A New Approach for Determining Optimal Fleet Procurement

I try to attend the SNAME annual meetings every year. Mustering the energy to attend can be daunting, but once I am there, I realize that there are so many benefits to attending the annual meeting that the cost and time are well worth it.

At every meeting I try to attend as many technical paper presentations as possible, but it is very difficult to get in more than about 8 presentations because there are so many other important activities. These activities range from my very satisfying involvement on the (mt) editorial board, to meeting with other professionals (which through a bizarre set of circumstances included Chris Kraft, the NASA legend), mining for new technical solutions at the exposition, re-establishing old contacts, and making new contacts (especially with the very committed young professionals who have decided to attend).

Regardless, central to all of this is the ability to learn, and at the end of each annual meeting I always ask myself: “What was the most important thing I learned?”

This year the outstanding learning experience was the paper by Dr. Doerry and Dr. Koenig: “Framework for Analyzing Modular, Adaptable and Flexible Surface Combatants.”

The paper can be downloaded at Norbert Doerry’s website, but here I will try to explain the gist.

I know why Doerry and Koenig picked their title, but to me the title translates as: “How to Mix and Match your Fleet to get the Best Tactical Outcome for a Fixed Dollar, but one that can Change from Year to Year.” (Still not a great title)

This Navy conundrum is ancient, and actually the original six frigates are an early version of this debate. An ideal Navy mixes and matches fleet units (combat vessels) but a small Navy cannot afford to do this, and therefore always has to spend money on fancy multipurpose ships, since the loss of a few specialized ships can render the navy ineffective. A large Navy can build capital ships, support ships, and special mission ships and afford to lose a few of each type. That is the simple thinking and we discuss this high/low mix issue, and suggest to address it (unsuccessfully) as a Nash equilibrium problem in this paper.

The real question is: What am I going to build for the money I have, so that, when the shooting starts, I will have the most capable Navy? And then there is a secondary question: What should my fleet look like in times of peace to scare the bejeezes out of potential opponents?

In practice, that has meant you scrap old ships and always build fancy new ones. The decision when to build new ones generally was analyzed in Present Value terms (Is it cheaper to upgrade the old ship or to build a new one?). For reasons explained in the paper, that approach does not work in the Navy procurement, because the problem becomes too complicated to be analyzed in PV terms. Meanwhile, the US Navy has been stuck in PV analysis since the McNamara days in the 1960’s.

Doerry and Koenig propose an alternate approach, instead of using PV analysis, they propose the use of Real Options Valuation. This method differs from PV because it attempts to analyze the best approach when there are additional options on a project in the future (think in terms of stock options). Real Option Valuation is not new, but to apply it to naval fleet mixes and procurement is really clever. The most obvious question in Navy vessels is: What if I think in terms of PV (my available dollar) but in the PV include an option to upgrade vessels later in their life? I may or may not spend the option amount depending on my fleet needs at any one stage, and since I may not spend it, my PV becomes lower and in the future I would have a more capable fleet.

This becomes very complex, but, amazingly, it is mathematically manageable, and the analysis can incorporate things that never could have been incorporated before. For example, the authors show that risk of war can be modeled (this risk of war analysis in the paper is worth the price of admission alone) versus different procurement options such as building good simple hulls, but waiting to fit fancy weapons until they are really needed as weapons packages. And at that time, the latest and greatest package can be fitted to dominate the battle space, instead of limping along with less than the state of the art.

The bigger the Navy, the cooler it gets (and this argues for hull commonality between friendly navies). One can build 10 hulls, and make them ready for sea, but only install one ship with the best weapons package. The world will know that you can build something that can dominate the battle space, but there is no need to fit all 10 with the latest and the greatest if there is no immediate threat of war. Meanwhile the “enemy” will know that when they start to rattle their sabers you will not have 10 obsolescent hulls, but instead will have access to 9 hulls that can be fitted with the hottest weapons much more quickly. This is a much better result than having 10 old fancy units and actually will defer cost until it is needed. This is not new thinking, but, up to now, it was difficult to model and to prove that there is a better way.

Now let’s cast this into a current debate: The Littoral Combat Ships (LCS).

For these vessels, the list of complaints about missing mission modules is endless, but, actually, from an economic real options valuation point of view, spending too much on mission packages is a waste of money. Let’s get the hulls out there and develop, but not over purchase, mission packages that we may never use anyway.

Clever stuff. Let’s hope that the US Navy and its allies adopt it before other Navies catch on. It is certainly a cost effective method of driving opposing Navies nuts in having to counter model it.