Risk-Based Return On Sales (ROS) As a Tool For Complex Contract Negotiations
With the requirement in the Weapons System Acquisition Reform Act of 2009 to estimate at the eightieth percentile, both government and contractor organizations need to understand the impact on the acquisition process, in particular on complex contract negotiations. This paper will show how a risk-based approach to negotiations, simultaneously considering the government’s paramount concern of contract price and the contractor’s paramount concern of return on sales (ROS, or margin), can lead to a more mutually beneficial contracting arrangement. This paper builds on the analytical foundations of “Risk-Based Return On Sales (ROS) for Proposals with Mitigating Terms and Conditions” (SCEA, 2009).
In negotiations, the government is primarily concerned with the resultant price of the contract, because it directly impacts needed budgets (together with government-furnished equipment (GFE) and other government costs (OGCs), such as the program office itself). In short, it is the final contract price, inclusive of all changes and adjustments, that becomes the cost to the government. By contrast, the contractor is primarily concerned with ROS, because it has a direct impact on the financial performance of the company (together with revenue), as ultimately reflected in stock price. Because both price and ROS fluctuate significantly with cost, depending on the contract type, associated contract parameters (commonly called the “contract geometry”), and terms and conditions (Ts & Cs) providing for equitable adjustments (fee-bearing or not), a rigorous risk-based approach to possible cost outcomes is required to fully understand the ramifications of negotiated contract type, geometry, and Ts and Cs on the final outcomes the two parties really care about. Using the Monte Carlo and analytical techniques detailed in the predecessor paper, this paper will fully develop a negotiations scenario to demonstrate the impacts of proposed changes in contract type, geometry, and Ts and Cs on various percentiles, primarily the 80th percentile of price and the 20th percentile of ROS, both representing the unfavorable outcome that both government and contractor organizations are being driven to consider. It will present recommendations for a systematic approach to negotiating contract type, geometry, and Ts and Cs, based on either a reconciled risk position or divergent views on risk (i.e., one S-curve or two), reducing the number of “levers” affecting the outcome to a minimal set.
The paper will also touch on techniques for better portfolio management, considering risk impacts across multiple programs and contracts. Whereas the particular percentiles mentioned above are informative and helpful in the consideration of possible outcomes for a single contract, the mean (or expected value) is generally more relevant from a portfolio management perspective. Ideally, a portfolio-wide risk model would be developed, with cost distributions for each component program or contract.
Peter J. Braxton holds an AB in Mathematics from Princeton University and an M.S. in Applied Science (Operations Research) from the College of William and Mary. He currently serves as a senior cost and risk analyst for TASC, Inc. He has worked to advance the state of knowledge of cost estimating and risk analysis, Cost As an Independent Variable (CAIV), and Target Costing on behalf of the Navy Acquisition Reform Office (ARO), the DD(X) development program, and other ship and intelligence community programs. He has reviewed several high-profile proposals as part of the Independent Cost Estimation (ICE) function for Northrop Grumman. He has over a dozen professional papers to his credit, including SCEA/ISPA International Conference award-winners in CAIV (1999) and Management (2005). He served as managing editor for both the original development of the acclaimed Cost Programmed Review Of Fundamentals (CostPROF) body of knowledge and training course materials and its successor, the Cost Estimating Body of Knowledge (CEBoK). He serves as SCEA’s Training Chair, was elected to the Board of Directors for the 2009-2011 term, and was named SCEA’s 2007 Estimator of the Year for contributions in Education. He serves as a TASC Technical Fellow, and received both a TASC President’s Award and Northrop Grumman Corporate Contracts, Pricing, and Supply Chain Award in 2008.
Richard L. Coleman is a Naval Academy graduate, received an M. S. with Distinction in Operations Research from the U. S. Naval Postgraduate School and retired from active duty as a Captain, USN, in 1993. His service included tours as Commanding Officer of USS Dewey (DDG 45), and as Director, Naval Center for Cost Analysis. At TASC and then Northrop Grumman, he worked extensively in cost, CAIV, and risk for the Missile Defence Agency (MDA), Navy ARO, the intelligence community, NAVAIR, and the DD(X) Design Agent team. He has supported numerous ship programs including the DDG 1000 class, DDG 51 class, Deepwater, LHD 8 and LHA 6, LPD 17 class, Virginia class SSNs, CVN 77, and CVN 78. He was the Director of Independent Cost Estimation for Northrop Grumman Information Systems and conducted Independent Cost Evaluations on Northrop Grumman programs. He is currently at TASC, Inc. as a Program Manager for cost and risk. He has more than 75 professional papers to his credit, including five ISPA/SCEA and SCEA Best Paper Awards and two ADoDCAS Outstanding Contributed Papers. He was a senior reviewer for CostPROF and CEBoK and lead author of the Risk Module. He has served as Regional and National Vice President of SCEA and is currently a Board Member. He received the SCEA Lifetime Achievement Award in 2008.
Michael Burton is currently a Director in the Contracts and Pricing Organization at Northrop Grumman Shipbuilding. In his current role, Michael is responsible for Contracts and Pricing Support related to all New Construction Aircraft Carrier Programs. Prior to assuming his current role, in 2004, Michael held various positions in Contracts, Pricing and Finance at Northrop Grumman Shipbuilding as well as AMSEC LLC. Michael’s educational background includes a BA from the Virginia Military Institute and an MBA from the College of William and Mary.