Industry CEO: No ‘Magic Formula’ Exists to Cut Cost of Navy Ships

12/1/2011
By Sandra I. Erwin

Shipbuilders have argued that if only the Navy ordered more ships, the industry could operate more efficiently. But with Pentagon budget cuts on the horizon, there may not be enough work to keep today's shipyards in business.
The United States faces a strategic choice of whether it wants to maintain its shipbuilding industrial base, said Mike Petters, president and chief executive officer of Huntington Ingalls Industries, the nation’s largest military shipbuilder.
The ships the Navy owns and plans to build in the future are highly complex and demand specialized facilities and workers that currently only exist in the private sector. Maintaining those industrial assets requires long-term planning and investment, Petters said Dec. 1 during a lunch meeting with reporters. Even if the government chose to nationalize the shipbuilding industry, it would be still be costly to sustain it, he said.
The expenses would have to be paid regardless of whether the money comes from private investors or from U.S. taxpayers, Petters said. “There’s no magic formula to this,” he said. “The ships we make are complex” and the “build rate” is not efficient. Unless the Navy bought more ships, costs will not come down, even if ships were built in government-owned yards. “I don’t see that as a panacea to save any money,” Petters said.
Petters also said it is a myth that shifting procurement contracts to fixed-price deals will save the Pentagon money.
In a fixed-price contract, payments are not based on actual costs, as opposed to a cost-plus contract, which covers expenses plus some amount of profit.
Petters pushed back on the conventional wisdom that defense contractors prefer cost-plus contracts because they provide a free license to run up the bill.
“Nothing could be further from the truth,” he said. “Our incentives are built around efficiency.” He claims that cost-plus contracts are unfairly vilified but in reality are necessary in order to manage the risk of building sophisticated warships, such as a new class of nuclear-powered aircraft carriers. Huntington Ingalls currently is building the first of the Ford class, under a cost-plus contract. Two-thirds of the company’s Navy contracts are cost-plus, said Petters.
“For us, the lower the cost the higher the return,” he said. Before a contract is signed, “We have some reasonable idea what the budget and the scope of work for a program is going to be. ... Our negotiations are less about the price on a contract and more about the risk. How will we share the risk or do we even share the risk?”
The perception is that “if we go fixed price and put the risk on the contractor, then it’s a good deal for the taxpayers,” he said. “It can be, if the risks are well understood.” He argued that if a contractor agrees to a fixed-price deal and fails to deliver, the costs to the taxpayers ultimately are higher than if the work had been carefully managed under a cost-plus arrangement.
Blaring headlines about “cost overruns” feed the belief that contractors are “bums” even when in some cases they have managed to reduce the risk in a program, he said. “The language we use when we talk about fixed-price versus cost-plus is somewhat inflammatory,” he said. “It’s the reality of the world we live in.”
The Pentagon’s “better buying power” procurement strategy calls for greater use of fixed-price contracts. Deputy Defense Secretary Ashton Carter, who previously served as the Pentagon’s senior acquisition executive, has championed fixed-price buying as a way to reduce cost overruns in weapons systems,
Petters contends that the issue is too complex to be condensed into sound bites.
Until successful cost-cutting measures can be found, the shipbuilding industry and the Navy will be under mounting pressure to fund current and future programs.
With 286 vessels in the fleet today, the Navy is the smallest it has been in decades. The service has projected an expansion in the coming years — to 313 ships by 2020 — but the growth is predicated on many hypotheticals.
The Navy’s shipbuilding plan assumes that manufacturers will lower costs and that ship procurement budgets will not be cut in the future. Both assumptions are highly questionable.
The Center for Strategic and Budgetary Assessments has estimated the average cost of each Navy ship at nearly $1.5 billion.
“Costs have been rising faster than our top line for a long time,” the Navy’s senior acquisition executive Sean Stackley told an industry conference in March. “If we don’t change that trend, we’re not going to be able to get there.”
Stackley said competition would benefit the Navy, but recognized that there is probably not enough work to keep more shipyards in business.
In the 2032-2041 forecast, average shipbuilding budgets are projected at $14.5 billion per year. Funding cuts already approved by Congress in the August debt deal could throw a wrench into that plan.
Navy officials have estimated that the price of Navy ships has doubled over the past 20 years and are on a path to continue that trend.
Unless those cost trends are reversed, ships will be caught in the dreaded “death spiral” that often haunts big-ticket Pentagon programs. As the Navy buys fewer ships, the cost of each vessel rises, leading to yet more cutbacks. At that rate, even one shipyard will be too many.
Petters said it is too early for shipbuilders to panic, even in the face of budget cuts. For the next five years, at least, the vast majority of Huntington Ingalls’ work has been appropriated and authorized. The current budget, he says, “is really a five-to-10-year issue for us.”
Trying to predict what will happen beyond that is fruitless, he said. “Every CEO on the planet believes their business is going to be different five to 10 years from now.”

Topics: Shipbuilding

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