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Lockheed Cost Overruns on Early F-35s May Be as Much as 15%

Lockheed Martin Corp. (LMT)’s F-35 Joint Strike Fighter, the Pentagon’ most expensive weapons program, may face cost overruns of as much as 15 percent on early production models, U.S. Vice Admiral David Venlet said.

The plane’s expense may exceed the contracted target cost by $964 million in the worst-case scenario, Venlet said in an April 28 interview in Washington. The overrun is calculated on $6.43 billion in aircraft and engine costs for 28 planes, according to F-35 program data. The low end of the overrun estimate is 11 percent, or $707 million, he said.

The first three “low-rate initial” production contracts are cost-plus agreements that require the U.S. to pay most of an overrun. Venlet inherited these contracts when he was assigned last year by Defense Secretary Robert Gates to improve the $382 billion program’s cost, schedule and performance.

“These bills are not all due now,” Venlet said in the interview. “They are spread out over the delivery of the program, so to the best of my ability I’ve told leadership I am not going to cause pain to others, I’m going to try and resource those” inside the program.

The Pentagon won’t have to pay all of the amount exceeding the contract target because Bethesda, Maryland-based Lockheed will make up much of the cost by losing incentive fees, said Venlet, who is the Pentagon’s F-35 program manager.

“That’s a lot of money,” he said. “We believe we have access to funds to pay those bills, so it’s not going to drive the program into a ditch.”

‘Lockheed’s Pain’

“Where is Lockheed’s pain? It’s in the fee decrement,” he said. “As target cost overruns, the fee comes down.”

Lockheed Martin spokesman Mike Rein said the company confirms the higher cost stated by the government.

“Lockheed is absorbing approximately 30 percent of the overruns cost,” Rein said in an e-mail.

The worst-case scenario would cost Lockheed about $289 million if the 30 percent forfeiture were realized. This fee is separate from $614 million for development-phase performance fees that Gates set aside last year.

The higher expense comes primarily from changes in material requirements and labor costs, Rein said. Lockheed staff worked with the government on the overrun estimates.

Early Costs

The early aircraft costs reflect more than the price of the planes, engine and mission systems used to fly the jets. Other expenses include one-time costs such as buying production equipment and setting aside funds to address engineering changes and retrofits.

Early-production planes generally have higher costs due to initial tooling investments. As the program moves from development jets into production jets, the learning curve and other improvements will help drive down costs, Venlet said.

The first contract for two aircraft with United Technologies Corp. (UTX) engines is valued at $591 million and is estimated to have exceeded its cost target by 11 percent, Venlet said. The work is complete.

The second contract for 12 aircraft and engines is valued at $2.74 billion and is 80 percent complete. The third contract, for $3.69 billion, covers 16 aircraft and engines and is 60 percent complete.

Unlike the first three cost-plus contracts, Venlet in November accelerated use of a fixed-price contract that includes an incentive fee and requires Lockheed to share overruns.

“We are positively protected,” Venlet said.

Shared Savings

Lockheed would earn $441 million in profit from the fixed- cost contract if it meets the target of $3.46 billion for 32 jets, according to F-35 contract data. In this instance, Lockheed and the Pentagon would share equally any savings if the jets cost less to build than the target cost.

Similarly, they would share cost overruns up to 120 percent of that figure. The full burden would fall on Lockheed for overruns above that.

Venlet said 10 percent of the contract work is complete so there isn’t enough data to estimate performance trends yet.

Lockheed is scheduled to accomplish 30 percent of its contract work by December.

“Thirty percent ought to be enough work to start to see deviations,” he said.

To contact the reporter on this story: Tony Capaccio in Washington at acapaccio@bloomberg.net

To contact the editor responsible for this story: Ed Dufner at edufner@bloomberg.net

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