Navy Shipbuilding: Need to Document Rationale for the Use of Fixed-Price Incentive Contracts and Study Effectiveness of Added Incentives
Published: 2017-03-01T00:00:00

Fast Facts:
The Navy buys ships using a certain contract type that outlines how it will share the burden of unexpected costs with shipbuilders, while also giving them additional money for constructing ships efficiently.
However, in the 6 contracts we reviewed, we found the Navy bore the majority of additional costs. Plus, the contracts included $700 million in extra incentives for things that shipbuilders should have been doing anyway. Shipbuilders could get these incentives even if they delivered ships late and above cost.
We made recommendations to help the Navy evaluate its contracts, and study the effect of extra incentives in such contracts.

Highlights:
section_title: Why GAO Did This Study
paragraphs: DOD encourages the use of FPI contracts because they allow for equitable sharing of costs savings and risk with the shipbuilder. Under FPI contracts, the shipbuilder's ability to earn a profit or a fee is tied to performance. After costs reach the agreed upon target cost, the shipbuilder's profit decreases in relation to the increasing costs. A ceiling price fixes the government's maximum liability.
A House Report on the Fiscal Year 2014 National Defense Authorization Act included a provision for GAO to examine the Navy's use of FPI contracts for shipbuilding. This report examines (1) the extent to which the Navy has entered into FPI contracts over the past 10 years, (2) how FPI contracts apportion risk between the Navy and the shipbuilder, and (3) the extent to which FPI contracts led to desired cost outcomes. GAO selected a non-generalizable sample of six contracts (for 40 ships) awarded during the past 10 years, analyzed Navy contract documents, and interviewed program, contract, and shipbuilding officials. This is the public version of a sensitive but unclassified report issued in November 2016.
section_title: What GAO Found
paragraphs: Over 80 percent of the Navy's shipbuilding contracts awarded over the past 10 years were fixed-price incentive (FPI). However, GAO found that half of the six selected contracts it reviewed did not document the Navy's justification for selecting this contract type. Moreover, key documents that should describe the rationale for selecting contract elements varied across these contracts. Given the Navy's plans to invest billions of dollars in shipbuilding programs in the future, without adequate documentation on the rationale for use of an FPI contract and key decisions made about FPI contract elements, contracting officers will not have the information they need to make sound decisions at the negotiation table.
Department of Defense (DOD) regulation suggests, as a point of departure for contract negotiations, that the government and shipbuilders share the cost risk equally and set a ceiling price 20 percent higher than the negotiated target cost. GAO found that, for most of the 40 ships on the contracts reviewed, these contract terms resulted in the Navy absorbing more cost risk, as shown below.
Many factors inform the Navy's and shipbuilder's negotiation positions, including the stability of the supplier base and extent of competition. That said, guidance states that the FPI contract elements should be the primary incentive for motivating the shipbuilder to control costs. But GAO found that in five of the six contracts, the Navy added over $700 million in incentives.
Of the 11 ships delivered as of December 2015 under the six contracts, 8 experienced cost growth. In one case, costs grew nearly 45 percent higher than the negotiated target cost. Further, it is unclear whether the additional incentives achieved intended cost and schedule outcomes, as GAO found a mixed picture among the contracts reviewed. Regulation, while not prescriptive, highlights the benefits of measuring the effectiveness of incentives. According to a senior Navy contracting official, the Navy has not measured incentive outcomes for its shipbuilding portfolio. Without assessing whether adding incentives is effective in improving shipbuilder performance, the Navy is missing an opportunity to better inform decisions about whether to include additional incentives in future awards.
section_title: What GAO Recommends
paragraphs: For shipbuilding contract awards, the Navy should (1) document in the contract file its rationale for selecting an FPI contract and the basis for contract elements and (2) conduct a portfolio-wide assessment of its use of additional incentives on FPI contracts across its shipbuilding programs. DOD agreed with GAO's recommendations and stated that actions will be taken in 2017 to address them.

section_title: Letter
paragraphs: The U.S. Navy builds the most sophisticated, technologically advanced  ships in the world, but pays a high premium for this capability. Recent  Department of Defense (DOD) initiatives have encouraged the increased  use of fixed-price incentive (FPI) contracts as a way to obtain greater  efficiency and productivity in defense spending. In the past 10 years, the  Navy has obligated more than $72 billion in contracts for detail design  and construction. The first ship of a class, called a lead ship, is often  purchased with a cost-reimbursement type contract under which the  government generally bears the risk of cost, schedule, or ship  performance problems. After contracting for the first few ships in a class,  the Navy generally moves to an FPI contract because greater certainty  about costs and performance allows for the use of this type of contract.  FPI contracts provide the shipbuilder an incentive to control costs by  linking final profit realized to final negotiated and actual costs. FPI  contracts also mitigate the shipbuilder’s cost risk in that the Navy shares  in cost increases up to a specified point, and conversely any cost savings  if actual final costs are less than the target cost. While FPI contracts  should motivate the shipbuilder to control costs, according to our past  work, cost and schedule growth remain a persistent problem in Navy  shipbuilding programs.
For nearly a decade, we have encouraged the use of fixed-price type  contracts for Navy shipbuilding programs. In 2007, we reported that  because the Navy commonly experienced cost growth on lead and follow- on ships it could improve cost outcomes for shipbuilding programs by  increasing the use of fixed-price contracts. We also noted that the use of  fixed-price contracts require that technologies be demonstrated early, the  design be stabilized before construction begins, and that realistic  estimates for cost and schedule be made. In 2009, we also reported on  the Navy’s use of contracts for detail design and ship construction, and  compared it to commercial practices. We found that leading commercial  shipbuilders and ship buyers exclusively employ firm-fixed-price contracts  with accompanying penalties for delays. In comparison, we found that the  Navy often relied upon contract structures that left a higher level of risk  with the Navy as the buyer—such as cost reimbursement and FPI  contracts—often because an incomplete understanding of the effort  needed to complete the ship translated into uncertainty about costs.
A House Report on the Fiscal Year 2014 National Defense Authorization  Act included a provision for us to examine the Navy’s use of FPI contracts  for shipbuilding programs. This report examines (1) the extent to which  the Navy has entered into FPI contracts over the last 10 years and the  factors that influence the Navy’s contracting approach when awarding FPI  contracts for ship construction, (2) how the Navy apportions risk between  the government and the shipbuilder for these contracts, and (3) the extent  to which use of the FPI contract type has led to desired outcomes.
To determine the Navy’s use of FPI contracts over the last 10 years, we  compiled and analyzed DOD data on contracts awarded for detail design  and construction of new ships from November 2005 through November  2015. To gain an understanding of how the Navy determines the use of  FPI contracts and implements them, we reviewed a nongeneralizable  sample of six FPI contracts awarded by the Navy for new ship  construction during our 10-year time frame. To select specific contracts  for review to address our second and third objectives, we first selected  shipbuilding programs that had at least one ship previously delivered by  the shipbuilder, or would be delivered imminently and represented the  majority of U.S. shipyards that build Navy vessels, including Austal USA  in Mobile, Alabama; General Dynamics Bath Iron Works in Bath, Maine;  General Dynamics Electric Boat in Groton, Connecticut; General  Dynamics NASSCO in San Diego, California; Huntington Ingalls  Industries in Pascagoula, Mississippi; and Marinette Marine Corporation  in Marinette, Wisconsin. Based on the shipbuilding programs that met this  criterion, we selected the following 6 Navy contracts for review, for a total  of 40 ships: one contract with two Arleigh Burke-class guided missile destroyers  (DDG 51 class), one contract with two expeditionary transfer dock (ESD) and two  expeditionary mobile base (ESB) ships,  two contracts with 10 Littoral Combat Ships (LCS) each, one contract with six San Antonio-class amphibious transport dock  ships (LPD 17 class), and one contract with eight Virginia-class submarines (SSN 774 class).
The five Navy shipbuilding programs associated with our six selected  contracts cover all of the major U.S. shipbuilders. Figure 1 depicts the  major U.S. shipbuilders for the specific programs we reviewed.
To determine how the Navy apportioned risk between the government  and shipbuilder, we reviewed contract file documentation including  acquisition planning documents, requests for proposals (RFP), business  clearance memorandums (key documents that explain the rationale for  contract selection and structure of FPI contract elements including target  cost, target profit, share line and ceiling price), the contracts, cost and  schedule data, and program briefings, among other documents, and  compared them to relevant guidance on contract selection and the use of  FPI contracts.
To determine the extent to which FPI contracts led to desired outcomes  and identify changes in cost, price, and incentives through contract  modifications over the life of the contract, we reviewed this information  both at the time of initial contract award—including target cost, share line,  ceiling price, and incentives—as well as the same updated information in  the conformed version of the contract as of December 2015. We  calculated the price to government for each ship, including the  shipbuilder’s profit or loss, by comparing the estimated cost at completion  as of December 2015 to the target cost, share line, and ceiling price in the  conformed version of the contract as of December 2015. We assessed  the reliability of DOD’s Electronic Document Access (EDA) System data  by reviewing existing information about the data and comparing it with  documentation in the contract files. EDA is a web-based system which  provides users with access to contractual and procurement documents  used by multiple DOD activities to streamline their business processes.  We determined that the data were sufficiently reliable for the purpose of  this report. We supplemented our review of contract file information with  interviews with program and contracting officials for each shipbuilding  program associated with our six selected contracts, senior contracting  officials in the Naval Sea Systems Command (NAVSEA) Contracts  Directorate, officials from the Navy’s Supervisor of Shipbuilding,  Conversion and Repair (SUPSHIP), officials from the Under Secretary of  Defense (Acquisition, Technology and Logistics) Office for Defense  Procurement and Acquisition Policy, and shipbuilders. Appendix I  contains more detail on our objectives, scope, and methodology.
This report is a public version of a sensitive but unclassified report that we  issued on November 9, 2016. DOD regarded some of the material in that  report as sensitive but unclassified information, which must be protected  from public disclosure and is available for official use only. As a result,  this public version of the original report does not contain certain  information deemed to be sensitive but unclassified by DOD, including  specific share lines, ceiling prices, and target costs of the Navy ships we  assessed, our assessment of the relative differences in share of cost risk  between the Navy and shipbuilder on the 40 ships reviewed, specific  dollar amounts of added incentives on ships we assessed, and Navy and  shipbuilder cost outcomes on six delivered ships with significant cost  growth. This report uses data from December 2015 to be consistent with  the report issued in November 2016.
We conducted this performance audit from September 2015 to March  2017 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 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
paragraphs: Navy ships are complex defense systems, using advanced designs with  state-of-the-art weapons, communications, and navigation technologies  and requiring many years to plan, budget, design, and build.
subsections: section_title: Navy Shipbuilding Contract Types
paragraphs: The Navy uses three primary contract types for shipbuilding programs— firm-fixed-price, FPI, and cost-reimbursement type contracts. Contract  type selection is a key factor in determining risk apportionment between  the Navy and the shipbuilder. According to the Director of Defense  Pricing, choosing a contract type is an important way of aligning the  incentives between the government and the shipbuilder. No single  contract type will work for all shipbuilding programs in all cases. The  following is a brief description of each contract type used in Navy  shipbuilding programs:
Cost-Reimbursement Contracts—the government pays the  shipbuilder’s allowable incurred costs to the extent specified in the  contract and may include an additional fee (profit). These contracts  establish an estimate of total costs and a ceiling that the contract may  not exceed without the approval of the government. The shipbuilder  must put forth its best efforts to perform the work within the estimated  costs. However, the government must reimburse the builder for its  allowable costs regardless of whether the work is completed.  Generally this contract type is used when requirements are not well  defined or lack of knowledge does not permit costs to be sufficiently  estimated to use a fixed-price contract, such as in the case of  designing and building lead ships.
Fixed-Price Incentive (FPI) Contracts—the contract specifies several  contract elements including a profit adjustment formula referred to as  a share line. In accordance with the share line, the government and  the shipbuilder share responsibility for cost increases, or decreases,  compared to the agreed upon target cost. The final negotiated cost is  subject to a ceiling price, which is the maximum that may be paid to  the contractor, except for any adjustment under other contract  clauses. Generally, the share line functions to decrease the  shipbuilder’s profit as actual costs exceed the target cost. Likewise,  the shipbuilder’s profit increases when actual costs are less than the  target cost for the ship. Since the shipbuilder’s profit is linked to actual  performance, FPI contracts provide an incentive for the shipbuilder to  control costs. Incentive arrangements can be designed to achieve  specific objectives by motivating contractor efforts that might not  otherwise be emphasized and discouraging contractor inefficiency  and waste.
Firm-Fixed-Price Contracts—the government agrees to purchase a  ship for a set price and the shipbuilder is required to deliver a ship  regardless of their actual costs. The shipbuilder bears the full  responsibility for increases in the cost of construction and therefore  can earn a higher profit if actual costs are below the contract price.  The shipbuilder bears the maximum risk and full responsibility for all  costs and resulting profit or loss. This contract type is suitable for  situations where the government and shipbuilder have a clear  understanding of the scope of work and are confident in the cost of  ship construction.
section_title: Elements of Fixed-Price Incentive Contracts
paragraphs: FPI contracts are complex and comprised of a target cost, target profit,  target price, ceiling price, and a profit adjustment formula, which the Navy  refers to as a sharing ratio, or a share line, which is used to determine  profit earned by the shipbuilder. The target cost, schedule, terms and  conditions, and the scope of work influence how the share line and ceiling  price are established. The structure of the share line establishes how cost  overruns (over target cost) and cost underruns (below target cost) are  shared between the government and shipbuilder, and is used to calculate  final profit earned by the shipbuilder. The ceiling price is the maximum the  government can pay under the contract, except for adjustments under  other clauses, and is expressed as a percentage of the target cost. The  share line is intended to be the primary incentive for the shipbuilder to  control costs.
The Navy uses various share line structures under FPI shipbuilding  contracts. A commonly used share line utilizes the same share ratio  between the shipbuilder and the government for both under target and  over target performance. Figure 2 depicts a hypothetical example contract  with a 50/50 share line above and below the target cost, with the ceiling  price set at 120 percent of target cost. This means that the cost overrun  or cost underrun savings would be shared equally between the Navy and  shipbuilder. As shown in the figure, the ceiling price represents the  government’s maximum liability under the contract. The figure also details  the elements of an FPI contract that are negotiated at the outset.
In instances when cost risk apportionment is not equally shared between  the shipbuilder and the Navy, a share line with different share ratios for  under target and over target performance—such as an 80/20 underrun  and a 70/30 overrun—can be used. In these scenarios, the Navy would  receive 80 cents of every dollar of cost savings or conversely pay 70  cents of every dollar of cost overrun.
section_title: DOD and Navy Guidance on FPI Contracts
paragraphs: In recent years, DOD has pushed for the increased use of FPI contracts  in major defense acquisition programs, where appropriate. Guidance and  regulations on the use of FPI contracts include:
A series of Better Buying Power initiative memorandums, including a  September 2010 memorandum in which DOD’s Office of the Under  Secretary of Defense for Acquisition, Technology, and Logistics (USD  (AT&L)) encouraged the use of FPI contracts for acquisition programs  in early production—this memorandum was followed by more detailed  guidance that specified actions that USD (AT&L) expected to be  executed. The September 2010, Better Buying Power initiative  encouraged the use of FPI contracts, in part, because in the past  DOD had awarded cost-plus-award-fee contracts with subjective  award fees not clearly tied to cost control. A November 2010  memorandum stated the expectation that acquisition teams pay  particular attention to share lines and ceiling prices, and that FPI  contracts with a 50/50 share line and 120 percent ceiling price should  be the norm, or starting point. The Director of Defense Pricing stated  that he believes DOD’s increased use of FPI contracts, coupled with a  more professional workforce that is more cost conscious, has saved  billions of dollars and will ultimately result in savings far in excess of  any other initiative associated with Better Buying Power.
In response to DOD’s Better Buying Power initiatives, the Office of the  Secretary of Defense’s Defense Procurement Acquisition Policy Office  released guidance for using incentive contracts in April 2016. This  guidance stated that the use of FPI contracts by programs leads to  better cost and schedule performance outcomes, and therefore  suggested employing FPI contracts when appropriate—such as in a  program’s early production phase or near the end of engineering and  manufacturing development.
The Defense Federal Acquisition Regulation Supplement (DFARS),  which has implemented the guidance set forth in the 2010 Better  Buying Power initiatives, states that the contracting officer shall pay  particular attention to share lines and ceiling prices for FPI contracts,  with a 120 percent ceiling and a 50/50 share ratio, or sharing  arrangement, as the point of departure for establishing the incentive  arrangement.
The Federal Acquisition Regulation (FAR) outlines the appropriate  use of FPI contracts. The FAR states that an FPI contract should be  considered appropriate when a firm-fixed-price contract is not suitable  or the nature of the supplies or services being acquired and other  circumstances of the acquisition are such that the contractor’s  assumption of a degree of cost responsibility will provide a positive  profit incentive for effective cost control and performance. The FAR  goes on to state that, if the contract also includes incentives on  technical performance and/or delivery, the performance requirements  should provide a reasonable opportunity for the incentives to have a  meaningful impact on the contractor’s management of the work.  Further, the FAR specifies that FPI contracts are appropriate when  the parties can negotiate at the outset a firm target cost, target profit,  and profit adjustment formula that will provide a fair and reasonable  incentive and a ceiling that provides for the contractor to assume an  appropriate share of the risk. When the contractor assumes a  considerable or major share of the cost responsibility under the  adjustment formula, the target profit should reflect this responsibility.
A series of memorandums released by the Assistant Secretary of the  Navy for Research, Development and Acquisition between 2003 and  2010 stressed the importance of structuring incentive contracts in a  way that best motivates the shipbuilder to meet requirements and  protects the government’s cost position.
While DOD has recently promoted the use of FPI contracts through its  Better Buying Power initiatives and changes to the DFARS, the Navy has  used FPI contracts for shipbuilding programs for over 40 years.  Specifically, FPI contracts have been the Navy’s primary contract type  since the mid-1970s, when the Navy shifted away from fixed-price sealed  bid contracting—which began in 1963 at the recommendation of the  Secretary of Defense. Moreover, during the 1980s, FPI contracts became  the preferred contract type for detail design and construction of lead ships  and follow-on ship construction, with many of the contracts using a 50/50  share line. According to DOD officials, FPI contracts fell out of fashion  after the 1980s, with the Navy awarding more cost-type contracts  throughout the 1990s. Beginning in 2000, FPI contracts once again  became the primary contracting method awarded for Navy ship  construction for all but lead and early follow-on ships. We elaborate below  on the picture over the past 10 years.
section_title: Differences between Navy and Commercial Shipbuilding
paragraphs: We have reported for many years on the long-standing problem of cost  growth in shipbuilding programs. In our prior work examining numerous  shipbuilding programs, we have found that cost growth was often  attributed to the Navy awarding contracts to design and construct its ships  before retiring technical risk. Without a full understanding of the effort  needed to deliver the ship, the government negotiated contracts where  the Navy assumed all or a large percentage of risk, and was largely  responsible for cost growth. In contrast, in our prior work when we  examined commercial shipbuilding practices we found that ships are  usually delivered on time, at cost, and with expected quality. Our prior  work highlights differences in Navy and commercial shipbuilding  contracting practices, which reflect differences in the two environments:  In May 2009, we found: (1) for commercial shipbuilders and ship  buyers, only firm-fixed-price contracts were used for design and  construction activities, and the delivery date of the ship is clearly  established in the contract with accompanying penalties for delays; (2)  commercial buyers were able to choose from a competitive global  base of available shipyards and suppliers without generally needing to  consider the long-term health of any individual yard or supplier; and  (3) buyers and shipbuilders both made acquisition decisions based on  anticipated return on investment.
In November 2013, we reported that as opposed to commercial  buyers, which typically operate in a robust, competitive environment,  the Navy has a limited industrial base to build its ships. We noted that  one result of the limited industrial base is that the Navy may award  sole source contracts in order to sustain workloads and the solvency  of the companies involved. This is because the Navy has fewer  choices of shipbuilders and has an interest in sustaining these  shipbuilders despite shortfalls in performance.
section_title: The Navy Primarily Used FPI Contracts for Shipbuilding over the Past 10 Years in an Effort to Share Cost Risk While Sustaining the Industrial Base
paragraphs: From November 2005 to November 2015, the majority—19 of 23—of the  Navy’s shipbuilding contracts were FPI, with contract obligations of $66.5  billion. According to Navy contracting officials, FPI contracts can enable  the Navy and the shipbuilder to share cost risk more equitably than other  contract types. However, three of the six selected FPI contracts we  reviewed lacked a key document describing the Navy’s rationale for  selecting an FPI contract. In addition, business clearance  memorandums—which document the basis for approval of the action and  for determining that negotiated prices are fair and reasonable, provided  varying levels of insight into the rationale for final contract terms. The  Navy is awarding these complex FPI contracts in an environment with a  limited industrial base and low volume of ship procurement. These factors  constrain the Navy’s ability to award shipbuilding contracts competitively.  While competition can better position the Navy to influence final contract  terms, the Navy is, for the most part, the only customer for the major U.S.  shipbuilders and therefore has a desire to sustain shipbuilders despite  shortfalls in performance. Many factors—such as the degree of  competition and the number of ships expected to be procured under a  contract—are considered during contract negotiations to determine FPI  contract terms. But the realities of the U.S. shipbuilding environment  reduce the Navy’s leverage to negotiate favorable contract terms even  when shipbuilder performance falters.
subsections: section_title: The Navy Primarily Used Fixed-Price Incentive Contracts for Shipbuilding over the Past 10 Years
paragraphs: Between November 1, 2005, and November 30, 2015, the Navy awarded  23 detail design and construction contracts for Navy shipbuilding  programs. Of the 23 contracts awarded in the 10-year time frame, 19  were FPI contracts as shown in figure 3.
A total of 83 individual ships were included under these 23 contracts,  accounting for over $72 billion in contract obligations. A majority of these  ships, 79, were awarded on an FPI basis, representing $66.5 billion in  contract obligations, or over 92 percent of the Navy’s total obligations for  detail design and construction during the time frame, as shown in figure 4.
section_title: The Navy Prefers FPI Contracts but Did Not Always Document Its Rationale for Determining Contract Type and Elements
paragraphs: According to Navy contracting officials, the Navy prefers FPI contracts for  shipbuilding programs over other contract types because cost risk can be  shared between the Navy and the shipbuilder more equitably. According  to the Director of Defense Pricing, contractors are trained to include the  price of all risks in their cost; therefore, FPI contracts can result in lower  contract costs than firm-fixed-price contracts because if risks do not  materialize under an FPI contract the government and the contractor  share any cost savings. Under a cost-plus-incentive-fee contract, once  costs exceed the target cost, the Navy continues to pay the allowable  costs and the shipbuilder only earns the minimum fee (profit). Under an  FPI contract, the shipbuilder generally absorbs costs above the ceiling  price. In contrast to both of these situations, under a firm-fixed-price  contract the shipbuilder assumes full responsibility for all costs and the resulting profit or loss. Navy contracting officials explained that the Navy  rarely uses firm-fixed-price contracts for shipbuilding because it would  likely result in higher offers. They noted that for ship construction,  shipbuilders would likely factor in additional costs to account for their  assumption of risk—particularly given the lack of competitive cost  pressures due to the limited shipbuilding industrial base. Figure 5  identifies cost risk to the Navy and shipbuilder by contract type.
A required contract document that is intended to convey the rationale for  selecting an FPI contract was not present in half of the six contract files  we reviewed. Beginning in October 2009, the FAR required the  government to complete a determination and findings document and  include it in the contract file for all incentive- and award-fee contracts  justifying that the use of this type of contract is in the best interest of the  government. Three of our six selected contract files, awarded after the  interim FAR rule was published in October 2009, did not contain this  required determination and findings document.
When we raised this issue, a senior Navy contracting official  acknowledged that the NAVSEA Contracts Directorate had not been  consistent in completing a determination and findings document for  incentive-fee type contracts. Better documentation would help ensure that  contract files reflect the rationale for why an FPI contract was determined  to be the preferred contract type. From a business perspective,  contracting officials who later revisit the file to make modifications or plan  for future awards may not have a thorough understanding of why this  contract type was selected. According to this same official, although the  directorate had not been consistent in completing a determination and  findings document for incentive-fee contracts, the general business  process in place within the directorate, even prior to the FAR change, was  to include discussion of contract type, including any applicable incentive  fees, in the business clearance memorandum or acquisition planning  documents.
Navy contracting officials told us that business clearance memorandums,  specifically, are key documents for obtaining insight into decisions  regarding FPI elements (e.g., target cost, share line, and ceiling price).  These memorandums are generally required for each negotiated contract  action by the Navy Marine Corps Acquisition Regulation Supplement,  which states that the purpose of a pre-negotiation business clearance  memorandum (completed prior to negotiations) and post-negotiation  business clearance memorandum (completed prior to a settlement  commitment) is to document the basis for approval of the action, and the  basis for determination that the negotiated prices are fair and  reasonable. Additionally, the FAR requires the contracting officer to  include this type of document in the contract file, and details specific  requirements as to the content. However, the business clearance  memorandums we reviewed provided varied levels of insight into  decisions surrounding the rationale for final FPI contract terms. For  example, the post-negotiation business clearance memorandum for the  LPD 22-25 contract was relatively robust in its level of insight; it included  a detailed rationale for the share lines, which were structured to reach  agreement for two risks—shipbuilder’s property insurance and facility  closure. Specifically, the post-negotiation business clearance  memorandum provided detailed information on the nature of each risk,  including a quantification of the potential cost impacts, to support the  steps in the overrun share lines. In contrast, we found that:
The SSN 784-791 contract, which was awarded on a sole source  basis, did not have a post-negotiation business clearance  memorandum in the contract file. According to a Navy contracting  official, the post-negotiation business clearance memorandum was  never completed because the staff responsible was reassigned to  other higher priority work.
The combined pre- and post-negotiation business clearance  memorandum for the DDG 115 and DDG 116 noted that the contract  includes a milestone-based incentive for each ship in order to  motivate the shipbuilder on technical and management performance.  However, while the memorandum provides a general statement on  the purpose of the incentive, it did not explain the rationale for how the  contracting officials determined the amount of the incentive or how it  would possibly impact the target profit available on the contract. The  contracting officials involved believed that the information in the  business clearance memorandum was adequate.
The post-negotiation business clearance memorandum for the two  LCS block buy contracts did not include any information on the Navy’s  rationale for selecting the share line and ceiling price for all 10 ships  on each contract. These terms had been specified in the RFPs and  were ultimately included in the contracts.
Without proper documentation for these complex contracts and the key  decisions made about contract selection and FPI contract elements, the  Navy does not position its contracting officials to clearly understand how  decisions were made or to understand how to negotiate new contract  terms in a way that would be most beneficial to the government. This is  particularly important for the Navy going forward, as it intends to invest  many billions of dollars in these same shipbuilding programs—in addition  to others—over the next few decades.
section_title: While a Limited Shipbuilding Industrial Base Restricts the Navy’s Bargaining Power, Competition Can Better Position the Navy to Influence Final Contract Terms
paragraphs: A limited number of U.S. shipbuilders and low volume of ship  procurement limit the Navy’s ability to award shipbuilding contracts  competitively. Two companies—General Dynamics Corporation and  Huntington Ingalls Industries—own five of the seven major U.S. shipyards  that build Navy vessels. Further, 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 seven shipyards, only Newport  News and Electric Boat have facilities for constructing nuclear  submarines. We previously reported that this is in contrast to commercial  ship buyers, who have an array of yards and suppliers to choose from.
The desire to sustain workloads of the major U.S. shipyards is a key  concern for the Navy, which also affects the Navy’s ability to procure  ships using full and open competition, because of the need to preserve  the industrial base long-term for future shipbuilding programs. However,  even in competitive procurements, the Navy’s interest in maintaining the  long-term health of U.S. shipbuilders can weaken its leverage at the  negotiation table. This is because, unlike commercial buyers, the Navy  and its shipbuilders largely operate in a symbiotic relationship, meaning  that the Navy is, for the most part, the only customer and the major  shipbuilders are the only providers of the desired product—the Navy ship.  Of the seven major shipyards, only General Dynamics NASSCO regularly  builds commercial ships alongside the Navy’s. As a result, the Navy can  be driven to sustain the shipbuilders for future programs despite shortfalls  in performance.
The impact of the shipbuilding industrial base on the Navy’s ability to  drive a favorable business deal is particularly highlighted in a sole source  environment. Two of the six contracts we reviewed were initially sole  source awards. In these cases, generally all contract terms—including  contract type—were established through bilateral negotiations between  the Navy and the shipbuilder. Therefore, once the Navy selects an FPI  contract, the contract elements that are used to determine final contract  price—including the share line and ceiling price—are subject to  negotiations; the Navy cannot rely on competitive forces to strengthen its  negotiation position. The LPD 21 is an example of the reduced leverage  the government has in a sole source environment. During negotiations for  detail design and construction of LPD 21, the Navy agreed with the  shipbuilder’s request to change from an FPI/award-fee contract—as had  been specified in the RFP—to a cost-plus-incentive-fee/award-fee  contract. Specifically, the shipbuilder informed the Navy that an  FPI/award-fee contract would require it to offer an excessively  conservative and unaffordable target cost. In light of this position, Navy  contracting officials believed that a cost-plus-incentive/award-fee contract  would be an acceptable solution. As a result, the program requested and  received approval from the Assistant Secretary of the Navy for Research,  Development, and Acquisition to proceed with cost-plus-incentive- fee/award-fee negotiations.
Even under the inherent constraints posed by the U.S. shipbuilding  industrial base, competition can better position the Navy in negotiations  than in a sole source environment. In a competitive RFP, for example, the  contract type and other terms, including the share line and ceiling price,  that the Navy specifies in its RFPs generally remain the same through  negotiations and award in competitive acquisitions. Under this scenario,  competition can help ensure that the shipbuilders put forth their best offer.  For example, the Navy’s RFP for DDG 114-116, which used limited  competition between the two builders of the DDG 51-class destroyers,  specified an FPI contract type, 50/50 share line, target profit, and ceiling  price.  These contract terms remained consistent throughout  negotiations.
section_title: The Navy and Shipbuilders Weigh Multiple Factors to Determine FPI Contract Elements
paragraphs: During our discussions with Navy contracting officials and shipbuilder  representatives they emphasized that they consider multiple factors  during contract negotiations to determine their negotiating positions  regarding the various FPI contract elements. As shown in figure 6 below,  how these factors are balanced in a contract ultimately determines the  Navy’s share of cost risk. Each contract is distinct with individual factors  that are weighed differently depending on the unique circumstances of  the acquisition. For example, if the contract is for a lead ship of a new  class, the Navy and shipbuilder may weigh factors differently than if the  contract is for a class where numerous ships have been delivered, since  as we have reported previously, cost growth and schedule delays can be  amplified for lead ships. The factors range from broad considerations— such as degree of competition and the health of the industrial base—to  considerations specific to individual shipbuilding programs, such as the  number of ships expected to be procured under a contract.
Across the six selected contracts we reviewed, several factors shaped the  structure of FPI contract elements. For example, one factor that shaped  the structure of the FPI contract for the ESD/ESB program was that  competition existed to build the ships, which enabled the Navy to issue a  competitive RFP for system design with options for ship construction  (lead ship and two follow-on ships) specifying an FPI contract type, share  line, and ceiling price. Two shipbuilders submitted offers; however, one of  the offerors withdrew and the contract was awarded to NASSCO. When  the Navy exercised the options for ship construction, NASSCO  representatives told us that NASSCO considered several factors in  developing its proposal, including the use of a commercial ship design  and the other workload NASSCO planned to have in the shipyard, which  impacts overhead rates. In response to the shipbuilder agreeing to the  Navy’s contract terms, the Navy altered the underrun share line stated in  the RFP and agreed to allow the shipbuilder to receive a greater share of  the profit in the event actual costs were lower than expected.
An important factor in determining FPI contract elements for the Navy and  shipbuilder is whether the contract will be a multi-year or block buy  contract. These special contracting methods, which can only be used if  Congress takes certain actions, allow DOD to acquire more than one  year’s requirements under a single contract award without having to  exercise a contract option for each year after the first. Three of the six  contracts we reviewed were awarded as block buy or multi-year  procurement contracts. In 2010, the Navy awarded a block buy contract  for 10 ships to each of the two LCS shipbuilders, and the SSN 774 class  contract was awarded in 2008 as a multi-year contract. These contract  methods have the potential to create cost savings compared to a series of  annual contracts because the shipbuilder is given an expectation of future  workload, and allow for more economic procurement from suppliers and  more efficient production which can translate into lower ship prices for the  government. Under these contracting methods, the Navy and the  shipbuilder typically negotiate prices for construction of all the ships on  the contract at the same time, as well as the share line and ceiling price.  Under such negotiations, the shipbuilder and Navy need to make assumptions regarding the shipbuilder’s efficiencies, learning, and  suppliers far into the future. For the three block buy or multi-year  contracts we reviewed, we found that the share lines and ceiling prices  did not change across the ships on each of these contracts, with target  costs generally lower for ships procured later in the build profile,  presumably to account for the shipbuilders’ efficiencies and learning.
section_title: Structure of FPI Contract Elements Often Resulted in the Navy Absorbing More Cost Risk Than Guidance Advises, and Added Incentives Increased the Shipbuilders’ Potential Profitability
paragraphs: Although FPI contracts are intended to motivate the shipbuilder to control  costs by requiring the shipbuilder to assume a suitable share of the cost  risk, the Navy often structured the FPI contracts we reviewed such that it  shouldered more cost risk than guidance suggests as a starting point.  While the guidance takes into account that each contract negotiation has  its own unique aspects, we found a number of occasions where the Navy  had departed from it, suggesting that the Navy may not be reaping the  expected benefits of this contract type. Specifically, we found that: (1) for  two of the six selected contracts, uncertainties at the time of contract  award made establishing a realistic target cost challenging and (2) for  most of the six contracts, share lines or ceiling prices were not in line with  what guidance suggests as a point of departure. Further, the Navy  included over $700 million in additional incentives in the contracts— outside of the share line. These incentives had the potential to increase  shipbuilder profitability and—in the event actual costs exceeded the  ceiling—cushion the shipbuilders’ losses. When the Navy assumes a  greater share of cost overruns above the target cost, accepts a higher  ceiling price, or both, the FPI elements may not provide sufficient  motivation for the shipbuilders to control costs.
subsections: section_title: Structure of FPI Contract Elements Resulted in the Navy Absorbing a Greater Burden of Cost Risk Than the Shipbuilder in Most of Our Selected Contracts
paragraphs: FPI contracts can promote shipbuilder efficiency and reduce overall cost  risk to the government when a firm-fixed-price contract is not appropriate.  However, if the structure of the contract elements results in the  government bearing too much of the cost risk, the effectiveness of FPI  contracts in motivating the shipbuilder to control costs may be weakened.  According to the Director of Defense Pricing, DOD’s guidance has been  to utilize FPI contract structures to align profitability with contract  performance when there are well-founded cost expectations. As  previously noted, DOD’s Better Buying Power initiative also encourages  use of FPI contracts, when appropriate, as a means to achieve better cost  performance. We compared certain FPI contract elements in our sample  to DOD and Navy regulations, guidance, and recommended practices for  establishing target cost, share line, target profit, and ceiling price, and  found that the Navy often ends up bearing more cost risk than these  criteria support as a starting point.
subsections: section_title: Significant Cost Uncertainty Made Establishing a Realistic Target Cost Challenging in Two Cases
paragraphs: Office of the Secretary of Defense and Navy officials, as well as the  shipbuilding representatives we spoke with, agreed that contract  negotiations often focus on the target cost, which according to a senior  DOD official and guidance should be an achievable—but somewhat  challenging—amount. According to April 2016 DOD guidance, the target  cost should factor in the costs of known risks. Thus, to determine a target  cost that reflects anticipated costs of performance, the Navy and  shipbuilders need to evaluate and attempt to determine the cost of the full  risk involved in constructing a ship. As we have previously found, the  Navy has often proceeded to contract award with significant technical  risk, unclear expectations between buyer and builder, and cost  uncertainty. This was in part because the Navy had not allocated  sufficient time prior to contract award to retire technical risks. We found  that in two of the six contracts we reviewed—the LPD 17 class and LCS  ships—significant cost uncertainties made establishing a realistic target  cost challenging. While various considerations need to be taken into  account in negotiating target cost—and, in the case of LPD 17 class,  Hurricane Katrina was an unusually disruptive factor—the Navy’s desire  to sustain the industrial base, as discussed earlier, was a key driver.
LPD 22-25: There was significant uncertainty at the time of contract  negotiations for LPD 22-23. During the course of contract negotiations  in summer 2005, the lead ship, LPD 17, was delivered incomplete at a  cost of $800 million more than planned. Then in August 2005,  Hurricane Katrina caused major damage to the Gulf Coast area and  the shipbuilder’s facilities, which resulted in the shipbuilder  withdrawing all of its proposals until operations resumed. The Navy  subsequently amended its solicitation to include options for two more  ships (LPD 24 and LPD 25). The shipbuilder increased its proposed  vessel labor hours for all 4 of the ships to account for increased use of  inexperienced labor, out of sequence work, and additional rework,  among other things, resulting from the hurricane. The contract was  negotiated even though these were the first LPD 17 class ships  beginning construction after Hurricane Katrina and there was still  considerable risk surrounding the ships’ likely costs; the unique  circumstances posed by the hurricane made it difficult to know  whether the vessel labor hour increase would be representative of the actual impact on labor hours. In contrast, the Navy agreed to an  increase in the target cost for LPD 26 when compared to LPD 25  because outcomes for LPD 22-25 were better understood at that time  and because of unique schedule challenges with LPD 26. The  business clearance memo for LPD 26 states that the Navy considered  the target cost aggressive because it was considerably below the  average estimates at completion for LPD 22-25.
LCS 5-23 odd only and LCS 6-24 even only: At the time the Navy  awarded the two LCS contracts with options for up to 10 ships each,  the shipbuilders had only delivered one ship each, both far exceeding  the Navy’s original contract value. Further, as we previously reported,  these ships were delivered in an incomplete state and had  outstanding technical issues. As a result, there was an incomplete  understanding of the costs on which to base the target costs when the  FPI contracts were awarded.
In contrast, on the SSN 784-791 contract, the Navy had greater certainty  about the shipbuilder’s ability to achieve its cost targets because the  shipbuilder had already delivered five ships at the time of contract award.
section_title: Navy and Shipbuilders Usually Shared Equally in Cost Overruns on the Share Line, but Navy Shouldered Additional Cost Risk by Setting Higher Ceiling Prices
paragraphs: Another critical element of an FPI contract is how the burden of cost  overruns or underruns is shared between the Navy and the shipbuilder,  which is a function of the share line. The ceiling price, or the maximum  amount the government will pay as part of the FPI structure (excluding  other contract clauses), is also used to apportion risk between the Navy  and shipbuilder. It is a combination of both the share line and ceiling price  that determines the amount of cost risk placed on both the Navy and the  shipbuilder. We found that, for the six shipbuilding contracts we reviewed,  the share lines or ceiling prices, or both placed more cost risk on the  Navy than guidance and regulation recommends as a starting point, as  seen in figure 7.
A memorandum issued by the Assistant Secretary of the Navy for  Research, Development, and Acquisition in 2003 stated that Navy  contracting officials should consider at least an equal sharing  arrangement, or “50/50 share line” for most FPI contracts. This guidance  also states that the contracting officer should use “aggressive” sharing  arrangements, requiring the shipbuilder to share a substantial portion of  both cost underruns and overruns whenever appropriate. The guidance  also states that the Navy should consider cost sharing arrangements that  increase the shipbuilder’s share if cost overruns increase, rather than  sharing them equitably. For example, in many cases it may be  appropriate to use a 50/50 share line for cost outcomes that are within  plus or minus 5 percent of the target costs and 40/60 or 30/70 for other  cost outcomes. In addition, since 2011, the DFARS has stated that the  contracting officer shall pay particular attention to share lines with a 50/50  share ratio as the point of departure for establishing the incentive  arrangement. With the exception of two contracts, the selected  contracts we reviewed used a share line with a 50/50 share ratio. The  exceptions were (1) the LPD 22-25 contract, which had overrun share  lines that varied depending on target cost performance and that held the  Navy accountable on the share line for a greater degree of cost growth  than the shipbuilder and (2) the SSN 784-791 contract, which had an  overrun share ratio that held the shipbuilder accountable on the share line  for a greater degree of cost growth than the Navy.
The ceiling price is also used to apportion risk between the Navy and  shipbuilder. The ceiling price is often expressed as a percentage of the  target cost; however, ceiling prices are dollar values, not percentages.  Since 2011, the DFARS has stated that for FPI contracts contracting  officers should consider a ceiling price of 120 percent of the target cost as  a point of departure for establishing the incentive arrangement, meaning  that the maximum the government could pay would be target cost, plus  an additional 20 percent. DOD recently reiterated this point in April 2016  guidance. The Director of Defense Pricing stated that the actual ceiling  price percentage to be used is a function of the perception of risk and  who should bear that risk on any particular contract. He noted that in most  instances, negotiated ceiling prices in contracts for major weapon  systems other than shipbuilding, have been less than 120 percent.
In 38 of the 40 ships on the contracts we reviewed (the exceptions being  ESD 1 and ESB 4), the Navy shouldered additional risk by setting higher  ceiling prices than guidance suggests as a point of departure. In the case  of the LPD 26 contract, the Navy agreed to a higher ceiling percentage  than guidance suggests; the Navy believed this was appropriate given,  among other things, the increased risk due to a gap in construction with  the prior hulls and the shipbuilder assuming a greater degree of risk on  the share line. Our analysis found that even an additional 5 percent above  what the guidance recommends as a starting point can significantly  increase the government’s potential liability, particularly given the high  value of shipbuilding contracts.
section_title: Majority of Contracts Included Additional Incentives That Provided the Potential for Shipbuilders to Earn Profit Outside of the Share Line
paragraphs: Although the cost incentive on the share line is intended to be the primary  incentive for the shipbuilder to control costs, in 5 of the 6 contracts we  selected for review, the Navy included additional incentives, which have  the effect of increasing the shipbuilder’s potential to earn profit or cushion  its potential loss in the event of cost growth. These incentives, which  totaled over $700 million available to the shipbuilders, fell into four broad  categories: award fee, cost incentives, milestone-based incentives, and  shipyard investment incentives—added both at the time of award and  post-award—that provided profit in addition to the target profit on the  share line:
Award fee: A shipbuilder may earn fee commensurate with overall  cost, schedule, and technical performance as measured against  contractual requirements in accordance with the criteria stated in the  award-fee plan.
Cost incentive (other than the share line): Only available to the  shipbuilder if actual costs incurred meet a predetermined threshold.
Milestone-based incentive: Encourages the shipbuilder to meet  objectives that may or may not be tied to a date (e.g., achieving  specified levels of ship completion at launch such as piping and cable  installation, resolving shipbuilder responsible construction defects, or  delivery on or before agreed upon delivery date, etc.).
Shipyard investment incentive: Encourages the shipbuilder to make  investments that reduce shipbuilding costs by improving construction,  facilities, equipment, and processes.
Only the ESD/ESB contract used the share line as its only incentive  mechanism, as shown in table 1.
Examples of the additional incentives added include:
LPD 22-25: The Navy added millions of dollars in milestone-based  incentives post-award to encourage the shipbuilder to complete work  more efficiently, by completing heavy industrial work (pipe installation,  hot work, cable pull, etc.) on land as opposed to in the water. Contract  file documentation states that the Navy’s analysis of the shipbuilder’s  performance on prior hulls indicated that there was a 50 percent  premium to complete heavy industrial work in the water; therefore, the  milestone-based incentives were structured to incentivize higher  levels of ship completion prior to launch. However, maximizing  construction work completed on land is an essential aspect of an  efficient build plan—and, presumably, already incentivized through  the profit that could be earned through the contract share line.
DDG 115 and DDG 116: The Navy increased the shipyard investment  incentive post-award. Contract file documentation states that the  additional shipyard investment incentives were added as part of a  comprehensive settlement agreement negotiated by the Navy and  Bath Iron Works in July 2013 on ship construction efforts for the DDG  51 program.
LCS 5-23 odd only and LCS 6-24 even only: The Navy added  millions of dollars in milestone-based incentives to each LCS block  buy contract post-award. According to a Navy contracting official, the  rationale for adding these incentives was twofold: as consideration in  exchange for the shipbuilders agreeing to fiscal year 2010 competitive  pricing for the fiscal year 2016 ship that was added to each existing  contract, and to motivate the shipbuilder to improve performance  given poor cost and schedule outcomes on prior ships. These  incentives did not apply to LCS 5 and LCS 6, the first ships on each  contract.
SSN 784-791: The Navy added additional incentives to encourage the  shipbuilder to deliver the ships at or below an agreed upon percent of  each ship’s target cost. This created, in effect, a further incentive for  the shipbuilder to minimize target cost overruns: (1) the share line for  overruns provided an incentive for the shipbuilder to minimize costs to  avoid losing profit, and (2) the additional cost incentive further  elevated profit opportunity if the shipbuilder could deliver at a total  cost that did not exceed the agreed upon percent of the target. Under  this incentive structure, if the shipbuilder delivered at or below the  agreed upon percent above target cost, then its share of an overrun  cost would be largely or completely—depending on the amount of the  overrun—covered by the additional cost incentive. In essence this  means the Navy would cover any overruns up to the agreed upon  percent. Figure 8 illustrates this duplicative incentive structure with a  hypothetical example of SSN 791 coming in at the agreed upon  percent over target cost.
The April 2016 DOD guidance stresses that the contractor should be  primarily incentivized by receiving profit through the reduction of costs—a  primary function of the share line, and in certain cases, by exceeding  performance thresholds or reducing schedule. While program officials  agreed that the share line should be a primary motivator on a contract,  they noted that additional incentives could be used to encourage the  shipbuilders to make targeted performance changes. Program and  contracting officials stated that they must examine these issues on a  program by program basis to determine whether an additional incentive is  appropriate.
section_title: Fixed-Price Incentive Contracts Did Not Always Lead to Desired Outcomes, and the Navy Has Not Assessed Whether Additional Incentives Improved Shipbuilder Performance
paragraphs: Although FPI contracts are used to manage some degree of uncertainty  (as compared with firm-fixed-price contracts), contract type alone cannot  always ensure that desired outcomes are achieved. DOD guidance states  that actual cost outcomes should approximate estimated costs within 2 to  4 percent before moving to a firm-fixed-price contract. We assessed  actual costs for 11 delivered ships under the six selected contracts and  found that the majority experienced cost growth above 4 percent, with six  ships having significant cost growth of at least 15 percent. Due to the  structure of the cost sharing arrangements, the Navy paid for the majority  of the cost growth. Further as mentioned previously, for the ships we  reviewed, the Navy added over $700 million in additional incentives  outside the share line. While these incentives reduced the shipbuilders’  loss in some cases, the Navy has not undertaken an assessment of the  effectiveness of these added incentives in terms of improved contract  outcomes.
subsections: section_title: Costs Grew above Target on the Majority of FPI Contracts We Reviewed
paragraphs: Of the 11 ships on the contracts we reviewed that had been delivered to  the Navy as of December 2015, 8 experienced cost growth, defined as  actual costs exceeding the target cost. Six of the delivered ships had  actual costs that were over 4 percent above target—with cost growth  reaching as high as nearly 45 percent. Table 2 shows the actual cost  outcomes for the 11 delivered ships.
In addition to the ships that had been delivered, ships that had not yet  been delivered as of December 2015 were also experiencing cost  increases. For example, DDG 115 and 116, which had not yet been  delivered as of December 2015, had incurred significant cost increases.  On the ships not yet delivered on the LPD 17 class and LCS contracts,  cost growth also has occurred.
While specific reasons for cost growth varied, unanticipated labor hour  increases were a key factor identified by shipbuilding and Navy officials.  In the case of LPD 22- 25, target costs may not have fully accounted for  the lingering inefficiencies associated with recovery from Hurricane  Katrina. Navy and shipbuilding officials cited increased labor hours  associated with an inexperienced labor force and increased rework which  impacted production schedules, along with increased costs due to  outsourced work. Additional labor hours were also needed to implement a  number of design changes starting on LPD 22 to address numerous  defects found on delivered LPD 17 class ships. On the LCS and LPD 17  class contracts, both of which had ships that surpassed target cost, the  government shared in at least 50 percent of the cost overrun up until  costs reached a specified point, with the government’s maximum liability  capped at the ceiling price.
Cost increases above target have required the Navy to request additional  funding from Congress, since ship construction budgets are generally  funded to the target price. The LPD 17 class and LCS ships in our  selected contracts have received a total of $711.40 million between fiscal  years 2007 and 2016 in additional funding above their original budgets  which includes the government’s portion of contract overruns. In addition  to the funding that has already been received, the Navy is likely to have a  continuing need for additional funding based on the cost growth identified  for ships still under construction. The LPD 17 program accounted for  $551.77 million of the $711.40 million over the past 10 years, including an  additional $45.10 million for the LPD 27 in the Navy’s fiscal year 2017  budget request, primarily to cover the government’s portion of the  shipbuilding contract overrun.
section_title: The Navy Paid the Majority of the Cost Overruns for Delivered Ships on Selected Contracts
paragraphs: Our analysis also found that, for the ships delivered on the contracts in  our review, the Navy paid over $549 million in cost growth and the  shipbuilder paid approximately $430 million in cost growth. For the six  ships that had been delivered as of December 2015 with significant cost  growth (over 15 percent), we determined the government’s and  shipbuilder’s share of cost overruns on the share line. Note that as costs  increase above target price the shipbuilder’s profit is reduced.
The Navy’s share of the cost growth for LPD 22-25 was hundreds of  millions of dollars. The cost to deliver three of these ships far  exceeded the ceiling price and the fourth ship came close to  exceeding the ceiling price, despite the fact that the contract had  some of the highest ceiling prices by percentage of all of the contracts  we reviewed. The shipbuilder lost hundreds of millions of dollars in  profit and had to absorb hundreds of millions of dollars in cost growth.
For LCS 5 and LCS 6 the Navy was responsible for paying millions of  dollars to address cost growth. Both ships were delivered over a year  late and significantly overran target price, but did not exceed ceiling  price. On LCS 5, the target cost was exceeded and the shipbuilder  earned minimal profit. On LCS 6, the target cost was exceeded, the  shipbuilder earned no profit, and incurred additional costs.
In contrast, the shipbuilders’ cost performance on SSN 784-785 and  ESD/ESB 1-3 resulted in better overall outcomes for the government and  the shipbuilders. In the case of SSN 784 and SSN 785, the Navy and the  shipbuilder paid a share of the cost overruns. The shipbuilder also earned  hundreds of millions in profit on the ships. In the case of the ESD/ESB 1- 3, the shipbuilder underran the target cost, resulting in the Navy saving  millions of dollars (its share of the cost underrun). Further, all three ships  were delivered on time or ahead of schedule. Ultimately, the shipbuilder’s  positive cost performance resulted in the shipbuilder earning hundreds of  millions of dollars in profit including tens of millions from the share line  incentive for underrunning its cost.
section_title: The Navy Has Not Assessed Whether Additional Incentives Helped to Achieve Desired Outcomes
paragraphs: For ships delivered under selected contracts, we analyzed the amounts  that the shipbuilders ended up earning, including the over $700 million in  additional incentives that had been added to the contracts. We found that  the Navy has paid over $166 million in these additional incentives  (beyond the incentive of the share line). However, it is unclear whether  these incentives resulted in the outcomes that the Navy desired since,  according to a senior Navy official, the Navy has not assessed the  effectiveness of these incentives across its shipbuilding portfolio. Our  analysis indicates that for the 11 ships delivered in our case study  contracts, cost and schedule outcomes were mixed, as shown in table 3.
For example, in the case of the SSN 784 and 785, the shipbuilder  received millions of dollars in additional incentives, a large portion of  which were shipyard investment incentives, and the ships were delivered  early and within the agreed upon percent of target cost. In contrast, for  LPD 22-25, the shipbuilder received millions of dollars in additional  incentives, but the ships were delivered 15 to 20 months behind their  initial schedules and three of the four exceeded their ceiling prices.  While the shipbuilder did not earn a target profit for LPD 22-24, the  additional incentives had the effect of reducing some of the shipbuilder’s  loss. Overall for these ships, the Navy paid more than what was  expected, added extra incentives, and did not receive the ships on time or  near the cost it originally expected.
On the DDG 115 and 116 contract, the shipbuilder was eligible to earn a  milestone-based incentive on each ship. Despite being over target cost  and behind schedule, the shipbuilder received a portion of the available  incentive for each ship. This is, in part, because the milestone-based  incentives are not tied to specific cost criteria; therefore, the shipbuilder is  eligible to earn those incentives regardless of cost performance  outcomes.
The FAR states that agencies should determine, on a regular basis, the  effectiveness additional incentives have in improving contractor  performance and achieving desired program outcomes. This is to be  done through the collection of relevant data on incentives paid to  contractors and include performance measures to evaluate the data. The  FAR goes on to state that this information should be considered as part of  the acquisition planning process in determining the appropriate type of  contract to be utilized for future acquisitions and that proven incentive  strategies be shared among contracting and program management  officials. Some contract files we reviewed included general statements on  the rationale and perceived benefits to the government for individual  incentives at contract award. However, according to a senior Navy  contracting official, the Navy has never completed an analysis on the  effectiveness of additional incentives on FPI contracts across its  shipbuilding programs. Further, this official stated that such an analysis  has not been on management’s radar screen, even though the Navy has  almost exclusively used FPI shipbuilding contracts for many years with  the exception of the first few ships in a class. Without such analysis, the  Navy cannot know whether or not these added incentives have achieved  their desired outcomes across its shipbuilding portfolio. The Navy is also  missing an opportunity to share information among its contracting and  program officials about how incentives may or may not yield their  intended benefits—particularly given the inherent complexities associated  with the U.S. shipbuilding industrial base. The Navy plans to continue to  invest billions of taxpayer dollars in procuring ships over the next 30  years—including more of the ships on our selected contracts as well as  the Columbia Class Ballistic Missile Submarine (formally known as the  Ohio Class Replacement, a $95 billion program). As a result,  competition for funding among shipbuilding priorities will continue, and it  is critical that the Navy has data on the effectiveness of additional incentives in improving performance and outcomes that can help inform  future contract award decisions.
section_title: Conclusions
paragraphs: Navy shipbuilding is a long and complicated process, which, coupled with  the symbiotic relationship between buyer and builder that characterizes  the Navy shipbuilding environment, makes contracting decisions  challenging. The Navy has relied heavily on FPI contracts for the last  decade, but has not taken some actions that could help ensure the Navy  is maximizing the effectiveness of these contracts. Given the looming  funding needs of major shipbuilding programs—including more of the  ships included in our case studies—there are opportunities to do so.
One way is to ensure that contracting officers document the rationale for  using an FPI contract, and that the basis for FPI contract elements be  clearly set forth in contract documents—in particular, determination and  findings documents and the pre- and post-negotiation business clearance  memorandums. Such documentation is required by regulation but we  found that it had not been completed consistently for our selected  contracts. From a business perspective, not having a record of these  decisions could put future contracting officers and decision makers at a  disadvantage when negotiating future contract awards or modifications.
A second way is to assess, on a shipbuilding-wide portfolio level, whether  the additional incentives added outside of the FPI share lines are  achieving desired outcomes and to gather insights from contracting and  program officials who have experience with these incentives. We  recognize that the additional incentives are but one of many factors the  Navy must take into account as it negotiates with shipbuilders within the  context of the U.S. industrial base. Nevertheless, for our selected  contracts, the Navy had made over $700 million available in additional  incentives, but has not taken steps to understand whether this money is  resulting in good outcomes for the government. Regulation, while not  prescriptive, highlights the benefits of measuring the effectiveness of such  incentives. Additionally, these actions make good business sense.
section_title: Recommendations for Executive Action
paragraphs: To help ensure the Navy thoroughly considers the relative benefits of  using FPI contracts for shipbuilding versus other contract types, we  recommend that the Secretary of Defense direct the Secretary of the  Navy to take the following two actions.
Issue a memorandum alerting contracting officials to ensure that they are  following guidance laid out in the Navy Marine Corps Acquisition  Regulation Supplement with regard to completing  determination and findings documents that explain the rationale for using an FPI contract and pre- and post-negotiation business clearance memorandums, which clearly explain the rationale for FPI contracts’ incentive fee structures (including the share line, ceiling price, and any additional incentives).
Conduct a portfolio-wide assessment of the Navy’s use of additional  incentives on FPI contracts across its shipbuilding programs. This  assessment should include a mechanism to share proven incentive  strategies for achieving intended cost, schedule, and quality outcomes  among contracting and program office officials.
section_title: Agency Comments
paragraphs: We provided a draft of the sensitive but unclassified version of this report  to DOD for review and comment. In its written comments, reproduced in  appendix II, DOD concurred with our recommendations and identified  dates by which it plans to implement them. Specifically, the Navy plans to  implement the recommendation related to issuing a memorandum  regarding the completion of determination and findings documents that  explain the rationale for using an FPI contract and pre- and post- negotiation business clearance memorandums which clearly explain the  rationale for FPI contracts’ incentive fee structures by March 31, 2017.  The Navy also plans to complete the recommended portfolio-wide  assessment of its use of additional incentives on FPI contracts across  shipbuilding programs by December 15, 2017. DOD also provided  technical comments, which we incorporated as appropriate.
We are sending copies of this report to the appropriate congressional  committees, the Secretary of Defense, and the Secretary of the Navy. 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 III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of this review assessed: (1) the extent to which the Navy  has entered into fixed-price incentive (FPI) contracts over the last 10  years and what influences the Navy’s contracting approach when  awarding FPI contracts for ship construction, (2) how the Navy apportions  risk between the government and the shipbuilder for these contracts, and  (3) the extent to which the FPI contract type led to desired outcomes.
This report is a public version of a sensitive but unclassified report that  was issued on November 9, 2016. DOD regarded some of the material in  that report as sensitive but unclassified information, which must be  protected from public disclosure and is available for official use only. As a  result, this public version of the original report does not contain certain  information deemed to be sensitive but unclassified by DOD, including  specific share lines, ceiling prices, and target costs of the Navy ships we  assessed, our assessment of the share of cost risk between the Navy and  shipbuilder on the 40 ships reviewed, specific dollar amounts of added  incentives on ships we assessed, and Navy and shipbuilder cost  outcomes on six delivered ships with significant cost growth. This report  uses data from December 2015 to be consistent with the report issued in  November 2016.
To determine the Navy’s use of FPI contracts over the last 10 years, we  compiled and analyzed Department of Defense (DOD) data on contracts  awarded for detail design and construction of new ships from November  2005 through November 2015. To ensure the reliability DOD data, we  compared it to data from DOD’s Naval Vessel Registry to confirm the  award date of each ship, and for all contracts awarded during our 10-year  time frame, we reviewed the documentation available in DOD’s Electronic  Document Access System to verify contract number, award date, and  contract type. As part of this process we determined that the data  provided by DOD was sufficiently reliable for the purpose of this audit.  Using this information, we identified the universe of Navy detail design  and construction contracts awarded on an FPI basis during our 10-year  time frame.
To identify factors that influence the Navy’s contracting approach when  awarding FPI contracts for ship construction and how the Navy apportions  risk between the government and the shipbuilder for these contracts, we  reviewed a non-generalizable sample of six FPI contracts for the detail  design and construction of five different shipbuilding programs using the  following characteristics:  contract award between November 1, 2005, and November 30, 2015; number of ships on the contract; at least one ship on the contract had previously been delivered or  would be delivered imminently; and  representative of the majority of U.S. shipyards that build Navy  vessels, including Austal USA in Mobile, Alabama; General Dynamics  Bath Iron Works in Bath, Maine; General Dynamics Electric Boat in  Groton, Connecticut; General Dynamics NASSCO in San Diego,  California; Huntington Ingalls Industries in Pascagoula, Mississippi;  Marinette Marine Corporation in Marinette, Wisconsin.
As shown in table 4, the five shipbuilding programs executed under the  six FPI contracts that met these criteria include 40 ships: one contract  with two Arleigh Burke-class guided missile destroyers (DDG 51 class),  one contract with two expeditionary transfer dock (ESD) and two  expeditionary mobile base (ESB) ships, two contracts each with 10  littoral combat ships (LCS), one contract for six San Antonio-class  amphibious transport dock ships (LPD 17 class), and one contract with  eight Virginia-class submarines (SSN 774 class).
For our six selected contracts, we reviewed contract file documentation  including acquisition planning documents, requests for proposals (RFP),  business clearance memorandums—key documents that explain the  rationale for contract selection and structure of FPI contract elements  including target cost, target profit, share line, and ceiling price, cost and  schedule data, and program briefings, among other documents. To  identify changes in FPI contract elements through contract modifications  over the life of the contract, we compared information in the base contract  at the time of initial award, including the target cost, share line, ceiling  price, and incentives, to this same information in the conformed contract,  or the most up-to-date contract as of December 2015, which reflects any  changes made to the contract since initial award. Note that ceiling prices  are often expressed as a percentage of the target cost in the contract  documentation; however, ceiling prices by definition are dollar values, not  percentages. Since target costs and ceiling prices can change through  modifications to a contract, the ceiling price and target cost indicated in  updated contract documentation may not equate to the previously  established ceiling price percentage denoted in the same documentation.  For consistency, we used the ceiling price percentage cited for each ship  when available to complete our analysis of this contract element.
We also reviewed relevant guidance on contract selection and the use of  FPI contracts including Federal Acquisition Regulation, DOD and Navy  guidance on FPI contracts including the DOD and National Aeronautics  and Space Administration Incentive Contracting Guide, and memorandum  from DOD and Navy regarding the implementation of FPI contracts. We  supplemented our review of contract file information by interviewing Navy  program and contracting officials for each shipbuilding program  associated with our selected contracts, senior contracting officials in the  Naval Sea Systems Command (NAVSEA) Contracts Directorate, officials  from the Navy’s Supervisor of Shipbuilding, Conversion and Repair  (SUPSHIP), officials from the Under Secretary of Defense (Acquisition,  Technology and Logistics) Office for Defense Procurement and  Acquisition Policy, and shipbuilding officials.
To determine the extent to which FPI contracts led to desired outcomes,  we analyzed contract file information and cost data for ships delivered as  of December 2015 on our selected contracts to identify the delta (cost  overrun or underrun) between the target cost for each ship in the most  up-to-date contract as of December 2015, to SUPSHIP’s estimated  construction cost of the ship at completion as of December 2015.  SUPSHIP officials agreed that the estimated construction cost of the ship  at completion is a reasonable estimate of ship construction cost at  delivery. According to SUPSHIP officials, the actual final cost of the ship  is determined when the contract is closed out which typically occurs  several years after the ship has been delivered, and none of our six  selected contracts had been closed out.
We then calculated the price paid by the Navy and shipbuilder profit or  loss for ships delivered as of December 2015 in the following manner:  1.  We calculated the delta between the target cost for each ship in the  most up-to-date contract as of December 2015 and SUPSHIP’s  estimated construction cost of the ship at completion as of December  2015 to identify if the ship was in a cost overrun or underrun scenario.  2.  Using the contract share lines, we calculated both the Navy and the  shipbuilder’s financial responsibility for the cost overrun, or conversely  any cost savings.  3.  We then calculated profit earned by the shipbuilder, if any, and added  this amount to the total cost that the Navy was responsible for to  determine price to the Navy (cost and profit earned on the share line)  for detail design and construction of the ship.  4.  To determine profit or loss for the shipbuilder, we calculated the  difference between target profit and the shipbuilder’s responsibility for  the cost overrun, or conversely any cost savings.
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 to the contact name above, the following staff members made  key contributions to this report: Diana Moldafsky (Assistant Director),  Jennifer Echard, Nathan Foster, Laura Greifner, Julie Hadley, Kurt Gurka,  Julia Kennon, Jean McSween, Roxanna Sun, Abby Volk, Alyssa Weir,  and Andrea Yohe.