Report to the Honorable Tom Harkin,

U.S. Senate

United States General Accounting Office

GAO

July 2001 CONTRACT

MANAGEMENT

DOD's Profit Policy

Provision to Stimulate

Innovation Needs

Clarification

GAO-01-801
Page 1 GAO-01-801 Use of Profit Policy to Promote Innovation

July 26, 2001

The Honorable Tom Harkin

United States Senate

Dear Senator Harkin:

In negotiating profit on contracts, the Department of Defense (DOD)

requires contracting officers to set negotiating objectives by relying on

guidelines contained in defense regulations. Congress mandated in the

National Defense Authorization Act for Fiscal Year 2000 (P.L. 106-65,

Oct. 5, 1999) that DOD review its profit guidelines and consider whether

modifying those guidelines would provide an increased incentive for

contractors to develop and produce complex and innovative new

technologies for weapon systems. After completing its review, DOD issued

a final rule in December 2000 that added a technology incentive to its

guidelines for setting profit objectives on negotiated defense contracts. At

your request, we reviewed DOD’s change to its profit policy to determine

whether the new policy is (1) likely to achieve its intended objective of

stimulating increased innovation and (2) consistent with its revised

policies for acquiring weapon systems.

Although the rule is new and has not yet been widely used, the new profit

policy may have limited effect on incentivizing additional innovation for

two reasons. First, the policy has limited reach during research and

development when technology innovation is a high priority. Most research

and development contracts either do not fall under the profit guidelines

containing the incentive or are appropriately excluded from the incentive.

Second, the rule does not provide adequate guidance on when to apply the

incentive. And the definition of innovation is so broad that it could be

interpreted to apply to almost any program with more demanding

performance characteristics than the system being replaced. This creates a

risk that contractors may be paid more for their current level of innovation

and may not reach for the technology incentive’s additional profit dollars

by introducing new, significant technological innovation.

United States General Accounting Office

Washington, DC 20548

Results in Brief
Page 2 GAO-01-801 Use of Profit Policy to Promote Innovation

The new profit policy may not reinforce DOD’s emphasis on technology

maturity in its revised guidance on the system acquisition process.1

 The

linkage between the technology incentive and the new system acquisition

process is unclear. The technology incentive encourages innovation while

the acquisition process stresses technology maturity. This sends mixed

signals to contractors and DOD’s own contracting and program

management staff about when innovation should be rewarded.

We are recommending that DOD clarify the definition of innovation used

in the new profit policy and define the policy’s relationship to DOD’s new

acquisition process. DOD stated it will re-examine the types of innovation

that may be rewarded with the technology incentive to determine if they

can be stated more clearly. However, DOD disagreed with the need to

define the relationship between the new profit policy and DOD’s new

acquisition process, saying that the two policies are not inconsistent. We

believe the potential for conflict exists if clear guidance is not provided to

support implementation. The best way to minimize the potential for

conflict is to articulate the relationship between these two policies in the

profit policy regulation.

DOD contracting officers use a structured approach called the Weighted

Guidelines Method to develop profit objectives for use in contract

negotiations.2

 Using these profit guidelines, contracting officers address a

contractor’s (1) risk in fulfilling the contract requirements, known as

performance risk; (2) degree of cost risk because of the type of contract

(e.g., fixed-price versus cost contract); and (3) investment in facilities that

benefit DOD. Prior to the profit policy change, the performance risk factor

consisted of three elements:

• Technical—the technical uncertainties of performance.

• Management—the degree of management effort necessary to ensure

that contract requirements are met.

• Cost control—the contractor’s efforts to reduce and control costs.

 1

 This guidance is in DOD Directive 5000.1, DOD Instruction 5000.2, and DOD

Regulation 5000.2-R.

2

 Generally, these guidelines would be used in negotiating sole source contracts, where

price is negotiated using certified cost or pricing data. Cost or pricing data means all facts

that prudent buyers and sellers would reasonably expect to affect price negotiations

significantly.

Background
Page 3 GAO-01-801 Use of Profit Policy to Promote Innovation

In the National Defense Authorization Act for Fiscal Year 2000, Congress

included provisions to stimulate technical innovation in military research

and development. Section 813 required DOD to review its profit guidelines

to consider whether modifications to the guidelines—such as placing

increased emphasis on technical risk as a factor for determining

appropriate profit margins—would provide an incentive for contractors to

develop and produce complex and innovative new technologies. After

completing its review, DOD reported to Congress that it planned to make

two changes to the guidelines.

As shown in table 1, the first change was to increase the weight

contracting officers would likely assign to technical risk by reducing

performance risk from three to two elements. The second was to add a

special incentive for contractors that propose significant technological

innovation. Using the technology incentive, contracting officers can assign

a profit range of 6 to10 percent for the technical element instead of the

standard range of 2 to 6 percent. On December 13, 2000, DOD published a

final rule in the Federal Register to implement the two changes.

(Appendix I presents an example of the application of the incentive to a

contract.)

Table 1: Changes in Profit Policy

Before After

Performance risk element Profit range Performance risk element Profit range

Technical Standard rangea of 2-6 percent Technical Standard range of

2-6 percent

Technology incentive

range of 6-10 percent

Management Standard range of 2-6 percent

Cost control Standard range of 2-6 percent

Management/cost control Standard range of

2-6 percent

a

The standard range is used to price most contracts.

Source: Defense Federal Acquisition Regulation Supplement.

During the same time period, DOD sought to realize the benefits of best

commercial practices3

 by revising its policies that guide the system

 3

 Commercial best practices are discussed in several GAO reports: Defense Acquisition:

Employing Best Practices Can Shape Better Weapon System Decisions

(GAO/T-NSIAD-00-137, Apr. 26, 2000); Best Practices: Better Management of Technology

Development Can Improve Weapon System Outcomes (GAO/NSIAD-99-162, July 30, 1999);

Best Practices: Successful Application to Weapon Acquisitions Requires Changes in

DOD’s Environment (GAO/NSIAD-98-56, Feb. 24, 1998).
Page 4 GAO-01-801 Use of Profit Policy to Promote Innovation

acquisition process. The result was a new system acquisition life cycle4

that separates technology development and system development. The

technology development phase generally begins with paper studies of

alternative technology concepts for meeting a mission (concept

exploration) and ends with the demonstration of component technology in

a relevant environment to reduce the risk of integrating the components or

subsystems into a full system (component advanced development). A

program is usually initiated at the beginning of system development, at

which point the system’s technology should be mature. During system

development and demonstration, the subsystems and components are

integrated into the system, the design is stabilized, and the system is

demonstrated in a realistic environment. The system then enters low-rate

initial production, during which the manufacturing capability is

established. By the time the system reaches full-rate production, the

technology should be mature, the design stable, and the manufacturing

processes established.

The profit guidelines containing the technology incentive do not apply to

most research and development contracts and, therefore, the incentive has

limited reach in the phases of DOD’s acquisition cycle where technology

innovation is expected to be high. Many contracts awarded in these high

innovation phases have technical reports as contract deliverables, and

these are appropriately excluded from the incentive. The profit guidelines

containing the incentive do not apply to contracts awarded with

competition, which is commonly the case for research and development

 4

 DOD’s system acquisition process begins when technology concepts are still in research

and development. During the process, technologies, designs, and manufacturing processes

are established and matured, and a system is ultimately produced, deployed, sustained, and

eventually retired. This process is referred to as the system acquisition life cycle.

Technology Incentive

May Not Achieve

Intended Objective

Incentive Has Limited

Reach Where Innovation Is

a High Priority
Page 5 GAO-01-801 Use of Profit Policy to Promote Innovation

contracts. Also, contracting officers already have available another

mechanism–award fees5

–to reward innovation.

Table 2 shows the expected level of innovation and the typical contract

deliverable for each phase of DOD’s system acquisition cycle. It also

shows what type of profit (fixed/incentive fee versus award fee) is used to

reward contractors during each phase—the profit guidelines only apply to

fixed/incentive fee contracts. For fixed/incentive fee contracts, the

percentage and dollar value of awards made without competition is

shown—the profit guidelines only apply to these awards. The table shows

that the guidelines (and therefore the technology incentive) do not apply

to many contracts in early research and development where innovation is

a priority.

Table 2: Innovation, Deliverables, and Profit Method in Acquisition Cycle

Phase Innovation

Typical contract

deliverable

Type of profit and percent of

dollars awarded in phase

(fiscal year 2000)

Percent and dollar value of

fixed/incentive fee awards without

competitiona (fiscal year 2000)

Percent Dollars

Concept exploration High Paper

Component

advanced

development High Hardware

Fixed/incentive fee 40

Award fee 46

Unknownb

 14

26 $0.5 billion

System

development &

demonstration High Hardware

Fixed/incentive fee 48c

Award fee 48c

Unknownb 4c

57 $2.3 billion

Low-rate initial

production Moderate Hardware

Full-rate production

& deployment Low Hardware

Fixed/incentive fee 88

Award fee 5

Unknownb

 7

60 $32.0 billion

a

The dollar values represent an estimate of the value of contracts to which the profit guidelines apply.

b

The specific type of fee could not be determined from information in DOD’s contracting database

(DD350).

c

Some of the contract funds in this category were used to conduct initial operational test and

evaluation and live fire test and evaluation, which normally occur during low-rate initial production.

Sources: DOD acquisition officials and DOD’s fiscal year 2000 contracting database (DD350).

 5

 Profit can take the form of fixed fees, incentive fees, or award fees. Fixed fees are

negotiated and fixed at the time of contract award and are not subject to change regardless

of a contractor’s performance. Incentive fees are adjusted throughout contract

performance based on the extent to which the contractor achieves cost or performance

targets set at contract award. Award fees are earned based upon a government panel’s

periodic assessment of the contractor’s performance against qualitative evaluation criteria.
Page 6 GAO-01-801 Use of Profit Policy to Promote Innovation

The profit policy excludes many contracts awarded during technology

development (concept exploration and component advanced

development). Concept exploration commonly consists of paper studies of

alternative concepts for meeting a mission and, therefore, contracts

generally have a technical report as their primary deliverable. The

technology incentive range does not apply to efforts restricted to studies,

analyses, or demonstrations that have a technical report as their primary

contract deliverable. Technical reports were excluded from coverage

because these efforts do not involve the risk inherent in producing and

fielding weapon system hardware.

Technology development contracts are typically awarded through

competition. DOD’s profit guidelines do not apply to competitively

awarded contracts because price reasonableness is established through

price competition rather than through use of the guidelines.

Contracting officers have available another contracting mechanism—

award fees—to reward innovation in research and development. Award

fees are used to motivate contractor performance in those areas critical to

program success, such as technical, logistics support, cost, and schedule.

Contracting officers can use the award fee to encourage contractors to

develop innovative new technologies by including these objectives in the

criteria for evaluating how much of the award fee the contractor has

earned.

The definition contained in the policy guidelines of what qualifies for the

technology incentive is so broad that it could be applied to almost any

contract with enhanced system performance. Our discussions with

contracting officials indicate that there is confusion over how and for how

long the incentive should be applied. This confusion may lead to

inconsistent and possibly inappropriate application of the incentive and

could result in contractors being paid more profit for their current level of

innovation, not for the intended new technological innovations that

significantly enhance performance, improve reliability, or reduce costs.

The rule states that contracting officers may use the technology incentive

range when a contractor proposes to develop, produce, or apply

innovative new technologies during contract performance. It further states

that contracting officers are to use the incentive only for the most

innovative efforts. The rule defines innovation as

• “Development or application of new technology that fundamentally

changes the characteristics of an existing product or system and that

Rule Does Not Provide

Clear Guidance for

Applying Technology

Incentive
Page 7 GAO-01-801 Use of Profit Policy to Promote Innovation

results in increased technical performance, improved reliability, or

reduced costs; or

• New products or systems that contain significant technological

advances over the products or systems they are replacing.”

Although the rule describes in broad terms when the application of the

incentive is appropriate, it leaves many questions unanswered in defining

key terms. For example, how “new” must a technology be to qualify? Does

“new” mean it is just out of the laboratory and has never been used before

on any system, or does it refer to a recently developed technology that has

been used on other products but not on the product in question? Should

the incentive apply to demonstrated technology or to the promise to

develop technology? And if a contractor is awarded additional profit for

developing, producing, or applying new innovative technology, when

should the reward stop? Should it apply only to the immediate contract, or

should a contractor receive the reward throughout some portion of

production contracts? By the same token, what measures are to be applied

in determining whether a technological advance is “significant” or whether

new technology “fundamentally changes” a product or system? Without

this information, the rule could be interpreted so that the incentive could

apply to almost any program with more demanding performance

characteristics than the system being replaced.

Although, at the time of our review, the new rule had not been widely

used, we discussed with agency officials the circumstances under which

they might apply the technology incentive. Air Force, Army, and Navy

officials agreed that the technology incentive could apply to both research

and development and production contracts, but they did not interpret the

rule’s guidance on when to apply the incentive in the same manner. For

example, officials at two Air Force program offices judged that upgrades

to their systems that included state-of–the-art technology used on other

products would not qualify for the technology incentive, but those at an

Army office said that similar applications of state-of-the-art technology to

their system would qualify. In fact, contracting officials at two Army

program offices told us that all weapon systems at their buying command

incorporated state-of-the-art, leading edge technology and would,

therefore, qualify for the incentive. On the other hand, officials for one Air

Force system did not believe a future upgrade to their system that may

incorporate brand-new technology developed by another military service

would qualify for the incentive because the other service would have

developed the new technology. Finally, the contracting officer for a Navy

system that incorporated brand-new, never-before-used, technology that

allowed the system to exceed performance requirements stated that the
Page 8 GAO-01-801 Use of Profit Policy to Promote Innovation

system would qualify for the incentive. These examples point to potential

confusion over how the rule’s broad definition of technological innovation

should be applied.

The officials were also uncertain about how long a contractor should be

rewarded with the technology incentive for significant, new innovative

technology introduced in the research and development phases of the

acquisition process. For example, a procurement official for an Army

system currently in the latter stages of research and development stated

that the system may qualify for the incentive during production, depending

on how the language in the rule is interpreted. A technical official for this

system at first stated that, hopefully, innovation and risk would be finished

before the system enters production, and therefore, the system would not

qualify for the incentive at that point. But, after reading the language in the

rule (“New products or systems that contain significant technological

advances over the products or systems they are replacing”), he said the

system may qualify after all. Also, technical officials for the Navy system

discussed previously did not disagree with the contracting officer that the

system, with new technology that enhanced performance, would qualify

for the incentive. However, they stated that, in general, the technology

incentive should be awarded during research and development because,

by low-rate production, the technology should be set, and, during

production, the emphasis should be on making manufacturing processes

more efficient and reducing costs.

The new profit guidelines do not identify how the incentive relates to the

revised policies that guide DOD’s system acquisition process. The new

acquisition process emphasizes technology maturity before committing to

a program to reduce its risk, but the profit guidelines reward contractors

with additional profit for introducing new technology, sending mixed

signals about the relative importance of innovation and technology

maturity. The new profit policy could be interpreted in such a way as to be

inconsistent with the new acquisition process.

In DOD’s traditional system acquisition process, program managers

matured a system’s technology throughout the weapon system phases,

resulting in a system that cost significantly more, took longer to produce,

and delivered less than was promised. A new weapon system was

encouraged to possess performance features that significantly

distinguished it from other systems. Consequently, the acquisition

environment led DOD program managers to promote performance

features and design characteristics that relied on immature technologies.

Managers were also subject to the pressures of successfully competing for

Relationship of Profit

Policy to DOD’s

Revised Acquisition

Policies Is Not

Defined
Page 9 GAO-01-801 Use of Profit Policy to Promote Innovation

the funds to start and sustain a DOD acquisition program. This encouraged

managers to launch product developments with more technical unknowns

and less knowledge about performance and production risks than best

commercial practices dictate. These managers relied on attaining

technology, design, and manufacturing knowledge concurrently–in the

higher cost environment of product development–throughout the weapon

system phases.6

In keeping with best commercial practices, DOD adopted a new system

acquisition approach in which key acquisition and long-term funding

commitments are discouraged until technology is mature and risks are far

better understood than under the traditional process. DOD’s new system

acquisition life cycle separates technology development from system

development. A system’s technology should be mature and demonstrated

before a program is initiated and system development begins. According to

DOD Instruction 5000.2, “entrance into System Development and

Demonstration is dependent on three things: technology (including

software) maturity, validated requirements, and funding. Unless some

other factor is overriding in its impact, the maturity of the technology will

determine the path to be followed.” When the system goes into full-rate

production, the technology should be mature, the design stable, and the

manufacturing processes established.

The technology incentive is not tied to the new acquisition cycle, and the

profit policy does not address technology maturation and risk reduction,

which are central to DOD’s revised acquisition policies. The revised

acquisition policies stress that technology be mature and demonstrated

before it is integrated into a system. But, the profit policy does not discuss

when in the acquisition cycle innovative technologies should be rewarded

with higher profits. Nor does the profit policy address if or when

contractor efforts to mature innovations should be rewarded through use

of the technology incentive. As a result, the risk is created that the two

policies will work against each other rather than reinforce each other.

The new profit policy may reward contractors for existing levels of

innovation rather than incentivize additional innovation. The definition of

innovation contained in the rule is overly broad and covers all programs

that improve performance over systems that are being replaced—the very

 6

 For a fuller discussion of this issue, see Best Practices: Better Management of Technology

Development Can Improve Weapon System Outcomes (GAO/NSIAD-99-162, July 30, 1999).

Conclusions
Page 10 GAO-01-801 Use of Profit Policy to Promote Innovation

reason for having a program in the first place. Moreover, the rule is silent

on several issues, including how long contractors should be rewarded for

significant innovation. And the relationship of the profit policy to the

acquisition process is not addressed, sending mixed signals to contractors

and contracting officials as to the relative importance of technology

innovation and technology maturation at different points in the acquisition

cycle.

To assure that the technology incentive is appropriately interpreted and

applied, we recommend that the Secretary of Defense

• clarify the definition of innovation contained in the profit policy rule;

• define how long contractors should be rewarded for innovations

introduced during research and development phases; and

• reconcile the relationship of the technology incentive with DOD’s new

acquisition process, including the emphasis on technology maturation.

In written comments on a draft of this report, DOD partially concurred

with the first recommendation that it clarify the definition of innovation

contained in the profit policy rule. DOD stated that it would examine how

the policy is being used after it has been in place for a year and, at that

time, determine if the types of innovation that may be rewarded with the

technology incentive factor can be stated more clearly.

DOD partially concurred with our second recommendation that it define

how long contractors should be rewarded for innovations introduced

during research and development phases. DOD stated that, after the policy

has been in place for a year, it will re-examine the regulations to determine

if there are relevant factors that can be provided for contracting officers to

consider in making this judgment.

DOD disagreed with our recommendation that it reconcile the relationship

of the technology incentive to the new acquisition process. DOD stated

that it did not believe the revised profit policy was inconsistent with its

new 5000 series acquisition regulations. DOD pointed out that the 5000

series stresses the need for balance among several key factors in planning

acquisition strategies and that, ultimately, DOD decides what it will buy

and how much technological risk it will accept. According to DOD, after

that decision is made, the technology incentive factor can be used to

reward contractors for the technical risk they undertake in developing or

applying new technologies or significant technological advances.

Recommendations for

Executive Action

Agency Comments

and Our Evaluation
Page 11 GAO-01-801 Use of Profit Policy to Promote Innovation

While the 5000 series discusses several factors to be considered in

planning acquisition strategies, there is a clear emphasis on technology

maturity to reduce program risk as a system progresses through the

acquisition process. DOD Regulation 5000.2-R identifies technology

maturity as a “principal element of program risk.” DOD Instruction 5000.2

provides managers with specific guidance for managing this element of

program risk and makes it clear that technology should be matured and

demonstrated during the technology development phase before a program

is initiated and component technology is integrated into a system. The

instruction states that “unless some other factor is overriding in its impact,

the maturity of the technology will determine the path to be followed.”

According to the instruction, “technology must have been demonstrated in

a relevant environment ... to be considered mature enough to use for

product development in systems integration. If technology is not mature,

the DOD Component shall use alternative technology that is mature and

that can meet the user’s needs.”

Although the acquisition guidance emphasizes technology maturity to

reduce program risk, the profit policy rewards contractors with additional

profit for undertaking technical risk in developing or applying new

technology at unspecified points in the acquisition cycle. Because the

profit policy does not discuss when in the acquisition cycle innovative

technologies should be rewarded with higher profits, it could be

interpreted in such a way as to be inconsistent with the new acquisition

process. We discussed this issue with the officials in the office responsible

for developing the new 5000 series. These officials were familiar with the

profit policy rule and, while they noted that the two were not necessarily

inconsistent, the potential for misinterpretation existed. These officials

said that if innovation meant new–but mature–technology, there would be

no conflict between the policies. On the other hand, they noted that if

“innovation” was misread for “risk taking” or “technology immaturity,”

especially late in the acquisition cycle, the policies could work against

each other. They added that the technology incentive would need to be

carefully managed to prevent a conflict and that this could be achieved

through means such as training. We continue to believe that the best

approach for managing this potential conflict is to explicitly discuss the

relationship between the two policies—particularly as they relate to

innovation—in the guidelines contained in the profit policy regulation on

when the technology incentive should be used.

DOD comments appear in appendix II.
Page 12 GAO-01-801 Use of Profit Policy to Promote Innovation

To determine whether the new profit policy is likely to achieve its

objective of stimulating increased innovation, we selected programs at

some of DOD’s highest dollar buying commands to review how contracting

and acquisition officials would apply the new policy to various programs.

We selected one buying command to represent each service. We discussed

the profit policy rule in general, the types of contracts the rule might apply

to, and the points in DOD’s acquisition cycle in which it could be applied.

We also talked specifically about each program selected to determine

whether there were innovative technologies that would have qualified for

the technology incentive if the policy had been in effect at the time of

contract award. In addition, we asked representatives from some of the

programs to reprice a sample contract using the new profit policy to

determine whether the profit objective would have been higher.

We also analyzed DOD’s fiscal year 2000 contracting database (DD350) to

identify the types of contracts awarded at each phase of the acquisition

cycle, the percentage of dollars awarded using the various profit award

mechanisms, and the proportion of dollars awarded with or without

competition.

To assess the relationship between the new profit policy and the new

acquisition process, we analyzed what the acquisition guidance and profit

policy say about technology development, maturation, and innovation. We

also discussed these policies with DOD officials who developed them.

We reviewed relevant documents and held discussions with officials at the

U.S. Army Aviation and Missile Command, Huntsville, Alabama;

Aeronautical Systems Center, Dayton, Ohio; Naval Air Systems Command,

Patuxent River, Maryland; Office of Defense Procurement, Cost, Pricing,

and Finance, Washington, D.C.; and Office of the Deputy Under Secretary

of Defense (Acquisition Reform) for Acquisition, Technology, and

Logistics, Washington, D.C.

We performed our review between January 2001 and May 2001 in

accordance with generally accepted government auditing standards.

As agreed with your office, unless you publicly announce the contents of

this report earlier, we will not distribute this report until 30 days from its

date. At that time, we will send copies of this report to the appropriate

congressional committees; the Honorable Donald H. Rumsfeld, Secretary

of Defense; and the Honorable Mitchell E. Daniels Jr., Director, Office of

Management and Budget.

Scope and

Methodology
Page 13 GAO-01-801 Use of Profit Policy to Promote Innovation

Please contact me at (202) 512-4841 if you or your staff have any questions

concerning this report. Major contributors to this report are Karen

Zuckerstein, Erin Baker, Julia Kennon and John Van Schaik.

Sincerely yours,

David E. Cooper

Director

Acquisition and Sourcing Management
Appendix I: Impact of Using Technology

Incentive on Sample Contract

Page 14 GAO-01-801 Use of Profit Policy to Promote Innovation

The following table shows the impact of using the technology incentive on

a sample contract repriced for us at one of the buying commands we

visited. The actual profit objective calculated prior to the profit policy

change was based on technical performance risk valued at the top of the

standard range. The repricing to reflect what would likely have occurred

after the profit policy change was based on technical performance risk

valued at the top of the technology incentive range. No other changes were

made in the profit objective calculation.

Table 3: Sample Contract

Profit objective before

change

Profit objective

using new method

Increase from

prior method

Increase in

profit rate

Dollars Rate Dollars Rate Dollars Percent

$ 8,472,933 13.98% $ 9,584,982 15.81% $ 1,112,049 1.83%

Appendix I: Impact of Using Technology

Incentive on Sample Contract
Appendix II: Comments From the Department

of Defense

Page 15 GAO-01-801 Use of Profit Policy to Promote Innovation

Appendix II: Comments From the

Department of Defense
Appendix II: Comments From the Department

of Defense

Page 16 GAO-01-801 Use of Profit Policy to Promote Innovation

See p. 10.

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