Impact of Overhead on Shipbuilding Cost

Shipbuilding costs have skyrocketed, generally exceeding the rate of inflation, exceeding all reasonable expectations, and blowing away all historical precedents.  The reasons for this cost explosion are many and not always obvious.  Unfortunately, the lack of obvious reasons leads to simplistic, sensationalistic explanations among naval observers and, disappointingly, they are largely wrong. 

 

One of the most common complaints/explanations is that the shipbuilding industry, in cahoots with government and corrupt admirals, is rife with fraud and if we could just eliminate the fraud, shipbuilding costs would drop precipitously.  While this explanation makes for a compelling and, in a sense, satisfying (because we have an identifiable ‘villain’) story, it is unsupported by any significant body of evidence and fails to stand up to analysis.  This is not to say that a degree of corruption and fraud does not exist but it is not responsible for the magnitude of the cost increases we see on every new shipbuilding project.

 

A far more significant explanation for runaway costs is simple overhead.  We’ve previously covered this in depth (see, “Shipbuilding Costs – Impact of Low Volume”) but it warrants some follow up.  For those who may not be familiar with the basics of accounting and cost allocation, the following is a brief and grossly simplified explanation of overhead.

 

A product’s cost is the sum of two components:  direct costs and overhead costs.

 

cost = direct + overhead

 

Overhead is the cost of business not specifically and directly related to producing a product. 

 

For example, regulatory compliance costs (diversity, gender, environmental, maternity leave, etc.) are necessary costs (are they really?) but they are not directly related to the cost of production.  A department of lawyers or accountants provide no direct contribution to production but their cost is indirectly included.  Taxes must be paid on land and facilities but they have no direct relation to production.  And so on.

 

Direct costs, on the other hand, include raw materials, cranes, assembly facilities, and labor.

 

So, again, a product’s cost is the sum of direct costs plus overhead. 

 

cost = direct + overhead

 

Seems simple enough, right?

 

The thing is, direct costs are fixed whereas overhead is variable.  I know, you think overhead is also fixed but we’re going to demonstrate that it’s not and we’re going to demonstrate how/why that variation impacts shipbuilding cost.

 

As an illustrative example, let’s pretend there’s an item that has $100 of direct costs to produce, regardless of the time required.  Let’s further assume that the overhead costs are $100/yr.

 

If that item takes us one year to produce then the total cost is

 

cost = direct + overhead

cost = $100 + ($100 * 1 yr)

cost = $100 + $100

cost = $200

 

Now, let’s suppose that item takes us two years to produce.  The total cost becomes

 

Cost = direct + overhead

Cost = $100 + ($100 * 2 yr)

Cost = $100 + $200

Cost = $300

 

Now, let’s suppose that item takes us five years to produce.  The total cost becomes

 

Cost = direct + overhead

Cost = $100 + ($100 * 5 yr)

Cost = $100 + $500

Cost = $600

 

Wait a minute, how can the costs vary widely if it’s the exact same item with the exact same direct cost?  It’s the overhead, of course.  More specifically, it’s the time required to complete the item;  the longer the time, the more overhead that has to be applied to the item’s final cost.

 

Now, suppose that the item is a US Navy aircraft carrier that has $10B of direct cost to produce and the shipyard has an additional $1B of overhead per year.

 

If the yard could build the carrier in one year, the total cost would be

 

Cost = direct + overhead

Cost = $10B + ($1B * 1 yr)

Cost = $10B + $1B

Cost = $11B

 

In reality, we have historically produced a carrier in four to five years (we’ll call it five) which makes the total cost

 

Cost = direct + overhead

Cost = $10B + ($1B * 5 yr)

Cost = $10B + $5B

Cost = $15B

 

However, the Navy sometimes stretches out the build times to around seven years which makes the total cost

 

Cost = direct + overhead

Cost = $10B + ($1B * 7 yr)

Cost = $10B + $7B

Cost = $17B

 

We see, then, that the carrier could cost anywhere from $13B (3 yr build time) to $17B (7 yr build time), depending on the build time and the number of years of overhead that have to be applied.

 

Why does overhead have to be applied?  A company does not produce products for free.  It has to pass on all its costs to the buyer.  Therefore, the overhead accumulates, year after year, for every year that it takes to build the carrier and, at the end, the total accumulated overhead gets dumped on the carrier and the Navy/taxpayer pays the cost.

 

Now, let’s take a look at the actual build times for Navy aircraft carriers, as shown in the table below. 

 

 

Carrier Build Time, yrs Laid to Commissioning
CV-63 Kitty Hawk	5
CV-64 Constellation	4
CVN-65 Enterprise	3
CV-66 America	4
CV-67 Kennedy	4
CVN-68 Nimitz	7
CVN-69 Eisenhower	7
CVN-70 Vinson	7
CVN-71 Roosevelt	5
CVN-72 Lincoln	5
CVN-73 Washington	6
CVN-74 Stennis	4
CVN-75 Truman	5
CVN-76 Reagan	5
CVN-77 Bush	6
CVN-78 Ford	8

 

 

We see that build times went from 3-5 years, pre-Nimitz, to 5-8 years.  That means that recent carriers are being hit with 2-5 years of added shipyard overhead.  Of course the total cost is going to increase and increase substantially! 

 

Someone with too much time on their hands is going to point out that the shipyard likely has other work and 100% of the yard’s overhead isn’t dumped on a single carrier.  That is true, of course, however, for our simplified discussion, the concept is valid and substantially correct.

 

While it may be satisfying and cathartic to blame all our shipbuilding cost problems on fraud and corruption, the reality is that those are minor factors.  Overhead is a much larger factor and may well be the main culprit.  Of course, without an itemized breakdown of the production costs, I can’t say for sure.