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Using the Steel-Vessel
Material-Cost Index to
Mitigate Shipbuilder Risk
Edward G. Keating, Robert Murphy,
John F. Schank, John Birkler
Prepared for the United States Navy
Approved for public release; distribution unlimited
NATIONAL DEFENSE RESEARCH INSTITUTE
The research described in this report was prepared for the United States Navy. The research
was conducted in the RAND National Defense Research Institute, a federally funded
research and development center sponsored by the Office of the Secretary of Defense, the
Joint Staff, the Unified Combatant Commands, the Department of the Navy, the Marine
Corps, the defense agencies, and the defense Intelligence Community under Contract
W74V8H-06-C-0002.
Library of Congress Cataloging-in-Publication Data is available for this publication.
ISBN 978-0-08330-4229-3
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Summary
The U.S. Navy wants to provide its shipbuilders with appropriate incentive to produce militarily effective vessels at minimum cost to the Navy.
The Navy can induce a shipbuilder to agree to any contractual arrangement by offering
the shipbuilder a high enough price. But it is likely to be preferable, at least ex ante, for the
Navy to dissipate risk external to its shipbuilder to pay less for the systems the Navy needs.
The Navy uses external labor- and material-cost indexes to attempt to correct for significant
cost risks outside its shipbuilders’ control. Shipbuilder profits are greater when actual cost
growth is less than the indexes’ cost growth and conversely.
A longtime material-cost index in Navy shipbuilding is the steel-vessel index. It is a
weighted average of three Bureau of Labor Statistics (BLS) producer price indexes (45 percent
iron and steel, 40 percent general-purpose machinery and equipment, and 15 percent electrical
machinery and equipment).
One criticism of the steel-vessel index is that it does not accurately cover the materials
used in building a modern ship. No modern U.S. Navy ship, for instance, has 45 percent of its
material costs in iron and steel. To combat this shortcoming, the DDG-51 and T-AKE programs created their own material-cost indexes with lower weighting on iron and steel.
Historically, BLS’s iron and steel price index has been much more volatile than has the
general-purpose machinery index, the electrical machinery index, or economywide inflation.
Consequently, the steel-vessel index has been more volatile than have material-cost indexes
with lower weights on iron and steel.
The known mismatch between the steel-vessel index’s composition and a shipbuilder’s
actual material cost structure is problematic. The shipbuilder bears a risk that the prices of iron
and steel may tumble while the shipbuilder’s costs do not. A risk-averse shipbuilder will require
a premium to bear this cost structure–mismatch-driven risk.
We urge the Navy to develop a modern-vessel index that more appropriately represents the material used in constructing ships. The more accurately a material-cost index captures a shipbuilder’s external material cost risk, the less we expect the Navy to have to pay its
shipbuilders.
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