Free-market capitalism brought the nation, among other things, Aegis cruisers like the USS Antietam.
Naval shipbuilding in the United States is in real trouble. With the exception of legacy shipbuilding programs, ship price changes outpace inflation. Ontime performance is increasingly rare. The Navy cannot articulate a shipbuilding strategy that Congress will accept. Conversely, naval shipbuilding, from the corporate business perspective, is doing well. Over the past decade, the industry consolidated from six independent, largely undercapitalized companies down to two large, well-capitalized, diversified corporations, both of which are quite profitable. Their products are increasingly being supplied in a low-risk, monopoly or cartel market. The Navy is absorbing virtually all increased costs.1 This dichotomy between the unmet requirements of the customer (Navy) and the happy state of the supplier (industry) indicates a severely distorted economic situation.
The profits that this uncontrolled price growth creates are of real benefit to the shipbuilding industry, but only in the short term. Eventually, this unhealthy market situation will bankrupt shipbuilders just as fast as it denies the Navy ships it needs. There is no money to be made from a customer who cannot afford to buy a product. There are no shipbuilding jobs if there is no ship production. Eventually, the entire industry will collapse as the Navy cuts shipbuilding budgets in response to steeply escalating ship prices. It is a death spiral for both parties. One need only to look at earlier naval powers to see this; where is the British naval shipbuilding industry today? Where is the Royal Navy today? the French? the Spanish? Shipbuilding industries and navies travel together.
Shipbuilding prices are controlled by two major factors: combat capability and economics. Combat requirements demand specialty skills in engineering, metals, electronics, and, increasingly, computer science. These skills are often so specialized that they exist nowhere else but in the naval engineering industry. Economic factors include numbers of ships procured, length and intensity of production runs, use of cost-plus or fixed-price contracts, the presence or absence of competition, and other subtle factors. Many naval officers, focused on the combat requirements of a shipbuilding program, and innocent of economic experience, disregard or ignore the economics of shipbuilding. Recent shipbuilding history, however, clearly indicates that economic rather than military factors dominate ship affordability issues.
In 1985, for example, a competitively awarded Aegis cruiser was budgeted at $884 million; by 2001, a competitively awarded Aegis destroyer—a dramatically different ship—was budgeted at $918 million, an increase of only 4% over 16 years, well below the rate of inflation.2 This was done in spite of the many substantial combat-capability improvements incorporated between ships of the mid-Ticonderoga (CG-47)-class Aegis cruisers and those of the late Arleigh Burke (DDG-51)-class Aegis destroyers. In contrast, a competitively awarded Los Angeles (SSN-688)class nuclear-powered attack submarine was budgeted at $638 million in 1987, but a cartel-built Virginia (SSN-774)class boat was budgeted at $2.5 billion in 2005, an increase of almost 300% over 18 years. Significant combat-capability improvements were incorporated between these two boats, just as in the Aegis example, but there were also substantial infrastructure reductions made in submarine shipbuilding because of the forced consolidation of the submarine shipbuilding infrastructure.
Outside of shipbuilding, a recent report on the Department of Defense's competitive sourcing program revealed 44% price decreases as a result of the introduction of competition into 1,200 formerly non-competitive DOD operations.3 This was done without regard to the specifics of the type of operation opened to competition.
Competition is what saves the customer money, irrespective of infrastructure or the level of combat capability. One more time: The controlling factor in shipbuilding pricing is the presence or absence of effective competition, not combat capability.
Capitalism 101
The pioneering economist Adam Smith described the current problem in naval shipbuilding quite well in his seminal 1776 work, The Wealth of Nations. He described the customer-supplier relationship in a capitalist market:
"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard for their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages."4
While American defense contractors are undoubtedly patriots, they provide defense products in order to earn profits. No profit, no product. No bucks, no Buck Rogers. In seeking profit in a balanced market, industry will innovate to the substantial betterment of the customer. Conversely, to the extent that industry can earn a profit without having to innovate, it will not expend the effort. This is the risk-reward equation. High potential for reward (profits) encourages high-risk behavior (innovation). Industry operates in its own self-interest, and optimum results occur when that self-interest coincides with a customer's needs.
The Information technology (IT) boom of the 1990s is a classic example. Companies did not sign on for those expensive-and enjoyable-Super Bowl commercials just for fun; they were intended to increase profits. It worked. An entirely new industry was created. Thousands became rich during the boom. The American consumer benefited through long-term improvements in the performance of computers, the Internet, and increased availability and performance of IT-based services and products. Products failed, of course, as markets became saturated and companies went bankrupt. New and costly infrastructure was created, but that was more than offset by long-term cost savings, measured in terms of reduced production costs, cheaper equipment, and more effective system performance. As consumers of IT services today, we receive far more capable, more cost effective, and much more innovative services than we received just a decade ago. Best, the increased level of performance cost the American consumer nothing. This is the innovation engine that Adam Smith discovered: companies operate to maximize their own self-interest, but, in so doing, drive innovation into the market as a whole, benefiting the paying customer. Properly managed, it has been a powerful, world-altering tool.
Capitalism can be mismanaged, however. In much of the defense industry, and particularly in naval shipbuilding, America has allowed the risk-reward equation to be turned upside down. High profits are awarded without economic incentives to innovate. Low-risk, monopoly shipbuilding contracts return high profits, but higher-risk, competitive contracts generally receive lower profit opportunities. One diversified shipbuilder, for example, earned 25% higher profits on monopoly shipbuilding work than on competitive work.5 This, not surprisingly, drives the industry to seek, and lobby for those low risk, high profit shipbuilding contracts. This has done much to drive innovation, particularly cost innovation, out of American naval shipbuilding.
In addition to the risk-reward equation, a second factor substantially affects the economy of naval shipbuilding: demand for revenue growth. Current business practice, as measured in stock exchanges and brokerage houses, requires that companies show year-to-year revenue growth in addition to simple profitability. This required growth rate is measured against national and industry-specific rates and helps to drive cost and price innovation in healthy competitive markets. The pressure for revenue growth in a market segment that is flat (or declining) pushes shipbuilders to find new revenue sources. That drives the industry into new ship husbandry markets, like ship design, repair, and logistics, moves that can be of benefit to their customer. It also helps to drive above-inflation price hikes. The Navy's push for reduced ship prices, which cuts profits by reducing revenue, pushes directly, and ineffectively, against this much more powerful business financial requirement.
Finally, there is a third component of the naval shipbuilding industry that drives innovation and cost control. Shipbuilding is a capital-intensive industry. Large investments are required to obtain cost reduction through production innovation. High profits in a healthy industry become the source, or at least justification, for large capital investments. Since shipbuilding revenue growth is far from assured, regardless of the level of new capital investment, corporations that own shipyards are leery of making the kinds of investments necessary to achieve real cost reduction. Rather than reinvest their Navy-generated profits into shipbuilding in order to generate future profits, they tend to move them into other, non-shipbuilding investments. Local or state governments now fund most new capital investments in American shipbuilding, either partially or wholly, in hopes of creating higher levels of employment and job training in return for their investment. That can negate the conflicting Navy desire to reduce the cost of shipbuilding by introducing laborsaving innovation.
Corporate self-interest, risk-reward, revenue growth, and capital investments represent the business side of shipbuilding, but they operate within five larger economic models that exist in shipbuilding today. Any shipbuilding plan that seeks to create and sustain an innovative industry with rigorous cost control must operate within one of these five discrete economic states.
* Full competition. This is the situation we are most familiar with as consumers. Many suppliers vie for the business of many customers. Price and quality competition drive all transactions, and innovation and cost control is maximized. This is capitalism at its finest and most productive. This economic state exists in the international commercial shipbuilding market.
* Limited competition. Two or three suppliers provide for one customer. All other suppliers are excluded. The customer drives the level of innovation and cost control: the less the customer is willing to pay, the higher the level of innovation and cost control. Until recently, this described naval shipbuilding in America. The SSN-688/688I (Improved) and the Aegis-equipped CG-47 and DDG-51 classes were built under this model. The Littoral Combat Ship (LCS) Flight O design/build and DD(X) design were successfully competed under this model.
* Monopoly/Cartel. "Monopoly control means that one company dominates its industry, being able to set prices, control production, and often raise barriers to competitors wishing to enter the field."6 This can be considered the natural end state of a mismanaged capitalist economic system. Cost savings, if found, are generally not passed on to the customer, but taken as additional profit. Profit becomes a right, not a reward. If a monopoly is protected or sanctioned by the government, it becomes a natural monopoly. Submarine, aircraft carrier and amphibious shipbuilding are monopolies (or cartels) today.
* Regulated. In order to avoid the deleterious effects of monopolies, governments can establish regulated monopolies. In return for a guaranteed customer base, natural monopolies (like utilities) accept lower profits and a high degree of customer involvement in their internal business decision-making processes in exchange for a guaranteed market. Innovation and cost control are better than in a monopoly, but not as high as in any competitive market. That is why most regulated industries have been deregulated in America today; the introduction of competition is used to drive innovation and cost control into an otherwise somnambulant business.
* Publicly owned. This eliminates all profit and business market issues, further reducing costs. Public financing of major capital improvements can occur, so innovation and cost control can be better than either a monopoly or a regulated industry. Since the industry is publicly run, however, it is often subject to other controls that keep its cost performance and ability to innovate below that of any competitive state.
Full or limited competition provides the highest opportunity for innovation and cost control in naval shipbuilding. Regulated and publicly owned naval shipbuilding provide the next, lower tier of innovation and cost control. Monopoly or cartel shipbuilding provides the least innovation at the highest cost.
The "Do Nothing" Option
Technical and engineering studies often cite a do-nothing or no-change option. What will happen if no action is taken? If that outcome is acceptable, then no time need be spent considering other options.
Today, the do-nothing option in naval shipbuilding allows the current trend towards monopoly and cartel suppliers to continue unabated. Only surface combatant and combat cargo (Logistics) shipbuilding remains competitive today. Two shipbuilding facilities could be closed or severely downsized to justify transitioning these last two product lines to monopoly status. Within submarine shipbuilding, one shipyard could close or exit submarine shipbuilding to reduce the current two-shipyard cartel to a simple monopoly. In theory, the Navy could save money from this industry-driven consolidation through infrastructure and overhead cost reductions. Or, maybe not. When the Navy tried to shut down one submarine shipbuilder in the late 1980s as submarine procurement quantities declined, the shipyard objected, in the courts, and that is why we have a submarine shipbuilding cartel today. Forced federal consolidation of private industry has its own risks.
Thus, the do-nothing option yields one of two equally unsavory results: a complete commercial monopoly in naval shipbuilding, or an over-facilitized cartel. Either result would drive ship prices ever higher in response to business revenue growth requirements. Both would result in low levels of innovation and very poor cost control. The industry would fund new capital investment only to the extent that local, state or federal governments would be willing to pay for it. High profits would be taken, and then funneled out of shipbuilding. Low capital investment rates would further erode shipbuilding cost performance, to the point that the Navy could probably afford to build only three ships a year: one submarine, one large amphibious ship, and one surface combatant. A nuclear aircraft carrier could be built every five to ten years, with the interval between new carriers increasing with each price hike. Amphibious ship and surface combatant production could easily slip to one every two years. These figures would sustain a Navy of perhaps 100 ships. Note that economics, not combat requirements, drive that calculation.
Other Options
If a 100-ship Navy is unacceptable, then other options present themselves. If competition cannot be restored, and monopoly or cartel suppliers are unacceptable, then the only two choices are to create a regulated naval shipbuilding industry or nationalize it.
If the industry were to be regulated, prices would drop roughly 10% to 15% as profits were brought down to levels consistent with a low-risk, federally regulated industry. Innovation would increase as the remaining profit levels were adjusted to allow for enough targeted capital investment to hold cost growth to no more than the rate of inflation. As businesses, regulated shipbuilders would have access to new commercial loans and bonds, reduc-ing the Navy's short-term cost for expensive new capital investments. The causal factors that create above inflation price increases would be eliminated and investment geared to increasing efficiency and enhanced innovation could begin.
Nationalizing the shipbuilding industry in America would be inconsistent with our current national economic policies. Doing so, however, would allow for further price cuts as all profits are eliminated. Cost increases would be limited to cost-of-living, as all business-driven economic requirements would be eliminated. Several successful foreign commercial and military shipyards are wholly or partially owned by their governments. Thus relieved of business-driven performance requirements, these shipyards often demonstrate remarkable cost control while showing substantial technical innovation in their products, which then makes them competitive-surprise-in the international commercial shipbuilding market.
In either case, a force structure somewhat higher than a monopoly-driven force structure could be provided by leveraging the 10% to 20% cost savings obtained through reduced profit levels and increased cost innovation. Based on a 30-year useful ship life, these savings could produce perhaps 1.5 submarines a year (45 boat fleet), two surface combatants a year (60 ship fleet), and some larger number of logistics ships, amphibious ships, and aircraft carriers, for a total Navy of 120 to 150 ships.
The only way to get real innovation and real cost control in America's naval shipbuilding industry today is to restore competition at the limited competition level. This would require the Navy to produce consistent, long-term shipbuilding procurement budgets in order to create an economic market large enough and stable enough to support privately funded innovation and healthy, productive competition. Annual shipbuilding budgets would likely not increase above existing levels (roughly $9 billion to $12 billion/year), but budgets would need to be stable, and both Congress and the Navy would have to take the long view throughout the current annual budget process. Three ship types would be subject to change:
* Restore competition in submarine construction: The SSN-774 class design is complete and the first boat has been has been built and delivered to the Navy. Soon, the second submarine shipbuilder will deliver the second boat. This means that the Virginia is a mature, proven design that is eligible for aggressive, fixed-price limited competition on the Navy's terms. Today, profits are earned on one-half of one $2.2 billion submarine a year, or roughly $175 million per shipyard, per year (assuming 16% profit and a 50/50 construction split). The current level of construction supports a 30-boat submarine fleet, not including nuclear-powered ballistic missile submarines (SSBNs) and nuclear-powered guided-missile submarines (SSGNs). If the Navy could use competition, multiyear procurement, learning, supplier consolidation, production innovation, and quantity discounts to reduce that $2.2 billion unit price by 33%, a realistic number based on past performance in other competitive shipbuilding programs, then the service could reasonably afford to buy three submarines a year for the price it would spend for two today. Three competed submarines present a total annual profit opportunity of $610 million at 14% profit. If the Navy ran a pricebased limited competition properly, awarding a large number of boats to a low-price shipbuilder and a smaller number of boats to a high-price shipbuilder, the winning submarine shipbuilder could easily see doubled levels of profitability. Submarine innovation and cost control, driven by a corrected risk-reward equation, would be at an all time high, delivering boats at an affordable cost. By doing this over the next five budget years, the Navy could buy at least 10 additional boats above a one-boat-per-year plan, for roughly $11 billion.
* Sustain LCS and Logistics ship competition. The LCS program did a superb job of opening up the competitive process for small ship construction. Building dissimilar hulls in multiple shipyards rather than common hulls in multiple shipyards is a brilliant new competitive strategy, enabled by the fleet's new willingness to operate non-homogeneous ships. This highly competitive process should be continued and sustained through serial production, should the program prove to be an operational success. Logistics ships, already competed, should continue their successful process.
* Compete DD(X). Congress opened the window for sustaining competition in surface combatant shipbuilding by delaying the procurement of the lead DD(X) until at least 2007. Since the design for this ship is supposed to be ready in 2007, the Navy could conduct a price-based limited competition for the lead ship, possibly fixed-price, based on a completed design. Since the designers would also be the competitors in this limited competition, a double benefit is created for the Navy. If the design is not done, then there can be no production competition, and the shipbuilders would lose revenue and profit. If the design is not done well, and the production contract is fixedprice, the shipbuilders will lose profits during construction due to production inefficiencies. These two factors would drive industry to create an accurate design on schedule, placing the customer firmly back in the driver's seat and re-aligning the risk-reward equation. Product will be delivered before profit, and higher profits would flow from successful innovation and satisfactory delivery of a product. Bucks would yield Buck Rogers. Unfortunately, strict affordability requirements were dropped in the transition from DD-21 to DD(X). Un-surprisingly, the price almost tripled and planned procurement quantities subsequently dropped 75%. Affordability has been a hallmark of past successful shipbuilding programs, such as the Los Angeles-class SSNs, the Oliver Hazard Perry-class frigates, and Aegis shipbuilding, so we ignore it at our peril. As with SSN competition, production quantity (volume) is critical to sustaining competition; the DD(X) must be affordable enough to allow the Navy to start the innovation engine of competition.7
Restoring competition in submarine construction and sustaining competition in surface combatants and cargo ships would allow for a 90-submarine and 90-surface combatant force structure, or a Navy of roughly 225 ships, plus LCS production. Aircraft carriers and amphibious ships also present future opportunities, albeit more challenging, for price reduction through competition.
Conclusions
The United States did not become the world's economic and military superpower by harnessing the power of monopoly economics. Free-market capitalism, inspired and guided by Adam Smith's concepts, and executed by talented and pragmatic American businesses brought us to where we are today. Military economics, although more focused and limited than consumer economics, have ridden this wave of economic innovation along with the rest of the nation. Naval shipbuilding in America is at a critical juncture. The Navy, not industry, holds the keys to success. The solution is not for the Navy to devise clever new ways of paying ever-higher monopoly shipbuilding prices; the solution lies in re-establishing and then sustaining a fully competitive shipbuilding process.
Congress, representing the taxpayer, has the bucks, and industry can deliver the Buck Rogers. It is up the Navy to draw the two together, building a modern shipbuilding marketplace that draws out the finest in American talent and American innovation through proven economic principles. From that firm industrial foundation the fleet can reap the force structure and technology innovation that sustains our worldwide military strength.
1 "Northrop's Profit Increases 44%; Raytheon has Loss". Wall Street Journal. July 30, 2004; ""General Dynamics Posts Profit". The Washington Post, Oct 21, 2004; "Defense Firms Post Earnings Gains: United Tech, Honey well, General Dynamics Record Double Digit Increases " Wall Street Journal, April 22, 2004; "Defense Dynamos," Business Week, March 25, 2003; "Purchases Help Lift Northrop Profit 71%," Los Angeles Times, January 29, 2003; "Northrop, General Dynamics Post Gains in Profits," Wall Street Journal, July 18, 2002.
2 It is important to distinguish between "budget" and "price," Budget is what the U.S. government reasonably believes that a ship will cost; price is what it actually costs to build. Budgets are public knowledge while prices, which can disclose sensitive data about corporate performance.generally are not. The ships mentioned may have had a price above or below the budget, and some are not yet complete, so their final price is not yet determined. Regardless, none of the ships discussed here and in the SSN section to follow could have prices so divergent from their budgeted estimates that the validity of the comparison is affected.
3 Hill, Tichakorn. "The Surprising Success of Competitive Sourcing," Federal Times, November 1, 2004.
4 Smith, Adam. The Wealth of Nations, (Modern Library Paperback Edition, 2000).
5 "Northrop Struggles to Control Costs," Los Angles Times, September 25, 2003.
6 Geisst, Charles R. Monopolies in America, (Oxford University Press, 200OJ.
7 In the early 1970's, planners decided to install Aegis on large, new-design ships, along with a new missile, new launchers, and a host of other new-technology equipment (that was unaffordable). The Surface Warfare leadership of the day wisely focused on fielding core mission requirements (the SPY-?? radar and the Aegis computer programs), and used existing technology for all other systems for USS Ticondewga (CG-47). The "lost" capabilities were all "bought back" in subsequent upgrades. Much of that buy-back was paid from savings generated through the competitive shipbuilding process. That is why the Surface Navy has 89 incrementally upgraded, but affordable Aegis ships today instead of just a few (four to eight) high-capability, but fundamentally unaffordable ships.
Captain Lewis is assigned to the staff of the Commander, Naval Surface Forces, San Diego, California.