Pentagon Fears Douglas Plan May Raise Its Costs : * Defense: As part of the Taiwan deal, McDonnell plans to put its C-17 program into a separate division. That is expected to affect overhead costs that are paid by the Air Force.
Although McDonnell Douglas hopes that its deal to sell 40% of its commercial aircraft business to Taiwan Aerospace will bolster its fortunes, defense officials are concerned that it will be partly at their expense.
As part of the Taiwan deal, McDonnell plans to put its massive C-17 cargo jet program in Long Beach into a separate division, a restructuring that is almost certain to affect certain costs, known as overhead, that are paid by the Air Force.
The Defense Contract Management Command, the powerful Pentagon agency that negotiates payment rates under government contracts, said in a carefully worded statement Friday that it “is watching the situation with concern.”
Under government rules, McDonnell is supposed to provide the contract command with a 60-day notification that it will change its accounting system, including a detailed “impact statement” of any effect on the C-17’s future costs.
McDonnell notified the Pentagon of its planned restructuring but has not provided the detailed cost assessment. Until it does so, the impact on C-17 costs is “not determinable,” the contract command said.
While future overhead costs on the C-17 could theoretically go down, “that is not likely,” a spokeswoman at the command said. The matter is not trivial, since it involves the accounting treatment on billions of dollars in future charges on the C-17.
Douglas Aircraft Executive Vice President David O. Swain said in a recent interview that the restructuring will have some impact on C-17 program costs but characterized it as relatively minor.
Swain said the cost increases will be “not nearly as much” as those caused by Congress’ recent decision to stretch out the C-17 program schedule. Congress voted to buy only four aircraft--compared to the previous plan of six aircraft--in fiscal 1992, which will add $900 million to the C-17 program over its lifetime, according to the company.
Pentagon contract administrators generally look with a jaundiced eye on corporate restructurings when commercial and military businesses are combined or separated, according to James Southerland, a contracts expert at Contracts Advisory Services in Torrance.
“Any time you have a split like this in an operation, the government is always afraid the contractors will load its overhead onto its government contracts,” Southerland said. “There is a built-in fear of that by the government.”
The C-17’s cost is already a controversial matter. The contract command has estimated that McDonnell will lose $700 million on its existing C-17 contract, and the agency may soon increase that estimated loss to $900 million. McDonnell dismisses those estimates as based on faulty analysis. It says it will break even.
Under its complex acquisition regulations, the Pentagon reimburses McDonnell for overhead and general/administrative costs on government programs. Every firm has a different accounting system, but overhead costs can generally include salaries of executives, accountants and lawyers. It can also include basic research facilities for engineers.
The Pentagon wants to ensure that McDonnell commercial costs are not billed to future Pentagon contracts. By dividing its operations into separate military and commercial divisions, McDonnell will be changing its accounting system.
As in all defense programs, overhead costs and general/administrative costs represent a significant portion of the C-17’s cost. For example, McDonnell posted cumulative overhead costs of $1 billion and general/administrative costs of $347 million out of total costs of $3.4 billion for the research and development portion of its C-17 contract, according to a confidential cost performance report to the Pentagon last year.
The firm’s production contracts added another $91 million, according to the report, which was obtained from congressional sources.
If McDonnell increases its overhead rates as expected, those past costs would not be restated, but costs on future C-17 contracts worth tens of billions of dollars would be affected.
Estimating future overhead costs is tricky business, because aircraft can take three to five years to build, and a big mistake in estimating future costs can result in big losses on fixed-price contracts.
The treatment of overhead and general/administrative charges is outlined in an arcane government manual called “Cost Accounting Standards,” an 80-page book. But the standards are explained in accompanying working papers that include thousands of pages of detailed explanations of how to follow the standards. A Douglas spokesman said Friday that McDonnell “will be meeting with (the contract command) next week to discuss the details of any cost impact” from the Taiwan deal.
