panel, concluded last year that “investors’ skepticism has caused a virtual closure of the equity and debt markets to all but a few major contractors.”

“These losses are weakening considerably the industrial base for national security,” said Paul Nisbet, an analyst at Prudential Bache Securities. “It is a bad way of doing business, and it is government shirking its responsibility. They are shifting as much risk as possible onto the industry.”

Hughes Official’s Complaint

In today’s competitions for defense contracts, companies sometimes go to extremes to get business. A few months ago, Hughes Aircraft bid a fixed price of $1 to win a position as a second supplier for a Navy electronic warfare program known as the SLQ-32. Although the future payoff may be substantial, the company is expected to lose as much as $10 million in qualifying as the second supplier.

“This is what we are forced to do,” a Hughes official complained. “We don’t like to make $1 bids.”

The tortured case of the AC-130U illustrates how competitive bidding and tough Pentagon negotiating can turn a relatively small contract carrying a modest profit into a nightmare involving a major loss.

The gunship would carry a crew of 13 into commando-type raids, such as the invasion of Grenada, and operate something like an airborne artillery system. It could safely circle a target at up to 10,000 feet altitude and blast away even at targets obscured by clouds.

Under the contract, Rockwell takes a standard C-130 Hercules cargo aircraft built by Lockheed and mounts a 105-millimeter howitzer into the fuselage, along with two smaller guns. The guns are aimed by a sophisticated airborne radar, the same one used on the F-15 jet fighter, and the entire aircraft is protected by sophisticated electronic defenses.

In July, 1987, Rockwell signed a $155-million fixed-price contract, which included a profit of $14 million, to develop the technology and produce the first AC-130U gunship. When Rockwell bid on the program, it looked deceptively simple.

Misunderstanding Cited

“I don’t think we understood what the Air Force wanted at the time, and I don’t think the Air Force understood what we were proposing,” said John J. Pierro, president of Rockwell’s North American Aircraft unit, in a recent interview.

“This AC-130U is going to be a pretty lethal weapon,” Pierro said. “But (the program) is harder and more complex than we thought.”

The contract required Rockwell to meet a “performance specification” on the gunship’s capabilities, which Rockwell thought allowed some degree of freedom on detailed design issues. In practice, however, the Air Force took control of planning the configuration of the system.

The changes demanded by Air Force officials have caused delays, and the service declined to exercise a contract option to start production of the gunship. Rockwell must still pass a “critical design review,” which has been postponed from February to May.

“What Rockwell did was underestimate the complexity of this thing,” said Col. Paul L. Beggs, director of the group of programs that includes the AC-130U at Wright Patterson Air Force Base, Ohio. “It sounds pretty simple, especially to a contractor who has just come through the B-1 program. It is not pressing the state of the art. But Rockwell discovered they were behind the eight ball and so we agreed to slip the schedule.”

The problems started before Rockwell even signed the contract.

In selecting Rockwell, the Air Force used a bargaining technique known as a “best and final offer” to haggle for a good deal. In its request for a best and final offer, dated May 29, 1987, the Air Force said that it had only $438 million to spend to buy 12 gunships and that bidders for the program were required to fulfill all of the requirements that the Air Force wanted or their bids would be thrown out.

The other bidder was Lockheed, which had built previous generations of gunships and knew something about the business. It thought the Air Force was asking too much for the amount of money it had to spend.

‘Hungry’ for Business

“We could never come up with the same capability as Rockwell for the amount of money the Air Force wanted to spend,” recalled John McLellan, vice president for programs at Lockheed’s Ontario operation. “We probably knew too much. That is what it amounted to.

“Rockwell was very hungry for business. They were laying off large numbers of people on the B-1, and they bid aggressively. It is going to be a costly lesson for somebody, either the company or the government.”

The Air Force also got Rockwell to accept something called “total system performance responsibility,” a Pentagon policy that essentially shifts all the technical risk onto a contractor.

“It is an interesting contract,” Pierro said. “We have learned some things about those kinds of contracts.”

One lesson is that total responsibility means total liability rather than total authority. It did not free Rockwell to design the gunship on its own terms, even if it met the performance requirement. The Air Force has insisted on changes that Rockwell had not anticipated when it bid on the program, Pierro said.

Rockwell, for example, has had vigorous negotiations with the Air Force on something called a system integration laboratory, which is a mock-up of all the gunship’s computers, software, radar and electronic boxes. The laboratory is supposed to make sure that the whole system works before it is put into the aircraft. Rockwell wanted to do less laboratory testing, but the Air Force believed that it was less risky to do more testing.

Another major additional expense occurred when the Air Force decided against Rockwell’s plan to use an electronic warfare system--a radar and communications jammer--mounted on a pod outside the aircraft, which is standard for most tactical aircraft.

Instead, the Air Force decided last year that it wanted an internal system and selected the very fancy one used on the B-52 bomber. Although Rockwell did not have to pay for the electronic warfare system itself, the more complicated internal system required additional wiring, antennas and structural modifications to the airframe. It also will need five months of flight testing that Rockwell had not expected, Pierro said.

Details Called Fuzzy

Even small items, such as the type of knobs on radar consoles, became a negotiating issue. The Air Force was not happy with the type of intercom that connects the cockpit with the battle management center in the belly of the aircraft.

“Everything was specified in the contract, but details were fuzzy,” said one Rockwell engineer who spoke off the record. “There was a lack of depth in the contract on the requirements.”

Concerns were raised even before the contract was signed, but “the whole thrust of the effort was to win the contract,” this engineer said.

Beggs, the Air Force official, disagrees that the Air Force was aggressive in its contracting practices. He said the Air Force simply asked, “Mr. Contractor, you tell us what you can do with this much money. We selected Rockwell because at the time they offered more for the amount of money we had to spend.”

Beggs also blamed some of Rockwell’s cost overruns on the company’s failure to firmly tie down supplier prices before it signed the contract. Pierro, however, said the modifications demanded by the Air Force have caused the suppliers to push up their prices.

Whatever the cause, costs have been mounting. The company took a writeoff on the program in the fourth quarter but declines to say how much it reserved for potential losses. Under its $155-million incentive contract, the government absorbs 75% of any overrun up to $177 million and then Rockwell takes 100% of the loss.

At the time of the writeoff, the gunship was expected to cost $50 million more than the $155-million target price. But since then the expected overrun has grown considerably. It is now said to be about $90 million over the target, authoritative sources in industry and government said. One securities analyst also estimated the overrun at about $90 million, but Pierro said the amount is still uncertain and that $90 million is “on the high side.”

Pierro denied that Rockwell low-balled the bid. Rather, the company sought to offset its declining B-1 bomber business by getting into weapons modernization, in which the military services update equipment rather than develop new systems.

Planned to Spend Full Amount

“We didn’t expect to lose money,” he said. “Philosophically, we would never bid a contract that way. We think good business, well performed, deserves a profit.”

But the Air Force was not so sure that Rockwell would make a profit. In fact, it planned from the beginning to spend the full $177 million, Beggs, the Air Force official, said.

“Did (Rockwell) buy in knowing they were going to lose their shirt?” Beggs said. “I don’t know. My personal opinion is that they bid this program expecting very little profit or possibly a small loss. But I doubt they bought in expecting to go $90 million over target.”

Meanwhile, Rockwell’s hiring of McKenna Conner Cuneo may be laying the groundwork for an eventual claim against the government or an effort to restructure the contract. Asked if the gunship contract is legally flawed, Pierro said, “It could be.

“In a case where we feel that we have a work requirement that is out of the scope of the contract, we would feel obligated to proceed with that (a legal effort).

“If we have legal issues, we are going to take those off to the side and not let those interfere with performance on the contract. We are maintaining very close liaison with our legal people.”

Then he said, “It doesn’t mean that we are running the program with lawyers.”

If Rockwell ends up with a large loss on the gunship, the diversified industrial firm is big enough and has enough profitable defense programs to afford it. But other firms are being jeopardized by such losses and many are leaving the industry.

Eaton, Unisys, Goodyear, Gould, United Technologies, Lockheed and Honeywell, among others, are selling some or all of their defense operations. Allied-Signal, IBM and Motorola have said they will not attempt to expand their defense businesses.

“The longer-term effect of these losses is that it drives the better people out of the industry,” said Michael N. Beltramo, a consultant and former Rand research analyst. “In the name of competition, the government is unleashing big anti-competitive forces that are going to result in an industry contraction.”

Although a shrunken defense industry may be inevitable in any case as defense budgets fall, the Pentagon lacks a policy or a scheme for managing the approaching shakeout, Beltramo said. So far, the Pentagon appears to be managing its industrial base by saddling contractors with losses, then seeing which ones are driven out.

“As far as I can tell, this is all happening by default,” he said.

But the alternative is equally abhorrent to the industry, which is opposed to the idea of the Pentagon being able to decide to put specific firms out of business in segments of the industry that have excess capacity, such as aircraft manufacturing.

“That’s not in the free enterprise system that we have in the U.S.,” said Lockheed Vice Chairman Robert H. Fuhrman, who led the Defense Science Board study. “We are big boys, and we win some and lose some. If we lose too many, then we aren’t going to be around anymore.”