NITED STATES OF AMERICA AU 9 '41 COST-PLUS-FIXED-FEE CONTRACTS MONDAY, JUNE 30, 1941 UNITED STATES SENATE, COMMITTEE ON NAVAL AFFAIRS, Washington, D. C. The committee met, pursuant to call, at 10:30 a. m. in room 212, Senate Office Building, Senator David I. Walsh (chairman) presiding. Present: Senators Walsh (chairman), Davis, Bone, Ellender, Andrews, Lucas, Brewster, and Byrd. STATEMENT OF REAR ADMIRAL BEN MOREELL (CIVIL ENGINEER The CHAIRMAN. Admiral Moreell, the committee have asked you to appear before us this morning for the purpose of discussing your experience in dealing with cost-plus contracts and cost-plus fixed-fee contracts in the Navy public-works program. Will you please present to us just what the difference is between these two forms of contracts and what your experience has been in dealing with either or both of them? Admiral MOREELL. Yes, sir. The so-called cost-plus-a-fixed-fee contract was revived by me in the winter of 1939, when I presented to this committee certain recommendations in favor of fixed-fee contracts in connection with the construction of the extra-continental air stations recommended by the Hepburn Board. The objective, as stated by me at that time, was to construct these extra-continental air stations with certainty, speed, and economy. The speed factor was important because we knew so little about many of the localities at which these stations were to be built. In order to make complete plans and specifications, which would have been necessary for competitive bidding contracts, it would have taken us at least a year. The economy of a fixed-fee contract for these works arose from the fact that a prudent contractor bidding on work which was to be conducted under conditions so little known, would have had to include in his bid a contingent item of very large proportions. A prudent contractor is the only one who could offer a sufficient guarantee of acceptable completion and, obviously, he is the only type, of contractor that we would want for those particular works, especially since they were to be built under most difficult conditions in Alaska, in the Western Pacific, and, to a lesser extent, in Puerto Rico. I therefore obtained the approval of this committee for the revival of the cost-plus-a-fixed-fee contract. That type of contract had been used to a limited extent during the World War. However, the type 1 of so-called cost-plus contract which was favored during the World War was the cost-plus-percentage contract. Under that type of contract, for every dollar that the contractor spends on the work, he receives a certain percentage. During the World War it was usually 10 percent. That type of contract-pardon-me, sir.." The CHAIRMAN. Does the Government supervise the expenditures of the contractor? Admiral MOREELL. Yes, sir. Very rigidly. The CHAIRMAN. He cannot buy supplies and he cannot pay wages and employ particular men without their approval? Admiral MOREELL. No, sir. That is correct. Senator BONE. Have you checked their pay rolls to see what sort of salaries are being paid to executives? Admiral MOREELL. Yes, sir. The salaries are all approved in advance on our type of contract. Senator BONE. Is that a continuing supervision, Admiral? Admiral MOREELL. Yes, sir. I didn't bring with me, but I have since sent for our accounting manual on cost-plus-fixed fee contracts which I will show to the committee in a few minutes. It will be here and you will see from that the completenesss of the control which we exe cise over this type of contract. Nothing is done without auditing by Government representatives before payment is made. Senator BONE. I asked that question because during the World War under these cost-plus contracts, the holder of the contract would run in all his relatives and pad his pay rolls excessively and it appeared on the face of it to be a legitimate expenditure, but it was an outrageous affair and resulted in excessively high cost. Admiral MOREELL. Yes, sir. The CHAIRMAN. You are speaking about the contracts in the World War? Admiral MOREELL. Yes, sir. The CHAIRMAN. Will you develop that? Admiral MOREELL. Yes, sir. The cost-plus-percentage type of contract which was favored during the World War constituted, in effect, an invitation to a contractor to spend money freely because for every dollar he spent he received a certain amount in profit. The degree of control and supervision of those contracts was undoubtedly the best that could be afforded at that time... When I presented the recommendation to this committee that we be permitted to make cost-plus-fixed-fee contracts, I pointed out that in this type of contract, the fixed-fee type, there is no incentive on the part of the contractor to spend a lot of money because he gets no more fee for it. Now, on the other hand, there is an incentive to do the work economically. In this commentary which I have passed along to the committee members, that matter is discussed in some detail. This commentary was prepared by Mr. William M. Smith, who was my special assistant, and who has recently died after some 48 years of service in the Navy Department. Mr. Smith wrote the original fee contract-that is, the fec.contract, which we first used in 1939, and I asked him to prepare these commentaries which would describe in complete detail the reasons why we adopted and recommended that form of contract. In this booklet you will find a complete contract with accompanying documents to explain the matter of plant rentals. On page 1 of this Commentary Mr. Smith makes this statement: Under the second class of contract speaking of the cost-plus-fixed-fee contract the fee is not affected by variations in costs, but only by changes in the scope of the work. From this it follows that it is to the advantage of the contractor to accomplish the work at as low costs as possible. First, there is the human factor. The honest and conscientious fixed-fee contractor, and a fixed-fee contract should be given to no other, is personally elated when he succeeds in accomplishing a job for less money than others thought possible. He "points with pride" and says "I told you so." Second, the contractor enhances his reputation for doing work at low cost and thus increases his chances for securing future contracts on favorable terms. Third, if a sufficient amount of money is accumulated by savings in costs it makes possible an extension of the scope of the work, which in turn entitles the contractor to an increase in the amount of his fee. Now, I would like to read The CHAIRMAN (interposing). When does he get an increase in the amount of his fee? Admiral MOREELL. When the scope of the work is increased, Senator. The CHAIRMAN. I see. Admiral MOREELL. You see, we have a certain number of projects in each contract. The CHAIRMAN. That is right. Admiral MOREELL. And when we add new projects to the contract it increases the scope, and justifies an increase in the fee. The next paragraph I think is very pertinent. The proposition that the public should have a chance to secure contracts for public works constructed by the Federal Government with funds collected from the public, represents a sound public policy. This means, of course, competitive bidding. In normal times and under normal conditions, it is unquestionably the more expedient procedure. It allays the ever-present suspicion of favoritism and graft and thus tends to sustain the confidence of the people in their Government. It also tends to keep prices low, but, where the contract price is too low to primise any profit for the contractor or indicates a certain loss, this seeming advantage is often turned into a disadvantage on account of skimping by the contractor on the work in an effort to prevent a loss or to make a profit. Work taken at a low price must be given rigid inspection and the Government representatives on the work must be constantly vigilant; this often leads to disputes and appeals. The accomplishment of the work is thus often delayed and the indirect costs increased. Senator DAVIS. When there is a dispute, to whom are the appeals made? Admiral MOREELL. The appeals are made first to the Chief of the Bureau and then to the Secretary of the Navy. Now, I would like to mention to the committee that I have repeatedly gone on record as stating that I favored the competitivebidding method of doing business under normal conditions. The reason I have favored the fixed-fee contract for our present abnormal conditions is becuase I am thoroughly convinced that this is the only way we can accomplish this national defense program with the speed that Congress and the public expects of us. To illustrate just what that means in actual figures, I have brought with me a statement which was published in the May-June 1941 issue of the magazine Military Engineer in regard to the speed with which some of this work has gotten under way. Senator BONE. Admiral, may I interpose one question there? Senator BONE. I don't think it will interfere with your line of thought. With respect to competitive bidding and cost-plus-fixed-fee, do you not run into almost an identical condition in both cases? Obviously your Engineering Department has to prepare some sort of plans and specifications in advance. You just don't start out to build an air base or a naval base of some sort without some plans. That is correct? Admiral MOREELL. Yes, sir. Senator BONE. So, having to face the necessity for plans, you would draw them in advance. Well then, where would the loss of time come-in calling for bids and having them examine the plans or how would that would necessitate a contractor facing precisely the same problem as though he was going to bid on it, because the fact that he does have to make a bid on it, in effect he has to make a bid, his engineers and his cost experts have to go over those plans, otherwise he couldn't possibly make an estimate of price? Admiral MOREELL. Well, we do Senator BONE (interposing). You get what I am driving at? Admiral MOREELL. Yes, sir; I understand your question thoroughly. Senator BONE. If I were counsel representing a contractor and I was going to do business with the Government, I would first want the details, plans and specifications and blueprint and the whole business. I would go over them and say to my men, "If you are going to bid on this, you want to be darn certain of what you are doing or you will get yourselves all messed up. If you make an estimate and it is 25 or 50 percent off, you are going to appear in a very funny position with the Government," and I would think he would have to be almost as careful with that and as precise in his estimates as though he were going to bid on it against a field of buyers. Now, what is the fundamental difference between his position in the case of the cost-plus-fixed-fee and his position as a potential bidder in the open market? Admiral MOREELL. The difference is this, Senator Senator BONE (interposing). Where would the loss of time come in? Admiral MOREELL. Yes, sir; In this respect. You take the construction of the air station at Kaneohe Bay. Now we started out with a general layout of that station, a layout plan showing the various buildings, and a statement showing the character of the construction of each building. That is, whether they were to be of steel or reenforced concrete or wood frame with galvanized metal siding or what not. For each one of those projects we, i. e., the Navy, made an estimate. The contractor did not make the estimate. Let us take a shop building for example. We calculated the cubage of that shop building and we said, "If we were building this shop building in San Francisco it would cost us 25 cents a cubic foot to build it, but because it has to be built at Kaneohe and the transportation difficulties and the difficulties of obtaining labor are great, we are going to add 25 percent to that estimate just as a stab in the dark.” So we estimated the building at 314 cents per cubic foot. We went to the contractor and said "We are going to make a fee contract for this building, and our estimate of the total cost is half a million dollars. We are going to allow you a 41⁄2-percent fee on our estimated cost, or $22,500, and you will have to put up this building for that much fee. The building is so many feet long, so many feet wide, so many feet high. It has a structural steel frame with galvanized iron roof and siding. We are going to allow you a fee of $22,500. That is, we will pay you the actual cost of the building plus $22,500. If the building costs more than our estimate of $500,000, you will receive no more fee. "Now, are you willing to accept?" He says, "Yes; I will accept if you will reimburse me whatever the building costs. I have no way of telling how to evaluate the difficulties of transportation, of recruiting, maintaining, and housing the labor, because the conditions are so utterly unknown to me, but if you will protect me on the actual cost, I will give you the use of my construction organization and of my central office organization for building that building for a fee of $22,500." Now, the contractor is taking a chance, because if we estimate that building too low, he might have to build a much more expensive structure for the same $22,500 fee. In this case he fails to make as large a profit as he anticipated. But he is not responsible for the accuracy of the original estimate. On the other hand, suppose he had to take that gamble on a competitive bidding contract. He takes that building and he estimates the cost and he says, "Well, it looks to me as though that building is going to cost about $650,000, but I don't know whether I am going to have to house my labor there; I don't know how much transportation difficulty I am going to have; I don't know what my labor turnover is going to be, so, in order to play safe, I am going to add $150,000 to that bid.' Now, suppose he doesn't do that. Suppose he estimates $650,000 and takes a chance on it and the building actually costs him $750,000. Well, instead of failing to make a profit, he actually suffers large outof-pocket loss. That is why a contractor who bids competitively must be very, very careful, because he, personally, guarantees the cost of the structure and so, in order to get proper competitive bids on a structure of that kind, we go into the market with very complete plans and specifications so that no bidder, after he gets the contract, can come to us with a claim and say, "You did not make the extent and scope of the work sufficiently accurate to permit me to make an accurate bid, and therefore you deceived me.' Senator BONE. In a sense then, he is to all intents and purposes an employee of the Navy Department? I don't use that in an invidious sense. He becomes their employee and instead of paying salary and wages you give him a certain amount of money. For $750,000 you do all this work? Admiral MOREELL. Yes, sir. Senator BONE. I have another question, which has interested me very much. You brought it up the other day. Suppose I am a contractor with the equipment and staff and my skeleton staff and the padding I can give it, in order to do a good job, and I am tendered one of these pieces of work and I do it. I do not have all the necessary machinery. We will assume that I have to get some bulldozers, steam shovels, and some heavy cutting |