* Industry asked to take on more F-35 production risk
* Lockheed cites potential liability in earnings report
* Lockheed, Northrop cite need for government funding
By Andrea Shalal-Esa and Karen Jacobs
WASHINGTON/ATLANTA, Oct 26 (Reuters) - After months of grumbling behind the scenes, U.S. arms makers are now publicly criticizing Pentagon plans to change the way it buys weapons and make industry shoulder more of the risks of development.
No. 1 U.S. defense contractor Lockheed Martin Corp used its quarterly earnings report to flag concerns about what it called an "unprecedented" move by the Defense Department's push to make the company pay for design changes in the F-35 fighter jet that come up during developmental testing, which is continuing even as the plane has already entered production.
Lockheed said the company needed funding to cover costs associated with the next production lot of F-35 planes, but Pentagon officials said such funding would be contingent on the company agreeing to be responsible for certain costs of changes arising from testing, under a "concurrency clause."
Chief Executive Robert Stevens told reporters after the earnings release on Wednesday that Lockheed would be reluctant to accept "unbounded liabilities for unpredictable or unknown events."
"I think the problem for industry everywhere would be ... to have a requirement or a responsibility to be accountable for things that aren't known, that you can't predict, that no one can reasonably at this time look forward and either schedule or define or articulate in some way," Stevens said.
Lockheed's F-35, or Joint Strike Fighter program, has been under tough scrutiny since it is the largest U.S. weapons program and has already seen costs rise sharply over the past 10 years -- making it a prime target for future cuts.
Officials estimate it will cost $382 billion to develop and build 2,447 of the radar-evading fighter jets for the U.S. military.
The F-35 may be a bellwether for the fate of other weapons programs as arms makers brace for up to $1 trillion in defense spending cuts over the next decade.
And Lockheed's frustration with Pentagon contract negotiations reflects growing unease across the industry.
"The defense industry has grown accustomed to certain kinds of terms and profits over the last 10 years and it simply isn't willing to sign up to the tougher conditions that the Pentagon is now imposing," said defense consultant Loren Thompson.
"There's no way that a company could sign up for unbounded risk; shareholders wouldn't stand for it," he said.
Lockheed said in its earnings report that it faces millions in potential termination liability for work it has funded should additional government funds not come for the next batch of F-35 production jets.
Wes Bush, chief executive of Northrop Grumman Corp , a key supplier on the F-35, said it was crucial to get the next production contract funded to keep the program and its entire supply chain on track.
"We're not in the business of financing these programs so there comes a limit in everyone's capacity to deal with that," Bush said during Northrop's earnings call, citing a "strong alignment" across industry on the issue.
A spokesman for the Pentagon's F-35 program office on Wednesday said the department had cut the number of planes to be bought under the fifth batch by four planes to 30, to help fund cost overruns and the cost of design changes that arose from testing on the first four production lots.
The change will reduce the value of the contract by hundreds of millions of dollars.
Proposed contract changes have also drawn the ire of contractors bidding to build Humvee replacements for the Army: Britain's BAE Systems Plc , which is also a major supplier on the F-35, Navistar International Corp , General Dynamics Corp , AM General and Lockheed.
Sources say several companies are considering withdrawing from the Army's Joint Light Tactical Vehicle competition if the Army does not change draft requirements issued this month.
Arms makers and their backers on Capitol Hill are growing increasingly worried that the Pentagon's aggressive acquisition reforms and cost-cutting measures could undercut the long-term health of the defense industry, which is already facing a dearth of new programs due to budget-cutting.
House Armed Services Committee Chairman Howard McKeon and the top Democrat on the panel met with Pentagon acquisition officials and the head of the F-35 program office, Vice Admiral David Venlet, this week to share their concerns about how they were trying to structure the next F-35 contract.
The F-35 program office responded to that meeting and others by telling Lockheed late on Tuesday that it recognized the need to cap the company's exposure and would no longer insist on Lockheed paying for all concurrency-related changes, one source familiar with the issue told Reuters.
Lockheed officials say they are anxious to begin formal negotiations on the next batch of F-35 production jets after Shay Assad, director of defense pricing, completes a review next week of what the planes should cost.
The Pentagon's F-35 program office responded to Lockheed's comments on Wednesday by saying it was continuing to work in "good faith" with the company to reach a deal.
Joe DellaVedova, spokesman for the F-35 office, said the government paid for "concurrent recurring costs" in all four previous low-rate production contracts.
But a new Pentagon acquisition memorandum dated Aug. 19 required the next contract to "reflect a reasonable allocation for Lockheed Martin to share in the concurrence risk associated with achieving F-35 configuration and capability requirements," he said.
"The government remains committed to securing a fair agreement with Lockheed Martin to share in concurrent costs. This agreement, or undefinitized contract, will happen in advance of the negotiated final contract," he said.