Navy and Coast Guard Shipbuilding: Navy Should Reconsider Approach to Warranties for Correcting Construction Defects
Published: 2016-03-03T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The U.S. government spends about $17 billion per year building ships to support national defense and homeland security. Defects often become evident shortly after a ship is delivered. Warranties and guarantees are both mechanisms to fix defects for which shipbuilders are responsible.
Warranties give the government a contractual right to direct the correction of defects at the contractor's expense.
Guarantees are Navy-specific contractual mechanisms that provide for the correction of defects; but unlike warranties are not covered in the FAR.
The House report accompanying the National Defense Authorization Act for Fiscal Year 2015 included a provision for GAO to review warranties and guarantees in government shipbuilding programs. This report assesses the extent to which (1) warranties and guarantees reduce the government's exposure to additional costs and risks of poor quality and (2) how the Navy and Coast Guard use acquisition regulations and guidance to implement warranties and guarantees. GAO reviewed the Navy's and Coast Guard's guaranty or warranty practices and policies and selected six case studies, comprised of four Navy ships—representing ships built in the last five years—and two vessels the Coast Guard most recently purchased.
section_title: What GAO Found
paragraphs: For five of the six Navy and Coast Guard ships GAO reviewed, guarantees did not help improve cost or quality outcomes. While the type and terms of each contract determine financial responsibility for correcting defects, the government, in most of the cases GAO examined, paid shipbuilders to repair defects. For the four ships with fixed-price incentive type contracts and guarantee clauses, the government paid the shipbuilder 89 percent of the cost—including profit—to correct these problems. This means the Navy and Coast Guard paid the shipbuilder to build the ship as part of the construction contract, and then paid the same shipbuilder again to repair the ship when defects were discovered after delivery—essentially rewarding the shipbuilder for delivering a ship that needed additional work. Navy officials stated that this approach reduces the overall cost of purchasing ships; however, the Navy has no analysis that proves their point. In contrast, the warranty on another Coast Guard ship—the Fast Response Cutter (FRC)—improved cost and quality by requiring the shipbuilder to pay to repair defects. The Coast Guard paid upfront for the warranty, which amounted to 41 percent of the total defect correction costs. The figure below shows the amount, as a portion of the millions of dollars required to address defects, shipbuilders and the government paid to correct defects for the ships GAO reviewed and the difference in defect-correction arrangements.
Although the Federal Acquisition Regulation (FAR) and the Department of Defense guidance instruct programs to, respectively, consider and document the use of a warranty, the use of warranties is not mandatory, and the Navy does not consider using them for ship contracts. In contrast, the Coast Guard's FRC warranty, as well as that planned for another upcoming ship class, fosters quality performance by following the FAR warranty provisions. The Navy may be missing opportunities for savings by not considering use of warranties. Further, the Navy has no stated objective for its guarantees, and guidance for contracting officers is minimal as to when or how to use a guaranty. While the FAR does not apply to guarantees, according to federal internal control standards, government programs require objectives and guidance to ensure that they achieve the desired results. Without a clear objective and guidance for using a guaranty and for determining when a warranty is appropriate in shipbuilding, Navy contracting officers do not have the information they need to make informed decisions regarding which mechanism is in the best interest of the taxpayer.
section_title: What GAO Recommends
paragraphs: DOD with the Navy should take steps to structure contracts so shipbuilders cannot earn profit for correcting defects for which they are responsible; determine whether a warranty is appropriate; and establish a guaranty objective and guidance. DOD partially concurred with the recommendations and it plans to complete a study by September 2016.

section_title: Letter
paragraphs: The U.S. Navy and Coast Guard together spend approximately $17 billion  per year building ships to provide the capabilities necessary to support  our national defense and homeland security. Given the difficult operating  environments and extended deployments for Navy and Coast Guard  ships, it is essential that they operate as intended. In the past 10 years,  several cases of poor quality in Navy shipbuilding programs focused  attention on the construction quality of new ships. In many cases,  deficiencies were attributable to problems with the basic elements of  shipbuilding, such as welding, installing propulsion and other mechanical  systems, and assembling the electrical systems. We have reported on  cost and quality problems facing Navy and Coast Guard shipbuilding  programs for many years. In May 2009, we compared Navy shipbuilding  programs with those of commercial shipbuilders and buyers and found  that the Navy accepts higher risks of quality expectations not being met  than commercial buyers. While Navy ships include complex and  technically sophisticated systems, we noted, in November 2013,  significant quality issues with the basic construction of some Navy ships.  We found that some ship classes are routinely delivered with thousands  of outstanding defects with the hull, mechanical, and electrical systems,  and made recommendations aimed at improving the Navy’s inspection  process. Further, we recently found that, in some cases, Coast Guard  ships did not meet all key performance requirements due to shipbuilding  deficiencies. The Navy and Coast Guard have taken action on some, but  not all of our recommendations.
Following ship delivery, Navy and Coast Guard ships undergo several  activities to prepare them for service within the fleet. The process of  preparing ships for operations often includes a specified period of time in  which the shipbuilder retains responsibility for correcting construction  defects that arise on the ship after delivery—known as a warranty or  guaranty period. Warranties and guarantees are contractual  arrangements made with the shipbuilder regarding the correction of  deficiencies discovered during this period, which generally lasts 8 to 12  months after delivery for Navy and Coast Guard ships. The House Report  113-446 on the National Defense Authorization Act for Fiscal Year 2015  included a provision that GAO review warranties and guarantees in  government shipbuilding programs and how these mechanisms compare  with commercial shipbuilding. This report assesses: (1) the extent to  which the Navy and Coast Guard’s guaranty or warranty mechanisms  reduce the government’s exposure to additional costs and improve the  quality of basic ship construction, if any, as compared to commercial  shipbuilding; and (2) the extent to which the Navy and Coast Guard use  available acquisition regulation and guidance in implementing warranties  and guarantees in shipbuilding programs.
To determine whether guaranty or warranty mechanisms reduce the  government’s exposure to additional costs and improve the quality of  these ships, we reviewed the Navy and Coast Guard’s guaranty and  warranty policies and procedures. To further our understanding of these  policies and procedures, we reviewed six case study ships that  encompassed the majority of all ship classes recently built by the Navy  and Coast Guard. Selected ships were delivered in the last 5 years. Most  of the contracts for the ships we reviewed were also used to purchase  other ships in the class. While we focused on six case studies, the  contracts and guaranty clauses we reviewed covered more than 20 ships.  Further, based on our analyses and our discussions with Navy  contracting officials, we believe our review is illustrative of Navy  shipbuilding in general because every Navy shipbuilding contract uses a  similar guaranty clause. The six ships in our scope are shown in table 1;  our scope includes most of the major Navy and Coast Guard shipyards.
We did not choose lead ships, because lead ships tend to be purchased  using cost-reimbursement type contracts and usually have more and  different quality issues than the rest of the class. For each ship, we  reviewed the guaranty or warranty contract language and other relevant  clauses. We interviewed officials from the Navy and Coast Guard to gain  an understanding of the guaranty or warranty process and compared our  observations to the Federal Acquisition Regulation (FAR), Department of  Defense, and Department of Homeland Security guidance on guaranties  or warranties. We also compared ships with guarantees to government  and commercial ships with warranties to determine the extent to which  each mechanism improves ship quality. During visits to the shipyards, we  met officials from Navy and Coast Guard offices, such as the Navy  Supervisor of Shipbuilding, Conversion and Repair, Program Executive  Offices, and Coast Guard’s Project Residence Offices. We also met with  Coast Guard contracting officials and contracting officers with the Naval  Sea Systems Command Contracting Directorate. These interviews  provided information on how the Navy and Coast Guard use and  implement warranties and guarantees on newly constructed vessels. We  also selected leading commercial buyers in the cruise, oil and gas, and  commercial shipping industries based on our previous work on  shipbuilding best practices and conducted interviews with them regarding  how they contract for and execute warranties on ships of similar size and  construction complexity as Navy and Coast Guard ships. Our  comparisons with commercial shipbuilding focused on basic ship  construction because the work is similar to hull, mechanical and electrical  work completed on Navy and Coast Guard ships. Appendix I contains  more detail on our objectives, scope, and methodology.
We conducted this performance audit from December 2014 to March  2016 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence for our findings and conclusions  based on our audit objectives. We believe that the evidence obtained  provides a reasonable basis for our findings and conclusions, based on  our audit objectives.
subsections: section_title: Background
subsections: section_title: Warranty and Guaranty Mechanisms in Navy and Coast Guard Shipbuilding
paragraphs: Acquiring a ship is a complex task and it is expected that, to a certain  degree, parts will break or welds may fail after a ship is delivered. Defects  related to the welding, fabrication, electrical, piping, and propulsion  systems on the ship that are the result of construction issues are typically  the shipbuilder’s responsibility to fix as opposed to problems with  systems, such as weapon or complex information technology systems,  which are purchased separately and, often, are the government’s  responsibility to correct. Warranties and guarantees are both mechanisms  to address the correction of shipbuilder-responsible defects, but they  differ in key ways. Warranty provisions are outlined in the FAR, while the  Navy sets forth its own guaranty provisions. In the case of the Coast  Guard’s NSC, program officials told us they adopted the Navy’s guaranty  provisions; therefore we refer to the guaranty in this report as “the Navy’s  guaranty” even though it also pertains to the NSC. Shipbuilding contracts  can either use a warranty, a guaranty, or have no mechanism to address  defects after delivery. Table 2 shows key elements of warranties and  guarantees.
In Navy and Coast Guard shipbuilding, the warranty or guaranty period  does not overlap with ship deployments but typically occurs while the  crew is conducting tests and trials, and also performing any additional  construction (such as modifications), among other activities. Generally,  the warranty or guaranty concludes with a ship’s final contract trials.  Figure 1 highlights where the warranty or guaranty period resides in the  typical Navy and Coast Guard shipbuilding process.
While there are some nuances, the basic process of adjudicating a  warranty or guaranty claim is the same for Navy and Coast Guard  programs. Figure 2 illustrates this process from the beginning—when a  sailor identifies a problem—through the end when the government utilizes  the warranty or guaranty to fix the defect.
While the focus of this report is on warranties and guarantees, these are  not the only mechanisms intended to address shipbuilder-responsible  defects after delivery. In some cases, the Navy and Coast Guard insert a  latent defect contract clause that provides for the correction of  deficiencies that could not be discovered through reasonable inspection  when the ship was delivered. At final acceptance, prior to delivery to the  fleet, the Navy and Coast Guard acknowledge that the ship conforms to  all quality requirements, with the exception of latent defects, fraud, or  gross mistakes amounting to fraud. Further, there is also a separate  process for deficiencies pertaining to fraudulent work or parts, such as  counterfeit parts.
section_title: Contract Types Used to Purchase Navy and Coast Guard Ships
paragraphs: The Navy and Coast Guard use three primary contract types when  purchasing ships—fixed-price type, incentive type, and cost- reimbursement type contracts. The first ships of a class, called lead ships,  are often purchased with cost-reimbursement type contracts under which  the government generally bears the risk of cost, schedule, or ship  performance problems. After the first few ships in a class, the Navy and  Coast Guard generally use firm fixed-priced or fixed-price incentive  contracts because, as more ships are built, there is greater certainty  about costs and performance.
The following is a brief description of each contract type used to construct  and repair the Navy and Coast Guard ships we reviewed:
Firm Fixed-Price Contract—The government agrees to purchase a  ship for a set price. The shipbuilder bears the full responsibility for  increases in the cost of construction and earns a larger profit if actual  costs are below the contract price. When using this contract type, the  cost of the warranty or guaranty can be included in the construction  price of the vessel or priced separately for an agreed-upon amount. In  the government, this contract type is usually used for mature  shipbuilding efforts because it works best when the ship buyer and  shipbuilder are confident in the cost of ship construction.
Fixed-Price with Economic Price Adjustment (EPA) Contract— Similar to a firm fixed-price contract, the government and the  shipbuilder agree to a set price for the ship, but in a fixed-price EPA  contract the government and shipbuilder agree to adjust, upward or  downward, the stated contract price upon occurrence of specified  contingencies, such as changes in costs of labor or material that the  shipbuilder experiences during contract performance. For example,  changes to the price of steel could be accounted for using this  contract type.
Fixed-Price Incentive Contract—Under fixed-price incentive  contracts, the government and the shipbuilder agree upon a target  cost, target profit, ceiling price, and a profit adjustment formula  referred to as a share line. The government and the shipbuilder share,  in accordance with the share line, responsibility for cost increases or  decreases compared to the target cost, up to the ceiling price at which  point the shipbuilder is responsible for all remaining costs. Generally,  the share line functions to decrease the shipbuilder’s profit as its  actual costs exceed the target cost. Likewise, the shipbuilder’s profit  increases when actual costs are less than the target cost for the ship.  In an illustrative example, typical of ships in our review, if a contract  has a 70/30 share line and the shipbuilder’s actual costs were over  the target cost by $1 million; the government would pay 70 percent  ($700,000) of the additional costs needed to complete the ship and  the shipbuilder would absorb 30 percent of the cost overrun  ($300,000) as a reduction to profit.
Cost-reimbursement Contract—Cost-reimbursement type contracts  provide for the government to pay the shipbuilder’s costs to the extent  specified in the contract and may include an additional fee (profit). As  opposed to a fixed price type contract that requires the shipbuilder to  deliver a ship for the price specified in the contract, under a cost- reimbursement type contract the shipbuilder agrees to use its best  efforts to perform the work within the estimated costs. But the  government must reimburse the builder for its allowable costs  regardless of whether the work is complete. These contracts can also  include a guaranty clause. In the case of the Coast Guard’s NSC, the  first three ships were built using cost-reimbursement type contracts  while the remaining five are being built with fixed-price incentive  contracts. After ship delivery, the Navy may award separate cost- reimbursement type contracts to complete post-delivery activities,  such as installing weapon systems and repairing defects.
Table 3 shows the contract and vessel type for each Navy and Coast  Guard ship we reviewed. As discussed earlier, we selected ships that  were constructed after at least one other ship in the class.
section_title: Navy’s Guaranty Mechanism Generally Has No Effect on Improving Cost and Quality Outcomes, in Contrast to FRC and Commercial Warranties
paragraphs: The Navy and Coast Guard paid shipbuilders to repair shipbuilder- responsible deficiencies after delivery for most of the ships that we  reviewed. In the four case study ships that used a fixed-price incentive  contract with a guaranty, the Navy and Coast Guard paid the shipbuilder  to build the ship as part of the construction process, and then paid the  same shipbuilder a second time to repair the ship when defects were  discovered after delivery. Navy contracting officials stated that the Navy  accepts the costs of fixing deficiencies to lower the overall purchase price  of its ships. However, this contracting approach results in the shipbuilder  profiting from fixing deficiencies on a ship that it was initially responsible  for delivering to the government in a satisfactory condition. In contrast,  commercial ship buyers and the Coast Guard—in the case of the FRC— used warranties combined with firm fixed-price or fixed-price with EPA  contracts, respectively, to lower the ultimate cost of the ship while also  improving the ship’s quality. The Coast Guard’s experience with the FRC  is akin to outcomes on large commercial ships. Buyers of these ships told  us that they include a warranty that holds the shipbuilder financially  responsible for correcting deficiencies following delivery and improves  ship quality through a variety of strategies.
subsections: section_title: Contract Type and Terms Dictate the Degree to Which the Government Pays for Defects after Delivery
paragraphs: For the six government ships we reviewed, the type of contract and terms  used to purchase the ship determined the degree to which the  government or the shipbuilder paid for shipbuilder-responsible  deficiencies after delivery. Figure 3 shows the percentage of shipbuilder- responsible defects that the government paid to correct, compared to  those absorbed by the shipbuilder.
As shown in figure 3, the government paid 86 percent of the costs  associated with fixing defects that were attributed to the shipbuilder for all  of the ships in our review, which we calculated as $6.4 million based on  available information. However, the full extent of what the government  paid to correct shipbuilder-responsible defects across all of our case  study ships is not known because the data did not identify whether or not  the shipbuilder or the government was responsible for each defect. These  data issues are addressed below, and appendix I contains more detail.  Also, as discussed below, the breakdown of who pays for shipbuilder- responsible defects is different depending on the contract type and terms  for the ships.
subsections: section_title: Under Fixed-Price Incentive Contracts, Government Pays Additional Costs and Shipbuilders Earn Profit to Correct Defects
paragraphs: For the four fixed-price incentive contracts in our review, the government  paid for almost all shipbuilder-responsible deficiencies found after  delivery. For example, on LPD 25, the ship’s exterior hull paint began to  peel shortly after delivery. The Navy determined that the shipbuilder did  not adequately prepare the surface of the ship prior to applying a second  coat of paint and submitted the issue as a guaranty claim. The Navy  docked the ship and the shipbuilder re-painted the vessel. The shipbuilder  submitted invoices for the work completed and the Navy paid the  shipbuilder $315,000—even though the shipbuilder was responsible for  the failure. This example illustrates how a guaranty functions with a fixed- price incentive contract type, which results in the government paying the  costs to correct problems. As shown in figure 4 the government paid for  89 percent of the costs to correct shipbuilder-responsible defects for the  ships in our review that had fixed-price incentive contracts, which we  calculated as $4.9 million based on available information. As noted  above, however, this figure does not include all shipbuilder-responsible  defects for these four ships due to the data issues we discuss in the  report.
For the fixed-price incentive contracts in our review, the government’s  share of the costs to correct shipbuilder-responsible defects is determined  by  1.  the share line up to the contractor’s limitation of liability; or  2.  in the case of NSC 4, a separate cost-reimbursement type line item in  the construction contract not subject to the share line calculation; and,  in many cases,  3.  follow-on contracts, or modification to existing contracts, to pay for  remaining shipbuilder-responsible deficiencies once the limitation of  liability was reached.
We elaborate on these three scenarios and how they impact the guaranty  calculations for each ship below.
The share line determines the government’s costs up to the  contractor’s limitation of liability:  For two of the three Navy ships in our review with fixed price incentive  contracts, the Navy paid for the guaranty work up to the contractor’s  limitation of liability for correction of defects—which was initially $1  million or less for all of the Navy ships with fixed-price incentive  contracts in our review. A key point is that, for these ships, the  government’s share of the payments for the correction of shipbuilder- responsible defects depends upon the overall cost performance of the  shipbuilder. While the specific share line calculations differ by ship, for  Navy ships with fixed-price incentive contracts, guaranty costs, up to  the limitation of liability, are included in the overall target cost of the  ship. As such, when actual construction costs are above the target  costs, the actual price of the ship to the government increases and the  shipbuilder’s profit decreases according to an agreed upon  percentage determined by the share line. This means that the  government pays additional costs for every dollar over the target cost  and, likewise, the shipbuilder absorbs its share of the cost overrun  through a reduction in its target profit. In the case of LPD 25 for  example, the contract initially included $1 million of guaranty work (the  limitation of liability). Actual costs for LPD 25 construction exceeded  the target cost by 32 percent, which, according to the share line,  reduced the shipbuilder’s profit by 12 percent for the whole ship  (including the guaranty work). This means that for the guaranty work  up to the initial $1 million limitation of liability, the shipbuilder lost  $120,000 in profit and the government paid $880,000 of the first $1  million of shipbuilder-responsible defects discovered after delivery. If  actual costs for the ship were lower than the target cost, the opposite  scenario would occur—meaning the shipbuilder would earn additional  profit for correcting errors determined to be its responsibility.
A separate cost-reimbursement type line item in the construction  contract not subject to the share line calculation determines the  government’s costs:  In the case of the NSC 4, a separate cost-reimbursement type line  item in the construction contract determined the Coast Guard’s share  of the guaranty costs for NSC 4. Unlike the Navy’s approach, the  Coast Guard’s guaranty on NSC 4 was purchased as a separate cost- reimbursement type line item in the construction contract and thus  was not subject to the share line calculation. Using this method, the  Coast Guard paid the shipbuilder $588,000 to fix claims under the  guaranty, which included a fixed-fee (profit) amount. However,  contracting for deficiency-correction on a separate line item allowed  the Coast Guard to track deficiency claims and payments by  specifically denoting it as guaranty work, a practice that could  increase the data available to improve agency assessments about  shipbuilder-responsible defects. According to Navy contracting  officials, the Navy has not considered the pros and cons of reflecting  guaranty work as a separate line item in shipbuilding contracts— potentially missing an opportunity to improve incentives and increase  transparency.
Follow-on contracts, or modification to existing contracts, to pay  for remaining shipbuilder-responsible deficiencies once the  limitation of liability was reached:  For the three Navy ships with fixed-price incentive contracts in our  review, costs associated with shipbuilder-responsible deficiencies  exceeded the initial limitation of contractor’s liability. Navy officials told  us, in most cases, they do not increase the limitation of contractor’s  liability under construction contracts to cover shipbuilder-responsible  defects because it is generally more expensive—due to the share line  arrangement—than paying the shipbuilder to correct deficiencies  under a separate contract. In general, to pay for the remaining  shipbuilder-responsible deficiencies beyond the contractor’s limitation  of liability, the Navy awards follow on contracts to the shipbuilders.  Navy officials stated that these follow-on contracts could be used  exclusively to pay for correcting the deficiencies, but—with respect to  LCS 3 and 4—these contracts were also used for other purposes. In  the case of NSC 4, the government did not reach the $1 million  shipbuilder’s limitation of liability primarily because the Coast Guard  chose to use other contracting mechanisms to address a majority of  shipbuilder-responsible defects.
For each case study ship with a fixed-price incentive contract, we  determined the total amount the government had to pay to correct  shipbuilder-responsible defects:
LPD 25—The shipbuilder exceeded the ceiling price of the vessel,  making it responsible for all additional costs to complete the ship after  that point. Under the contract, the contractor’s limitation of liability for  correction of defects was initially $1 million, but the government found  $4.8 million in deficiencies. The Navy modified the contract to  increase the contractor’s limitation of liability to $4.8 million to cover  the costs for correcting all shipbuilder-responsible deficiencies. In  increasing the contractor’s limitation of liability, the Navy also  increased the contract’s target cost and ceiling by $3.8 million each,  since $1 million was included in the initial target cost. In addition, the  Navy increased the contractor’s target profit. These changes resulted  in a slight improvement in the shipbuilder’s cost performance and  reduced the amount of profit that the shipbuilder lost. While the  shipbuilder earned less profit than it would have earned had the ship  been delivered at its target cost, it still earned some profit. Based on  our analysis of the final cost of the ship and how the share line applied  to the guaranty work, we found that the shipbuilder was responsible  for $578,000 of the $4.8 million in guaranty claims under the  construction contract.
LCS 3 and 4—According to Navy contracting officers, the Navy  negotiated lower construction costs for these vessels by reducing the  limitation of contractor liability associated with the guaranty from $1  million to $100,000 and $0, respectively. Given the low or non-existent  limitation of contractor’s liability for guaranty work, the Navy paid for  almost all of the shipbuilder-responsible deficiencies discovered after  delivery using cost-reimbursable orders under basic ordering  agreements. However, these agreements were used for many  purposes, including correcting defects on the installation of  government purchased systems and completion of construction work.  The Navy does not separately track guaranty work when using these  basic ordering agreements. As a result, we could not determine the  total amount of claims that were the result of shipbuilder-responsible  defects. For LCS 3 and LCS 4, the Navy spent $46 million and $77  million, respectively, under these post-delivery agreements to correct  defects, complete ship construction, and assist with tests and trials,  among other tasks.
NSC 4—Because the guaranty on NSC 4 is a separately priced cost- reimbursement type contract line item from the construction line, it  was not subject to the construction share line. The guaranty line item  provides for the Coast Guard to pay for guaranty claims on a cost- reimbursable basis, up to the contractor’s limitation of liability for  correction of defects, which was $1 million. In addition to the $588,000  paid by the Coast Guard under the guaranty, Coast Guard program  officials also told us that a majority of the shipbuilder-responsible  defects were corrected through other contracting mechanisms or  Coast Guard units, particularly if these solutions were less expensive.  However, the Coast Guard does not track the costs associated with  the shipbuilder-responsible defects paid through these other means.
Although the Navy uses profit or fee as an incentive to encourage cost  efficiency, the Navy’s guaranty, when used with a fixed-price incentive  construction contract, results in the shipbuilder earning profit or fee from  correcting its own mistakes. For ships with fixed-price incentive contracts,  we found that, included in the costs the government paid to correct  shipbuilder-responsible defects, the shipbuilders earned between 1 and  10 percent profit or fee under the construction contract or under a follow- on arrangement to correct the defects determined to be their  responsibility for both guaranty claims and follow-on work to correct the  defects. Shipbuilders earn profit under the construction contract, and also  earn a fee (profit) to correct remaining deficiencies under any applicable  follow-on arrangement.
According to the FAR, incentives should motivate contractor efforts  towards efficiency and improve contractor cost performance. Navy  contracting officials stated that shifting additional cost burden or reducing  the shipbuilder’s profit for correcting defects will result in more expensive  ships, as the shipbuilder will shift this additional risk into higher target  costs for the ships. However, the Navy has not assessed different  methods to change the terms of the guaranty in the contract with regards  to paying for deficiencies. For example, it has not assessed the pros and  cons of structuring contracts to prevent shipbuilders from earning profit  from guaranty work; breaking the guaranty out as a separate line item not  subject to the share line, or revisiting the limitations of liability amounts.  Without reassessing its practice of allowing the shipbuilder to earn profit  for correcting shipbuilder-responsible defects, the Navy may be missing  opportunities to improve incentives and lower costs to the taxpayer.
section_title: Under Other Fixed-Price Contracts, Shipbuilder Pays to Correct Defects, but Value of Guaranty or Warranty Depends on Contract Terms
paragraphs: For the two ships we reviewed that used a firm fixed-price and fixed-price  with EPA contract, the shipbuilder, rather than the government, paid for  shipbuilder-responsible deficiencies after delivery, but the value of the  warranty or guaranty was different for each ship. The Coast Guard paid  $629,315 at contract award for the warranty on the Coast Guard’s sixth  FRC. Under the terms of the warranty, the Coast Guard could require the  shipbuilder to repair an unlimited amount of shipbuilder-responsible  defects within the first year after delivery, and the shipbuilder was  responsible for all costs to do so. To date, the Coast Guard has claimed  over $1.5 million worth of repairs under the warranty for the ship. Thus,  the warranty provided a 145 percent return on investment.
In the case of the DDG 112, the Navy included a guaranty with a $5  million limitation of liability. The DDG 112 contract was originally fixed- price incentive but was later modified to a firm fixed-price contract. As a  result of this modification, the Navy did not change the guaranty terms or  limitation of liability amount, but the modification of the contract type  altered responsibility for paying for guaranty work. Instead of the Navy  paying the shipbuilder its costs (which could include profit) subject to the  share line—as would have been done under the fixed-price incentive  contract type—the shipbuilder now had to absorb the costs for the  correction of up to $5 million in deficiencies. However, the Navy made a  total of $459,000 in guaranty claims by the time the guaranty period  expired, but paid the shipbuilder approximately $902,000—principally for  the services of a shipbuilder guaranty engineer who rode with the ship’s  crew for the 12 month guaranty period—to administer the guaranty.  According to Navy program officials, the guaranty engineer, who works  for the shipbuilder, provides value by scheduling repair, maintenance, and  upgrade work and lowering guaranty claims since he or she works with  the ship’s crew to correct problems as they occur without filing a formal  claim. Nevertheless, taking into account the cost to administer the  guaranty, it cost the government $443,000 ($902,000 paid for the  guaranty engineer minus the $459,000 in claims). As a result, DDG 112’s  guaranty resulted in a lower value than FRC 6’s warranty, particularly  since the shipbuilder’s personnel to administer the warranty on the FRC  are provided at no additional cost to the government. Figure 5 illustrates  the costs borne by the government and shipbuilder to correct shipbuilder- responsible defects on the FRC 6 and the DDG 112 after delivery.
section_title: Unlike Navy Guarantees, Warranties Used in Commercial Shipbuilding and FRC Program Improve Ship Quality Outcomes
paragraphs: Commercial ship buyers and the Coast Guard, in the case of the FRC,  demonstrate that warranties can be valuable in shipbuilding because they  save the ship buyer money and improve the quality of the vessel.  Commercial ship buyers and Coast Guard officials stated that warranties  foster quality performance because the shipbuilder’s profit erodes as it  spends money to correct deficiencies after delivery, during the warranty  period. In assessing commercial and Coast Guard warranties in contrast  with the Navy’s guaranty terms for the ships we reviewed, we found that  for ships with warranties: (1) the shipbuilder corrected more deficiencies,  (2) the value of the warranty was increased through extensions, (3) the  government incentivized better terms from shipbuilder suppliers and class  quality improvements and (4) a warranty engineer who worked for the  ship buyer helped improve quality outcomes.
subsections: section_title: Robust Defect Correction
paragraphs: In general, commercial buyers, as well as the Coast Guard for the FRC,  submitted more claims for correcting defects than the Navy did for its  ships with guarantees. On average, commercial ship buyers told us that  the number of warranty claims totals 1 to 2 percent of the construction  value of the ship, but can range as high as 3 to 4 percent if key systems  experience failures during the warranty period. For example, one  commercial ship buyer had to take a ship out of operation for 2 months  due to engine failures, which were repaired at the shipbuilder’s expense.  Commercial ship buyers told us that even well-built and mature ships  generally have claims totaling at least 1 percent of the cost of  construction. For FRC 6, the Coast Guard’s program office estimates that  the shipbuilder will pay about 4 percent of the construction cost of the  ship to fix deficiencies.
In comparison, the Navy has typically claimed significantly fewer  construction defects on its ships following delivery. Based on our prior  work, this situation is not because the Navy’s ships had fewer defects, as  Navy ships are delivered to the government with numerous defects that  must be corrected later. For the two Navy ships we reviewed that  tracked guaranty claims (LPD 25 and DDG 112), the Navy, on average,  made guaranty claims totaling less than one-tenth of a percent of the  construction cost of the ship. For example, on DDG 112, the Navy  submitted claims equal to 0.08 percent of the ship’s $602 million  construction cost. Navy officials attribute the DDG 112’s low number of  claims to its well understood design and construction because the  shipbuilder has delivered 34 ships. In November 2013, we found that  commercial ship buyers have more effective inspection practices than the  Navy to discover and resolve quality issues prior to delivery. In addition,  commercial buyers told us that even the most mature and well-built ships  typically experience shipbuilder-responsible deficiencies after delivery  that total about one percent of the vessel’s cost—more than 10 times as  many deficiencies as were discovered and attributable to the shipbuilder  on the DDG 112. The Navy had a similar low level of claims on LPD 25— equaling about one-third of one percent of the ship’s construction cost—a  ship that had fewer predecessor ships, a history of quality problems, and  exceeded its ceiling cost, which we discussed in our November 2013  report. Since the Navy pays the shipbuilder to correct deficiencies  regardless of responsibility, there is less incentive than in commercial  shipbuilding or the FRC program to discover every deficiency during the  guaranty period.
Further, the Navy may not file a guaranty claim for every shipbuilder- responsible issue if it decides that another contract mechanism is better  suited to address the problem. According to several Navy and Coast  Guard officials, the government does not always submit a guaranty claim  to correct shipbuilder-responsible deficiencies, particularly in cases where  a correction is not needed immediately or can be accomplished using a  less expensive contracting arrangement. For example, according to these  officials, if the fleet that maintains in-service ships has a contract in place  that can purchase needed parts and services more cheaply, then the  Navy or Coast Guard will likely use that contract instead of the guaranty.  In these cases, the deficiency would not be documented as a guaranty or  shipbuilder-responsible defect. We plan to examine the Navy’s defect  correction process as a part of future work focused on the Navy’s  shipbuilding practices after ship delivery.
section_title: Extended Warranty Period for Repaired Defects
paragraphs: Another critical aspect of commercial ship and Coast Guard warranties is  that they contain provisions to extend warranties on parts replaced during  the warranty period. On the FRC 6, the shipbuilder replaced a water  heater 9 months into the 12-month warranty period, and the warranty  period for the water heater was subsequently extended for an additional  12 months. Commercial companies extend the warranty on parts that  break during the warranty period as well, in some cases capping the  extensions at either 24 or 36 months. For most Navy ships, extending the  guaranty would not provide additional coverage since the Navy, under a  fixed-price incentive arrangement, would also pay for any defects found  during the extension period. This is because the Navy’s practice for its  fixed-price incentive contracts is to include the guaranty as part of the  overall negotiated target cost for construction of the ship subject to the  share line. Thus, an extended guaranty period would not decrease the  Navy’s financial liability.
section_title: Better Terms with Suppliers and Class-wide Quality Improvements
paragraphs: In the case of the Coast Guard’s FRC warranty, shipbuilder  representatives told us the terms force them to ensure that they receive  the same warranty terms from their suppliers. This arrangement, in turn,  can result in a better value for the government. Due to the length of time  required to build a ship, supplies are no longer covered under their  original warranties because parts are often purchased and installed a  year or more before the ship is delivered to the government. To address  this issue, shipbuilder representatives stated that they actively seek  supplier warranties that mirror the Coast Guard’s terms and conditions to  share the potential costs associated with the warranty. For FRC 6, the  subcontractors are to conduct repairs accounting for about 40 percent of  the warranty work, while the shipbuilder is responsible for the remaining  warranty work. As an example of how this can benefit the government  and the shipbuilder, on two earlier ships of the class—FRC 2 and 3—the  Coast Guard submitted over $10 million worth of warranty claims.  According to FRC program officials, these claims were primarily engine  problems that were paid for by the engine supplier. As it turned out, these  engine issues comprised more than 90 percent of the total amount of  warranty claims on these ships.
Likewise, a commercial ship buyer told us that their company prefers  supplier warranties on key parts that extend beyond the shipbuilder’s  warranty on the full vessel and work to negotiate these terms directly with  the original equipment manufacturers. Thus, a significant portion of the  claims have not fallen solely on the shipbuilder to fix, demonstrating how  a warranty can provide value without unduly harming the shipbuilder’s  profits. For instance, the shipbuilder is incentivized to negotiate extended  warranties with its suppliers that match the duration of the warranty on the  whole ship. However, for the Navy ships we reviewed, the shipbuilders do  not have this same incentive since the Navy absorbs the risk of paying for  defects.
In addition, commercial ship buyers and the Coast Guard have received  improvements and corrections to ships during construction as the result of  defects found on previous ships in the class—at the shipbuilder’s  expense. For example, representatives from a commercial company told  us about a defect in the anchor of a ship that required a design change.  The shipbuilder made the changes to the ship, at its own expense, during  the warranty period and also absorbed the costs associated with  changing the design and fixing other ships already in construction. The  Coast Guard’s FRC warranty fosters quality performance by encouraging  the shipbuilder to address class-wide issues efficiently through the  construction process. For example, according to FRC program officials,  when a quality problem is identified on a particular ship that impacts the  entire class of FRC ships, the shipbuilder corrects the problem and works  with the Coast Guard to back fit and forward fit other ships in the class at  the builder’s expense to avoid a potential warranty claim regarding the  problem in the future. Using its guaranty with a fixed-price incentive  contract, the Navy would likely pay for all costs associated with such a  change.
section_title: Warranty Engineers Advocate for Ship Buyers, not Shipbuilders
paragraphs: A final difference between commercial and Coast Guard ship buyers and  the Navy is the use of a warranty engineer that represents the interests of  the ship buyer. According to several commercial ship buyers we spoke  with, the ship buyer’s warranty engineer identifies defects by reviewing  failures that occurred on the ship, identifying them as a warranty issue,  and submitting a warranty claim to the shipbuilder. The warranty engineer  also ensures that the work is completed to the ship buyer’s satisfaction.  One commercial ship buyer stated that, in theory, the most experienced  and “crankiest” senior engineer in the fleet best suits the purpose of the  warranty engineer. The Coast Guard’s warranty engineer performs similar  functions on the FRC.
In contrast, the Navy generally pays the shipbuilder to supply a guaranty  engineer whose roles and responsibilities vary among the ships we  reviewed. Navy program and contracting officials, for the ships we  reviewed, stated that the shipbuilder’s guaranty engineer provides  valuable services ranging from mentoring new ship crews to scheduling  the remaining work that needs to be completed on the vessel. However,  because the guaranty engineer works for the shipbuilder, he or she does  not identify defects. Rather, the guaranty engineer works with the ship’s  crew to primarily support the Navy in troubleshooting the issue and  scheduling necessary corrective actions.
These comparisons highlight differences between the Coast Guard (in the  case of the FRC) and commercial buyers’ warranty practices versus the  Navy’s guaranty practices.
section_title: Objective of the Guaranty Is Unclear and Navy Has Not Fully Considered the Costs and Benefits of Using a Warranty per DOD Guidance
paragraphs: The Navy’s guaranty lacks a clear objective, with insufficient guidance on  when or how to use a guaranty. Without a clear objective, Navy  contracting officials cannot properly implement the guaranty or assess its  effectiveness. While use of a warranty per the FAR is not mandatory, the  Navy has not examined whether or not a warranty is appropriate for the  ships it purchases—a practice recommended in DOD guidance. Further,  we found that the Navy’s data regarding ship deficiencies is not sufficient  to estimate the total expected shipbuilder-responsible defects on its  ships—critical for understanding what the benefits of a warranty could be.  In contrast, the Coast Guard’s FRC program warranty is based on FAR  principles. The FAR provides that: (1) the agency assesses whether or  not a warranty is worth the cost, (2) the government may direct the  contractor to repair or replace defective items at the contractor’s expense,  and (3) a principal purpose of a warranty in a government contract is to  foster quality performance.
subsections: section_title: Unclear Objective and Sparse Guidance Make It Difficult to Assess Whether Low Guaranty Liability Limits Are Effective
paragraphs: The Navy does not have a clear objective for using its guaranty, which  makes it difficult for Navy contracting and program officials to implement  the guaranty effectively. According to Standards for Internal Control in the  Federal Government, government programs require objectives and  guidance to ensure that a program is achieving the desired outcomes in a  manner that effectively uses funding. Navy program officials provided  various responses to us regarding the objective of the guaranty. For  example, officials from several Navy program offices acknowledged that  the guaranty clause is not a tool to improve ship quality. Rather, they  noted that the guaranty clause helped expedite the procurement of  needed parts after delivery by establishing a contractual relationship with  the shipbuilder for all services and parts associated with the construction  of the ship, as opposed to purchasing these items individually through  other means. Because the guaranty is included in the construction  contract, the guaranty clause allows the government to purchase parts  and labor in the same manner and pricing as for ship construction. Other  Navy program officials stated that the guaranty is useful because it  involves purchasing the services of an experienced guaranty engineer,  who helps schedule work that needs to be done and to mentor the ship’s  crew—usually comprised of junior officers who are new to the ship at the  time the ship is delivered. While these services can provide meaningful  benefits, it is unclear whether or not the guaranty is the appropriate and  most cost effective mechanism to accomplish these tasks, and the Navy  has not assessed whether or not this is the case.
Further, the Navy lacks sufficient instruction and data to guide contracting  officers on how to correctly implement the guaranty to achieve an  intended result. A senior Navy contracting official provided us with the  available guidance for guarantees, which primarily consists of standard  contract language used to establish a guaranty in ship contracts. The  Naval Sea Systems Command Handbook also provides some instruction  on how to execute the guaranty after a ship is delivered, but there is little  guidance that focuses on specific contract terms to help contracting  officers develop an effective guaranty. Navy contracting officials  confirmed that they have historically used the existing guaranty on all ship  purchases dating back 50 years without assessing the use of a warranty  or whether or not the guaranty is effective. A senior Navy contracting  official provided us with an assessment from 1980, but this assessment  did not include any analysis about how the Navy’s guaranty provision  compared to alternatives.
In addition, without sufficient guidance, Navy contract officials have at  times confused the guaranty with a FAR-based warranty. For example, in  a recent contract memo, Navy contracting officials documented that a  DDG 51 class vessel had a warranty based upon the FAR. Instead, this  ship actually had a typical Navy guaranty, which is not based on the FAR,  exemplifying that these officials did not have a clear understanding of the  objective and process associated with the Navy’s guaranty provision.  Moreover, according to internal control standards, government programs  are required to provide guidance that instructs program managers about  how to best accomplish the program’s objective that incorporates lessons  learned from experience over time.
Further, the Navy cannot measure the effectiveness of the guaranty  mechanism because it lacks a clear objective. According to Standards for  Internal Control in the Federal Government, measuring the effectiveness  of a program is required to provide reasonable assurance that the  program will achieve its designated objective and that these objectives  align with the organization’s overall goals. For example, it is difficult to  determine if the Navy’s practice of establishing low limitations of  contractor’s liability for the correction of defects has a negative effect  because the Navy’s objective for the guaranty is not clear. The Navy’s  standard clause on limitation of liability states that the shipbuilder’s  limitation of liability should be set at two percent of the target construction  cost of the ship or an amount to be determined by the program. However,  for the programs we reviewed, the Navy sets the limitation of liability  significantly below the level suggested in its guidance. As noted, the  limitation of liability for LPD 25 was initially set at $1 million—equal to  0.08 percent of the target price of the ship.
Navy contracting officials told us that they keep the limitation of liability  low because it allows the Navy to pursue other, less expensive  contracting arrangements to fix the deficiencies, while at the same time  extending the contractual relationship with the shipbuilder after delivery to  provide for an expedited method for fixing any issues that arise shortly  after delivery. If, on the other hand, as Navy contracting officials stated,  the guaranty is meant to address shipbuilder-responsible deficiencies  after delivery—while the guaranty period is still in effect—then a low  limitation of liability is counter to this objective. Without a clear objective  backed by instructive guidance, the Navy is not well-positioned to  measure the effectiveness of the guaranty and then make improvements  to it if necessary.
section_title: FRC Warranty Adheres to Federal Acquisition Regulation While Navy Has Not Considered Using a Warranty
paragraphs: The FRC’s warranty is based on principles set forth in the FAR that  discuss the objective and effective implementation of a warranty. While  the FAR asks agencies to consider the use of a warranty, it notes that the  use of a warranty is not mandatory. The FRC’s warranty also adheres to  Department of Homeland Security guidance regarding warranties, which  implements the FAR provision on warranties. If an agency chooses to  use a warranty, the FAR discusses principles for effectively using them to  better ensure that the government derives benefits. In contrast, there is  no FAR provision that pertains to the Navy’s guaranty, as it is an agency- specific contracting mechanism. Table 4 highlights the FAR principles  compared with the Coast Guard’s warranty on the FRC and the degree to  which the Navy’s guaranty mechanism demonstrated similar principles.
The Department of Defense created a warranty guide in September 2009  that expands upon the principles in the FAR. For example, the guide  requires documentation, in a warranty plan, of why a warranty is, or is not,  appropriate for an acquisition. While not required to use a warranty, the  Navy neither considers using a warranty for large ship programs nor  documents how it came to the decision not to use one. According to Navy  contracting officials, the Navy does not know how a shipbuilder would  price a warranty and, ultimately, what the Navy would have to pay in  comparison to its current guaranty structure. Moreover, the Navy cannot  assess the potential benefits since it does not have a full understanding of  the total amount of shipbuilder-responsible deficiencies on its ships after  delivery. For example, we reviewed deficiency data documented by the  ships’ crews after delivery and found that these data rarely differentiate  between shipbuilder and government-responsible defects and often do  not include the estimated cost to correct defects. By contrast, the Coast  Guard documents each deficiency, the date the shipbuilder fixed the  issue, the estimated cost of the issue, and any warranty extensions that  apply. Navy contracting officials stated that shipbuilding is radically  different from most Department of Defense acquisitions, in part because  of the limited shipbuilding industrial base which they believe makes a  warranty not cost effective for its ships. While using the warranty  mechanism in a non-competitive ship purchase will likely require some  customization and analysis, without assessing the value of using a  warranty, the Navy cannot make an informed decision about which  mechanism best protects the government from paying for shipbuilder- responsible defects after ships are delivered.
Finally, Navy contracting officials did not think a warranty would work  effectively with the fixed price incentive contracts typically used with the  Navy’s large, complex, and often sole-source shipbuilding programs.  However, the Coast Guard is planning to use a warranty with a fixed-price  incentive contract on its forthcoming Offshore Patrol Cutter—a ship of  similar size and complexity as the Navy’s LCS. In doing so, the Coast  Guard plans to purchase the warranty as a separate firm-fixed price item  in the construction contract, which should prevent the shipbuilder from  earning profit for these corrections in accordance with the share line.  According to Coast Guard program officials, the Offshore Patrol Cutter’s  planned warranty will function similar to the FRC’s warranty. According to  Coast Guard officials, using this warranty will ensure that the shipbuilder  pays for shipbuilder-responsible defects even though the planned  contract is a fixed-price incentive type contract. Further, structuring the  warranty as a separate line item in the contract ensures that any profit  earned by the contractor to construct the ship due to the share line will be  completely separate from the warranty work.
section_title: Conclusions
paragraphs: Shipbuilding is a complex endeavor, and a certain amount of shipbuilder- responsible deficiencies can be expected after delivery. This is the case  for the Navy and Coast Guard ships in our review and is also the case in  the commercial shipbuilding industry. However, key differences exist in  how these deficiencies are dealt with—specifically, whether the builder or  the buyer pays for corrections. The value of a warranty or guaranty  depends primarily on the government’s diligence in discovering defects  after delivery (and ensuring the contractor corrects the defects), and the  type and terms of the contract.
Fixed-price incentive contract types used commonly in Navy shipbuilding,  coupled with certain terms within the contract, result in the government  paying to correct shipbuilder-responsible defects. Further, these  contracting arrangements allowed the shipbuilder to earn profit from fixing  deficiencies discovered after delivery. Partly because the guaranty is  included in the target cost of the ship and part of the construction line item  of the contract subject to the share line, the shipbuilder earns the same  level of profit for correcting defects as it does for building the ship. In  addition, this contracting strategy obscures the Navy’s ability to track  payments and defects associated with the guaranty because guaranty  claims are not differentiated from other costs. Further, the award of  follow-on, cost-reimbursement arrangements to correct remaining  defects—under which the contractor also earns fee (profit)—creates an  apparent disincentive for quality ship construction.
The Navy has no guidance that clearly explains the guaranty’s objective  and, further, little instruction to contracting officers on how to implement  the guaranty. Without an objective and associated guidance, the Navy is  not well-positioned to ensure the effectiveness of the guaranty and  associated policies. For example, it cannot know whether its strategy of  including a low limitation of liability is effective. Although the FAR provides  for consideration of certain factors in determining whether a warranty is  appropriate for an acquisition and DOD requires documentation of why a  warranty is or is not appropriate, the Navy has not considered or  documented whether or not a warranty would be appropriate for its ships.  Navy officials have set forth reasons why their historical approach lowers  the overall construction cost of the vessel and results in a better deal than  pricing a warranty. Their reasons could have merit. However, the Navy  has no data on the full costs of correcting shipbuilder-responsible defects  after delivery. Therefore, it is not positioned to know whether or not  warranties would increase the price of its ships. Because the Navy has  not historically used or considered warranties for its ships, it may be  prematurely discounting their use as a mechanism to improve ship quality  and cost. In this regard, there may be benefit in examining the practices  of others, such as the Coast Guard, which has adopted a warranty  approach for the FRC and plans to do so for its upcoming Offshore Patrol  Cutter.
section_title: Recommendations for Executive Action
paragraphs: To improve the use of warranties and guarantees in Navy shipbuilding,  we recommend that the Secretary of the Defense direct the Secretary of  the Navy to take the following three actions:  1.  In arrangements where the shipbuilder is paid to correct defects,  structure contract terms such that shipbuilders do not earn profit for  correcting construction deficiencies following delivery that are  determined to be their responsibility.  2.  Establish and document a clear objective for using a guaranty, and  then create guidance for contracting officers that illustrates how to  implement a guaranty that meets this objective. This guidance should  describe how contracting officers should use aspects of the guaranty,  including determining an appropriate limitation of liability, to achieve  the objective and include considerations as to when a guaranty should  be a separate contract line item.  3.  For future ship construction contracts, determine whether or not a  warranty as provided in the FAR, provides value and document the  costs, benefits, and other factors used to make this decision. To  inform this determination, the Navy should begin differentiating the  government’s and shipbuilder’s responsibility for defects and track the  costs to correct all defects after ship delivery.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of our report to the Departments of Defense and  Homeland Security for review and comment. In its written comments,  which are reprinted in appendix II of this report, DOD partially concurred  with all three of our recommendations, and stated the issues will be  addressed in a study to be completed by September 2016. The  Department of Homeland Security had no comments.
With regard to the first recommendation, DOD agreed that guaranty terms  should be reviewed, but disagreed that shipbuilding contracts always  result in the shipbuilder earning profit to correct defects determined to be  the shipbuilder’s responsibility. The latter point is not in contention, as our  report found that the extent to which the shipbuilder earns profit for  shipbuilder-responsible defects depends upon the type and terms of each  ship construction contract. Nevertheless, as noted in the report, we found  that for the four fixed-price incentive contracts in our review, the  government paid for almost all shipbuilder-responsible deficiencies found  after delivery. In its response, DOD stated that its policy changes, if any,  should avoid resulting in higher overall costs to the government due to  shipbuilder pricing associated with correcting defects. We agree; as we  have found, in the case of the Coast Guard’s Fast Response Cutter and  several private ship buyers discussed in this report, the use of a warranty  did not increase the cost of the ship. For example, we found several ship  buyers, in both government and private industry, that require extensive  warranties when purchasing ships and often receive this coverage with  little or no increase in cost.  The Navy plans to conduct a study to further  examine the details and determine what policy changes, if any, could be  implemented to change the structure of non-cost reimbursable contracts.  The Navy plans to coordinate its findings with DOD’s Defense  Procurement and Acquisition Policy and complete the study by  September 30, 2016.
With regard to our second recommendation, DOD also agreed that the  considerations underlying a decision to use a guaranty provision should  be documented, and that formal policy guidance on implementing a  guaranty would be helpful. DOD disagreed, however, that a single  objective for using a guaranty would satisfy the needs of all potential  shipbuilding programs. While we understand that each contract will  require different warranty or guaranty contract structures and provisions,  our recommendation was that the Navy define the basic purpose of its  guaranty, which is currently lacking. As noted in the report, we found that  different stakeholders within the Navy used the guaranty to accomplish  differing and, at times, contradictory objectives. Without a clear, basic  objective and associated guidance, the Navy is not well-positioned to  establish provisions that ensure the effectiveness of the guaranty. The  Navy plans to conduct a study to determine what policy, if any, and  guidance changes are necessary to effectively implement warranty or  guaranty provisions. Once again, the response states that the Navy will  coordinate with DOD’s Defense Procurement and Acquisition Policy and  complete the study by September 30, 2016.
In its response to our third recommendation, DOD stated that the Navy’s  planned study in response to our second recommendation will also  consider whether policy changes would be beneficial. DOD noted,  however, that the FAR already requires contracting officers to ensure that  the benefits of using a warranty are commensurate with the costs and  that the FAR prohibits warranties under cost-type contracts without  authorization. We found no evidence during the course of our review that  the Navy considers using a FAR-based warranty for its ship contracts. In  addition, all of the ships in our review were fixed price-type contracts.  DOD also disagreed with our finding that the Navy has not been tracking  costs to correct deficiencies after delivery. As we state in the report, the  Navy only tracks the costs of shipbuilder-responsible defects up to the  limitation of liability, which is often set very low compared to the total  number of defects. After the limitation of liability is reached, the cost to  repair shipbuilder-responsible defects is not tracked.
A final observation is that, in its response, DOD used the terms “warranty”  and “guaranty” interchangeably. As we have found, however, these two  mechanisms are very different and none of the Navy ships in our review  used a FAR-based warranty. As the Navy and DOD move forward with  the planned study and with implementing any changes to policy or  guidance, it will be important to make this distinction clear.
We are sending copies of this report to the Secretary of the Department  of Defense, the Secretary of the Department of Homeland Security, the  Secretary of the Navy, the Commandant of the Coast Guard, and  appropriate congressional committees. In addition, the report is available  on our website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-4841 or mackinm@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 key contributions to this  report are listed in appendix IV.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report assessed: (1) the extent to which the Navy and Coast Guard’s  guaranty or warranty mechanisms reduce the government’s exposure to  additional costs and improve the quality of basic ship construction, if any,  as compared to commercial shipbuilding; and (2) the extent to which the  Navy and Coast Guard use available acquisition regulation and guidance  in implementing guarantees and warranties in shipbuilding programs.
Our methodology for both objectives included reviewing the Navy and  Coast Guard’s guaranty and warranty policies and procedures. To assess  the implementation of these policies and procedures, we selected a non- generalizable case study analysis of six ships that encompassed the  majority of all ship classes recently delivered to and accepted by the Navy  and Coast Guard in the last five years. Although our sample is non- generalizable, the Navy told us that they use the same guaranty for each  ship and, though there are variations in contract type that impact how the  guaranty works, the guaranty mechanism that we reviewed is used for all  ships. Most of the contracts for the ships we reviewed were also used to  purchase other ships in the class. So while we focused on the six case  studies, the contracts and guaranty clauses we reviewed covered more  than 20 ships. The case studies were chosen to represent the majority of  shipyards in the United States that build Navy vessels, including Austal  USA in Mobile, Alabama; Bollinger Shipyards in Lockport, Louisiana;  General Dynamics Bath Iron Works in Bath, Maine; Huntington Ingalls  Industries Ingalls Shipbuilding in Pascagoula, Mississippi; and Marinette  Marine Corporation in Marinette, Wisconsin. We chose to review ships  that were purchased using fixed-price type and incentive-type contracts,  since warranties and guarantees on cost-reimbursement type contracts  reimburse the shipbuilder for deficiencies and these contracts are used  for immature shipbuilding efforts and we wanted to look at the hull,  mechanical, and electrical aspects of more mature ship construction  efforts. We did not choose lead ships, since lead ships tend to be  purchased using cost-reimbursement type contracts and usually have  more and different quality issues than the rest of the class. As shown in  table 5, the ships that met these criteria were the following: USS Michael  Murphy (DDG 112) guided missile destroyer, USS Somerset (LPD 25)  amphibious transport dock, USS Fort Worth (Littoral Combat Ship 3) and  USS Coronado (Littoral Combat Ship 4). From the Coast Guard, we  reviewed the following ships: USCGC Hamilton (National Security Cutter  4), and USCGC Paul Clark (Fast Response Cutter 6). Five of these ships  had guarantees while the FRC was the only ship with a warranty. We  also made observations about the FRC class of ships beyond just FRC 6.
To identify the extent to which the Navy’s guaranty mechanism reduces  the government’s exposure to additional costs resulting from defective  workmanship or equipment, we analyzed the costs to repair deficiencies  after delivery for the six Navy and Coast Guard case studies. To  determine the amount paid by the Navy and the Coast Guard for the  correction of deficiencies, we examined each ship’s contract and  calculated the amount paid in accordance with the contract. In the cases  where the ships were built using fixed-price incentive contracts, we  calculated the costs paid by the government in the following manner:  1.  We determined the estimated construction cost of the ship at  completion based upon the government’s estimate at complete at the  time the ship was delivered. Navy officials agreed that this is a  reasonable estimation of what the ship will cost when the contract is  officially closed out. The estimated construction cost at completion for  LPD 25, LCS 3, LCS 4, and NSC 4 is the government’s estimate of  the cost of the ships at the time the ship is delivered to the  government. The actual final cost is determined several years later  when the contract is closed.  2.  If the share line applied, which it did for LCS 3 and LPD 25, we  calculated each estimate at completion on the applicable portion of  the share line to determine how much the government paid (cost and  profit) for the portion of the ship to which the share line applied (in  both cases this was most of the construction effort of which the  guaranty is a very small segment). The share line did not apply to  LCS 4 because the contractor’s limitation of liability for guaranty work  was $0. In the case of NSC 4, the share line did not apply because  the guaranty was on a non-construction line item that did not have a  share line. Table 6 displays the share lines for LCS 3 and LPD 25.  The share line applies to the guaranty work only until costs for  guaranty work reach the limitation of contractor liability for correction  of defects specified in each ship’s contract.  3.  For the whole portion of the contract to which the share line applied,  we calculated the added or reduced profit based upon the share line  and the cost performance of the shipbuilder.  4.  We then applied the cost performance of the shipbuilder under the  share line to each portion of ship construction equally. For example, if  a shipbuilder earned 10 percent profit on the portion of the ship  construction to which the share line applied, we applied this profit  percentage to the guaranty work.  5.  We then combined what the government paid to correct defects per  the share line with the amount, if tracked, of shipbuilder-responsible  deficiencies the government paid for using other means such as post- delivery cost-reimbursement type arrangements.
To understand the effect of the warranty or guaranty on ship quality, we  reviewed documentation of defects after delivery, including trial cards,  current ship maintenance project documentation, and data collected by  shipbuilders. As reported, we found that these data were not reliable for  our purposes of understanding the total amount the government paid to  correct all shipbuilder-responsible defects. For example, the data did not  contain cost information for all defects and did not identify whether or not  the shipbuilder or the government was responsible for each defect. We  also compared ships with guarantees to ships with warranties used in  government and commercial shipbuilding programs to determine the  extent to which each mechanism improves ship quality. We  supplemented our information by interviewing Navy and Coast Guard  program and contracting officials, as well as by visiting three U.S. private  shipyards that build Navy and Coast Guard ships and spoke with shipyard  representatives regarding these case studies. We also met with officials  from several Navy offices responsible for building and delivering ships,  including various Supervisor of Shipbuilding, Conversion and Repair  (SUPSHIP) commands; Navy Sea Systems Command Contracting and  Logistics directorates. We also met with officials from Navy and Coast  Guard offices, such as the Program Executive Offices, and Coast Guard’s  Project Residence Offices to gain a full understanding of the execution of  a warranty and guaranty.
To assess the extent to which the Navy and Coast Guard use available  acquisition regulation and guidance in implementing warranties and  guarantees, we reviewed and analyzed the ship construction contracts for  each of the six case studies. We reviewed available guidance related to  warranties and guarantees, including the FAR, the Department of  Defense Warranty Guide, the SUPSHIP Operations Manual, and the  Naval Sea Systems Command Contracts Directorate Book of Standard  Component Clauses. We also reviewed federal standards for internal  control related to designing control activities, and assessed cost  estimating best practices guidance. Based on the available guidance, we  developed a list of the principles and their objectives regarding the use of  warranties and compared how these were implemented for the six case  studies we reviewed. In addition, we participated in the government’s  acceptance of FRC 13 from the shipbuilder (also known as ship delivery)  in July 2015, which provided us with a better understanding of how the  Coast Guard executes its warranty.
Our methodology also included learning about key practices used by  leading commercial ship buyer regarding the structure and  implementation of warranties for newly constructed vessels. We  compared the execution of the guaranty or warranty of our government  ship case studies to the execution of warranties on commercial ships of  similar size and construction complexity. Our comparisons with  commercial shipbuilding focused on basic ship construction because the  work is similar to hull, mechanical and electrical work completed on Navy  and Coast Guard ships. To do so, we interviewed leading ship buyers  from the cruise, oil and gas, and commercial shipping industries some of  which also provided us with supporting documentation, such as contract  clauses. For the purposes of this review, the leading commercial ship  buyers we spoke with included a number of companies that we identified  in our previous work as leaders in their industry in terms of being large  operators of cruise ships, oil and gas vessels, or containerships, and that  agreed to participate in our review, including: Carnival Corporation and  Royal Caribbean Cruises, Ltd.; Chevron Inc; and A.P. Moller-Maersk A/S,  respectively.
We conducted this performance audit from December 2014 to March  2016 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence for our findings and conclusions  based on our audit objectives. We believe that the evidence obtained  provides a reasonable basis for our findings and conclusions, based on  our audit objectives.
section_title: Appendix II: Comments from the Department of Defense
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition the contact name above, the following staff members made  key contributions to this report: Diana Moldafsky, Assistant Director;  Laurier Fish; Joseph Franzwa; Ronald Freeman; Laura Greifner; Kristine  Hassinger; Marie Suding; Roxanna Sun; and Abby Volk.
section_title: Related GAO Products
paragraphs: National Security Cutter: Enhanced Oversight Needed to Ensure  Problems are Discovered during Testing and Operations are Addressed.   GAO-16-148. Washington, D.C.: Jan. 12, 2016.
Littoral Combat Ship: Navy Complied with Regulations in Accepting Two  Lead Ships, but Quality Problems Persisted after Delivery. GAO-14-827.  Washington, D.C.: Sept. 25, 2014.
Coast Guard Acquisitions: Better Information on Performance and  Funding Needed to Address Shortfalls. GAO-14-450. Washington, D.C.:  June 05, 2014.
Navy Shipbuilding: Opportunities Exist to Improve Practices Affecting  Quality. GAO-14-122. Washington, D.C.: Nov. 19, 2013.
Best Practices: High Levels of Knowledge at Key Points Differentiate  Commercial Shipbuilding from Navy Shipbuilding. GAO-09-322.  Washington, D.C.: May 13, 2009.
Weapons Acquisition: Warranty Law Should Be Repealed. NSIAD-96-88.  Washington, D.C.: June 28, 1996.