.-. REPORT TO THE CONGRESS pplicatisn Of “Should Cost” Concepts In Reviews Of Contractors’ 0 perat ions B - 159696 Department of Defense BY THE COMPTROLLER GENERAL OF THE UNITED STATES COMPTROLLER GENERAL OF THE UNITED S A T E S WASHINGTON. D.C. 20548 B- 159896 To the President of the Senate and the Speaker of the House of Representatives This is our report on application of "should cost'' con- cepts in reviews of contractors' operations, Department of Defense. Our examination was made pursuant to the Budget and Accounting Act, 1921 (31 U.S.C. 53), and the Accounting and Auditing Act of 1950 (31 U.S.C. 67). Copies of this report a r e being sent to the Director, Office of Management and Budget; the Secretary of Defense; and the Secretaries of the Army, Navy, and Air Force. Comptr olle r Gener a1 of the United States I I I COMPTROLLER GENERAL 'S APPLICATION OF "SHOULD COST" CONCEPTS IN I REPORT TO P'HE CONGRESS REVIEWS OF CONTRACTORS' OPERATIONS I I Department o f Defense B-7 59896 I I I I D- - IG --E- ST- I I I I WHY THE REVIEW WAS MADE I I I In May 1969, the Subcommittee on Economy i n Government, Joint Economic I I Committee, reporting on "The Economics of Military Procurement," ex- I pressed concern t h a t the traditional method o f pricing negotiated con- I I tracts--primarily on the basis o f past or historical costs--did not I protect the interests of the Government adequately. I I I The Subcommittee recommended t h a t the General Accounting Office (GAO) I I "study the f e a s i b i l i t y of incorporating i n t o i t s audit and review of contractor performmce the should cost method of estimating contractor costs on t h e basis of in- I dustrial engineering and finunciaZ management I I I The should-cost approach attempts t o determine the amount' t h a t weapons I systems or products ought t o cost, given attainable efficiency and econ- I I omy of operations. I I I In May 1970, GAO reported to the Congress t h a t i t appeared t o be fea- I sible t o apply should-cost concepts i n i t s reviews. GAO also stated I I t h a t i t would perform t r i a l reviews o f this type t o o b t a i n additional I information concerning benefits t h a t could be realized and problems I I t h a t might be encountered. I I T h i s report presents GAO's f i n d i n g s and conclusions based on i t s t r i a l I I applications of should-cost concepts. I I I I FINDINGS AND CONCLUSIONS I 4 I I On the basis of four t r i a l reviews applying should-cost techniques, GAO I has concluded t h a t such reviews can be extremely beneficial and t h a t i t I I should make should-cost-type reviews i n the future. I GAO found a number of areas a t each of four contractor plants where i n - creased management attention could result i n lower costs t o t h e Gover- ment. For example, I --improvements were needed i n production pl anni ng and control --there was a need f o r increased competition i n the procurement o f material from subcontractors, and Tear Sheet 1 FEB.26,%971 I I I I --higher q u a l i t y engineering t a l e n t was utilized than was required by I I the nature of the work being performed. I I I GAO brought the specific f i n d i n g s t o the attention of appropriate con- I tractor and agency officials and made suggestions for improvements. I (See pp. 8 t o 10 and 14 t o 15.) I I I A1 though should-cost review techniques primarily are intended t o f i n d I I o u t how contractors' operations can be improved, they also lead t o d i s - I closures of areas where Government contracting or administration prac- I I tices affect contract costs adversely. GAO noted instances of exces- I sive packaging requirements, failure t o consolidate purchasing, and ex- I cessive testing requirements. (See p. 14 and 15.) I The t o t a l savings which could accrue t o the Government 'as a result of I I the GAO reviews and the resulting improvements i n contractor and Govern- I ment management practices cannot be determined readily because the ef- I I fects on costs of certain of the suggestions could not be measured I readily. In those instances where they could be determined, the sav- I I ings amounted t o almost $6 m i l l i o n . (See p. 33.) I I The military services have performed should-cost reviews i n order t o be I I i n a better position t o negotiate contract prices for major weapons sys- I tems. Recognizing that the negotiation of contract prices is the re- I I sponsibility of the procuring agency, GAO believes that i t s reviews I should not be conducted i n a preaward environment. I I 1 Future GAO reviews therefore will attempt t o evaluate how procuring agen- I cies and contract administrators are discharging their responsibilities I I and t o suggest ways i n which contractors can reduce the costs to the I Government. (See p. 21 .) I I I Procuring agencies t h a t perform should-cost reviews prior t o the awards I I of major contracts are i n a strategic position t o obtain contractor co- I operation and concurrence in changes needed. Application of should-cost I concepts d u r i n g preaward reviews enables Government contracting officers I I t o negotiate from positions of strength because the comprehensive f i n d - I ings and observations of the review teams are available during negotia- I 1 tions. Since this type of information i s available, the contracting I officer can influence the contractor t o adopt recommendations for im- proved operations. (See p. 21 .) 1 Although GAO had some success i n encouraging contractors t o study and/ o r improve their operations, GAO could not be as effective as the pro- curing agencies i n motivating the contractors. There was no o b l i g a t i o n on the p a r t of contractors t o accept the suggestions of the GAO review teams, and i n some instances no interest was shown i n considering GAO proposals objectively. In other instances contractors took a positive attitude toward reducing the costs of future operations. (See p. 22.) 2 I I I I I I I I The success of future reviews of this type by GAO probably will depend I almost entirely on the cooperation of contractors and on the extent to I I which the Department o f Defense contracting o f f i c i a l s apply GAO f i n d - I i n g s and recommendations during negotiations of contracts. (See p . 22.) I AGENCY AND COX!T?ACTOR C O W N l ' S The Office o f the Assistant Secretary of Defense (Installations and Lo- I g i s t i c s ) advised GAO t h a t the Department of Defense agencies concerned would look into the specific matters reported by GAO a t the contractors' I I plants. I I Pertinent contractor comments were: I I I --GAO should place greater emphasis on reviewing overall Government I I and contractor procurement systems rather than detailed costs. I I I --There should be some additional evaluation of cost benefits result- I i n g from should-cost reviews versus the costs of accomplishment. I I I --Additional statutory authority f o r GAO may not be necessary. I I I GAO does place primary emphasis on evaluating procurement systems rather I than detailed costs, and GAO reviews a r e so designed. GAO also applies I criterl'a t o ensure, insafar as possible, t h a t the benefits resulting I I from should-cost reviews wtll be signiffcant i n relation t o the costs I of making the reviews. I I I I MATTERS FOR CONSIDERATION BY TBE COiVGRESS I I I I Should-cost revl'ews requtre examinations into many facets of contractors ' I operations and management. The present provisions o f GAO' s statutory I authority t o examine contractors' recorck are not broad enough t o en- able GAO t o cover a l l of the matters whfch should be considered. The Congress therefore may wish t o consider expanding GAO's statutory au- I thority t o enable GAQ t o make effective should-cost reviews on an i n - dependent basis. I I I I I I I I I I I I I 1 I I I Tear Sheet I I I 3 I C o n t e n t s Page DIGEST 1 CHAPTIB 1 INTRODUCTION 4 Scope of trial applications 5 2 RESULTS OF GAO TRIAL APPLICATIONS OF SHOULD- COST CONCEPTS 7 Comprehensive reviews of contractors' operations can provide identification of potential savings 8 Identification of needed improvements in award and administration of con- tracts 13 I .3 SHOULD-COST REVIEWS BY THE MILITARY SERVICES 16 Department of the Navy review of pro- posed costs of engines for the F-111 aircraft 16 Department of the Army review of pro- posed costs f o r HAWK missiles 17 Current DOD position on future role of should-cost reviews in Government procurement 18 4 CONTRAST BETWEEN DOD AND GAO SHOULD-COST REVIEWS 21 Effectiveness of reviews 21 Lack of statutory authority for GAO to perform should-cost reviews 22 5 CRITERIA FOR FUTURE APPLICATIONS OF SHOULD- COST CONCEPTS BY GAO 24 6 DOD AND CONTRACTOR COMMENTS 26 7 CONCLUSIONS 28 Matters for consideration by the Con- gress 29 APPENDIX Pane I Summary of quantifiable potential savings identified through application of should- cos t concepts 33 I1 Letter dated November 12, 1970, from the Deputy Assistant Secretary of Defense (Installations and Logistics) to the Gen- era1 Accounting Office 34 I11 Principal officials of the Department of Defense and the military services respon- sible for administration of activities discussed in this report 36 ABBREVIATIONS DOD Department of Defense GAO General Accounting Office COMPTROLLER GENERAL ' S APPLICATION OF "SHOULD COST" CONCEPTS IN REPORT TO THE CONGRESS REVIEWS OF CONTRACTORS' OPERATIONS Department of Defense B-159896 D- - IG --E- ST- WllY T3E REVIEW WAS MADE In May 1969, the Subcommittee on Economy i n Government, J o i n t Economic Committee, reporting on "The Economics of Military Procurement,'' ex- pressed concern t h a t the traditional method o f pricing negotiated con- tracts--primarily on the basis of past or historical costs--did not protect the interests of the Government adequately. The Subcommittee recommended t h a t the General Accounting Office (GAO) "stud9 the feasibiZity of incorporating i n t o its audit and review of contractor performance the shou2d cost method of estimating contractor costs on the basis of in- dustrial eng;neering and financia2 management principles. I r The should-cost approach attempts t o deterrpine the amount t h a t weapons systems or products ought t o cost, given attainable efficiency and econ- omy of operations. In May 1970, GAO reported t o the Congress t h a t i t appeared t o be fea- s i b l e t o apply should-cost concepts i n i t s reviews. GAO also stated t h a t i t would perform t r i a l reviews of this type t o obtain additional information concerning benef i ts t h a t coul d be real i zed and problems t h a t might be encountered. T h i s report presents GAO's f i n d i n g s and conclusions based on i t s t r i a l applications of should-cost concepts. FINDINGS AND CONCLUSIOMS On the basis of four t r i a l reviews applying should-cost techniques, GAO has concluded t h a t such reviews can be extremely beneficial and t h a t i t should make should-cost-type reviews i n the future. GAO found a number o f areas a t each of four contractor plants where i n - creased management attention could r e s u l t i n lower costs t o the Gover- ment. For example, --improvements were needed i n production planning and control, --there was a need for increased competition i n the procurement of material from subcontractors and I --higher quality engineering talent was utilized than was required by the nature of the work being performed. GAO brought the specific f i n d i n g s t o the attentjon of appropriate can- tractor and agency official s and made suggestions for improvements. (See pp. 8 t o 10 and 14 t o 15.) A1 though should-cost review techniques primarily are intended t o f i n d o u t how contractors' operations can be improved, they also lead t o d i s - closures of areas where Government contracti ng or administration prac- tices affect contract costs adversely. GAO noted instances o f exces- sive packaging requirements, failure t o consolidate purchasing, and ex- cessive testing requirements. (See p. 14 and 15.) The total savings which could accrue t o the Government as a result of the GAO reviews and the resulting improvements i n contractor and Govern- ment management practices cannot be determined readily because the ef- fects on costs of certain of the suggestions could n o t be measured readily. In those instances where they could be determined, the sav- ings amounted t o almost $6 m i l l i o n . (See p . 3 3 . ) -/The military services have performed should-cost reviews i n order t o be i n a better position t o negotiate contract prices for major weapons sys- tems. Recognizing that the negotiation of contract prices is the re- sponsibility of the procuring agency, GAO believes that i t s reviews should not be conducted i n a preaward environment. Future GAO reviews therefore will attempt t o evaluate how procuring agen- cies and contract administrators are discharging their responsibilities and t o suggest ways i n which contractors can reduce the costs t o the Government. (See p. 21.) Procuring agencies that perform should-cost reviews prior t o the awards of major contracts are i n a strategic position t o obtain contractor co- operation and concurrence i n changes needed. Application of should-cost concepts d u r i n g preaward reviews enables Government contracting officers t o negotiate from positions of strength because the comprehensive f i n d - i n g s and observations of the review teams are available d u r i n g negotia- tions. Since this type of information i s available, the contracting officer can influence the contractor t o adopt recommendations for i m - proved operations, (See p. 21 .) Although GAO had some success i n encouraging contractors t o study and/ o r improve their operations, GAO could not be as effective as the pro- curing agencies i n motivating the contractors. There was no o b l i g a t i o n on the p a r t of contractors t o accept the suggestions of the GAO review teams, and i n some instances no interest was shown i n considering GAQ proposals objectively. I n other instances contractors took a positive attitude toward reducing the costs o f future operations. (See p. 22.) The success of future reviews o f this type by GAO probably will depend almost entirely on t h e cooperation of contractors and on t h e extent t o which the Department of Defense contracting o f f i c i a l s apply GAO f i n d - ings and recommendations during negotiations of contracts. (See p . 22.) AGENCY AND CONTRACTOR C O W f l T S The Office of the Assistant Secretary of Defense (Installations and bo- g i s t i c s ) advised GAO that the Department o f Defense agencies concerned would look into the specific matters reported by GAO a t the contractors' plants. Pertinent contractor comments were: d --GAO should place greater emphasis on reviewing overall Government and contractor procurement systems rather than detai 1ed costs. --There should be some additional evaluation of cost benefits result- i n g from should-cost reviews versus the costs of accomplishment. - - Additional statutory authority f o r GAO may not be necessary. GAO does place primary emphasis on eval uatj ng procurement systems rather than detailed costs, and GAO reviews a r e so designed. WO also applies c r i t e r i a t o ensure, insofar as possible, t h a t the benefits resulting from should-cost reviews wfll Be significant i n relation t o the costs of making the reviews. MATTERS FOR CONSIDERALPIOfl BY T%E COMGRESS Should-cost review require examinations into many facets of contractors ' operations and management. The present provisions o f GAO's statutory authority t o examine contractors' records are not broad enough to en- able GAO t o cover a l l of the matters which should be considered. The Congress therefore may wish t o consider expanding GAO's statutory au- t h o r i t y t o enable GAO t o make effective should-cost reviews on an i n - dependent basis. 3 j: I _, CHAPTER 1 INTRODUCTION At the request of the Subcommittee on Economy in Gov- ernment, Joint Economic Committee, the General Accounting Office has studied the feasibility of applying should-cost concepts in reviews of contractor operations. The should-cost approach attempts to determine the amount'that weapons systems or products ought to cost, given attainable efficiency and economy of operation. Emphasis, in this type of review, is placed on a study and evaluation of a contractor's system of managing and controlling costs and on the procedures instituted to pro- vide surveillance of these activities and costs to achieve economy and efficiency. Should-cost reviews utilize the concepts employed by the Department of Defense (DOD) in price proposal reviews, including use of historical data, but place primary emphasis on ways and means of improving . upon prior cost experience. In our report to the Congress, entitled ttFeasibility of Using 'Should Cost' Concepts in Government Procurement and Auditing" (B-159896, May 20, 1970), we stated that: --It was feasible to apply should-cost concepts during the prenegotiation and/or the postnegotiation phase of the Government's procurement process. --The greatest opportunity for the Government to bene- fit from the application of should-cost was through ;its . - use, on a selective basis, in preaward evalua- cions of contractors' price proposaLs, i --Gbvernment agenctes should also provide a continuing capability to perform, on a selective basis, should- cost types of reviews after contracts were awarded. % --The degree of effectivene8s that could be expected from should-cost reviews w1 a s dependent on the con- tractor's willingness io cooperate fully with the re- view team. 4 --GAO would perform trial should-cost reviews which would provide additional data relative to (1) the benefits that could be expected to result from should-cost reviews, (2) the problems which might be encountered in performance of such reviews, and (3) the size of programs or contractors and the types of contracts which should be selected for review. This report presents the findings and conclusions re- sulting from our applications of should-cost concepts at four contractor locations. SCOPE OF TRIAL APPLICATIONS Four contractors were selected for our trial should- cost reviews. Because GAO lacks firm authority for access to much of the contractor data essential to the effective performance of a should-cost review, we were able to per- form our reviews only at those contractors plants that vol- untarily agreed to cooperate with us on a trial basis, To effectively evaluate the various cont*actor functions and perform this review on a timely basis, we selected contrac- tor plants of medium size, The types of products produced by these contractors varied and their manufacturing opera- tions ranged from mass production to job-order processing, In our selection process we also considered the types of programs that the contractors were involved in and the types of contracts that they had been awarded. In our re- view we included contractors operating under cost-type and incentive-type contracts as well as firm fixed-price con- tracts. We did not attempt, at each location, to make a com- prehensive review of all aspects of the contractors' man- agement. Rather, we limited our reviews to those areas that appeared to warrant attention on the basis of previous Government reviews and other preliminary investigation. In general, our reviews included examinations into such areas as (1) the contractors' management of direct and indirect labor; (2) the effectiveness and adequacy of the contrac- tors' systems for estimating labor hours and material costs; (3) the adequacy and usefulness of the contractors' sys- tems for estimating, accumulating, and recording contract costs; and (4) the effects of Government procurement poli- cies and practices on contractors' operations and efficiency. 5 In performing the should-cost reviews, our objectives were to (1) evaluate the efficiency and effectiveness of the contractor's operating practices, (2) examine into the reasonableness of costs, and (3) identify conditions which, in our opinion, either resulted in unnecessary costs or precluded the Government and contractor from establishing a reasonable price. 6 CHAPTER 2 RESULTS OF GAO TRIAL APPLICATIONS OF SHOULD-COST CONCEPTS Our trial reviews demonstrated that GAO could effec- tively apply should-cost concepts. We found that these re- views could be effective in identifying ways to reduce con- tract costs because they permitted a comprehensive evalua- tion of the efficiency and effectiveness of contractors' operations and DOD procurement and contract administration activities. In general, we found a number of areas at each of four contractor plants in which increased management attention could result in lower costs to the Government. We noted, for example, that (1) improvements were needed in produc- tion planning and control, (2) increa'sed competition was needed in the procurement of material from subcontractors, and ( 3 ) proposed engineering costs were not representative of the efforts required. Although should-cost review tech- niques were primarily intended to ascertain how contractors' operations could be improved, they also led to disclosures of aspects of Government contracting or administration practices that adversely affected contract costs. In this connection, we noted instances of excessive packaging re- quirements, failure to consolidate procurements, and exces- sive quality control procedures. In our opinion, the problems disclosed in our trial reviews could have been identified and/or correctkd by more effective procurement practices and contract administration. We therefore believe that one of the major benefits of fu- ture GAO should-cost-type reviews will be the identifica- tion of ways in which the overall Government procurement process can be improved. The total savings which could accrue to the Government as a result of our reviews cannot be determined readily be- cause the effects on costs of certain of our recommenda- tions could not be quantified readily. In those instances 7 where savings could be measured, however, they amounted to almost $6 million. These savings are summarized in appen- dix 1. Further details of our findings folilow. COMPREHENSIVE REVIEMS OF CONTRACTORS ' OPERATIONS CAN PROVIDE IDENTIFICATION OF POTENTIAL SAVINGS In the past, reviews of contractors' records were pri- marily financial in nature, with the objective of validating recorded historical costs, These costs then became the bases of estimated costs on future contracts. The emphasis in the should-cost approach, however, was to utilize the skills of engineers, mathematicians, and audit personnel to determine how costs could be reduced in the future. GAO previously utilized selected should-cost concepts in functional reviews of contractor management and issued a number of reports pointing out the need for improvements. The current reviews, however, have indicated that a compre- hensive analysis of many aspects of a contractor's opera- tions can also be beneficial because the review team obtains a better understanding of the contractor's overall manage- ment policies and practices. The following are examples of some of our findings, Savings attainable by the use of an effective production planning and control system A production planning and control system is supposed to achieve efficient performance by coordinating and guid- ing the physical activities of manufacturing a product. We , found that 6ne contractor's production control system was in need of improvement because --the manufacturing schedule did not include provi- sions for all parts which were to be manufactured, --manufacturing start and finish dates had not been established for parts included on the schedule, 8 price competition on the material purchases for follow-on contracts. This action could reduce costs on follow-on contracts by about $150,000 each year. Higher quality engineering talent was utilized than was required by the nature of the work being performed The work of designing and developing a fully opera- tional weapon system, along with the capability to produce it in production quantities, requires the efforts of highly skilled engineering and technical personnel. As a program reaches the production stage, the major functions of design, analysis, and testing are reduced, and the need for highly skilled engineers decreases, At one location we found that engineering labor costs for a €allow-on production contract were being proposed at hourly rates which included those for highly skilled engi- neers, even though the need f o r such engineering support had diminished and their skills were no longer required on a continuing basis. The contractor agreed that the hourly cost of engineering support was increasing as the effort changed from research and development to production. They stated that the reasons for the increased costs were three- fold: (1) need to have a few highly skilled engineers ca- pable of responding to various technical requirements which might occur, ( 2 ) reduction in requirements for lesser skilled engineers, and ( 3 ) inflation, We estimated that the use of engineering talent, overhead included, which was no longer commensurate with the engineering effort required, could increase the 1970 production contract price by about $99,000. Opportunities to apply economic-order-quantity techniques The economic-order-quantity concept is designed to re- duce total costs by balancing the costs to procure an item against the holding costs, such as investment and storage. One contractor could have reduced its annual overall costs by between $174,000 and $297,000 if economic order quantities had been utilized. The fewer purchases which 10 would have resulted from the application of economic order quantities would have reduced costs substantially, while the increased holding costs of a larger inventory would have been relatively minor. The contractor agreed with our conclusions and said that it would utilize economic-order-quantity techniques in the future. During our reviews we observed other conditions which, we believed, had adversely affected the ability to control contract costs. We were not able to quantify the effect that these conditions would have on costs, but we believe that improvements will result in the negotiation of more reasonable contract prices. These improvements include: --The need for better documentation and support for . make- or- buy decisions --The need to make the material estimating systems more responsive to changes in make-or-buy decisions. --The need to establish new systems or to refine ex- isting systems to provide for the segregation of re- curring and nonrecurring engineering and manufactur- ing costs. --The need for more equitable distribution of general and administrative-type expenses between contractor divisions operating at the same location, --The need to account for and control labor and mate- rial charges for end items that must be reworked be- cause of defective material, wor'kmanship,or engi- neering changes, --The need for improvements i n plant layouts to provide for (1) arrangement of machine tools in relationship to their operational sequence, ( 2 ) sufficient spac- ing of machines, and ( 3 ) a sufficient number of material-staging areas. --The need for management systems which will measure labor efficiency and productivity. 1 11 --The need for establishing labor groupings and com- posite rates which are more representative of the task to be performed. --The need for accurate recording of labor charges. --The need for the accumulation of labor hours by part number and by production lots. --The need f o r production labor standards to be inter- related with accounting records so that equivalent unit costs can be determined during the life of a contract . --The need for updated and reliable labor hour stan- dards. --The need for information that shows in greater detail the composition of proposed overhead costs, includ- ing the additional costs which will be distributed to Government contracts as a result of decreasing production and excess plant capacity. --The need for contractor and Government representa- tives to utilize learning-curve techniques in the preparation and evaluation of proposed labor hours. 12 IDENTIFICATION OF NEEDED IMPROVEMENTS IN AWARD AND ADMINISTRATION OF CONTRACTS In commenting on our report on the feasibility of GAO applying should-cost concepts, DOD officials stated that the Armed Services Procurement Regulations and contract admin- istration and audit manuals provide for the application of should-cost review techniques in the Government's preaward evaluation of contractor cost proposals and in the day-to- day monitoring of contractor activities. Those officials observed that, if all current policies were adhered to and if the cognizant audit and administrative organizations were fully effective, there would be no need for the type of reviews discussed in this report. We agree that prescribed DOD policies provide for the application of should-cost concepts on a continuing basis. We believe, however, that the results of recently completed should-cost efforts by the Army and the Navy, as well as our reviews, demonstrate that the traditional Government preaward reviews of contractor proposals and the day-to-day functional audits and reviews of contractor management have not been fully effective. Although a should-cost review is intended primarily to .evaluate a contractor's operations, it also serves to ob- jectively evaluate (1) the effect of Government procurement procedures on costs and contractor operations and (2) the adequacy and effectiveness of contract proposal and func- tional reviews performed by cognizant DOD audit and admin- istrative activities. This ability to identify problem areas and to suggest corrective action is, in our opinion, another major benefit accruing from should-cost reviews. The following are some examples of observations which, in our opinion, demonstrate that procurement and adrninis- trative policies can adversely affect contract costs and that should-cost reviews can be an invaluable tool with which to identify problem areas within the Government's pro- curement processes, 13 Savings obtainable through reduced packaging requirements for spare parts A review of the packaging requirements f o r certain spare parts being produced at one contractor's plant re- vealed that, although the spare parts were being used for overhaul purposes in the continental United States, they were being packaged for indeterminate storage or overseas shipment. In mid-1967 the Government procuring officer no- tified the contractor and the cognizant administrative con- tracting officer to reduce the level of packaging, Due to a misinterpretation of the notification and subsequent di- rectives relating to this subject, however, the packaging was not changed Contractor and cognizant Government procurement and administration officials agreed that the packaging level should be reduced for spare parts to be used in overhaul and that savings would result, Based on variances in quan- tities procured, changes in delivery schedules, and other factors, annual savings could range between $200,000 and $600 ,3000e Savings achievable in consolidating procurements based on cost-impact studies One procurement activity could realize substantial savings if procurements were based on cost-impact studies to determine the economies of consolidating procurements at the time total requirements first become known. These savings are attributable to lower prices associated with volume orders, the availability of more favorable prices during a period of rising costs, and the related reduction in the contractor's administrative efforts. Although we could not readily measure the total effect of incremental ordering practices, we estimated that savings of about $116,000 could have been realized under a current contract if three separate orders had been consolidated, Contractor representatives agreed that savings could have been realized on the current contract had requirements been consolidated into a single order, Furthermore, we were advised that similar economies could have been realized on two earlier contracts where orders were placed in the 14 same piecemeal manner. Procuring office representatives advised us that consolidation of their requirements was not affected by funding limitations and that trade-offs between lead time and cost were not considered. We were advised that, as a result of a recent DOD review in this area, the total requirements for a single fiscal year would be pro- cured on a test basis. Use of more realistic acceptance-test procedures The military specifications for an item being produced by one contractor required that all production items be ac- ceptance tested under stringent sampling and test require- ments until the production quality warranted less stringent testing. We analyzed in detail the contractor's test procedures and the results of the inspection program. On the basis of this analysis, it appeared that more flexible requirements might be implemented. We discussed our findings with con- tractor and Government quality-assurance representatives and they acknowledged the validity of our observations. The following actions represent the initial steps taken by a joint Government-contractor task force established to re- view the problem. --Full teardown inspection of one model has been changed from one in ten to one in twenty. For two other models, as well as a critical component used in all models, full teardown inspection has been changed from 100 percent to 10 percent. P --Other test requirements have generally been reduced from 100 percent to a 10-percent sample. We estimate that, on the basis of recent production levels, the reduced level of testing could result in future annual savings of about $1.1 million. 15 CHAPTER 3 SHOULD-COST REVIEGaS BY THE MILITARY SERVICES Should-cost reviews have been and are currently being utilized by the three military departments as an aid in the negotiation of lower prices for major weapons systems. The results to date indicate that such reviews are an effective tool in identifying ways in which contractors can produce more efficiently and economically and therefore reduce con- tract costs. On the basis of the reviews completed to date, it ap- pears that the should-cost team approach has a significant advantage over the usual method of developing data for Gov- ernment contract negotiators. The negotiation of a price for a major contract often involves the efforts of a number of dif'ferent organizations, such as the Defense Contract Audit Agency, the Defense Contract Administration Service, and the procuring activity. It is frequently difficult to coordinate the organizations' diverse efforts so as to pro- vide the Government contract negotiator with all the infor- mation needed at the proper time. The should-cost teamo on the other hand, can make a coordinated and timely effort which enables the negotiator to discuss contract provisions with better data at his disposal. Following are summaries of the results of major should- cost reviews that have been completed by the Departments of the Navy and the Army and a discussion of the future use of should-cost reviews in the DQD procurement process. DEPARTIGNT OF THE NAVY REVIF33 OF PROPOSED COSTS OF ENGINES FOR THE F-111 AIRCRAFT This review was conducted during an 11-month period in 1967 and 1968 by a team of highly skilled individuals se- lected from various DOD activities. The Navy concluded that such a review was necessary because the c~ntractor~s pro- posed costs f o r 2,053 aircraft engines appeared to be arnrea- sonablee 16 The should-cost review indicated that savings substan- tially in excess of $100 million could be realized out of total costs which the contractor originally estimated at about $1.5 billion. Some of the areas in which potential savings were identified were: 1. Lack of adequate labor standards. 2. Inefficient plant layout. 3 . Noncompetitive procurements from subcontractors. 4. Poor production scheduling and control. Subsequent to the negotiation of the contract, the F-3.11 program was drastically reduced and the anticipated savings were not fully realized. D E P M m OF THE iU?i?E REVIW OF PROPOSED COSTS FOR HAWK MISSILES In May 1970, Army officials estimated that utilization of should-cost concepts in the preaward review of a $96 116.1- lion proposal for the production of 600 HAW missiles re= s u l t e d in a substantial reduction in contract costs. Addi- tional mmagement improvements which the contractor will institute in the future may produce additional savings of about $14 million. As in the case of the review conducted by the Navy, a team of DOD personnel w a s assembled for a period of"2 months during 1969. The impetus f o r this effort w a s the signifi- cant increases in the production costs of HAWK missiles over a period of time. Army offfciabs believe that, in addition to identifying areas for increased contractor efficiency and economy simi- lar to those disclosed by the Navy review, should-cost re- views : --Provide the contracting officer with a negotiation objective we11 supported by facts. --Result in m c h improved coordination and integration of previously fragmented prenegotiation activities. --Help to identify and reward truly efficient producers. 19 CURRENT DOD POSITION ON FUTURE ROLE OF SHOULD-CQST REVIENS IN GOV- PR0C"T Each of the military services has taken a somewhat differeat approach toward the future role of should-cost reviews. Following is a summary of military services'cur- rent applications and future plans, Department of the Navy The Navy is currently involved in its second should- cost review. This review is being performed at two poten- tial ,contractors and several selected subcontractors prior to the award of a production contract f o r MK-48 torpedos. The contractors have been involved in the development of competing torpedo designs and have been awarded prototype production contracts. One contractor will be selected for production after evaluation of the pei..formmceand costs of the two models. The should-cost effort is one segment of a three-part review which is divided into (1) a production cost (should cost) study, (2) a product-engineering review, and ( 3 ) performance requirements ( i . . e e 9performance-cost trade-off) analysis. A s opposed to other should-cost ef- forts which were performed by teams comprised entirely of Government personnel, this review is being performed en- tirely by consultant firms. The production cost study portion of the overall re- view will require a broad-based industrial engineering ef- fort €or about 1 year. During the initial phase the con- sultant's work primarily will be investigative in nature to arrive at preliminary conclusions about what the competing torpedo models should c o s t and to prepare a plan for fur- ther investigation of major cost segments that appear to have cost-reduction potential. During the second phase the consultant firm will continue the investigation supported by special studies structured to determine the full cost- reduction potential for several alternative production schedules We have been informed by Navy officials that, barring unforeseen special circuanstances such as a significant rise c in a particular program's C Q S ~ S ,the Navy does not plan to a. perform additional should-cost reviews, Instead, the Navy 18 plans to upgrade and more fully train its field organiza- tions so that the routine reviews of contractors' cost pro- posals and operations will be more effective and useful to the procuring activities. Navy officials believe that, if such improvements are made to the existing procurement sys- tem, the need for should-cost reviews will be very limited. Department of the Army In addition to performing a review of costs for the HAW missile (see p. 171, the Army is currently performing a review of W-1 helicopter production costs and is making plans for a third review in the near future. Army offi- cials believe that the should-cost technique is fully con- sistent with the Armed Services Procurement Regulation Man- ual. for contract pricing. It was their opinion that the primary 'differences between the traditional preaward review and the should-cost technique are essentially the depth to which the ~ontractor~s management and operations are ana- lyzed. and the use of a combined audit, engineering, and pr'icing team to perform the evaluation; h y officials have informed us that9 whereas the tra- ditional approach to contract negotiation has been to ac- cept the contractor's mode of operations, the Army's should-cost approach is based on (1) a challenge of the contractor's operating practices, (2) a coordinated in- depth analysis of the contractor's manufacturing operations, management controls, purchasing practices, etc. 9 and (3) an identification of reasonably attainable economies and effi- ciencies. The Army does not intend to apply the substantial ef- fort involved in a should-cost review to every contract where inefficiencies are suspected. Rather, such reviews will be limited to a small number of contractors when it is determined that cost, delivery, or technical problems make such an effort appropriate. Department of the Air Force 9 The Department of the Air Force recently initiated its first should-cost review. In the past the Air Force has 19 maintained industrial management assistance survey efforts, which in some respects were comparable to should-cost reviews. '. 1 i 20 CHAPTER 4 CONTRAST BETWEEN BOD AND GAO SHOULD-COST REVIEWS The military services have performed should-cost reviews in order to be in a position to better negotiate contract prices for selected major weapons systems. GAO, on the other hand, recognizing that the negotiation of contract prices is the responsibility of the procuring agency, be- lieves that its reviews cannot be conducted prior to awards of the contracts. Future GAO reviews will therefore have the objectives of evaluating how procuring agencies and contract administration activities are discharging their responsibilities and of suggesting ways in which contractors can reduce future costs to the Government. Although similar techniques have been utilized by DOD agencies and by GAO to accomplish should-cost-type reviews, the basic differences in the objec.tives and in the time fr&s in wh-ichthe reviews are conducted will have an im- pact on the benefits which can be realized. Furthermore, GAO is currently faced with the fact that there is no firm statutory authority for it to perform should-cost reviews. These.matters are discussed in the following sections. EFFECTIVENESS OF REVIWS In our o p i n i o n , procuring agencies t h a t perform should- cost reviews prior to the awards of major contracts are in an excellent position to obtain Contractor cooperation and concurrence in needed changes. Application of should-cost concepts during preaward reviews enables Government contrac- ting officers to negotiate from positions of strength be- cause the comprehensive findings and observations of the review teams are available during negotiations., Since this type of data is available, the contracting officer can in- fluence the contractors to adopt recommendations for im- proved operations. A s a result of the findings of the should-cost review conducted prior to the negotiation of the contract for the engines for the F-111 aircraft, the contractor was required 21 by the terms of the production contract to study and effect improvements in selected management functions. Similarly, in the case of the HAWK missile, the Army included eight management improvement goals as part of the production con- tract. Although we had some degree of success in encouraging contractors to study and/or improve their operations, we could not be as effective as the procuring agencies in moti- vating the contractors. There was no obligation,onthe part of contractors to accept the recommendations'ofthe GAO re- view teams, and in some instances no interest was shown in objectively considering our proposals. It should be noted, however, that we did call our findings to the attention of the cognizant Government procurement and contract adminis- tration activities, and it is probable that many of the re- commendations will be actively considered during negotiations of future contracts. In other instances, contractors took an active interest and a positive attitude toward reducing the costs of future operations. It seemed clear, therefore, that the success of future GAO reviews of. this type would depend on the coopera- tion demonstrated by the contractors and the extent to which DQD contracting officials utilize our findings and recommen- dations during negotiations'of future contracts. LACK OF STATUTORY AUTHORITY FOR GAO TO PERFORM SHOULD-COST REVIEWS Should-cost reviews performed by procuring agencies are accomplished in connection with preaward analyses of con- tractors' proposals. A s sucho there is no question as to the Government's right to analyze contractors' operations and to suggest ways in which costs can be reduced. I W Q r s right to examine contractorsP records, however, is limited to those books, documents, gapers, and records directly pertaining to a particular contract in question. There are many aspects of a sontractorasmanagement and operations which appear to be outside the scope of that au- thority but whish must be incorporated in should-cost re- views. Our current trial reviews were conducted at loca- tions where management voluntarily agreed to cooperate with 22 GAO. E f f e c t i v e a p p l i c a t i o n of should-cost concepts i n t h e f u t u r e , however, w i l l r e q u i r e t h a t GAO be c a p a b l e ’ o f making independent s e l e c t i o n s of c o n t r a c t o r s t o be t h e s u b j e c t s of reviews. 23 Effective application of the techniques of should-cost analysis requires that any aspect of a contractor's manage- ment that could affect contract costs be open to inquiry. A s a practical matter, however, it is necessary to limit the areas of review to those matters that appear to offer poten- tial for substantial savings. The review team must there- fore make maximum use of prior reviews by both Government activities and by internal contractor organizations in order to identify those functional areas requiring more detailed review. On the basis of our trial applications, we believe that the following areas, as a minimum, should be considered during the preliminary phases of a should-cost review. --Labor standards and direct labor controls. --Production processes and controls. --Plant layout. --Material controls. --Procurement practices. --Make-or-buy policies. --Accounting and cost estimating systems. --Indirect expense controls and allocations. --Quality-control procedures. 25 CHAPTER 6 DOD AND CONTRACTOR COMMENTS By letter dated November 12, 1970, the Deputy Assistant Secretary of Defense (Installations and Logistics) advised us that the cognizant DOD components would look into the specific matters noted at the various contractors' plants during our reviews. The Secretary's letter also stated that DOD would continue to apply should-cost techniques whenever conditions warrant. (See app. 11.1 Outlined'below are the pertinent comments of the con- tractors that were included in our review and our evalua- tions of their comments. 1. GAO should place greater emphasis on reviewing the overall Government - procurement system as well as contractors' systems rather than on reviewing de- tailed costs. GAO's detailed should-cost analysis was essentially a direct duplication of those func- tions normally accomplished by the Defense Contract Administration Services and the Defense Contract Audit Agency. We agree with the contractor's position that GAO should place greater emphasis on procurement systems rather than on detailed costs in conducting should- cost reviews. It is not our objective in conducting these reviews to verify or analyze detailed contract cost data, but rather to evaluate the efficiency and economy of the contractors' operations and the ef- fectiveness of the Government's procurement pro- I cesses. With respect to duplication of effort, our review procedures are designed to utilize the data available from other Government agencies to minimize duplication of effort. ?. There was no measure of the costs to the Government and to the contractor of making the study; and the 26 potential savings therefore appear to be overstated. Some additional evaluation of cost benefits versus cost detraction should be made. The cost of our studies was considerably less than the quantifiable potential savings that we identi- fied. Certainly, studies such as these should not be undertaken without some reasonable basis for anticipating that the benefits will outweigh the costs. It should be realized? however, that many of the benefits of a should-cost study are long-term and not readily measurable and that the cost of mak- ing a review, as opposed to the immediate measurable benefits, should not be the prime determining fac- tor. 3 . The proposed request for additional statutory au- thority seems inappropriate in the context of a should-cost study. GAO already has authority to review the procuring agency's actlvities. The em- phasis on the cooperation required for successful should-cost reviews seems to belie the need for au- thority for additional access to plants, personnel? and records and contains a comotation of duress which would defeat the purpose. We have found? in the great majority of cases, that contractors will cooperate with Government audit agencies and will provide the necessary data and personnel. On occasions, however, there have been differences of opinion as to the right of Government personnel to examine certain records and/or to look into selected aspects of contractors' operations. To avoid such problems in the future and to enable GAO to make effective independent examinations, we believe that the Congress should clearly state its intent concerning the extent of GAO's authority to review contractors' operations. 27 CHAPmR 7 CONCLUSIONS A s a result of our t r i a l reviews, w e believe t h a t should-cost concepts can be e f f e c t i v e l y applied t o contrac- t o r operations and t h a t GAO should continue t o make such reviews. In our opinion, however, t h e g r e a t e s t b e n e f i t s w i l l accrue when t h i s type of review i s performed by procur- ing a c t i v i t i e s as p a r t of t h e i r preaward analyses of con- t r a c t o r s ' proposals. A t t h a t time, t h e r e s u l t s of should- c o s t reviews would be of maximum effectiveness i n a s s i s t i n g Government negotiators i n a r r i v i n g a t f a i r and reasonable prices. m e n more importantly, p o t e n t i a l Government con- t r a c t o r s w i l l be more l i k e l y t o accept should-cost findings and t o implement any needed c o r r e c t i v e procedures p r i o r t o t h e award of a major contract. Should-cost review techniques can be e f f e c t i v e l y ap- p l i e d by GAO as a means of identifying p o t e n t i a l economies through improvement i n contractor operations and as a means of evaluating t h e effectiveness of agency procurement p o l i - c i e s and p r a c t i c e s , preaward proposal reviews, and contract a u d i t and administration activities. GAO, however, has no firm s t a t u t o r y a u t h o r i t y t o make these reviews and, u n t i l t h e Congress grants such a u t h o r i t y , GAO w i l l have t o depend on t h e voluntary cooperation of contractors f o r access t o t h e i r p l a n t s and records. Whether performed by procuring agencies o r by GAO, t h e o v e r a l l success of any should-cost review w i l l be l a r g e l y dependent upon t h e cooperation and a t t i t u d e of t h e contrac- t o r . These reviews require f u l l d i s c l o s u r e , f r e e and com- p l e t e access t o t h e c o n t r a c t o r ' s p l a n t and management per- sonnel, and an objective a t t i t u d e by t h e contractor toward t h e constructive c r i t i c i s m of t h e should-cost review team. In our opinion, should-cost-review emphasis should be given t o l a r g e r contractors, operating under negotiated c o n t r a c t s , i n a noncompetitive atmosphere. Within t h i s broad c r i t e r i o n , both the bases f o r s e l e c t i o n of a s p e c i f i c c o n t r a c t o r f o r review and t h e extent and depth of t h e ap- p l i c a t i o n of should-cost concepts should remain f l e x i b l e 28 and should be based on consideration of p a s t c o n t r a c t o r c o s t performance on s p e c i f i c c o n t r a c t s and on evaluation of ef - f o r t s made t o implement previous recommendations f o r improve- ments. MATTERS FOR CONSIDERATION BY THE CONG'RFSS As pointed out on page 22, GAO has only l i m i t e d author- i t y t o examine c o n t r a c t o r s ' records, and many a s p e c t s of c o n t r a c t o r s ' operations and management would appear t o be o u t s i d e of t h e scope of t h a t a u t h o r i t y , The Congress t h e r e - f o r e may wish t o consider appropriate l e g i s l a t i o n t o expand our a u t h o r i t y and t o c l a r i f y t h e i n t e n t of t h e Congress con- cerning t h e scope of reviews t o be undertaken by GAO i n con- tractors' plants, 29 APPENDIXES APPENDIX I SUMMARY OF QUANTIFIABLE POTENTIAL SAVINGS IDENTIFIED THROUGH APPLICATION OF SHOULD-COST CONCEPTS Potential annual Observation cost savims 1. Savings attainable through a contractor's implementation of an effective production control system (required one-time invest- ment of approximately $580,000) $3,100,000 2. Increased use of competition by a prime contractor in awarding subcontracts 150,000 3. Reduction in labor cost by elimination of costs related to engineering organizations and skills which are no longer required to support items being produced 99,000 4. Reduction in annual contractor procurement costs through use of economic order guan- tity techniques ($174,000 to $297,000, de- pending on volume of purchases) 297,000 5 . Reduction in the level of packaging re- quirements for spare parts produced for use in overhaul activities within the conti- nental United States ($200,000 to $600,000, depending on contract quantities) 600,000 6. Change from extensive contractor acceptance test procedures to more realistic testing for the purpose of product verification 1,100,000 7. Consolidation of Government and contractor- operated motor pools located at the same location and utilization of regularly scheduled service rather than chauffeured service to and from airports 209,000 8. Elimination of prime contractor profit on subcontracted effort where about 90 percent of the total effort is subcontracted to one vendor and the prime contractor has minfmal responsibility ! 77,000 9. Reduction in indirect labor force due to a more efficient use of personnel 75,000 $5,707,000 33 APPENDIX I1 Page 1 ASSISTANT SECRRARY OF DEFENSE WASHINGTON, D.C. 20301 12 NOV 1970 INS?ALLAlION5 AND LOOlSTlCS Mr. C. M. Bailey D i r e c t o r , Defense Division U. S , G e n e r a l Accounting Office Washington, D. C. 20548 Dear Mr. Bailey: T h i s is i n r e s p o n s e to your l e t t e r of October 14, 1970 transmitting f o r comment your d r a f t r e p o r t titled, "Application of 'Should Cost' Concepts i n (GAO) Reviews of Contractors' Operations'' (OSD Case #3192). The d r a f t r e p o r t p r e s e n t s the r e s u l t s of a GAO test f o r utilizing the "should cost" concept i n performing GAO audit reviews. This t e s t w a s made in response to a recommendation by the Subcommittee on Economy and Government Joint Economic Committee in its r e p o r t of May 1969. The GAO r e p o r t s t a t e s that four trial reviews utilizing the "should cost" concept w e r e conducted. It is concluded that such reviews can be beneficial and that GAO should continue to make such reviews. No specific recommendations a r e made. However, the r e p o r t m a k e s the observation that the p r e s e n t statutory authority of GAO to examine contractor's r e c o r d s 4 s not broad enough to enable it to examine all the matters which should be considered in "should co st" reviews . Though your r e p o r t contains no specific recommendations a d d r e s s e d to the Department of Defense, it does provide comment on s e v e r a l matters of suggested improvement noted in connection with the GAO review at the four c o n t r a c t o r plants mentioned i n the r e p o r t . The cognizant DoD components will, of c o u r s e , look into t h e suggested management improvements . 34 APPENDIX I1 Page 2 With respect to your basic observation that GAO can utilize the "should cost" concept in conducting its audit reviews, we a r e hopeful that the GAO m a y benefit f r o m the DoD experiences. A s the GAO report notes, DoD has used this technique on a very selected basis. We a r e prepared to perform such reviews wherever conditions warrant. However, our experience demonstrates that this approach requires a substantial number of talented personnel f o r an extended period. We appreciate this opportunity to comment upon your report. 35 APPENDIX I11 Page 1 PRINCIPAL OFFICIALS OF THE DEPARTMENT OF DEFENSE AND THE MILITARY .SERVICES RESPONSIBLE FOR ADMINISTRATION OF ACTIVITIES DISCUSSED I N THIS REPORT T e n u r e of o f f i c e - From - To DEPARTMENT OF DEFENSE SECRETARY OF DEFENSE: Melvin R. L a i r d Jan. 1969 Present Clark M. C l i f f o r d Mar. 1968 Jan. 1969 ASSISTANT SECRETARY OF DEFENSE (INSTALLATIONS AND LOGISTICS) : B a r r y J. S h i l l i t o Jan. 1969 Present Thomas D. Morris S e p t . 1967 Jan. 1969 DEPARTMENT OF THE ARMY SECRETARY OF THE ARMY: Stanley R. Resor July 1965 Present ASSISTANT SECRETARY OF THE ARMY (INSTALLATIONS AND LOGISTICS) : J. Ronald Fox June 1969 Present Vincent P. Huggard (acting) Mar. 1969 -June 1969 D r . Robert A. Brooks O c t . 1965 Feb. 1969 DEPARTMENT OF THE NAVY SECRETARY OF THE NAVY: John H. Chafee Jan. 1969 Present P a u l R. Ignatius Aug. 1967 Jan. 1969 36 APPENDIX I11 Page 2 PRINCIPAL OFFICIALS OF THE DEPARTMENT OF DEFENSE AND THE MILITARY SERVICES RESPONSIBLE FOR ADMINISTRATION OF ACTIVITIES DISCUSSED IN THIS REPORT (continued) Tenure of office - From - To DEPARTMENT OF THE NAVY (continued) ASSISTANT SECRETARY OF THE NAVY (INSTALLATIONS AND LOGISTICS) : Frank Sanders Feb. 1969 Present Barry J. Shillito Apr. 1968 Jan. 1969 DEPARTMENT OF THE AIR FORCE SECRETARY OF THE AIR FORCE: DP. Robert C. Sewans, Jr. Jan. 1969 Present Dr. Harold Brown Oct. 1965 Jan. 1969 ASSISTANT SECRETARY OF THE AIR FORCE (INSTALLATIONS AND LOGIS- TICS) : Phillip N. Whitaker May 1969 Present Robert H a Charles Nov. 1963 May 1969 U.S. GAO Wash.. D.C. t 37
Application Of "Should Cost" Concepts In Reviews Of Contractors' Operations
Published by the Government Accountability Office on 1971-02-26.
Below is a raw (and likely hideous) rendition of the original report. (PDF)