This week, the Navy Department here in the US began floating an idea for a drastic change in its approach to the Littoral Combat Ship (LCS) program. Previously, the Navy had planned on awarding a single contract for ten ships to whichever of the two competing shipbuilding teams—Austal USA, or Lockheed Martin and Marinette Marine—offered a lower price. The latest idea is for a split procurement—ordering each type of ship from both teams, initially in equal quantities. Later on, the split procurement would effectively rerun a small competition every so often to keep, in theory, each contractor’s pencil sharp, awarding variable quantities based on each new bid and the relative past performance of the suppliers. The US Navy has, after all, used the technique to good effect in the Arleigh Burke destroyer program: pitting two yards against one another for more than two decades has produced an impressive cost curve, though one which has more than run its course.
Split procurement is not uncommon practice in commercial procurement, though as I make clear below, there are good reasons that it’s not commonplace. What’s remarkable is how this badly the split procurement idea was received the last time it was suggested to the Pentagon: back at the turn of the year, in the KC-X aerial tanker program. At the time, Defense Secretary Robert Gates called the thought of ordering two different types of large transport aircraft from two different suppliers a “nightmare”, with parallel training organizations, parallel logistics flows, and different pools of air and ground crews. His opposition has been adamant, so assuming that Gates is on board with Navy Secretary Ray Mabus’s plan, there must be something about split procurement of LCS warships that differs from split procurement of KC-X aerial tankers.
In my column of 7 January 2010, I explored whether split procurement in the KC-X program made any sense. Split procurement, I argued then, can be relatively recommended for any of seven reasons:
▪ Buying off political opposition
▪ Inducing potential bidders to bid
▪ Reducing bid prices (when managed carefully)
▪ Promoting a competitive industry
▪ Reducing the risk from correlated defects and uncertainty over future requirements
▪ Inducing faster innovation
▪ Delivering larger quantities faster
As the questions are so similar, I am repeating my review of each factor in the theory, just for the LCS program, with a similar concluding analysis at the end.
Buying off political opposition. Split procurement has been notably and recently forwarded by military and aviation analysts such as Loren Thompson and Richard Aboulafia as a convenient way to discourage further contract protests.  Using split procurement in this fashion is not, however, a new concept: the idea had similarly been suggested for the NATO AWACS program in the late 1970s. The British government (formed at the time by the Labour Party) insisted that the aircraft be based on the Hawker Siddeley Nimrod; the German and French governments had Airbuses in mind; but ultimately, the contract went to Boeing.  The story has obvious parallels to the last run of the KC-X competition beyond the mere similarity of the equipment: a rent-seeking company and its supportive labor union lobbied hard for a domestic solution, on all sorts of grounds supposedly “strategic”, but were ultimately rebuffed by a government which preferred value-for-money and good relations with trading partners and military allies. Further, while this move may be politically appealing, it is also potentially politically dangerous. Bidders and their political supporters might start to get the impression that deals can be fixed for a lot less than outright collusion or bribery.
Inducing potential bidders to bid. In part, this buying-off works by offering a consolation prize. When bidding is costly—and it is with large airliner projects—“the split award mechanism provides additional insurance against the possibility of losing the bid and, therefore, any bidding costs.”  As I noted in January in discussing the KC-X competition, EADS has seemed at least interested in the concept in its program, and generally speaking, contractors in two-horse races have often liked ongoing contract splits. Most pointedly for the LCS competition, Bob Browning, then CEO of Austal, said last year that he and his company would "rather have a 100 percent chance at building 27 ships than a 50 percent chance of building 55.” 
This may contravene a common, if simplistic, assumption in financial analysis of risk-neutrality. Ceteris paribus, the simple expected value of 27 certain units would seem slightly less than that of 55 half-likely units. In truth, though, few really expect the simple notion to hold, and for several possible reasons. Agency issues are probably present—managers like their jobs, most of which survive whether they build half the fleet or all of it. This builds in some incentive for bunting before swinging for the fences on price. Relatively concentrated ownership and control may play an issue as well, and in a similar way. Whether or not it is true about Austal or Marinette, or Boeing or EADS, there are certainly closely-held enterprises in which not all investors are equally widely diversified and risk-neutral. Investors who really are that passive aren’t likely to cause much trouble at the shareholders’ meeting, after all.
But if expected values aren't actually neoclassically interesting to the bidders, they probably figure much more prominently in the Pentagon’s calculations. Potential suppliers may think about these based on non-recurring investments. Assuming that the probability of half-the-deal were really 100 percent, those 27 ships in the LCS example could really be worth more than half as much as 55 awarded to a single company on a fixed-price, winner-take-all basis. That is because the Pentagon frequently pays contractors based on what they claim as their costs, and not what prices they can really deliver. So, if both contractors’ unit costs increase in a split award, the government could wind up paying for the same fixed costs twice—and for the margin that both earn on it.
Reducing bid prices (when managed carefully). Indeed, the usual approach to procurement assumes that buying from a single seller generally produces the lowest price. As alluded above, production scale economies suggest that the efficient outcome, ceteris paribus, will concentrate production in a single firm. This has been repeated argued theoretically in the literature, and shown empirically in military procurement in general, though with limited data sets.  That said, merely the threatened addition of a second source can be valuable to the buyer because it lends immediate credibility to the threat of switching suppliers.  Recent evidence from missile procurement in particular suggests that “dual sourcing as used in practice reduces procurement costs signiﬁcantly, apparently spurring efforts at cost control that outweigh any lost economies of scale or learning that result from splitting production across two suppliers.”  Further, in a duopoly with long-lead contracts but soft current sales, one could theoretically do well to split procurement by capacity—each contractor might give a good deal to fill the remaining space in the factory, if other orders are unlikely to be forthcoming.
Promoting a competitive industry. Filling factories seems to have been a serious concern of the US Navy for some years now. Split awards have featured heavily in shipbuilding programs, but their track record has been mixed. Where required quantities are genuinely competed, as in the Arleigh Burke-class destroyer program, inflation-adjusted cost curves have often decreased over time—and shipyards focused on military production have remained in business for the next program opportunity. However, when the buyer has clearly signaled willingness “to pay a premium for a split award on strategic grounds, sole-source threats are not as effective in disciplining split prices.” 
The Virginia-class submarine program may be the leading bad example here. Northrop Grumman’s Newport News Shipbuilding and General Dynamics’ Electric Boat Company were encouraged to divide the production of individual submarines between their yards in the interest of “preserving the industrial base.” If the next submarine program does not offer better scale economies than this one, then the current work sharing arrangement cannot be said to have eliminated competition in some hope of someday restoring it. Rather, one can make a prima facie case that it has likely induced collusion and increased costs to appease the politically connected. And yet, without better ship-by-ship pricing data from the program office, even this is difficult to conclude. As a consultant to one of the builders put it to me earlier this year, the variability of the workshare splits has induced at least his client to repeatedly sharpen his pencil to keep the work that he has.
Reducing the risk from correlated defects and uncertainty over future requirements. Second sources can be strong hedges against relying too strongly on any single supplier for quality and schedule performance. This is managed by gathering information over time related to correlated defects, and grading the contractors accordingly in the performance reviews.  Bad welding, poorly installed cabling, and gundecked inspections in the Virginia and San Antonio programs may remind the Navy that single supply chains have lots of single points of failure.
But material defects and delivery delays may not be the most important risks to mitigate with split procurement. The strategic question of which ship is most suitable to US military needs may not be answered before quite a few years of production have passed. The two designs, after all, differ remarkably for ships designed to fulfill the same set of requirements. Austal and General Dynamics' trimaran is clearly the better aviation platform, with a flight deck larger than any but a carrier's. Marinette and Lockheed's monohull is arguably the better platform for launching and servicing boats, with a stern ramp much closer to the water. Austal's triple aluminum hulls are more fuel-efficient at a given speed, but Marinette's single steel hull may prove more shock-resistant and repairable worldwide.
By buying both ships now, the Navy could shade its grading in future competitions based of whether it found that it cared more about helicopters or boats, and fuel costs or repairability. By a reasonable counter-argument, the service could simply wait to discover whatever problems may emerge, and if necessary, switch suppliers at that point. This could involve a wholly fresh design, and opportunities for yards and designers not in the competition today. The trouble is that establishing a new program in the presence of entrenched interest has often proven very difficult, so splitting the program ex ante could greatly aid shifting quantities ex post.
Inducing faster innovation. Pencils can be kept sharp not just for shading costs, but for designing the next new thing. Keeping more than one contractor in the game, the argument goes, can create a sort of internal market in which the competing suppliers repeatedly try to best one another’s innovations. Moreover, “when this incentive translates into large innovation expenditures and reductions in joint costs, the resulting price in a [split award] auction can be less than the price in the corresponding [winner-take-all] auction.”  Multiple rounds would thus keep multiple players in the game, and eager for business. On the other hand, second sourcing could reduce the innovative investments by reducing the suppliers’ rents from production. This has been long argued, dating back to Schumpeter’s claim that monopoly was the cost of progress, but the evidence is far from clear. 
As I observed back in January, that argument fell a bit short when applied to the KC-X competition. Airbus and Boeing would continue to innovate in large transport aircraft, but the focus of those efforts will be on advances which will appeal to their more important customers, the airlines. Most of the value of those innovations will spill over into their military transport efforts, as air forces appreciate lower maintenance burdens, lower fuel consumption, and higher carrying capacity just the same. And frankly, much of the argument holds true with the LCS as well. Both designs have substantially commercial provenance: Austal's comes from its long line of car ferries, and Lockheed's from Fincantieri's concept for a superyacht. Both designs again have overseas provenance, Austal's from Australia and Fincantieri's from Italy. Indeed, several of the losing designs in the competition featured foreign ideas as well: Northrop Grumman had pitched a scaled-up version of Kockum's Visby-class stealth corvette, and Raytheon had pitched a super-scaled-up version of Umoe Mandel's Skjold-class surface effect missile boat. It's a reasonable guess that plenty of overseas shipbuilders will be available for the next round as well, and with the usual raft of innovative designs.
Delivering greater quantities faster. In principle, engaging multiple factories will, as General Nathan Bedford Forest might have put it, build the most first. This was entirely the approach in the recent Mine-Resistant Ambush Protected (MRAP) vehicle program, in which the US Army and Marine Corps bought armored trucks in quantity for the same purpose from (depending on how one counts) three to five different contractors. Dual sourcing, it can be argued, could procure the ships twice as fast, if large quantities were ordered from both Austal and Marinette. These could be variably awarded in the split procurement approach discussed, or they could even be awarded in even quantities, just to keep all the rent-seeking political, corporate, and labor groups happy.
In the case of the KC-X, where the newest of the KC-135s are about 45 years old, there exists a prima facie case for replacing the aircraft relatively quickly—before one falls from the sky in a ball of fire. The argument for dual sourcing, however, thereafter proves a bit thin, because dual sourcing isn't really necessary for doubling the production rate: both Airbus and Boeing have ample capacity for additional A330s or 767s. In the case of the LCS, the idea is more appealing. While there may be ample excess military shipbuilding capacity in the US today—witness the looming closure of Avondale—capacity is not an amorphous scalar. Each individual yard has a unique set of capacities, capabilities, and learning curves. Moreover, learning-by-doing has documented effects through both quantity and time. So, doubling expected production at a yard which could otherwise face no production could produce an impressive cost curve. It's hard to say, but the case with an almost de novo shipbuilding program is stronger than with an add-on to existing commercial aircraft programs.
THE ANALYSES TO UNDERTAKE NEXT
Thus, and as I noted in my analysis in January of the KC-X program, we might conclude that the split-award concept is not a priori flawed. If applying it to KC-X program would hardly be the nightmare that the Defense Secretary once called it, I can agree with the Navy Secretary's implicit view that it has considerable merit for the LCS program.  The real question is whether, in the LCS program particularly, the sometime positive aspects of split procurement might outweigh the disadvantages.
To consider that question, let’s review how the theory applies. Two of our original seven propositions don't make a strong case for splitting the buy. While the discussion of inducing bidding is useful to understanding how costs accumulate, the program is a fixed-price deal with two bidders already firmly in the game. Ordering more ships from more small yards also probably isn't critical to inducing innovation, as most of the innovation occurred overseas before the designs came to the US for the LCS.
Four of the factors seem to argue strongly for a two-ship solution. A split buy could neutralize political opposition in either Alabama or Wisconsin, and probably with fewer long-term consequences than its potential application to the KC-X. The two ships are sufficiently different that buying both can't clearly be seen as buying off. The yards could crank out their ships at a higher pace, refilling the fleet faster. And if the Navy became dissatisfied with the composition of that fleet in the near future, either due to defects or shifting requirements, it could more readily shift production—or just some of that production—on an annual basis. Bid prices may very well stay sharp, but particularly so if the Navy can commit to a higher building rate at each yard, so that fixed costs are spread across more units.
The nagging issue concerns the remaining criterion, which is a potential matter of industrial strategy. Maintaining a high pace of production at two yards which hadn't been on the Navy's preferred suppliers list, so to speak, necessarily means shifting money in the long run from those who have. Massive overspending by the US government over the past several years has created an alarming fiscal reality in which total military spending—like all federal spending—must soon be trending down. At some point, a high rate of building small warships must be offset by a lower rate of building large warships—in yards, noted above, that haven’t exactly been running at capacity. Sooner or later, more than just Avondale will close. That’s not a reason to forgo a program, but the admiralty ought to enter the future with its eyes open to the full implications of its priorities for force structure.
None of this, of course, can be conclusive, because we haven’t really run the numbers. One would hope that the Navy Department has already done just that, but decision-making in the federal bureaucracy isn’t always what it should be. Anyone looking to analyze the soundness of the decision should apply some serious analytical tools to the four factors most relevant to the issue:
Review the history to evaluate whether splitting the buy would be taken as buying off. If so, what could be done to mitigate the perception, both in the short run and the long run? In the short run, the Navy and those supporting the split deal will want to get the program restructuring past congressmen who might be concerned about the effect on long-term costs, and who might see this as a ploy. In the long run, the Defense Department shouldn’t want contractors begging for split buys all the time, regardless of whether any individual split deal would make sense for the government. The analysis here is narrative, and primarily historical, looking at the history of how the Pentagon has used split procurements in the past, how successful they have been, and whether these have been perceived as political accommodations.
Build capacity models to estimate how much a split buy might facilitate a higher production rate. Shipyards aren’t chemical plants; their output is lumpy, rather subject to throughput vagaries, and highly dependent on large workforce. When management or just the customer get the model wrong in their heads, quality, cost, and schedule can suffer abjectly. Recent experience on the Gulf Coast has rather borne out this view. This is not to say that shipbuilders and the Navy haven’t been trying. Indeed, constructing those enterprise models can be very challenging, in that the discontinuities aren’t easily uncovered until they’re actually reached. But modeling the throughputs is important if the customer is really going to know just how many ships he can get how fast.
Build cost curves and a game theoretic model to estimate how much a split buy might reduce unit prices. An eventual output of that modeling is a set of cost curves for different productions rates of different mixes of ships at different yards. There are more than a few questions to ask: could production of JHSVs at Austal slow down if production of LCSs ramps up? How might this affect prices across programs—at least in programs that aren’t fixed-price? Might LCSs be cost-effectively built at Bath or Ingalls or anywhere else, and if so, what prices might be offered? The Navy has a whole branch of folks devoted to questions like these. At some point, they might useful review the accuracy of their work over time, and adjust those models accordingly. But beyond that, every shipbuilder ought to have a solid understanding of his significant competitors’ costs, at different points in production loads, to inform any strategic decisions that he might make regarding price and quantity.
Estimate the learning possible with larger flotillas of each ship to evaluate how much they might mitigate risks of poor quality or uncertain requirements. Perhaps the greatest commonality between the two types on offer is their speed: at least 45 knots in a sprint. That requirement has been somewhat controversial, in that it dictates a lower payload for the ships than would be expected in any other underarmed frigate. Austal’s version offers more payload and flight deck space than Lockheed’s, but at a cost of more difficult boat handling, and a perception (valid or not) that the design is less conservative. After the fact, either yard could be discovered to have produced ships of higher or lower quality than expected—it wouldn’t be the first time. The lines of analysis here are challenging. Concerning quality, one must weigh the likelihood and significance of drastic flaws discovered only after a class of ships has entered service. Concerning requirements, one must estimate how much more will be learned from more years of experience with ten ships —rather than one—while also estimating how requirements may evolve as military-political threats change. That’s a tall order, but it’s probably the most important line of thinking needed to judge how the LCS program should proceed.
- Julie Johnsson, “Split could seal Air Force aerial-refueling tanker contract,” Chicago Tribune, 19 July 2009.
- Arnold Lee Tessmer, Politics of compromise: NATO and AWACS, National Defense University Press, 1988.
- Dorothy E. Klotz and Kalyan Chatterjee, "Variable Split Awards in a Single-Stage Procurement Model," Group Decision and Negotiation, vol. 4 (1995), pp. 295–310
- George Talbot, “Murtha talks of splitting LCS contract,” (Mobile) Press-Register, 30 January 2009.
- W. R. Greer and S. S. Liao, "An Analysis of Risk and Return in the Defense Market: Its Impact on Weapon System Competition," Management Science, vol. 32, no. 10 (1986), pp. 1259-1273.
- James J. Anton and Dennis A. Yao, "Second Sourcing and the Experience Curve: Price Competition in Defense Procurement," RAND Journal of Economics, vol. 18, no. 1 (Spring 1987), pp. 57–76. For Anton’s most recent work on the subject, see James J. Anton, Sandro Brusco, and Giuseppe Lopomo, “Split-Award Procurement Auctions with Uncertain Scale Economies: Theory and Data,” Games and Economic Behavior, vol. 69, no. 1 (May 2010), Pages 24-41.
- Thomas P. Lyon, “Does Dual Sourcing Lower Procurement Costs?” Journal of Industrial Economics, vol. LIV, no. 2 (June 2006), pp. 223–252. For more on the subject, see William B. Burnett and W.E. Kovacic, “Reform of United States Weapons Acquisition Policy: Competition, Teaming Agreements, and Dual-Sourcing,” Yale Journal on Regulation, vol. 6, no. 2 (July 1989), pp. 249-317; and E. Pyatt, “Procurement Competition at Work: The Navy’s Experience,’ Yale Journal on Regulation, vol. 6, no. 2 (July 1989), pp. 319-331.
- Sudhindra Seshadri, Kalyan Chattterjee, and Gary L. Lilien, “Multiple Source Procurement Auctions,” Marketing Science, vol. 10, no. 3 (Summer 1991), pp. 246–263.
- Andrew Yim, “Failure Risk and Quality Cost in the Choice of Single Versus Multiple Sourcing,” Department of Accountancy, Tilburg University, 9 September 2009, p. 8.
- James J. Anton and Dennis A. Yao, "Split Awards, Procurement, and Innovation," RAND Journal of Economics, vol. 20, no. 4 (Winter 1989), pp. 538–552. In a subsequent paper, the same authors term this implicit coordination. See "Coordination in Split Award Auctions," Quarterly Journal of Economics, vol. 107, no. 2 (May 1992), pp. 681–707.
- For more recent arguments in favor of keeping contractors’ profits up to encourage future innovation, see Jean-Jacques Laﬀont and Jean Tirole, A Theory of Incentives in Procurement and Regulation, The MIT Press, 1993; Michael H. Riordan and David E. M. Sappington, “Second Sourcing,” RAND Journal of Economics, vol. 20, no. 1 (Spring 1989), pp. 41-58; and William P. Rogerson, “Proﬁt Regulation of Defense Contractors and Prizes for Innovation,” Journal of Political Economy, vol. 97, no. 6 (December 1989), pp. 1284-1305. For an interesting view of how the trusts of Schumpeter’s time may have had lasting, beneficial effects, see Tom Nicholas, “Why Schumpeter was Right: Innovation, Market Power, and Creative Destruction in 1920s America,” Journal of Economic History, vol. 63, no. 4 (December 2003), pp. 1023-1058.
- “Albaugh as BCA head will be key to Boeing tanker bid,” Leeham News & Comment, 19 December 2009.