Background

The shipbuilding industry in the United States is predominantly composed  of three different types of shipyards: (1) privately owned shipyards that  build naval vessels; (2) small privately owned shipyards that build  commercial vessels; and (3) U.S. government-owned naval shipyards that  conduct maintenance, repairs, and upgrades on Navy and Coast Guard  vessels. As a result of consolidation, two major corporations—General  Dynamics and Northrop Grumman—own most of the private shipyards  that build Navy ships. General Dynamics owns Bath Iron Works in Bath,  Maine; Electric Boat in Groton, Connecticut, and Quonset Point, Rhode  Island; and NASSCO in San Diego, California. Northrop Grumman owns  Northrop Grumman Shipbuilding–Gulf Coast with locations in Pascagoula,  Mississippi, and New Orleans, Louisiana; and Northrop Grumman  Shipbuilding–Newport News in Virginia. Some of these shipyards maintain  additional support facilities in other locations to assist in production  processes, such as Gulf Coast’s Gulfport, Mississippi facility that  constructs lightweight ship components also known as composites. Along  with these five major shipyards, there are two midsized shipyards that  construct smaller Navy ships. Marinette Marine Corporation in Marinette,  Wisconsin, is owned by the Italian shipbuilder Fincantieri, and Austal USA  in Mobile, Alabama, is owned by Austal, which is headquartered in  Western Australia. Figure 1 shows the location and the current product  lines of each shipyard.
Several of these shipyards have specialized production capabilities that  constrain and dictate the types of vessels each can build and limit  opportunities for competition within the shipbuilding sector. For instance,  of the five major shipyards, only Newport News is capable of building  nuclear-powered aircraft carriers, and only Newport News and Electric  Boat have facilities for constructing nuclear submarines. Furthermore, of  the five major shipyards, only NASSCO builds commercial ships alongside  Navy ships. It typically builds Navy auxiliary ships, such as the T-AKE  class of dry cargo / ammunition vessels, that share similarities with  commercial ships, and, according to the shipbuilder, production processes  and equipment are shared between the two types of projects.
When the Navy contracts with these shipyards, it must follow provisions in  the Federal Acquisition Regulation (FAR), which establishes uniform  policies and procedures for acquisition by all executive agencies. In  addition, the Cost Accounting Standards provide uniformity and  consistency in cost accounting practices across government contracts. As  a general policy under the FAR, contractors are usually required to furnish  all facilities and equipment necessary to perform government contracts.  However, in specific situations, including when it is clearly demonstrated  that it is in the government’s best interest or when government  requirements cannot otherwise be met, the government may provide  government property to contractors to perform a contract. For example,  as part of the DDG 1000 destroyer contract, the Navy included a  requirement for Bath Iron Works to purchase unique equipment necessary  to produce the DDG 1000. This equipment was acquired as government  property because the equipment is unique to DDG 1000 construction and  the contractor is unlikely to use it to perform another contract.
When a contractor furnishes facilities and equipment to perform a  contract, the government recognizes the costs associated with these items  by paying depreciation and facilities capital cost of money costs allocated  to the contract. Depreciation and facilities capital cost of money costs are  indirect contract costs, or costs incurred for the general operation of the  business that are not specifically applicable to one product line or  contract. The FAR, in conjunction with the Cost Accounting Standards,  includes provisions for how a contractor recovers costs such as  depreciation and facilities capital cost of money as part of indirect  contract costs allocated to government contracts. By recovering  depreciation costs, the contractor recoups the cost of an asset—a facility  or a piece of equipment—over the asset’s estimated useful life. Facilities  capital cost of money acknowledges the opportunity cost for a contractor  when it uses its funds to invest in facilities and equipment in lieu of other  investments such as relatively risk-free bonds. Facilities capital cost of  money is determined by multiplying the net book value of the contractor’s  capital assets by a cost-of-money rate, which is a rate tied to the U.S.  treasury rate.
With respect to Navy shipbuilding, a shipyard’s indirect costs, including  depreciation and facilities capital cost of money, are allocated to the  Navy’s shipbuilding contracts at the shipyard in accordance with the Cost  Accounting Standards. When a shipyard makes facilities and equipment  investments, all ships under contract during the life of those assets are  allocated a portion of the assets’ indirect costs. Therefore, if the number of  ships under construction at a given time in a shipyard increases, the  indirect costs per ship decrease, and if the number of ships under  construction at a given time in a shipyard decreases, the indirect costs per  ship increase.

	Private Shipyards Made Investments to Improve, Upgrade, and Maintain Facilities and Equipment over the Last 10 Years

Over the last 10 years, major shipyards used public and corporate funds to  invest more than $1.9 billion in facilities and equipment that improved  shipbuilding efficiency, developed new capabilities, and maintained  existing capabilities. Figure 2 shows the amount of money invested in each  category.
These categories are defined as follows:  Improving shipbuilding efficiency. Investments in improving  shipbuilding efficiency generally reduce the number of hours shipbuilders  spend on a given task, and often allow shipbuilders to reorder the  sequence of shipbuilding work to achieve new efficiencies. For example,  investments in improving efficiency can make it possible for shipbuilders  to complete more work in specially-designed workshops and modular  assembly buildings, thus having to complete less of the work later on in  the shipbuilding process inside the more constrained environments of  almost-completed areas of the ship. To illustrate how these investments  improve efficiency, shipyard officials often describe the “1-3-8 rule of  thumb” of shipbuilding work: work that takes 1 hour to complete in a  workshop, takes 3 hours to complete once the steel panels have been  welded into units (sometimes called modules), and 8 hours to complete  after a block has been erected or after the ship has been launched. For  example, inside the recently-constructed Ultra Hall at Bath Iron Works,  shipbuilders can now access work spaces more easily in a climate- controlled environment allowing them to finish units at a higher stage of  completion before they are erected and then moved into the water. Figure  water. Figure  3 is a photo of a unit being moved out of the Ultra Hall.  3 is a photo of a unit being moved out of the Ultra Hall.
Developing new capabilities. Shipyards make investments to develop new  capabilities so that they can complete new types of tasks. In some cases,  shipyards need these new capabilities to meet the Navy’s technical  requirements for new ships. For example, to build a newly-designed  aircraft carrier with heavier metal plate requirements than those of  previous aircraft carriers, Newport News invested in new facilities and  equipment. These investments included building a heavy-plate facility, and  upgrading a crane to make it capable of lifting heavier modules. Other  shipyards also identified purchasing cranes as examples of investments to  develop new capabilities.
Maintaining capabilities. From time to time, shipyards make major  investments to replace or repair facilities and equipment. This allows the  shipyards to maintain existing capabilities for years or decades. For  example, Electric Boat officials explained that its shipyard had to make a  major investment in dock repair in order to maintain the shipyard’s ability  to launch and repair submarines.
Through investments to improve efficiencies and develop new capabilities,  major shipyards modernized their facilities and equipment, thus  transforming their shipbuilding processes. Some of these investments  completely changed the physical layouts of shipyards. For example, Bath  Iron Works completed a Land Level Transfer Facility in 2001, replacing an  inclined-way transfer facility used since 1890. Bath Iron Works officials  explained that with the Land Level Transfer Facility, the shipyard now has  the capability to construct ships in larger, more fully outfitted units on any  one of three construction lanes. The shipyard also has a floating dry dock  that it can move to any of the three construction lanes to transfer the ship  into the water. With this arrangement, the shipyard can better manage  when a ship is ready to be moved to the water. Another example includes  NASSCO’s facility expansion project, which fundamentally changed the  layout of the shipyard to increase production capacity, throughput, and  efficiency. In particular, NASSCO added new production lanes to reduce  shipyard congestion, allowing builders to move units around the shipyard  with reduced bottlenecks, and added a modern blast and paint facility to  improve paint process efficiency while reducing emissions. Finally,  Newport News built a new pier, thus increasing its capacity for servicing  and completing construction of aircraft carriers.
Table 1 shows selected investments at each major shipyard, sometimes  funded through public or corporate funds, over the last 10 years. These  selected investments highlight examples of projects by investment  category as well as the magnitude of some investments at shipyards.
Two midsized shipyards, Austal USA and Marinette Marine Corporation,  started construction of two different designs of the Littoral Combat Ship  for the Navy in 2005, and their investments have focused primarily on  maintaining shipyard capabilities and developing new capabilities in order  to compete for Navy contracts. Austal USA used both public and corporate  money to complete investments of approximately $155 million in facilities  and equipment since 1999, and Austal USA officials said these investments  were mostly to develop new capabilities to compete for Navy business.  For example, Austal USA officials said that to develop the capacity to  work on new Navy ships, their shipyard invested approximately $85  million to build the Modular Manufacturing Facility. Shipyard officials said  that with this facility, the yard constructs ships in a modular fashion to  maximize productivity, efficiency, and throughput. Marinette Marine  Corporation officials stated that investments over the last 10 years have  largely been to maintain capabilities, but the shipyard’s new owner,  Fincantieri, plans to make significant investments in the future.

	The Navy Supports Facilities and Equipment Investments by Offering Incentives at Most Major Shipyards and Has Expanded This Support over the Last 10 Years

To incentivize investments, the Navy has provided support to most major  shipyards with four mechanisms: early release of contract retentions,  accelerated depreciation, special contract-incentive fees, and contract  share-line adjustments. However, the Navy has not incentivized  investments at the two midsized shipyards. Navy officials cited the lack of  competition and instability of Navy work in shipbuilding as major reasons  why the Navy needs to incentivize investments in facilities and equipment  at major shipyards. At the shipyards, officials argued that they cannot  secure corporate support for many investments without Navy incentives.  Shipyard officials also pointed to instability in the Navy’s long-range  shipbuilding plans as a reason their shipyards usually do not pursue  investments without Navy support. Over the last 10 years, the Navy has  expanded its use of investment incentives and is now involved with  providing some form of investment support at all major shipyards.

		The Navy Negotiated Facilities and Equipment Incentives with Most Major Shipyards

The Navy has provided support to most major shipyards with four types of  investment incentives: early release of contract retentions, accelerated  depreciation, special contract-incentive fees, and share-line adjustment.
Early release of contract retentions. By releasing contract retentions  early, the Navy disburses money to a shipyard earlier than scheduled from  a reserve normally retained to ensure ships are delivered according to  specifications. For example, instead of holding 3.75 percent of the contract  payments in retentions, the Navy might hold only 1.5 percent of the  contract payments, releasing the remaining 2.25 percent early to a  shipyard in exchange for the shipyard investing in facilities or equipment.  Navy officials said that with this incentive, the Navy does not provide  additional funds to the shipyard, but rather provides funds to the  contractor it would receive anyway upon successful completion of the  contract. Shipbuilders said the early release of contract retentions  provides funds with which the shipyard can make investments that it  might otherwise not be able to make. The early release of contract  retentions may fund the entire capital investment or a portion of the  investment.
Accelerated depreciation. When accelerating depreciation, the Navy pays  the shipyard higher payments for depreciation of an asset over a shortened  timeline than under a normal depreciation payment schedule. In exchange,  the shipyard agrees to fund the investment. This benefits the shipyard  because it recoups its investment faster than it would have under a normal  depreciation schedule. For example, if a shipyard asset has a useful life of  9 years, the shipyard recoups a portion of the investment each year over  that span. However, if an incentive agreement accelerated the depreciation  schedule, the shipyard would receive larger payments earlier and over  fewer years. Navy and shipbuilding officials explained that this kind of  incentive can help bridge a gap between an investment’s expected rate of  return and the corporation’s desired rate of return to help justify making  an investment. See table 2 for a comparison of normal and accelerated  straight-line depreciation.
Special contract-incentive fee. While incentive fees are used in contracts  across the Department of Defense generally to motivate contractor efforts,  the Navy also uses special contract-incentive fees to specifically  encourage investments in facilities and equipment. On a contract that  includes such a special incentive fee, a shipyard may earn a fee for making  an investment. This special fee is available to the shipyard only if it agrees  to make a Navy-approved investment. The special fee may pay for all or  part of the investment. In some cases, the incentive bridges the difference  between the corporation’s desired rate of return and the projected return  on an investment.
Contract Share-Line Adjustment. The contract share-line defines what  share of underruns or overruns will accrue to the contractor and the Navy.  By adjusting the contract share-line ratio, the Navy can incentivize a  contractor to invest in facilities or equipment that will reduce costs. For  example, during original contract negotiations for a fixed-price incentive  or cost-plus incentive contract, the two parties may agree to an even share  of the savings if the total negotiated or allowable cost ends up being less  than the total target cost. Through a contract modification, the Navy could  change the original sharing ratio so that more of the savings are given to  the contractor. Under this modification, the contractor is incentivized to  invest in a facility or equipment that may reduce costs so that it earns a  higher fee. The Navy will benefit from these lower costs on all future  contracts. See figure 4 for an example of a share line adjustment.
The Navy also manages Hurricane Katrina relief funds, which Congress  appropriated for infrastructure improvements at shipyards that build Navy  ships in states affected by Hurricane Katrina. This support differs from  incentive programs at other shipyards because it is direct federal funding  and is not tied to a specific Navy shipbuilding program. These funds were  not directed to repairing specific damage from the hurricane, but can be  used for a variety of projects at eligible shipyards.
Table 3 provides an overview of investment incentive mechanisms and  how the Navy has used each incentive to support investments at shipyards.  Appendix II includes additional details of the investment incentives at  each shipyard.
The Navy has not negotiated investment incentives at the two midsized  shipyards, Austal USA and Marinette Marine Corporation, which are both  competing for the Littoral Combat Ship contract, though both received  other forms of federal government support for facilities and equipment  investments. Both shipyards received grants from the U.S. Department of  Transportation’s Maritime Administration, which are available to small  shipyards for capital and related improvements that foster efficiency and  competitive operations. For example, Marinette Marine Corporation  officials said that their shipyard received $1.4 million to help finance  investments for new cranes. In addition, Austal received almost $34  million of federal Hurricane Katrina funds to help finance its Modular  Manufacturing Facility. Both midsized shipyards have plans for further  expansions, but as of now, neither shipyard plans to request Navy  investment incentives to execute these plans.

		Incentives May Encourage Major Shipyards to Make Facilities and Equipment Investments That They Might Not Make on Their Own

Navy officials, shipyard officials, and corporate officials from Northrop  Grumman and General Dynamics provided different perspectives on  reasons for using incentives to encourage investment in the Navy  shipbuilding market.
Navy officials told us that the Navy negotiates investment incentives with  major shipyards because limited competition in the market does not foster  an environment that encourages shipyards to invest without incentives.  For example, Newport News is the only shipyard capable of building  aircraft carriers. A Navy contracting officer said that, as a result, there may  be a disincentive for Newport News to invest in projects that improve  efficiency. Generally speaking, at contract negotiation, the government’s  proposed contractor fee is based on a percentage of total estimated  allowable contract costs, with the percentage reflecting various weighted  risk factors. Newport News, as a sole supplier, will likely construct all  future aircraft carriers but could earn a lower fee if new efficiencies  reduce the total cost of construction. Even in cases where there is  limited shipbuilding competition, such as with surface combatants,  shipyards may face similar disincentives to invest. If the shipyard invests  to improve efficiency, these investments will likely reduce the price of a  ship and can lower future profits. However, where some competition  exists, better efficiency may lead to winning a greater allocation of future  work. Navy officials added that shipyards that are not confident Navy  work will materialize or be funded as scheduled are reluctant to make  capital investments without government incentives.
Officials from major shipyards argued that instability in long-range Navy  shipbuilding plans discourages shipyards from making investments  without guaranteed Navy work. Because major shipyards generally do not  perform commercial work, there are few other inducements to invest in  new facilities and equipment other than Navy shipbuilding opportunities.  For example, at one shipyard, an official explained that it had invested in a  facility in anticipation of an upcoming contract. The Navy changed the  shipbuilding program and did not award the contract, rendering this  facility underutilized until receipt of another contract several years later.  The official emphasized that this shipyard will never invest again in new  facilities without a signed contract guaranteeing future work. The official  added that to do otherwise would not be a prudent business decision.
Officials from major shipyards also argued that their shipyards need Navy  incentives because many potential investments in facilities and equipment  do not meet the corporation’s desired rate of return. In addition, some  shipyard officials stated that since they cannot secure corporate  investments for many projects, they often looked first for state or federal  support for new investments to help to bridge the gap between their  corporation’s desired rate of return and the expected rate of return of the  investment.
Corporate officials argued that the low rates of shipbuilding production,  low shipbuilding fees relative to invested capital, and length of time it  takes to build a ship sometimes mean investments take too long to  generate an acceptable return, or will never generate an acceptable return.  Moreover, officials stated that shipyard investments are large, sometimes  exceeding $25 million for a single investment. Furthermore, other sectors  of these corporations are often better positioned than shipyards to  propose investments that achieve the corporation’s desired rate of return  because these sectors can use less expensive investments to improve  processes for high-volume products. Corporate officials agreed that  corporations would generally make investments in maintaining  capabilities without meeting a corporation’s desired rate of return because  these investments are necessary to stay in business.

		The Navy Increased Support for Investments at Major Shipyards over the Past 10 Years, Generally by Expanding the Use of Investment Incentives

Over the past 10 years, the Navy has moved from providing onetime  support of major capital investments to more routine support of  investment spending at all five major shipyards. In 2000, Bath Iron Works  was in the process of completing construction of its Land Level Transfer  Facility, which was an investment that the Navy incentivized through early  release of contract retentions. Since then, the Navy has used investment  incentives to facilitate facilities and equipment investments at four of the  five major shipyards, across multiple shipbuilding programs. At the fifth  major shipyard, Gulf Coast, the Navy administered Hurricane Katrina  recovery money to support investments. Since 2007, the Navy has actively  supported investments at all major shipyards with investment incentives  or Hurricane Katrina recovery funding. Figure 5 shows the Navy’s  expanded support to private shipyards over the last 10 years.
Senior-level Navy officials stated that negotiating facilities and equipment  incentives are becoming a routine part of contract negotiations, but  officials expressed different opinions over which mechanisms are most  useful. While the Navy has used early release of retentions and accelerated  depreciation throughout the past 10 years, it has recently started to  negotiate special contract-incentive fees during contract negotiation as a  part of its cost-control strategy, such as during the Virginia-class  submarine Block II and Block III contract negotiations. Senior-level Navy  officials have differing views on whether it is better to include incentives  as part of a contract or to negotiate after the Navy awards a contract. One  contracting officer observed that the length of time involved in obtaining  the required Cost Accounting Standards Board waiver for accelerated  depreciation may have led officials to pursue other investment incentives.
Potential exists that contractors may ask the Navy and other services to  expand the scope of current incentive activities. Shipyards have already  started to request incentives for a variety of projects outside of  investments in facilities and equipment, and a shipyard recently requested  funding assistance for lean six-sigma process-improvement training. In  addition, the T-AKE contract includes a cost-reduction initiative in which  the Navy paid for projects that reduced costs through design and  producibility improvements, but did not require new investments in  facilities or equipment. Moreover, we were told by one company that  corporate divisions supporting other government-related product lines  have expressed interest in these types of facilities and equipment  incentives.

	The Navy Lacks a Policy to Ensure Investment Incentives Achieve Expected Outcomes

The Navy does not have a policy outlining its goals and objectives for  providing financial incentives to shipyards to encourage facilities and  equipment investments. Without such a policy, the Navy has not identified  if there is a minimum return on investment expected for this support and  the kinds of investments that are in the best interest of the Navy to  support. The Navy has also not considered the extent to which investment  incentives affect depreciation and facilities capital cost of money at  shipyards. Navy officials also lack guidance on how to validate outcomes  and safeguard financial interests, thus resulting in varying approaches  across programs.

		The Navy Has Not Defined Objectives for Providing Investment Support to a Shipyard

In a 2008 report to Congress, the Navy recognized a need to clarify its  priorities and objectives for supporting investments at shipyards, but has  not yet developed this clarifying guidance. Navy officials stated that  program offices and contracting officers negotiate incentives on a  program-by-program basis and there is no guidance on which investment  mechanism is appropriate under which circumstances. Use of special  contract incentives fees is becoming common, yet some Navy officials  suggested that adjustments in contract terms such as a share-line  adjustment provide a strong incentive for successful program  implementation.
While reducing cost is the goal of many facilities and equipment  investment incentives, the Navy does not define a metric or minimum  desired level for these reductions in cost. This results in differences in  expected outcomes across investment mechanisms. Table 4 highlights  variations in the types of expected outcomes with examples by shipyard,  investment, and investment mechanism. Given the variation in the  expected outcomes, it is difficult to ascertain if the Navy has a minimum  return it expects to receive by providing financial support or if just any  return is sufficient. the Contractor shall be eligible to receive a special incentive based upon the Contractor  and/or Major Subcontractor Newport News Shipbuilding investing in such projects that  result in savings to the Government for the submarines under this contract and long term  savings to the Government for the Virginia Class submarine program.
As a result of this contract language, the contractors are not required to  include return on investment calculations, calculate the net present value  of savings on future submarines, or consider the share-line ratio to  calculate actual savings to the government. Reviewing officials stated that  even when contractors included return-on-investment calculations in the  business cases, the officials did not review it because such calculations  were not required in the contract language. The contracting officer  responsible for managing Virginia-class submarine CAPEX stated that this  contract language is too vague concerning when to approve or disapprove  a project based on estimated savings, and if a similar incentive is used  again, the contract should include criteria for when to approve or  disapprove a project. To illustrate, the contracting officer stated that a  contractor submitted a business case under Block II CAPEX for a project  expected to cost $4 million with $10,000 in expected savings on Block II  submarines and additional saving accruing on future submarines beyond  Block II. The contracting officer stated that the Navy did not approve the  project because the expected savings on Block II were so low, but such a  decision was difficult to support based on the contract language.
Individual program offices and contracting officers also make decisions  about which types of investments to pursue, without any policy from the  Navy about the kinds of investments that are in its best interest. Most of  the investments the Navy supported fall into the category of improving  efficiency at the shipyards. Some of the more recent investments,  however, could also be considered as maintaining or developing  capabilities at the shipyards. It is unclear whether or not the Navy has  determined that these investments are in fact in its best interest. For  example, according to officials, the Virginia-class submarine Block II and  Block III clauses do not prohibit approving maintenance projects as long  as these projects generate cost savings. In 2009, the Navy paid a special  contract-incentive fee to Electric Boat to refurbish equipment past its  normal service life in order to prevent major failures that would result in  an injury or equipment damage and affect production schedules. In a  similar manner, Newport News submitted a business case to receive a  special contract-incentive fee to support repairs to its foundry, stating that  near-term investment was necessary because the average age of most of  the equipment is well past its average useful service life and at a high risk  of mechanical failure. The Navy did not approve this business case under  the Block II special contract incentive fee because Newport News was  unable to demonstrate savings on the Block II submarines, a stipulation in  the contract language. However, the Navy encouraged the shipyard to  resubmit the proposal if it could demonstrate savings on future submarine  construction. Such investments to maintain capabilities are likely to  generate some cost savings and may better position the shipyards to  increase submarine production rates, but some officials indicated that  such investments should actually be contractor responsibilities.

		The Navy Has Not Considered the Extent to Which Investment Incentives Affect Indirect Costs at Shipyards

The Navy also lacks policy on how to determine an incentivized  investment’s effect on indirect costs to the Navy. As the Navy is  incentivizing investments up front, it is unclear whether contractors  should be able to recover indirect costs associated with these assets  through depreciation and facilities capital cost of money. While the Navy  did not allow the contractor to recover depreciation and facilities capital  cost of money for investments supported with Hurricane Katrina funds,  some agreements explicitly provide that the contractor can recover costs  for incentivized facilities and equipment investments. However, Defense  Contract Audit Agency officials questioned a facilities capital cost of  money claim that one shipyard included in its indirect costs because the  Navy provided an incentive to construct the facility. Nonetheless, officials  concluded that the contractor could recover these costs from the Navy  because it was unclear in the terms of the contract, and neither the  Federal Acquisition Regulation nor the Cost Accounting Standards address  recovery of facilities capital cost of money for facilities receiving incentive  support. Defense Contract Audit Agency officials stated that they believe it  is unfair that contractors can recover facilities capital cost of money costs  on incentivized facilities and this issue needs to be reevaluated if the Navy  continues to incentivize investments.
In instances where the incentive agreement explicitly states that the  contractor can recover these long-term costs, officials evaluating business  cases stated that they do not always consider these long-term costs when  comparing the cost of the project with potential savings. Specifically, Navy  officials stated that they did not consider the effect of depreciation when  evaluating Virginia-class submarine Block II CAPEX projects.

		Differences Exist for Validating Expected Outcomes and Safeguarding Financial Interest If Expected Outcome Is Not Achieved

In the absence of Navy guidance, approaches vary by investment incentive  for validating whether or not a project achieves expected outcomes and  safeguarding Navy financial interest if a project does not achieve expected  outcomes. Some investment incentives require validation of anticipated  savings whereas others only require a validation of project construction  milestones. For example, officials described a lengthy review of savings  validation associated with the first Virginia-class submarine CAPEX Block  II project, but later indicated the process has evolved over time and other  validations have been more straightforward. According to Navy officials  managing the Virginia-class CAPEX incentive, the contract provides little  guidance on how to validate outcomes, so program officials developed the  current validation process after the contract was signed. However, the  CVN 21 program office did not validate anticipated savings after  investments were complete, but validated investments based on  construction milestones. Because the Navy negotiated a lower target cost  for the future carrier, Navy officials stated that it is not necessary to  validate the savings associated with these projects. These officials added  that it would be difficult to calculate an accurate baseline against which to  compare labor hours with and without the new investments because the  new carrier had never been constructed.
In the absence of a Navy policy, program and contracting officials also  negotiate various methods to safeguard the Navy’s financial interest in the  event that expected outcomes for the investment incentive are not  achieved. The range of methods is seen in table 5.
In addition to variation in the types of safeguards used across incentive  mechanisms, the Navy has used the same investment mechanism—early  release of contract retentions—for two different programs, but the  safeguarding mechanism differed. The Navy modified the terms of the  DDG 51 contract by negotiating changes to target price as a safeguard  when it agreed to support the Ultra Hall investment through early release  of contract retentions and payment of a special contract-incentive fee. In  comparison, when the Navy agreed to an early release of contract  retentions to support the facilities expansion project at NASSCO, program  officials stated that the Navy did not renegotiate the terms of the T-AKE  contract. In both instances, officials stated that the maturity of the DDG 51  and T-AKE programs were factors in deciding to release contract  retentions early; the Navy awarded Bath Iron Works the first DDG 51  destroyer contract in 1985 and NASSCO started construction of the T-AKE  class in 2003.

	Conclusions

Over the past 10 years, the Navy has expanded the use of investment  incentives to encourage shipyards to make investments that may reduce  costs of future ships. In a 2008 report to Congress, the Navy acknowledged  a need to clarify its priorities and objectives for providing investment  incentives to shipyards. However, the Navy has yet to do this, and the  absence of policy leaves the overall goals and intended outcomes of this  support unclear. Decisions about when a particular incentive should be  chosen, what returns are acceptable across programs, and what types of  investments the Navy should support are made on a case-by-case basis  without guidance. Also, it is unclear whether or not contractors should be  able to claim recovery for certain indirect costs related to assets  supported by incentive mechanisms. Further, given the absence of policy,  inconsistencies exist regarding the importance attached to validating  outcomes and how to safeguard the Navy’s financial support in the event  that the expected outcome is not achieved.

	Recommendations for Executive Action

We recommend that the Secretary of Defense direct the Secretary of the  Navy to develop a policy that identifies the intended goals and objectives  of investment incentives, criteria for using incentives, and methods for  validating outcomes.

	Agency Comments and Our Evaluation

The Department of Defense agreed with our recommendation to develop a  policy that identifies the intended goals and objectives of investment  incentives, criteria for using incentives, and methods for validating  outcomes. The department stated that the Navy intends to include  guidance for program managers and contracting officers in a Navy best-  practices guidebook.
The department’s written comments can be found in appendix III of this  report. The department also provided technical comments, which were  incorporated into the report as appropriate.
We are sending copies of this report to interested congressional  committees, the Secretary of Defense, and the Secretary of the Navy. The  report also is available at no charge on the GAO Web site at  http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-4841 or martinb@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. GAO staff who made major contributions to this report are  listed in appendix IV.

Appendix I: Scope and Methodology

To identify facilities and equipment investments over the last 10 years, we  obtained and analyzed data on all capital investments over $1 million at all  major, privately owned shipyards including General Dynamics Bath Iron  Works, General Dynamics NASSCO, General Dynamics Electric Boat,  Northrop Grumman Shipbuilding–Gulf Coast, Northrop Grumman  Shipbuilding–Newport News, and two smaller, privately owned shipyards,  Austal USA and Marinette Marine shipyard. We supplemented our analysis  of the data by interviewing officials at each shipyard to obtain an  understanding of the purpose of these investments. We then categorized  the investments at major shipyards into three groups, and shipyard  officials confirmed our categorization of the investments. In our analysis  we excluded some investments such as investments that exclusively  supported nuclear aircraft carrier and submarine refuelings,  modernizations, and service life extensions programs. We also excluded  information-technology investments and annual operating capital. To  assess the reliability of each shipyard’s data, we interviewed  knowledgeable shipyard officials about the data and confirmed that the  data are subject to external audits. We determined that the data were  sufficiently reliable for the purposes of this report. We also interviewed  officials at each shipyard’s Supervisor of Shipbuilding, Conversion, and  Repair to understand investments over the past 10 years and how those  investments may have affected each shipyard’s work flow and processes.  We also interviewed relevant Defense Contract Audit Agency officials at  major private shipyards.
To determine the role the Navy had in facilities and equipment  investments at privately owned shipyards, we reviewed shipbuilding  contracts, legislation making funds available for shipyards affected by  Hurricane Katrina, and Deputy Assistant Secretary of the Navy for Ship  Programs reports to Congress regarding capital-investment strategies at  shipyards. To assist with identifying when the Navy has provided support  for facilities and equipment investments, we held discussions with: the  CVN 21 program office; DDG 51 program office; Joint High Speed Vessel  program office; T-AKE program office; Virginia-class submarine program  office; Program Executive Office, Ships; Supervisor of Shipbuilding,  Conversion, and Repair (Bath, Groton, Gulf Coast, and Newport News);  and Naval Sea Systems Command–Contracts. After identifying which  mechanisms the Navy uses to provide support to shipyards for facilities  and equipment investments and when these investments were used, we  analyzed the data to determine any trends over the past 10 years. To  supplement this analysis, we met with officials from the Office of the  Deputy Assistant Secretary of the Navy–Ships, the Office of the Deputy  Assistant Secretary of the Navy–Acquisition and Logistics Management,  and the Office of the Secretary of Defense–Industrial Policy to understand  how the Navy’s role in investment support at shipyards has evolved over  the past 10 years. We also met with officials from General Dynamics  Marine Systems and Northrop Grumman Shipbuilding to understand their  corporate processes for when to make facilities and equipment  investments and how the Navy’s support is considered during that process.
To evaluate how the Navy ensures its role in facilities and equipment  investments results in expected outcomes, we reviewed shipyard business- case analyses and accompanying documents for Navy-supported projects  and analyzed approaches across programs to identify differences and  presence of formal validation of attainment of expected benefits. We  supplemented this analysis with interviews of officials responsible for  managing investment incentives including the CVN 21 program office; T- AKE program office; Virginia-class submarine program office; Program  Executive Office, Ships; Supervisor of Shipbuilding, Conversion, and  Repair (Bath, Groton, Gulf Coast, and Newport News).
We conducted this performance audit from October 2009 to July 2010 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives.

Appendix II: Overview of Private Shipyards and Summary of Navy Investment Incentives

	Austal USA

		Corporation and Location

Austal is an Australian-based company with a U.S. location in Mobile,  Alabama.

		Year Acquired (Corporation)

Austal USA is the Navy’s prime contractor for the Joint High Speed Vessel  and teamed with General Dynamics Bath Iron Works for construction of  the Littoral Combat Ship. The Navy has contracted with Austal USA for  three Joint High Speed Vessels and an option for seven more. The Navy  has also contracted with General Dynamics Bath Iron Works for two  Littoral Combat Ships built at Austal USA shipyard. Austal is currently  competing as the prime contractor for the next 10 Littoral Combat Ships.

		Navy Investment Incentives over the Past 10 Years

In June 2006, Congress enacted the Emergency Supplemental  Appropriations Act for Defense, the Global War on Terror, and Hurricane  Recovery, 2006, which included funding for infrastructure improvements  at Gulf Coast shipyards that had existing Navy shipbuilding contracts and  were damaged by Hurricane Katrina. Following this legislation, the  Assistant Secretary of the Navy for Research, Development and  Acquisition issued a memorandum that outlined goals for competitively  awarding the funding, provided general instructions for how contractors  should develop business cases supporting funding requests, and  established a panel to review contractor proposals for funding. The panel  awarded Austal USA a contract supporting construction of the Modular  Manufacturing Facility. Disbursement of funds from the Navy to Austal  USA was based upon completion of predetermined construction  milestones.

	Bath Iron Works

		Corporation and Location

Bath Iron Works operates facilities principally in Bath, Maine, and has  support facilities in Brunswick, Maine.

		Year Acquired (Corporation)

1995 (General Dynamics)

		Product Line

Bath Iron Works builds surface combatants including DDG 51 and DDG  1000.

		Navy Investment Incentives over the Past 10 Years

		Description of Investment Incentives

The Navy used early release of retentions to help support the Bath Iron  Works investments in a Land Level Transfer Facility.
The Navy supported Ultra Hall construction by modifying the terms of the  DDG 51 contract and adding three incentive mechanisms. As part of the  incentives, the Navy also negotiated a reduced maximum price for each  DDG 51 ship.
By releasing retentions early, corporate and shipyard officials stated that  the Navy helped Bath Iron Works, and its corporate owner General  Dynamics, avoid negative cash flows during construction, a primary  objective of the shipyard and corporate owner.
The addition of a special contract-incentive fee gave Bath Iron Works an  opportunity to earn additional profit by investing in the facility.
By changing the incentive fee structure, the Navy also gave Bath Iron  Works an incentive to achieve savings.

	Electric Boat

		Corporation and Location

Electric Boat operates two facilities in Groton, Connecticut, and Quonset  Point, Rhode Island.

		Year Acquired (Corporation)

1952 (General Dynamics)

		Product Line

General Dynamics Electric Boat is the Navy’s prime contractor for  Virginia-class submarines. Through a teaming agreement, Electric Boat  and Northrop Grumman Shipbuilding–Newport News work together to  build the submarines. Each contractor is responsible for building  designated sections and modules, and the contractors alternate final  assembly, outfitting, and delivery. To date, the Navy has contracted to  purchase submarines in three blocks. Block I includes four submarines,  Block II includes six submarines, and Block III includes eight submarines.

		Navy Investment Incentives over the Past 10 Years

		Description of Investment Incentives

In 2000, the Navy agreed to accelerate depreciation on five investments  over the course of the Virginia-class Block I contract.
In 2004, Electric Boat initiated funding long-term repair of three graving  docks. The Navy agreed to accelerate depreciation of the long-term repairs  to 16 years rather than over the docks’ entire useful life, expected to be  over 30 years.
The Virginia-class submarine Block II and Block III contracts include  special incentives to reward the contractor if it develops more efficient  and cost-effective practices that contribute to the production of more  affordable submarines. On both contracts, the contractor can claim a  special incentive for investing in facilities and process-improvement  projects. Since the submarines are built at both Electric Boat and Newport  News, both contractors can claim the incentive under these contracts.
Under the Block II contract, the contractor submits a business-case  analysis to the Supervisor of Shipbuilding, Groton. Within 30 days after  approval by the Supervisor of Shipbuilding and start of the project, the  Navy pays the contractor a special incentive not to exceed 50 percent of  the estimated investment cost. After the contractor successfully  implements the project as defined in the business-case analysis, the Navy  pays the contractor another special incentive not to exceed 50 percent of  the original estimated investment cost. The sum of the two incentive  payments cannot exceed 100 percent of the approved business-case  analysis estimated investment cost.
During the Block III contract negotiations, Newport News and Electric  Boat proposed facilities and equipment investments, and savings from  these investments were included in the target cost. For these investments,  the contractor submits a business case to claim a special incentive fee tied  to the first four submarines for the amount necessary to achieve the  documented corporate minimum return on investment. To claim a special  incentive fee for the last four submarines on the Block III contract, the  process mirrors the process under Block II. For these projects, the  incentive amount can equal up to 100 percent of the approved business- case analysis estimated investment cost.

	Marinette Marine Corporation

		Corporation and Location

Marinette Marine Corporation is located in Marinette, Wisconsin.

		Year Acquired (Corporation)

2008 (Fincantieri)

		Product Line

The Navy has contracted with Lockheed Martin for two Littoral Combat  Ships built at Marinette Marine shipyard. The Navy is currently holding a  competition for remaining Littoral Combat Ships.

		Navy Investment Incentives over the Past 10 Years

		Corporation and Location

NASSCO operates in San Diego, California.

		Year Acquired (Corporation)

1998 (General Dynamics)

		Product Line

NASSCO builds auxiliary ships including the T-AKE for Navy sealift  operations. In recent history, NASSCO’s work has been divided  approximately as follows: 60 percent new construction for the Navy, 20  percent repair work, and 20 percent new commercial construction.  NASSCO is the only major private shipyard to perform commercial work  along with Navy shipbuilding.

		Navy Investment Incentives over the Past 10 Years

		Description of Investment Incentives

The Navy used early release of contract retentions to incentivize  investments at NASSCO three times over the last 10 years. In 2001, the  Navy released retentions early to support the acquisition of new cranes. In  2006 and 2008, the Navy released retentions early to support investments  at NASSCO, including some support for investments that were part of  NASSCO’s facility expansion project. These investments included projects  to modernize the preoutfitting facilities such as expanding the M-Lane,  improving stage of construction 4 activities, and constructing a new blast  and paint facility. By releasing retentions early, the Navy helped NASSCO  maintain a positive cash flow while the shipyard made new investments,  NASSCO officials said.

	Northrop Grumman Shipbuilding–Gulf Coast

		Corporation and Location

Northrop Grumman Shipbuilding–Gulf Coast operates in Pascagoula,  Mississippi, and New Orleans, Louisiana, with other support facilities.

		Year Acquired (Corporation)

2001 (Northrop Grumman)

		Product Line

Surface combatants, amphibious assault ships, auxiliary ships, and Coast  Guard patrol boats (cutters)

		Navy Program Overview

Northrop Grumman Shipbuilding–Gulf Coast builds DDG 51 surface  combatants and the hangar, rear Peripheral Vertical Launching System,  and the composite deckhouse for DDG 1000 surface combatants. It is also  the prime contractor for the LPD 17 amphibious transport ship and the  LHA 6 amphibious assault ship.

		Navy Investment Incentives over the Past 10 Years

In June 2006, Congress enacted the Emergency Supplemental  Appropriations Act for Defense, the Global War on Terror, and Hurricane  Recovery, 2006, which included funding for infrastructure improvements  at Gulf Coast shipyards that had existing Navy shipbuilding contracts and  were damaged by Hurricane Katrina. Following this legislation, the  Assistant Secretary of the Navy for Research, Development and  Acquisition issued a memorandum that outlined goals for awarding the  funding, provided general instructions for how contractors should develop  business cases supporting funding requests, and established a panel to  review contractor proposals for funding. Northrop Grumman  Shipbuilding–Gulf Coast submitted several proposals for review and the  panel awarded this shipyard one contract supporting two separate  investments, with an option for a third. The contract includes funding to  support purchasing equipment for a panel line at the Pascagoula,  Mississippi, shipyard, an option for funding to support equipment for a  panel line at the New Orleans, Louisiana, shipyard, and special tooling for  the composite manufacturing facility in Gulfport, Mississippi.  Disbursement of funds from the Navy to Northrop Grumman  Shipbuilding–Gulf Coast is based upon completion of predetermined  construction milestones. To date, the Navy has expended 100 percent of  funding on the contract for the Pascagoula panel line, 0 percent of funding  on the contract for the Avondale panel line, and approximately 90 percent  of funding on the contract for the composite manufacturing facility. Navy  officials stated that funding for the Avondale panel line is contingent upon  Northrop Grumman Shipbuilding–Gulf Coast demonstrating returns on the  panel line in Pascagoula, Mississippi.

	Northrop Grumman Shipbuilding– Newport News

		Corporation and Location

Northrop Grumman Shipbuilding–Newport News operates in Newport  News, Virginia.

		Year Acquired (Corporation)

2001 (Northrop Grumman)

		Product Line

Northrop Grumman Shipbuilding–Newport News is the Navy’s prime  contractor for aircraft carriers and refueling and complex overhauls.  Newport News is currently constructing CVN 78, the lead ship of the new  CVN 21 class of nuclear-powered aircraft carriers.
Through a teaming agreement, Northrop Grumman Shipbuilding–Newport  News also works with General Dynamics Electric Boat to build the  Virginia-class submarines. Each contractor is responsible for building  designated sections and modules, and the contractors alternate final  assembly, outfitting, and delivery. To date, the Navy has contracted to  purchase submarines in three blocks. Block I includes four submarines,  Block II includes six submarines, and Block III includes eight submarines.

		Navy Investment Incentives Over the Past 10 Years

		Description of Investment Incentives

In 2003, the Navy and Newport News signed a memorandum of agreement  to accelerate depreciation of a new pier, known as Pier 3. Before  construction of Pier 3, Newport News had one pier where it could perform  work on aircraft carriers. This pier was in use for almost 60 years and  Newport News was planning to replace it in 2012. Due to a Navy  scheduling conflict, Newport News was going to have two aircraft carriers  that needed to be at this pier at the same time in fiscal year 2007. To  address the scheduling conflict, the Navy agreed to accelerate  depreciation of the new pier if Newport News accelerated its planned  timeline to construct the pier. Under this agreement, Newport News is  allowed to depreciate the pier over 7 years rather than over the estimated  useful life of the pier, expected to be 40 years.
Virginia-class submarine. The Virginia-class submarine Block II and  Block III contracts include special incentives to reward the contractor if it  develops more efficient and cost-effective practices that contribute to the  production of more affordable submarines. On both contracts, the  contractor can claim a special incentive for investing in facilities and  process-improvement projects. Since the submarines are built at both  Electric Boat and Newport News, both contractors can claim the incentive  under these contracts.
Under the Block II contract, the contractor submits a business-case  analysis to the Supervisor of Shipbuilding, Groton. Within 30 days after  approval by the Supervisor of Shipbuilding and start of the project, the  Navy pays the contractor a special incentive not to exceed 50 percent of  the estimated investment cost. After the contractor successfully  implements the project as defined in the business-case analysis, the Navy  pays the contractor another special incentive not to exceed 50 percent of  the original estimated investment cost. The sum of the two incentive  payments cannot exceed 100 percent of the approved business-case  analysis estimated investment cost.
During the Block III contract negotiations, Newport News and Electric  Boat proposed facilities and equipment investments, and savings from  these investments were included in the target cost of the contract. For  these investments, the contractor submits a business case to claim a  special incentive fee tied to the first four submarines for the amount  necessary to achieve the documented corporate minimum return on  investment. To claim a special incentive fee for the last four submarines  on the Block III contract, the process mirrors the process under Block II.  For these projects, the incentive amount can equal up to 100 percent of the  approved business-case analysis estimated investment cost.
CVN 78 Construction-Preparation Contract. The CVN 78 construction- preparation contract includes a special contract-incentive fee available to  Newport News if it invests in 10 facilities identified during contract  negotiations as investments that would contribute to reducing the  construction cost of CVN 21 aircraft carriers. The special contract  incentive fee for each facility is a portion of the total cost of the facility.  The Navy pays the special incentive fee for each facility based upon  Newport News’s progress constructing the facility. Newport News agreed  to include savings from these facilities in the construction proposal.

Appendix III: Comments from the Department of Defense

Appendix IV: GAO Contact and Staff Acknowledgments

	Staff Acknowledgments

In addition to the contact named above, Karen Zuckerstein (Assistant  Director), Matthew Butler, Kristine Hassinger, Michelle Liberatore, Aron  Szapiro, and Molly Traci made major contributions to this report.

Summary:
Why GAO Did This Study

As fiscal constraints increasingly shape Navy shipbuilding plans, the pressure to increase efficiency mounts. Modernizing facilities and equipment at shipyards that build Navy ships can lead to improved efficiency, ultimately reducing the cost of constructing ships. In response to a request from the House Appropriations Subcommittee on Defense, GAO (1) identified investments in facilities and equipment at privately-owned shipyards over the last 10 years; (2) determined the Navy's role in financing facilities and equipment investments at these shipyards; and (3) evaluated how the Navy ensures investments result in expected outcomes. To address these objectives, GAO analyzed shipyard investment data over the past 10 years; interviewed shipyard, corporate, and Navy officials; and reviewed contracts, investment business cases, and other Navy and contractor documents.

What GAO Found

Over the past 10 years, large shipyards that build Navy ships used public and corporate funds to invest over $1.9 billion in facilities and equipment to improve efficiency, develop new shipbuilding capabilities, and maintain existing capabilities. Examples of each category include the following: (1) Improving efficiency--General Dynamics Bath Iron Works built a new facility--the Ultra Hall--that improves efficiency by allowing shipbuilders to access work space more easily in a climate-controlled environment. (2) Developing capabilities--Northrop Grumman Shipbuilding-Newport News built a replacement pier that allowed shipbuilders to work on two aircraft carriers simultaneously due to a Navy scheduling conflict. (3) Maintaining capabilities--General Dynamics Electric Boat invested to repair docks in order to maintain the shipyard's ability to launch and repair submarines. Investments at two smaller shipyards, Austal USA and Marinette Marine shipyard, were primarily to maintain and develop new capabilities as both are competing for new Navy contracts. Over the last 10 years, the Navy expanded its use of investment incentives and has recently provided some form of investment support at all large shipyards. To incentivize facility and equipment investments, the Navy has (1) released money early from the reserve of contract funds normally held back to ensure ships are delivered according to specifications, (2) accelerated asset depreciation schedules, (3) tied a portion of the contractor's fee to investing in new facilities and equipment, and (4) adjusted the contract share-line to give the contractor more of the savings if costs decrease. The Navy also manages funds appropriated by Congress for Hurricane Katrina relief at shipyards in the Gulf Coast. Outside of Hurricane Katrina funding, the Navy has not supported investments at the two smaller shipyards. Navy officials stated that the Navy has to negotiate investment incentives with large shipyards because limited competition and instability of Navy work does not foster an environment for shipyards to invest without incentives. Shipyard officials argued that instability in Navy shipbuilding plans makes it difficult to invest without guaranteed work from the Navy and incentives are necessary to help meet corporate minimum rates of return needed to justify an investment, especially given the large dollar amounts involved with some investments. The Navy lacks policy to help ensure it achieves goals and objectives from providing facility and equipment investment incentives at private shipyards. Absent this policy, individual program offices and contracting officers make decisions about what type of incentive to use, desired return on investments, and what kinds of investments to support. Without policy, program officers and contracting officers use different methods to validate expected outcomes and safeguard the Navy's financial support.

What GAO Recommends

GAO recommends that the Navy develop a policy that identifies the intended goals and objectives of investment incentives, criteria for using incentives, and methods for validating outcomes. The Department of Defense concurred with this recommendation.