In its reports on shipbuilding, the European Commission has made allegations that Korean vessels have been sold below cost. These allegations were based on cost model calculations.

　

Fundamentally it is not meaningful to try and assess profitability at an individual contract level. Profitability should be considered at company or shipyard level as it is determined by the workload levels and the contribution of individual contracts towards the recovery of overhead and other fixed costs.

　

In particular the use of CGT based calculations for specific contract-by-contract assessments is considered insupportable given the general 'coarseness' of the measure. Whilst CGT may be the best available measure of work content, its crudeness makes it suitable for use at an aggregate level and not suitable for contract-by-contract comparisons.

　

Specifically the question of allocation of non-direct costs to determine a stand-alone contract cost is considered inappropriate, inaccurate and a cause for major differences in calculated costs. Additionally, the basis of the assumed mandatory 5% profit margin and a 10-13%band of acceptability is neither justified nor supportable.

　

The sample size is minute in relation to the overall contracting levels and, as such, any results, irrespective of the issues raised, could not be considered to be representative of the broader situation. Furthermore, the method or sample selection and the details of certain of the selected contracts is considered to potentially skew the results.

　

In summary, the adoption of the cost model is considered to be an inappropriate, unreliable and inherently misleading basis for assessing alleged subsidisation. Furthermore, the results of the cost model assessments have been progressively updated demonstrating an inherent inaccuracy.

　

Considerable reference has been made to the results of the Cost Model developed by independent consultants on behalf of the Commission. The general impression conveyed regarding the results arising from this seems to be a claim that the contracts reviewed are loss-making and that the Korean yards are pricing at loss making levels allegedly to grasp new orders at the expense of EU subsidies. Consideration of the inherent accuracy and relevancy of the model itself and, such an approach, raises many issues that are not addressed in the Commission's reports and would seriously challenge the validity of their findings and interpretation of any cost model projections.

　

Full details of the methodology have not been made available by the Commission despite the importance that has been placed on the results of the cost model. However, from the information available in the three Commission reports and other information made available an insight can be gained of the approach adopted.

　

This approach and the interpretation of the model results raise numerous concerns over the validity of this model and the relevance of the findings. The following sections identify some of the main issues in this respect and try to demonstrate the limitations of such an approach.

　

In general terms the model has been developed to provide a cost reconstruction for individual ship newbuilding contracts. In information provided by the Commission to the KSA, it is stated that a break-even price has been calculated comprising, direct costs (material, labour, financing and other) plus overhead costs plus debt service costs, to which a profit margin has been added to arrive at a 'normal price'. This normal price has then been compared with the actual contract price (as understood by the Commission's consultants) as a basis for calculating the assumed loss or gain of the contract for the shipbuilder.

　

Inevitably such an approach raises a number of fundamental issues including:

　

　

The issue of estimating accuracy is considered to be fundamental. Many shipyards have traditionally had great difficulty in accurately estimating their own performance on newbuilding contracts, resulting in significant outturn variations at the end of the contract execution. In part this reflects the complexity of work content assessment but it also reflects inadequacies in measuring and monitoring productivity.

　

Such difficulties exist for the yards themselves, which have access to, if not always full understanding of, accurate in-house information. It is impractical, if not impossible, for an external third party to achieve the level of accuracy necessary to support such claims (which has neither access to or understanding of the full context of such accurate information). It is considered therefore that a major question must hang over the viability of a cost model developed by third parties in concept as welt as practice.

　

Specifically the contract based concept of the cost model raises major issues over the treatment of overhead and other non-direct costs which require understanding and discussion of the limitations of full absorption costing/pricing, differing parametric bases for allocation and the issues of marginal/market costing approaches in respect of profit/contribution margins for different products. Full absorption costing raises further issues in a volatile market situation where workloads from one year to another can vary significantly, or in situation where either expansion or decline of workloads exists.

　

The accuracy of the terms of the contracts used in the cost model analysis is questionable. For instance, in the second EU shipbuilding report, it is stated that in one of the contracts for a 5500 teu containership HHI paid for the use of a design by CSBC. Whereas, in reality, HHI actually supplied the design to the Taiwanese yard. Also, the cable layer contract attributed to Hyundai Mipo never materialised.

　

Considerable concern also exists over the sample size and selection criteria of the contracts reported on and the effect on the significance of these in interpreting the results of the study, and also at looking at the situation in the broader Far Eastern market - rather than simply the Korean shipbuilding industry.

　

In large part few, if any, of these arguments seem to be addressed in the reports or taken into account in the interpretation of the results.

　

The disclosure of full details of the parameters and algorithms used in the cost model has been refused by the Commission. Without this information it is not possible to comment in detail on the general validity of the calculations or to identify and comment on any inappropriate assumptions. However, the results have been published in the public domain in a manner that suggests an inherent accuracy and validity. The KSA and their advisors therefore have a totally inadequate basis on which to discuss the Commission's findings. Given the extent of disclosure requested by the Commission of the KSA and Korean yards, this seems surprising and disparate/unreasonable.

　

In the Commission's first report on shipbuilding considerable confidence was expressed that all assumptions of the cost model were taken on the 'safe' side and, as such, the implication given that the results if anything would understate the situation. Furthermore, considerable confidence was expressed in the accuracy of the cost model and the validity of this approach. However, in subsequent reports, updated calculations for contracts reported on earlier showed significant reductions as a result of updated information, particularly regarding debt service costs. The magnitude of these changes that have shown the initial results to be overstated would seem to refute the claims of the earlier report. Furthermore, the development of the cost model results in the third report to take into account aspects such as inflation that were considered impractical or not significant initially, would also serve to question the validity of the Commission's confidence in the cost model.

　

Based on the limited information that has been provided, some major issues emerge. Labour costs are stated to be based upon productivity and work content information measured in CGT. Productivity levels have apparently been based upon a detailed analysis in the Korean shipyards, however, the Commission has elsewhere indicated that the absence of CGT workload statistics for Korean yards has required the uses of an assumed average compensation factor. It is hard to reconcile these points.

　

Additionally, the CGT measure is inevitably crude and is assigned as a range of 'step function' bands for different vessel types based mainly on deadweight size bands. At the boundaries this can yield results that are widely different. For example, on crude oil tankers, the differences can be around 15 - 20%. On more complex vessels such as cruise ships and passenger ferries the differences can be even greater.

　

The use of CGT to calculate productivity and work content upon which to base labour cost estimates is, in such circumstances, subject to considerable margin of error. It would also be very surprising if such an approach was adopted by the estimating function of a shipyard and, as such, adds an additional factor in terms of comparing the basis of contract pricing decisions.

　

In the cost model, overhead costs are apparently estimated as a percentage of net sales. Clearly the factors that influence overhead costs have no logical correlation to the net sales of the shipyard. Such costs are generally accepted to represent mainly fixed and semi-variable cost elements and, as such, by definition would not vary directly with net sales. The implication here is that when ship price levels rise, the overhead costs would rise for executing the same orderbook - this is clearly nonsensical. Even as a basis for the retrospective allocation of overheads such an assumption is questionable.

　

In respect of overhead costs, it must be recognised that the cost model is simply providing a method of allocation of overhead costs and that this is an accounting technique rather than a cost calculation or estimation factor. In this context there are well-established arguments within management theory regarding the limitations of full absorption costing assumptions in terms of product costing and cost estimation.

　

The fundamental problem here lies with the concept of trying to evaluate the profitability of shipbuilding operations on a contract-by-contract basis. Profitability of shipbuilding operations are determined by the contribution levels of individual contracts towards the recovery of overhead and other fixed costs. Shipbuilding profitability must therefore be considered at shipyard level rather than contract level.

　

One of the limitations of overhead cost allocation or full absorption costing is that there are a range of parameters on which such allocation can be based, including direct man-hours, CGT, added value, direct cost, workshop capacity utilisation etc. with each parameter providing a different result.

　

The allocation of overheads based on net sales value, as opposed to CGT for example will tend to increase the estimated costs of the higher complexity ships such as passenger and LNG ships and will decrease the estimated value of the lower complexity vessels such as tankers and bulk carriers. It can be seen therefore that in adopting the cost allocation approach, not only are the results likely to be unreliable or misleading but the contentious issue of the basis of allocation is raised.

　

In contrast to the approach for overhead costs, the allocation of estimated debt service costs is stated to be based upon CGT. In general the same points apply, however, it is unclear why it is that one basis of allocation has been used for overheads and another for debt service costs in the cost model. This apparent inconsistency of approach serves to further question the results of the model.

　

Debt service cost estimation requires, in many instances, not only assumptions regarding the treatment of such costs on a contract by contract basis but also the determination of these between divisions of the chaebols and between shipbuilding and any other activities within a division. Once again little detail is given about the specific methodology and assumptions, however, the need to update early results for improved information and the

magnitude of the revised results may give an indication of the complexity and sensitivity of this aspect of the cost model.

　

The above points demonstrate that even at a mechanistic level the approach to cost estimation is subject to considerable question in respect of its accuracy and relevance. In particular the question of allocated costs is of special concern when applied at an individual contract level. Such a contract-by-contract approach does not provide any insight into whether the overall recovery of overhead and other non-direct costs would reasonably have been achieved by the yard concerned.

　

The cost model assumes a fixed 5% profit margin in calculating the 'normal price' and implies therefore that profit margins are uniform between product types and based upon the full absorption costing. However, in the first report reference is made to the validity of variable profit margins and pricing policy in the arbitrary adoption of a 10 - 13% acceptance margin for 'error and strategic pricing'. In merging these factors together there is no clear indication of the considered accuracy range of the model or the level of market pricing deemed acceptable. This is extremely unhelpful in facilitating any necessary discussion or consideration of the issues.

　

Also, since it typically takes around two years to deliver a vessel after contract signing, major cost factors affecting the shipyard could change substantially, thereby altering the costs faced by the yard. Such factors can be difficult to predict in advance.

　

A total of 29 contracts have been specifically reported upon within the three 'Situation in World Shipbuilding Reports' issued by the Commission. Twenty five of these contracts are from Korean shipyards whilst the other four are from Chinese yards.

　

In the first report it is stated that a total of 33 contracts were to be analysed as part of the study undertaken by the Commission's appointed consultants which covers shipyards in four countries - Korea, Japan, China and Singapore. In the first report 9 contracts are reported on, which are all from Korean yards. In the second report an additional 13 contracts were reported on, 9 from Korea and 4 from China.

　

In the third report a further 7 contracts were analysed, all from Korean yards. It is not clear whether any further contracts have, or will, be analysed to bring the total up to the stated limit of 33. From this it can be seen that no contracts at all have been reported on from either Japan or Singapore and that therefore some 85% of the sample has related to Korean built contracts with the remaining being Chinese built contracts. For a study that covers four countries, such coverage raises major questions over the selection criteria adopted.

　

It is not clear what the timescale for the review and selection of contracts was, however, with around 1,500 - 2,000 new orders placed world wide every year it can be seen that the sample is a minute proportion of this. Within the four countries encompassed by the study annual ship deliveries represent around 750 - 1,100 every year and within Korea alone the annual ship deliveries level is around 180 - 250 according to the AWES statistics. The number of contracts analysed, whichever way it is considered, represents an extremely small percentage of the total activity level, and it is hard to see how the results can be presented as representative of the total situation. Similarly it is hard to understand on what basis the study can be described as a thorough investigation as claimed in the CESA complaint document (page 5).

　

The criteria for selection of the contracts to be analysed are unclear. In the first report it is stated that the ships were selected for analysis in co-operation with the European(presumably EU European) shipbuilding industry to ensure the availability of technical information. The same report also states that the Commission ensured a balanced selection of cases whilst taking into account the political objectives of the study. It is not clear what the term 'political objectives' means, but the distribution of contracts might suggest that the main interest was solely in the Korean yards and not the broader Asian 'four country' scenario.

　

In the invitation to tender for the Commission's market monitoring study, it states that an evaluation of costs of production of contracts will be required for contracts that 'are below a level that will be indicated by the Commission'. In this case it would suggest that the contracts analysed are those of the lowest priced vessels only, rather than a representative or balanced selection.

　

Furthermore, the question of co-operation with the European shipbuilding industry raises the question of whether these yards have influenced the choice of contracts and as such skewed the basis of evaluation.

　

The contracts reported on from the Korean yards comprise:

　

　

As has been previously mentioned, the CGT concept provides broad-brush work content assessment based upon agreed coefficients for certain ship types by size range. At the boundaries of the size bands therefore there is a step change in the coefficient and therefore the work content. This phenomenon can therefore generate anomalies at the boundaries and at the extreme ends of the scale. Certain of the specific contracts reported on reflect such concerns.

　

There is no specific category for Cable Layers and therefore it is not clear how the CGT value of this contract has been calculated. If one of the general categories such as other non-cargo has been used, it will be recognised that the coefficients in such instances are very general as they cover a multitude of vessels.

　

Additionally, 3 of the container ship contracts reported on are very large at 6,200, 6,800 and 7,200 TEU respectively. These ships reflect the increasing size of container vessels and would fall into the 75,000 - 100,000 dwt size range. In terms of CGT coefficients. the upper size band for container vessels is 50,000 dwt and larger, which probably accurately catered for the size of vessels under construction at the time of the last CGT coefficient update in 1994.

　

Reflecting the general trend of such coefficients it would be anticipated that an additional size band would be introduced for vessels of 70 - 80,000 dwt and upwards, which would attract a lower coefficient and hence lower work content, lower labour costs and lower estimated cost. The results for these three largest vessels must therefore be viewed with considerable doubt in terms of the accuracy and validity, and must serve to question the wisdom of the mechanistic adoption of such measures. In such instances, the allocation of debt service cost from the cost model would also be lower given the tower CGT values.

　

Similarly the two LNG vessels, at 71,250 and 88,500 cgt respectively, are large vessels falling into the 80,000 - 95,000 dwt range. The largest size band in the 1994 coefficients for these vessels is similarly for vessels of 50,000 dwt and above, and an additional size band with lower coefficient would also be anticipated in these cases too, reflecting the increasing incidence of larger sized vessels.

　

The cost model analysis for the 29 contracts resulted in estimated variations between the calculated 'normal price' and the reported (or rumoured) contract price. Initial analyses for certain contracts were updated in later reports based upon revised information on prices, costs or cost model parameters.

　

In the first Commission report, a variation of up to 10 - 13% calculated loss is considered acceptable to account for errors and adoption of 'strategic pricing' policy (or market/marginal pricing). No explanation is given for the assumption of this 10 - 13% margin, but contracts showing negative variations greater than 13% are assumed to have been 'loss making'. Such a precise and unequivocal definition of loss-making contracts seems hardly credible given the extent of estimation, assumption and context.

　

Based upon the updated analyses and the above definition, 12 of the 29 contracts are reported as loss-making, with one of these being a Chinese built vessel and a further two falling just outside the prescribed margin at 14% and 15% negative variation respectively. One of the remaining 9 contracts is the cable-laying vessel over which there must be severe doubt regarding the validity of the CGT coefficient. (We have learnt subsequently that this contract never actually existed).

　

On this basis the reports claim that 8 out of 25 Korean contracts have proved to be loss making, albeit against criteria that are arbitrarily adopted and which it is considered raises major questions over the accuracy, validity and relevance of the approach. Additionally, it would seem that the selection of these contracts has been on the basis of perceived low prices in the first instance.

　

In terms of ship types, these 8 contracts comprise 3 bulk carriers, 3 container ships, 1 passenger Ro-Ro and 1 chemical/product tanker. This would not, therefore, support the view that pricing policy has been particularly targeted at higher complexity and higher value vessels to win market share in these sectors.

　

In general as the study progressed the calculated variations generally seemed to reduce, either through the updating of calculations based upon new information or as the scope of selected contracts broadened. In the third report, an additional calculation was made for some of the contracts which showed increased variations based upon inflation assumptions, although in the first report this had been excluded on the basis that it was not practicable to assess.