Feb 25

Feb 25 Cost-Plus Contracts in a New Space Age

NASA Administrator Bridenstine signing an agreement with Dr. Serres, CEO of Luxembourg Space Agency (Courtesy of NASA)

“[I]n the law of contracts, as in all other legal fields, “justice” is not attained by giving the parties unlimited freedom or power”

— 1 Corbin on Contracts § 1.9

In recent weeks, the White House and Congress have both previewed their hands for NASA’s Fiscal Year 2021 budget. Though the end results will be murky for a while, it is clear that the two branches have very different priorities: while the Trump administration is literally shooting for the Moon, Congress is aiming for Mars. But beyond this thematic debate, there is also one interesting policy wrinkle in the Congressional bill: the preference for NASA to continue its cost-plus contract practice. While newer commercial Outer Space enterprises have pointed to these contracts as emblematic of budget overruns and missed deadlines at NASA, cost-plus contracts are unlikely to go away any time soon.

Given their continued prevalence, I will provide a high-level overview of cost-plus contracts in this post. I will start by providing a brief background and introduction to the different types of cost-plus contracts. Then, I will explore the arguments for and against these contracts. Finally, I will argue that, for all of their limitations, cost plus contracts still have a role to play in this new commercialization era of Outer Space exploration.

Cost-Plus Contracts: An Overview

In its authorization bill, Congress wants NASA to “develop and operate an integrated human lunar landing system . . . [that is] developed through a means that allows for the United States Government to retain . . . full ownership of the human landing system.” (emphasis added). By desiring NASA to take ownership of the lunar landing system, Congress is signaling its preference for NASA to continue its cost-plus contracting practice (see Arguments for Cost-Plus Contract section for the connection). But before we get to the incentives for NASA to use cost-plus contracts, it is helpful to explore the different categories of cost-plus contracts.

Types of Cost-Plus Contracts

In a cost-plus contract, a customer will reimburse all of its contractor’s expense and pay an additional amount on top of that. This is financially lucrative for the contractor as a profit is essentially guaranteed. Unlike a fixed-fee contract where the customer will only pay for a certain pre-determined amount, once the cost-plus structure is used, the customer’s expenditures does not have a ceiling as the contractor will likely spare no expenses in getting the job done. Within this framework, NASA uses three primary types of cost-plus contracts: cost plus (1) incentive fees, (2) award fees, and (3) fixed fees.

Cost-plus-incentive-fee contracts

Under a cost-plus-incentive-fee contract, NASA will pay for the contractor’s costs and remit an additional amount based on the contractor meeting certain project goals. These targets tend to be reasonable for both sides; achievement can be measured through performance (the deliverables performed as or better than promised), cost (the project was kept within or below the budget), or time (work schedules tracked according to or ahead of plan). Generally, the incentive fee will be increased for exceeding baseline metrics and reduced—though typically not eliminated—for unmet targets.

Cost plus incentive fee contracts are generally used when there is a possibility that actual costs can be lower than planned costs if the project is managed efficiently. Additionally, NASA might choose a cost-plus-incentive-fee contract if the technical performance of the deliverable could be improved over baseline as ancillary technologies develop. Under these circumstances, a contractor will be incentivized to achieve those higher metrics for the bigger payout.

Cost-plus-award-fee contracts

NASA tends to use cost plus award fee contracts when it is impossible to set baseline objectives prior to the start of a project. Under this type of contract, a contractor is paid its expenses and will be awarded additional fees if certain objectives—that become apparent during the course of performance—are met. This is very much a “pay-as-you-go” model in which NASA determines project goals as the work-in-progress unlocks new information about what is achievable.

Cost-plus-award-fee contracts require NASA to be more actively engaged during the project’s performance. These contracts enable NASA to pivot project workflows by incentivizing contractors to hit certain new objectives as they appear. Hence, these contracts provide maximum flexibility to NASA. But, for this adjustability, NASA is expected to pay a price premium as the costs for these projects can increase dramatically as new goals are discovered and workstreams are tweaked.

Cost-plus-fixed-fee contracts

Under a cost-plus-fixed-fee contract, a contractor will be reimbursed for its costs and shall receive an extra fixed fee that is determined prior to the start of the contract. While the fixed fee might be adjusted from change orders made during the project, both parties will mutually agree to such adjustments.

NASA typically uses this type of cost-plus contract when the project is for preliminary studies or minor developments where the amount of effort needed is unknown but relatively contained. Cost-plus-fixed-fee contracts are not suitable for long-durational or major system projects with unknown variables as change orders are frequent and likely, defeating the purpose of fixed fees. In addition, contractors are not incentivized to finish projects early or try to reduce their costs under these contracts since they will be paid the same regardless.

Arguments for Cost-Plus Contracts

While cost-plus contracts are financially advantageous for contractors, customers such as NASA do come away with benefits as well. These contracts are especially useful when the customer wants to (1) own the resulting intellectual property, (2) reduce certain known costs, (3) have greater control and management, and (4) proceed in the face of many unknown objectives.

One primary advantage of cost-plus contracts is the customer’s ability to own any and all intellectual property resulting from the project. As the customer is essentially footing the bill for the contractor’s research and development process, all of the project’s underlying know-how, technologies and related intellectual property rights are generally owned by the customer. Contractors may be granted licenses, potentially exclusive, to use such intellectual property that they develop but cost-plus contracts are generally seen as a work-for-hire type of contract. In these cases, customers, such as NASA, are essentially offshoring their workload. Hence, when Congress emphasized the ability of NASA to own certain technologies in its authorization bill, it is implicitly stating its preference for cost-plus contracts.

Properly managed cost-plus contracts can also keep their underlying projects’ costs down. Contractors have less incentive to drag out projects and are implicitly discouraged from cost inflation: the sooner they complete the objectives, the better their profit margins. These contracts also encourage suppliers to use high-grade supplies when constructing sensitive deliverables; because contractors can recoup their costs as a separate line-item, they do not have to cut corners on the quality of materials and can focus on getting whatever supplies that are needed to achieve the stated performance metrics.

Customers also have better management and control rights under cost-plus contracts. With incentive fees and award fees, customers can redirect their contractors to focus on specific areas through financial incentives. Even under cost-plus-fixed-fee contracts, contractors will only get paid the fee premium if they can achieve the objectives laid out in the contract. Therefore, active communication with their customers throughout the process can ensure that contractors will perform to their customers’ satisfaction, enabling them to collect the fees in a timely fashion.

Finally, for developing new technologies, cost-plus contracts might be the only way to induce contractors to bid on the project. When designing and constructing something that has never been done before, it is hard to predict how much it might cost and how long it will take. Without assurances that their costs are fully paid for, contractors will be less willing to participate in these projects as the chances of entering quagmires are strong, potentially bankrupting the contractors if their projections are wrong. This is especially true in the Outer Space sector, where failures are expected and deliverables can only succeed through an iterative design process. For these projects, cost-plus contracts are the only way to induce contractors to assist in turning theoretical research concepts into successful real-world innovations.

Arguments against Cost-Plus Contracts

As we have battle-tested Outer Space-related technology over the past half century, many people now believe that NASA should no longer have a heavy reliance on cost-plus contracts.

Generally, critics of cost-plus contracts argue that the need for these contracts in the exploration of Outer Space is no longer as relevant as before. Many governmental agencies and companies have become masters of rocketry and other space-faring techniques. With objectives generally known and commonly built on past experiences, companies can usually assess their own risks accurately during the planning process.

Additionally, as research and development are now more focused on incremental improvements in existing Outer Space-related technologies, private companies should have enough capital to bring this research in-house. Furthermore, as the sector matures, private investors are more willing to contribute their own capital in pushing new concepts forward; hence, governmental agencies, such as NASA, no longer need to be the primary driver and have absolute management and control over future innovations. This enables agencies to take more of a backseat, allowing them to reduce their expenditures by focusing on a licensing model rather than the ownership of such improvements.

Furthermore, an overreliance on cost-plus contracts with no time horizon or cost limitations have distorted many contractors’ incentives in finishing on-time. Rather than trying to improve their profit margins by seeking ways of completing projects on or even ahead of time, some contractors have become complacent and are more focused on the reimbursement of cost: dragging out and renewing existing cost-plus contracts rather than trying to obtain the “profit fees” for meeting milestones and completing projects on-time.

For these reasons, opponents see cost-plus contracts as an anachronistic concept of a bygone Outer Space era dominated by public initiatives and do not fit well with a new Space Age that is increasingly reliant on private entrepreneurial spirit.

Finding a Place at the Table: Cost-Plus Contracts in the New Space Age

According to NASA’s latest annual procurement report, in Fiscal Year 2018, NASA entered into about $9.1 billion worth of cost-plus contracts; this represents 63% of all contracts awarded by NASA that year. Of these cost-plus awards, about $300 million were for cost-plus-incentive-fee, $6.8 billion were for cost-plus-award-fee, and about $2 billion was for cost-plus-fixed-fee. It is clear from this data, cost-plus contracts are still alive and well at NASA today. Although many are seeking to change this practice at NASA, I believe the political winds will likely make this effort futile. In addition, I think cost-plus contracts, for all of their limitations, still has a place in the modern Space Age as they continue to play a role in shaping innovations and launching private Outer-Space related companies to new heights.

First of all, Congress is unlikely to let NASA pivot away from cost-plus contracts for one simple reason: jobs. Cost-plus contracts provide a seemingly boundless source of revenue for the private sector, enabling many companies to create numerous jobs in congressional districts throughout the United States. If NASA were to stop its cost-plus contracting practice, the economy of those “Outer Space-dependent” districts will greatly suffer as companies shutter and jobs are lost. So even if not swayed by the lobbyists, you can bet those congressional members will do everything in their power to keep these contracts flowing—just look at the latest authorization bill.

Recognizing the political impasse, some critics are also arguing that the long delays associated with cost-plus projects should provide the impetus needed to change public sentiment. But, this thinking might be too near-sighted. While the delays associated with the Space Launch System is a very public example of what could go wrong with cost-plus contracts, history might be kind when it is all said and done. When the SLS Program finally makes voyages to the Moon, Mars, and beyond, the public could be singing a very different tone. For evidence, you don’t have to look further than the Apollo Program. While many are rightfully proud of Apollo Program’s accomplishments today, it was not that popular during the 1960s with a majority of Americans consistently believing it was not worth the cost. Some even actively railed against the program. Hence, criticism of cost-plus contract-related projects might be too myopic in nature, and final judgment might have to be reserved for another 50 years.

Although many of today’s innovations in the Outer Space sector seem increasingly driven by private funding, I believe that cost-plus contracts still have a place at NASA. Unproven technologies generally come with a lot of risks; and with profits unknown, many commercial entities will not be able to justify the research and development costs needed to generate the next great innovation. In these circumstances, public spending—through governmental agencies—is essentially mandatory in getting new technologies into the marketplace. To create the right incentives, cost-plus contracts remain the best mechanism to achieve these goals.

Cost-plus contracts also empower NASA to fund immediate areas of needs for Outer Space that might not be profitable, creating competition and innovation. Once those areas become sustainable for private enterprises, NASA can then play around with its budget to “prop up” companies with more long-horizon based moonshot but revolutionary ideas. For instance, while many look to SpaceX as a golden symbol of why cost-plus contracting is wholly unnecessary, its survival during the early days was very much dependent on NASA funding; without securing the commercial cargo resupply contract for the International Space Station, SpaceX would surely be bankrupted; then, who knows how many more years would have passed before reusable rocket technology would have been proven as the eventual norm for Outer Space launches. Likewise, Blue Origin, even with its deep-pocket owner, would not be in this industry if it cannot secure NASA contracts. Hence, even when cost-plus contracts might not seem directly relevant, it could be a shadow driver for innovations.

For these reasons, I believe that cost-plus contracts will always, and should, have a place in NASA’s contracting toolkit. During the bygone early Outer Space days, cost-plus contracts played a visible role in recruiting private enterprises’ aid in building unproven components for NASA’s iconic Apollo Program, leading America to the Moon. Now, while the mistakes of cost-plus contracts always seem to be in the spotlight, they still subtly play a critical role in the background to assist NASA in directing new inventions in the modern Space Age.