As shown in the figure, the ceiling price represents the  government’s maximum liability under the contract. We elaborate below  on the picture over the past 10 years. These factors  constrain the Navy’s ability to award shipbuilding contracts competitively. The Navy Prefers FPI Contracts but Did Not Always Document Its Rationale for Determining Contract Type and Elements

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. 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. These contract terms remained consistent throughout  negotiations. 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. Under such negotiations, the shipbuilder and Navy need to make assumptions regarding the shipbuilder’s efficiencies, learning, and  suppliers far into the future. 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. Majority of Contracts Included Additional Incentives That Provided the Potential for Shipbuilders to Earn Profit Outside of the Share Line

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. Costs Grew above Target on the Majority of FPI Contracts We Reviewed

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. 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. 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. 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. Regulation, while not  prescriptive, highlights the benefits of measuring the effectiveness of such  incentives. Conduct a portfolio-wide assessment of the Navy’s use of additional  incentives on FPI contracts across its shipbuilding programs. Appendix I: Objectives, Scope, and Methodology

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. 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.
Why GAO Did This Study

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.

What GAO Found

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.

What GAO Recommends

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.