Buying the last procurement

[This post was originally published on June 28, 2023.]

There's a famous proverb that generals are always preparing to fight the last war. Similarly, one way to think about government contracting is that the government is always preparing to buy the last procurement. Today, we discuss an example of how the government learns — and sometimes overlearns — from its past procurement.

In the late 1990s, as part of a broader set of reforms aimed at rooting out fraud, waste, and abuse in defense inventory management, the Defense Logistics Agency (DLA) started to adopt a practice that it called the "prime vendor program." Here's the basic idea:

1. The government needs to buy a bunch of stuff from a bunch of different suppliers. This is a huge pain for the government because, normally, the government would need to negotiate a bunch of contracts and make sure that the government manages a bunch of inventory. All of the suppliers likely have different ordering terms and conditions and shipping expectations. And sometimes, internal government customers have unreasonable demands. It's a huge pain!
2. What would be better for the government is for the government to instead just buy a bunch of stuff from one company — a prime vendor — that then handles all of the negotiation with the different suppliers and that manages the inventory. And even better for the government is that the internal customers can have more predictable deliveries![1]

A problem, though, with having a prime vendor is that the prime vendor will actually handle all of the negotiation with the different suppliers and manage the inventory for the government. In other words, a prime vendor is a middleman, and middlemen charge for their services! In fact, stretching back to 2000, one of the big concerns about prime vendors has been perceptions about inflated item prices.

Still, one of the theoretical benefits of using a prime vendor is that it can leverage its buying power and create efficiencies to reduce costs. In the consumer experience, this is pretty well established. If you need evidence, look no further than Walmart, which by 1999 became the largest retailer in the world on the promise of everyday low prices achieved through vertical integration and large purchasing power. Even after a prime vendor adds its price markup to an item, an effective prime vendor can frequently offer a lower price to the government.

Which brings us to a recent GAO decision involving DLA and the procurement of "commercial maintenance, repair, and operation supplies and incidental services" for military operations.

Like traditional prime-vendor contracts, DLA expected the prime vendor to be "responsible for supplying all products listed in the solicitation’s price evaluation list." Also like a traditional prime-vendor contract, DLA recognized that the price of a product would include two elements: (1) the prime vendor's acquisition price and (2) the prime vendor's markup on the product.

And here's where things start to get interesting.

One of the things that DLA realized over time is that beyond efficiencies that show up in lower markups, when prime vendors get discounts and rebates on specific products, they don't always pass those savings on to the government. How dare they?! Economists might argue that the competition can address that concern, but ... shrug? Wouldn't it all just be better for the government if the government could realize those discount and rebate savings directly from their prime vendors!

So, DLA included a requirement in the solicitation for prime vendors to be as "aggressive as possible in pursuing all discounts and rebates on items ordered" and to "pass all discounts and rebates so obtained through to the Government in the form of an up-front reduction in the acquisition price of the items." Now the government gets all of those savings!

Problem solved, right?

Well, no. Problem not solved because the solicitation left in a loophole: affiliate markups. The way an affiliate markup works is that a prime vendor, instead of the paying a discount for a product, pays the full price for a product to an affiliate and then later the affiliate pays some sort of commission or fee to the prime vendor for all of the products that the affiliate sold to the prime vendor. Now it's not a discount or a rebate: it's just a commission!

So, DLA got hip to that, and included an amendment to its solicitation:

The prime vendor shall not collect any sort of discount, rebate, fee, payment, remittance, or other thing of value from its suppliers and/or subcontractors related to products or incidental services purchased to fulfill delivery order line items under this contract without immediately tendering the full value of those fees, payments, or other things of value to the Government, in the form of a reduction to the acquisition price of the line item and a corresponding downward adjustment to the distribution fee price for the line item (where applicable).

Huzzah! Problem solved, right?

Well no. Problem not solved because then one of the potential prime vendors filed a protest arguing that the terms of the solicitation were not consistent with "customary commercial practice," in violation of the Federal Acquisition Regulations. Sure enough, DLA clearly recognized that the terms of the solicitation were inconsistent with customary commercial practice because it decided to take corrective action.

Readers here might guess how the corrective action went: DLA's simply waived the requirement that it follow customary commercial practices and issued a new amendment that eliminated another loophole — prompt payment discounts — to boot! Problem solved!

Well no. Problem not solved! Because now two protestors argued that the waiver and the prompt-payment discount terms were unlawful.

Under the FAR, waivers are allowable if they "describe the customary commercial practice found in the marketplace, support the need to include a term or condition that is inconsistent with that practice, and include a determination that the use of the customary commercial practice is inconsistent with the needs of the government." And GAO doesn't really second guess a waiver unless it is unreasonable.

The protestors, though, argued that the waivers were unreasonable because "a 'prompt payment discount' differs from other discounts and rebates" and that "prohibiting affiliate mark-ups deprives all parties of certain benefits of the bargain."

And, again, from an economics perspective, that kind of makes sense? If the prime vendor has to pass all discounts to the government, why would the prime vendor pursue the discounts in the first place? What's in it for the prime vendor to "aggressively pursue" discounts and rebates if the prime vendor doesn't take a cut? It's even possible that the government will pay more because the prime vendor can't smooth costs across different products, etc. etc.

But whatever... GAO ultimately upheld the waiver because, well, the government was worried about fraud, waste, and abuse again! Here's what the agency wrote in its waiver, and yeah, the waiver is the result of "buying the last procurement":

Absent such requirements, it is possible for a Prime Vendor to artificially increase the acquisition price of an item to the detriment of the Government and the taxpayer, while receiving discounts, rebates, and/or other remittances from its supply sources to augment its profits without the Government’s knowledge. It is also possible for a Prime Vendor to utilize an affiliate to source supplies, while inflating the acquisition price charged for an item or service through a discretionary mark-up imposed by that affiliate, potentially at the direction of the Prime Vendor and/or its principals, to the detriment of the Government and the benefit of the Prime Vendor, the affiliate, and/or their principals.

And how might the government know that it's possible to artificially increase the acquisition price of an item to the detriment of the Government and the taxpayer? Here's the GAO:

In support of this rationale, the waiver enumerates DLA’s past encounters with these problems. For example, in 2017, Public Warehousing Company, K.S.C., a prime vendor under DLA’s subsistence provision program, pled guilty to inflating the price of a supplied product by including charges from a supplier that had already been billed to other entities. In another example, in 2014, Supreme Foodservice, GMBH, a subsistence prime vendor, pled guilty to perpetrating a fraud against the government through a concealed affiliate mark-up of the acquisition price.

Oh sure. Sure. The government learned that prime vendors' use of affiliates can lead to higher prices because the government has been previously defrauded by prime vendors![2] I mean, POGO has even written exposes on these sorts of abuses. Ha!

So, based on that lived experience of prime vendors charging higher prices by concealing affiliate markups, GAO concluded that agency’s decision to "include certain pricing provisions intended to ensure pricing transparency and to avoid possibly fraudulent business practices" to be reasonable.

Protests denied. Problem solved, right?

Yes. Finally yes. Problem solved.

Until, that is, the next procurement...

[1] As I was writing this I couldn't help but wonder the concept of a Prime Vendor as a logistics intermediary is why Amazon called its ordering membership "Amazon Prime". I think maybe it is? Maybe? That said, I've done no research to confirm or deny it, so maybe don't quote me on that.

[2] The DOJ press release for the 2017 conviction of Public Warehousing Co. KSC does a pretty good job of explaining the scheme: "Agility and TSC knowingly overcharged the Department of Defense for locally available fresh fruits and vegetables that Agility purchased through TSC, and falsely charged the full amount of TSC’s invoices despite agreeing that Agility would pay 10 percent less than the amount billed. The United States also alleged that Agility failed to disclose and pass through rebates and discounts it obtained from U.S.-based suppliers, as required by its contracts."