Spare parts pricing -- still crazy after all these years

I recently had an interesting conversation with a GS-15 contracting officer participating in a Kennedy School executive education program. She is involved in buying spare parts for weapons systems for one of the military services, and she wanted to talk with me about ongoing issues her organization is having with getting decent prices for parts. It sheds light on what may be a real target of opportunity for cost savings from contracting in this tight budget environment – if Defense Department contracting leadership will pay attention.

Needless to say, this issue has been around more or less forever. It first came to public attention with the spare parts horror stories of the 1980s (the infamous, but mythical, $600 hammer). The specifics of these stories were generally either wildly exaggerated or even completely false, but it is true that there were problems with poor pricing for sole-source parts (parts where the contractor developed the part and owned the data rights, so competition was not possible). In those days, the government got data for production costs for those parts, but problems frequently arose anyway, whether because the contractor’s monopoly position allowed them to insist on high prices though profits were way outside the government’s guidelines or because there were so many thousands of parts that it was impossible for the government to pay attention to prices for all of them (or a mixture of both).

The efforts in the 90’s to encourage commercial firms to do business with the government by reducing demands for intrusive cost data for commercial items (including commercial spares) probably went overboard in eliminating cost data requirements for these sole-source buys from defense contractors, but this has swung back in recent years. The issue this contracting officer was raising was somewhat different. She was buying commercial spare parts that were also sold to non-government customers. However, industry has a different spare parts pricing model for government versus commercial sales. For government sales, the government pays the development costs for the underlying platform (for example, a military jet), while for commercial sales, the company pays development costs. On the commercial side, then, vendors follow a version of a “razor and blade” model, where they price spares high as a way to recoup their investment on development of the original equipment.

A problem then arises if a vendor says to the government “you need to pay my commercial prices.” Even if these are the genuine commercial prices, they have been developed in an environment that is not analogous to the government one – if the government pays both development costs and high spares costs, it is in effect paying twice.

The contracting officer who brought this issue up with me said she really wanted senior contracting leadership, either in her military service or in the Acquisition, Technology and Logistics, to pay attention to this issue on a Defense Department corporate basis. She felt she lacked bargaining power with the contractor working on her specific weapons system.

As I said, this issue has been around for really a long time. I am guessing it is not rocket science to make some noticeable progress here, though I’m sure it’s hard to solve this problem completely. And given the budget pressures on the Defense Department, this would appear to be a target of opportunity. This isn’t exactly my area, but a few thoughts:

1) I agree with this contracting officer that this issue needs to be managed to a greater extent than currently at a higher level. The Defense Department has started talking about managing the relationship with large IT contractors as a corporate issue as well as an individual contract issue, and this approach is probably even more appropriate here. The Department will have more leverage if these issues are handled corporately. I have long advocated the idea that the key spares buyers be included in the process of assigning a past performance score to weapons vendors. When the government is caught in a sole-source environment, a past performance evaluation of the quality of contractor attention to the government’s interest in pricing and delivering spares is one of the few levers the government has available. This will be more-effective if the evaluation is done at a higher level.

2) Another advantage of a more corporate approach is a smaller set of negotiations, though of course only big issues – such as overall discount levels for the large bulk of parts – are likely to be appropriate for central negotiations. What about a detailed study, perhaps centrally at the military service or ATL level, of a few high-volume commercial parts for each major vendor, using cost and pricing data for those few parts, to serve as a basis for negotiations on a uniform discount on a vendor’s total commercial spares inventory sold to a military department or to the government? The goal here would be to establish a standard discount off of commercial prices for a vendor’s government spares sales.

3) Let’s apply the 80-20 rule here. There are so many spare parts out there that we can be sure the government will at least occasionally overpay. Let’s not let the unattainable perfect solution to this issue be an excuse for doing nothing. We should look at some of the big volume buys and try to get better deals there.

Remember the DOD budget environment. This is the time to do something about this issue.