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This paper has been prepared by the Congressional Budget Office at the request of Congressman Joseph Addabbo, Chairman of the Subcommittee on Defense of the House Appropriations Committee. It analyzes savings in U.S. Air Force aircraft procurement contracts resulting from economic price adjustment clauses which link contract costs to the rate of inflation.

This paper was prepared by R. William Thomas of the National Security Division and Barbara Hollinshead of the Budget Analysis Division, under the general supervision of Robert F. Hale and John D. Mayer, Jr. Robert Kornfeld and Christian Frederiksen assisted with the analysis. Frank Pierce edited the paper.
 

August 1985
 
 

BACKGROUND AND SUMMARY

Marked declines in the rate of inflation since 1980 have resulted in lower than anticipated costs for some Department of Defense (DoD) weapons systems acquisition programs. In 1980, the overall rate of inflation, as measured by the implicit price deflator for the Gross National Product (GNP), was 9.3 percent. In 1984, the GNP inflation rate was 3.7 percent and CBO projects that it will remain in the range of 3 to 4 percent through 1987.¹ DoD prices have mirrored these trends in the economy. The rate of increase in prices for DoD purchases (excluding compensation and fuels) was 4.7 percent in 1984 as against 11.5 percent in 1980.

The rapid ebbing of inflation was not fully anticipated by the Administration or the Congress. Consequently, in the 1982-1985 period, DoD budgets included inflation projections that exceeded the actual rates by one to two percentage points. The extent to which DoD received funding in excess of its needs because of these overestimates is currently an issue of debate in the Congress.

For some weapons systems, at least, inflation savings are directly measurable. The U.S. Air Force is currently procuring a number of aircraft under contracts that incorporate an economic price adjustment (EPA) clause. This clause provides for upward or downward adjustments in the total contract cost based on the rates of inflation in labor and materials used in the production program.

Inclusion of an EPA clause transfers the risk associated with predicting inflation from the contractor to the government. During the 1970s, inflation at higher than expected rates led to large increases in certain Air Force contracts that used the EPA mechanism. More recently, the fact that inflation has been at lower rates than projected has led to substantial savings in contracts that include EPAs.

Inflation is measured using national data compiled by the Bureau of Labor Statistics, which may not be the same as the prices paid by the contractors. Normally, EPAs adjust for "abnormal" escalation; that is, for deviations from the rates of inflation projected at the time the contract was negotiated. No adjustment is typically made for the first two years of the contract or if the deviations are small (less than 1-2 percent). EPAs are used only with firm fixed-price or fixed-price-incentive contracts.²

EPA clauses are not often used, since it is Air Force policy that the use of an EPA must be of demonstrated potential benefit to the government. In practice, this often means that the Air Force will propose using an EPA clause if the contractor will agree to reduce his price. Actual benefits or costs of the EPA will, of course, depend on the rate of inflation. Only 42 contract actions in 1984 (out of more than 16,000) included an EPA clause. These represented 6 percent of the value of all contracts let by the Air Force that year.

It now appears that the use of EPAs in the current generation of contracts will prove of substantial benefit to the government. CBO projects that for the five aircraft and three engine contracts included in this study, a total of over $1.1 billion will be saved through EPA cost reductions over the lives of the contracts. Of this amount, $735.5 million results from the C-5B contract alone. Table 1 shows CBO's savings projections. The first column gives actual savings through calendar year 1984, which amount to $116.0 million. These results, being based on actual changes in labor and materials prices, may be considered firm.³
 

Most of the $1.1 billion total represents CBO estimates of EPA savings during 1985-1989, which are shown in column two of Table 1. These estimates are based on CBO projections for the wage and price indexes used in each contract to adjust the allowed cost. In the case of the C-5B, for example, the first of the 50 aircraft is not expected to be delivered until December 1985, while the last aircraft is scheduled to arrive in February 1989. Thus, actual EPA savings, based on prices prevailing when the contractor incurs his costs for labor and materials, may prove to be either higher or lower than these CBO estimates. Column three totals actual and expected savings for each system examined in this study.

Not all of the $1.1 billion, however, represents savings from the Administration's 1986 defense budget. At least $568.6 million of the amount has already been removed or reprogrammed.⁴ The data in the fourth column of Table 1 represent both prior-year appropriated funds that have been identified and released ("deobligated") by the system program office and funds that were removed from the 1986 budget request and future-year spending projections as a result of either recorded or anticipated savings. Deobligated funds are returned by the program office to the Air Force Comptroller, where they may be reprogrammed to support unanticipated costs in other programs or may simply lapse when spending authority expires. (CBO has not attempted to track the disposition of deobligated funds.) After making these adjustments, net savings of $575 million for these specific programs appear to remain in the current budget plan.

To test the sensitivity of these results to the CBO inflation projections, an alternative projection was developed for each index employing the annual rates of increase for 1985-1989 assumed for major weapons systems⁵ in the President's 1986 budget request (see Table 2). Contract savings under the Administration's assumptions total $951.5 million, about 17 percent less than the estimate using CBO assumptions. (Table 3 displays these savings by weapons system.) Even though the Administration's projected inflation rates are higher than CBO's in 1985 and 1986, they still permit substantial savings. In later years, the CBO projections actually exceed those used by the Administration.

The remainder of this paper discusses the methods used to project savings for these contracts, and presents the estimates for individual systems.

This document is available in its entirety in PDF.

1. See Congressional Budget Office, The Economic and Budget Outlook; Fiscal Years 1986-1990 (February 1985), p. 40.

2. In a fixed-price-incentive contract, the contractor's profit depends on his success in meeting a target cost. Increases in cost above this target are shared between the government and the contractor, up to a ceiling on the government's liability. Economic price adjustments change both the target cost and ceiling cost upward or downward, but do not affect the profit-sharing formula.

3. One widely used index, the hourly earnings of production workers in the aircraft industry, was unavailable in 1984. In order to estimate savings, CBO projected its values for 1984.

4. It is possible that additional inflation-related savings reported by the DoD since the budget was submitted in February include savings from the programs examined in this study. CBO was unable to confirm this.

5. These include aircraft, missiles, ships, and other major weapons systems, which are budgeted assuming rates of inflation 30 percent greater than those used for the rest of the items DoD buys.