The Price is Right? (A) Strategic Pricing to Land Air Force Contracts

James Taylor, Director of Operations at Logistic Specialties, Inc. (LSI), had just hung up the phone. He had extended a supplier an offer to tender a best and final offer (BAFO) for "The F-16 Strut." The supplier had politely declined, saying, "We'll have to pass on this one. We can't go any lower."

As James sat down, he glanced out his window. The sun was setting on a beautiful April evening and flickers of light were glistening off the Great Salt Lake. He wasn't surprised at the supplier's reaction. He had done the pricing analysis and he didn't expect any of the five higher-priced suppliers competing for the right to make The F-16 Strut to beat Touch-and-Go Landing Gear's (TGLG) quote. The quote was low—perhaps too low. Even so, James always gave each supplier one opportunity to stay in the hunt for business.

It was already 7:30 pm. Within the hour, James hoped to select the right supplier, finalize the pricing, and submit the final bid to the Air Force. He was already pretty confident who the supplier would be, but he knew that getting the price right would be tricky. Landing contracts gave him a rush. However, tired and hungry, James sometimes wished he could keep bankers hours.

Earning a Hunting License

In 2003, the United States Air Force released a rather distinctive request for proposals (RFP). The Air Force was seeking to build a team of prime contractors to manage the acquisition of almost 2,000 unique landing gear parts and assemblies. Several details made the RFP intriguing:

  • Potential primes would have one year to put their proposals together. (However, five years elapsed from initial RFP to the actual award.)

  • Each proposal needed to provide pricing and capacity details for the entire and diverse range of landing-gear components for all of the Air Force's aged aircraft—trainers, fighters, transports, and tankers (see Table 3-1).

  • Table 3-1
    Aircraft Covered by LGPVC
    Name Class
    KC135 Cargo
    C5 Cargo
    C30 Cargo
    B52 Bomber
    B1 Bomber
    B2 Bomber
    F15 Fighter
    F16 Fighter
    F4 Fighter
    A10 Attack
    E3 AWACS
    T38 Trainer
  • Companies that earned a landing gear prime vendor contract (LGPVC) would win a 10-year contract. However, because some parts can take up to five years to procure, the actual contract length could actually extend to 14 or 15 years.

  • If selected as a prime contractor (frequently called simply "prime"), a company would win the right to bid on individual parts contracts as they came to market. Of course, being selected for an LGPVC didn't guarantee a prime any business. Landing an LGPVC only granted a prime a "hunting license" for the duration of the contract.

  • Beyond demonstrating that the prime could deliver on the range of parts, the Air Force required that potential primes include a ceiling price on each and every part. A ceiling price sets the cap on the price for the entire 10-year span of the contract. In other words, regardless of what a part actually costs five or eight years out, the prime can only charge the Air Force its previously quoted ceiling price. None of the primes wanted to win a contract based on its quoted lowest ceiling price.

    • Individual parts contracts could be released from any one of five buying centers (see Table 3-2):

    • Defense Logistics Agency (DLA)-Ogden

    • DLA-Columbus

    • DLA-Richmond

    • DLA-Philadelphia

    • Global Logistics Supply Center (GLSC)

Table 3-2
Buying Centers
Customer Volume by Order

2,015 Orders
Volume by Dollar

$239,806,415
Part Difficulty
AFSC 26% 21% Complex
DLA-OO 24% 68% Highly Complex
DSC 50% 11% Not Complex
AFSC = Air Force
DLA-OO = DLA Ogden
DSC = DLA Supply Centers (Richmond, Columbus, and Philadelphia

Each buying center purchased from a unique parts list. For example, DLA-Ogden parts were often very complicated, hard-to-build assemblies. The other DLA centers were known for large volumes of small-dollar orders. More perplexing

than each center's order profile was the fact that each buying center had its own culture—its own way of doing things. Some were flexible; others were somewhat intransigent—a real pain to do business with. Nonetheless, to be successful over the long haul, a prime needed to work well with them all.

  • Buying centers released orders for three highly distinctive parts categories—each possessing unique competitive dynamics (see Table 3-3).

  • Table 3-3
    Part Codes and Types
    AMSC Code Definition
    C Requires the use of a government-approved source specific to this part. New sources must be approved by the Engineering Support Authority (ESA) at Hill Air Force Base.
    G Full and open to all manufacturers with a Government Cage Code. Does not require ESA approval for a manufacturing source.
    R Restricted to approved sources. Current sources own the right to all manufacturing data.
  • R-coded Parts are restricted or proprietary. The originator of the parts never sold the drawings or data package needed to build the part to the Air Force. As a result, they own the part for life. No one else can bid on it. The key to winning a bid on an R-coded part is to build a strong relationship with that supplier.

  • C-coded Parts are both complex and critical; government engineers must qualify them and potential suppliers. For each C-coded part, legacy suppliers exist. When a buying center issues an order, it provides each prime a list of qualified suppliers. The primes then work with these suppliers to put a winning bid together or develop a new supplier through the government's "Source Approval Request" Process.

  • G-coded Parts are non-critical, easy-to-make parts that can be built by any supplier. Some g-coded parts are made in micro shops located in a technician's garage.

All in all, being chosen as a prime contractor was a mixed blessing. It was tough to make a living with this LGPVC hunting license.

The Competitors and The Rules of the Hunt

By May 2008, the Air Force had selected four primes: ES3, Helicopter Tech Inc. (HTI), Héroux-Devtek (HDI), and LSI.

ES3. Founded in 2000, ES3 is an engineering services firm with facilities in San Diego, Clearfield, Utah, and Warner Robbins, Georgia. Primary customers include the Air Force, Navy, Army Corps of Engineers, and NASA. ES3 is very proud of its Dun & Bradstreet 100% customer satisfaction rating and is known for its 1) commitment to research and development and 2) positive relationships with subcontractors and suppliers. ES3 accelerates supplier payment to help suppliers manage cash flow and remain solvent.

HDI. Manufacturing landing gear since 1960 and headquartered in Québec, Canada, HDI specializes in landing gear for both commercial and military sectors. Over the years, HDI has grown through acquisition, gobbling up six rivals since 1987. As a result, HDI offers a full spectrum of service from design to manufacturing and from OEM to spare parts. HDI hawks its R&D and systems integration capabilities, claiming to be the preferred partner for the "design, qualification, and manufacture of complete landing gear systems."

HTI. Established in 2002, HTI is a Woman-Owned and Operated Small Business (WOSB) that specializes in program integration and logistics support. HTI relies heavily on its tight relationship with the Air Force and aggressively pursues new supply partners. HTI's goal is to broaden and deepen its product line to be a one-stop shop for landing-gear parts. HTI touts its "impeccable record of performance, leadership, reliability, and trust."

LSI. Operating since 1972, LSI had established 43 offices across the U.S. Close customer and supplier relationships, deep knowledge, and IT systems helped LSI build long-term partnerships. LSI invested heavily in its IT systems so it could help clients not just win government contracts but also manage them successfully over time. In 2012, Scott Reynolds, Deputy Assistant Secretary of the Air Force for Logistics described LSI as follows: "Over the years LSI has performed as a thought leader, business facilitator, and process improvement coordinator. They have excelled in every capacity."

The Competition

The Air Force's standard for contracting landing-gear parts was "lowest price technically feasible." Once the feasibility hurdle was surpassed, contracts were awarded strictly on price. Primes competed fiercely to offer that lowest-price bid. Two factors drove the race to the lowest price.

  • Qualified Suppliers. For all but g-coded parts, which were very low margin and typically small-contract items, the number of qualified suppliers was limited. Worse, the process of certifying was laborious and painful. Many potential suppliers simply didn't want to go through the hassle to certify for a shot at winning a one-time parts contract without a guarantee of future business.

  • Transparency. When the Air Force needed to acquire a landing-gear part, it issued a request for order proposal (RFOP) to all four primes. Included in each RFOP was a list of all qualified suppliers. The result: All four primes knew who the acceptable suppliers were and competed to get the best suppliers to join with them in preparing a bid that could win the contract.

The bottom line: Earning a living as a systems integrator on a LGPVC was tough business. To survive, primes had to be masters of the hunt and able to live on low margins.

Rewriting The Rules

To alleviate some of the pricing pressure, LSI had aggressively and persistently sought to change the competitive bidding dynamics. LSI had adopted four strategies—some more creative than others.

  • Disrupt the Supply Base. For each new RFOP issued by the Air Force, a prime could seek to disrupt "sourcing as usual" by qualifying a new supplier.

    Sneaking in a new supplier to win a part traditionally supplied by a competing prime was not easy. LSI first had to convince the supplier that joining the hunt was worth the time and effort. Then LSI had to get the supplier qualified. To do so, LSI had to submit a source of approval request (SAR). A SAR might include engineering specs, manufacturing capacity and plans, and a history of delivering similar parts to the Air Force. The goal: Demonstrate that the supplier could successfully build and deliver the part. Despite the hassle, James aggressively exploited the SAR process, seeking to approve a new source on about 15% of Air Force RFOPs. LSI won about half of these bids.

    Unfortunately, such stealth provided a fleeting advantage. Once a new supplier was approved for the part, the Air Force would include it on all future RFOPs for the same or similar parts. The rival primes—especially the one that used to supply the part—could sharpen their pencils and try to win the part back in the next round. They could even invite the "new" supplier to team up with them on future bids.

  • Past-Performance Record. The Air Force's practice of awarding contracts strictly on price rendered past performance—i.e., a successful track record—meaningless. Confident that it offered superior performance, LSI sought to persuade Air Force decision makers that issues beyond price mattered. James had pressed for more comprehensive appraisal for three years before convincing the Air Force in 2011 to adopt a multi-dimensional scorecard to assess not just price but also delivery performance, quality, and price improvement (see Table 3-4).

    Importantly, the Air Force also began using this scorecard to track historical performance. Each prime's track record was compiled into a past-performance index. This index was a composite score calculated for all contracts—regardless of dollar value—won and executed by a prime. The Air Force reported relative index scores (i.e., the prime's score and its percent compared to the mean) on a quarterly basis. Further, the Air Force added the index into the evaluation and selection process. That is, if LSI and HTI offered the two most competitive bids on a specific part and LSI's index were 4% higher than HTI's, for every $100 HTI bid, LSI could bid $104 and still win the contract.

    The LGPVC contract administrators were so pleased with the scorecard that they nominated LSI for the Small Business Performer of the Year Award. LSI won the award in 2012.

  • Table 3-4
    Past-Performance Scorecard
    Award Term Plan Score Card
    Average Days Late 17 out of 20
    On-Time % 14 out of 15
    Corrective Action Request 21 out of 21
    First Article Approval % 12 out of 14
    Proposed PLT 9 out of 10
    Actual PLT 10 out of 10
    Customer Support 9 out of 10
    Total 92 out of 100
    Mean Points assigned for all primes 75
    LSI's % of mean points for all primes 122.60%
  • Small-dollar-value Orders. The classic rule in government contracting is to compete hard for the big contracts. As Willie Sutton responded when asked why he robbed banks, "That's where the money is." In landing gear, RFOPs could range from a measly $300 to $5+ million. The low-dollar contracts could actually cost more to process than their total dollar value. Thus, the government did not require ES3, HDI, HTI, or LSI to accept any order under $2,500.

    James, however, viewed small-dollar RFOPs as a great opportunity. He took pride in winning and performing on contracts that none of the other primes felt were worth handling. One time, an Air Force contractor had commented, "You guys took 150 orders last year that were only $300. I don't know how you make money on orders that small." James smiled every time he remembered that conversation. He hadn't told the contractor that LSI couldn't do it profitably. Those skinny orders were one reason he worked late so many nights. James wasn't just interested in making money; he also wanted to earn good will.

  • Zero-margin Orders. A second classic rule is to go hard after the high-margin orders. James understood the logic: If you're going to sweat to earn every contract, you might as well be compensated for it. Even so, James was willing to take a lot of orders at zero margin.

    In fact, during an audit of 2012's orders, the audit team discovered that over 3% of all the orders LSI had won and executed were at zero margin. When the audit team reported this result, some of James' colleagues shook their heads in dismay and grumbled, "That's no way to run a profitable business." James hadn't argued the point, but he was confident that the good will LSI was earning was worth the investment.

    What was LSI's reward for working so strenuously to rewrite the rules? For the previous year, LSI had won about 50% of the orders—and almost 45% of the dollars spent on the landing-gear program (see Figure 1). When asked about LSI's success, James responded, "Everyone works for low margins almost all of the time. The difference is who is willing to work the most. We win so much because we are willing to do the work."

Panel A: Fiscal Year 2013
Panel B: Total Awards
Figure 3-1: LSI's Winning Track Record

Winning An Order

Once the Air Force issued an RFOP, James and his team had 10 days to put a winning proposal together. The preparation process consisted of three main phases:

  • Day 1—Sourcing Strategy. The first task on James' radar each morning was to check how many RFOPs had been released by the Air Force. On average, he expected five RFOPs to be waiting for him. However, he wouldn't be surprised to see anywhere from zero to 25. Once, he found an astonishing—almost unmanageable—49 RFOPs demanding action.

    For each RFOP, James' team needed to build a sourcing strategy. The team would send an RFQ to every supplier identified on Air Force's attached qualified supplier list. However, out of the up to 150 suppliers typically listed, James expected only four to six suppliers to really go after any specific part order. His job was to identify the preferred suppliers, gauge their ability to put together a winning bid, and decide whether or not to bring in new supplier through the SAR process.

  • Day 2-9—Homework. After sending out the RFQs, LSI's workload broke down into two distinct activities:

    1. Follow-up. Given the compressed timing, LSI aggressively followed up with it preferred suppliers, asking questions like, "How is it looking?" or "What questions do you have?" It wasn't uncommon for a supplier to respond, "We've looked at the data package. On note 17, it says to heat treat the spec from standard 129. It used to be 130 and we think the tensile strength is too soft. We're a little nervous about that." LSI's job was to follow up with the Air Force to obtain an engineering review and clarification. This query-and-clarify process could happen multiple times on a single part.

    2. Pricing. As the suppliers were setting up their supply chains and preparing their bids, James' team was digging into the bidding history on the part. How many times had the Air Force put this part out to bid? Which prime had won the bid? Who were the lead subcontractors? What were the volumes? What was the winning price? Developing an accurate pricing profile was the key to a productive Day 10—and to winning the bid.

  • Day 10—Decision. Although it was possible for suppliers to come back with their bids earlier in the timeline, they almost always pushed into the 10th day. As busy as LSI was during days 2-9, the suppliers had a far more difficult and hectic job. They had to resolve all technical issues, assess materials availability, verify capacity, schedule production, and come up with a firm price. The result: Almost all of the suppliers' quotes came in on Day 10 (sometimes very late in the day).

    With the quotes lined up, James' Day 10 was drawing to a close. After reviewing each package to make sure it was valid, James was ready to initiate the final delicate step in the selection process. He would call each of the high-bid suppliers and say, "On this part, you are not the lowest price. You've got an hour to bring back your best and final offer." James was always very careful to never divulge rivals' pricing information to suppliers during this "best-and-final offer" process. James wanted to give everyone a fair shot, but he did not want to drive an artificial feeding frenzy (a practice often pursued by rival primes). He was sure that although sharing pricing information might drive price down, it would undermine trust, reducing supplier willingness to respond to future RFQs. Suppliers needed to know that their prices were safe with LSI! This was one reason LSI received more quotes per part than rival primes. If one of the higher-priced suppliers came back with a lower bid than the previous low-price supplier, James would have to make one last "best-and-final offer" call to that supplier. Every supplier deserved one chance to improve its bid.

    With the right partner selected, the time had come for a final phone call. James would call the winning supplier and say, "Here's the deal, I got your price, you're the lowest, we're using you. Now, let's talk about what we need to do to win this contract." One of three conversations could ensue.

    1. Too High. "The last seven times this part has come out, Héroux has won it and built in-house. Your $35 higher than I think you need to be based on the pricing history. So, I'll bid the way you have it written up, or you can drop the price. If you really want to win this part, I think you will need to drop your price by $35—and then it will be close. What do you want to do? Of course, if you think my pricing analysis is wrong, I'd appreciate any feedback. We don't just want to win this, we both want to make a little money."

    2. Too Low. "We've done the price analysis going back 15 years on this part, and I think you are about $60 too low on a per-unit basis. To double check, we took one of the bids from a rival supplier who consistently quotes us 20% higher than its preferred partner HTI. Working backward from its bid, your price is $63 below market. I see two possibilities. One, maybe you need to go back and check your quote and make sure you caught all of the requirements. For example, are you sure you accounted for two forgings on this part and didn't price it with just one. Two, maybe you are that efficient. If so, I'm telling you that you can raise your quoted price. Just to be on the safe side, I'm going to bid this $55 higher. I'll give you half of the difference. You deserve to keep some of your efficiency."

    3. Just Right. "We've done the price analysis going back 15 years on this part, and I think you're price is right on target. I'll get the paperwork done and get this submitted. We'll know in a few days if we've done our homework well."

To reliably win parts contracts, LSI had invested in leading-edge information systems. Given the fact that Day 1 for one part could be Day 10 for another, accurate and comprehensive data were needed to keep the details straight. James remembered a few times when LSI had to juggle 50 RFOPs in a single day (25 Day 1s and 25 Day 10s). Beyond systems, a strong team of loyal subcontractors was also vital. By law, LSI could not lock in a subcontractor via contract. Trust and the ability to be partners in profit was all that kept many subs as consistent members of LSI's hunting party. Of course, a culture of meticulously doing the homework didn't hurt!

The Right Pricing Strategy For Part XYZ

As the last light faded from the mountains, James swung his chair around to his desk. The last "best-and-final" offer on The F-16 Strut had just come in. No one had come close to Touch-and-Go Landing Gear's original bid of $3,142 per unit (see Table 3-5). James smiled, wondering whether the bid team at TGLG knew what it meant when he never called to ask for a "best-and-final offer."

Table 3-5
Bids for the F-16 Left Strut
Current Opportunity For 146 Units
Supplier Supplier Notes Approved Quoted Each Price Delivery Time
TGLG In production now. Gives LSI a 20% discount Y $3,142 1050 days
Bemsco Not in production, no discout to any Prime Y $3,456 1000 days
MSI Not in production, no discount to any Prime Y $3,242 1500 days
Johnson Not in production, gives other Prime a 20% discount Y $4,100 1000 days
Alpine Not approved. Submitting an approval request. Only bids LSI N $3,885 1100 days
Notes: Allowed to bid an unapproved source with an alternate bid. Alternate bid will be used in the event that the approval request is denied.
Requirements: Price per part cannot exceed 12,000 and delivery time cannot exceed 1200 days.

James glanced at the pricing history on The F-16 Strut (see Table 3-6 and Table 3-7) as he picked up the phone and began dialing. Smiling, he said to himself, "This should be a fun conversation." A moment later, James heard a familiar voice say, "Hello, . . ."

Table 3-6
Price History: Panel A—Left Hand
Part Number Description AMSC Code
200143-118 F-16 Strut LH C
Purchase History
Prime Quantity Total Price Award Date
HDI 1 $6,425.87 6/20/2013
ES3 3 $17,700.00 11/7/2012
LSI 133 $424,378.00 12/22/2010
LSI 120 $356,690.00 8/4/2010
ES3 94 $382,612.00 3/1/2010
LSI 206 $765,423.00 12/22/2009
LSI 32 125,466 9/29/2009
Non LGPVC History
Vendor Quantity Total Price Award Date
TGLG 75 $270,000.00 8/3/2008
TGLG 88 $301,300 9/20/2007
Eagle 25 $113,800 6/29/2007
Eagle 7 $46,680 6/5/2006
Eagle 8 $38,708 6/1/2006
MSI 40 $164,000 1/31/2006
Cagas 7 $29,260 2/15/2000
DAF 7 $31,822 4/24/1996
Lockheed 1 $12,042 1/29/2009
DAF 11 $50,721 1/29/2009
Lockheed 7 $48,669 5/1/1983
Lockheed 6 $30,970 11/1/1982
Table 3-7
Price History: Panel B—Right Hand
Part Number Description AMSC Code
200143-117 F-16 Strut RH C
Purchase History
Prime Quantity Total Price Award Date
LSI 1 7,000.00 4/4/2013
LSI 3 23,868.00 3/29/2013
LSI 111 314,130 9/15/2011
HTI 177 470,542.11 4/14/2011
LSI 120 333,240.00 1/11/2011
LSI 139 341,349.25 8/6/2010
LSI 44 127,379.56 6/9/2010
LSI 156 430,630 2/12/2010
Non LGPVC History
Vendor Quantity Total Price Award Date
TGLG 126 428,600 9/6/2007
Kellstrom 13 89,570 8/16/2006
MSI 125 472,500 6/6/2005
MSI 12 68,800 4/15/2005
SP 15 80,790 12/2/2002
Cummins 39 141,774 8/21/2002
Kellstrom 8 59,640 4/19/2002
Kellstrom 2 14,720 2/22/2001
SP 3 13,194 7/30/1996
DAF 11 48,378 4/24/1996
Goodrich 1 8,020 11/1/1995
Lockheed 1 11,557.46 10/1/1992
Lockheed 8 38,888 6/1/1990
Lockheed 10 60,611.18 5/1/1983
Lockheed 6 30,970.26 11/1/1982

Questions

  1. Which conversation should James pursue? How vigorously should he press his point? What are the potential outcomes of this conversation?

  2. For what price would you write the bid? Remember, you want to win the bid. You also want to make money.

  3. What are the pros and cons of each of LSI's four initiatives/behaviors to rewrite the rules of the bidding environment? Why would LSI take small-dollar or zero-margin orders?

Experiential Exercise

Imagine you are in James chair. Script your conversation. Consider the following:

  • How would you begin?

  • What evidence would you use to support your discussion to more powerfully and convincingly make your point?

  • How would you expect your counterpart to respond?

Sit down with a team member and role play this scenario.