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Testimony: 

Before the Subcommittee on Readiness and Management Support, Committee 
on Armed Services, U.S. Senate: 

United States Government Accountability Office: 

GAO: 

For Release on Delivery Expected at 3:00 p.m. EDT: 

Wednesday April 5, 2006: 

Defense Acquisitions: 

DOD Wastes Billions of Dollars through Poorly Structured Incentives: 

Statement of David M. Walker: 

Comptroller General of the United States: 

GAO-06-409T: 

GAO Highlights: 

Highlights of GAO-06-409T, a testimony before the Subcommittee on 
Readiness and Management Support, Committee on Armed Services, U.S. 
Senate 

Why GAO Did This Study: 

With DOD spending over $200 billion annually to acquire products and 
services that include everything from spare parts to the development of 
major weapon systems, our numerous, large, and mounting fiscal 
challenges demand that DOD maximize its return on investment and 
provide the warfighter with needed capabilities at the best value for 
the taxpayer. In an effort to encourage defense contractors to perform 
in an innovative, efficient, and effective way, DOD gives its 
contractors the opportunity to collectively earn billions of dollars 
through monetary incentives known as award and incentive fees. Using 
these incentives properly—in concert with good acquisition practices—is 
a key to minimizing waste, maximizing value, and getting our military 
personnel what they need, when and where they need it. 

The subcommittee asked GAO to testify on DOD’s use of award and 
incentive fees and the role they play in the acquisition system. This 
statement highlights the risks of conducting business as usual and 
identifies the actions DOD needs to take to use these fees more 
effectively. DOD concurred or partially concurred with the seven 
recommendations GAO made in a previously issued report on award and 
incentive fees. GAO looks forward to seeing DOD turn these promised 
steps into actual policy and practice. 

What GAO Found: 

DOD’s use of award and incentive fees is an issue at the nexus of two 
areas that GAO has designated “high risk” for DOD—contract management 
and weapon system acquisition. Contract management has been a long-
standing business management challenge for DOD because it often cannot 
assure that it is using sound business practices to acquire the goods 
and services the warfighter needs. For weapon system acquisitions, the 
persistent and long-standing nature of acquisition problems has perhaps 
made a range of key decision makers complacent about cost growth, 
schedule delays, quantity reductions, and performance shortfalls. DOD’s 
strategies for incentivizing its contractors, especially for weapon 
system development programs, reflect the challenges in these areas. 

DOD programs routinely engage in award-fee practices that do not hold 
contractors accountable for achieving desired outcomes and undermine 
efforts to motivate contractor performance, such as 

* evaluating contractors on award-fee criteria that are not directly 
related to key acquisition outcomes (e.g., meeting cost and schedule 
goals and delivering desired capabilities to the warfighter); 
* paying contractors a significant portion of the available fee for 
what award-fee plans describe as “acceptable, average, expected, good, 
or satisfactory” performance; and
* giving contractors at least a second opportunity to earn initially 
unearned or deferred fees. 

As a result, DOD has paid out an estimated $8 billion in award fees on 
contracts in GAO’s study population, regardless of whether acquisition 
outcomes fell short of, met, or exceeded DOD’s expectations. Despite 
paying billions of dollars, DOD has not compiled data or developed 
performance measures to evaluate the validity of its belief that award 
and incentive fees improve contractor performance and acquisition 
outcomes. 

These issues, along with those GAO has identified in DOD’s acquisition 
and business management processes, present a compelling case for 
change. By implementing the recommendations GAO has made on award and 
incentive fees, DOD can improve incentives, increase transparency, and 
enhance accountability for the fees it pays. At the same time, by 
working more broadly to improve its acquisition practices, DOD can set 
the right conditions for getting better acquisition outcomes and making 
more efficient use of its resources in what is sure to be a more 
fiscally constrained environment. 

www.gao.gov/cgi-bin/getrpt?GAO-06-409T. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Katherine Schinasi at 
(202) 512-4841 or schinasik@gao.gov. 

[End of section] 

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here today to discuss the Department of Defense's 
(DOD) use of monetary incentives known as award and incentive fees. 
With DOD spending over $200 billion annually to acquire products and 
services that include everything from spare parts to the development of 
major weapon systems, our numerous, large, and mounting fiscal 
challenges demand that DOD maximize its return on investment and 
provide the warfighter with needed capabilities at the best value for 
the taxpayer. In an effort to encourage defense contractors to perform 
in an innovative, efficient, and effective way, DOD gives its 
contractors the opportunity to collectively earn billions of dollars 
through monetary incentives known as award and incentive fees. Using 
these incentives properly, in concert with sound acquisition practices, 
is a key to minimizing waste, maximizing value, and getting our 
military personnel what they need, when and where they need it. 
Unfortunately, DOD has not used these incentives effectively. How they 
have been used and how we believe they should be used is the focus of 
my statement today. 

To put the issues related to DOD's use of award and incentive fees in 
context, I want to step back and look at some of the broader management 
challenges that confront DOD. The department is facing a significant 
number of recurring problems in managing its major weapon acquisitions. 
Although U.S. weapons are the best in the world, DOD's acquisition 
process for weapons programs consistently yields undesirable 
consequences--dramatic cost increases, late deliveries to the 
warfighter, and performance shortfalls. These problems occur, in part, 
because DOD tends to consistently overpromise and underdeliver in 
connection with major acquisition efforts. In addition, DOD's weapons 
programs do not capture, early on, the requisite knowledge that is 
needed to efficiently and effectively manage program risks. For 
example, programs lack clearly defined and stable requirements, move 
forward with unrealistic program cost and schedule estimates, use 
immature technologies in launching product development, and fail to 
solidify design and manufacturing processes at appropriate junctures in 
development. As a result, wants are not always distinguished from 
needs; expectation gaps are the norm; problems often surface late in 
the development process; and fixes tend to be much more costly than if 
they were caught earlier. 

Cost increases incurred while developing new weapon systems typically 
mean that DOD cannot produce as many of those weapons as intended nor 
can it be relied on to deliver them to the warfighter when promised and 
with the initially advertised capabilities. In addition, military 
operations in Afghanistan and Iraq are consuming a large share of DOD 
resources and causing the department to invest more money sooner than 
expected to replace or fix existing weapons. Meanwhile, DOD is intent 
on transforming military operations and currently has its eye on 
multiple megasystems that are expected to be the most expensive and 
complex ever. These new desires and long-standing acquisition and 
contract management challenges are running head-on into the nation's 
current imprudent and unsustainable fiscal path. At the same time, 
DOD's numerous business management weaknesses continue to result in 
reduced efficiencies and effectiveness that waste billions of dollars 
every year. These business management weaknesses touch on all of DOD's 
major business operations, ranging from the department's inadequate 
management of its overall business transformation effort to decades-old 
financial management and information technology problems to various 
contracting and selected supply chain challenges. In fact, all these 
areas and more are on GAO's 2005 "high-risk" list of programs and 
activities that need urgent attention and fundamental transformation to 
ensure that our national government functions in the most economical, 
efficient, and effective manner possible. 

DOD's use of award and incentive fees is an issue at the nexus of two 
of these high-risk areas--DOD contract management and DOD weapon system 
acquisition. Contract management has been a long-standing business 
management challenge for the department. DOD is the government's 
largest purchaser, yet it is often unable to assure that it is using 
sound business practices to acquire the goods and services needed to 
meet the warfighter's needs. For example, we have found that DOD has 
not used various contracting tools and techniques effectively--such as 
performance-based service contracting, multiple-award task order 
contracts, purchase cards, and, most recently, award and incentive 
fees. For DOD weapon system acquisitions, we have found the persistent 
and long-standing nature of acquisition problems has perhaps made a 
range of key players both in the Pentagon and the Congress complacent 
about cost growth, schedule delays, quantity reductions, and 
performance shortfalls in weapon system programs. DOD's strategies for 
incentivizing its contractors, especially on weapon system development 
programs, reflect this complacency and are symptomatic of the lack of 
discipline, oversight, transparency, and accountability in DOD's 
acquisition process. As a result, DOD programs routinely engage in 
practices that undermine efforts to motivate positive contractor 
performance and that do not hold contractors accountable for achieving 
desired acquisition outcomes, such as meeting cost and schedule goals 
and delivering desired capabilities to the warfighter. 

Specifics follow: 

* DOD generally does not evaluate contractors based on award-fee 
criteria that are directly related to key acquisition outcomes. In 
addition, the link between the elements of contractor performance that 
are included in the criteria and these outcomes is not always clear. As 
a result, DOD paid out an estimated $8 billion in award fees over the 
life of the contracts in our study population (from their inception 
through our data collection phase),[Footnote 1] regardless of whether 
acquisition outcomes fell short of, met, or exceeded DOD's 
expectations. 

* DOD programs engage in practices that undermine efforts to motivate 
excellent contractor performance by regularly paying contractors a 
significant portion of the available fee for what award-fee plans 
describe as "acceptable, average, expected, good, or satisfactory" 
performance. Although the definition of this level of performance 
varies by contract, these definitions are generally not related to 
outcomes. About half of the contracts in our sample, allowed 70 percent 
or more of the available fee to be paid for this level of performance. 

* DOD award fee practices do not promote accountability. DOD programs 
gave contractors on about half of the award-fee contracts in our study 
population at least a second opportunity to earn an estimated $669 
million in initially unearned or deferred fees. 

Taken together, DOD's acquisition, business, and contract management 
practices are contrary to the purpose of performance-based contracting 
concepts and have resulted and, if not corrected in both form and 
practice, will continue to result in wasting billions of dollars in 
taxpayer funds. My statement today will focus on what steps DOD must 
take to strengthen the link between monetary incentives and acquisition 
outcomes and by extension increase the transparency and accountability 
of DOD programs for fees paid and of contractors for results achieved. 
This testimony draws upon our recently issued report on DOD's use of 
award and incentive fees as well as the GAO High-Risk series and our 
body of work on weapon system acquisitions. 

GAO's many acquisition-related reports over the years raise serious 
questions about the reasonableness, appropriateness, and affordability 
of DOD's current investment plans; the soundness of the acquisition 
process which implements those plans; and the effectiveness of the 
practices DOD uses to manage its contractors, including the use of 
award and incentive fees. These reports collectively present a 
compelling case for change. 

Appendix I contains information about the scope and methodology for GAO-
06-66, Defense Acquisitions: DOD Has Paid Billions in Award and 
Incentive Fees Regardless of Acquisition Outcomes. The work was 
conducted in accordance with generally accepted government auditing 
standards. 

Background: 

Federal agencies, including DOD, can choose among numerous contract 
types to acquire products and services. One of the characteristics that 
vary across contract types is the amount and nature of the fee that 
agencies offer to the contractor for achieving or exceeding specified 
objectives or goals. Of all the contract types available, only award- 
and incentive-fee contracts allow an agency to adjust the amount of fee 
paid to contractors based on the contractor's performance.[Footnote 2] 

Federal acquisition regulations state that award-and incentive-fee 
contracts should be used to achieve specific acquisition objectives, 
such as delivering products and services on time or within cost goals 
and with the promised capabilities. For award-fee contracts, the 
assumption underlying the regulation is that the likelihood of meeting 
these acquisition objectives will be enhanced by using a contract that 
effectively motivates the contractor toward exceptional performance. 
Typically, award-fee contracts emphasize multiple aspects of contractor 
performance in a wide variety of areas, such as quality, timeliness, 
technical ingenuity, and cost-effective management.[Footnote 3] These 
areas are susceptible to judgmental and qualitative measurement and 
evaluation, and as a result, award-fee criteria and evaluations tend to 
be subjective.[Footnote 4] Table 1 provides a description of the 
general process for evaluating the contractor and determining the 
amount of award fee earned. 

Table 1: General Process for Determining Award-Fee Amounts: 

1; DOD officials provide input on the contractor's performance for an 
evaluation period that just ended. 

2; Program officials compile data and prepare briefing or summary for 
award-fee evaluation board.[A]. 

3; Award-fee evaluation board convenes meeting; contractor has option 
to submit a self-assessment and brief the board. 

4; Award-fee evaluation board considers all the input and recommends a 
fee rating for the contractor. 

5; Fee-determining official (usually outside the program) makes an 
initial fee determination and notifies contracting officer.[B]. 

6; Contracting officer notifies contractor of initial determination; 
contractor has the option to appeal the decision to the fee-determining 
official. 

7; Fee-determining official makes final determination, including 
whether to roll over unearned fee, and notifies contracting 
officer.[C]. 

8; Contracting officer issues final determination to contractor and 
processes a contract modification authorizing payment. 

Sources: Army Contracting Agency Award Fee Handbook, Air Force Award 
Fee Guide, Navy/Marine Corps Award Fee Guide (data); GAO (analysis). 

[A] Award-fee evaluation board members may include personnel from key 
organizations knowledgeable about the award-fee evaluation areas, such 
as: engineering, logistics, program management, contracting quality 
assurance, legal, and financial management; personnel from user 
organizations and cognizant contract administration offices; and the 
local small business office in cases where subcontracting goals are 
important. On major weapons programs, the boards are generally made up 
of personnel from the program office. 

[B] The fee-determining official is generally at a higher level 
organizationally than those directly involved in the evaluation of the 
contractor (e.g. award-fee board members). For instance, this official 
can be the program executive officer for a weapons system acquisition 
contract or a garrison commander on a base support services contract. 

[C] Rollover is the practice of moving unearned award fee from one 
evaluation period to a subsequent evaluation period or periods, thus 
providing the contractor an additional opportunity to earn previously 
unearned fee. 

[End of table] 

Prevalence and Use of Award and Incentive Fees: 

From fiscal year 1999 through fiscal year 2003, award-and incentive-fee 
contract actions[Footnote 5] accounted for 4.6 percent of all DOD 
contract actions over $25,000. However, when taking into account the 
dollars obligated--award-and incentive-fee contract actions accounted 
for 20.6 percent of the dollars obligated on actions over $25,000, or 
over $157 billion, as shown in figure 1. Our sample of 93 contracts 
includes $51.6 billion, or almost one-third, of those obligated award- 
and incentive-fee contract dollars.[Footnote 6] These obligations 
include award-and incentive-fee payments as well as other contract 
costs. 

Figure 1: Prevalence of Award-and Incentive-Fee Contracts, Fiscal Years 
1999-2003: 

[See PDF for image] 

[End of figure] 

DOD utilized the contracts in our sample for a number of purposes. For 
example, research and development contracts accounted for 51 percent 
(or $26.4 billion) of the dollars obligated against contracts in our 
sample from fiscal years 1999 through 2003; while non-research-and- 
development services accounted for the highest number of contracts in 
our sample. Further, we estimate that most of the contracts and most of 
the dollars in our study population are related to the acquisition of 
weapon systems. 

DOD has the flexibility to mix and match characteristics from different 
contract types. The risks for both DOD and the contractor vary 
depending on the exact combination chosen, which, according to the 
Federal Acquisition Regulation, should reflect the uncertainties 
involved in contract performance. Based on the results from our sample, 
about half of the contracts in our study population were cost-plus- 
award-fee contracts. The theory behind these contracts is that although 
the government assumes most of the cost risk, it retains control over 
most or all of the contractor's potential fee as leverage. On cost- 
plus-award-fee contracts, the award fee is often the only source of 
potential fee for the contractor. According to defense acquisition 
regulations, these contracts can include a base fee--a fixed fee for 
performance paid to the contractor--of anywhere from 0 to 3 percent of 
the value of the contract;[Footnote 7] however, based on our sample 
results, we estimate that about 60 percent of the cost-plus-award-fee 
contracts in our study population included zero base fee.[Footnote 8] 
There is no limit on the maximum percentage of the value of the 
contract that can be made available in award fee, although the 20 
percent included in the Space-Based Infrared Radar System High 
development contract we examined was outside the norm. The available 
award fees on all the award-fee contracts in our study population 
typically ranged from 7 to 15 percent of the estimated value of the 
contract. 

A System in Need of Reform: 

DOD's use of award and incentive fees is symptomatic of an acquisition 
system in need of fundamental reform. DOD's historical practice of 
routinely paying its contractors nearly all of the available award fee 
creates an environment in which programs pay and contractors expect to 
receive most of the available fee, regardless of acquisition outcomes. 
This is occurring at a time when DOD is giving contractors increased 
program management responsibilities to develop requirements, design 
products, and select major system and subsystem contractors. Based on 
our sample, we estimate that for DOD award-fee contracts, the median 
percentage of available award fee paid to date (adjusted for 
rollover)[Footnote 9] was 90 percent, representing an estimated $8 
billion in award fees for contracts active between fiscal years 1999 
and 2003. Estimates of total award fees earned are based on all 
evaluation periods held from the inception of our sample contracts 
through our data collection phase, not just those from fiscal years 
1999 through 2003.[Footnote 10] Figure 2 shows the percentage of 
available fee earned for the 63 award-fee contracts in our sample. 

Figure 2: Percentage of Available Fee Paid to Date for 63 Award-Fee 
Contracts in GAO's Sample: 

[See PDF for image] 

Sources: DOD submissions to GAO and contract documentation (data); GAO 
(analysis and presentation). 

[End of figure] 

The pattern of consistently high award-fee payouts is also present in 
DOD's fee decisions from evaluation period to evaluation period. This 
pattern is evidence of reluctance among DOD programs to deny 
contractors significant amounts of fee, even in the short term. We 
estimate that the median percentage of award fee earned for each 
evaluation period was 93 percent and that the contractor received 70 
percent or less of the available fee in only 9 percent of the 
evaluation periods and none of the available fee in only 1 percent of 
the evaluation periods. 

A Case for Change: Moving Toward Outcome-Based Award-Fee Criteria: 

Recommendations made: 
* Move toward more outcome-based award-fee criteria that are both 
achievable and promote accountability for positive acquisition 
outcomes; 
DOD response: 
* DOD issued a policy memo on March 29, 2006, emphasizing the need to 
link award fees to desired program outcomes. 

Award fees have generally not been effective at helping DOD achieve its 
desired acquisition outcomes, in large part, because award-fee criteria 
are not linked to desired acquisition outcomes, such as meeting cost 
and schedule goals and delivering desired capabilities. Instead, DOD 
programs structure award fees to focus on the broad aspects of 
contractor performance, such as technical and management performance 
and cost control, that they view as keys to a successful program. In 
addition, elements of the award-fee process, such as the frequency of 
evaluations and the composition of award-fee boards, may also limit 
DOD's ability to effectively and impartially evaluate the contractor's 
progress toward acquisition outcomes. Most award-fee evaluations are 
time-based, generally every six months, rather than event-based; and 
award-fee boards are made up primarily of individuals directly 
connected to the program. As a result of all these factors, DOD 
programs frequently paid most of the available award fee for what they 
described as improved contractor performance, regardless of whether 
acquisition outcomes fell short of, met, or exceeded DOD's 
expectations. 

High award-fee payouts on programs that have fallen or are falling well 
short of meeting their stated goals are also indicative of DOD's 
failure to implement award fees in a way that promotes positive 
performance and adequate accountability. Several major development 
programs--accounting for 52 percent of the available award-fee dollars 
in our sample and 46 percent of the award-fee dollars paid to date--are 
not achieving or have not achieved their desired acquisition outcomes, 
yet contractors received most of the available award fee. These 
programs--the Comanche helicopter, F/A-22 and Joint Strike Fighter 
aircraft, and the Space-Based Infrared System High satellite system-- 
have experienced significant cost increases, technical problems, and 
development delays, but the prime systems contractors have received 85, 
91, 100, and 74 percent of the award fee, respectively to date 
(adjusted for rollover), totaling $1.7 billion (see table 2). 

Table 2: Program Performance and Award-Fee Payments on Selected DOD 
Development Programs: 

Acquisition outcomes: Research and development cost increase over 
original baseline; 
Comanche reconnaissance attack helicopter: $3.7 billion, 41.2 percent; 
F/A-22 Raptor tactical fighter aircraft: $10.2 billion, 47.3 percent; 
Joint Strike Fighter tactical fighter aircraft: $10.1 billion, 30.1 
percent; 
Space-Based Infrared System High: $3.7 billion, 99.5 percent. 

Acquisition outcomes: Acquisition cycle time increase over original 
baseline; 
Comanche reconnaissance attack helicopter: 33 months, 14.8 percent; 
F/A-22 Raptor tactical fighter aircraft: 27 months, 13.3 percent; 
Joint Strike Fighter tactical fighter aircraft: 11 months, 5.9 percent; 
Space-Based Infrared System High: More than 12 months[A]. 

Acquisition outcomes: Number of program rebaselines; 
Comanche reconnaissance attack helicopter: 1[B]; 
F/A-22 Raptor tactical fighter aircraft: 14; 
Joint Strike Fighter tactical fighter aircraft: 1; 
Space- Based Infrared System High: 3. 

Acquisition outcomes: Total award fee paid to prime systems contractor; 
Comanche reconnaissance attack helicopter: $202.5 million paid through 
2004; 
F/A-22 Raptor tactical fighter aircraft: $848.7 million; 
Joint Strike Fighter tactical fighter aircraft: $494.0 million; 
Space-Based Infrared System High: $160.4 million[C]. 

Acquisition outcomes: Percentage of award fee paid to prime systems 
contractor (adjusted for rollover)[D]; 
Comanche reconnaissance attack helicopter: 85 percent of available fee; 
F/A-22 Raptor tactical fighter aircraft: 91 percent; 
Joint Strike Fighter tactical fighter aircraft: 100 percent; 
Space-Based Infrared System High: 74 percent. 

Acquisition outcomes: Total award fee paid to prime engine contractor; 
Comanche reconnaissance attack helicopter: No engine contractor; 
F/A-22 Raptor tactical fighter aircraft: $115 million paid through 
2004; 
Joint Strike Fighter tactical fighter aircraft: $35.8 million; 
Space-Based Infrared System High: No engine contractor. 

Acquisition outcomes: Percentage of award fee paid to prime engine 
contractor (adjusted for rollover)[D]; 
Comanche reconnaissance attack helicopter: N/A; 
F/A-22 Raptor tactical fighter aircraft: 89 percent of the available 
fee; 
Joint Strike Fighter tactical fighter aircraft: 100 percent; 
Space-Based Infrared System High: N/A. 

Sources: DOD submissions to GAO, contract documentation, and GAO-05-301 
(data); GAO (analysis and presentation). 

[A] The Air Force Space Command has not specified the acquisition cycle 
time for the Space-Based Infrared Radar System High program; however, 
the delivery of the first two satellites has been delayed by more than 
a year. 

[B] Overall, there were five rebaselines for the Comanche program; 
however, only one occurred after development start. The Comanche 
program was canceled in 2004. 

[C] The program also utilizes incentive fees tied to cost and mission 
successes. The award fee paid does not include fee earned through 
mission success incentives. To date, the contractor has earned $3 
million in these fees and could earn over $70 million over the life of 
the contract. 

[D] When calculating the percentage of award fee paid to date (i.e., 
percentage of award fee paid to date = total fee paid to date/(total 
fee pool - remaining fee pool)), we included rolled-over fees in the 
remaining fee pool when those fees were still available to be earned in 
future evaluation periods. For instance, even though the Joint Strike 
Fighter prime contractor has not been paid 100 percent of the award fee 
that was made available for each evaluation period, it retains the 
ability to potentially earn all of this unearned fee at a later date. 
By reflecting the continued availability of this unearned fee in the 
percentage calculation, it becomes clear that the contractor has, in 
essence, earned 100 percent of the total award fee to date. 

[End of table] 

DOD can ensure that fee payments are more representative of program 
results by developing fee criteria that focus on its desired 
acquisition outcomes. For instance, DOD's Missile Defense Agency 
attempted to hold contractors accountable for program outcomes on the 
Airborne Laser program. On this program, DOD revised the award-fee plan 
in June 2002 as part of a program and contract restructuring. The award-
fee plan was changed to focus on achieving a successful system 
demonstration by December 2004. Prior to the restructuring, the 
contractor had received 95 percent of the available award fee, even 
though the program had experienced a series of cost increases and 
schedule delays. Importantly, the contractor did not receive any of the 
$73.6 million award fee available under the revised plan because it did 
not achieve the key program outcome--successful system 
demonstration.[Footnote 11] 

A Case for Change: Motivating Excellent Contractor Performance and 
Promoting Accountability: 

Recommendations made: 
* Ensure that award-fee structures are motivating excellent contractor 
performance by only paying award fees for above satisfactory 
performance; 
DOD response: 
* While DOD stated that award fee arrangements should be structured to 
encourage the contractor to earn the preponderance of fee by providing 
excellent performance, it maintains that paying a portion of the fee 
for satisfactory performance is appropriate to ensure that contractors 
receive an adequate fee on contracts. In its March 29, 2006 policy 
memo, DOD reiterated this position and emphasized that less than 
satisfactory performance is not entitled to any award fee. 

Recommendations made: 
* Issue DOD guidance on when rollover is appropriate; 
DOD response: 
* In its March 29, 2006 policy memo, DOD provided guidance and placed 
several limitations on the use of rollover. 

DOD programs routinely engage in award-fee practices that are 
inconsistent with the intent of award fees, reduce the effectiveness of 
these fees as motivators of performance, compromise the integrity of 
the fee process, and waste billions in taxpayer money. Two practices, 
in particular, paying significant amounts of fee for "acceptable, 
average, expected, good, or satisfactory" performance and providing 
contractors multiple opportunities to earn fees that were not earned 
when first made available, undermine the effectiveness of fees as a 
motivational tool and marginalize their use in holding contractors 
accountable for acquisition outcomes. 

Although DOD guidance and federal acquisition regulations state that 
award fees should be used to motivate excellent contractor performance, 
most DOD award-fee contracts pay a significant portion of the available 
fee for what award-fee plans describe as "acceptable, average, 
expected, good, or satisfactory" performance. Although the definition 
of this level of performance varies by contract, these definitions are 
generally not related to outcomes. Some plans for contracts in our 
sample did not even require the contractor to meet all of the minimum 
standards or requirements of the contract to receive one of these 
ratings. Some plans also allowed for fee to be paid for marginal 
performance. Even fixed-price-award-fee contracts, which already 
include a normal level of profit in the price, paid out award fees for 
satisfactory performance. Figure 3 shows the maximum percentage of 
award fee paid for "acceptable, average, expected, good, or 
satisfactory" performance and the estimated percentage of DOD award-fee 
contracts active between fiscal years 1999 through 2003 that paid these 
percentages. 

Figure 3: Maximum Percentage of Award Fee Available for "Acceptable, 
Average, Expected, Good, or Satisfactory" Performance and the Estimated 
Percentage of DOD Contracts That Paid These Percentages: 

[See PDF for image] 

Note: Sampling errors for percentages in this figure do not exceed plus 
or minus 13 percentage points. 

[End of figure] 

The use of rollover is another indication that DOD's management of 
award-fees lacks the appropriate incentives, transparency, and 
accountability necessary for an effective pay-for-performance system. 
Rollover is the process of moving unearned available award fee from one 
evaluation period to a subsequent evaluation period, thereby providing 
the contractor an additional opportunity to earn that previously 
unearned award-fee. We estimate that 52 percent of DOD award-fee 
contracts rolled over unearned fees into subsequent evaluation 
periods,[Footnote 12] and in 52 percent[Footnote 13] of these periods, 
at least 99 percent of the unearned fee was rolled over. Overall, for 
DOD award-fee contracts active between fiscal years 1999 through 2003, 
we estimate that the total dollars rolled over across all evaluation 
periods that had been conducted by the time of our review was $669 
million. 

A Case for Change: Ensuring Practice Is Consistent with Policy: 

Recommendations made: 
* Requiring appropriate approving officials to review new contracts to 
make sure award-fee criteria reflect desired acquisition outcomes and 
award-fee structures motivate excellent contractor performance by only 
providing fees for above satisfactory performance; 
DOD response: 
* DOD plans to conduct an analysis to determine what the appropriate 
approving official level should be for new contracts utilizing award 
fees and issue additional guidance if needed by June 1, 2006. 

The inconsistent application of DOD's existing policies on award fees 
and weapon system development reinforce the need for increased 
transparency and accountability in DOD's management of award fees. 
Although DOD award-fee guidance and federal acquisition regulations 
state that award fees should be used to motivate excellent contractor 
performance, most DOD award-fee contracts still pay a significant 
portion of the available fee for what award-fee plans describe as 
"acceptable, average, expected, good, or satisfactory" 
performance.[Footnote 14] Air Force, Army, and Navy guidance that 
states rollover should rarely be used in order to avoid compromising 
the integrity of the award-fee evaluation process; however, about half 
of the contracts in our study population used rollover. 

A Case for Change: Developing and Sharing Proven Incentive Strategies: 

Recommendations made: 
* Develop a mechanism for capturing award-and incentive-fee data within 
existing data systems, such as the Defense Acquisition Management 
Information Retrieval system; 
DOD response: 
* DOD will conduct an analysis of existing systems and determine which, 
if any, is best suited, to capture this type of data and at what cost. 
DOD expects to complete the study by June 1, 2006. 

Recommendations made: 
* Develop performance measures to evaluate the effectiveness of award 
and incentive fees as a tool for improving contractor performance and 
achieving desired program outcomes; 
DOD response: 
* DOD will review and identify possible performance measures and 
determine the appropriate actions by June 1, 2006. 

Recommendations made: 
* Develop a mechanism to share proven incentive strategies for the 
acquisition of different types of products and services with 
contracting and program officials across DOD; 
DOD response: 
* In its March 29, 2006 policy memo, DOD tasked Defense Acquisition 
University to develop an online repository for award-and incentive-fee 
policy information, related training courses, and examples of good 
award fee arrangements. 

Very little effort has gone into determining whether DOD's current use 
of monetary incentives is effective. Over the past few years, officials 
including the Undersecretary of Defense for Acquisition Technology and 
Logistics and the Assistant Secretary of the Air Force for Acquisition 
expressed concerns that contractors routinely earn high percentages of 
fee while programs have experienced performance problems, schedule 
slips, and cost growth. However, DOD has not compiled information, 
conducted evaluations, shared lessons learned, or used performance 
measures to judge how well award and incentive fees are improving or 
can improve contractor performance and acquisition outcomes. The lack 
of data is exemplified by the fact that DOD does not track such basic 
information as how much it pays in award and incentive fees. Such 
information collection across DOD is both necessary and appropriate. 

Conclusions: 

DOD's use of award-fee contracts, especially for weapon system 
development, reflects the fundamental lack of knowledge and program 
instability that we have consistently cited as the main reasons for 
DOD's poor acquisition outcomes. DOD uses these fees in an attempt to 
mitigate the risks that it creates through a flawed approach to major 
weapon system development. The DOD requirements, acquisition, 
budgeting, and investment processes are broken and need to be fixed. 
DOD's requirements process generates much more demand for new programs 
than fiscal resources can reasonably support. The acquisition 
environment encourages launching product developments that promise the 
best capability, but embody too many technical unknowns and too little 
knowledge about the performance and production risks they entail. 
However, a new program will not be approved unless its costs fall 
within forecasts of available funds and, therefore, looks affordable. 
Further, because programs are funded annually and departmentwide, cross-
portfolio priorities have not been established, competition for funding 
continues over time, forcing programs to view success as the ability to 
secure the next funding increment rather than delivering capabilities 
when expected and as promised. 

The business cases to support weapon system programs that result from 
these processes are in many cases not executable because the incentives 
inherent in the current defense acquisition system are not conducive to 
establishing realistic cost, schedule, and technical goals. As a 
result, DOD has to date not been willing to hold its programs or its 
contractors accountable for achieving its specified acquisition 
outcomes. Instead, faced with a lack of knowledge and the lack of a 
sound business case, DOD programs use award-fee contracts, which by 
their very nature allow DOD to evaluate its contractors on a subjective 
basis. This results in billions of dollars in wasteful payments because 
these evaluations are based on contractors' ability to guide programs 
through a broken acquisition system, not on achieving desired 
acquisition outcomes. 

Implementing our recommendations on award and incentive fees will not 
fix the broader problems DOD faces with its management of major weapons 
or service acquisitions. However, by implementing our recommendations, 
DOD can improve incentives, increase transparency, and enhance 
accountability for the fees it pays. In particular, moving toward more 
outcome-based award-fee criteria would give contractors an increased 
stake in helping DOD to develop more realistic targets upfront or risk 
receiving less fee when unrealistic cost, schedule, and performance 
targets are not met. To make this new approach to incentives function 
as intended, DOD would also need to address the more fundamental issues 
related to its management approach, such as the lack of a sound 
business case, lack of well-defined requirements, lack of product 
knowledge at key junctions in development, and program instability 
caused by changing requirements and across-the-board budget cuts. 
Working in concert, these steps can help DOD set the right conditions 
for more successful acquisition outcomes and make more efficient use of 
its resources in what is sure to be a more fiscally constrained 
environment as the nation approaches the retirement of the "baby boom" 
generation. 

Recent DOD Actions: 

Last week, DOD issued a policy memorandum on award-fee contracts that 
takes steps towards addressing several of the recommendations made in 
our report, and the department has indicated that further actions are 
planned to address the remaining recommendations. This guidance is a 
positive first step, but, like so many prior DOD concurrences, its 
effectiveness will ultimately be determined by how well it is 
implemented. Identifying who will be responsible for ensuring it is 
carried out and how progress will be monitored and measured are key 
ingredients that are missing in the new guidance. We continue to 
believe that DOD must designate appropriate approving officials to 
review new contracts to ensure that award-fee criteria are tied to 
desired acquisition outcomes; fees are used to promote excellent 
performance; and the use of rollover provisions in contracts is the 
exception not the rule. Changing DOD award-fee practices will also 
require a change in culture and attitude. The policy memorandum's 
position that it is appropriate to pay a portion of the available award 
fee for satisfactory performance to ensure that contractors receive an 
"adequate fee on contracts" is indicative of DOD's resistance to 
cultural change. Finally, we encourage the department to fully 
implement our remaining recommendations including developing a 
mechanism to capture award-and incentive-fee data and developing 
performance measures to evaluate the effectiveness of these fees. 

Mr. Chairman and Members of the Committee, this concludes my prepared 
statement. I would be happy to answer any questions you may have at 
this time. 

[End of section] 

Appendix I: Scope and Methodology: 

In this statement, we examine fixed-price and cost-reimbursable award- 
and incentive-fee contracts, as well as contracts that featured 
combinations of these contract types. These contracts were selected as 
part of a probability sample of 93 contracts from a study population of 
597 DOD award-fee and incentive-fee contracts that were active between 
fiscal years 1999 and 2003 and had at least one contract action coded 
as cost-plus-award-fee, cost-plus-incentive-fee, fixed-price-award- 
fee, or fixed-price incentive valued at $10 million or more during that 
time. Unless otherwise noted, the estimates in this statement pertain 
to (1) this population of award-and incentive-fee contracts, (2) the 
subpopulation of award-fee contracts, or (3) the evaluation periods 
associated with contracts described in (1) or (2) that had been 
completed at the time of our review. In the sample, 52 contracts 
contained only award-fee provisions; 27 contracts contained only 
incentive-fee provisions; and 14 contracts included both. Estimates of 
total award fees earned and total award fees that contractors received 
at least two chances to earn are based on all evaluation periods held 
from the inception of our sample contracts through our data collection 
phase,[Footnote 15] not just those from fiscal years 1999 through 2003. 
Because the estimates in this report are derived from a probability 
sample, they are subject to sampling error. All percentage estimates 
from our review have margins of error not exceeding plus or minus 10 
percentage points unless otherwise noted. All numerical estimates other 
than percentages (such as totals and ratios) have margins of error not 
exceeding plus or minus 25 percent of the value of those estimates. 

FOOTNOTES 

[1] Estimates of total award fees earned are based on all evaluation 
periods held from the inception of our sample contracts through our 
data collection phase, not just those from fiscal years 1999 through 
2003. The oldest award fee contracts in our sample were signed in 
fiscal year 1991. For some contracts, the data collection phase ended 
as early as November 2004. For at least one contract, data collection 
was not complete until April 2005. 

[2] Other contract types do not provide this same level of control over 
fees and profits. The two most prevalent DOD contract types (based on 
the number of contract actions) are firm-fixed-price and cost-plus- 
fixed-fee. Under firm-fixed-price contracts, DOD and the contractor 
agree on a price and the contractor assumes full responsibility for all 
costs and the resulting profit or loss. Under cost-plus-fixed-fee 
contracts, DOD provides payment for the contractor's allowable incurred 
costs, to the extent prescribed in the contract, and the contractor 
receives a fee that was negotiated and fixed at the inception of the 
contract. 

[3] Award-fee contracts are intended to be flexible, so award-fee plans 
allow contracting and program officials to change the fee criteria in 
these areas and the weight given to each criterion from evaluation 
period to evaluation period. 

[4] The Navy Award Fee Guide suggests that objective measures also be 
utilized, to the maximum extent possible, to support the subjective 
evaluation of the contractor's performance. 

[5] Contract actions include any action related to the purchasing, 
renting, or leasing of supplies, services, or construction. Contract 
actions include definitive contracts; letter contracts; purchase 
orders; orders made under existing contracts or agreements; and 
contract modifications, which would include the payment of award and 
incentive fees. 

[6] These contracts were selected as part of a probability sample of 93 
contracts from a study population of 597 DOD award-fee and incentive- 
fee contracts that were active between fiscal years 1999 and 2003 and 
had at least one contract action coded as cost-plus-award-fee, cost- 
plus-incentive-fee, fixed-price-award-fee, or fixed-price incentive 
valued at $10 million or more during that time. 

[7] The two F/A-22 development contracts in our sample included a 4 
percent base fee. The program office received a deviation from the 
Defense Federal Acquisition Regulation Supplement, which allows for a 
maximum of 3 percent base fee. 

[8] The 95 percent confidence interval surrounding this estimate ranges 
from 46 percent to 73 percent. 

[9] When calculating the percentage of award fee paid (i.e. percentage 
of award fee paid = total fee paid to date/(total fee pool - remaining 
fee pool)), we included rolled-over fees in the remaining fee pool when 
those fees were still available to be earned in future evaluation 
periods. 

[10] The oldest award fee contracts in our sample were signed in fiscal 
year 1991. For some contracts, the data collection phase ended as early 
as November 2004. For at least one contract, data collection was not 
complete until April 2005. 

[11] According to DOD, the contract was restructured again in May 2004 
and the cost ceiling was increased from about $2 billion to $3.6 
billion and the period of performance of the contract was extended more 
than 3 years, from June 2005 to December 2008. 

[12] The 95 percent confidence interval for this estimate ranges from 
40 percent to 64 percent. 

[13] The 95 percent confidence interval for this estimate ranges from 
34 percent to 69 percent. 

[14] According to FAR 16.404(a)(1), in a fixed-price-award-fee 
contract, the fixed price (including normal profit) will be paid for 
satisfactory contract performance. Award fee earned (if any) will be 
paid in addition to that fixed price. According to FAR 16.405-2(a)(2), 
a cost-plus-award-fee contract should include an award amount that is 
sufficient to provide motivation for excellence in such areas as 
quality, timeliness, technical ingenuity, and cost-effective 
management. 

[15] For some contracts, the data collection phase ended as early as 
November 2004. For at least one contract, data collection was not 
complete until April 2005.