Close-to-Shore Ship: Far Off Budget

By BEN FREEMAN

Contractor low-balling and misplaced confidence in defense procurement estimates have found another victim: the Littoral (close to shore) Combat Ship (LCS). The FY 2012 National Defense Authorization Act (NDAA) passed by the House grants more than $2 billion requested by the Navy for the LCS. This includes approximately $1.8 billion for the building of four new LCSs and $286 million for research and development.

On December 9, 2010, POGO wrote a letter to the Senate Armed Services Committee opposing the Navy’s plan to change its LCS acquisition strategy without providing time for meaningful congressional consideration. Originally, two distinct LCS designs were created—one by a team led by Lockheed Martin and the other by a General Dynamics-led team. In this “down-select strategy,” adopted in 2009, these two teams would vie to create the optimal LCS design and then, with one optimal design in hand, another bidding competition would be held to build 19 more ships. The new acquisition strategy, however, awards the two different LCS design teams a ten-ship contract each, and effectively blocks out all other shipbuilders from competing to build the LCS.

This strategy was adopted in spite of the Congressional Budget Office's (CBO’s) finding that it would ultimately cost $740 million more than the down-select plan.

A Congressional Research Service (CRS) report also noted that “Managing the construction of two very different LCS designs could place increased demands on overall Navy program management capacities…factors that might increase the chances of program-management challenges in the LCS program or of the Navy not detecting in a timely manner construction-quality problems that might occur in one or both LCS designs.”

But those aren’t the only drawbacks to the new plan: It is also highly doubtful that LCS funding for fiscal year 2012 will actually lead to the building of all four ships. Originally, the Navy estimated that each ship would cost $220 million. Just five years later, the Navy expects each ship to cost more than double this amount, and just last year the Navy spent more than a billion dollars on the procurement of just two littoral combat ships. In fact, no LCS has been built for less than $500 million. The CBO estimates that these four ships, built under the dual award plan, will cost a total of $2.29 billion ($572.5 million per ship), or more than $400 million more than has been budgeted. Yet, the House acquiesced to the Navy’s faulty LCS cost projections and continues to be low-balled by defense contractors that lock in immense procurement efforts with artificially low initial bids. The Senate should not be similarly duped when it authorizes funding for the LCS.

Ben Freeman is a National Security Fellow for POGO.

Image: Surface Forces.

Comments

[Ben Freeman]

George:

Thanks for your comment.

For the sake of brevity I left that quote out of my response. It is important to note though that this is NOT a CRS opinion; the CRS cites this “worst case” as a statement made by the Navy. And, because it falls under the adjusted cost cap figure this additional $20 million per ship will be partly shouldered by taxpayers.

Ken:

Thanks again for your comments.

Once again, you make some great points. Here are my rebuttals to your disputations of my rebuttals:

1. You are absolutely correct – well said. I too hope that both factors will motivate the builders to deliver.

2. I, once again, agree completely with you.

3. Unfortunately, the Navy did not provide these contract bids to the CBO. Without them the CBO is forced to provide the best estimate with the information that is available. This does not necessarily mean that their estimate is better or worse than the Navy’s, which is precisely what the quote you provided indicates.

4. It’s not clear to me how this works against my central theme. As you correctly pointed out, there is a steep learning curve in ship building and we cannot expect the costs of these first ships to be indicative of the costs of future ships. With these ships now built and the designs available for comparison the cost savings of down select are evident.

5. Yet again, I completely agree with you. We should evaluate the current procurement costs based on the ships actually procured under the current budget. I’m willing to bet, based upon the history of LCS cost overruns, that these four ships will cost more to procure than the approximately $1.8 billion allocated for them. In fact, I would enjoy a friendly wager with the Lockheed or General Dynamics building teams on the matter. If I am wrong and all four are built within budget, I’ll write a blog for POGO admitting I was wrong and applauding the ability of the Lockheed and General Dynamics teams to deliver within budget. If I’m correct the Lockheed or GD, team will write a blog for POGO explaining the cost overruns and applauding the prophetic powers of POGO’s Ben Freeman. Any takers?

[Ken Adams]

Ben, appreciate the direct response to my comments. Have to dispute some of your rebuttals though..

1. Granted that there is no longer competition between the contractors to win the FY-10 ships, but that doesn't guarantee either side the remaining options. Each contractor still has to deliver on his negotiated price or risk not being awarded future ships. Additionally, this contract only covers 20 of the Navy's stated need for 55 ships, so future competition for shipbuilding is still an option. So is cancellation, if it turns out the designs don't work as the Navy needs them. I think both factors will motivate the builders to deliver.
2. Agree that the government does bear some cost risk as stated, but the risk to the government is limited by the ceiling as you point out. What we do not know is where each company and the Navy negotiated the share line and the ceiling.
3. Taken in context, Table 2 of the CBO letter does not support your statement. Yes, the CBO estimate of per-unit costs in that table is higher, but CBO qualifies their assessment on the same page. "With the Navy in possession of contract bids, it is not clear that CBO’s cost-estimating model is a better predictor of LCS costs through 2015 than the Navy’s estimates."
4. Your statement that the original contracting strategy (competitive design and prototype construction with eventual down select) "did little to deter significant cost overruns, so much so that two of these ships were actually cancelled" argues against your central theme, that the dual-purchase strategy would cost more than a down-select to a single design with competition later for follow-on hulls.
5. No argument with your call for scrutiny of Navy estimates. Every government agency should have that same scrutiny, but at some point we have to stop beating them over the head with an old number that they acknowledged as faulty as early as the FY07 budget. The CRS report gives an excellent history of the revised estimates in Appendix C. A more effective argument at this point would be to hold them accountable for their estimates in the current budget for the ships procured under that budget.

[George]

On point (2), you need to read the CRS report further. It goes on to say: "...as a worst case, if the costs of the 20 ships under the two FPI contracts grew to the ceiling figure and all change orders were expended, the average cost of the ships would increase by about $20 million, to about $460 million, a figure still well below the adjusted cost cap figure of $538 million."

[Ben Freeman]

Hi Ken,

Thank you for your comments. You make some strong points. Here’s my point by point rebuttal:

1. Your explanation of the down-select strategy is absolutely correct – well said. This, however, in no way changes the point that the dual award plan eliminates all competition to build the remaining ships.

2. The dual-award strategy includes an average unit cost of $440 million and an adjusted unit procurement cost cap of $538 million. “Any cost growth above the target cost and up to the ceiling cost would be shared between the contractor and the Navy according to an agreed apportionment (i.e., a “share line”). Any cost growth above the ceiling cost would be borne entirely by the contractor,” according to the CRS report (pg. 9). The report also notes that the Navy does not expect per unit costs to exceed the cost cap, NOT average unit cost. So, your comment that the, “Risk of construction cost increases falls to the contractors, not to the government,” is a misrepresentation; contractors will split the bill with taxpayers.

3. The available non-Navy cost estimates I cited unequivocally state that the dual-purchase strategy will cost more than the down-select strategy on a per-ship basis. This is in black and white in Table 2 of the CBO’s letter and in Table F-1 of the CRS report.

4. You’re correct that these first four ships were under contract. Unfortunately, this did little to deter significant cost overruns, so much so that two of these ships were actually cancelled “in response to significant cost growth and delays in constructing the first LCS sea frames,” according to the CRS Report. This, of course, includes the original LCS-3 that was under contract with the Lockheed team. Incidentally the Lockheed version recently came under fire when a crack in its hull, as long as six inches, was discovered after sea trials.

5. I absolutely agree that the $220 million figure from the Navy's original program proposal was not credible; this was precisely my point. I never claim, nor believe, that per unit costs will not decrease. My argument is simply that the Navy’s cost projections should be heavily scrutinized given their track record in the LCS program.

[Ken Adams]

You misrepresent multiple facts in this article.
(1) The Navy's strategy was not to compete "19 more ships" after down-select, as you state. The CBO letter to Senator McCain, which you linked, states the 2009 strategy. "The Navy planned to select one of the two versions of the LCS, awarding a contract for those 10 ships to the winning bidder, and then, through another competition, to introduce a second yard to build 5 more ships of that same design from 2012 to 2014. In 2015, the Navy would purchase 4 more ships; the acquisition strategy for those vessels has not been specified. A total of 19 ships of one design would be purchased by 2015 (see Table 1). Any shipyard could bid in that second competition except the winner of the contract for the first 10 ships."
(2) You claim that Congress "acquiesced to the Navy's faulty cost projections." The Navy did not base its recommendation to Congress on projections, but on fixed-price contract bids. You ignore this fact. Risk of construction cost increases falls to the contractors, not to the government.
(3) You attempt to show that the dual-purchase strategy will cost more than the down-select on a per-ship basis. CBO clearly stated in its letter that "per-ship construction costs ... are about the same for the two plans."
(4) You stated that the first four ships ordered, of which two have been delivered, were "built under the dual award plan." This is not true. The first four ships purchased were all under contract, as part of a down-select strategy, for years before the Navy's decision to recommend purchase of both ship designs.
(5) Your attempt to extend the costs of the first four ships directly to the 10-ship purchase, ignoring a significant number of factors that tend to drive construction costs downward. Each of the first four was essentially bought as a unique item. There could be no economy of scale. According to CBO, "The Navy stated that the contractors achieved a substantial savings in the cost of materials because, under the block buy, the Navy would be committing to purchase 10 ships from one or both shipyards."
The first ship of each class experienced significant cost growth above the original "estimate" because there was no real estimate of cost. The $220 million figure from the Navy's original program proposal was not credible. According to the Congressional Research Service "Navy Littoral Combat Ship (LCS) Program: Background, Issues, and Options for Congress" report of April 29, 2011, that estimate "did not include items that are traditionally included in the so-called end cost." In addition, many other factors laid out in the CRS report document the cost growth factors for these first-in-class ships. It is illogical to expect that every ship in a production run would cost the same as the first.