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Cost-plus contracts reward overruns
How cost-plus pays
Picture a build that costs $100 million: the contractor earns $15 million on top. If the same build costs a billion dollars, the contractor earns $150 million. Every extra year and every extra dollar pays, a perverse incentive to drive costs up. It is not the only reason the defense industry is where it is today.
Design split from building
Shipbuilding adds a second problem. The design is separated from the builder: one party is paid to design, and the ground-up assembly is handed to a totally different party. About 70% of sequence-critical components on some Navy ships come from sole source suppliers. Nothing pushes anyone to change that, because payment is coming either way.
The fixed-price push
Firm fixed price contracts remove the incentive, and the administration has pushed to move away from cost-plus, with a maritime executive order, a maritime action plan, and the SHIPS Act sitting in Congress. Saronic, about four years old, has raised $2.5 billion in private capital and spent it on R&D, including building the 180-foot Marauder with its own money.
Why do cost-plus contracts exist at all?
Cost-plus contracts exist because the government sometimes buys things whose cost cannot be estimated in advance, such as a new technology. The approach became widespread in World War II, when Washington needed production to start before prices could be set. A fixed-price contract works poorly when the work is unknown, because the builder either bids too high or loses money. Federal acquisition rules today allow cost-reimbursement contracts when uncertainty makes a fixed price impractical.
Why does one supplier slow a whole ship?
When a part has a single source, every ship in the program waits on that one factory's schedule, quality, and capacity. A shortfall there has no workaround, because no other firm is qualified to make the part. Qualifying a new supplier for a Navy part can take years of testing. The US Government Accountability Office has pointed to supplier delays in its reports on the Navy's Virginia-class and Columbia-class submarine programs.
How do fixed-price contracts shift the risk?
Under a firm fixed price contract, the builder agrees on a price up front, keeps any savings it finds, and pays for any overruns itself. That puts the pressure to control cost on the builder instead of the government. Estimates for unproven designs are often wrong, so fixed price has generally been used for mature designs and cost-plus for early development. Contractors have taken large losses on fixed-price development work when their estimates came in too low.
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