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Washington claims that it wants private industry to do more of the Pentagon's work. So why do the rules for outsourcing help keep it in government hands?
Michelle Celarier, CFO Magazine
June 1, 1998
After DynCorp's bid on a $40 million contract to maintain the C-141 cargo plane at Oklahoma's Altus Air Force Base was turned down (along with several other competitors') by the Department of Defense last year, president and CEO Paul Lombardi could hardly conceal his disgust. "It left a bad taste," he says.
In the two-year competition between $1.3 billion (in revenues) DynCorp, a Reston, Virginia-based high-tech professional and services firm, and a local Defense Department bidder, the department had no choice but to stick with its own. Lombardi claims the government was able to come up with a lower bid because it didn't have to count all the employees involved. At the same time, the Source Selection Evaluation Board, a government entity, was telling the defense contractor it needed to hire additional workers for the job. "We had to jack our costs up because we were told we needed more labor, while the government bid had less," Lombardi recalls.
DynCorp's experience is not uncommon in the Byzantine world of government outsourcing. And Lombardi, for one, is reluctant to enter the fray again. "The bid for Altus cost me $400,000 to $500,000 to put together, and if the deck is stacked against you, there's no point in doing it."
The DynCorp incident appears to belie the Clinton Administration's much-ballyhooed effort to "reinvent" government, which aims not only to emulate best practices in the private sector but also to make use of that sector's services — through outsourcing or asset sales — whenever and wherever appropriate. And no place seems more appropriate than at the Department of Defense, which is estimated to account for half of discretionary spending by the federal government — that is, outlays other than entitlement spending on such programs as Medicare and Social Security, which are set by Congress.
The stakes for private industry are huge, with the Pentagon's budget totaling $256 billion for the current fiscal year. Everything from weapons maintenance to housing, accounting, and computer systems is on the table.
The department plans to sell off, or privatize, such assets as utility systems on bases and family-housing construction for military personnel. But in large part, the zeal for privatization was quelled in 1995 as a result of the controversial selling off of two Air Force bases in Texas and California. With a Presidential election approaching, the Administration proved unwilling to confront the powerful government unions whose members' jobs were at stake, and Congress has since resisted other asset sales.
Now, instead of getting out of many businesses altogether, the Department of Defense has decided to have private industry bid against government entities for contracts to perform services currently being handled by the Pentagon. But as the DynCorp case shows, the rules for these competitions allow government entities to appear more efficient than they really are (see "How Public-Private Competitions Work," at the end of this article).
And the obstacles for private industry don't end there. Indeed, DynCorp's rival might have won the Altus competition even without the ability to understate its head count. The reason: Government entities can take advantage of old-fashioned accounting standards that allow them to exclude the cost of senior executives' salaries, along with other overhead costs, such as insurance and retirement benefits. What's more, the rules say that government entities win the contests even if their bids are 10 percent higher than a private company's.
From the private-industry perspective, the process under which it is supposed to bid for government business is fundamentally flawed. And while proponents of reform are seeking to correct that, opponents within Congress and the Pentagon's bureaucracy are well positioned to keep the playing field tilted in the government's favor.
Out with Infrastructure?
To be sure, the Pentagon has long relied on private industry for its most important work: building missiles and fighter jets. But that's different from outsourcing, which is usually accomplished via public-private competitions like the
one involving DynCorp. This process merely farms out the job and, in contrast to privatization, leaves the government with ownership.
Public-private competitions have existed since the 1950s, when the Office of Management and Budget (OMB) under the Eisenhower Administration established new rules for commercial activities by the government. But the mandate to save money at Defense has given such competitions a much more prominent role in public policy. If the government can come up with a cost-competitive alternative to private industry and save jobs and pensions, why not keep the business in-house?
Officially at least, the Defense Department states that all noncore military business should be performed by private industry when it makes economic sense to do so. While that's always been the policy, it was ignored when the Pentagon's power grew unchecked. Now, however, the department must save money to finance arms procurement. Since the end of the Cold War, the Defense Department has borne up to 80 percent of federal spending cutbacks, resulting in four rounds of base closures and the loss of some 355,000 civilian and 743,000 military jobs. With annual budgets barely keeping pace with inflation, "our war-fighting structure is about to break," argues Lt. Gen. Thomas McInerney, a retired U.S. Air Force general who is president and CEO of a Washington, D.C., defense reform group called BENS, or Business Executives for National Security. "We've got airplanes older than ships. The equipment is rapidly aging, and we still have a huge infrastructure to support."
This year alone, according to the Pentagon, only $45 billion is available for such investments, while Defense has a $60 billion procurement need. Acknowledging the problem, Defense Secretary William Cohen last November unveiled a far-reaching reform initiative that would help free up money for arms procurement and replenish its rapidly aging war machine; the latest hardware was built during the Reagan era. To try to close the gap, Defense is planning more base closures and is trying to streamline transactions through computerization and credit card purchasing authorization.
That's not all. BENS estimates that 70 percent of the annual budget of the Defense Department, or about $172 billion, goes into infrastructure, or what it calls noncore businesses, which should be contracted to the private sector. These have included such nonmilitary activities as running the world's largest travel agency and the largest housing developer, as well as more-obvious military functions, such as repair and maintenance work on fighter jets. For the activities that represent the bulk of that $172 billion, private industry so far has won outsourcing contracts worth only about $37 billion, or a little more than a third.
Business executives prefer privatization to outsourcing, if only because the former doesn't require public-private competition. "The free-enterprise system is just more efficient than government," says Norm Augustine, Lockheed Martin's former chairman. "You either believe that profit is a motivator and a good thing in the marketplace or you don't."
The Pentagon's top brass doesn't agree. "Privatization assumes that it's always better to do something in private industry, but I'm not sure about that," says John Hamre, Deputy Secretary of Defense. And Hamre, who served as comptroller of Defense for four years before assuming the Deputy Secretary post last summer, would apply the same observation to outsourcing. He points to a recent study that the department commissioned by a Big Six accounting firm to see whether a private company could run its payroll less expensively than the Pentagon could. Even before going to a private-public competition, Hamre says, the government learned that the answer was no.
Nonetheless, the Pentagon's senior officials agree with BENS that it's in the nation's best interest to direct more nonmilitary business to private industry. During the next five years, according to the Defense Reform Initiative, work involving some 30,000 civilian jobs — a 10-fold increase from 1996 — will be put up annually for private-public competitive bids. But business executives contend the Pentagon's stated interest in directing more work their way looks real only on paper.
DynCorp's Lombardi isn't the only bidder to voice frustration about the way private-public competitions are handled. Last fall, Lockheed CEO Vance Coffman told Defense that unless the rules were changed, Lockheed would no longer compete against public depots for billions of dollars' worth of major weapons maintenance deals. That decision reflected the loss of a competition involving a weapons maintenance contract to a public depot at Warner Robbins Air Force Base in Georgia. Like DynCorp, Lockheed was undercut because it was planning to hire more workers than the government — or so it appeared on paper. As it turned out, the government had 500 idle government workers that could be brought onto the job, but because they were hired in another area, their cost was not included in the government's bid. "Lockheed should have won that contract," says McInerney. "It had a cheaper and better proposal, but the government cooked the books."
Conceding the point, Hamre says that since Lockheed raised the issue, "we learned we had an incomplete model regarding the understanding of overhead, so we changed it." Now Hamre contends the model more accurately reflects the government's actual costs. And Lockheed has since been awarded a subcontract on the same job.
But business executives doubt the change goes far enough. When government entities win these competitions, they produce cost savings of only 20 percent on average, compared with 40 percent for a private company, when one does manage to prevail. The fact that the government wins half the time, even though it doesn't save the government as much money, is a conundrum Hamre admits he can't explain. But it seems to highlight the very problems industry protests.
While business executives rail about a tilted playing field, Hamre contends their protests are overdone. "We've had 2,000 competitions, and half the time the private sector wins. So I'd argue that it's level," he says. And Hamre says the process will save the Pentagon an estimated $2.5 billion annually. But he concedes that the private sector might have won more contracts "if the rules had been different."
Even the Pentagon's own brain trust has attacked public-private competitions. In 1996, the Defense Science Board, a federal advisory committee reporting to the Pentagon, stated in a report on outsourcing and privatization that "public/private competitions are fundamentally inequitable and generally favor the government entity. Pentagon organizations generally lack the accounting systems and internal controls needed to ensure an accurate allocation of indirect costs. As a result, [these] competitions may be decided on the basis of government proposals that do not include all relevant costs."
Outside critics are more blunt. "The government systems are 19th-century accounting," says Bert Concklin, president of the Professional Services Council, a lobbying group for the professional and technical service contractors industry, in Vienna, Virginia.
Spurred by the CFO Act of 1990, however, the OMB is moving away from old-fashioned accounting. "We're doing a lot of work to correct that problem," says an Administration official who nonetheless adds that he was not "sure what the timeline for implementing the CFO Act is." In fact, that deadline has passed. New legislation making its way through Congress would force the government to use activity-based accounting methodology or its like, according to Concklin.
In the meantime, the administration official says that OMB is making incremental adjustments to try to make the public-private comparisons more equitable. As a result, he says, government accounting for purposes of most competitions now includes the cost of labor, retirement benefits, overhead, insurance, and capital if an asset has yet to be financed. "We don't charge for capital if the asset has been there for 50 years," says the Administration official, "but if the agency has to buy it in the next five years, it is included."
Still, many of those costs must be estimated. "They mean well," allows Concklin, referring to the OMB. But he believes the estimates typically underestimate indirect costs, especially overhead. In operating and maintaining a base, for example, Concklin says overhead costs would be 30 to 50 percent of the direct costs. While the revised rules address the problem of understating costs for the first time, Concklin contends they still fall far short. How so? The rules stipulate that the overhead must represent at least 12 percent of the direct costs. "A ludicrous understatement," he says.
The Administration disagrees, arguing that its overhead costs are different from those of a private company. "We are the government. This is something the private sector has trouble grasping," says the administration official. "We are not a business. We will be here regardless. We're going to maintain the White House. The President will be here; the Defense Department is going to exist. The people who run Defense also run, indirectly, the public-works center in San Diego, and indirectly provide support to the guy who cuts the grass." In other words, no portion of either the Secretary of Defense's or the President's salary is going to be included in the overhead costs of any public bid.
That, of course, is quite different from the requirements for the business world, where corporations are obliged by such agencies as the Financial Accounting Standards Board and the Securities and Exchange Commission to account precisely for every dollar spent. And the OMB's rules force private companies to a rigorous accounting of their government-related costs. Explains Milt Cooper, president, federal sector, of Computer Sciences Corp., a $7 billion professional services firm based in Falls Church, Virginia, "All our costs that are pertinent to the conduct of business with the U.S. government, the cost of the chairman and corporate offices, have to be allocated for in our bids. All of my salary would be included, since I am completely dedicated to serving the federal business sector. I report to the chairman and CEO, so portions of his costs are allocated, too."
The Real Issue
The requirement that private industry's bids come in at least 10 percent below those of the public sector to win may not be as unreasonable as it sounds. "We are not going to disrupt employees' lives unless there are reasonable savings," argues the Administration official. Yet that rationale points to the real issue at stake: government jobs. Although the winner of a public-private competition typically must give civil servants first right of refusal for jobs that already exist, the new jobs won't automatically be unionized, the same level of pay is not guaranteed, and pension benefits won't be transferred. These issues are the most problematic for federal employees who were hired before 1984. Their lucrative defined-benefit pension plans have been grand-fathered into the current system.
Moreover, the generation with the most to lose — the most-senior civil servants, who make up the bulk of the Pentagon's bureaucracy — is typically in charge of the competitions. Even Hamre considers the involvement of government employees in bid proposals one of the system's biggest flaws. "The organization that may lose its jobs gets to design the competition. It raises the question of whether a proposal is properly structured," he says.
Concklin goes further: "The whole public-private competition will be conceived, designed, and executed" by those whose jobs are at stake, he says.
Not surprisingly, private industry remains wary. "A lot of guys went through this and got burned in the 1980s," says Mark Wagner, manager of federal government relations at Johnson Controls Inc., a facilities-management company based in Milwaukee. The Lockheed story has made many wonder whether there has been any substantial change in the Defense culture. Wagner insists that there is "enormous skepticism right now."
A big reason is that the improvements OMB is seeking for public-private competitions won't affect the largest contracts of all — those, as in the Lockheed case, that involve depot maintenance. Congress took over jurisdiction for these contracts from the OMB during the 1980s because they often represent the biggest single source of employment in a congressional district. While the department has attempted to contract out more depot maintenance, a group of congresspeople led by James V. Hansen (R-Utah) and Solomon P. Ortiz (DTex.), known as the Depot Caucus, has managed to restrict the percentage of depot maintenance to be done by the private sector to 50 percent. "Depots are the fulcrum of the policy debate. They dominate the political chessboard," says Concklin.
The playing field for competitions here is even more slanted in favor of the government. For example, the public entity's bids needn't include the cost of retirement benefits or insurance.
Change on this front would require the Pentagon to take on Congress. Assuming Defense wants to do that, it could point to the Defense Science Board's 1996 recommendation that the Pentagon reduce its reliance on public-private competitions, using waivers whenever possible. BENS has also argued this point. Theoretically, any Defense operation that can be shown to have some military or intelligence function could avoid the process and simply be contracted out to the private sector.
Hamre counters that the best way around the controversy over public-private competitions is to change the Pentagon from the inside out. In fact, he insists that focusing on public-private competitions misses the point of the department's reform effort. "The work will go away as you think about doing it in a different way," he contends. Hamre points to the department's implementation of best business practices, such as the use of electronic catalogs to order weapons and the use of commercial credit cards for transactions under $2,500 by the year 2000. Until recently, the finance office processed all transactions. In essence, a process that used to require the effort of numerous individuals within the Pentagon bureaucracy will be contracted to a private credit-card firm.
Yet skeptics doubt that such changes will result in substantial savings, at least not for many years. "It's peanuts," scoffs Concklin.
Adds DynCorp's Lombardi: "You just hope that somewhere along the line logic will save the day."
Michelle Celarier is a writer in Croton-on-Hudson, New York.
How Public-Private Competitions Work
Under the Office of Management and Budget's (OMB) rules, bureaucrats in charge of an activity slated to be outsourced take the first step by defining the activity. Then the public entity currently performing the work, or another public-sector bidder interested in doing it, presents a cost proposal. That proposal is not based on its current costs, but on what its cost structure could be if operated as what is known as a "most efficient organization," or MEO. That analysis also comes from those already working in the area being put out for bid, and isn't available to private contractors. Most important, it is only a projection.
According to DynCorp CEO Paul Lombardi, the projection caused the Reston, Virginia-based company to lose the Altus case (see main story). "We didn't have the benefit of MEO treatment, which told the government it needed, say, 10 electrical technicians, while we bid for, say, 15 because another government body told us we needed them."
Under revised OMB rules, if the public sector wins, it will be subject to a government review to determine if it is meeting the standards of an MEO. But, according to Bert Concklin, who heads the Professional Services Council, an industry lobbying group in Vienna, Virginia, there's no sanction or penalty for failing to do so. "If they have a cost overrun, they don't have to eat it; it doesn't come out of their profits," says Concklin. Would they ever be fired? "I don't know how you would find them in default of the contract," suggests Ronald Ross, president and chief operating officer of CACI, an information technology services firm based in Arlington, Virginia. —M.C.