Navy Contracting: Ship Construction Contracts Could Cost Billions Over Initial Target Costs

Published by the Government Accountability Office on 1990-10-05.

Below is a raw (and likely hideous) rendition of the original report. (PDF)


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             United States
GAO          General Accounting Office
             Washington, D.C. 20648

             National Security and
             International Affairs Division


             October 5,199O

             The Honorable John P. Murtha
             Chairman, Subcommittee on Defense
             Committee on Appropriations
             House of Representatives

             Dear Mr. Chairman:

             As the former chairman requested, we have been monitoring cost
             growth on Navy ship construction contracts. Over the past few years,
             we have testified and issued several reports on this subject (see p. 28 for
             a list of our prior products). This report, in addition to updating the
             status of cost growth, describes the reasons for cost growth and the
             future budget implications of cost growth.

             The Navy relies on commercial shipyards for accomplishing its ship con-
Background   struction. The US. government, especially the Navy, is the shipbuilding
             industry’s primary market. Currently, the work is performed under
             three types of fixed-price contracts- fixed-price incentive contracts
             with an escalation clause, fixed-price contracts with an escalation
             clause, and firm fixed-price contracts. Fixed-price incentive contracts
             contain provisions for the shipyards and the Navy to share the costs
             above the target cost up to the ceiling price; any amounts above the
             ceiling are to be borne entirely by the shipyards. Fixed-price incentive
             contracts, as well as fixed-price contracts with an escalation clause,
             leave some contingencies open, such as price changes on certain mater-
             ials or labor costs, and allow the final prices to be adjusted in terms of
             contingencies. Firm fixed-price contracts, with few exceptions such as
             contract changes, allow no price adjustments. The type of contract
             selected depends on the degree of risk involved in building a ship. The
             Navy also can be liable for additional ship construction costs that arise
             from requests for contract adjustments and claims against the govern-
             ment. A request for a contract adjustment can be for an additional pay-
             ment, extension of a ship delivery schedule, or both. If requests for
             contract adjustments cannot be settled by agreement, shipyards may file
             claims against the Navy.

             Appendix I provides some background information on ship construction

             page 1                                       GAO/NSIADBl-18   Navy cOnstruction

                         As of the beginning of fiscal year 1990, the estimated cost of the Navy’s
Results in Brief         open shipbuilding and conversion fixed-price contracts had increased
                         $6.6 billion over the initial target cost. The Navy has already agreed to
                         pay $1.5 billion for contract change orders, contract adjustments, and
                         claims on these contracts, and it may need another $1.7 billion to pay
                         for its share of projected contract cost overruns and potential contract
                         adjustments and claims. The shipyards may need to pay the balance
                         ($2.3 billion) for their share of the potential cost growth. In addition,
                         many of the contracts are less than 60 percent complete; thus, the likeli-
                         hood exists that contract cost growth will increase.

                         The reasons for this cost growth are many and varied. Contract cost
                         overruns, according to shipyard and Navy officials, often result from
                         low bids for Navy shipbuilding contracts that historically have experi-
                         enced program changes and increased costs. Contract adjustments and
                         claims also contribute to increased costs.

                         Due to Navy budgeting procedures and practices and redistribution
                         authority, the Navy currently has funds in its shipbuilding and conver-
                         sion account to cover its share of the cost growth. However, some con-
                         tract implementation practices for contracts experiencing cost overruns,
                         as well as some adjustment and claim trends, may have future cost
                         implications for the Navy.

                         We reviewed the Navy’s open shipbuilding and conversion fixed-price
Ship Construction Cost   contracts-44 fixed-price incentive with an escalation clause, 9 fixed-
Growth                   price with an escalation clause, and 9 firm fixed-price contracts. To
                         measure cost overruns, we used as a base the initial target costs for the
                         fixed-price incentive contracts and the initial contract prices for the
                         other types of contracts. For the 62 contracts, these totaled $27.3 billion.
                         However, this amount could increase by almost $6 billion because of
                         nearly $1.4 billion in contract change orders and nearly $3.6 billion in
                         revised completion cost estimates. In addition to the possible increases
                         due to change orders and completion cost estimates, the Navy has
                         already paid $182 million and is potentially liable for up to $368 million
                         on the remaining open contract adjustment requests and claims, which
                         could raise cost growth another $660 million-to       an estimated total of
                         $6.6 billion, (See app. II for a detailed discussion of cost growth.)

                         Cost growth will likely continue because past experience indicates that
                         costs tend to increase as shipbuilding contracts neared completion and
                         because many contracts are still less than 60 percent complete. A

                         Page 2                                        GAO/NSIAD-91-18   Navy Construction

                     schedule showing the current projected cost overrun for each of the ship
                     construction contracts and other data is provided in a restricted supple-
                     ment to this report.

                     Shipyard and Navy officials attributed cost overruns primarily to low
Reasonsfor Cost      initial prices due to intense competition for Navy contracts. According to
Growth               these officials, the shipyards submitted low bids to obtain Navy con-
                     tracts Shipyard officials said that they were bidding low because of the
                     current market environment in which the Navy is virtually their only
                     customer. Other reasons for cost overruns include problems with ship
                     designs and with late government-furnished equipment deliveries or
                     installations, changes to original contracts, and unrealized gains in pro-
                     ductivity as a vessel or a class of vessels moves through construction.
                     Increases in contract costs also result from contract adjustments and
                     claims when shipyards incur expenses they believe were caused by the
                     Navy and were not covered by the contracts. (See app. III for a detailed
                     discussion of the reasons for cost growth.)

                     We found that contract cost growth was being covered from the differ-
Budgeting for Cost   ence between the Navy’s ship construction appropriations and the ships’
Growth               construction contract prices. For example, initial appropriated ship con-
                     struction funds, totaling $23 billion for 46 selected ship construction
                     contracts, exceeded the total initial contract price of $21.2 billion by
                     $1.8 billion, or 8.6 percent. Following congressional guidance, the
                     Department of Defense and the Navy routinely redistribute appropriate
                     funds to cover funding deficiencies, including ship construction cost
                     growth, through transfer authorizations and reprogramming actions.
                     (See app. IV for a detailed discussion of the future budget implications
                     of cost growth.)

                     Navy officials said that they do not foresee any major problems in cov-
                     ering the Navy’s current share of the forecast cost growth. However, we
                     observed some contract implementation practices for contracts exper-
                     iencing cost overruns and noted some adjustment and claim trends that
                     may have future cost implications for the Navy.

           Y         We did not obtain official agency comments. However, Navy officials
                     reviewed a draft of this report, and we have incorporated their com-
                     ments as appropriate.

                     Page 3                                      GAO/NSIADQl-18   Navy Construction

Our scope and methodology for the review are provided in appendix V.

We are sending copies of this report to the Chairmen, Senate Committees
on Governmental Affairs and on Appropriations, House Committee on
Government Operations, and Senate and House Committees on Armed
Services; the Director, Office of Management and Budget; and the Secre-
taries of Defense and the Navy. Copies will also be made available to
others upon request.

Please contact me at (202) 276-6604 if you or your staff have any ques-
tions concerning this report. Other major contributors to this report are
listed in appendix VI.

Sincerely yours,

Martin M Ferber
Director, Navy Issues

Page 4                                      GAO/NSIADQl-18   Navy conrrtruetion
Page 5   GAO/NSIABQl-18   Navy Construction


Letter                                                                                                      1

Appendix I
Ship Construction        Ship Construction Acquisition Environment
                         Shipbuilding and Conversion Contracts
Contracting              Contract Adjustments and Claims

Appendix II                                                                                                11
Forecast Cost Growth     Cost
                           Overruns                                                                        11
on ~~~~   Shipbuilding   Adjustments and   CkihS                                                           13

Appendix III                                                                                               16
Reasonsfor Cost          Intense Competition for Navy Contracts
                         Problems With Ship Design Changes
Growth                   Problems With Government-Furnished Equipment                                      16
                         Changes to Contracts                                                              17
                         Low Productivity of Shipyards                                                     17
                         Contract Types for Lead Ships                                                     18
                         Adjustments and Claims                                                            18

Appendix IV
Budgeting for Cost       Budgeting Procedures and Practices
                         Redistribution Authority
Growth                   Contract Implementation Practices
                         Adjustment and Claim Trends

Appendix V                                                                                             22
Appendix VI                                                                                            24
Major Contributors to
This Repofi

                         Page 6                                      GAO/NSIAD-91-18   Navy Construction

Related GAO Products                                                                                    28

Tables                 Table II. 1: Ship Construction Contract Cost Increase From
                           Initial to Current Amount
                       Table 11.2:Ship Construction Projected Cost Overruns
                           Less Underruns
                       Table 11.3:Ship Construction Contract Adjustments and

Figure                 Figure II. 1: Net Contract Cost Growth Over Target Costs
                            for Originally Reviewed Contracts


                       FFP        firm fixed-price
                       FP-E       fixed-price with escalation
                       FPI        fixed-price incentive with escalation

                       Page 7                                        GAO/NSIAD-Bl-18   Navy Cmatructh
Appendix I

Ship Construction Contmcting

                       All new construction of naval vessels is accomplished by commercial
                       shipyards. During the 19809, private shipyards administered a Navy
                       ship construction program that averaged over $10 billion a year. With
                       this level of construction, the Navy fleet has grown from 479 ships in
                       fiscal year 1980 to 666 at the start of fiscal year 1990.

                       In the 1980s the Secretary of the Navy increased the reliance on the
Ship Construction      competitive process in the award of contracts. According to the Navy,
Acquisition            this has resulted in favorable ship construction awards. For example,
Environment            the Navy’s Office of the Competition Advocate General stated in a 1986
                       report that 96 percent of ship construction placed under contract in
                       fiscal year 1986 was awarded competitively. This competition,
                       according to the Navy, would generate $968 million in savings when
                       compared to past sole-source negotiated contracts. In later reports, the
                       Navy cited additional potential savings due to competition.

                       According to the President of the Shipbuilders Council of America, Navy
                       shipbuilding savings have been attained because competition for Navy
                       ship construction has become increasingly aggressive, and accordingly,
                       shipyards are pricing work close to their break-even points. According
                       to the council’s president, this has occurred because the U.S. ship-
                       building industry is currently experiencing one of the most financially
                       vulnerable periods of its financial existence. Part of this vulnerability
                       has been created because the shipbuilding industry has virtually no
                       other market to pursue other than that of the U.S. government, princi-
                       pally the Navy.

                       The council’s president said that the collapse of US. commercial ship
                       building was caused by the executive branch’s 1981 decision to termi-
                       nate subsidies for merchant shipbuilding. The termination of those
                       subsidies increased U.S. shipbuilding prices, thus, in effect, transferring
                       commercial shipbuilding work to Europe, Japan, and South Korea where
                       shipyards continue to receive subsidies.

                       For ship construction, the Navy uses various1fixed-price contracts; It
Shipbuilding and       primarily uses fixed-price incentive @PI) contracts with an economic
Conversion Contracts   price adjustment, allowing for compensation adjustments for material
             I         and/or labor price escalation. An FPI contract has a negotiated target
                       cost, a target profit, a ceiling price, and a cost share formula for costs
                       above the target cost up to the ceiling price. Material and labor compen-
                       sation adjustments are not a part of the F+PI   target or ceiling price

                       Page 8                                       GAO/NSIAD-Bl-11   Navy Comtructio~
                      Appendir I
                      Ship Conntruction   Contracting

                      amounts; such amounts are paid outside the incentive price computa-
                      tions. Generally, the ceiling price is 125 to 145 percent of the target
                      price. The cost incurred over the target cost is a cost overrun’ that is
                      shared, usually equally, by shipyards and the Navy until the ceiling
                      price is reached. The ceiling price is the maximum amount the Navy will
                      pay, regardless of a shipyard’s actual cost experience. This type of con-
                      tract allows financial risk to be shared by a shipbuilder and the Navy.

                      The Navy uses two other types of fixed-price contracts-fixed-price
                      with an economic price adjustment or escalation clause (W-E) and firm
                      fixed-price (FFP). An FP-Econtract also leaves some contingencies open,
                      such as price changes on certain materials or labor costs, and allows the
                      contract price to be adjusted for these contingencies. An ITP contract
                      stipulates a firm price allowing few exceptions, such as contract
                      changes, and no price adjustments to be made to the original work after
                      the contract has been awarded.

                      The type of contract the Navy selects depends on the degree of risk
                      involved in building a ship. If the risk is too much for an FFP arrange-
                      ment, a shipyard may be willing to take an FP-Econtract, which leaves
                      the price open on certain items. If the risk is calculable to a reasonable
                      degree, a shipyard may be willing to take an FPI contract.

                      On ship construction contracts, the Navy also can be liable for additional
Contract Aaustments   ship construction costs that arise from requests for contract adjust-
and Claims            ments and claims. A request for contract adjustment can be for an addi-
                      tional payment, an extension of a delivery schedule, or both, which a
                      shipyard requests and is not in dispute when the Navy receives it.
                      Whenever such requests cannot be settled by agreement, shipyards may
                      file claims against the Navy.

                      To facilitate the resolution of requests for contract adjustments, the
                      Navy has established a claims avoidance program. Under the program,
                      Navy personnel are assigned to each ship being built to monitor con-
                      struction They monitor such items as noncompliance with contract
                      terms, differences in interpretation of contract provisions, and changes
                      in the method or sequence of work. An important aspect of this program

                       ‘The term for costs over current target costs is “cost overruns.” Navy officials, however, have said
                      that thii term is somewhat misleading because Navy acquisition executives expect costs to exceed
                      targets and because the Navy has testified to the Congress that it has sufficient funds to cover pro-
                      jected costs.

                      Page 9                                                         GAO/NSIADBl-18      Navy Construction
    Appendix I                                                                    .
    Ship Conetruction   Contracting

    is maintaining a documented record of significant events occurring
    during the administration of each contract that may lead to a future


    Page 10                                      GAO/NSIADBl-18   Navy Construction
Appendix II

ForecastCost Growth on Navy Shipbuilding

                                        We reviewed the Navy’s open shipbuilding and conversion fixed-price
                                        contracts-44 FPI,9 IT-E, and 9 FFP-and found that as of September
                                        1989, about $2.3 billion may be needed by the shipyards and about $1.7
                                        billion by the Navy to pay for forecast cost growth (projected contract
                                        cost overruns less underruns plus potential contract adjustments and
                                        claims). This $4 billion for forecast cost growth is in addition to the $1.5
                                        billion the Navy has agreed to pay the shipyards for contract change
                                        orders, contract adjustments, and claims and involves (1) a net projected
                                        contract cost overrun (overruns less underruns) of about $3.6 billion
                                        and (2) a potential, additional liability for contract adjustments and
                                        claims of up to about $0.4 billion.

                                        A schedule showing the projected cost overrun for each of the ship con-
                                        struction contracts that we reviewed and other cost data is provided in a
                                        restricted supplement to this report.

                                        The Navy can increase the initial contract amount on ship construction
Cost Overruns                           contracts for approved changes by using funds that are a part of its ship
                                        construction budget. For the 62 contracts reviewed, the total of the FPI
                                        contracts’ initial target costs and the IT-E and FF’Pcontracts’ initial con-
                                        tract prices was $27,276.9 million. This initial amount, as shown in table
                                        II. 1, has increased to $28,643.2 million because of Navy contract change
                                        orders, yielding an initial ship construction cost increase of $1,366.3

fable 11.1:Ship Construction Contract
Cost Increase From Initial to Current
Amount (Dollars in millions)            Contract type
                                                                             Target cost/contract price
                                                                                     Initial        Current -_______
                                        FPI               -                      $24,279.1         $25,126.3  -.-~- $847.2
                                        FP-E                                       18502.2           1,667.7          165.5
                                        -_---..-__                                 1,495.6       --~ i,a49.2         353.6
                                        Total                                   $27.276.9         $28.643.2       $1.366.3

                                        For an FPIcontract, the estimated cost over the current target cost up to
                                        the ceiling price is a projected cost overrun and represents an additional
                                        liability that, generally, is shared equally by the concerned shipyard and
                                        the Navy; the cost over the ceiling price is a shipyard’s liability. For an
                                        W-E or FFP contract, the cost incurred over the current contract price is a
                                        shipyard’s liability.

                                        Page 11                                        GAO/NSIADSl-18    Navy Construction
                                         Appendix II                                                                                             .
                                         Forecast Cost Growth      on Navy Shipbuilding

                                         The total estimated completion cost for the contracts reviewed is
                                         $32,196.5 million. On the basis of this estimated completion cost, we
                                         estimate the total projected cost overrun to be $3,784.1 million on 24
                                         contracts. Of the remaining contracts, 6 are projected to underrun their
                                         completion costs by a total of $230.8 million, and 32 are projected to be
                                         completed at their estimated completion costs. As shown in table 11.2,
                                         the net projected cost overrun is $3,563.3 million.
Table 11.2:Ship Construction Projected
Cost Overruns Less Underrun8
                                         -Dollars in millions                                                                             -__
                                                                    Overrun                   Underrun
                                         Contract type           Amount Number             Amount Number              No change        Net overrun
                                         .---__I_                $3,784.1_-          24      $230.8             6                14        $3,553.3
                                         FP-EB                        0.0             0          0.0            0                 9              0.0
                                         .--..-                       0.0             0          0.0            0                 9              0.0
                                         Total                   $3,784.1            24      $230.8             6                32     $3,553.3
                                         aOn this type of contract, the Navy has no liability in regard to shipyard cost overruns/underruns.

                                         These overruns include $964.3 million in costs above ceiling prices,
                                         which are a shipyard’s liability. The shipyards and the Navy are each
                                         potentially liable for about one half of the remaining $2,589 million
                                         (costs between the target costs and ceiling prices), or about $1,294.5 mil-
                                         lion each. The attack submarine program accounts for nearly 60 percent
                                         of the projected cost overruns.

                                         Our analysis of contract costs indicates that costs over target costs on
                                         FPI contracts tend to increase as the contracts age. We found that of the
                                          22 FPI contracts that we reviewed in April 1987, the 18 that remained
                                         open as FPIcontracts were experiencing even greater cost overruns in
                                         September 1989 than in 1987. As shown in figure 11.1,the total pro-
                                         jected net completion cost over current target cost on these 18 contracts
                                          increased (1) $100 million from April 1987 to April 1988, (2) $300 mil-
                                         lion from April 1988 to March 1989, and (3) $500 million from March
                                          1989 to September 1989-a total net increase of $900 million, or 69

                                         Page 12                                                           GAO/NSIADL)l-18       Navy Construction
                                       Appendix    II
                                       Forecast Cvat Growth       on Navy Shipbuilding

Figure 11.1:Net Contract Cost Growth
Over Target Coats for Originally
Reviewed Contracts                     9.0   Dollamln   Bllllom



                                              -         Total Cost Over Initial Target Cost
                                              - - - -   Total Cost Over Current TarQet cost

                                       Also, as shown in figure 11.1,the total net cost increase over the initial
                                       target costs on these 18 contracts increased $1,300 million, or 87 percent
                                       between April 1987 and September 1989.

                                       Many of the estimated completion costs on the 44 FPI contracts we
                                       reviewed this time (which included the original 18) were near or above
                                       their ceiling prices. Currently, 16 of these FPI contracts, or 36 percent,
                                       have estimated completion costs ranging from 90 to 160 percent of their
                                       ceiling prices-10 contracts, or 23 percent, are above ceiling prices. One
                                       half of the 44 FPI contracts are under 50 percent complete. Thus, the
                                       likelihood exists that the estimated completion costs, and accordingly,
                                       the cost overruns on these contracts will increase.

                                       On ship construction contracts, shipyards can attempt to recoup
Adjustments and                        incurred expenses that are not covered by contractual agreement
Claims                                 through requests for contract adjustments and claims. For the contracts

                                       Page 13                                                GAO/NSIAD91-18   Navy Construction
                                        Foreeaet    Cost Growth   on Navy ShiphiMi.ng

                                        we reviewed, 82 contract adjustments and claims, totaling $689.3 mil-
                                        lion, had been submitted on 27 contracts, as shown in table 11.3.
Table 11.3:Ship Construction Contract
Adjustments and Clalma                  Dollars in millions
                                                                                           Contract                    adjustments and
                                        Contract           Number of         Adjustments              Claims                claims
                                        we                  contracts      Number Amount          Number Amount        Number Amount
                                        iii                          16          31     $515.1         10      $33.8        41     $548.9
                                        FP-E                          7          23       105.8         3        0.9        26       106.7
                                        FFP                           4          15        33.7         0        0.0        15        33.7
                                        Total                        27          69     $654.6         13      $34.7        62     $669.3

                                        The attack submarine program accounts for 50 percent of the total
                                        amount that the shipyards sought.

                                        The Navy has already settled 44 of the contract adjustments and claims,
                                        totaling $321.4 million, for $181.9 million. In one large settlement, Gen-
                                        eral Dynamics Corporation, Electric Boat Division submitted two
                                        requests for contract adjustments on two of its contracts for attack sub-
                                        marines. These requests were submitted to recover $109.4 million in
                                        expenses that were not covered by the contracts and were resolved in
                                        April 1988 for $82.4 million.

                                        The Navy has denied $139.5 million on the 44 requests for contract
                                        adjustments and claims because of time limitations or inadequate justifi-
                                        cations. Rejected contract adjustments and claims may be resubmitted
                                        by the shipyards through the contract change or litigation process. On
                                        the other 38 contract adjustments and claims that are pending, the Navy
                                        is potentially liable for up to $367.9 million.

                                        We observed that as ship construction cost overruns increased, so did
                                        contract adjustment and claim amounts. For example, in August 1989,
                                        we reported’ that on 24 of the Navy’s open FPI ship construction con-
                                        tracts, the shipyards had submitted $213.7 million in contract adjust-
                                        ments and claims as of March 1989. During this review, we found that
                                        the Navy’s potential liability had increased to $535.5 million on these
                                        same contracts as of September 1989, or over 150 percent, during these
                                        6 months.

                                        Page 14                                                       GAO/NSIADSl-18   Navy Construction

‘&Gns       for Cost Growth

                        The reasons for contract cost growth are many and varied. They include
                        intense competition for Navy contracts, problems with ship design
                        changes, problems with government-furnished equipment installations,
                        changes to contracts, low productivity of shipyards, and the type of con-
                        tract used for a lead ship. Increases in contract costs also result from
                        adjustments and claims.

                        In our 1987 report,’ we stated that, according to shipyard and Navy offi-
Intense Competition     cials, shipyards submitted low bids to obtain Navy contracts. Our inter-
for Navy Contracts      views with shipyard officials, at that time, confirmed that the
                        shipbuilding industry was competing in a close to the margin environ-
                        ment on Navy ship construction contracts because of a decline in com-
                        mercial shipbuilding work.

                        During this review, we found that the same market environment existed
                        and that the shipyards were continuing to submit low bids to win Navy
                        shipbuilding contracts, as illustrated by the following examples.

                      . According to Navy officials, Ingalls Shipbuilding, Inc., wanted to build
                         amphibious assault ships. Consequently, to obtain a 1986 contract to
                         build three follow-on assault ships, its average bid was only 42 percent
                        of the bid to build the first ship. An Ingalls official said that to maintain
                        the shipyard’s work load, it had to bid low. Currently, the Navy is pro-
                        jecting a cost overrun on this contract.
                      . Newport News Shipbuilding’s best performance for building attack sub-
                         marines was for the SSN-721 under a 1981 contract. However, Newport
                         News’ later bids on three additional contracts to build a total of 11 more
                         attack submarines were based on an average of about 25 percent fewer
                         labor hours per submarine. These three contracts are currently pro-
                        jected to overrun, and they are near or above their current ceiling

                        Shipyard officials said that the current shipbuilding environment in
                        which the Navy is virtually their only customer has forced them to bid
                        lower than normal to obtain Navy contracts.

                        ‘Navy Contracting: Cost Overruns and Claims Potential on Navy Shipbuilding Contracts
                        (GAWSIAD _88 _16, Oct. 16,1987).

                        Page 15                                                   GAO/NSIAD-91-18     Navy Construction
                       Appendix III
                       Reasons for Cost Growth

                       The Navy seeks to improve its ships through design changes. During
Problems With Ship     ongoing ship construction, however, such improvements have resulted
Design Changes         in construction delays and consequently have increased construction

                       For example, according to a Navy official, Navy-initiated changes for a
                       new vertical launch system and for an upgrade to an anti-air warfare
                       system caused major construction problems that delayed Bath Iron
                       Works Corporation’s construction of guided-missile cruisers. The official
                       said that 1,300 of the 2,200 ship drawings had to be revised because of
                       design changes and, in effect, were totally new drawings. These new
                       drawings were not covered by the original contract. Thus, construction
                       costs increased.

                       In another instance, the Navy decided to install retractable bow planes
                       on attack submarines being constructed by the Electric Boat Division to
                       allow the submarines to break through ice. Because of the heat gener-
                       ated from welding in areas adjacent to the bow plane location, some
                       other work on the submarines could not be completed before the sched-
                       uled launch date. This work was completed subsequent to construction,
                       which resulted in increased contract costs.

                       The Navy also seeks to improve its ships by installing the latest, most
Problems With          advanced systems and equipment. However, new systems and equip-
Government-            ment are not always ready to be installed when scheduled, which delays
F’urnished Equipment   ship construction and consequently increases construction costs.
Installations          For example, attack submarines, beginning with the SSN-751, were to
                       have included a new combat system (SUBACS); however, the system
                       was not ready for installation when needed, and the Navy replaced it
                       with a subset of the system. The replacement system, according to the
                       Electric Boat Division and Newport News Shipbuilding-the        contractors
                       for attack submarines-caused       construction delays because the struc-
                       ture drawings for the originally planned system were not accurate for
                       the replacement system. It also caused costs to increase because the
                       replacement system required changes, including heavier deck supports
                       and relocation of electric components. These changes added substan-
                       tially to the construction cost of the submarines.

                       In another instance, according to a Navy official, Newport News Ship-
                       building only partially installed a vertical launch system in the SSN-72 1,
                       -722, -723, and -750 attack submarines it was building because the

                       Page 16                                       GAO/NSIAD-91-18   Navy Construction
                      Appendix   III

                      system was not completely ready. As a result, work was delayed and the
                      overall cost of the submarines increased because Newport News had to
                      finish outfitting these submarines with the system at a later date.

                      During the performance of a ship construction contract, many changes
Changesto Contracts   are made to the original work. For example, under a 1981 contract with
                      Newport News Shipbuilding to construct four attack submarines, the
                      Navy has made 4,299 changes increasing the contract’s initial target cost
                      of $773.6 million to the current target cost of $833.3 million-a $59.8
                      million increase.

                      According to Navy officials, change orders present shipyards with an
                      opportunity to be aggressive in recovering from their initial low bids;
                      that is, in addition to the work and cost necessitated by change orders,
                      shipyard officials claim delays or disruptions are attributable to the
                      Navy. For example, a formal change order can require employees to be
                      temporarily reassigned from their primary duties to secondary duties,
                      which decreases productivity and consequently increases construction

                      According to shipyard and Navy officials, low productivity of shipyards
Low Productivity of   increases ship construction costs by requiring more than the budgeted or
Shipyards             planned labor hours to build ships. Productivity is highest when a ship-
                      yard’s work force is at an optimum mix of skills and numbers. However,
                      shipyards have difficulty in maintaining an optimum mix. In times of
                      slowed activity, shipyard officials said that they were reluctant to
                      release highly skilled workers because of the difficulty in retrieving
                      them at a later date. For example, after Newport News Shipbuilding
                      ceased bidding on submarine overhaul work, it had about 5,200
                      employees dedicated to that type of work. Newport News furloughed
                      1,200 employees and let go another 1,800. The remaining 2,200
                      employees were absorbed in other areas of the shipyard. According to
                      local Navy officials, absorbing these additional employees increased
                      labor costs and decreased overall productivity.

                      Unanticipated increases in overhead rates and labor costs can make it
                      difficult for shipyards to achieve the productivity assumed in their bid
                      process. For example, according to a Pennsylvania Shipbuilding Com-
                      pany official, the winning bid to build four oilers was based on the ship-
                      yard having 3,000 workers at a labor rate of $8 per hour over a 5-year
                      period. At that labor rate, the shipyard could hire only 1,850 workers.

                      Page 17                                      GAO/NSIAD-91-16   Navy Construction
                     Appendix III
                     Reasons for Cost Growth

                     Having fewer workers to do the same amount of work required overtime
                     pay, which increased the shipyard’s construction costs.

                     According to shipyard officials, it has become widely recognized in the
Contract Types for   industry that the use of a fixed-price contract is not compatible with the
Lead Ships           development of a highly complex ship. Shipyard officials said that a
                     fixed-price contract appears to be appropriate when dealing with a
                     known procurement because many of the problems associated with per-
                     formance of the contract should have been identified and actions taken
                     to correct them. Both shipyard and Navy officials said that using fixed-
                     price type contracts for lead ships involves risks that are not totally
                     known to either the shipyards or the Navy when entering into a contract
                     and consequently usually results in contract cost growth.

                     As an example, the first Arleigh Burke class guided-missile destroyer is
                     being procured under an FPI contract awarded in April 1985. As of Sep-
                     tember 1989, the contract’s target cost had increased from $268.1 mil-
                     lion to $324 million, or 21 percent, and the completion cost was
                     estimated to be $499.6 million, or 54 percent, above the current target
                     cost. In September 1989, Department of Defense policy was changed to
                     preclude fixed-price type contracting for a lead ship.

                     Shipyard officials submit requests for contract adjustments and claims
Adjustments and      when a shipyard incurs expenses that shipyard officials believe were
Claims               not covered by its contracts and were the result of the Navy’s actions or
                     inactions. Causes often cited by shipyard officials for contract adjust-
                     ments or claims include disputes over the amount of money owed for
                     completed work and late or defective government-furnished information
                     or equipment.

                     Page 18                                      GAO/NSIAD-91-18   Navy Construction
Appendix IV

Budgeting for Cost Growth

                       The Navy’s shipbuilding and conversion account has sufficient funds to
                       cover all current ship construction contract cost growth. The account is
                       sufficient because of (1) Navy procedures and practices for budgeting
                       ship construction programs and (‘2) existing authority to redistribute
                       surpluses and to adjust appropriated funds within each ship construc-
                       tion program.

                       Navy officials said that they do not foresee any major problems in cov-
                       ering the Navy’s share of the projected $3.6 billion in cost overruns and
                       the potential $0.4 billion for contract adjustments and claims. However,
                       some contract implementation practices for contracts experiencing cost
                       overruns, as well as some adjustment and claim trends, may have future
                       cost implications for the Navy.

                       The Navy’s budgeting procedures and practices for requesting ship con-
Budgeting Procedures   struction appropriations help to ensure that sufficient funds are avail-
and Practices          able to cover shipbuilding contract cost growth. These procedures and
                       practices take into account the fact that the appropriation obtained by
                       the Navy from the Congress is for the Navy’s estimate of the total costs
                       to build the ships, not the actual bids accepted to build the ships. As
                       discussed throughout this report, contract bids are generally well below
                       the eventual contract cost.

                       Our analysis of 46 of the 62 contracts reviewed shows the total amount
                       of initial ship construction appropriated funds of $23,037.6 million for
                       basic construction exceeded the total contract award price of $2 1,234.7
                       million by $1,802.9 million, or 8.6 percent. In addition, as of September
                       1989, the current total amount of appropriated ship construction funds
                       of $24,727.4 million for basic construction and change orders on these
                       same contracts was $2,763.2 million, or 12.5 percent, more than the cur-
                       rent total contract price of $21,974.2 million. These funds represent
                       $1,086.1 million, or 66 percent, more than the Navy’s current total share
                       of projected net cost overruns and potential contract adjustments and
                       claims ($1,668.1 million).

                       Following congressional guidance, the Departments of Defense and the
Redistribution         Navy routinely redistribute appropriated funds to cover funding defi-
Authority              ciencies, including ship construction cost growth, through transfer
              Y        authorizations and reprogramming actions. For example, since fiscal

                       Page 19                                     GAO/NSIADSl-18   Navy Construction
                 AppencUx    TV                                                                    ,
                 Budgeting   for Chst Growth

                 year 1985, the Navy has processed 13 reprogramming actions that redis-
                 tributed $12 1 million within the shipbuilding and conversion account to
                 cover ship construction cost growth.

                 The Navy’s ship construction program managers also have the flexi-
                 bility of adjusting the amount of appropriated funds within each ship
                 construction program to cover funding deficiencies. For example, the
                 basic construction cost element for the fiscal year 1989 attack subma-
                 rine program increased from $610.5 million in February 1988 to $680
                 million in January 1989, or 11 percent, and the propulsion cost element
                 decreased from $186 million to $167.7 million, or 9 percent. Additional
                 revisions were made in the cost elements for planning and future char-
                 acteristic changes, which increased, and for electronics, hull mainte-
                 nance, miscellaneous cost, and escalation, which decreased. Overall, this
                 submarine program had a net $42 million increase during this period.

                 With the approval of the Naval Sea Systems Command’s Shipbuilding
                 and Conversion Appropriation Division, the ship construction program
                 managers have no monetary limit on the amount of funds that can be
                 moved among cost elements within the fiscal year’s ship construction
                 appropriations. The managers are limited only by contract and other lia-
                 bilities when decreasing amounts for one purpose (e.g., electronics) to
                 cover another purpose (e.g., escalation); they do not otherwise have a
                 monetary limit in making such actions. According to a Navy official, this
                 feature is used extensively to cover fund deficiencies within the ship
                 construction program.

                 Some contract implementation practices for contracts that are exper-
Contract         iencing cost overruns may have future cost implications for the Navy.
Implementation   For example, when shipyards have exceeded their contract ceiling
Practices        prices in the past, the Navy has agreed in some instances to contract
                 modifications, such as revising FPI cost share arrangements and con-
                 verting FPI contracts to FIT contracts. We are concerned that these modi-
                 fications could establish a precedent of significant importance in Navy
                 shipbuilding programs.

                 We found that the Navy awarded Bath Iron Works Corporation an FPI
                 contract in 1985 to design and construct the lead ship of the Arleigh
                 Burke class destroyer program. As of September 1989, the cost overrun
                 on this contract was $175.6 million, of which the shipyard’s share was
                 $78.1 million. At that point, according to Navy data, the shipyard would
                 have incurred a net $41.5 million loss on the contract. However, in mid-

                 Page 20                                     GAO/NSIAD-91-18   Navy Construction
                      Appendix IV
                      Budgeting for Cost Growth

                      September 1989, the Navy adjusted this contract by negotiating a con-
                      tract modification that consisted of a number of changes in the con-
                      tract’s work sc0pe.l According to the Navy, the contract was modified to
                      provide a more appropriate sharing of contract risk associated with per-
                      forming work that was not clearly defined in the original contract.
                      According to the Navy’s estimates, the shipyard’s share of the projected
                      cost overrun will be reduced from $78.1 million to $40 million, and its
                      net $41.6 million loss will be reduced to zero.

                       In another instance, the Pennsylvania Shipbuilding Company was
                       awarded an FPIcontract in 1986 to build two oilers with an option for
                       two more. According to a company official, because the shipyard was
                       experiencing productivity and financial problems, the Navy agreed to
                       transfer the option for the two additional ships to Avondale Industries,
                       Inc., under an FFP contract and to convert the contract for the original
                       two ships to an FFP contract. Before the conversion, the Navy was pro-
                      jecting a $160.6 million contract cost overrun. The Pennsylvania Ship-
                       building Company later ceased operations as a shipbuilder. The two
                       ships under construction were terminated for default and were later
                       awarded under a reprocurement contract to Tampa Shipbuilding.

                      Historically, shipyards in a loss position or approaching such a position
Ajustment and Claim   have made claims against the Navy. The Naval Ship Procurement Pro-
Trends                cess Study of the late 1970s stated that the Navy suffered from unreal-
                      istic prices in the long run because shipbuilders facing losses on
                      contracts were likely to submit claims.

                      Our analyses show that many ship construction contracts with large
                      overruns also have requests for contract adjustments or claims sub-
                      mitted. Conversely, many contracts with no or small overruns also have
                      no or few contract adjustments or claims submitted. For example, Bath
                      Iron Works Corporation and Ingalls Shipbuilding, Inc., both have con-
                      tracts to construct guided-missile cruisers, but only Bath Iron Works,
                      which has substantial overruns on its contracts, has submitted requests
                      for contract adjustments and claims.

                      ‘Changes included revisions in ship specifications resulting from maturing design, definitization of
                      authorized changes, resolution of essentially all outstanding contractual issues, increased contractor
                      guaranty, late delivery penalties, and contract risk adjustments on share and ceiling ratios.

                      Page 21                                                        GAO/NSIADdl-18      Navy Construction
Appendix V

Scopeand Methodology

             To update the status of potential cost growth on Navy ship construction
             contracts, we interviewed officials at and obtained documents from
             Navy Headquarters-the       Office of the Assistant Secretary of the Navy
             (Shipbuilding and Logistics),’ the Office of the Comptroller, and the
             Naval Sea Systems Command-Washington,           D.C. At Navy Headquar-
             ters, we reviewed cost data on the Navy’s 62 shipbuilding and conver-
             sion fixed-price contracts. These contracts accounted for all open Navy
             ship construction contracts as of December 31,1988. They covered 20
             Navy ship programs involving 176 vessels at 17 private shipyards. For
             these contracts, we obtained and analyzed the most recent budget data
             and other financial data to establish the magnitude of potential contract
             cost overruns and the extent of contract adjustments and claims as of
             September 1989. In addition, we interviewed Navy officials and
             obtained information on the reasons and budget implications of cost

             We also interviewed officials at six private shipyards and Navy officials
             at the concerned Navy contract oversight offices and obtained informa-
             tion on contract costs, claims potential, and reasons for cost growth
             from these organizations. The six private shipyards were (1) Bath Iron
             Works Corporation, Bath, Maine, (2) General Dynamics Corporation
             (Electric Boat Division), Groton, Connecticut, (3) Ingalls Shipbuilding,
             Inc., Pascagoula, Mississippi, (4) National Steel and Shipbuilding Com-
             pany, San Diego, California, (6) Newport News Shipbuilding, Newport
             News, Virginia, and (6) Todd Shipyards Corporation, San Pedro, Cali-
             fornia. The contract oversight offices were Supervisors of Shipbuilding,
             Conversion and Repair.

             We selected these six shipyards because, in March 1989, they were per-
             forming 86 percent of the Navy’s ongoing ship construction program. In
             addition, in March 1989, five of these shipyards had been awarded con-
             tracts involving most of the ship construction contract cost overruns
             and the other shipyard had the most ship construction cost overruns as
             a percentage of its total Navy shipbuilding program.

             During our review, we discussed ship construction with officials at the
             Office of the Secretary of Defense, Washington, DC.; the Navy’s Compe-
             tition Advocate General, Washington, D.C.; the Shipbuilders Council of
             America, Washington, D.C.; and the Pennsylvania Shipbuilding Com-
             pany, Chester, Pennsylvania, which recently ceased operations as a

             ‘This office is now referred to as Research, Development and Acquisition.

             Page 22                                                      GAO/NSIAD-91-18   Navy Construction

    Scope and Methodology

    In conducting our review, we used the same accounting systems, reports,
    records, and statistics that the Navy uses for ship construction to make
    decisions, establish program budgets, and monitor contracts. We did not
    independently determine their reliability.

    Our review was performed from June 1989 through March 1990 and
    was conducted in accordance with generally accepted government
    auditing standards.

    Page 23                                     GAO/NSIAD-91-18   Navy Construction
Appendix VI

Major Contributors to This Report

                         Richard J. Herley, Assistant Director
National Security and
International Affairs
Division, Washington,

                         Hugh E. Brady, Jr., Regional Management Representative
Norfolk Regional         Johnnie M. Phillips, Evaluator-in-Charge
Office                   Oried E. Graves, Evaluator
                         George 0. Morse, Evaluator

                         Kevin F. Murphy, Regional Assignment Manager
Ebston Regional Office   Lionel A. Ferguson, III, Evaluator

                         Dennis A. DeHart, Regional Assignment Manager
Los Angeles Regional     James R. Bancroft, Evaluator

                         Page 24                                   GAO/NSIAD91-18   Navy Construction
Page 26   GAO/NSIAD-fU-18   Navy Construction
Page 20   GAO/N&W-91-18   Navy Cmwtruction
Page 27   GAO/NSW91-19   Navy Conetruction
RelaM GAO Prcxhxts

             Navy Shipbuilding: Cost and Schedule Problems on the DDG-61 AEGIS
             Destroyer Program (GAO/T-NSIAD-90-14,Jan. 24, 1999).

             Navy Shipbuilding: Cost and Schedule Problems on the DDG-61 AEGIS
             Destroyer Program (GAO/NSIAD-90-84,
                                               Jan. 17, 1996).

             Navy Contracting: Status of Cost Growth and Claims on Shipbuilding
                                        Aug. 4,1989).
             Contracts (GAO/NSIAD-89-189,

             Navy Ship Construction Contracts (GAO/T-NSIAD-88-27,Apr. 19, 1988).

             Navy Ship Construction Contracts (GAO/T-NSIAD-88-9,Dec. 8,1987).

             Navy Contracting: Cost Overruns and Claims Potential on Navy Ship-
                                               Oct. 16,1987).
             building Contracts (GAO/NSIAD-88-16,

             Navy Contracting: Fiscal Year 1986 Contract Award for Construction of
             SSN 688 Submarines (GAO/NSIAD-87-120,May 4, 1987).

             Navy Ship Construction Contracts (GAO/T-NSIAD-87-30,Apr. 23, 1987).

(wraaa)      Page 28                                    GAO/NSIAD-91-18   Navy Condruction

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