By Nick Sanders, Director A&D Advisory Services, PricewaterhouseCoopers LLP, Irvine, California July 26, 2007 11:15

2. Subcontractor Management: Your Achilles’ Heel By Nick Sanders, Director A&D Advisory Services, PricewaterhouseCoopers LLP, Irvine, California July 26, 2007 11:15 AM & 3:10 PM

3. Agenda • Make vs. Buy: The Changing Paradigm • The Transformation of the Defense Industrial Base • Recent Regulatory Issues • Not Your Father’s Subcontracting • Implications of the New Environment • Transforming for Successful Subcontract Management

4. Ground Rules • What is a subcontract? • FAR Part 44.101: “Subcontract” means any contract as defined in Subpart 2.1 entered into by a subcontractor to furnish supplies or services for performance of a prime contract or a subcontract. It includes but is not limited to purchase orders, and changes and modifications to purchase orders. “Subcontractor” means any supplier, distributor, vendor, or firm that furnishes supplies or services to or for a prime contractor or another subcontractor.

5. The Changing Paradigm • Good-bye to the vertically integrated business model; Hello to the outsourced business model • Growth of acquisition of services • What has been gained • What has been lost • What must be done

6. Make vs. Buy • From 80% Make to 20% (or less) Make • Rise of the Lead System Integrators (LSIs) • Program Management  Program Integration • Rise of the Program Supply Chain • The Extended Enterprise • The Supplier Network • Increasing labor content in acquired goods • Increasing acquisition of services

7. The Transformed Industrial Base • Why contractors subcontract • Flexibility & agility • Capacity management • Workforce management • Access to expertise and process knowledge • System of systems management • Cost savings

8. The Transformed Industrial Base • What has been lost • Communication • Information/data transfer: knowledge management • Alignment of objectives • Integration • Agility & flexibility • Optimization of program outcomes

9. Program Success Largely Depends on Subcontractor Execution • 80 percent of respondents stated that they “were using different metrics than their suppliers, customers, or trading partners.” • Nearly 60 percent “expressed deep concern about the ability of their suppliers or partners to meet schedule requirements.” Source: “Over Budget, Behind Schedule: New Survey Underscores Aerospace and Defense Industry's Less-than-Stellar Record of Program Management” (AW&ST, 13 Nov. 2006)

10. Recent Regulatory Initiatives • Earned Value Management (EVMS) • Identification of critical subcontractors • Integration of subcontractors • Prohibition on excessive pass-through charges (April 2007) • Identification of Subcontractors • Changes in subcontracting % after award • Justification of indirect allocations and profit on subcontracts

11. Recent Regulatory Initiatives • Billing Subcontractors under T&M • Identification of subcontractors • Negotiation of subcontractor billing rates before award • Interorganizational transfers as subcontracts

12. Recent Regulatory Initiatives • Code of Business Conduct/Internal Control System Requirements • Proposed Rule • Mandatory flow-down at $5 Million • Implications for subcontract formation and administration

13. Summary of Implications • Identification of subcontractors early in the process – the earlier, the better • Finalization of T&M billing rates before prime proposal submission • Sensitivity to indirect cost & profit pyramiding • Subcontracting across sister divisions • Integration of key business systems • In-depth discussion regarding control systems

14. Other Implications of the New Business Environment • Cost estimating and pricing issues • Why PBSA has not been The Answer • Risk transfer to subcontractors • Other implications • HR & QA issues within the supply chain

15. Program Cost Estimating/Pricing • “73 percent of all respondents believe that [defense] industry cost estimates are inaccurate, and yet the ‘system’ contracts to proposed prices based on these estimates.” • Defense Acquisition Performance Assessment Summary (January 2006).

16. Program Cost Estimating/Pricing • The old system RFP  Marketing  Proposal Team  Subcontractor Management  Subcontractor  Proposal Team  Management Review  Proposal Team (Rework)  Management Review & Approval  Gov’t. customer/Source Selection • The old system doesn’t work in the new environment

17. “X and Y are clueless as to how to work with their suppliers. Sometimes they try to crush their bones—which only works when the suppliers have any profits to squeeze, and few currently do. Then they embrace contentless cooperation that makes everyone feel better briefly but fails to produce lower costs. Z, by contrast, is getting brilliant results and lower prices … while also giving suppliers adequate profit margins. How? By relentlessly analyzing every step in their shared design and production processes to take out the waste and put in the quality. … There is no mystery about the lean business model. … Why is mysterious is why X and Y can’t embrace it.” • “Why Z Won,” James P. Womack, Wall Street Journal, Feb.13, 2006 • Who are X, Y and Z? Is your company X, Y or Z?

18. PBSA Has Not Been as Successful as Hoped • “We think it is unrealistic to ask agencies to specify services at the time of contract award in clear, specific, objective, and measurable terms when future needs are not fully known or understood, requirements and priorities are expected to change during performance, and the circumstances and conditions of performance are not reliably foreseeable.” Source: Procurement Round Table input to SARA Acquisition Advisory Panel (March 13, 2006).

19. More Thoughts on PBSA “… when an agency cannot describe its requirements and the circumstances and conditions of performance, competing firms cannot do so either. So when an agency evaluates a proposal for a service contract it evaluates the product of the marketing imagination, which describes something that does not yet exist and cannot be examined or tested before purchase.” Source: Procurement Round Table input to SARA Acquisition Advisory Panel (March 13, 2006). Citing V.J. Edwards, “Streamlining Source Selection by Improving the Quality of Evaluation Factors,” The Nash & Cibinic Report, 8 N&CR 56, Oct. 1994.

20. More Thoughts on PBSA • PBSA has failed to produce “verified quality improvements or costs savings” Source: Procurement Round Table input to SARA Acquisition Advisory Panel (March 13, 2006). [sic] Citing Interagency Task Force on Performance-Based Services Acquisition, “Performance-Based Service Acquisition: Contracting for the Future” (OFPP, July 2003) and “Performance-Based Contracting in the Air Force: A Report on Experiences in the Field” J. Ausink, F. Camm, C. Cannon, RAND Corporation, 2001.

21. If PBSA is Not The Answer … Then what is the proper methodology to use when acquiring complex services or goods with high labor content? Before answering the question, let’s look at some other aspects of subcontract management …

22. Risk Transfer to Subcontractors • 4 types of risk response • Assume • Avoid • Control • Transfer • Subcontracts are often structured so as to transfer risk from one legal entity to another

23. Techniques Used to Transfer Risk • Contract type (e.g., firm fixed-price) • Contract terms and conditions • Linking of variable fees to Earned Value (EV) metrics (e.g., CPI/SPI) • Required compliance with insurance requirements • Additional named insured

24. Risk Transfer: Action and Reaction • FFP contract type  change orders • Linking to EVM metrics  “gaming” the system • Additional insurance requirements  additional premium cost/administrative cost

25. Risk Transfer: Why it’s Ineffective • Pushing risks from one legal entity to another in the extended enterprise does not reduce program execution risk • Additional risks are introduced to the program • Communication & information flow delays reduce PM’s ability to intervene, avoid or mitigate

26. The Program’s Perspective • Risk transfer often-- • Does not result in any reduction to overall program risk; and • Almost certainly increases overall risk; and • Very likely increases cost while negatively impacting schedule • It also tends to undercut the “team” environment and to decrease alignment and cooperation between the parties

27. Subcontract Risk Transfer: Bottom Line • Pushing risks into the program supply chain reduces certain risks for one legal entity. It does not reduce program execution risk and likely increases execution risk • The negative outcome(s) associated with program execution failure(s) almost always outweigh any risk reduction benefits

28. Other Matters Worth Discussing • What is the role of HR in subcontract management? • Acquisition of services • Acquisition of high labor-content goods • What is the role of Quality Assurance? • Acquisition of services • Acquisition of high labor-content goods

29. Summary of the Key “Soft” Issues • Internal controls do not extend beyond the four walls of the organization • Insufficient communication channels • Separate silos do not align and integrate well • Lack of incentive to transform and create Integrated Teams

30. Contract/Subcontract Management Judged “We believe that CICA price competition and FAR Part 15 source selection are ill-fitted for the procurement of long-term and complex services.” Source: Procurement Round Table input to SARA Acquisition Advisory Panel (March 13, 2006)

31. Transforming Subcontractor Management • Transform for program success • “The way we’ve always done it” doesn’t work anymore • Modern subcontract management looks more and more like program management • Barriers to transformation include: • Required skill set & expertise • Organizational inertia • Compensation & salary structure

32. Thoughts Toward a Solution • Use of technology enablers, including virtual communication tools • Collaborative discussions regarding: • Program requirements baseline planning • Technical baseline planning • Detailed, objective technical performance metrics that are frequently updated • Advance agreements regarding “gate” exit criteria (e.g., PDR, CDR)

33. Modern Subcontract Management • Key behaviors • Integration of trusted supplier inputs based on in-depth knowledge & discussions • Consultation; collaboration; alliances • Risk sharing • Key avoidances • Transactional approaches • Adversarial or win/lose relationships • Risk transfer for profit

34. Relational Contracting • Competency-based contractor selection • In-depth, one-on-one negotiations with the contractor selectee before contract award to jointly develop a contract work statement • Joint management to budget instead of a fixed-price or estimated costs • Ad hoc specification of results and adjustment of expectations during performance

35. Competency-Based Selection • Similar to A/E selection as per FAR 36.6 • Price is not a factor in contractor selection. Main factors are experience, past performance, and key personnel qualifications • After selection of one firm, negotiations include discussion of budget & objectives, joint fact-finding about known and anticipated requirements and anticipated performance circumstances and conditions • Joint development of work statement, advance agreement on SB subcontracting

36. Why Use a Flexible SOW? “We think it is unrealistic to ask agencies to specify services at the time of contract award in clear, specific, objective, and measurable terms when future needs are not fully known or understood, requirements and priorities are expected to change during performance, and the circumstances and conditions of performance are not reliably foreseeable.” Source: Procurement Round Table input to SARA Acquisition Advisory Panel (March 13, 2006).

37. Conclusion • IPT-like approach utilizing multiple talents and disciplines • Long-term arrangements (e.g., ID/IQs) with proven partners • Preposition • Pre-negotiate key terms and conditions • Cost and time savings available • Develop lines of communication into the supply chain