ETS News featured the following article in their Winter 2001-2002 Issue describing the differences between commercial-off-the-shelf (COTS) products and cost-plus-fixed-fee (CPFF) development.
COTS versus CPFF
Which offers the best value – COTS or CPFF? ETS News (Winter 2001-2002) looks at the pros and cons of these purchasing systems.
In an effort to save dollars, many U.S. Department of Defense policy-makers are promoting the use of commercial-off-the-shelf (COTS) products in lieu of customised, cost-plus-fixed-fee (CPFF) development. Theoretically COTS products are cheaper to purchase, maintain and upgrade, and the free market can provide more innovative options than a single government-furnished solution. However, the move is meeting resistance at the execution level of government contracting.
When asked about COTS, government programme managers will sometimes tell stories about a CPFF contractor that claimed that intellectual property the government paid for was ‘proprietary’. To use the intellectual property the government would have to continue contracting with that same vendor for more CPFF labour. It is understandable that government programme managers might be wary, but true COTS products are developed at private expense and risk, in the hope of selling it to as many end users as possible. Most of the benefits COTS products offer over CPFF procurement come from the open market business model. Competition and consumer demand create a procurement process that offers value and adaptability.
- Customer satisfaction: A product sells only if it meets customer needs. With end-user demand changing, COTS products must adapt or become obsolete. This provides the largest choice of functionality.
- Pricing: In an open market, success brings competition. This lowers price. Profit margins are squeezed down and the government gets more for its dollar.
- Increased choice: A competitive market creates a broader choice .
- Best products win: Since customers ‘vote’ with dollars, superior products sell more. Inferior products lose market share and are discontinued.
- All risk is on investor: Since investors have a stake in product success, they must ensure proposed innovations are worth investment. Developers are encouraged to minimise cost, maximise product appeal, and shorten the development cycle.
Develop Simulations Faster
The COTS business model works because the incentives and market pressures compel economically rational decisions, resulting in constant innovation, little waste and a rising standard of development.
Unfortunately for defence departments, there are some areas where investors are unwilling to risk developing new products. In markets with only one customer, such as submarine procurement, if the government does not buy the innovation, the investment is unrecoverable. It would be foolhardy for a shipbuilding company to invest billions of dollars in a new submarine without advance orders. For these types of product, capital investment must be funded, because the innovation is in the national interests. In this CPFF business model, the government pays a contractor 100 per cent of their labour costs, plus a fixed fee, usually five to ten per cent. The competition for the contract is through a submission of proposals describing how the contractor will approach the development. This marketplace has several undesirable side effects:
- Buying proposals not products. Since the financial reward is determined by the proposal, this marketplace values proposal-writing over actual product development. There is no correlation between the proposal and the quality of the end product.
- Detachment from market reality. The ‘wish list’ of features is often developed by a very small subset of potential end users, often without an understanding of the costs. This leads to products being developed that are vastly overpriced for the benefits they provide. Since no buyer decides on purchasing after the product is finished, and there are no alternatives, excessively expensive features are included. COTS product companies, by comparison, only develop features the market demands, saving dollars. According to Dell Lunceford, Director of the Army Modelling and Simulation Office (AMSO), the number of major Army modelling and simulation development programmes that actually meet 100 per cent of the ORD requirements, on-time and on-budget according to the original proposal, is close to zero per cent.
- All development risk is on the government. Paid 105 per cent plus for product development, CPFF contractors have no incentive to save money. Instead, they are financially rewarded for overruns, mistakes and duplication of work that could be purchased elsewhere.
- Bad ideas can live forever. In an open market, companies quickly kill their investment once a product starts to lose market share. In the CPFF contract development world, there is no quantifiable market feedback. Poor products continue because their relative value is determined by a philosophical debate between the beneficiary constituencies.
Despite the many benefits the COTS model offers over CPFF, the contract business model cannot always be replaced using COTS products. Certainly, governments could not trust a black-box software product that purported to perform some critical function such as fire control of a missile system. Security often dictates that the ‘content’ must be completely transparent, and independently verifiable by the customer. High-risk research, where the end goal is discovery, not the development of a product, is another area where the CPFF model is superior to COTS.
More spending equals more profit
Why don’t programme managers and contractors buy COTS products when it will save them money? CPFF contractors that save $1m in duplicative development just lost $1m in gross revenue and about $80,000 in profit. The nature of CPFF rewards contractors for replicating things they could buy off the shelf. Government programme managers are not comfortable buying COTS because they are not experienced in purchasing fixed price items or the benefits they offer. The government buys close to 100 per cent of non-commodity items through CPFF.
COTS products and CPFF contracting are both necessary. To determine the best procurement policy, the government needs to review the number of potential users and the amount of initial development investment. For needs where the initial investment is great and potential market share is small, CPFF must be the preferred procurement method. When there is obvious market demand for a product, the government must look to COTS products. Until programme managers are comfortable with this method, there will be no change in purchasing methods.
Government programme managers and CPFF contractors shy away from COTS due to financial disincentives, and lack of familiarity. To stimulate the development and migration to COTS for products with no compelling reason to be developed via CPFF, government programme managers and defence contractors must be rewarded for the money they save the DoD, not how much they spend.