NAVY CONTRACTING Cost Growth Continues On Ship Construction Contracts

About 90 percent of the dollar value of the Navy ships under construction as of July 1991 can be accounted for in fixed-price incentive contracts with commercial shipyards. A fixed-price incentive contract establishes a target cost and profit, a ceiling price, and a share formula that is used to determine the cost to the Navy and the profit earned by the shipyard. The targetcost— a negotiated estimate of the ship's actual cost—and target profit—the profit the shipyard should earn if the contract is completed at the target cost—can be adjusted by mutal agreement as work progresses, in which case the Navy is responsible for any additional expense. The target price is the sum of the target cost and the target profit. The ceiling price — generally 120 to 135 percent of the target cost — is the maximum amount the Navy will pay on the contract. The Navy and the shipyard share any "over-target" costs that exceed current target costs up to the ceiling price based on a formula that is negotiated as part of the contract.

Generally, the Navy and the shipyard share this increase equally.

However, all costs above the ceiling price are borne by the shipyard.

Thus, the shipyard's profit is determined by how well it meets the target cost. Firm fixed-price or fixedprice with escalation contracts were used for the remaining 10 percent of the remaining ships under construction in July 1991. These contracts generally contain no provisions for adjusting the price after the award of the contracts.

The Navy conducts annual ship cost adjustment reviews to develop updated cost estimates for each ship under construction. The information is used to establish a financial baseline for managing ongoing shipbuilding programs and for budget preparation and is provided to all Navy management levels for those purposes.

The potential total cost for completing construction of the 165 ships under the Navy's 54 ship construction contracts that were open at the end of fiscal year 1991 was about $6.4 billion (24 percent) higher than the contracts' initial target costs of about $27.1 billion. The Navy's share of that increase is about $4 billion; the shipyards are liable for the remainder. Cost growth has increased over the years. When last reported on cost growth in 1990, the potential cost for completing the 62 ship construction contracts that were open at that time was about $5.5 billion Figure 1 Basic Construction as a Percentage of the Total Ship Cost Percent of Total Ship Estimate 100 (20 percent) higher than those contracts' initial target costs of $27.3 billion.

In the past, the Navy, with congressional approval, has made up funding shortages in individual ship construction accounts by transferring funds to those programs from other shipbuilding and procurement programs that were reduced, canceled, or were of a lower priority.

However, for fiscal year 1992, in addition to the transfer of $1.5 billion among programs, Congress provided $463.6 million in new funding to make up existing funding shortages. The overall increasing cost growth and a potential decline in the number of ships under construction will reduce the total funds available for shipbuilding. Thus, the Navy will find it increasingly difficult to make up shipbuilding funding s h o r t f a l l s through transfers among programs as it has done in the past. As a result, itmay have to request additional funds from Congress, as it did in fiscal year 1992.

Because of increased costs, the Navy has had to provide substantially more funds to the shipbuilding programs that were originally appropriated.

Generally, the programs funded in fiscal year 1987 and earlier received 10- more appropriations than have been needed to date and thus have served as a source of funds for other ship construction programs experiencing cost growth. Programs begun since fiscal year 1988 originally received less appropriations than have been needed and have required additional funding. The fiscal year 1992 Defense Appropriations Act redressed shipbuilding funding shortfalls by providing $463.6 million in new budget authority for increased inflation on existing contracts and by approving the Navy's proposal to transfer about $1,496.6 million from existing Navy and Marine Corps programs to shipbuilding programs to cover the remaining cost growth.

90- 80 As acknowledged by a Navy official in an April 1992 congressional testimony, the Navy will face increasing difficulty in completing its ship construction programs within the appropriated funding levels because costs continue to increase while the number of ships under construction is likely to decline. If fewer ships are built, the total available shipbuilding funds will be reduced, and funds potentially available for transfer to programs experiencing cost growth will be limited.

The Navy's actual cost and the shipyard's acutal profit, which depends on how well the shipyard meets the target cost, are determined after all work is completed on the contract. During the course of the contract, the Navy periodically develops an estimated completion cost for the contract (estimate at completion, or EAC) based on contractor-provided and Navydeveloped information.

These estimates are used to measure contract performance and are the basis of our discussion on cost growth.

The following contract illustrates cost sharing on a current FPI contract. The original target price was $225.4 million (the target cost of $193.8 million plus the target profit of $31.6 million). Because of agreed-upon contract changes, the target price increased to $244.8 million, which included a target cost of $210.5 million and a target profit of $34.3 million. The Navy is responsible for the $19.4 million increase $16.7 million for the target cost and $2.7 million for the target profit.

However, the July 1991 estimated cost to complete the contract was $221.7 million, an $11.2 million increase over the current target cost, which the Navy and contractor will share equally. The Navy and the contractor will share any additional cost increases up to the ceiling price of $263.1 million. At that point the contractor will absorb any additional TAO LHD DDG-51 Ship Type costs.

The costs incurred by the Navy through its contracts with the shipyards are for the ships' basic construction and are only a portion of the total cost of those ships. Funds budgeted for basic construction provide for shipyard contract costs of (1) labor to construct the ships, (2) material obtained by the shipyards for the ships' construction, (3) shipboard installation of governmentfurnished equipment such as guns, (4) allowable shipyard overhead costs, and (5) the shipyards' profit. Overall, basic construction accounted for about 47 percent of the total budgeted estimated cost of $76.1 billion for the ships under construction in July 1991.

Additional costs may be incurred, for example, to (1) purchase electronics systems, weapon systems, and other government-furnished equipment installed on the ships; (2) conduct tests and provide various services related to the ships' construction; and (3) reimburse the shipyards for subsequent changes made in the ship designs.

The cost of basic construction varies significantly depending on the type of ship and its complexity. Figure 1 illustrates the variation in the cost of basic construction for three types of vessels—fleet oilers (TAO), amphibious assault ships (LHD), and guided missile destroyers (DDGIf a shipyard incurs additional costs, it can request that the Navy adjust the contract to recognize those costs. If the Navy agrees to an adjustment, it is liable for the additional costs. If the Navy does not agree to the request, the shipyard may file a claim against the Navy. Since July 1991, the Navy has agreed to settle adjustments and claims of about $309.8million. These settlements represent about 59 percent of the amounts originally submitted. The AOE-6 fast combat support ship program accounted for about $239million of the total settlements. As of February 1992, about $349.7 million in additional claims and adjustments were pending resolution. It is true that larger initial appropriations could lessen the future need for additional funding for contract cost growth and that the additional funding required has declined from the fiscal year 1989 program to that required for the 1991 program. It is believed that, because of the long term of shipbuilding contracts, it will require several years to determine if any such change is successful in reducing the need for additional funds.

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