WASHINGTON — The US Navy's use of fixed-price incentive contracts came under fire today with the release of a new report claiming the service is paying shipbuilders a profit to correct construction mistakes made by the builders.

"The shipbuilder earns the same level of profit for correcting defects as it does for building the ship," the Government Accountability Office (GAO) said in the report — despite guarantees in the contracts that should prevent that situation.

Even more, said GAO, "the award of follow-on, cost-reimbursement arrangements to correct remaining defects — under which the contractor also earns fee (profit) — creates an apparent disincentive for quality ship construction."

GAO, however, praised the US Coast Guard for its use of warranties on the Fast Response Cutter (FRC) program, noting that in similar situations where builder defects needed to be corrected, shipbuilders bore the brunt of the costs, not the government.

Shipbuilders paid about 11 percent of the cost to fix five of six ships in the study, GAO said, while the government picked up the remaining 89 percent. The cost to fix defects on the FRC, however, were mostly borne by the shipbuilder, which picked up 59 percent of the costs, leaving the government responsible for 41 percent.

While the Navy uses guaranty mechanisms in its fixed-price incentive contracts, GAO said those methods "generally [have] no effect on improving cost and quality outcomes, in contrast to FRC and commercial warranties."

As an illustration of the problem, GAO noted that shortly after the amphibious ship Somerset was delivered from Ingalls Shipbuilding, the ship's exterior hull paint began to peel.

"The Navy determined that the shipbuilder did not adequately prepare the surface of the ship prior to applying a second coat of paint and submitted the issue as a guaranty claim," GAO wrote. "The Navy docked the ship and the shipbuilder re-painted the vessel. The shipbuilder submitted invoices for the work completed and the Navy paid the shipbuilder $315,000 — even though the shipbuilder was responsible for the failure.

"This example illustrates how a guaranty functions with a fixed-price incentive contract type, which results in the government paying the costs to correct problems," GAO added.

GAO also noted that the Somerset was delivered with a cost overrun of 32 percent, and that, while Ingalls "earned less profit than it would have earned had the ship been delivered at its target cost, it still earned some profit."

Of more than $1.3 million needed to repair defects on the General Dynamics-build destroyer Michael Murphy, GAO reports the shipbuilders at Bath Iron Works paid for $460,000, while the government paid twice that, $900,000.

GAO noted the government got a better deal when the Coast Guard's Fast Response Cutter Paul Clark needed more than $2.1 million in defect repairs. Shipbuilders Bollinger paid $1.5 million, while the government paid less than half that, about $630,000.

The difference, GAO said, is that the Coast Guard paid extra for the warranty clauses in the FRC contracts, which paid off then the defect costs were higher. And when the shipbuilder agreed to the higher warranty terms, they also passed them on to their suppliers, resulting in even better performance.

The Navy, GAO recommended, needs to structure its contracts so that shipbuilders cannot make a profit for correcting construction deficiencies deemed to be their responsibility. Contracting officers need better guidance as to how and when to use guarantees, GAO added, and the Navy needs to differentiate and track defects between government and shipbuilder responsibilities and the costs to fix problems.

The Fast Response Cutter Paul Clark being lowered into the water at Bollinger Shipyards in August 2012.

Photo Credit: Bollinger Shipyards/US Coast Guard

The Navy partially concurred in all the GAO recommendations, but took issue with specific points. While the service agreed that contract terms need to be reviewed, it disagreed "that shipbuilding contracts always result in payment for profit for correction of defects judged as shipbuilder responsibility." The Navy agreed to conduct a study and determine policy changes, if any, for future shipbuilding contracts.

The Navy also disagreed that a single objective for using warranty or guaranty provisions can be found, but it will study the issue.

The service also pushed back on GAO's assertion that it has not been tracking the costs of correcting defects. "The Navy has been differentiating the government's and shipbuilder's responsibility for defects and tracking the costs to correct all defects after delivery on shipbuilding contracts," the service said in its response, pointing out such costs are reported by several offices within the Naval Sea Systems Command.

To carry out the study, GAO studied the situations of six ships purchased using fixed-price or incentive contracts: the destroyer Michael Murphy (DDG 112), delivered in 2012 from General Dynamics Bath Iron Works; the amphibious transport dock Somerset (LPD 25), delivered from Ingalls Shipbuilding in 2013; the littoral combat ships Fort Worth (LCS 3) delivered in 2012 from Lockheed Martin and Fincantieri Marinette Marine and Coronado (LCS 4), delivered by General Dynamics and Austal USA in 2013; the Coast Guard National Security Cutter Hamilton (WMSL 753), delivered from Ingalls Shipbuilding in 2014; and the Coast Guard Fast Response Cutter Paul Clark, delivered in 2013 from Bollinger Shipbuilding.

None of the ships, GAO noted, were lead ships, meaning the first of a class, which generally have more defects and cost more than follow-on ships.